What will be the impact of proposed new rules for taxation of leased plant and machinery?

In this special contribution to LAWE's Tracking Trends feature on hire and finance, Nigel Greenaway, Marketing Manager of JCB Finance Ltd, who has over 20 years'experience in the finance industry, assesses the potential impact of new taxation rules on aspects of leasing plant and machinery. JCB Finance Ltd was formed in 1970 as the in-house finance arm of J C Bamford Excavators. Originally known as JCB Credit Ltd, the company has wide ranging experience in the finance of all makes of construction, industrial and agricultural plant and equipment.

The UK 2006 Finance Bill will include substantial changes in the way in which some “long funding leases” of plant and machinery are taxed with effect from 1 April 2006. The changes were announced in a News Release issued on 21 July 2005 by HM Revenue and Customs (HMRC). The precise nature of these changes may ultimately differ from those already announced but there is no doubt that substantial change will occur, if all goes to plan.

These changes will impact on the way that capital allowances on finance leases are claimed and by whom, and may even affect some operating leases. The rapidly expanding waste and recycling sector, with its penchant for using various forms of external asset finance, will need to take note of these changes. Added to these changes is the recent prudential framework that will govern the way local authorities determine their own programmes for capital investment.

The old tax regime

Before assessing the impact of the changes it is probably wise to clarify why a business would choose to lease plant and machinery. Traditionally, the use of capital allowances was to encourage businesses to invest in new plant with the expenditure being deductible from taxable profits. However, many companies found that their taxable profits were not great enough to take full advantage of this tax break. Enter the finance house (lessor) who, as the owner of the asset, claimed the available capital allowances but reflected this benefit in the form of cheaper than usual finance for the customer (lessee).

However, progressive reductions in the amounts of capital allowances from the 100% of the early 1980s, down to the current 25% per annum on a reducing balance, have seen a fall in the popularity of the finance lease. 2001 saw another nail in the coffin by restricting lessors to a proportion of the first year’s capital allowances depending on the inception date of the lease within their tax year. In a worst case scenario these changes in tax treatment meant that the finance lease was little cheaper than ordinary hire purchase.

Operating leases were viewed differently because the risk and reward equation meant that the lessor must have an element of residual value risk, with only a proportion of the original capital cost being paid by the lessee. As long as the lessee paid no more than 90% of the net present value of the original capital cost this left the lessor having to sell the asset at the end of the lease in order to recover this unpaid residual value. The lessee could offset 100% of the rentals against taxable profits, probably writing off the cost of the asset against tax in a much shorter period than a cash purchase or a hire purchase agreement. Such an operating lease also allowed the lessee to treat the asset as “Off Balance Sheet” which could significantly improve some key accounting ratios such as return on capital employed. This was also an important definition for local authorities who needed to account for these asset funding arrangements as operating leases in order to avoid paying for the rentals from their capital budgets.

The new tax regime

A funding lease will include all finance leases and a very small proportion of operating leases. Essentially the tax rules have been reversed so that a long funding lease will be treated much like a loan or hire purchase agreement with the lessee, instead of the lessor, claiming the available capital allowances and offsetting the interest element against taxable profits.

A lease will fall within the new regime if any of the following apply:

  • it is accounted for as a finance lease;
  • the net present value of the rentals is more than 80% of the fair value of the asset;
  • the minimum term of the lease is more than 65% of the remaining useful life of the asset,

    The main exceptions to the rule are those leases where:

  • the leasing of plant and machinery is incidental to a property lease (ie a generator);
  • the term of the funding lease is not more than five years;
  • the term of the funding lease is between five and seven years, provided that:

    a) the residual value implied in the lease is not more than five per cent of the fair value of the asset at commencement; and

    b) the rentals due in any year do not vary by more than five per cent from the rentals due in any other year (other than due to changes in interest rates).

    Impact on lessees

    All is not doom and gloom and in some cases the situation has improved for the shorter term finance leases because the apportionment rule mentioned earlier may no longer apply. As long as the lessor transacts the lease within their group’s tax year end, the full year’s tax benefit will be reflected in the form of cheaper finance or lower rentals for the lessee. However, the new rules will mean that businesses contemplating using finance leases and some operating leases, will need to carefully consider:

  • The length of the funding lease agreement and the useful economic life of the asset in the business because this could alter the lease cost and the accounting method applied.
  • The benefits of most operating lease and contract hire arrangements will fall outside the scope of these changes and therefore continue to confer all the cost and tax efficiencies plus removal of residual value risk.
  • The precise timing of the new lease agreement and the construction date of the plant because the old rules will apply if the plant is leased and made available before 1 April 2006, or a written agreement was entered into before 21 July 2005 with the asset to be leased under construction before 1 April 2006 and made available to the lessee before 1 April 2007.

    For further information at JCB Finance or a free guide, “What is the best way to fund your plant?” telephone 0800 150650 or email [email protected]

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