When it comes to buying business assets - whether they be company cars or factory equipment - there are a number of ways to finance the purchase.
Deciding the method of finance can make a significant difference to the after-tax cost to the business, its cash flow, and its overall financial position.
Some of the most common forms of finance used include:
There are a number of tax and financial issues associated with each of these different types of financing and, while the tax treatment is important, it is by no means the only consideration and nor should it be the dominant motivating factor.
For cars purchased or leased through the company there are a number of additional tax considerations such as the luxury car limit (currently $57,009) and Fringe Benefit Tax (FBT).
For comparison purposes, I have assumed an asset will be used 100% for business purposes and, for a car, that the GST-exclusive cost of the car is less than the luxury car limit.
Where the luxury car limit is exceeded, the tax and GST treatment may differ and for cars where there is private use by employees, there are often FBT consequences. Where there is private use by sole business proprietors there will be both a partial loss of tax deductions and GST input tax credits.
There are a number of other factors that should be considered against the type of financing that is available, not only these tax considerations.
General considerations
Surplus cash
- Where the business has surplus cash available, at first the obvious thought could be to use it to finance purchases and save interest costs. However, the alternative uses for the funds (eg as working capital to fund business expenses, to repay existing business debt, to fund profit distributions to the business owners, or for other investment in the business) should be considered carefully. It may therefore be in the best interests of the future of the business to retain these funds and purchase new assets with cheaper finance available elsewhere.
- Thus the relative cost of different types of finance available should be considered. For example, it may be best to use surplus cash available to repay any high cost existing business debt and borrow to acquire the new assets (perhaps by commercial hire purchase or lease finance) at a lower implicit interest rate. It might even be best to use part of the cash in hand and finance the rest.
- With an outright purchase, any GST credits will generally be available at the time the asset is purchased, whether the business accounts for GST on the cash or accruals basis. This could impact on cash flow.
- While the purchase may be a lump sum, depreciation is claimed on cost at a rate that writes off the cost of the asset over the asset's effective life. For example, cars are estimated to have an effective life of eight years, giving a depreciation rate of 12.5% p.a. prime cost, or 18.75% p.a. diminishing value.
Purchase from general borrowings
- It may be possible to fund an asset purchase from the business overdraft or other general business borrowings at a comparable, or better, interest rate to commercial hire purchase or lease finance. If so, it could be simpler to use the general borrowings of the business to acquire the assets, rather than obtaining specific asset finance. This can save time and the complication of administering another debt.
- Taking this approach, for example for taking advantage of an under-utilised bank overdraft and very strong cash flow, can often be the best and easiest option , giving extra negotiating power on the price of the asset being purchased. However, the risk of tying up the company’s easy access to funds in the future must be assessed.
- Unlike a hire purchase loan, where a purchase is funded from general borrowings, any GST credits will generally be available at the time the asset is purchased, whether the business accounts for GST on the cash or accruals basis.
- Again, depreciation is claimed on the purchase cost from the date of purchase over the effective life of the asset. The interest on the business borrowings from which the purchase was funded is also tax-deductible.
Commercial hire purchase (HP)
- An important consideration is to understand the interest rate implicit in HP finance, both for comparison with alternate forms of finance and for comparison between different financiers. It is always worth shopping around as different rates and fees often make a big difference in the total after-tax cost.
- Hire purchase is also more flexible than general finance as an HP agreement can be structured with either an up-front 'balloon payment’ or a ‘residual payment’ at the end of the term. In both these instances the balance is payable in equal monthly instalments. However, there are also some inflexibilities built in. For example, while HP loans may be terminated early, there is often a penalty interest charge for doing so. The business must also take ownership of the asset (generally by making the residual payment) before selling it or trading it in.
- While an up-front GST credit is available for businesses accounting for GST using the accruals basis, this is not available where the business uses the cash basis. Under the cash basis, the GST credit to be claimed is calculated as 1/11th of the principal portion of the total HP payments made during the relevant month or quarter, i.e. the credit is claimed progressively over the term of the HP loan.
- As with an outright purchase, where HP finance is used depreciation may be claimed on the purchase cost over the effective life of the asset, and a tax deduction is also available for the interest portion of each monthly HP payment.
Lease finance
- As with HP finance, it is essential for purposes of comparison to know the interest rate and total fees and charges implicit in any form of lease finance.
- Unlike HP finance, in certain circumstances lease finance may be kept ‘off-balance sheet’, which is sometimes desirable.
- Like an HP loan, a finance lease may often be structured with either an up-front ‘balloon payment’ or (more commonly) a ‘residual payment’ at the end of the term. The balance is then payable in equal monthly instalments. Again, there is often a penalty interest charge for early termination.
A distinguishing feature of a lease is that the business has no specific right to acquire ownership at the end of the lease term, and is not compelled to make the residual payment. There is generally an understanding that the business may make an offer to acquire the asset from the financier for an agreed residual amount.
If the business does not wish to acquire the asset it may simply be returned to the financier for sale or trade-in, although generally the business will be required to pay any shortfall between the sale proceeds and the agreed residual amount. This may make it easier for a business to upgrade or roll over its cars and business equipment, particularly where there is a need to keep up with changing technology.
- Unlike HP finance, a lease agreement does not involve the sale of the asset, and GST is not charged on the purchase cost. Instead, GST will be charged on the full amount of each lease payment, and the business will be entitled to claim a GST credit equal to 1/11th of each lease payment that is made during the relevant month or quarter.
- Also unlike HP finance, tax deductions are not claimed for depreciation and interest charges, but instead a tax deduction is available for the full amount of each monthly lease payment. While the overall tax treatment, over the full term of the loan, will be the same whether HP finance or lease finance is chosen, there can be a timing difference in the tax deductions available, and this should be considered.
Novated lease
- This is a form of lease involving a three-way agreement between a financier, an employer, an employee, under which the employer agrees to assume responsibility for monthly lease payments for the term of the lease, or until employment ceases. The employer’s role ceases at the end of the lease term or upon termination of employment, and any offer to purchase the car is made by employee, with no further obligations for the employer.
- Novated leases provide greater flexibility for both employers and employees, particularly for company cars, as the employer has no continuing liability for cars leased by departing employees, and the consequences for dealing with the car at the end of the lease term (whether the car is retain, sold or traded in) fall entirely on the employee.
Table – GST and income tax treatment
| Acquisition method | GST credits # | Income tax deductions (if income or business use) |
|---|
| Cash | - Full input tax credit on purchase
- Input tax credits for running costs
|
- Running costs
- Depreciation *
|
| Loan | - Full input tax credit on purchase
- Input tax credits for running costs
|
- Interest on loan
- Running costs
- Depreciation *
|
| Hire purchase | - Accruals basis – full input tax credit on first payment or receipt of invoice, whichever is earlier
- Cash basis – input tax credits claimed on each payment
- Input tax credits for running costs
|
- Interest component
- Depreciation *
- Running costs
|
| Lease | - Input tax credits claimed on each lease payment due (accruals basis) or paid (cash basis)
- Input tax credits for running costs
|
- Lease payments
- Running costs
Luxury car (cost > $57,009):
- Interest component
- Depreciation *
- Running costs
|
| # If the GST-inclusive cost of a car is more than the car depreciation limit ($57,009 in 2004/05), the input tax credit is limited to 1/11th of that limit. Therefore, the input tax credit for cars is currently limited to $5,183.
* Depreciation is limited to the car depreciation limit of $57,009 where the cost of the car (less any GST input tax credit claimed) exceeds this threshold. |
10 key points to consider
- When deciding how to finance business assets take all relevant commercial issues into account – never make financing decisions based solely on the tax treatment, or the particular asset in isolation.
- Consider the alternative uses of available surplus cash before deciding whether to purchase business assets outright. If practical, and taking future needs and considerations into account, use surplus cash or existing funding wholly or in part. However, don’t cripple the future of the business by tying up all surplus cash and existing funding arrangements unless you are sure that your cash flow needs are taken care of.
- Compare the interest rates and other costs such as fees and duties implicit in alternatives forms of finance. Some finance companies quote a total monthly repayment amount including fees and duty, but others do not. Make sure you compare like with like.
- A key advantage of HP finance is that it can be very flexible and for most SMEs this can be a key consideration.
- Lease finance may allow debt to be kept ‘off-balance sheet’. Again, for some businesses this can be a major advantage.
- Lease finance does not require the business to buy the asset at the end of the lease term (unlike HP finance), and may be well suited to assets that will be regularly upgraded such as cars and business equipment.
- Novated leases are particularly suited to financing company cars, as the employer’s obligations cease when the employee leaves their employment.
- The overall tax treatment is the same for lease finance and HP finance, but there are timing differences in the tax deductions available under each. The situation is more complicated for ‘luxury’ cars costing more than $57,009.
- HP finance provides an up-front credit for the GST included in the cost of the asset if the business is accounting for GST on the accruals basis – a cash flow benefit.
- There is no such advantage for businesses using the cash basis for GST, however, and GST calculations under HP finance are more complicated than under lease finance.
The final, overriding, consideration is whether the purchase is really necessary and whether the business is in a position to fund it. Vanity purchases, such as a luxury car for a fledgling business, can be a warning sign that the owner is losing focus.