Hire purchases, leases and their differences
Making the correct financial decisions is a difficult but integral component to running a successful business. Often, your decisions may revolve around the purchase of assets such as machinery, vehicles and property. When considering such purchases, you will likely look into terms such as hire purchases and leases. What do you know about hire purchase accounting?
Knowing the difference between a hire purchase and a lease is key to making the most financially beneficial decision for your business. Here at POP Business, we are the small business tax accounting experts!
In this blog, we’ll cover the ins and outs of both hire purchasing and leasing, and sum up their differences in practice for you.
What is a hire purchase?
Hire purchasing, or a hire purchase agreement, is a legal contract in which one party purchases a good or service by making an initial down payment (or deposit). They then pay the remaining balance in instalments, sometimes with interest.
Under a hire purchase agreement, buyers can use the good or service while paying it off, however, do not own the good or service until they have paid the final instalment. A hire purchase can also be referred to as an instalment plan.
What are the advantages and disadvantages of hire purchasing?
It is important to weigh up the advantages and disadvantages of a hire purchase agreement before making any big expense decisions for your business.
Advantages to a hire purchase agreement include:
- flexible and negotiable repayment terms (usually ranging from one year to five years),
- low deposit rates (usually under 10% of the initial good or service price),
- acting as an alternative to unsecured loans in the case that you have a low credit score, and
- fixed interest rates so that you know exactly how much you will be needing to repay.
- Claim GST credits up-front on the asset purchase
- Depreciate/expense part or the full amount of the asset
Disadvantages to a hire purchase agreement include:
- no complete ownership of the good or service until you make your last repayment,
- sellers may repossess the good or service at any point in time (before you have made a third of the total payment in the case of a motor vehicle), and
- monthly repayments may be higher than those for personal contract purchases and leases.
Instant asset write-off and GST on hire purchases
To make informed and suitable decisions, businesses need to be aware of the tax considerations that come with hire purchasing or signing a hire purchase agreement.
A hire purchase is treated the same way as a stand-alone sale in a tax period. All components of the supply of goods and services under a hire purchase agreement are subject to Goods and Services Tax (GST). Associated fees incurred while hire purchasing (such as late payment fees) are also subject to GST (get GST advice here).
The following tax considerations apply if a business entered into a hire purchase agreement after 1 July 2012 in Australia as per ATO regulations:
- Hire purchases under the relevant financial year’s threshold can be claimed as part of the instant asset write-off scheme.
- Businesses can claim full GST credit on their hire purchase agreement during their first payment if they account for GST on a non-cash basis.
- Businesses can claim one-eleventh of all components of a hire purchase agreement that have been subject to GST if they account for GST on a cash basis.
It can be confusing to claim GST credits on hire purchases depending on a business’ GST-accounting methods. In the case that you are unclear of the tax considerations of your hire purchase, give POP Business a call and we’ll help you out!
What is a lease?
A lease acts as a legal contract in which a party borrows an asset from another. For example, leasing business equipment, a vehicle or even a property.
A lease is less committable than an outright purchase, however is subject to restrictions based on terms negotiated in the contract. Such terms usually include making a series of payments over an extended period of time.
What are the advantages and disadvantages of leasing?
Be sure to note both the potential benefits and risks that come with entering a lease for your business.
Advantages to entering to a lease agreement include:
- you do not have to commit to the asset and can upgrade after your lease term is over,
- leases are often inexpensive compared to other loans such as hire purchases, and
- leases (especially for new vehicles) often include warranty.
In contrast, disadvantages to entering a lease agreement are as follows:
- Businesses which enter into a lease agreement do not gain ownership of the asset and thus cannot claim depreciation nor apply for the instant asset write-off scheme,
- You will need to make payments accounting for depreciation during the use of the asset, and
- Insurers usually charge higher costs for leased assets.
Instant asset write-off and GST on leases
In most cases, leases are subject to GST. Each payment you make under a lease is reported as part of your business activity statement (BAS) and is treated as a separate purchase during each tax period.
The following tax considerations apply for Australian businesses who have entered into a leasing agreement, as per ATO regulations:
- Leases for a business asset are not eligible for the instant asset write-off scheme or for depreciation.
- Businesses can claim GST credit equivalent to one-eleventh of each lease repayment instalment when they receive an invoice from the supplier or for the tax period in which they paid.
- Businesses can claim GST credit for any GST they paid on the price of the purchase, in the case that they decide to take ownership of the goods after a lease agreement.
If you have any further questions regarding the tax considerations of leases for your business, get in touch with POP Business today.
What is the difference between hire purchase and leasing?
Now that we’ve covered the basics of both hire purchases and leases, you may be wondering which is better suited for your business when looking to pay for the use of an asset. The key point to consider is how important an asset is for your business and whether you are planning on owning the asset.
A hire purchase may be more suitable for your business in the case that you want to own an asset for the long term. It may also be beneficial if you find that its depreciating value is manageable due to its integral role in your business operations (for example, machinery).
Keep in mind that monthly repayments for a hire purchase are typically more expensive than those of a lease. However, you can claim depreciation costs and apply for the instant asset write-off scheme in hire purchase as you have presumed ownership of the asset.
In contrast, a lease agreement may be more suited for an asset that you would like to upgrade regularly (for example, technology, vehicles or office space).
It may also be suitable for assets you do not want to take on board depreciation costs for. As leases will not grant businesses ownership of the asset, they will not be able to claim depreciation costs or apply for the instant asset write-off scheme.
Hire Purchase Accounting vs Leasing Examples
To put things into perspective, here are a few practical examples of hire purchase accounting and leases and how they may differ in numbers.
Example 1: Hire Purchase vs Lease of an Industrial Fridge
You are looking to purchase an industrial fridge for your butchery business. The fridge’s listed price is $33,000.
Under a Hire Purchase
Under a hire purchase agreement between the fridge dealership and your business, you will pay monthly instalments of $670 over 5 years, amounting to a total of $40,200 for complete ownership of the product.
This means you will be paying an extra $7,200 over the original price in interest.
You will also need to take into account the industrial fridge’s decline in value as the years pass (averaging 20% per year for its effective 10 year lifespan according to the ATO) and consider claiming asset depreciation.
Numbers are quoted from the ATO here.
Under the current rules, you could write-off the fridge as an expense if acquired prior to 31 December 2020. If acquired after, there is accelerated depreciation of 50%, meaning you can get a deduction for 50% of the value for the portion of the year in which it is acquired.
Under a Lease Agreement
You want to rent a fridge for five years under a lease agreement for the same industrial fridge. A lease may require you to pay $750 a month, meaning you pay a total of $45,000 over the five year lease period.
Although this means you pay $4,800 more under a lease than a hire purchase for the same fridge, you will not have to worry about asset depreciation and can upgrade to a new fridge immediately after your lease is up.
You effectively claim the lease expenses as you make the payments along with the GST. This contrasts to hire purchase arrangements whereby you claim the tax benefits up-front vs when repayment is made.
Example 2: Hire Purchase Accounting vs Lease of a Car
You are looking to purchase a company car for $25,000.
Under a Hire Agreement
Under a hire purchase agreement, you pay an initial deposit of $1,000 and make monthly repayments for a 5 year term with an average (yearly) percentage rate of 6.9%.
Your monthly payments will add up to $471.74 and for complete ownership, you will need to pay an extra $200 at the end of your hire purchase.
This totals to $29,504.40 and you will also need to account for your vehicle’s depreciation rate at around 40% after five years.
Numbers are taken from Money Advice Service.
Under a Lease Agreement
In comparison, when entering a car lease for a $25,000 valued car and a five year term, the typical monthly payment fee amounts to $760 (according to MyFleet lease), which brings about a total of $45,600.
While much more than a hire purchase agreement, monthly lease payments also include ongoing vehicle and tyre management as well as insurance and registration payments based on annual kilometres. Monthly payments with a car hire purchase will not account for these extra ongoing fees.
In most instances, a hire purchase makes the most sense.
The reason being, you get the GST credits upfront which helps with cash flow, in addition to the depreciation to reduce your tax.
Conclusion
Such are the major differences between hire purchases and leases when it comes to the core money numbers behind the two purchasing options.
Knowing the potential differences between the two may help you to better understand the asset payment options available to you and which ones are best suited for your business.
Need some help with your business purchases or have some more questions about hire purchases and leases? Don’t be shy to contact us today for some business advice! We can help with company, partnership and trust tax returns. We also
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