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 accounting perspective
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.
IFRS recognises 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.
An 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.
It is 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
In contrast 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.
In addition 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 leases
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:
- There needs to be a lease agreement under which goods are supplied in exchange for rent (whether its payable once-off or periodically).
- The lease agreement must stipulate the interest portion of the total amount payable in terms of the contract.
- The 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).
- The lessee must be entitled to use the leased asset for a minimum period of twelve months.
- The 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.
Value-added tax 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 addressed below.
On termination 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.