Chapter 3 Assignment Solutions

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Okanagan College *

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Apr 3, 2024

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Solution to AP 3-6 Part A The first year income tax consequences for Trisha would be a taxable benefit on the loan of $4,500 [(2%)($225,000)]. This would result in an increase in income tax of $2,205 [(49%)($4,500)]. The cost of the loan to the company for the first year would be calculated as follows: Lost Earnings on Funds Loaned [(11%)($225,000)] $24,750 Income Tax on Imputed Earnings (at 27%) (6,683) Net Cost to the Company - Loan $18,067 This will result in Trisha having the use of $225,000 at a tax cost to herself of $2,205 and an annual cost of $18,067 to the company. Part B If instead of giving Trisha the $225,000, the company pays her the potentially lost annual earnings of $24,749, the after-tax cost to the company will be the same, as shown in the following calculation: Additional Salary ($18,067/(1 – 0.27) $24,749 Savings in Income Tax (at 27%) (6,682) Net Cost to Company - Salary $18,067 Part C Trisha can borrow from the bank at a rate of interest of 4.8%. The annual interest payments on $225,000 would be $10,800 [(4.8%)($225,000)]. If she receives the additional salary, her after tax income would be as follows: Additional Salary $24,750 Additional Income Tax (at 49%) (12,128) Net Increase in Cash $12,622 Trisha should accept the additional annual salary of $24,749 as it results in an annual net cash inflow of $1,822 ($12,622 - $10,800) after paying the income tax and the mortgage interest. This compares to a cash outflow of $2,205 if the company makes the loan to Trisha. Note The loan would qualify as a “home purchase loan” which results in locking-in the 2% prescribed interest rate for a period of 5 years.

Solution to AP 3-8 Part A There would be no income tax consequences resulting from the granting of the options in September 2021. The stock option deduction restrictions apply to stock option plans granted after June 30, 2021, where the issuer of the stock option was a public corporation with gross revenues of $500 million or more. Since the gross revenues are only $190 million, the stock option deduction restrictions do not apply to this stock option plan. As Floretta’s employer is a public company, the exercise of the options in 2022 will result in the following addition to employment income, net income and taxable income: FMV at Exercise [(1,000)($27)] $27,000 [(1,000)($32)] 32,000 Total FMV $59,000 Option Price [(2,000)($19)] (38,000) Employment Income = Increase in Net Income for 2022 $21,000 Stock Option Deduction [(1/2)($21,000)] (10,500) Increase in Taxable Income for 2022 $10,500 In 2023, when the shares are sold, there is the following addition to taxable capital gains, net income and taxable income: POD [(2,000)($30)] ACB $60,000 [(1,000)($27)] ($27,000) [(1,000)($32)] (32,000) (59,000) Capital Gain $ 1,000 Inclusion Rate 1/2 Taxable Capital Gain $ 500 Note: Technically the ACB of the shares would be averaged to $29.50 each. This would not change the capital gain consequences, however. This ACB averaging process is discussed in Chapter 8. Part B There would be no income tax consequences resulting from the granting of the options in September of 2021. If the 2021 FMV of the shares had been $22, the option price would have been below the FMV and the stock option deduction would not be available. On this basis, the 2022 results would be revised as follows: FMV at Exercise [(1,000)($27)] $27,000 [(1,000)($32)] 32,000 Total FMV $59,000

Option Price [(2,000)($19)] (38,000) Employment Income = Increase In Net Income and Taxable Income for 2022 $21,000 The results for 2023 would be unchanged from Part A. Part C If Floretta’s employer had been a CCPC, there would be no income tax consequences in either of 2021 or 2022. The stock option deduction restrictions do not apply to CCPCs. ITA 7(1.1) defers the stock option benefit until the year in which the stock option shares are sold. With respect to Part A, when the shares are sold in 2023, the results would be as follows: FMV at Exercise (1,000)($27)] $27,000 [(1,000)($32)] 32,000 Total FMV $59,000 Option Price [(2,000)($19)] (38,000) Employment Income $21,000 Taxable Capital Gain POD $60,000 ACB (59,000) Capital Gain $ 1,000 Inclusion Rate 1/2 500 Increase in Net Income for 2023 $21,500 Stock Option Deduction [(1/2)($21,000)] (10,500) Increase In Taxable Income for 2023 $11,000 In Part B, there still would be no stock option deduction allowed under ITA 110(1)(d). However, for a CCPC, there is a potential stock option deduction equal to 50% of the stock option benefit amount under ITA 110(1)(d.1), as long as the shares are owned for at least two years. As this was not the case with Floretta’s shares, the stock option deduction remains unavailable. Given this, the revised Part B results for 2023 are as follows: FMV at Exercise [(1,000)($27)] $27,000 [(1,000)($32)] 32,000 Total FMV $59,000 Option Price [(2,000)($19)] (38,000) Employment Income Taxable Capital Gain $21,000 POD $60,000 ACB (59,000) Capital Gain $ 1,000 Inclusion Rate 1/2 500 Increase in Net Income and Taxable Income for 2023 $21,500

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