Reference no: EM13510408

QUESTION

Miracle Muthi Ltd manufactures a tonic made from the African potato, garlic and olive oil. It manufactures this tonic at its own factory situated just outside Bloemfontein. The manufacture of the tonic is regarded as a manufacturing process by the South African Revenue Service (SARS).

Miracle Muthi Ltd is a resident of the Republic for tax purposes. Its financial year ends on the last day of February each year. Its 2006 annual financial statements, which include the effects of the journal entries below, reflect net income before tax of R3 534 500.

In preparation of its annual financial statements a number of unrelated journal entries were made, some of which were as follows:
1 Investment in rent-producing property
Dr Cr
Investment property 250 000
Income statement (fair value adjustment) 250 000
Investment in a property valued at its fair value in terms of IAS 40,
Investment property (AC 135)
Explanation: Miracle Muthi Ltd purchased a rent-producing property, namely a four-bedroom house, two years ago for R600 000. The house is subject to an annual fair value adjustment. On 28 February 2006 its fair value was R1 050 000. (On 28 February 2005 its fair value was R800 000.)
Dr Cr
Bank 48 000
Income statement (rental) 16 000
Income received in advance (creditors) 32 000
Rental received for six months, of which four months are in advance
Explanation: Miracle Muthi Ltd lets the property at a market-related rental. The tenant paid
R48 000 to Miracle Muthi Ltd on 7 January 2006, being rental for the six-month period 1 January 2006 to 30 June 2006. The rental for the four months that fall in its 2007 financial year has been included in Miracle Muthi Ltd's creditors.
2 Investment in 'local' listed shares
Dr Cr
Investment in a 'local' listed company 180 000
Bank 180 000
Investment in a 'local' listed company
Income statement (fair value adjustment - investment) 11 000
Investment in a 'local' listed company 11 000
Investment in a 'local' listed company restated at its fair value
Explanation: On 1 September 2005 Miracle Muthi Ltd purchased shares in a 'local' listed company as an investment for R180 000. It does not deal in shares. On 28 February 2006 the fair value of this investment was R169 000. In accordance with IAS 39, Financial instruments:

recognition and measurement (AC 133), Miracle Muthi Ltd classified this investment as 'at fair value through profit and loss'.
Dr Cr
Bank 16 000
Income statement (sundry income: 'local' dividend) 16 000
'Local' dividend received from its investment in the 'local' listed company
Explanation: On 31 January 2006 Miracle Muthi Ltd received a 'local' dividend of R16 000 from its investment in the 'local' listed company. This was the only dividend that accrued to it in its 2006 financial year.

3 Capitalised finance lease
Dr Cr
Computer 300 000
VAT input account 42 000
Lease liability 342 000
Computer purchased under a finance lease
Lease liability 130 000
Bank 130 000
Settlement of the first annual lease rental under the finance lease
Income statement (finance charges) 2 607
Lease liability 2 607
Interest for one month (to 28 February 2006) calculated as follows:
(R342 000 - R130 000) x 14,756% x 1/12
Income statement (depreciation) 5 000
Accumulated depreciation 5 000
Depreciation on the computer for the 2006 financial year calculated as
follows: R300 000 x 20% x 1/12
Explanation: On 1 February 2006 Miracle Muthi Ltd leased a computer for a three-year period at a lease rental of R130 000 per annum payable annually in advance. Miracle Muthi Ltd capitalised this finance lease in its accounting records. The lease agreement reflects a cash cost for the computer of R300 000, VAT of R42 000 and finance charges of R48 000. On 1 February 2006 Miracle Muthi Ltd paid its first annual rental of R130 000.

4 Impaired plant
Dr Cr
Income statement (depreciation) 30 000
Accumulated depreciation 30 000
Depreciation on the plastic bottle plant at 20% per annum on the
straight-line basis
Income statement (impairment loss) 25 000
Accumulated impairment 25 000
The plastic bottle plant reflected at its recoverable amount
Explanation: Miracle Muthi Ltd used to sell its tonic in plastic bottles, but stopped doing so in order to comply with environmental requirements. The plant that was used to fill the plastic bottles with tonic is now only used occasionally, and solely for special export orders.

Because of the decline in popularity of plastic bottles the value of this plant has also declined. After provision for depreciation of R30 000 for its 2006 financial year, the carrying amount of the plant was R30 000. It originally cost R150 000 (excluding VAT) and depreciation has been provided at a rate of 20% per annum on the straight-line basis. The asset was acquired, brand new, on 1 March 2002 and it qualified for the section 12C allowance from that date as it was immediately brought into use. Its market value is now R5 000, which is both its scrap value and the recoverable amount. To reduce the value in the financial statements to the recoverable amount, an impairment loss of R25 000 was charged to the income statement.

5 New plant
Dr Cr
Plant 750 000
Bank 750 000
Purchase on 1 September 2005 of a tablet-making plant
Income statement (depreciation) 75 000
Accumulated depreciation 75 000
Depreciation on the tablet-making plant at 20% for the 2006 financial
year calculated as follows: R750 000 x 20% x 6/12

Explanation: Miracle Muthi Ltd now also sells its tonic in tablet form, which necessitated the purchase of plant to convert the tonic into tablets. Miracle Muthi Ltd purchased a new and unused tablet-making plant on 1 September 2005 which was immediately brought into use.

6 Defined benefit pension fund
Dr Cr
Defined benefit pension liability 432 000
Bank 432 000
The contribution of Miracle Muthi Ltd (as the employer) to the pension fund
Income statement (defined benefit pension expense) 253 000
Defined benefit pension liability 253 000
The charge for the net pension expense to the income statement for the
2006 financial year. This amount was determined as follows:
Current service costs
Plus: Interest cost on pension obligation
R
225 000
610 000
Less: Return on pension plan assets
835 000
570 000
Less: Actuarial gains recognised
265 000
12 000
Charge to income statement 253 000

Explanation: Miracle Muthi Ltd employees contribute 6% of their salaries to the company's pension fund, while the company contributes on the basis of R2 for each R1 contributed by an employee, which in effect means that the company contributes 12% of the value of employees' salaries to the pension fund. SARS has indicated that it will limit Miracle Muthi Ltd's tax deduction under the provisions of section 11(l) to 10% of salaries.

Miracle Muthi Ltd has a defined benefit fund. At the end of the company's financial year an actuary determines the pension fund assets and liabilities. Miracle Muthi Ltd provides for a defined benefit pension liability in terms of IAS 19, Employee benefits (AC 116). On 1 March 2005 the balance of its defined benefit pension liability was R1 million.

7 Prepaid expenses
Dr Cr
Prepaid expenses (balance sheet) 60 000
Income statement (insurance) 40 000
Income statement (property rates) 15 000
Income statement (Medical Council levy) 5 000
The portion of the above expenses that relates to its 2007 financial year

Explanation: Miracle Muthi Ltd pays the insurance premium on its business assets, the property rates for its trade premises and a levy to the Medical Council annually in advance.

Amount
paid
(excluding
VAT)
Date paid Period covered
Insurance premium R60 000 29 October 2005 1 November 2005 to 31 October 2006
Property rates R18 000 24 December 2005 1 January 2006 to 31 December 2006
Levy to the Medical
Council
R12 000
27 July 2005
1 August 2005 to 31 July 2006
There were no prepaid expenses at 28 February 2005.
8 Doubtful debts
Dr Cr
Income statement (increase in the provision for doubtful debts) 9 000
Provision for doubtful debts 9 000
The adjustment to increase the provision for doubtful debts from
R33 000 to R42 000
Explanation: The SARS has agreed that Miracle Muthi Ltd may claim only 25% of its accounting provision for doubtful debts as a tax deduction in terms of section 11(j) of the Income Tax Act. The same agreement applied in its previous year of assessment.

9 Bad debt
Dr Cr
Income statement (bad debt expense) 27 200
Loan to employee 27 200
The amount owing by an employee, Mr Mali, written off as a bad debt
Explanation: Miracle Muthi Ltd is not a moneylender, but on 1 March 2003 lent R20 000 to an employee, Mr Mali, to partly finance his study expenses. The loan was at an interest rate of 12% per year. However, Mr Mali has for the past three years neither repaid any portion of this loan nor any of the interest due. It is clear that he will not be able to repay any of the amount owing and the company has therefore decided to write off the amount of the loan as well as the interest as a bad debt.
11
10 Cottages for employees
Dr Cr
Buildings (ten cottages) 1 500 000
Bank 1 500 000
The erection of ten cottages at R150 000 each
Bank 1 500 000
Debentures 1 500 000
Funds borrowed to pay for the cottages
Buildings (pre-production interest on the ten cottages
capitalised)
67 500
Bank 67 500
The debenture interest for the first six months
Buildings (pre-production interest on the ten cottages
capitalised)
22 500
Income statement (interest incurred) 45 000
Bank 67 500
The debenture interest for the second six months
Income statement (depreciation of buildings) 26 500
Accumulated depreciation on buildings 26 500
Depreciation on these buildings provided for in terms of IAS 16,
Property, plant and equipment (AC 123), and calculated as follows:
(R1 500 000 + R67 500 + R22 500) x 5% x 4/12
Explanation: On 1 March 2005 Miracle Muthi Ltd commenced with the erection of ten cottages (ten dwellings) on its own premises. These cottages were completed at a cost of R150 000 each on 30 October 2005. They were occupied rent-free by ten of its employees as from 1 November 2005. To finance the entire cost of the cottages, Miracle Muthi Ltd issued 9% debentures on 1 March 2005. Interest on the debentures is payable six monthly.
11 Share options
Dr Cr
Income statement (staff costs - share options) 37 500
Equity (share options) 37 500
The cost of the equity settled options of the third and final year of the
vesting period recognised as follows:
(50 x 1 000 x R3) x 9/36 = R37 500
Previously recognised as follows up to 28 February 2005:
(50 x 1 000 x R3 x 27/36) = R112 500
Loan to employees 500 000
Equity (share options) 150 000
Share capital 50 000
Share premium 600 000
500 000 shares with a nominal value of R1 each issued to employees in terms of the share option scheme
12
Dr Cr
Loan to employees 20 000
Income statement (interest accrued) 20 000
Interest accrued on the loan to employees at a rate equal to the
dividend declared
Explanation: On 1 December 2002 Miracle Muthi Ltd granted share options to 50 of its employees, enabling each of them to purchase 1 000 Miracle Muthi Ltd shares at R10 a share. The par value of a Miracle Muthi Ltd share is R1. Each option had a fair value of R3 on the grant date. Each grant is conditional on the employee remaining in the employ of the company until 30 November 2005. During its 2003, 2004 and 2005 financial years it was estimated that no employee would leave Miracle Muthi Ltd's employ before the vesting date (30 November 2005).

Indeed, all 50 employees were still employed on 30 November 2005 and exercised their options on this date. The value of a Miracle Muthi Ltd share was then R16. In terms of the articles of association of the company, the employees are not entitled to continue to hold the shares after they cease to be employed by the company.

Miracle Muthi Ltd granted loans of R10 000 each to the employees for the purchase of the shares. The loans bear interest at a rate equal to the dividend that accrues to the employee. On 28 February 2006 a dividend of R400 accrued to each of the 50 employees. (It should be noted that this share option scheme is not a 'broad-based employee share plan' as envisaged by section 8B and section 11(lA) of the Income Tax Act.)

12 Research and development
Dr Cr
Income statement (research costs) 60 000
Development costs (balance sheet) 180 000
Bank 240 000
Research and development costs incurred to determine the viability of producing the tonic in tablet form Income statement (amortisation of development costs) 18 000

Development costs (balance sheet) 18 000
Capitalised development costs being written off over a five-year period
commencing on 1 September 2005
Explanation: Miracle Muthi Ltd first researched the viability of producing its tonic in tablet form and then commenced development work on this 'new' format. The company capitalised the development costs incurred in accordance with IAS 38, Intangible assets (AC 129). The intangible asset arising out of this development work was available for use on 1 September 2005 and is being amortised over a five-year period. Although the development costs are being capitalised, it does not consist of a building, machinery, plant, implement, utensil, or other article of a capital nature as listed in section 11B(3) of the Income Tax Act.

13 Disposal of land and administration building
Dr Cr
Accumulated depreciation - Land and buildings 2 300 000
Bank 5 000 000
Land and buildings 4 800 000
Income statement (profit on disposal) 2 500 000
Disposal of land and administration building
13
Explanation: Miracle Muthi Ltd acquired a new administration building which it occupied in the current financial year. As a consequence, the previous land and administration building became excess to requirements and was disposed of in the open market for R5 million (excluding VAT) on 15 August 2005. The land and building were originally acquired prior to 1 October 2001 at a cost of R1 million (excluding VAT). Improvements of R3,8 million (excluding VAT) were effected in 1979. No other improvements were made prior to 1 October 2001. Miracle Muthi Ltd valued the land and building as at 1 October 2001 for capital gains tax purposes at R4 500 000 and has not claimed any tax allowances on the land and building. The time-apportionment base cost (TABC) has been calculated at R4 833 333.

REQUIRED

(a) Calculate the taxable income of Miracle Muthi Ltd for its financial year ended 28 February 2006. Start with net income before tax of R3 534 500. Support your answer with workings and reasons.

(b) Calculate the temporary differences at 28 February 2006 in respect of the following items only:

• Capitalised finance lease;
• Prepaid expenses;
• Cottages for employees; and
• Capitalised development costs.

Indicate in each case whether the temporary difference is taxable or deductible. Provide reasons for your calculations.