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When calculating tax on capital allowances I have seen two methods or rather approaches.
In one method the tax relief (saving) portion is included in the tax calculation ie 80m asset depreciated over 4 years straight line. The depreciation charge is 20m but only the tax on the 20m will be used to reduced the tax liablilty.ie 20m x 30% =6m tax relief .
In another case they use the whole 20m depreciation charge to reduce the profit before calculating tax.
Please assist with the basic explanation on why the two different approaches and how I can spot which method to use in an exam
You can do it either way – both will give the same answer.
You either subtract the capital allowances from the cash flow to get the taxable profit, then calculate the tax outflow, then add back the allowances because they are not a cash flow.
Alternatively you calculate the tax on the cash flow as though no capital allowances, and then calculate the tax saving as a result of the allowances.
For a full explanation you should watch the free lectures on investment appraisal (either in the P4 section, or in the F9 section because it is the same problem as in F9)
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If you use method 2 which seems to be preferred method in exam answers.. in many instances you end up making a taxable loss because the TAD is so high. How do you deal with taxable losses ?
Although method 2 is more common in Paper FM, it is method 1 that is better for Paper AFM.
If the investment is in the home country then there are no tax losses because we always assume that they company is already making sufficient profits and is already paying tax. Therefore a ‘loss’ on the new investment simply reduces the company’s profit and therefore results in a tax saving.
It is only when the investment is in another country that tax losses can occur (because it is a separate tax entity). In this case losses are carry forward and reduce the taxable profit of the company in later years – the question normally tells you what the tax rules are.
Again, have you watched the free lectures?
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