6-1

Capitalized Expenditures

Expenditures which create an asset whose useful life extends beyond the current taxable year must be capitalized Examples: equipment, buildings, land, patents Exceptions: R & D costs, advertising costs

Note: Capitalize means to treat a cost as an asset rather than a current expense In tax lingo, a capital asset is a certain type of

asset, with a narrower definition than a capitalized expenditure

6-2

Cost Recovery of Capitalized Expenditures

When is the cost of a capitalized expenditure ‘recovered’ for tax purposes? Over time? When the asset is sold? Other?

How is the cost of a capitalized expenditure recovered for tax purposes? Permissible cost recovery methods? Treatment of unrecovered cost on sale?

6-3

Types of Property

Define the following and provide examples of each: Tangible property Intangible property Real property Personal property

6-4

Initial Tax Basis of Business Assets

General rule: initial tax basis equals purchase price: Cash paid + debt assumed or incurred + FMV of

other property or services given up Other purchase-related costs also included in

initial tax basis: Sales tax Freight Installation charges

6-5

Adjustments to Tax Basis of Tangible Business Assets

Must capitalize the costs of additional expenditures which materially increase the value or extend the useful life of the asset Repairs vs. capital improvements Which of the following costs must be capitalized?

Environmental cleanup/asbestos removal New roof on building Landscaping costs Interior remodeling (carpet, partitions, etc.) Paint

6-6

Adjustments to Tax Basis continued

Adjusted tax basis = Initial tax basis + capital improvements - depreciation/amortization/ depletion allowed or allowable

Adjusted tax basis represents the taxpayer’s unrecovered cost of the asset

6-7

Tax Depreciation under MACRS

WARNING: MACRS rules have changed significantly several times since enacted in 1981. Depreciation is determined by the rules in effect for the year in which an asset is placed in service.

The following discussion pertains to rules in effect for assets placed in service since 1993.

6-8

MACRS

Ten recovery periods Specified by type of property Usually shorter than useful life for GAAP

Conventions for year placed in service and year of disposition Mid-year convention for 3- through 20-year

property Midquarter convention if > 40% of depreciable

personalty acquisitions occur during final quarter Mid-month convention for >20-year property

Tax depreciation ignores salvage value

6-9

MACRS Depreciation Methods

200% DB for 3- through 10-year property 150% DB for 15- and 20-year property Straight-line for >20-year property IRS tables provide percentages

Table percentages are applied to the asset’s initial tax basis (not adjusted tax basis) to determine each year’s depreciation amount

Mid-year and mid-month conventions for year of acquisition are built into tables

For year of disposition (if before end of recovery life) table percentages must be adjusted

6-10

Tax Basis of Intangible Assets

Costs of self-created intangibles must be capitalized and amortized over time period for which economic benefits expected

Many purchased intangibles subject to IRC. Sec. 197 Amortized on straight-line basis over 15 years Examples: Goodwill, covenant-not-to-compete,

customer-based and workforce intangibles

6-11

Start-up and Organization Costs

Start-up Costs: Pre-operational costs and costing of investigating either the creation or acquisition of a business

Organization Costs: legal, accounting, filing and registration costs related to formation of a new corporation or partnership

Taxpayer may elect to amortize these costs over 60 months, beginning in the first month of operation of an active business

6-12

Mineral Rights

Costs of acquiring mining or drilling rights must be capitalized and are subject to depletion as mineral is removed Cost = Adjusted Basis * Current production in units

Depletion Estimated total units of production

Percentage Depletion = Gross Income * Statutory Rate

Greater of cost or percentage depletion for taxable year is deductible (property-by-property)

6-13

Current Deductions of Capital Expenditures

Sec. 179 (Limited Expensing) Election – NEW LAW CHANGES $100,000 (2003-2006) of tangible personal property costs

deductible in year of acquisition Phased out for taxpayers with annual property expenditures > $400,000 Currently deductible amount limited to taxable business income before

this deduction Post-Sept. 11 additional first year depreciation

Applies to tangible personal property, computer software and leasehold improvements

30% of cost deductible in year of acquisition for acquisitions after 9/11/01 and before 5/6/03

50% of cost deductible in year of acquisition for acquisitions after 5/5/03 and before 1/1/05 (NEW LAW CHANGE)

6-14

Current Deductions of Capital Expenditures continued

Costs of removal of barriers to handicapped access ($15,000 annual maximum)

Soil and water conservation expenditures by farmers

Research and experimentation costs Advertising Costs of environmental remediation at targeted

contamination sites Intangible Drilling Costs

6-15

Tax Incentives Example: Oil and Gas Drilling and Development

Independent oil and gas companies receive two important tax incentives: Current deduction for intangible drilling costs Percentage depletion (15% of gross revenue)

Why are these favorable tax breaks offered? Without them, the riskiness of oil and gas exploration would deter many companies from investing in this activity

6-16

Example 1: Oil and Gas Incentives Assume drilling costs of $100,000 for a well

expected to produce 2,500 barrels of oil annually for 5 years. Current oil prices are $18 per barrel, and expected operating costs for the well are $6 per barrel. Assume a marginal tax rate for the independent producer of 34%, and a 7% discount rate.

6-17

Example 1 continued

Without special tax incentives to promote exploration, drilling costs would be capitalized and depleted, using cost depletion, over the productive life of the well. Annual gross revenue $45,000

Annual operating costs 15,000Annual depletion 20,000Net taxable income 10,000Annual tax cost 3,400Annual after-tax cash flow 26,600

PV of 5 year after-tax returns $109,065Rate of Return on investment 9%

6-18

Example 1 continued By allowing immediate expensing of drilling costs,

the return on this investment increases significantly. Annual gross revenue $45,000

Annual operating costs 15,000Annual depletion 0Net taxable income 30,000Annual tax cost 10,200Annual after-tax cash flow 19,800

PV of 5 year after-tax returns $81,184Tax benefit in year 1 from drilling cost deduction

34,000Total NPV $115,184

Rate of Return on investment 15%

6-19

Example 1 continued By also allowing percentage depletion of 15% of

annual gross revenue, the return on this investment more than doubles from the non- tax-favored return. Annual gross revenue $45,000

Annual operating costs 15,000Annual depletion 6,750Net taxable income 23,250Annual tax cost 7,905Annual after-tax cash flow 22,095

PV of 5 year after-tax returns $90,594Tax benefit in year 1 from drilling cost deduction 34,000Total NPV $124,594

Rate of Return on investment 25%

6-20

Incorporating Cost Recovery into NPV Analysis

Initial cost of asset results in cash outflow If acquired with debt, cash outflows occur for debt

principal and interest payments Tax savings generated by interest expense represents a

cash inflow

Depreciation expense is not a cash outflow Tax savings generated by depreciation expense

represents a cash inflow

6-21

Accounting for Inventories

Must use accrual method - only cost of goods sold (COGS) is deductible

Two issues in determining COGS: Product versus period costs (which costs are

inventoriable) Manufacturers and large retailers/wholesalers must

determine inventory cost (product cost) for tax purposes using uniform capitalization rules, which are NOT consistent with GAAP

Allocation of costs to goods on hand versus goods sold (cost flow assumptions): Specific identification, FIFO, LIFO LIFO conformity requirement

6-22

Tax Implications of Asset Acquisitions: Planning Issues

The after-tax cost of an asset acquisition increases as the recovery life (period of time over which the asset’s cost may be deducted for tax purposes) increases

Leveraged financing of asset purchases, where the cost of the asset is financed over a period longer than the recovery period, can decrease the after-tax cost of an acquisition

6-23

Planning Issues continued

Another alternative: Lease vs. purchase Tax treatment of leases:

Generally, annual lease payments are deductible Up-front payments to acquire a lease must be

capitalized and amortized over lease term Some leases may be treated as purchases for tax

purposes, depending on facts

6-24

Update to Book/Tax Difference List

Temporary Differences

• Differences in inventoriable costs under Unicap rules

• Differences between book and tax depreciation/ amortization/depletion

• Sec. 179 (immediate expensing) deduction

• Intangible drilling costs (full cost method for GAAP)

•Deductible R&D costs

Permanent Differences

• Percentage depletion in excess of investment