Taxation — Practice Case 6

Case (120 minutes)

It is October 13, 2023. 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 owner 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, CPA Canada, CPA

are trademarks and/or certification marks of the Chartered Professional Accountants of Canada.
© 2023, Chartered Professional Accountants of Canada. All Rights Reserved.

Les désignations « Comptables professionnels agréés du Canada », « CPA Canada » et « CPA »

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© 2023 Comptables professionnels agréés du Canada. Tous droits réservés.
2022-10-13
Taxation — Practice Case 6 Case

Appendix I
Email from Hayley King

Date: October 10, 2023

From: Hayley King, BSL
Subject: Shiraz Deodorant Inc. (SDI)

Hi Mr. Koulev,

I think acquiring SDI is a good business opportunity. Since 2014, 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, 2021 and 2022, and for the first nine months ended
September 30, 2023. SDI’s financial statements are prepared in accordance with
accounting standards for private enterprises (ASPE). The planned closing date is
November 1, 2023.

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 2004.

Please also provide any other relevant advice.

Thanks,

Hayley

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Appendix II
Excerpts from financial statements

Shiraz Deodorant Inc.

Balance sheet
(in thousands of dollars)

Sept. 30, Dec. 31, Dec. 31,

2023 2022 2021
(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

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Appendix II (continued)
Excerpts from financial statements

Shiraz Deodorant Inc.

Income statement
(in thousands of dollars)

Year-to-
date
Sept. 30, Dec. 31, Dec. 31,
2023 2022 2021
(unaudited) (audited) (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 — 895 945
amortization
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

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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 2021 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 2021 and 2022.

• 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, 2022, SDI had $2 million in non-capital loss carry forwards, plus
unclaimed charitable donations of $120,000 from 2022. The non-capital losses were
generated in fiscal 2019 and 2022 and the earliest ones will expire in 2039. I would
like to fully use the losses well before they expire.

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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

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