TAXATION IMPLICATIONS OF VARIOUS MACHINERY FINANCING OPTIONS
Michael Wheatley, Manager of IFAC Accountants, Monaghan Office for the past 18 years
The main choices open to farmers remains either outright purchase using cash generated from farm profits, financing through a Term Loan from a bank, entering a Lease or a Hire Purchase contract with a Finance and Leasing Company.
Value Added Tax
Being registered for VAT has a big cash flow advantage favouring outright purchase through cash generated from farm profits, term loan or hire purchase but not for leasing and reduces the long-term up front borrowing requirement for all options except leasing.
Hire Purchase/Term Loan versus Leasing:
|Hire Purchase/Term Loan||Leasing|
|Tractor cost (incl. vat)||€60,500||€60,500|
|Vat reclaimable immediately||€10,500||-|
|Long-term up front borrowing requirement||€50,000||€60,500|
Being vat registered allows you to claim the input vat immediately in order to reduce the overall long-term financing requirements.
Income Tax Allowances for outright purchase, Term Loan or Hire Purchase.
You cannot claim a tax deduction for the cost of the machine against farm profits in the year in which the machine is purchased. The tax system gives relief for the net cost (net of vat if you are vat registered) of the machine purchased through "Capital Allowances".
The current rates of capital allowances are 12.5% of the net cost of the machine each year for eight years. The capital allowance may be deducted from farm profits in the first year in which the machine is used in the business and for each of the subsequent seven years.
Capital and Interest Repayments
The Term Loan and Hire Purchase repayments are split between capital repayment and interest charged. The interest charged is an allowable deduction against the farming profits while the capital repayment element is not tax deductible in the year in which it is paid but by reference to the capital allowances applicable to the machine purchased. This gives rise to a mismatch between the yearly repayment and the yearly tax allowance.
A farmer purchases a tractor for €30,000 financed by a 3 year Term Loan. In this example we are ignoring interest as it is tax deductible in the year in which it is charged.
|Year||Capital Repayment||Yearly Tax Allowance 12.5%||Cumulative mismatch|
This example shows at the end of year 3 the farmer has had to raise €30,000 of which €18,750 had to be found from after taxed income. A mismatch occurs with the €18,750 deferred allowances being claimed over years 4 to 8.
This mismatch gave rise to a gap in the market for a type of financing which would match the repayments to the tax allowance i.e. leasing.
Technically under a Finance Lease you do not own the asset until you make the final lease payment. You are leasing/renting the asset from the Leasing Company until you make the final payment. Virtually all of the payments/repayments are made in the "primary period" with an option to pay nominal amounts in a "secondary period" to avoid transfer of ownership. (See below "Planning Lease Terminations").
Tax treatment of Leasing
The ordinary recurring leasing payments spread over the period of the lease are allowable as a tax deductible expense, where the period is standard for the type of machinery in question. This period is called the primary period. In practice, the Revenue Commissioners have indicated that the primary leased period should not be less than three years.
The income tax impact is that the leasing option will allow tax relief over a 3-year period while under the Term Loan/Hire Purchase option set out above, a farmer must wait for eight years to receive the full tax allowances.
This removes the mismatch set out in the example above.
Instead of financing the purchase of the €30,000 tractor by way of Term Loan or Hire Purchase the farmer opts for leasing. Ignoring the financing charges which are allowed as a tax deduction in the year in which they are paid the income tax position is as follows:
|Year||Capital Repayment (Leasing)||Tax write-off||Mismatch|
Major Pitfall of Leasing
If a lease is terminated, the farmer is deemed to have received a rebate of some of the lease payments for which tax deductions have already been allowed and the rebate is taxed as income in that year.
In the example above, if the lease was terminated in year 4 and the tractor had a market value of €14,500 then €14,500 is deemed to be a rebate on the €30,000 rental charges paid in the previous three years and is taxable as income in year 4. There is a deemed purchase of the tractor for €14,500 by the farmer from the Leasing Company which now can be written off over 8 years at 12.5% per annum i.e. €1,812 per annum.
Planning Lease Terminations
In order to avoid this nasty claw-back surprise you should ensure, on entering into a lease arrangement, you have the flexibility on agreeable commercial terms to dictate when a lease should terminate. Finance leasing contracts vary from company to company, but in all cases the term of the lease is divided into two distinct periods.
The first period is known as the primary leasing period.
The second period is known as the secondary leasing period.
During the secondary leasing period, nominal leasing payments are made with the Leasing Company still retaining ownership of the equipment. While healthy competition has disappeared from the banking/financing market you should endeavour to negotiate the "nominal" leasing payment. This would allow you on the payment of a nominal sum each year to defer ownership until such time as the market value of the leased machine had reduced considerably thereby minimising the amount of the clawback.
Farming as a Limited Company
For those farmers using a Limited Company Structure, or thinking of doing so, the above tax dynamics are altered. While the same taxation principles outlined apply, the consequences of mismatch of capital allowances and repayments and the leasing allowances clawback are not as severe because of the corporation tax rate.
The Corporation Tax rate is 12.5% while Personal Sole Trader Tax and Levy rates commence at 24% and increase to 55%. This also has a dramatic impact on the ability of the company to repay loans compared with the sole trader farmer.
The company tax rate of 12.5% leaves 87.5 cent from every euro trading profit retained in the company for development/loan repayments compared with as little as 45 cent when trading as an individual sole trader.
The table below shows that a company requires to earn €1,143 pre-tax to repay a €1,000 loan while an individual taxed at 55% must generate €2,222.
|Less 55% Tax||€1,222|
|Less 12.5% Tax||€143|
|Available after tax to repay loans||€1,000||€1,000|
I have restricted my comments to the taxation aspects of machinery financing and of course the cost of financing is also vital to assessing any of the options above.