Taxation Practice Case 6 Case (120 minutes) It is October 13, 2024. You, a CPA with the firm of Koulev & Vogel, LLP (K&V), are called into Murray Koulev's office. Murray has been the partner in charge of the Bold Spice Ltd. (BSL) account since the company became a client of the firm. "I need your help with some issues raised by one of our clients, BSL. As you know, BSL is a public company that manufactures and distributes perfumes and colognes. The company is considering acquiring Shiraz Deodorant Inc. (SDI), a company that manufactures and distributes men's deodorants in Canada. I will forward to you the email I received from Hayley King, the CFO of BSL." After you get back to your office, you review the email (Appendix I), along with excerpts from SDI's financial statements (Appendix II), and call Hayley. She says, "While we haven't been involved in the deodorant market, I think that SDI's business infrastructure lends itself very well to the perfume and cologne industry. I'm sending you some additional information (Appendix III). I want to make sure that I would be paying a fair price for this business. If there is anything I should know related to this purchase, please let me know." Your response should be no longer than 3,600 words, excluding any Excel files Chartered Professional Accountants of Canada. All rights reserved. No part of this publication may be reproduced or transmitted, in any form or by any means, without the prior written consent of CPA Canada. For information regarding permissions, please contact p..s@cpacanada.ca. 2023-09-13 Taxation Practice Case 6 Case (120 minutes) It is October 13, 2024. You, a CPA with the firm of Koulev & Vogel, LLP (K&V), are called into Murray Koulev's office. Murray has been the partner in charge of the Bold Spice Ltd. (BSL) account since the company became a client of the firm. "I need your help with some issues raised by one of our clients, BSL. As you know, BSL is a public company that manufactures and distributes perfumes and colognes. The company is considering acquiring Shiraz Deodorant Inc. (SDI), a company that manufactures and distributes men's deodorants in Canada. I will forward to you the email I received from Hayley King, the CFO of BSL." After you get back to your office, you review the email (Appendix I), along with excerpts from SDI's financial statements (Appendix II), and call Hayley. She says, "While we haven't been involved in the deodorant market, I think that SDI's business infrastructure lends itself very well to the perfume and cologne industry. I'm sending you some additional information (Appendix III). I want to make sure that I would be paying a fair price for this business. If there is anything I should know related to this purchase, please let me know." Your response should be no longer than 3,600 words, excluding any Excel files. Taxation Practice Case 6 Case 2 / 6 Appendix I Email from Hayley King Date: October 10, 2024 From: Hayley King, BSL Subject: Shiraz Deodorant Inc. (SDI) Hi Mr. Koulev, I think acquiring SDI is a good business opportunity. Since 2015, SDI's profits have slumped, and it is not clear if it will ever fully recover. I would like to acquire SDI's productive assets. I think its plant and truck fleet would fit in nicely with the expansion of BSL's existing product lines. SDI's owner is offering to sell the shares only, not the assets, and I was wondering what your thoughts were about this. SDI's owner has indicated that he is willing to sell his shares for an amount determined by applying the industry standard multiplier of 3 to normalized average earnings before interest, taxes, depreciation, and amortization (EBITDA). From the information provided by SDI, I have estimated the value of the assets of the business (Appendix IV). I have attached excerpts from the financial statements for the years ended December 31, 2022 and 2023, and for the first nine months ended September 30, 2024. SDI's financial statements are prepared in accordance with accounting standards for private enterprises (ASPE). The planned closing date is November 1, 2024. SDI has tax losses available that I would like to access for my business. I am not interested in continuing with the deodorant business, so my plan is to sell off SDI's inventory, and any other SDI assets not needed in my business, as soon as possible after acquisition. I have been told that the seller normally prefers to sell shares instead of assets for various reasons. I would like to understand the implications of both the sale of assets and the sale of shares from both the seller's and buyer's perspectives. I believe this knowledge will help me to negotiate a better purchase price. The owner of SDI is a Canadian resident and has owned 100% of SDI's shares since its inception in 2005. Please also provide any other relevant advice. Thanks, Hayley Taxation Practice Case 6 Case 3 / 6 Appendix II Excerpts from financial statements Shiraz Deodorant Inc. Balance sheet (in thousands of dollars) Sept. 30, 2024 Dec. 31, 2023 Dec. 31, 2022 (unaudited) (audited) (audited) Assets Current assets Cash $ $ $ 100 Accounts receivable 1,348 1,029 1,278 Inventory 5,221 4,882 4,323 6,569 5,911 5,701 Trademarks and trade names 1,000 1,000 1,000 Property, plant, and equipment 5,194 5,003 5,876 $ 12,763 $ 11,914 $ 12,577 Liabilities Current liabilities Bank indebtedness $ 111 $ 122 $ Accounts payable 711 678 587 Sales taxes payable 71 68 47 Current portion of long-term debt 112 113 115 1,005 981 749 Long-term debt 5,224 5,332 5,433 6,229 6,313 6,182 Equity Share capital 100 100 100 Retained earnings 6,434 5,501 6,295 6,534 5,601 6,395 $ 12,763 $ 11,914 $ 12,577 Taxation Practice Case 6 Case 4 / 6 Appendix II (continued) Excerpts from financial statements Shiraz Deodorant Inc. Income statement (in thousands of dollars) Year-todate Sept. 30, 2024 (unaudited) Dec. 31, 2023 (audited) Dec. 31, 2022 (audited) Revenue Sales $ 27,965 $ 34,787 $ 32,453 Cost of sales 20,933 25,772 24,001 Gross margin 7,032 9,015 8,452 Expenses Advertising and donations 2,051 2,497 2,233 Depreciation and amortization 895 945 Bad debt 278 478 132 Interest 568 722 754 Insurance 609 725 500 Office 177 276 234 Professional fees 234 223 176 Repairs and maintenance 177 222 324 Utilities 649 877 759 Management salaries 550 750 600 Wages 806 1,066 1,013 6,099 8,731 7,670 Income before other items 933 284 782 Other items Loss on disposal (178) Other expenses (900) (1,078) Net income (loss) $ 933 $ (794) $ 782 Taxation Practice Case 6 Case 5 / 6 Appendix III Additional information from Hayley King Per discussions with SDI, inventory consists of 90% raw materials and 10% finished goods. The bulk of the raw materials consists of commodities, the prices of which fluctuate based on the market. There are a limited number of suppliers for these commodities so I plan to sell the inventory to other deodorant makers. Capital assets have the following fair values and tax values: Fair value ACB UCC Land $ 1,650,000 $ 750,000 N/A Building (Plant) 4,350,000 4,250,000 3,740,000 Equipment 600,000 1,100,000 762,000 Vehicles 800,000 1,250,000 855,000 Total $ 7,400,000 $ 7,350,000 $ 5,357,000 SDI holds trademarks and trade names for its products. I estimate the total market value of these assets equals book value. I would sell these as well. The tax value is $587,000. In fiscal 2022 a lawsuit was filed against SDI for wrongful dismissal. It was settled last year for $900,000. Legal fees related to the lawsuit of $100,000 were incurred in each of fiscal 2022 and 2023. The owner's salary represents about 80% of total management salaries. The owner would have to be replaced by an additional manager. A manager at that level in this industry would normally be paid $150,000. Based on my knowledge of the industry, I would have expected yearly repair and maintenance expenses to be higher than what SDI has incurred in the last few years. I discussed this with management at SDI. They indicated that they had deferred some repairs and maintenance work to future years. They suggested that annual repairs and maintenance should have been closer to $350,000 to properly maintain the plant and equipment on an annual basis. SDI sold a storage facility, including land, at a loss last year. This resulted in realization of a capital loss, which combined with previous years' capital losses, results in $1.5 million of unused capital losses. At December 31, 2023, SDI had $2 million in non-capital loss carry forwards, plus unclaimed charitable donations of $120,000 from 2023. The non-capital losses were generated in fiscal 2020 and 2023 and the earliest ones will expire in 2040. I would like to fully use the losses well before they expire. Taxation Practice Case 6 Case 6 / 6 Appendix IV Estimated value of SDI's assets Here is my estimate of what the SDI's assets are worth (in thousands of dollars): Accounts receivable (per financial statements, rounded) $1,350 Inventory (per financial statements, rounded) 5,000 Capital assets 7,400 Trademarks and trade names 1,000 Loss carryforward at a 25% tax rate 875 Undeducted donations at a 25% tax rate 30 $15,655