Should you lease or buy?

Posted by Mike McLenehan Jan 20, 2016 10:17:38 PM

Buy/lease decisions are much more than a matter of taxes.

Buy or lease? That is the question that arises whenever a business needs a new asset. The question usually elicits a follow-up comment that a 100% write-off of the lease expense is available, whereas a purchased asset can only write off the capital cost allowance.

The conclusion of the discussion is that there is a tax advantage to leasing.

Advantages of Leasing

1. Your business gets the full use of the asset while the cost is spread over a number of years (i.e., there is no immediate drain on cash flow). This may be important if the business has limited lines of credit, limited cash reserves or is cyclical and the asset is required immediately.

2. The lower cash outlay may allow the business to acquire better equipment with only a marginal increase in cash paid, whereas a significant additional capital outlay would be required to purchase the asset.

3. Businesses normally establish cash flow and budgets based on operating revenue and expenses and often ignore the need to budget for capital asset acquisitions. Because the lease expense is a regular monthly withdrawal, budgeting for future expenditures may be easier than predicting the impact on cash flow and profit and loss of a major capital purchase.

4. Depending on the product and the leasing company, you may find it easier to cancel the existing lease and renegotiate a lease on a newer, better piece of equipment with payments that are not much different from those of the existing lease. If technology in your business is changing rapidly, leasing may be advantageous.

5. Leasing from the same company that manufactures the asset may be beneficial if the asset turns out to be a lemon. Because the manufacturer wants to retain the customer, it may be more willing to provide a replacement.


Disadvantages of Leasing

The lessor continues to control the asset through the leasing contract. This may have the following disadvantages:

1) Payments may continue longer than the usefulness of the asset.

If the lessor is financing the asset, it may not be possible to upgrade the equipment until the lease is paid in full or a buyout has been negotiated.

2) Businesses in possession of the asset after the lease period must continue payments even though the lease has been fully paid.

3) Lessees are responsible for maintaining the equipment unless maintenance is covered or a separate charge is paid. In fact, you may be required to follow a predetermined maintenance schedule. If the equipment is not maintained, the lessor may charge your company for restoring the asset to its original condition.
4) An operating lease (i.e., the term of the lease is shorter than the useful life of the asset) is an “off balance sheet” form of financing because only the rental expense is recorded on the income statement. Nevertheless, the lease creates a legal obligation even though nothing shows up on the balance sheet. Management may be unaware of this legal obligation for this kind of indebtedness. This situation can be mitigated by treating the lease as a capital lease and recording the value of the leased asset on the balance sheet and showing a corresponding liability. In some instances the contractual obligation is shown within the notes to the financial statements.


Tax Considerations

Normally, when an asset is leased, the cost of the lease is immediately expensed and the income is reduced by the lease amount. If, for instance, the lease cost is $1,000 per annum and the corporate tax rate is 17%, the income tax expense will be reduced by $170. The GST/HST input tax credit (ITC) is calculated each month based on the monthly lease amount.

When an asset is purchased, the cost of the asset is capitalized and, for purposes of the Canada Revenue Agency, the capital cost allowance (CCA) is applied to the cost of the asset and the amount is deducted for income tax purposes. The CCA amount is calculated using a percentage (such as 20%) of the cost of the asset. In the first year of purchase the CCA is usually limited to one-half of the CCA calculated on the purchase price. Thus, if an asset cost $1,000, the first year CCA would calculate as 20% of $1,000 equals $200 divided by 2 or $100. In the ensuing years, full CCA is calculated on the original asset cost less the accumulated capital cost allowance. ($1,000 less $100 or $900 times 20% or $180) until the asset is effectively amortized.

From a tax viewpoint, the first-year deduction for the CCA equivalent is $100. A first-year tax benefit approximates $17 assuming (17% of $100); whereas in the second year, the tax benefit approximates $31 (17% of 20% of $900). If the asset is purchased, the ITC on the original cost is calculated on the initial purchase cost and applied against the GST/HST payable. Further, if the capital asset is financed, the interest on the loan is a deduction from income.


More Than Just Taxes

Making a decision as to whether to lease or buy an asset should take into consideration more than just the tax implications. Cash flow, maintenance, financing ability, obsolescence, long-term capital asset needs combined with the impact on the financial statement should all be factors when discussing the pros and cons with your CPA.

 

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