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ABC Ltd, a firm of environmental consultants; has advised that new equipment costing $1m can be installed to virtually eliminate illegal discharges. Unlike fines, expenditure on pollution control equipment is tax allowable via a 25% writing-down allowance (reducing balance). The rate of corporate tax is 33%, paid with a one-year delay. The equipment will have no resale value after its expected four-year working life, but can be in full working order immediately prior to Ballet’s next financial year.
Question: Why is the solution (page 184) saying the tax allowance of $250 must start at Year 0? My understanding from the notes is that it must start in Year 1.
It does start at time 1. I think it is the layout of the answer that is confusing you.
The row with ‘CA’ against it is simply the calculation of the capital allowance (and is not added into the PV’s). It is the row with ‘tax saving at 33%’ against it that is the actual tax saving, and this has been added into the PV’s.
Usually, if there is a one-year lag in tax, the first tax saving will be at time 2. (Because we assume that the machine is bought on the first day of an accounting period, the tax is calculated at the end of the period (time 1) and the actual effect is one year later (time 2).
However, in this example, it says that the machine will be in full working order immediately prior to the next financial year. So…..it is effectively bought just before the end of a financial year, so the capital allowance would be calculated immediately (time 0) and the tax effect will be one year later (time 1).
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