Practice problem — Answer

a) Reconciliation approach

Net income per draft financial statements $ 55,104

Add:
Provision for income taxes 29,671
Depreciation (Note 1) 18,100
Charitable donations (Note 2) 5,000
Non-deductible golf fees (Note 3) 3,750
Non-deductible meals and entertainment (Note 4) 2,625
Staff Christmas party is 100% deductible (Note 5) -
Penalties and interest (Note 6) 850
Financing fee paid (Note 7) 5,000
Salary to husband — reasonable (Note 8) -

Deduct:
Gain on sale of investment (Note 9) (23,475)
Rental income (Note 10) (5,500)
Financing fee (1/5 of $5,000) (Note 7) (1,000)
Reserve for services to be performed (Note 11) (7,500)
Capital cost allowance (Note 1) (25,400)
Net income for tax $ 57,225

Notes:

Note 1: Accounting depreciation is not deductible for tax purposes. Capital cost
allowance calculated for tax is deductible in determining net business income for tax.

Note 2: Charitable donations are not deductible in determining net business income
for tax. Charitable donations form the basis for a tax credit that Leigh may deduct in
calculating her personal taxes payable.

Note 3: Green fees are considered club dues and recreation fees that are not
deductible for tax purposes.

Note 4: 50% of the cost of meals and entertainment is deductible. The costs of both
the season's tickets to the local hockey team and the meals with clients are subject to
this rule. The required adjustment is ($2,000 + $3,250) / 2 = $2,625.

Note 5: The cost of the Christmas party is 100% deductible, provided all employees
are invited to attend.
Note 6: Penalties and interest on late payment of income taxes are not deductible.

Note 7: Fees incurred for the purpose of borrowing money are deductible on a
straight-line basis over five years [per ITA 20(1)(e)]. The $5,000 fee paid to the bank
and expensed in the year for accounting purposes is added back, and 1/5 of $5,000 =
$1,000 is deducted for tax purposes over five years.

Note 8: The salary paid to Leigh's husband is the same as the amount Leigh would
have had to pay to an arm's length person, so it is reasonable and, as a result,
deductible for tax purposes.

Note 9: The gain on sale of the investment is not considered business income. One-
half of the gain will be included in the taxable capital gains section of Leigh's
personal tax return.

Note 10: The rental income is not considered business income. It will be included in
the property income section of Leigh's personal tax return.

Note 11: A reasonable reserve is deductible for goods that will be provided in the
future.
Note 12: Bad debt expense is based on accounts written off in the year. Accounts
written off in the year are specifically allowed as a deduction under the ITA.

b) T2125 approach

Plumbing revenue: $229,000 – $7,500 (Note 1) $ 221,500

Gain on sale of investments (Note 2) -
Rental income (Note 3) -
Advertising expense: $7,500 – $5,000 (Note 4) (2,500)
Bad debts (3,750)
Fee paid to bank to acquire financing: $5,000 / 5 (Note 5) (1,000)
Interest on bank loan used to acquire equipment (Note 6) (7,750)
Cost of the staff Christmas party (Note 7) (4,500)
Meals and entertainment expense (Note 8) (2,625)
Professional fees (1,250)
Rent (17,500)
Repairs and maintenance (12,450)
Travel (2,750)
Wages and benefits (Note 9) (82,800)
Capital cost allowance (25,400)

Net business income $ 57,225

Note 1: The amount received from the customer prior to the services being provided
is not taxable until the work has been done.

Note 2: The gain on sale of the investment is not considered business income. One-
half of the gain will be included in the taxable capital gains section of Leigh's
personal tax return.

Note 3: The rental income is not considered business income. It will be included in
the property income section of Leigh's personal tax return.

Note 4: Charitable donations are not deductible in determining net business income
for tax. Charitable donations form the basis for a tax credit that Leigh may deduct in
calculating her personal taxes payable.

Note 5: Fees incurred for the purpose of borrowing money are deductible on a
straight-line basis over five years; 1/5 of $5,000 = $1,000 is deducted.

Note 6: Interest on the loan to acquire equipment is deductible because the loan was
used to acquire property used to earn business income.

Note 7: Cost of the staff Christmas party is fully deductible, assuming all staff were
invited.

Note 8: 50% of the cost of meals and entertainment is deductible. The costs of both
the season's tickets to the local hockey team and the meals with clients are subject to
this rule. The required adjustment is ($2,000 + $3,250) / 2 = $2,625.

Note 9: The salary paid to Leigh's husband is the same as the amount Leigh would
have had to pay to an arm's length person, so it is reasonable and, as result, deductible
for tax purposes.