Share Capital, Taxation

Problem Solutions

Review Questions – Ch 12

1.When a company has either been trading unprofitably for a number of years orsuffers abnormally large losses in a single year, it may have accumulated losses.Despitethese losses, which have eroded capital, a company may still be viable and be able toearn profits in the future. In these circumstances, it is reasonable to recognise thatsome of the capital has been lost and to reduce its value accordingly.

A further reasonfor engaging in capital reduction is that the CompaniesAct 2006 prohibits the distributionof current profits before past losses have been made good, but allows pastlosses to be removed fromthe calculation of distributable profits if they arewritten offin a capital reduction.

Thus, a capital reduction scheme enables dividends to be paidfromcurrent profits despite the fact that losses have beenmade in the past that have notbeenmade good.Also, a reduction scheme that removes accumulated lossesmakes thecompanymore attractive to prospective investors and providers of credit.

  1. The benefits to a company holding treasury shares are that it has greater flexibility to respondto investors’ attitude to gearing, e.g. reissuing the shares if the gearing is perceived to be toohigh. It also has the capacity to satisfy loan conversions and employee share options withoutthe need to issue new shares which would dilute the existing shareholdings.

Problems – Ch 12

  1. Ch 12 Question 3 – Doxin Plc – p.313

This question is essentially concerned with the issue and redemption of shares by a plc where there is a trading loss that has an impact on the cash liquidity position.

Part (a) requires students to illustrate the effect on key balance sheet components.

Part (b) requires a discussion and evaluation of the effects of applying capital maintenance rules in circumstances where shares are redeemed partly out of distributable profits.

(ii) (a) Premium on redemption:

  • Out of profits or
  • Lowest of
  • Premium received on issue of shares to be redeemed (£75,000),
  • Balance of share premium account including premium on new issue (£20,000) and
  • Total proceeds of the new issue (£220,000).

(ii) (b) Capital redemption reserve:

  • excess of nominal value of shares redeemed over total receipt from new issue (£300,000 − 220,000 = 80,000).

Comments on Doxin plc

(a) (i) The issue of 200,000 ordinary shares at a premium of 10p each increases the sharecapital, the share premium and cash balance. Please note that the issue must be madewithin specified time limits if it is to be effective in applying the capital maintenancerules that require a transfer to capital redemption reserve.

(ii) On redemption of the preference shares, it is necessary to calculate the extent towhich the premium on redemption can be charged to the share premium account, andthe transfer, if any, to the capital redemption reserve from distributable profits – in thiscase, from the general reserve £200,000.

The full premium on redemption can be charged to the share premium account, whichwas brought into existence by the replacement issue. The limitation imposed by per centpremium originally received on the shares does not apply.

The preference shares (300,000) disappear from the balance sheets and the sharepremium account becomes £5,000 with the bank balance reduced by £315,000.

The transfer from general reserve to CRR is always in excess of nominal valueredeemed over the proceeds of other issue (made specifically for redemption).

(iii) The issue of 7 per cent debentures £4,000 valued at £90 results in a long-termliability of £400,000 and a net increase in the bank balance of £360,000 with discounton debentures £40,000.

The Companies Act 1985 is silent on treatment of this item apart from the option towrite it off against the share premium account. Write-off over the life of the debenturemight be the appropriate treatment.

(iv) The use of the share premium balance £5,000 to cover a bonus issue of ordinaryshares is reflected by a transfer to the ordinary share capital account as permitted by theCompanies Act 1985.

(v) The trade loss £500,000 incurred in the year is recorded as impacting on the bankbalance, where it creates an overdraft of £35,000.

(b) The interest of creditors is protected by the creation of the CRR £80,000, which is nondistributableand can only be used to issue bonus shares.

However, because of the use of share premium account (SPA) to cover premium onredemption, £15,000, the original capital of £1,100,000, is only maintained up to £1,085,000capital, that is, issued share capital plus undistributable reserves.

The effect of this loophole in capital maintenance regulation could be remedied by anadditional transfer from distributable profit to CRR – in this case, £15,000.

  1. Ch 12 Question 4 – Share buybacks – p.314

(a) The advantages of purchasing and cancelling own shares

It is a method of returning surplus cash that a company is unable to invest profitably within thecompany.

It can also overcome a problem when shares are acquired from a dissenting shareholder toremove the nuisance value.

It provides cash as a help to shareholders in liquidating their shareholding when shares havebeen issued to employees as part of a profit-sharing scheme and the employee wishes to convertthem to cash or when they are acquired from the estate of a deceased shareholder.

It improves the share price if the directors consider that the current share prices are undervalued– on cancellation; each remaining share has a greater interest in the net assets.

It is taken as a means of increasing the earnings per share.

(b) The advantages of purchasing and holding shares in treasury

It provides a company with greater flexibility in managing its share capital.

It allows a company to optimise its gearing by buy-back instead of increasing or decreasing itsdebt.

It reduces the cost of raising new capital when the shares are reissued later through a brokerinstead of a more expensive placing or rights issue.

It can stimulate an inactive market particularly if existing shareholders have been finding itdifficult to sell their shares.

It can lead to an increase in the earnings per share.

Treasury shares can be used to satisfy the exercise of employee share options and may beacquired at the date the option is granted and held in treasury.

Review Questions – Ch 16

1.Because of differences between reporting income under accounting rules and calculating tax according to tax rules. These differences lead to a mixture of permanent, temporary and timing differences in when tax falls due for payment.

2.There are four main reasons why deferred taxes areimportant in truly understanding the financial situation of a company’s earnings:

  • Provides a more accurate calculation of accrualearnings
  • Provides a more accurate measure of your equityposition
  • Moderates earnings by increasing the tax liability in“good” years (reducing income) and decreasing the tax liability in “bad”years (increasing income)
  • When deferred taxes decrease from one year to the next, a tax reversal is created thereby providingcushion to the earnings
  1. See p.408-410. In taxavoidance, people take advantage of the tax law to find ways to reduce their total tax liability. This is entirely legal and many people practice it every year at tax time. With taxavoidance, taxpayers seek out tax credits, write-offs, and other means of cutting down on their tax liability.

With taxavoidance, people declare all of their income as required by law and submit other financial documents as needed, and the means used to reduce their tax liability are clearly documented on their tax returns.

With taxevasion, people avoid taxes by hiding or moving income, making false claims on a tax return, and utilizing other illegal means to pay less on their taxes. Some tax evaders avoid paying taxes altogether; people who work as independent contractors or receive monies under the table for their work, for example, may simply not declare this income and thereby avoid paying taxes on it.

The line between taxavoidance and taxevasion can sometimes be very fine. There are some things people can do with their money that are perfectly legal under the law, but could be read as attempts to evade taxes. Moving funds suspiciously and with no clear reason or documentation can attract the attention of tax authorities. Once tax authorities suspect someone of taxevasion, they will scrutinize that taxpayer closely.

4. See p.416/417. Deferral method uses the tax rate in effect at the time the deferred tax arises and so there may be several tax rates being applied in the cumulative deferred tax account.

The Liability method uses the current tax rate in application at the time of reporting. Thus, whenever the tax rate changes, the total balance in the deferred tax account is calculated at the current tax rate.

  1. See p.424/425

Ch 16 Question 2 – Adjourn plc – p.430

(b) Requirement

Under the liability method the focus is on the statement of financial position (the objectivebeing to compute the deferred tax liabilities), whereas the deferral method places the focuson the profit and loss account (the objective being to show the annual effect that has arisenin the year of account).