5 QUESTION 2 40 marks This question consists of two parts. During the course of the audit of Cemer Holdings Ltd and its subsidiaries for the year ending 31 March 2004, a number of tax related issues have arisen. As the tax advisor you have been asked to advise on two of these matters, which are set out below. ISSUE 1 13 marks During July 2003, IT Systems (Pty) Ltd, a Cemer Holdings Ltd subsidiary, won a R105 million (excluding VAT) government tender for the provision of 21 000 personal computers to the Department of Education – i.e. at a price of R5 000 (excluding VAT) per computer. IT Systems (Pty) Ltd has to manufacture the personal computers to set specifications. IT Systems (Pty) Ltd received an advance payment of R5 million from the Department on 15 November 2003. This amount was used to partially finance the acquisition of new manufacturing equipment in January 2004, at a cost of R6 million (excluding VAT), that will be used to manufacture the personal computers. IT Systems (Pty) Ltd is expected to start actual production of the personal computers, using the new manufacturing equipment, in June 2004. The total direct and indirect manufacturing costs are estimated to be in the order of R4 000 (excluding VAT) per computer (i.e. the gross profit is expected to be approximately 20% of the selling price). The personal computers must be delivered to the Department at a fixed rate of 1 000 every month from and including the month of July 2004. All 21 000 computers must be delivered to the Department by March 2006. Ownership of the personal computers will pass upon delivery. The Department will be invoiced on the last day of each month for that month’s deliveries. The amount owed by the Department in respect of the deliveries for July 2004 (to be invoiced on 31 July 2004) will be set off against the advance payment of R5 million received by IT Systems (Pty) Ltd in November 2003. Thereafter the Department must pay each invoice on or before the end of the following month. On 1 July 2003 IT Systems (Pty) Ltd paid R60 000 for advertising space for 12 monthly issues of a local IT magazine. This payment covers the monthly issues for the period 1 July 2003 to 30 June 2004. REQUIRED (a) State what amounts should be included in the taxable income of IT Systems (Pty) Ltd in each of the 31 March 2004, 2005 and 2006 years of assessment as a result of the above transactions. (4) (b) State what amount(s) IT Systems (Pty) Ltd will be entitled to claim as a deduction or allowance in each of these three years of assessment as a result of the above transactions. (9) You may assume that all the entities are registered VAT vendors. Give reasons to support your answers and show all workings. ISSUE 2 27 marks Properties (Pty) Ltd, a subsidiary of Cemer Holdings Ltd, owns the office building in which the personnel of the Cemer Holdings Ltd group is located. All the shares in Properties (Pty) Ltd are held directly by Cemer Holdings Ltd. The group’s personnel only utilise one of the available five floors of the office building. The remaining four floors of office space are rented out to third parties. The management of Cemer Holdings Ltd is considering disposing of the building as the return on the group’s investment has been poor. This is mainly due to the inefficiency of the management of 6 Properties (Pty) Ltd in administering the building and collecting rental from third party tenants. Cemer Holdings Ltd is considering the following two options: Option A: Sale of Properties (Pty) Ltd shares Cemer Holdings Ltd has received an offer of R23 million from a third party for all the shares in Properties (Pty) Ltd. In addition, its loan to Properties (Pty) Ltd of R4 million would be repaid in full prior to transferring the shares to the third party. Option B: Winding-up Properties (Pty) Ltd Under this alternative Cemer Holdings Ltd would cause Properties (Pty) Ltd to dispose of its assets, after which Properties (Pty) Ltd would be liquidated. If this option were followed, the following amounts are expected to be realised by Properties (Pty) Ltd, net of any selling costs, on the sale of its assets (see balance sheet set out below): Office building Trade receivables – ceded to a factoring house “without recourse” Motor vehicles R million 21,0 8,2 0,7 Once the liquidator had settled all the Properties (Pty) Ltd liabilities, all surplus cash would be distributed to Cemer Holdings Ltd. The balance sheet of Properties (Pty) Ltd as at 31 March 2004 shows the following assets and liabilities: Notes R’000 ASSETS Office building Motor vehicles Trade receivables Cash on hand 1 2 3 18 000 400 9 000 700 Total assets 28 100 EQUITY AND LIABILITIES Capital and reserves Share capital and share premium Non-distributable reserve Retained income 4 5 6 15 000 6 000 1 000 Shareholders’ funds 22 000 Liabilities and provisions Loan from Cemer Holdings Ltd Accounts payable 4 000 2 100 Total equity and liabilities 28 100 Notes 1 Office building Properties (Pty) Ltd acquired this building in 1995 at a cost of R13 million. It was revalued in 1999 to R18 million and the revaluation surplus was transferred to the non-distributable reserve (see note 5). On 1 October 2001 Properties (Pty) Ltd revalued the building for capital gains tax purposes for an amount of R19,5 million. 2 Motor vehicles The vehicles originally cost R1,1 million in total. The book and tax values of the vehicles are the same. None of the vehicles has a realisable (market) value in excess of its original cost. 7 3 Trade receivables These all relate to outstanding rentals due from third party tenants and arose during the previous two financial years. The company has never previously factored its debtors. 4 Share capital and share premium The share capital and share premium total R15 million, which includes capitalised reserve profits of R5 million. The company had only one capitalisation issue, a one for two issue, in 1999. The capitalised revenue profits were earned during the March 1998 year. 5 Non-distributable reserve The reserve consists of – Capital profit on sale in 1998 of a flat used by the directors Revaluation surplus – office building (see note 1) R’000 1 000 5 000 6 000 6 Retained income Consists of only revenue profits earned during the March 2002 to March 2004 years. 7 Tax The company has no assessed loss, no assessed capital loss and no secondary tax on companies (STC) credits available. Other information The shares in Properties (Pty) Ltd originally cost Cemer Holdings Ltd R7 million in September 1985. On 1 October 2001 Cemer Holdings Ltd valued the shares at R21 million for capital gains tax purposes. Cemer Holdings Ltd has neither an assessed loss nor an assessed capital loss. Both companies have elected not to use the Time Apportionment Base Cost method to calculate their gains or losses for purposes of capital gains tax. REQUIRED Advise the Board of Cemer Holdings Ltd about which of the two options would result in Cemer Holdings Ltd receiving the greater cash proceeds on disposal of its investment in Properties (Pty) Ltd, after taking account of any tax resulting from the transactions. Give reasons and calculations to support your advice. Ignore the future cost to the group of leasing office space, and under Option B ignore the cost of liquidator’s fees.