When you’re expanding your business, you often need new tools, equipment, or vehicles. This typically requires financing for purchasing or leasing these items.
Understanding the difference between hire purchase (HP) and lease rental (LR) can be challenging due to confusing terminology and distinct tax and VAT treatments.
This article clarifies the key distinctions between HP and LR, including how they are taxed.
What distinguishes HP from LR?
Both HP and LR enable a business to utilise an asset. Whether it’s machinery or equipment, it’s available for use in your operations.
However, the key difference lies in who legally owns the asset:
Hire Purchase (HP): With HP, you make payments and use the asset immediately. After completing payments, your business owns the asset. Essentially, you’re buying the asset over time.
Lease Rental (LR): With LR, you also make regular payments and can use the asset immediately. But, you’re only renting it, not buying. At the lease’s end, you don’t own the asset, though you might get a chance to buy it.
Impact of Buying or Renting on Taxes
The method of acquiring an asset (buying or renting) influences your tax deductions:
Buying: For a purchased asset, you reclaim VAT at purchase and claim the cost through capital allowances, often fully in the purchase year.
Renting: For a rented asset, you claim VAT monthly against rental invoices, and rental payments are expensed over the rental period.
Confusion in Tax Issues with HP or LR
The tax implications vary significantly between buying and renting. Confusion arises when an asset is financed through HP or LR, as it’s not always clear which is being used.
Financing with HP: You can claim full VAT on the purchase price at acquisition. The asset’s full cost appears in your balance sheet, with a liability for future capital repayments. As you make payments, the interest is expensed and the capital reduces the liability.
Financing with LR: VAT on monthly payments is claimed as it arises, and the net payment is expensed.
Ownership of the Asset
For an agreement to be considered HP, it must transfer ownership to the business. The nature of the ownership option at the lease’s end determines whether it’s HP or LR. A nominal purchase option indicates HP, while a significant balloon payment suggests LR. If payments cover at least 80% of the asset’s cost over a minimum 7-year lease period, it’s treated as HP.
Choosing the Right Finance Option for Cashflow
Selecting HP or LR impacts future tax liabilities and cashflow. The timing of VAT claims and tax relief significantly affects cashflow, so it’s crucial to understand which route you’re taking and ensure proper tax treatment.
Consultation for Optimal Finance Decisions
Before acquiring an asset through finance, seek advice to determine the correct VAT, corporation tax, and accounting treatments. This helps avoid future complications and makes informed decisions about purchasing vehicles, equipment, or other assets.