CL-419 Process Economics

Depreciation and Taxation

Reference:
• Max Peters, Klaus Timmerhaus, Ronald West –

Plant Design and Economics for Chemical Engineers

Fifth Edition

• Personal notes for Indian depreciation and taxes

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 Fixed Charges

 Among the many costs included in the total product

cost are a group of fixed charges which include
- Depreciation
- Property taxes
- Insurance
- Financing
- Rent
 Once the plant is built, these charges are fixed – i.e.,
they are not related to the level of activity of the plant
and continue even if the plant does not operate.
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 Depreciation
 Depreciation is an unusual fixed charge since it has a
significant effect on corporate cash flow
 Physical facilities deteriorate and decline in usefulness
with time – the value of the facility decreases
 Physical depreciation is measure of the decrease in
value of facility due to changes in the physical
aspects of a property
 Wear and tear, corrosion, accidents and deterioration
due to age or the elements are all causes of physical
depreciation
 With this type of depreciation, serviceability of the
property is reduced 3
 Functional Depreciation
 Depreciation due to all other causes is known as
functional depreciation
 One common type is obsolescence – caused by
technical advances
 Other causes are
 Decrease is demand for the service rendered by the
property
 Shifts in population
 Changes in requirements of public authority
 Inadequate or insufficient capacity
 Abandonment of the enterprise
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 Depreciation and Income Tax

 Depreciation impacts the tax liability of a corporation

 Therefore both the government and the corporation
have an interest in depreciation
 Income tax laws closely control the manner in which
depreciation is charged
 Depreciation is charged as an expense and then paid
to the corporation
 In other words, it is subtracted and added in the
corporate books – but it is not an accounting artefact
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 Depreciation and Income Tax (cont’d 1)

 The deduction of Depreciation allows the corporate to

recover their cost for the property over a period of
years.
 Amortization – a word sometimes used
interchangeably with depreciation – has a more
restricted meaning in tax policy.
 Amortization is a deduction for intangibles, such as
patents and copyrights that have limited useful lives
that can be estimated with reasonable accuracy
 Depreciation affects the amount of income tax that a
corporate must pay.
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 Depreciation and Income Tax (cont’d 2)
 Cash flow resulting from process operations (A) in the
year j is given by
Aj = (Sj – Coj)(1 – Φ) + Φdj
where Aj = Annual cash flow from the project to the
corporate reservoir resulting from the cost of operation in year j
Sj = Sales in year j
Coj = Total product cost in year j (except depreciation)
dj = Depreciation in year j
Φ = fractional income tax rate
 The recovery of depreciation increases the net cash flow
to the company from the project 7
 Depreciable Investments

 In general, all property with a limited useful life of more

than 1 year that is used in business is depreciable
 Physical facilities, including such costs as design and
engineering, shipping and field erection are depreciable
 Land is not depreciable, but improvements to land
(such as grading) are depreciable
 Working capital, start-up costs and inventories for sale
are not depreciable
 In other words, fixed capital investment (FCI), excluding
land, is depreciable
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 Depreciable Investments (cont’d)

 Cost of maintenance and repairs are direct operating

expenses and thus not depreciable
 Total amount of depreciation that may be charged is
equal to the amount of the original investment in a
property – no more, no less
 In other words, depreciation does not inflate or deflate

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 Current Value, Book Value

 Current value of an asset

= value of the asset in its condition at the time of
valuation
 Book value
= (original cost of a property)
- (total depreciation charged up to a time)
 Depending on company policy, method of depreciation
for purposes of obtaining book value may be different
from that used for income tax purposes
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 Market Value, Salvage Value, Scrap value
 Market value
= Price that could be obtained if the asset is sold
in the open market. It is different from book value; it is
important for determining the true asset value of the
company
 Salvage value is the net amount of money that can be
obtained from the sale of used property after deducting
any charges involved in its removal and sale. Salvage
value implies that the property can be of future service.
 If the property is not useful, it can often be sold for
recovery of material. Income obtained from such sale is
known as scrap value
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 Recovery period

 Period over which the use of a property is economically

feasible is known as service life of the property.
 Recovery period is period over which depreciation is
charged; it is established by tax codes
 There is no direct correlation between service life and
recovery period
 See Table 7 – 8 for various recovery periods

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Recovery period (cont’d 1)

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 Methods for Calculating Depreciation

 Straight line
 Double – declining balance
 Modified accelerated cost recovery system (MACRS)

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Methods for Calculating Depreciation (cont’d)

 Total amount of depreciation that can be charged is

equal to the investment in depreciable property (fixed)
 Therefore, over any recovery period, the same total
amount is depreciated; hence the same total amount of
tax is paid
 However, since money has a time value, the corporate
would like to depreciate property as rapidly as possible,
while the government would also like to recover tax. To
balance both, the government sets out its policy on rate
and length of time over which depreciation is charged
and the method of calculating depreciation
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 Straight Line (SL) method of Depreciation

 In this method, property value is assumed to decrease

linearly with time over the recovery period. No salvage
or scrap value may be taken
 This amount of depreciation (d) in each year of the
recovery (n) is
d = V/n
where V is the original investment at the start of
depreciation period
d is annual depreciation
n length of straight line recovery period
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 Double Declining Balance (DDB) method

 Double Declining Balance method is an accelerated

version of the Declining Balance method
 This method allows a depreciation charge in each year
of the recovery period that is twice the average rate of
recovery on the remaining un-depreciated balance

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 DDB method (cont’d)

 For 5 year recovery period,

 Depreciation in first year is 2(1/5) = 40% (balance 60%)
 Depreciation in 2nd year is 2(0.6/5)= 24% (balance 36%)
 Depreciation in 3rd year is 2(0.36/5)= 14.4% (balance
21.6%)
 And so on for 5 years

• Depreciation is calculated as a fraction of the balance;

this leaves the rest of the balance pending. The asset
therefore is never fully depreciated by this method
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 MACRS

 MACRS stands for Modified Accelerated Cost Recovery

System
 It is the method used for most income tax purposes and
economic evaluations in the US
 It is a combination of double declining method and
straight line method. As a result there is no salvage or
scrap value. It also uses a half year convention
 It starts off with the double declining method, and
switches to straight line method as soon as the straight
line method provides a higher depreciation than the
declining balance method
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 MACRS (cont’d)

 The half year convention indicates that in the first year

only one half of the double declining balance method is
allowed
 Balance remaining after the end of the recovery period
is depreciated in the next year
 The result is that the MACRS depreciation always
requires an additional year over the length of the
recovery period

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 Depreciation methods in India

 As per the Companies Act, Financial Reporting has to

be as per Indian Accounting Standard (IAS)
 Straight line method is to be used for depreciation for
preparation of the Company’s Profit & Loss (P&L)
statement
 Companies Act provides the rates for depreciation of
various assets
 It also permits the company to assess the useful life
based on the recommendation of competent technical
personnel, provided it is accepted by the company’s
auditors
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 Depreciation methods in India (cont’d 1)

 Most companies in India tend to use the values as per

the Companies Act
 E.g., value of an asset is Rs. 1000. Residual value is Rs.
50 (max. permissible is 5% of the value of the asset)
Useful life is 20 years as per the Companies Act
Depreciation = (1000 – 50) / 20 = 4.75%
 Useful life can be changed from one year to the next
provided there is proper justification. In this case, full
disclosure has to be made and the resultant impact has
to be stated in the Company’s Annual Accounts
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 Depreciation methods in India (cont’d 2)

 “Cost matching concept” for depreciation is also

permitted; i.e., use of machine can be accounted against
revenue generated
 Companies Act also permits component-wise
depreciation provided it can be justified (e.g., a turbine
can be depreciated at a different rate than a pump)

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 Depreciation methods in India (cont’d 3)

 For Income Tax purposes, only Written Down Value

(WDV) method is acceptable
 Permissible depreciation rates are provided by Income
Tax authorities
 Residual value / scrap value is recognised by the IT
authorities

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 Depreciation methods in India (cont’d 4)

 For the first year, if the asset is in service for more than
182 days (i.e., purchase is before September 30) full
depreciation is allowed, and for less than 182 days, half
depreciation is applicable
 Sometimes the government gives special incentives
such as higher depreciation rate in the first year
 Depreciation rate of plant and machinery is 15%
currently

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 Income Taxes

 Corporate income taxes are levied by the US Federal

Government and some of the states as well. Federal
income taxes are the largest by far
 Federal income tax is as high as 39% of net profit –
therefore it is extremely important in corporate planning
 Income taxes are paid on a corporate wide basis
 Gross profit / gross earnings equals Total revenue
minus Total Product Cost (TPC)

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 Income Taxes (cont’d 1)

 Total Revenue comes from all sources

 Product Sales
 Sales of assets
 Royalties
 Etc.
 Dividend and interest to the corporation (i.e., parent
company) and shareholders are not allowable costs for
IT purposes. Repayment of loan principal is also not an
allowable cost
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 Income Taxes (cont’d 2)

 In evaluating a new investment, income tax attributable

to that investment is the gross income it is expected to
generate multiplied by the marginal income tax rate
associated with the addition of that income to the
corporate income. An income tax rate of 35% is normally
used
 Corporate income tax payments are due in instalments
of 25% of the projected annual total in mid April, June,
September and December. In cash flow calculations,
they are usually treated as occurring once a year at year
end
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 Income Taxes (cont’d 3)

 Tax law is subject to legislative actions, rulings by tax

authorities and court interpretations; As a result, there
are frequent changes
 So consult the experts!

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 Capital Gains Tax

 Capital gains tax

- Levied on profits made from sale of capital assets (land,
buildings, equipment)
- For non-depreciable assets such as land
Profit = selling price – acquisition price - cost of
selling - cost of improvements
- For depreciable assets such as buildings and equipment
Profit = selling price – acquisition price reduced by
amount of depreciation already charged
as expense – cost of selling
(advertisement + removal from service)
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 Capital Gains Tax (cont’d)

Capital gain on an item held for 1 year or more is known as

long term capital gain, else short term capital gain. Tax rate
on long term capital gain is 20%; Short term capital gain is
marginal tax rate (normally 35% is used for estimates)

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 Losses

• Tax laws also make provision for losses

• Losses within the company may be used to effect gains
within the company in the same year, thereby reducing
the taxable income.
• If corporate operations show a loss within a year, that
loss can be carried back for up to 3 years to offset past
profits, or carried forward for up to 5 years to offset
future profits

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 Losses (cont’d)

• A particular project may be profitable overall but show

losses in one or more years. These losses could be
used to reduce overall corporate income tax.
Alternatively it can used as a “negative income tax” in
the evaluation of the project. Company policy
determines the decision
• Negative income tax (though justifiable) is not used to
establish the economic viability of a new project

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 State Taxes

• Some states in the US levy a corporate income tax;

many do not
• State tax rate differs from state to state.
• For preliminary analysis, federal income tax rate can be
increased to 40% to reflect this possibility

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 Income tax for India

• Income tax rate for Domestic Companies

- Profit less than Rs. 1 crore - 30% tax + 3% cess (30.9%)
- Profit > or = Rs. 1 crore - 30% tax + 7%surcharge +
3% cess (33%)
• Income tax rate for foreign companies
40% tax + 7% surcharge + 3% cess (44%)
• Foreign company is defined as a company not
incorporated in India but doing business in India

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 Income tax for India (cont’d 1)

• For new companies incorporated in India in 16-17,

corporate tax rate is 25% instead of 30%
• Government’s stated goal as per budget 2016 is to
reduce the basic income tax rate to 20% over a period
of 4 years
• In 16-17, government has released Income Tax
Computation Disclosure Scheme ((ICDS) comprising of
10 procedures clearly defining the method of
calculation for various items. It also clearly states that
land is not depreciable

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 Income tax for India (cont’d 2)

• Indian financial year is from April 1 to March 31 of the

following year.
• Advance Income taxes are payable in 3 instalments –
mid-September, mid-December and mid-March
• Indian states do not levy any income taxes
• Tax laws in India also are subject to legislative actions,
rulings of tax authorities and court interpretations.
Hence the eagerly awaited budget pronouncements in
February of each year.

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