Assume the date is 25 January 2024.

You work for a firm of ICAEW Chartered Accountants. Yesterday, your manager met with the chief financial officer (CFO) of the Red Lion Sdn. Bhd. (RLSB). Extracts of the record of the meeting and from an email from your manager are set out below. RLSB is a family owned company whose shareholders are all tax residents of Malaysia. The firm has been selling pharmaceutical items for the last three years and has just started to become profitable in the financial year ended 31 December 2023.

Extract of note during the meeting with the CFO:

RLSB is determining the best method to raise the extra RM 1 million required to purchase new equipment (general plant). For taxation purposes, RLSB is currently categorised as a small and medium business (SME). The financial statements of RLSB for the year ended 31 December 2023 indicate the following:

 paid-up share capital of RM2 million;

 bank borrowings of RM4 million at 6% interest per annum which give rise to annual interest expense of RM240,000 and

 retained earnings of RM1 million;

All borrowed funds were put to use in the company.

To eliminate the interest expense, RLSB is considering offering a rights issue to its shareholders to raise an additional RM5 million in the financial year ended 31 December 2024. 

The amount raised from right issue will be used to fully repay the bank borrowings and also to acquire 500 units of new equipment from an overseas supplier. The new equipment costs RM1,950 per unit and will be used in inventory management. The overseas supplier will also provide some technical advice to RLSB on how to operate the equipment.

RLSB forecasts a net profit (before interest expense and tax) of RM3 million for the year ended 31 December 2024. It proposes to distribute an annual dividend of 6% in each of the next three years .

The CFO wants to know the tax treatment of the expenditure incurred in connection with the rights issue, payments to the overseas supplier for the equipment and technical advice and the impact on RLSB’s SME sAs an alternative, if RLSB decides not to pursue the rights issue, the CFO has indicated that the company will take out additional bank borrowings to fund the acquisition of the equipment.

RLSB has a plan to venture into other product line as part of its business expansion strategy. Hence, the CFO is interested to know is there any tax efficient strategy to achieve this

objective.

You have received an email for your tax manager concerning the business matter of RLSB.

The extracts of the email from your tax manager as follows:

Please draft a report to the CFO which considers the effect of the two alternative methods of financing:

Option 1: Debt financing – Increase the current bank borrowing to RM5 million from the initial RM4 million at the same interest rate and maintain RLSB’s paid-up share capital at the original RM2 million; or

Option 2: Equity financing – Increase the paid-up share capital to RM7 million from the initial RM2 million by way of a rights issue to repay all borrowings and acquire new equipment as outlined in the notes from the client meeting.

The report should address the following issues:

(i) The costs involved in debt and equity financing under each option.

(ii) The income tax treatment of

– the incidental costs of raising the debt/equity finance;

– the interest expense and the dividend to be distributed.

- The payment to the overseas supplier with regards to the equipment and technical advice costs.

(iii) Whether RLSB will retain its SME status under each option (with reasons) and the tax treatment of the new equipment for each option.

(iv) In a comparison of RLSB’s retained earnings after taking into account the interest expense, tax payable and dividend distribution under the two options and your advice on which should be the preferred option.

Note: For the purpose of these computations you should assume that the tax adjusted income for the business for YA 2024 will be RM3 million before deducting the interest expense, and

that capital allowances (CA) are available in respect of the equipment acquired in the current year.

(v) Identify tax efficient strategy which can assist RLSB to achieve its objective to venture into new product line.

Required:

(a) Prepare a report for part (i) to (v) to the CFO of RLSB as requested by your tax manager. Prepare relevant tax computation to support your rationale when necessary.

Note: Marks will be awarded for proper format, clear explanation and relevant tax computation. You may follow the tax law in YA2022 while preparing your work.

(b) As for part (v), each member in a group is requested to do a video presentation. The recorded video must be submitted together with the soft copy report. You are allowed to

make relevant assumptions in answering part (v). The slides presentation should not more than 2 pages for part (v). The presentation duration is within 5 to 10 minutes for each

groupo new product line.