Henrietta Aguirre, CGA, is the newly hired director of corporate taxation for Mesa Incorporated

Henrietta Aguirre, CGA, is the newly hired director of corporate taxation for Mesa Incorporated, which is a publicly traded corporation. Aguirre's first job with Mesa was to review the company's accounting practices for future income taxes. In doing her review, she noted differences between tax and book depreciation methods that permitted Mesa to recognize a sizeable future tax liability on its balance sheet. As a result, Mesa did not have to report current income tax expenses. Aguirre also discovered that Mesa had an explicit policy of selling off plant and equipment assets before they reversed in the future tax liability account. This policy, together with the rapid expansion of Mesa's capital asset base, allowed Mesa to defer all income taxes payable for several years, at the same time as it reported positive earnings and an increasing EPS. Aguirre checked with the legal department and found the policy to be legal, but she is uncomfortable with the ethics of it.

Instructions

(a) Why would Mesa have an explicit policy of selling assets before they reversed in the future tax liability account?

(b) What are the ethical implications of Mesa's deferral of income taxes?

(c) Who could be harmed by Mesa's ability to defer income taxes payable for several years, despite positive earnings?

(d) In a situation such as this, what might be Aguirre's professional responsibilities?

(a)  Accelerated depreciation, such as the double declining balance method used for income tax purposes, allows a company to deduct substantial capital cost allowance early in the asset’s life.  Yearly CCA declines to a point where the accelerated CCA amount is lower than the depreciation expense computed under the straight-line method. The reversing point occurs when the accelerated CCA matches the straight-line rate.  Some companies are motivated to sell assets prior to this point to maximize the CCA benefit provided in terms of income taxes.  The selloff might result in less recaptured CCA being reported and taxed at ordinary income tax rates.   In addition, as long as the company is growing, the company may receive a prolonged deferral of income taxes.

(b)    The deferral of income taxes means that, due to temporary differences caused by the difference in financial accounting principles and tax laws, a company will be able to defer paying its income taxes until future periods. The practice of selling-off assets before they reverse means that the company may pay a lesser amount of taxes to the government.

(c)    Shareholders would be harmed by Mesa’s income tax practice. In order to maintain this policy, and using the mechanism described in (a) above, the company has to systematically acquire new assets at a cost higher than the previously disposed assets. To repurchase assets at a lower cost would trigger recaptured CCA in several cases. This means that management is probably embarking on a short-term policy of improving its financial picture at the cost of a damaging cash management policy, or it is indebting itself. One would also have to question whether there is a legitimate need for these new assets. This would be demonstrated by a decrease in the effectiveness of their use of assets in declining return-of-assets or asset-turnover ratios.

(d)    As a CGA, Henrietta is obligated to uphold objectivity and integrity in the practice of financial reporting. If she thinks that this practice is unethical, then she needs to communicate her concerns to the highest levels of management within Mesa, including members of the Board and/or the Audit Committee. However, it would appear here that Mesa is simply trying to minimize its income taxes, which should not be considered unethical.

Current tax legislation permits taxpayers to arrange their affairs in order to pay the minimum amount of tax—when it is done within tax rules. However, transactions whose sole purpose is to avoid paying income taxes and have no bona fide business purpose can be caught under GAAR (General anti-avoidance rules). These transactions, if caught, could be recharacterized by Canada Revenue Agency.