To Purchase or Not To Purchase Assets Weigh Equity, Credit and Duration Of Value

Introduction

Buying or leasing assets is an issue that often comes up often in business. Before making a decision, consider the many significant financial and business issues involved.

Almost all assets can be leased these days, from aircraft to oil wells, but leasing usually involves vehicles, heavy equipment, computers and other office equipment.

Leasing can be advantageous if the assets are subject to rapid obsolescence, you need a quick income tax write-off, you can’t afford a large down payment, or you don’t want to take out a loan.

However, there are some downsides to leasing:

  1. You don’t actually own the equipment.
  2. You may pay higher interest than on a loan.
  3. You don’t build up equity.
  4. You could wind up with lease payments when your business no longer needs the equipment.

So before deciding to lease, take a close examination of the many income tax and business implications.

There are two varieties of leases and each involves different tax treatment:

  1. Capital leases transfer all or most of the benefits and risks of ownership to you. The asset is reflected on your balance sheet and amortized for income tax purposes over time, as if you purchased it. Payments are treated like loan payments, with only the interest portion being allowed as an expense.
  2. Operating leases leave the ownership with the leasing company. The down payment is amortized over the life of the lease and the individual lease payments are written off to expense in the period they are made.

Many leases are structured to be, or appear to be, operating leases. They can be written off immediately and don’t appear on your financial statements. This is often called “off balance sheet financing”. If you have loans outstanding or other contractual obligations that prevent you from taking on additional debt, you may still be able to take on a lease.

In addition to the income tax implications, there are several business factors to consider.

Insurance

When an insurance policy pays out for the destruction of an owned asset, it usually pays the fair market value. But on a leased asset, the pay out generally is the amount remaining on the lease or whatever the leasing company settles for. That can be substantially less than fair market value if you made a large down payment or the lease is nearing completion and the asset has been well maintained.

Ownership

Since you don’t own the asset, you are out of luck if the leasing company pledges the asset as security and it is seized to satisfy creditors. This has occurred when automobile dealerships are bankrupt and the automobile manufacturer re-possessed leased vehicles.

Obsolescence

Leasing can be cost effective when you require assets such as computers and other electronics equipment because the resale value is low and if you buy, you may wind up frequently upgrading and scrapping old equipment.

Liability

Leases are often difficult to get out of, and may not be transferable, leaving you liable for continuing payments even if you no longer need the asset.

Cash Flow

With the exception of a few assets, including automobiles, leasing often requires little or no down payment when compared with a loan. However, the effective interest rates for leases are higher than interest rates for loans.

Residual Value

Leasing companies don’t want to lose money, so they come up with a residual (or future sale) value and at the end of the term. You will likely have to pay the difference between that value and the actual value. However, you won’t be liable for the payments if you return the asset in satisfactory condition so that it’s worth more that the residual value.

The Importance Of Value

Lease contracts generally include residual value, the amount of your monthly payments, interest, taxes, related fees, and any amount owed at the end of the lease term.

The residual value is an estimate of what the assets will be worth at the end of the lease. It is based on past experience, and in some instances, a prediction of consumer tastes.

Here’s how residual value comes into play with two different cars, assuming the lease required no down payment:

  1. A Luxury Car. Let’s say a luxury vehicle costs $35,000 and has a 70 per cent residual value after three years. In other words, at the end of the lease, it’s worth $24,500 – or you’ve used $10,500 divided by 36 months (plus interest, tax and related fees).
  2. A Minivan. In this case, the mini-van costs $25,000 and has a 50 per cent residential value after three years. The minivan lost $12,500 of its value, and the monthly payment would be $347 a month (plus interest, tax and related fees).

It appears that luxury is a more advantageous deal than practicality in this case. However, a low monthly payment isn’t the only consideration. In some instances, a residual value may be inflated to move slow-selling cars. At the end of this “subvented” lease, if you decide you want to purchase the car, you could wind up paying more than you would if you bought an identical used car.

The quarterly Black Book publishes residual rates and is usually available at a bank’s auto loan department. Online, you can check the Automotive Lease Guide.

Conclusion

There’s more to leasing than writing off the cost of the lease. Consult with your Chartered Accountant to determine if leasing makes sense for you and your business. And remember, leases may be subject to provincial legislation that prohibits you from using the leased asset as security or collateral until it is fully paid for and the agreement is discharged.

Joe Truscott has been assisting small business owners for over 30 years with their decisions on whether to purchase or lease their assets.

If you would like to engage Joe Truscott with respect to the above business matters or any other income tax matters, please contact Joseph A. Truscott, Chartered Accountant at 905-528-0234 ext: 224, or email Joe at joetruscott@josephtruscott.com.

February 2013