In this article, John Davison gives a brief overview of the different ways a business can acquire assets, such as company cars, and the accounting and tax implications.
When assets are acquired by a business the way this is financed will change the accounting and tax treatment. This article gives a brief overview of the differences. It would, however, be prudent to obtain professional advice as the differences between the various financing products can be difficult to ascertain and providers of finance often describe their products differently.
It is also important to remember that accounting and tax treatments may differ where a car is the asset being financed; there are often exceptions to the general rules that are being described. For example, while VAT incurred on a new car that is purchased is generally not recoverable, where the car is used in the trade for resale, taxis or driving schools, the VAT can be reclaimed. To further complicate matters VAT on secondhand cars is often charged in such a way that it cannot be reclaimed by any business.
Identifying the finance product
The key for determining the accounting and tax treatments of products is to identify the finance product that is being used to acquire the asset.
A purchase is perhaps the clearest financial product. Title passes to the new owner and any financing is often not tied to the asset even when a loan may be taken out to finance the acquisition and the loan may be provided by a third party.
Hire purchase (also called lease purchase) is similar to a purchase. The key distinguishing feature of a hire purchase agreement is that the asset is actually hired until the final payment is made when title passes to the purchaser. As it is envisaged that title will pass to the purchaser, a hire purchase agreement is treated as a purchase for most purposes.
Accounting standards define an operating lease as any lease that is not a finance lease. So, understanding what a finance lease is becomes important. A finance lease is where the leasing business (the lessor or the owner of the asset) buys the asset for the user (the hirer or lessee) and rents it to the user for an agreed period. The finance lease transfers the risks and rewards of ownership to the lessee, it is as if the lessee (the user) has bought the asset. Usually, the finance lease commits the lessee to make payments for the cost of the asset. Often the payments require a large or balloon payment at the end of the agreement. At the end of this period of leasing (usually called the primary finance lease period) there are several possible outcomes (which will depend upon the agreement that is entered into). The lessee may sell the asset to a third party on behalf of the lessor. The asset can be returned to the lessor for the lessor to sell. Or, the lessee may enter into a secondary lease period.
The difference with an operating lease is that the risks and rewards of ownership of the asset are retained by the owner/lessor. Operating leases are frequently called contract hire agreements. As the lessor has an interest in the asset the lease will usually run for less than the economic life as the asset and it is expected that the asset will have a residual value at the end of the lease period. The lessee gets to use the asset over the agreed contract period but the payments made do not cover the full cost of the asset (usually in a finance lease the full cost of the asset is charged over the life of the lease agreement). At the end of the lease agreement the asset is usually returned to the lessor as ownership has been retained by the lessor. It is possible for it to be re-hired to the lessee.
Accounting and tax treatments
Where an asset is purchased the asset will be included on the balance sheet. A deduction will be made in the accounts for the depreciation of the asset. Depreciation cannot be claimed as a tax deduction. Instead of depreciation a capital allowance is claimed.
A different treatment for those that are cash accounting, which is available for businesses with a turnover of less than £150,000.
Where total assets acquired have a value less than £200,000 a full deduction can be made using the annual investment allowance (AIA). An AIA cannot be claimed on cars, but cars with a CO₂ emissions of less than 75g/km qualify for a full deduction as a first year allowance. Purchases in excess of this amount are eligible for a writing down allowance. There are three pools for writing down allowances. Most assets will be included in the main pool where a writing down allowance each year of 18% is allowed. This includes cars with emissions between 75g/km and 130g/km. The special rate pool applies to certain long-life assets and cars with CO₂ emissions of more than 130g/km.
The VAT on the purchase of an asset is usually reclaimable in full but needs to be supported by the supplier’s tax invoice. VAT on cars is usually non-deductible even when used in the business.
Assets that are acquired by way of hire purchase follow the same accounting and tax treatment as those that are bought outright.
Finance leases are treated differently for purchases and hire purchases. Where the finance lease is a short lease (up to seven years), the accounting treatment follows the legal position. The rental payment made is shown as an expense in the accounts. The lessee will claim the rental payment as a tax deduction, but where the CO₂ emissions exceed 130g/km only 85% of the rental payment is allowed (15% is disallowed). Where the lease is a long-funded lease (usually those leases that last over seven years), the asset is capitalised in the accounts and future rentals are shown as liabilities in the balance sheet. Rents are apportioned between the finance charge and a reduction of the outstanding liabilities. The total finance charge is shown as an expense in the profit and loss account. The tax treatment follows the accounting treatment and the lessee can claim capital allowances on qualifying assets. VAT incurred can be claimed but where the asset is a car only 50% of the car lease can be claimed (but the full amount of any maintenance charge can be claimed).
The asset is not capitalised for an operating lease. The rental charge is charged as an expense in the profit and loss and is allowed as a deduction for tax. Where, however, the CO₂ emissions of the car exceeds 130g/km only 85% of the rental is allowed as a deduction. Again, only 50% of the VAT on the leasing charge can be claimed.
A change to the accounting and tax rules is being introduced for accounting periods starting on or after 1 January 2019 for leases. This will only impact the largest businesses as IFRS only applies to listed companies, although the standard can be adopted by other businesses if they wish. If this impacts your business it would be prudent to take further advice.
The rules concerning the tax and accounting treatment of acquiring assets are complex. Determining what type of lease is the first hurdle to overcome. It is then necessary to identify the cash effect of the tax treatment. Are the costs incurred allowed or is a capital allowance allowed? Can the full cost be deducted or is there a 15% restriction? Where there is a capital allowance, how much can be claimed (the full amount, 18% or 8%?). Finally, how much VAT can be reclaimed? These are important factors to take into account when deciding whether to use a finance or operating lease, or to buy.