Financing a vehicle purchase

Expenses Aug 11, 2011

When purchasing a vehicle for your business, there are many different financing options. While they might look similar, each one has benefits and drawbacks, especially from a tax standpoint. Here are the most popular financing options. Please note that VAT on cars is recoverable only in rare circumstances. For other vehicles (and other asset classes for that matter), the VAT is fully recoverable as per described below.

Outright Buy

Obviously, this is the simplest option when you don't need any financing or when the financing is provided separately (with a line of credit for example). From an accounting viewpoint the actual cost of the vehicle is capitalised in the balance sheet and an annual charge for depreciation is shown in the accounts as an expense in the profit and loss account. This therefore has the effect of showing the asset in the balance sheet at cost, reduced by the cumulative charge for depreciation. The annual depreciation charge is calculated in accordance with accounting standards, based on the useful economic life of the asset and the residual value.

Tax wise, you will be allowed capital allowance deductions. Those depend on the type of vehicle and the tax year (as the rules tend to change quite often). Usually, your accountant will do that for you. As for VAT, unless the vehicle is a car, it will be recovered in full (with a delay of four months however).

Hire Purchase (HP)

This is the most common form of financing an asset. customer selects the supplier of the asset and negotiates directly the specification and the price. An initial deposit plus the full VAT, if applicable, is paid leaving the balance, plus interest, to be spread over an agreed term, typically 1-5 years. The finance company pays the supplier and lets the asset to the customer under the terms of the Hire Purchase agreement. Once the customer has made the required regular rents, he is entitled to buy the asset at a nominal price, known as the Option-to-Purchase fee. Until this happens, the asset belongs to the finance company as their security.

On all Hire Purchase Agreements, the equipment is shown on the balance sheet as a fixed asset and depreciation and capital allowances are accounted for as if the equipment had been purchased outright (see above). The benefits of a Hire Purchase are:

The equipment is owned at the end of the agreement
Existing bank credit lines are not tied up
The agreement can be settled at any time
Rents can be monthly, quarterly or annual
There are both fixed and variable rate schemes available

Finance Lease

An initial deposit or advance rents are paid leaving the balance, plus interest, to be spread over an agreed term, typically 1-5 years. The finance company pays the supplier and leases the asset to the customer under the terms of the Finance Lease agreement. VAT is payable on the deposit as well as each rent and can be claimed back within the VAT period. The customer is not entitled to become the owner of the asset at any time but is entitled to sell the asset at the end of the lease and keep between 95-99% of the proceeds. The customer can however continue leasing the equipment by entering a secondary period with annual rents. On all Finance Lease agreements, the equipment is shown on the balance sheet as a fixed asset. Capital allowances are not allowed however even though the finance company can claim them and pass the benefit onto the customer. The benefits of a Finance Lease are:

The initial VAT payment is lower than that of Hire Purchase or a cash purchase
Existing bank credit lines are not tied up
Rents can be monthly, quarterly or annual
Fixed rents for accurate budgets

Operating Lease

This is designed for businesses that wish to operate equipment and vehicles with fixed rents, minimal administration and without affecting balance sheet ratios. The customer can never obtain title to the asset and at the end of the contract the equipment is returned to the supplier or finance company. The asset does not appear on the balance sheet, rents are offset against taxable profits and therefore capital allowances are not disallowed. VAT is payable with each rent and can be claimed back within the VAT period.

A Contract Hire is a form of Operating Lease that allows the customer to build in further fixed costs such as repair, maintenance and servicing. The benefits of an Operating Lease are: