Required:
(a) Determine the economic benefits, if any, to the consolidated entity from tax savings as a result of this intercompany transaction. Was it a good financial decision to undertake this transaction? Explain.
(b) Would your answer to (a) be any different if Plum owned only 60% of the common shares of Slum? Explain.
(c) Indicate what amount of tax savings related to depreciation expense would be reflected on the consolidated income statement under the alternatives sug gested by the controller and manager, or other options you could suggest.
Which method would you recommend? Explain your answer using basic accounting principles.
On January 1, Year 1, Plum purchased 100% of the common shares of Slum. On December 31, Year 2, Slum purchased a machine for $84,000 from an external supplier. The machine had an estimated useful life of six years with no residual value.
On December 31, Year 4, Plum purchased the machine from Slum for $100,000. The estimated remaining life at the time of the intercompany sale was four years. Plum pays income tax at the rate of 40%, whereas Slum is taxed at a rate of 30%.
When preparing the consolidated statements for Year 5, the controller and manager of accounting at Plum got into a heated debate as to the proper tax rate to use when eliminating the tax on the excess depreciation being taken by Plum. The controller thought that Slum's tax rate should be used since Slum was the owner of this machine before the intercompany sale. The manager of accounting thought that Plum's tax rate should be used since Plum was the actual company saving the tax at the rate of 40%.
In Year 6, the Canada Revenue Agency (CRA) audited Plum. It questioned the legitimacy of the intercompany transaction for the following reasons:
1. Was the selling price of $100,000 a fair reflection of market value?
2. Was Plum trying to gain a tax advantage by saving tax at a rate of 40% rather than the 30% saving that Slum used to realize?
Plum argued that, under the terms of the sale, CRA was better off because CRA received tax in Year 4 from the gain on the intercompany sale. Had the inter company sale not occurred, CRA would not have received this tax.