Albert Lee is an employee of a large Canadian company.  As he has performed exceptionally well in  recent years and has become sought after by competitors, the Company is planning to increase his compensation in an effort to retain him.

Mr. Lee has developed a growing interest in investing in options and, in order to finance this activity, he is looking to borrow $500,000.  His bank has indicated that they would be prepared to loan this amount to him at a rate of 6 percent.   This is attractive in that he anticipates that his activity in the options market will generate a pre-tax return of at least 15 percent.

Given this situation, Mr. Lee has indicated to his employer that, instead of additional remuneration in the form of salary, he would be prepared to accept a $500,000 interest free loan for 3 years. He would fully invest this sum in options.

The Company is subject to tax at a combined federal/provincial rate of 27 percent. When funds are available, the  Company  has  alternative  investment  opportunities  that  earn  a  pre-tax  rate  of  9  percent. Any additional compensation for Mr. Lee will be taxed at a combined federal/provincial rate of 46 percent. Assume that the prescribed rate for the current year is 2 percent.

Required:

A. Determine the tax consequences to Mr. Lee and the cost to the Company, in terms of lost after-tax  earnings, of providing Mr. Lee with a $500,000 interest free loan for the first year of the loan.

B. Determine the amount of additional salary that could be provided to Mr. Lee for the same after tax cost to the Company that you calculated in Part A.

C. Which alternative would you recommend that Mr. Lee accept?  Explain your conclusion.