Taxation of leases that are not long funding leases: How tax advantages arise: tax timing disadvantages of finance leasing, a worked example
Tax timing advantages arise where the rate of capital allowances gives rise to initial tax losses.
Where an asset has a very short life there will be no initial tax deferral, and the rate of capital allowances may mean that the lessor has unrelieved expenditure at the end of the lease term.
For example, capital allowances will write off only about 58% of the value of an asset over three years and yet if the lease is for only three years the lessor will have received income to cover the initial cost and its cost of borrowing.
- Asset cost £30,000.
- Lease is for 3 years at £1,000 a month, so gross rentals £36,000.
- Lessors’ costs of borrowing are £4,000.
- The lessor’s commercial profit is £2,000.
However, after 3 years the lessor
- has received taxable income of £36,000
- has allowable interest relief of £4,000
- has capital allowances of about £17,300
- leaving it with taxable profits of £14,700
Eventually, the lessor will receive the remaining capital allowances of £12,700 (£30,000 less £17,300), thus reducing its taxable profits to £2,000. But that takes some time and, in the meantime, early payment of tax has to be funded at a cost to the lessor that must be included in the lease rentals.
In some cases it would be possible for a lessor to enter into a hire purchase arrangement that would eliminate the problem. This is, however, understood not always to be possible, particularly in the case of leased software.