East Side Products Ltd. (ESP) recently expanded its business by acquiring the operations of a competitor. As a result of the expansion, additional office space was needed. On the first day of the current fiscal year, ESP rented additional premises under a five-year lease agreement with two three-year renewal options. As an inducement to sign the lease, the landlord paid ESP $20,000 to cover part of the cost of improving the offices. Before occupying the premises, ESP spent $38,000 for necessary renovations.
Profits from business operations for the current year are expected to be $175,000. Because of the expansion, future years’ profits are expected to exceed $550,000 annually. For several years, ESP had invested its excess cash from annual profits in secure bonds. The proceeds from all of these bonds were used to acquire the competitor’s business. For the next several years, the company will again invest excess cash in secure bonds; it expects to earn an average yield of 9%.
ESP is a Canadian-controlled private corporation. The first $500,000 of annual business profits are subject to a 15% tax rate. Annual business profits over $500,000 are taxed at 25%.
Required:
Describe the alternative tax treatments for the inducement payment. Which treatment should ESP use? Show a detailed calculation that compares the tax cost of each alternative.