Taxation Issues Company Cars and Taxation

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The Tax Conundrum

Lease or Buy?

Or, the point at which the VAT Advantages are outweighed by the Direct Tax Advantages

Most companies continually search for ways to reduce overheads. The company car fleet is an obvious area that needs to be closely examined. However, many cars are not only a necessary tool but also represent a visible form of remuneration.

There are so many ways to finance the company car, that finding the cheapest option can be a difficult and time-consuming process. For example, if the most important issue is that cars are off-balance sheet, contract hire may provide the solution. However, if the fleet consists of high value vehicles, then a purchase agreement may be the cheapest option. If the right decision is to be reached, then the various requirements need to be carefully balanced.

Direct cost, for some companies, may be the most significant issue, but for others there may be more important factors to consider, for example:

Some Questions to Ask:

• Who should take the risk on residual values?
• Does the cost of providing the fleet need to be "off-balance sheet"?
• Would it be beneficial to outsource the management of the fleet?
• Can the company make better use of the cash tied up in the fleet?
• Should we offer our company car drivers a cash alternative?
• Is the fleet large enough to benefit from significant discounts?

The logical starting place is to consider whether to "lease or buy"? To do this, consideration of the potential tax effects (both direct tax and VAT) are essential as these play a vital role in reaching the correct decision.

VAT

The decision to lease or buy became more relevant after the changes to the VAT legislation were introduced in August 1995. Since this date, companies using cars solely for business purposes can recover the VAT incurred because leasing and contract hire companies only use the cars they lease for their business purposes; it is irrelevant what the lessee does with the cars. Therefore the monthly rentals are reduced.

However, two factors offset this saving:

• lessors have to account for the VAT when they sell the cars
• lessees can only recover half the VAT that had previously been recoverable on the rental.

Consequently this means that there is a reduction in the cost of leasing or contract hiring a car compared to pre August 1995 due entirely to the VAT saving. This leads to leasing (which includes contract hire) being significantly more attractive than purchasing (which includes outright purchase, contract purchase, and hire purchase) from a VAT point of view.

DIRECT TAX (CORPORATION TAX)

Corporation tax or business tax relief, on the purchase of a car is achieved by way of capital allowances. These are set at a rate of 25% per annum on a reducing balance with a maximum deduction of £3,000 for a car costing over £12,000. For tax reasons a car costing over £12,000 is called an " expensive" car (obviously this has not changed for some time).

This means the company will eventually receive full tax relief for the difference between the purchase and sale price of each car. For the cars that the company leases, the tax relief available to the company will normally be received when the rental payments are charged to the accounts.

With leased cars a problem arises when the retail price of the car exceeds £12,000, as a permanent tax disallowance is applied to the monthly rental. The term 'retail price' is not precisely defined in the tax legislation. The Inland Revenue regard the term to be the price an ordinary member of the public might pay, which therefore includes VAT and excludes bulk or special discounts.

In April 2000 the Inland Revenue published a bulletin stating that where the lessee knows the actual price paid by the lessor for the car when new, this can be used as the retail price when new, but must include VAT.

The disallowance is based on the following formula:

½ (Retail Price - £12000
Retail Price

So for example the proportion of rentals disallowed would be:

While the VAT rules usually favour leasing, the direct tax rules make purchasing progressively more attractive for those cars with a retail price in excess of £12,000. At first sight, it would seem relatively straightforward to find the point at which the company should change its method of finance from leasing to purchasing.

However, the break-even point is sensitive to several other factors, such as:

• The car’s residual value
• The month of acquisition, in relation to the company's financial year-end
• The company's tax and VAT recovery rate
• The company's internal rate of return.

Most experts agree the break-even point occurs at around £20,000. However, if the company pays tax at the small companies rate this figure increases to nearly £26,000.

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