Question

In: Finance

Ms. Bea Essee is the vice-president of SR&ED with Dundas Manufacturing Ltd. She is one of...

Ms. Bea Essee is the vice-president of SR&ED with Dundas Manufacturing Ltd. She is one of a group of eight senior executives who have been granted options to purchase from the corporation unissued non-voting Class B common shares of the corporation. She presently owns 15% of these shares. In order to assist this group of employees to acquire shares under the stock option plan, the corporation provides loans at low interest rates under an established policy approved by the Board of Directors.

On April 1, 2019, Ms. Essee borrowed $50,000 to enable her to exercise some of her stock options. She signed a note promising to repay $10,000 of principal on the anniversary date of the loan in each of the next five years and to pay interest at a rate of 1% per year paid quarterly. Assume that the prescribed rates in 2019 were: first quarter, 3%; second quarter, 3%; third quarter, 2%; fourth quarter, 3%.

REQUIRED: Show all calculations necessary to support your conclusions.

Advise Ms. Bea Essee of the 2019 Division B income tax effects to her of receiving the loan amount of $50,000 and of paying interest of 1% to the corporation.

Be complete in your analysis of these features of the loan in respect of the likely provisions of the Act that could apply and support your advice with complete calculations where necessary. Section references may be helpful in providing precision to your answer.

Solutions

Expert Solution

Ms Bea will be receiving tax advantage for the interest amount that she will have to pay. Interest are deducted before computation of Tax. So as Ms Bea is paying less tax, so the tax shield will be less.

For example. Consider tax rate to be 20%

As Tax is calculated for an year, so we will be seeing the annual effect.

Current Scenario- Ms Bea paid interest of 1% on 50,000. Total Interest paid $500

So Ms Bea will not have to pay tax on $500. Total tax saved 20% of 500 = 100 is the tax shield

If Ms Bea would have paid normal quarterly interest, then she would have paid

1st Quarter - 3% of 50,000 *0.25 --- Multiplyimg by 0.25 as quarterly.

=$375

2nd Quarter - same as $375

3rd Quarter - 2% of 50,000*0.25  

= $250

4th Quarter - same as $375

Total Interest paid = 375 + 375 + 250 + 375

= 1375

In normal interest rate condition, she would have saved tax on $1375. Tax shield is 20% of 1375 is $275

The tax shield will be more in later case.


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