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Finance leases – some interesting tax implications

We are back to the normality of the working week after such an exciting weekend of sport and music with the Munster and Leinster hurling finals and Glastonbury to calm us all down afterwards. The Cats & Tipp would have started as favourites with Kilkenny on quite familiar territory in Croke Park and Tipp given the superb form that they had been in so far this year.  The biggest crowd of the GAA calendar so far this year, nearly 52,000, were in Croke Park with at least 40,000 coming from Wexford. Cody and co would be very disappointed as they were in the game all along but the concession of the late penalty with Rory O’Connor waltzing in unopposed would have been hard to take for the former full back and the following panic, when there would usually be calm, to get a goal when points would do.  Despite my disappointment there were great scenes of joy for the yellow bellies at the final whistle and there wouldn’t have been much work done down there on Monday.  Limerick had a super win against Tipp and looked hugely impressive in the second half when all the parts of the well-oiled machine came together to lord it over the neighbours. With all the sport I didn’t get to see much of Glastonbury bar a brief look at Stormzy on Friday night when I realised, pretty quickly, that this wasn’t my cup of tea and the button on the remote got pressed very swiftly. My 14 year old son told me he liked him on the way up to Dublin on Sunday. Enough said getting old!! However I got to see Hozier in Cork last Tuesday evening and he was just immense. What a voice and talent.    

Coming back to our series of “You ask we answer” we had two interesting queries on assets purchased by finance lease and a subsequent trade in of that asset against a new asset. These came from a client and another accountant. We will look at the Income Tax and Corporation Tax implications of leasing assets and how deposits or trade ins are dealt with.  

Leased Asset

When looking at this type of finance one of the first things to understand is who has the legal ownership of the asset. When the asset is leased under a finance lease it is the leasing company [lessor] who retains legal ownership. Therefore the person acquiring the asset [lessee] doesn’t have legal ownership. There is a primary leasing period. This is the period over which the asset will be effectively paid for and is usually over 3, 4 or 5 years or whatever is the norm for the type of asset being acquired.  At the end of the primary period the lessee can continue to lease the asset for a nominal amount. This is known as the secondary period. 

Tax adjustments

In the accounts of the lessee the asset goes into the balance sheet of the business so depreciation and finance charges would go into the profit and loss account. When completing the adjusted profit computation for the business the depreciation and finance lease interest is added back to the net profit. That is the bad news. The good news is that the lease payments can be taken as a deduction in the adjusted profit computation. Let’s look at an example

Boris Escobar runs a very good grass cutting business and he needs to purchase a new mower in 2019. His net profit, per his accounts for the year ended 31st June 2019 come to €100,000. During that year he had to purchase a new mower for €50,000. He decided to purchase this by way of a finance lease and with interest charges of €5,000 the total cost over the 5 year primary period is €55,000. Boris will repay €11,000 per annum, of which €1,000 is interest and €10,000 is a repayment of capital.  The adjusted profit computation would look as follows;

Net Profit per the Accounts100,000
Add back: Lease Interest1,000
Deduct: Lease Payment(10,000)
Adjusted Profit91,000

Trade ins or up-front payments

A trader may only wish to finance some of the cost of the leased asset with the balance of the cost coming from two possible sources

  • Trade-in of an asset including a leased asset, or
  • An up-front payment made by the lessee to the supplier of the asset

The above upfront payments are regarded as an advance payment of leasing charges and are written off, not in the year of payment or trade-in but over the primary lease period.

Therefore, if Boris had decided at the outset to put €20,000 of his money down as a deposit, to save on the interest cost and reduce the repayments over the coming 5 years then the deposit (upfront lease payment) would be written off over the primary lease period and not in full in the year the deposit was paid. In this scenario Boris is paying back €33,000 in total, in the 5 year primary period, with €30,000 being the capital repayment and €3,000 being the interest element. 

The adjusted profit computation would be as follows;           

Net Profit per the Accounts100,000
Add back: Lease Interest600
Deduct: Lease repayment(6,000)
Deduct: Lease upfront payment (€20,000/5 years)(4,000)
Adjusted Profit90,600


Similarly, if Boris had an old mower, that was leased, to trade in against the cost of the new mower, we can look at what the tax implications would be. Let’s assume the value of the old mower was €15,000 and the profits, per the previous example, were €100,000 to the end of June. He was trading this machine in against the cost of the new mower for €50k. In this case the trade in value is treated as a refund of lease payments and unfortunately for Boris this is treated as a trading receipt. In this scenario Boris is paying back €38,500 in total, in the 5 year primary period, with €35,000 being the capital repayment and €3,500 being the interest element.  The adjusted profit computation would be as follows;

Net Profit per the Accounts100,000
Add Back: Lease Rebate15,000
Add Back: Lease Interest700
Deduct: Lease repayment(7,000)
Deduct: Rebate payments (€15,000/5 years)(3,000)
Adjusted Profit 105,700


From a tax point of view the above scenario is not ideal in that Boris is caught for the rebate of lease rentals in year 1 and only get a right off for that over the primary leasing period. The additional €12,000 will cost Boris at least 52% [€6,240] in tax but it will be even higher than that given that he is getting into the top USC rate of 11%. However if Boris was trading through a limited company then the additional tax would only be €1,500 as the company rate is 12.5%.    

Leasing v Hire Purchase

We often get asked the question from clients whether they should acquire an asset on Hire Purchase [HP] or by leasing and it will always depend on the circumstances of each particular case.  This question is more relevant for those carrying on a trade as a sole trader or in partnership given the low corporate tax rate. From a leasing perspective the key is how long the business owner will hold onto the asset. Will he/she dispose of the asset at the end of the primary leasing period or would the intention be to enter into a secondary leasing period where they pay a nominal rent for a number of years. The big advantage of leasing is that the cost is written off over the primary leasing period.

If we take our first example above Boris is getting a deduction for the cost of the asset over a 5 year period which is a deduction of €10,000 per annum. When acquiring a machine under HP you are regarded as owning that machine and can claim capital allowances at 12.5% per annum. So effectively the cost is written off over 8 years. If Boris had acquired the machine by HP the write off would be €6,250 per annum plus he would also get a deduction for the HP interest of €1,000. Therefore the total deduction under HP is €7,250 but €9,000 under leasing.  However, as seen from above, Boris could get caught at the end of the leasing period for a rebate of lease rentals which is a nasty surprise that he may not be aware of. However should Boris enter into a secondary lease for another few years then the rebate should be a lot lower. Under the capital allowances regime the penalties at the end are not quite as severe and any balancing charge can be reduced if a machine is replaced in the same basis period [We will look at this in a later blog]  

Summary

In summary leasing seems like the best option especially when leasing machinery or vehicles over a shorter primary period and once the lease ends entering into a secondary period.  However the business owner needs to be very mindful of the rebate of lease rentals especially when not trading through a company. The main thing is to seek the advice of your accountant before deciding on the best option for you so that they can run the figures.

In our client’s case he completed the transaction before contacting us. He traded in a leased asset against the cost of a new machine and the rebate of lease rentals came to €35,000 and the leasing period of the new asset was 7 years so the deduction or write off of the rebate was only €5,000. Therefore the net cost was €30,000 in year one. Ouch!!!

See attached link to the Revenue Tax and Duty manual on leasing



 

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