Income Tax Implications of Finance Leases for the Lessee
15 August 2013
Posted by: Author: Doria Cucciolillo
Author: Doria Cucciolillo (The SAIT)
Assets used by a taxpayer to conduct business do not necessarily belong
to such a person but the use of these assets may have been acquired in terms of
a lease agreement. There are two main types of leases, namely operating leases
(where rent is paid in exchange for the right to use an asset) and finance leases
(which is a method used by the lessee to finance the purchase of an asset).
This article focuses on the Income Tax implications that result from
finance lease agreements from the perspective of the lessee. Simultaneously the
Value-Added Tax (VAT) implications of finance leases need to be considered as
the amounts recognised for Income Tax purposes should exclude amounts that was
declared or claimed for VAT-purposes.
The accounting treatment of finance leases in terms of the International
Financial Reporting Standards (IFRS) is another key aspect to consider since
the calculation of taxable income of certain taxpayers (e.g. companies) starts
with the accounting profit before tax. To ensure that the correct adjustments
are made during the conversion of the accounting profit to taxable income, one
needs to understand how the accounting profit is compiled.
Finance leases from an
In terms of the International Financial Reporting Standards (IFRS) a
lease is considered to be a "finance lease” if at least one of the following
requirements is met:
- Ownership of the asset will be transferred to the
lessee at the end of the lease agreement.
- The lease agreement provides an option to the lessee
to purchase the leased asset at a price that is significantly lower than the
fair value of the asset on the purchase date.
- The lease term covers a major part of the asset’s economic lifetime.
- The minimum lease payments (on inception of the
lease) equal the greatest portion of the leased asset’s fair value.
- The asset is of a specialised nature and without
significant changes it can only be used by the lessee.
this transaction on a substance over form basis. In other words, the fact that
ownership of the leased asset passes to the lessee is acknowledged for
accounting purposes. Therefore, the leased asset is capitalised in the
accounting records of the lessee who can claim an expense for depreciation.
additional effect on the lessee’s accounting profit will result from the
instalments payable in terms of the lease. These instalments represent a
capital portion as well as an interest portion. The total interest-portion of
instalments payable during the accounting period will be recognised as an
expense in the Statement of Comprehensive Income of the lessee.
important to consider the above accounting implications when the taxable income
of a lessee is calculated. Since the calculation usually commence with the
accounting profit before tax (especially for companies), the lessee needs to
reverse the accounting entries and make the necessary adjustments to ensure
compliance with the Income Tax Act.
Basic Income Tax implications of finance leases
with accounting provisions, a finance lease is treated the same as an operating
lease for Income Tax purposes. From an Income Tax perspective, ownership of the
leased asset still vests in the lessor. Therefore, the lessor and not the
lessee will be entitled to claim the capital allowance available in terms of
the Income Tax Act. However, the lessor needs to examine the provisions of the
relevant section to determine if the section will allow the capital allowance
in the specific instance.
section 11(a) of the Income Tax Act will entitle the lessee to claim a deduction
equal to the total amount of rent that is payable during the year of assessment.
The before-mentioned deduction is available if the asset is applied in the
taxpayer’s trade and all requirements of section 11(a) are met. Therefore, the
asset needs to be used in the production of income.
The Value-added tax (VAT) implications of finance
Next, the VAT
implications of finance leases need to be considered since it will affect the
Income Tax implications thereof. The VAT Act provides special rules where
installment credit agreements are concerned. In terms of section 1 of the VAT
Act, an installment credit agreement includes a finance lease, which will be
present if all of the following requirements are met:
needs to be a lease agreement under which goods are supplied in exchange for
rent (whether its payable once-off or periodically).
lease agreement must stipulate the interest portion of the total amount payable
in terms of the contract.
total amount payable in terms of the lease agreement (e.g. rent and residue
value payable at the end of the lease) must exceed the cash value of the supply
(which excludes VAT and finance charges).
lessee must be entitled to use the leased asset for a minimum period of twelve
lessee must accept the risks associated with ownership of the asset, for
example risk of destruction, loss or disadvantage of the asset as well as
obligations relating to insurance, maintenance and repair of the asset.
legislation provides special rules relating to the time and value of the supply
of finance leases. If a lease complies with the above-listed requirements, it
will have the following VAT implications for the parties involved (if they are
registered VAT vendors):
- The value of the supply is the total cash value in terms of the lease
agreement. Therefore, VAT is calculated at a rate of 14% on the cost of the
leased vehicle excluding finance charges.
- The time of supply is the earliest of the date on which delivery of the
asset takes place or the date that any payment is made. An exclusion to this
rule will apply if the lease agreement provides for a "cooling-off” period. In
such instances the time of supply will be when the "cooling-off” period expired.
From the above it
is evident that the lessee will be entitled to claim an input tax deduction
equal to 14% of the total cash value stipulated in the lease agreement, rather
than on the monthly installment. The input tax may only be claimed if the
lessee is in possession of a valid tax invoice or the lease agreement.
Section 23C of
the Income Tax Act deals with the relationship between VAT and Income Tax. In terms of this section 23C it is required
that the VAT portion of expenditure is excluded from the amount recognised for
Income Tax purposes if the taxpayer was entitled to an input tax deduction. Therefore,
the lessee needs to reduce the deduction claimed on the rental installments
with the VAT portion that relates to it. Since input tax is claimable once-off
at the commencement of a finance lease, it needs to be determined how much of
the total VAT paid in terms of the agreement relates to the rental payments
actually incurred during the assessment period.
The VAT portion
of the current assessment period’s rental payments are calculated as follows:
the total installments payable during the current assessment period in relation
to the total installments payable in terms of the agreement are multiplied with
the total VAT input claimable under the lease agreement. This amount is used to
reduce the deduction relating to rental expenses actually incurred during the
current assessment period.
Special Income Tax provisions: ownership on
termination of the lease
At the end of
the lease term ownership of the leased asset may be transferred to the lessee
or the lessee may continue to use the asset under an extended lease agreement.
The Income Tax implications that may result in each of these situations are
of the lease, the lessee needs to include a recoupment in its taxable income if
the ownership of the leased asset is obtained by the lessee at no consideration
or consideration that is regarded inadequate. The recoupment is calculated as
the difference between the market value of the leased asset on the date that ownership
is transferred and the consideration paid to obtain ownership of the
asset. It is important to note that the
recoupment will be limited to the deductions previously claimed by the lessee
in terms of the lease payments.
In the instance
where a lessee does not obtain ownership of the leased asset at the end of the
lease term, it shall be deemed that the lessee acquired this asset at a cost
equal to the cost for the lessor reduced with a tax allowance of 20% per year
on the reducing-balance method. This situation will only occur when the lessee
continues to use the asset, for example if the lease term is extended. However,
these provisions shall not apply if the nominal annual rent equal 10% or more
of the above-mentioned calculation.
Based on the
above, it is important that the lessee takes the accounting treatment of
finance leases into consideration when taxable income is calculated. The
accounting treatment needs to be compared with the Income Tax implications if
the taxpayer’s taxable income calculation starts with the accounting profit
before tax. Since there exists various dissimilarities between these two
fields, the taxpayer needs to familiarise himself thereof in order to identify
the required adjustments. In addition, the amount taken into account for income
tax needs to be adjusted in the correct manner to exclude input VAT claimable.
Finally, use of the asset at the end of the lease term needs to be considered
to determine the value of the recoupment, if any, that needs to be included in
the lessee’s taxable income.