Management
September/October 2002

To Beg or to Borrow
By Geoff Coy, Certified Practising Accountant

M

ake sure you check out the options when it comes to acquiring your business assets.

With interest rates at their lowest level for some time, it may be advantageous to investigate the possible alternatives when considering buying business plant, equipment and motor vehicles.

The Australian finance industry has undergone major transformation in recent years and business owners are now confronted with a wide array of individual finance packages from a multitude of sources.

The most common forms of finance available to small business are:
Equity capital or owners funds
• Trading Bank Overdraft
  
• Lease Finance
  
• Hire Purchase
  

The purpose of an overdraft is to finance the short term seasonal fluctuations that occur in business. For this reason an overdraft facility or extension would not be considered an appropriate method of financing capital expenditure.

When the time comes to invest in new capital equipment, small businesses are often faced with a difficult lease or buy decision. More and more businesses are leasing equipment as an alternative to buying. However, it is not always the best option.

A lease is a contract where the lessor receives a rental payment in exchange for the use of an asset to the lessee for a specified period of time. The residual value of the asset is determined at the commencement of the lease and should represent the estimated commercial value of the asset at the end of the lease. At the end of the lease period, the equipment can either be returned or bought at an agreed price. Some of the benefits of leasing are:

• The lease payments are fully tax deductible;
  
• The business can conserve its capital; and
  
• The lease can be structured to suit the business.

If the item to be leased can produce a net increase in cash flow or a net gain in profit, over and above the tax deduction on the rental costs then leasing may be a good option. If it cannot, then other options should be considered. Hire purchase arrangements and bank loans are the most common alternatives to leasing. Each has its own particular tax benefits.

The choice between the three options will generally depend on costs, prevailing interest rates and depreciation allowances. As the costs of each of the alternatives are similar, depreciation often becomes the determining factor.

However, the move away from accelerated to effective life depreciation for most assets from 21 September 1999 means that the tax benefits available from depreciation allowances (particularly for long-life assets such as heavy trucks and machinery) have now been significantly reduced. The business also needs to determine whether it is in a position to claim available tax deductions or will be in a tax loss situation.

The impact of GST on the relevant transaction may also have to be taken into account. A business will be able to claim a full input tax credit for any GST in most cases, other than for motor vehicles up until 30 June 2002 and items which are input taxed such as borrowing costs.

Leasing

The business obtains a full tax deduction for the lease rental payments. As the bank or finance company providing the lease finance retains ownership of the item, the bank and not the business is able to claim depreciation. At the end of the lease period, the business usually has the first opportunity to buy the item at its residual value (the written down value after depreciation). In some cases, when the business does not buy the item as it fetches less than the residual value on the open market, the business may be liable for the shortfall.

Commercial Hire Purchase Agreement

This involves the business hiring the plant or equipment with an option to purchase later. The finance company retains ownership of the equipment until the business pays it off on a principal plus interest basis. The interest is tax deductible and, as the implied owner of the equipment, the business can also claim depreciation deductions on it.

Depending on the nature of the equipment involved, the tax benefits from depreciation in the early years of the agreement may be greater than those achievable by leasing, but this is probably less likely now than under the previous depreciation regime. If the credit component of the agreement is input taxed, an additional cost may be imposed on the business hirer.

It is normally a condition of these agreements that the user, not the finance company, pays registration, insurance and maintenance costs (as for a loan arrangement). Stamp duties and statutory fees would also be payable by the user.

Loans

If a business takes out a loan to purchase plant or equipment, the interest on the loan is tax deductible. As the business takes title to the equipment, the business can also claim a tax deduction for depreciation over the item's effective life. A bank or other financial institution may not provide loan finance unless the business puts up security for the loan.

Before making any lease or buy decisions, a business should analyse all options to determine both the tax benefits through tax deductions and depreciation and also the net cost of the alternative financing options to the business and their respective impact on profits.

The critical choice of method nearly always comes down to whether the payment is affordable i.e. do the monthly payments fit within the business cashflow and not necessarily the extent of the tax deductions on offer.

Your decision should not be based on buying tax deductions, but rather the best possible way of saving money.