Corporate tax adjustments and an unlawful dividend proposal
Nexus Trading (Pvt) Ltd is a resident company with a year ended 31 March 2025. Accounting profit before tax is LKR 18.0 million. The accounts include: depreciation LKR 2.4 million; a donation of LKR 1.2 million to a political party; business entertainment LKR 0.9 million; a late VAT penalty LKR 0.15 million; a general provision for doubtful debts LKR 0.6 million; and legal fees of LKR 0.25 million for acquiring a new machine. Tax depreciation allowances for the year are LKR 3.1 million and do not include any allowance for the legal fees. The company is not a small or medium enterprise and the standard corporate income tax rate applies. Separately, the directors propose a dividend of LKR 5 million to be paid from a revaluation reserve of LKR 8 million. The company has accumulated losses of LKR 2 million, cash of LKR 3 million and current liabilities of LKR 9 million. The bank has not given any waiver of its loan covenants.
1. Compute taxable income and income tax for the year ended 31 March 2025. Explain each adjustment.
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Taxable income computation: Accounting profit before tax: LKR 18.00m Add accounting depreciation: 2.40m Less tax depreciation allowances: (3.10m) Add political party donation: 1.20m Add business entertainment: 0.90m Add late VAT penalty: 0.15m Add general doubtful debt provision: 0.60m Add legal fees on machine acquisition: 0.25m Taxable income = LKR 20.40m Tax at 30% = LKR 6.12m
Reasoning: accounting depreciation is replaced by tax depreciation. A donation to a political party is not deductible. Business entertainment is disallowed. Fines and penalties, including a late VAT penalty, are not deductible. A general provision is not a specific bad debt write-off and is disallowed. Legal fees to acquire a capital asset are capital and are added back; if they form part of the machine's capital cost and qualify for allowances, the company should claim the correct allowance, which would reduce taxable income.
2. Advise the board on whether the proposed LKR 5 million dividend can lawfully be paid.
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The board should not proceed on the current facts. A revaluation reserve is generally unrealized and is not a distributable profit. Dividends must be paid out of distributable profits and the company must satisfy the solvency test under the Companies Act: it must be able to pay its debts as they fall due, and its assets must exceed its liabilities.
The company has accumulated losses of LKR 2 million, cash of LKR 3 million and current liabilities of LKR 9 million. Paying LKR 5 million would leave it with negative liquidity and would likely breach the solvency test. Directors who approve an unlawful distribution risk personal liability and repayment. The board should obtain legal advice, restore distributable profits and cash flow first, and document the solvency assessment before declaring any dividend.
3. Explain how the tax treatment would change if the LKR 0.25 million legal fees were treated as part of the machine's capital cost.
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If the legal fees are directly attributable to bringing the machine into use, they may form part of the capital cost of the machine for tax purposes. In that case, the LKR 0.25 million should not simply be added back and ignored; it should be included in the capital allowance base and depreciated at the applicable tax rate.
The current computation adds back the full LKR 0.25 million because no allowance has been claimed. If a qualifying allowance is available, taxable income would fall by the allowance attributable to the LKR 0.25 million. The company should review the tax depreciation schedule, claim any missed allowance and amend the return if necessary. The key judgement is whether the fees are capital or revenue in nature and whether they are directly attributable to the asset.