Tax Treatment of Lease Agreements

Lease agreements

Over the years, leasing of assets has taken on many different names and forms – hire purchase agreements, lease to buy, operating lease, finance lease, multi-lease to name a few. Most times, the variations are used about motor vehicles more than other assets.

Financing Options

Broadly speaking, there are three financing options when an asset is acquired in the course of a business:

Buying – purchase the asset outright from either cash available or by borrowing purchase funds from your bank;
Renting – the lessee agrees to pay regular (usually monthly) payments to the lessor for the use of the asset over the term of the lease. It is often referred to as an “operating lease” in the context of motor vehicles;
Financing – this option is by far the most common one since the purchase price of the asset is paid over the term of the lease while the asset is being used. Financing is usually provided by the lessor or a finance company simultaneous with the lease agreement

Tax Treatment

For tax purposes, substance overrides form so regardless of what the lease is called, the tax treatment of any lease agreement depends on the terms of the agreement entered into between the lessee and the lessor. These leases fall into two broad categories – operating leases and finance leases. Lease payments for operating leases are treated as expenses whereas finance lease payments are not.).

Any lease is a finance lease if one of the following applies:

The term of the lease is greater than 75 percent of its estimated useful life; or
The asset is transferred to the lessee at the end of the lease term; or
The lessee has the option to buy it at the end of the lease term.

Even when the lease is established as a finance lease, the GST treatment differs for finance leases where the ownership of the asset is transferred over to the lessee on the final lease payment. The following table sets out both, the tax and the accounting treatment of the three common types of leases available for any type of asset:

Operating Lease

The term of the lease is less than 75 percent of the useful life of the asset.

GST is claimed on the monthly installments.

The full monthly rental (net of GST) is treated as an expense.

No depreciation can be claimed on the asset.

This does not affect the Balance Sheet.

Legal ownership remains with the finance company at all times to the end of the lease term.

Finance Lease

The lease term is greater than 75 percent of the useful life of the asset.

GST is not recoverable “up front” but can be claimed on the monthly payment (net of interest).

Only the interest content of the monthly installments is claimed as a business expense.

Depreciation can be claimed on the cost of the asset.

The asset is capitalised and the amount owing to the finance company is shown as a liability.

Legal ownership remains with the finance company but may pass to the lessee for further nominal consideration at the end of the lease. Legally, this sale is a separate contract from the finance lease.

Lease to Buy

The term of the lease can be flexible.

GST can be claimed on the purchase price of the asset in the GST period in which the lease agreement begins.

Only the interest content of the monthly installments is claimed as a business expense.

Depreciation is claimed on the cost of the asset.

The asset is capitalized and the amount owing to the finance company is shown as a liability.

Legal ownership transfers to the lessee on repayment of the financed amount.

Important: This is not advice. Clients should not act solely based on the material contained in the Client Newsletter. Items herein are general comments only and do not constitute or convey advice per se. Changes in legislation may occur quickly. We, therefore, recommend that our formal advice be sought before acting in any of the areas.

Lease agreements

Financing Options

Tax Treatment

by knob21

Knobloch & Associates Ltd - Chartered Accountants

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