In Year 1, with Book Depreciation of 10 per year and Tax Depreciation of 15 in Year 1, what are the Book NI and Tax NI changes (assume 40% tax rate and a starting Pre-Tax Income of 100)?

In Year 1, with Book Depreciation of 10 per year and Tax Depreciation of 15 in Year 1, what are the Book NI and Tax NI changes (assume 40% tax rate and a starting Pre-Tax Income of 100)?

• A. Book Pre-Tax Income down 10; Book Net Income down 6; Tax Net Income down 9
• B. Book Pre-Tax Income down 10; Book Net Income down 6; Tax Net Income down 6
• C. Book Pre-Tax Income down 15; Book Net Income down 9; Tax Net Income down 4
• D. Book Pre-Tax Income down 5; Book Net Income down 2; Tax Net Income down 12

Answer: (A)

A key idea here is that depreciation changes both pre-tax earnings and, through taxes, net income, but book and tax depreciation can differ, creating a tax shield that changes net income differently under each basis. Start with a baseline pre-tax income of 100. Book depreciation is 10, so Book pre-tax income becomes 90. With a 40% tax rate, tax on this is 0.40 × 90 = 36, leaving Book net income of 90 − 36 = 54. Relative to the baseline net income of 100 − 40 = 60, Book net income has fallen by 6. For tax purposes, depreciation reduces taxable income by 15, so taxable income is 100 − 15 = 85. Tax on that is 0.40 × 85 = 34, so Tax net income is 85 − 34 = 51. Relative to the baseline net income of 60, Tax net income has fallen by 9. Therefore, the changes are: Book pre-tax income down 10 (from 100 to 90), Book net income down 6, and Tax net income down 9. The larger tax depreciation creates a bigger tax shield, causing a bigger drop in Tax net income compared with Book net income.

A key idea here is that depreciation changes both pre-tax earnings and, through taxes, net income, but book and tax depreciation can differ, creating a tax shield that changes net income differently under each basis.

Start with a baseline pre-tax income of 100. Book depreciation is 10, so Book pre-tax income becomes 90. With a 40% tax rate, tax on this is 0.40 × 90 = 36, leaving Book net income of 90 − 36 = 54. Relative to the baseline net income of 100 − 40 = 60, Book net income has fallen by 6.

For tax purposes, depreciation reduces taxable income by 15, so taxable income is 100 − 15 = 85. Tax on that is 0.40 × 85 = 34, so Tax net income is 85 − 34 = 51. Relative to the baseline net income of 60, Tax net income has fallen by 9.

Therefore, the changes are: Book pre-tax income down 10 (from 100 to 90), Book net income down 6, and Tax net income down 9. The larger tax depreciation creates a bigger tax shield, causing a bigger drop in Tax net income compared with Book net income.