Disposal Tax Effect

April 8, 2009

Descriptive Overview

Disposal tax effect as a finance phrase, traces its origin from engineering economics whereby it can be depicted as a situation of tax savings or additional taxes ensuing from disposing off the last item of its class in account by selling it, because of the difference between the items’s (UCC) Undepreciated Capital Cost and its (SV) salvage value. The salvage Value in this case is the remaining value of an asset after depreciation. It can also be referred to as residual value.

Conversely, when the Salvage Value is more than the Undepreciated Capital Cost, (SV>UCC), then it means that the item being sold has had a relative gain, commonly known as a recaptured CCA or a recaptured depreciation. In such a case, the relative gain is subject to taxation. On the other hand, when the Salvage Value is less than the Undepreciated Capital Cost, (SV

Capital Costs and Depreciation

It is important to understand what capital costs and depreciation are, to be able to understand their relation to disposal tax effect. Capital costs in very simple terms are the total cost incurred while bringing up a project to a commercially usable status. This may include costs incurred while purchasing a piece of land and constructing it. Note that capital costs exclude labor costs, apart from for construction labor costs.

Depreciation on the other hand is used in general to spread the cost of an asset over a period of several years. Thus, depreciation can be described as the diminishing of the value of an asset because of its usage, wear and tear, passage of time, obsolescence or technological outdating, inadequacy, rot, depletion, decay, rust among many other factors.

Illustration

Take for example P to stand for Initial Cost, S to stand for the Salvage Value at the time of disposal, U to stand for Undepreciated Capital Cost at the time of disposal, t to represent the tax rate on normal income and t cg to represent the tax rate on capital gains income.

Thus, when S is more than P (S>P), regardless of whether the asset is depreciable or not, the amount of S less P is known as Capital Gain. The Tax rate for t on capital gains (tcg) is about half of the tax rate for (t) for regular income. Capital loss is the reverse of this process when the amount of S is less than P (S

Typically, depreciable assets are those that have declining value as time passes and they age. In such assets, CCA is claimable as they are used. Similarly, Non-depreciable assets are those that do not depreciate with time, assets such as bonds, stocks and land among many others. In case of non-depreciable assets, no CCA is claimable.

It is of utmost importance to keep in mind that when a capital asset is disposed off by selling, its Undepreciated Capital Cost is rarely equal to its Salvage Value, and the difference usually has tax insinuations.