To appraise fully an investment, management must take account of the impact of taxation, as it is the after-tax cash flows that are relevant to decision making.
As a result of accepting a project tax payments or savings will, generally, be made by the company. These relate to:
- Corporation Tax payments on profits.
- Tax benefits due to capital allowances granted on certain expenditure.
Annual cash inflows from a project will cause an increase in taxable profits and, hence, a tax payment. Annual cash outflows (e.g. cost of materials, labour etc.) will reduce taxable profits and yield tax savings. However, tax payments or savings can be based upon the net cash inflows or outflows each year.
One can assume that an annual cash flow (inflow or outflow) will produce a similar change in taxable profits, unless the exam question specifically indicates otherwise. For example, you may be told that a particular item of expenditure (say, a contract termination payment of RWF100,000) is not allowable for tax purposes. In this instance, the RWF100,000 must be shown as an outflow of the project but it is ignored when calculating the taxation effect.
It is important to appreciate that the taxation payment or saving is the cash flow multiplied by the rate of Corporation Tax. For example, if the net cash inflow in a particular year is RWF50,000 and the rate of Corporation Tax is 40% an outflow of RWF20,000 (RWF50,000 x 40%) is shown in the taxation column.
The Revenue does not allow depreciation charges as a deduction in calculating the tax payable. However, it does grant capital allowances, which can be quite generous. These allowances on capital items can be set-off against taxable profits to produce tax savings (i.e.
The capital allowances can take various forms. The most common are:
- 100% initial allowance, whereby an allowance equivalent to the full cost of the item is available up-front.
- A writing-down allowance of, say, 25% per annum on a straight line basis. This means that the benefit of the allowance is spread equally over 4 years.
- A writing-down allowance of, say, 25% per annum on a reducing balance basis. This means that the allowance is spread over a number of years but on a reducing basis. 25% of the expenditure is allowable in the first year (as under number 2) and a reducing allowance thereafter.
Again, it is important to appreciate that the cash flow effect is the capital allowance multiplied by the rate of Corporation Tax. For example, if the capital expenditure (which qualifies for 100% allowances) in a particular year is RWF50,000 and the rate of Corporation Tax is 40% then a saving of RWF20,000 (RWF50,000 x 40%) is shown in the taxation column.
The eventual sale of capital items will usually cause a balancing charge or a balancing allowance, which must also be taken into account in the project appraisal.
TIMING OF TAXATION EFFECTS
Unless specifically advised to the contrary in an examination, assume that there is a time lag of one year between a cash flow and the corresponding taxation effect. Thus, expenditure on a capital item in year 0 will usually be accompanied by a tax saving in year 1.