Taxation — Integrated Problem 1

Scenario (90 minutes)

It is April 1, 2023. You, CPA, have just met with Jenny Ellis, the CFO of Home Decor
Inc. (HDI), a new client. Your tax consulting firm will be preparing HDI’s corporate tax
return this year. Jenny provided you with financial statements and other information
needed to prepare the return (Appendix).

Task #1

Prepare a memo to Jenny regarding the gain on the sale of the vacant land (Appendix –
item #5.). The memo should provide an analysis of how the gain should be treated for
tax purposes.

Your memo should be no longer than one page, excluding any Excel files.

Task #2

In Excel, prepare a calculation of HDI’s taxable income for the year ended
December 31, 2022. In addition, determine property income and net taxable capital
gains included in net income and aggregate investment income (AII) included in taxable
income of HDI for the year ended December 31, 2022.

For the purposes of this analysis, assume that the gain on the sale of the land is a
capital gain.

Your memo should be no longer than one page, excluding any Excel files.

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2022-10-12
Taxation — Integrated Problem 1 Problem

Task #3

Much of the “other information” received from Jenny came in the form of spreadsheets,
which is what HDI uses to track its capital asset transactions. Jenny started using the
spreadsheets when HDI was run by Jenny and one assistant, and as the company has
grown, so has the number and complexity of the spreadsheets. While HDI’s accounting
software has the ability to track almost all of the information contained in the
spreadsheets, Jenny has never transferred the data, believing that “why fix what’s not
broken?”

However, Jenny reconsidered her position recently when a significant error was found in
the depreciation worksheet. She would like some guidance on whether she should
continue to use the spreadsheets or transfer the data to the accounting system. She
would like your advice on the best way to manage the data transfer, should it be
necessary.

Other relevant information to consider is that the spreadsheets are unprotected. They
require neither a password to open the file, nor to make any changes to data or
formulas. They are located in the general “Finance” folder on the HDI’s admin server,
which is backed up weekly.

HDI’s accounting software is an established enterprise software solution, with back-ups

every 12 hours, and 24-hour support. Each user has a unique username and password,
and the system automatically prepares an electronic audit trail.

Please prepare a memo that discusses any benefits of using spreadsheets as well as
any data quality and security concerns you have over leaving HDI’s accounting
information in a spreadsheet, and the impact that may have on the company. Be sure to
address Jenny’s request regarding the best way to manage a data migration.

Your memo should be no longer than two pages, excluding any Excel files.

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Taxation — Integrated Problem 1 Problem

Appendix

Home Decor Inc. — Tax information

Extracts from statement of profit and loss
For the year ended December 31
(in $’000s)

2022 2021
(unaudited) (audited)

Sales $19,643 $15,470

Cost of sales 13,755 10,904
Gross profit 5,888 4,566

Operating expenses:
Selling and general operating 3,896 2,936
General and administrative 337 300
Amortization 232 181
4,465 3,417
Operating income 1,423 1,149

Other income (expenses):

Interest and other income 237 118
Interest and other expenses (125) (72)
Earnings before taxes 1,535 1,195

Income taxes expense (recovery) 211 211

Net income $ 1,324 $ 984

Retained earnings, beginning of year $ 3,474 $ 2,640

Net income 1,324 984
Dividends - (150)
Retained earnings, end of year $ 4,798 $ 3,474

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Appendix (continued)

Extracts from statement of financial position

As at December 31
(in $’000s)

2022 2021
(unaudited) (audited)
Assets
Current:
Cash and cash equivalents $ 37 $ 21
Short-term investments 69 100
Investment in Kids Place Inc. 350 327
Receivables 1,690 1,289
Merchandise inventory 3,107 2,180
5,253 3,917
Unlimited life franchise 68 -
Property, plant, and equipment, net 2,433 2,575
$7,754 $6,492

Liabilities
Current:
Bank indebtedness $ 25 $ 349
Accounts payable and accruals 342 430
Deferred revenue 65 195
Income taxes payable 0 48
432 1,022
Long-term debt 1,247 720
Other liabilities 177 176
1,856 1,918

Shareholders’ equity
Share capital 1,100 1,100
Retained earnings 4,798 3,474
5,898 4,574

$7,754 $6,492

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Appendix (continued)

1. The following were included in selling, general, and administrative expenses:

Charitable donations $ 3,000

Reserve for potential merchandise theft 7,500
Season tickets to the local junior hockey team used for business 2,000
Staff Christmas party 4,500
Green fees for golf games with customers 4,000
Dinners attended with customers 3,250

2. The following were included in interest and other income:

• Taxable Canadian dividends of $10,000 from public corporations.
• HDI owns 40% of Kids Place Inc. (KPI) common shares. Equity income of
$35,000 on this investment is included in other income. During the year, HDI
received a $12,000 non-eligible dividend from KPI. KPI received an $8,000
dividend refund in the year.
• Interest income includes $9,800 on an investment in bonds and $1,200 from
overdue trade accounts receivable.
• Temporary investments were sold for $53,500, resulting in a gain on sale of
$14,000 based on the difference between the selling price of the investments and
the net book value of those investments of $39,500. The investments originally
cost $29,400.
• Included in other income is an unrealized holding gain on temporary investments
of $8,200.
• A government grant of $96,400 to assist with the cost of purchasing the new
warehouse (see “capital assets” below) was recognized in other income.

3. The following were included in interest and other expenses:

• Brokerage fees of $2,000 were incurred on the sale of temporary investments
noted above.
• $850 of interest was paid to the Canada Revenue Agency (CRA) for the late
payment of 2021 taxes.
• Legal fees of $2,500 were incurred to negotiate the terms of a debenture to
finance the acquisition of the new property (information provided below).

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Appendix (continued)

4. Capital assets:

The ability to immediately deduct the cost of $1.5 million of eligible depreciable
property acquired in 2022 has been allocated to an associated company and is not
available to HDI in 2022.

The undepreciated capital cost of the assets owned by HDI as at December 31,
2021, was as follows (after the 2021 capital cost allowance claims):

Class 1 (Note 1) $422,000

Class 8 (Note 2) 90,400
Class 10 (Note 3) 194,300
Class 50 56,400

Note 1

The Class 1 building and associated land were sold in the year for proceeds of
$920,000. The net book value of the land and building was $890,000, and the
accounting gain is included in other income. Sixty percent of the selling price was
allocated to the land, and the remainder is attributable to the building. The original
cost of the building was $490,000, and the original cost of the land was $530,000.
Prior to the acquisition of a new warehouse, this was the only Class 1 building
owned by HDI.

During the year, HDI paid $1,240,000 to acquire a new property that will be used as
a warehouse. The cost allocated to the building was $794,000, and the remainder of
the cost was allocated to the land.

Note 2

Furniture with a net book value of $89,000 was sold in the year for $89,000 and new
furniture costing $120,500 was purchased.

Note 3

During the year, HDI traded in an old delivery truck. A new delivery truck was
acquired for $34,500 net of a trade-in value of $9,800 for the old delivery truck. No
gain or loss was reported on the disposal of the old delivery truck because the trade-
in value was equal to the net book value.

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Appendix (continued)

5. Other information:

In 2021, HDI purchased a piece of land for $326,000 in order to build a building on
the land. At the time the land was purchased, it was not zoned for industrial use, but
HDI was quite confident it could apply for and obtain rezoning. If HDI was unable to
obtain rezoning, it was sure it could sell the land for more than it paid for the land.
While HDI waited for rezoning approval, the land was used as a temporary parking
lot. Income earned and interest and property taxes incurred were as follows during
2021 and 2022 (prior to the sale of the land):

Interest and
Year Income property taxes
2021 $4,500 $6,200
2022 $2,400 $3,600

Despite repeated attempts, HDI was unsuccessful in obtaining the required

rezoning. In 2022, HDI listed the land with a realtor and sold it for $396,500.

An unlimited life franchise was purchased for $68,000 in 2022.

HDI’s 2021 notice of assessment indicates HDI has a $2,000 net capital loss carry-
forward from 2015.

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