Each year, we have a number of conversations with clients about financing expenditure on projects, whether that’s a business acquisition or simply investing in IT, premises or other fixed assets in order to support a growth strategy.
In this blog we address the typical questions that clients have when considering acquiring assets for their business.
- I understand that the mainstream choices are leasing or Hire Purchase (HP) – how will these different finance arrangements affect my accounts?
Sadly, this is a not a straight forward answer! With HP you bring the net (i.e. excluding VAT) value of the asset on to the balance sheet at the date that you take delivery. Although, technically, the asset doesn’t belong to you at that stage it’s treated as if it does. You depreciate the asset using the depreciation rate that you apply to other assets of the same type. The capital repayments to be made under the agreement are recognised as future liabilities on the balance sheet so this will affect areas like a company’s gearing ratio which looks at the value of debt compared to the value of shareholders’ funds. Interest payments should be recognised over the course of the agreement and should be calculated with reference to the capital outstanding – this method is sometimes called “Sum of Digits” or “Rule of 78”.
Where it gets a bit tricky is the different types of lease arrangements. The accounting rules look at two types of arrangement – the first is an operating lease and the second is a finance lease. In the minds of we accountants, this is what each of those mean:
An operating lease involves the lessee paying a rental for hire of an asset for a period of time which is normally substantially less than its useful economic life. The lessor retains most of the risks and rewards of ownership of an asset in the case of an operating lease.
A finance lease usually involves payment by a lessee to a lessor of the full cost of the asset together with a return on the finance provided by the lessor. The lessee has substantially all the risks and rewards associated with the ownership of an asset, other than the legal title. In practice all leases transfer some of the risks and rewards of ownership to the lessee, and the distraction between a finance lease and an operating lease is essentially one of degree.
So, clear as mud then!
As a rule of thumb, if the value of the total net lease payments (so without VAT) over the term of the lease exceeds the net value of the asset at the date of the agreement, then it’s likely to be a finance lease arrangement.
In accounting terms, a finance lease is treated in the same way as an HP agreement, but an operating lease is notably different with no recognition of the future capital repayment liabilities and no distinction between capital and interest. The monthly payments (net) are recognised each month in the Profit and Loss Account, and that’s pretty much it.
One word of warning here though, the accounting standard setters are looking at leasing at the moment and it is expected that they will propose that operating leases should be treated in the same way as finance leases.
- How does tax relief work for the different types of arrangement?
Let’s start with corporation tax and with HP agreements. The net value of the asset (assuming we’re talking about plant or equipment – there are different rules for cars) will be treated as qualifying expenditure for the purposes of capital allowances and at the moment will be eligible for the Annual Investment Allowance (AIA) which gives tax relief at 100% of the cost of the asset in the year it is acquired up to a value of £200,000. After that, tax relief is available for the interest cost that you recognise in the Profit and Loss Account over the course of the agreement.
With finance leases, although the accounting treatment is the same as with HP agreements, the tax rules work differently. The main reason for this is that the leasing company will be claiming capital allowances for the asset that they’re leasing to you, and two businesses can’t each claim capital allowances for the same asset. As the lessee, because you can’t claim capital allowances, you can’t claim under the AIA either. Instead, what happens is that you are given effective tax relief for the depreciation charge that goes through the Profit and Loss Account each year as well as the interest cost.
An operating lease is rather more straight forward when it comes to tax. You simply get tax relief in line with whatever expense is recognised in the Profit and Loss Account.
Turning to VAT, the general principles are that with an HP agreement you will pay and reclaim the input VAT at the date you enter into the agreement, and with either a finance lease or operating lease VAT will be charged (and therefore reclaimable) on the monthly rentals. An exception to these general principles is with regard to motor cars where you cannot claim the VAT on HP financed vehicles at all, whereas in most cases, with monthly rentals, you can claim 50% of the input VAT.
Tax is not the be all and end all when deciding on how to finance an asset but it can certainly make a difference and you should consult your normal UHY contact if you’re unsure, particularly when considering a large amount of expenditure.
It’s actually a bit more complicated than that but you wouldn’t thank us for going into the detail! Your normal UHY contact will be able to advise you more fully.