Financing your assets – The taxation issues

01 March 2019

One of the fundamental questions any business owner needs to address is how to finance their assets. On commercial grounds, the various options have important implications.

Purchasing assets outright using cash from within the business (whether capital contributed or retained profits), provides the benefits associated with outright ownership but also impinges on cash flow (for example, spending $100,000 on acquiring a truck means that there is $100,000 less for the next wages bill). It also comes with the need to maintain the asset itself as well as the need to sell the asset at the end of its useful life should scrapping not be desired.

The major cash flow problem may be mitigated through borrowing funds to acquire the asset, but as well as the responsibilities of outright ownership being present, the business’ borrowing capacity is necessarily affected by this as well as the legal obligation to fund at least the interest payments on that debt as and when they fall due.

Leasing assets, where available, alleviates most of these problems, but that may bring attendant responsibilities, such as relating to maintenance, depending on the terms of the lease agreement.

All of these options have different tax consequences, which need to be considered in light of the commercial decision.

Owning the asset outright, whether through the business’ own funds or borrowed monies, will normally allow the business to claim depreciation deductions for assets that can reasonably be expected to depreciate in value over time (which covers most tangible assets except for land). The ability to claim depreciation was discussed in an earlier article.

A further tax consideration that arises with outright ownership is what happens when the asset is eventually sold or written off. If the asset is (genuinely) written off, the business may claim a deduction for the undepreciated value that is carried on its books. This will normally be the difference between the purchase price and the total amount of depreciation claimed for tax purposes (often called the tax written down value or WDV). Note that this WDV may be (and often is) different to the WDV for accounting purposes due to the different depreciation rates that apply for tax compared with accounting purposes.

If the asset is sold, then there will be tax implications depending on the sale price. If the sale price is less than the (tax) WDV, then the business may claim a deduction for the difference between these two amounts. If the sale price is higher, then the difference needs to be included in the business’ assessable income. These amounts are often referred to as balancing adjustments. Note that balancing adjustments are treated in the same manner as general business income or expenses; they do not come within the capital gains tax rules (which is a common client question).

If the asset acquisition is financed by a loan (rather than the business’ own internal funds), the interest and associated ongoing costs (such as monthly fees) will normally qualify for a deduction. Borrowing costs associated with obtaining the loan may be deductible over five years.

If the assets are leased, the tax treatment will depend on the terms of the lease agreement entered into.

Under what accountants have traditionally called an “operating lease”, in which periodic lease payments are made and no ownership rights are transferred to the lessee (ie the business), the entire lease payments will normally be deductible in the same manner as other general business expenses, such as rent.

This is in contrast with a financing lease. Such leases often include provision for the lessee to acquire ownership of the asset at the end of the lease period. In such cases, the tax treatment will depend on the terms of the lease. In some cases, the lease payment may need to be split into a principal and interest component, with only the interest component being deductible. This applies where the “lease” is regarded as effectively being a loan provided by the lessor for ownership to be transferred ultimately to the lessee. In these cases, the lessee will normally be able to claim depreciation deductions based on the deemed cost of the asset.

While the decision on how to finance assets needs to be taken based on commercial considerations, it is important that the tax implications of this decision are considered so that there are no unexpected surprises. Seeking advice before formalising any decision is, therefore, imperative.