Hire Purchase: How to Maximise Your Tax Relief
AN IMPORTANT choice that many business owners face when acquiring new machinery, equipment, or other assets for use in their business is whether to lease or buy.
The decision gets further complicated by additional choices, such as whether to purchase outright or through hire purchase (HP) or, if leasing, what form of lease to take.
Cashflow is usually a major factor and this will often rule out an outright purchase, leaving the business owner to choose between HP and leasing.
Here we will take a look at HP: how it’s treated for tax purposes and how to get the most out of the deductions available.
What Is Hire Purchase?
Under an HP agreement, you technically only hire the equipment for the term of the agreement and then have an option to buy it at the end of that period. Typically, there will be a small additional charge added to your last payment which is the fee for exercising your purchase option and gives you legal ownership of the asset.
For tax purposes, you are treated as if you had purchased the asset at the beginning of the HP agreement. This has the advantage of providing tax relief via the capital allowances system.
Any agreement which gives you legal title to an asset at the end of its term, or which gives you an option to purchase the asset at that time, is treated as HP for tax purposes, regardless of what the agreement is actually called. Many so-called ‘lease purchase’ agreements are therefore treated as HP for tax purposes.
As well as claiming capital allowances on the purchase price of an asset acquired under HP, you will also be able to claim tax deductions for the interest charges arising under the agreement. There are several acceptable methods for calculating the interest charges arising in each period, including:
- The actuarial method
- Straight line
- The ‘rule of 78’
The actuarial method is the most accurate and reflects the true allocation of the interest costs arising. It is, however, extremely difficult to calculate, so it is generally only practical to use this method if the finance company provides you with the relevant figures.
At the other extreme is the simplest, but crudest and most inaccurate method: straight line. Under this method, you simply allocate all of the interest over the period of the agreement on a straightforward time-apportionment basis. Hence, for example, if you are paying £3,000 in interest over a three year period, you claim £1,000 each year.
My favourite method is the ‘rule of 78’. It’s a bit more complex than the straight line method but provides a much better approximation of the true interest cost arising in each period. Most importantly, it accelerates tax relief quite considerably when compared with the straight line method.
Moffat Ltd buys a new machine under HP. The cash purchase price of the machine is £12,300 and the total interest charge is £3,000. The company pays 36 monthly instalments of £425 (total £15,300) plus an administration charge of £50 which is added to the first instalment and an option fee of £50 which is added to the last instalment.
(Being quite small amounts, I would generally simply claim each of the two additional fees of £50 as an additional finance cost when they are paid.)
The company allocates the interest cost using the ‘rule of 78’. This is done as follows:
- Allocate a number to each instalment in reverse order. Hence, in this case, the first instalment is allocated 36; the second is allocated 35; and so on until the last instalment is allocated 1.
- Add up all these numbers (36+35+34+.....+2+1). In this case, this comes to 666.
- For each instalment, you multiply the total interest charged under the agreement by the number allocated under (i) above and then divide it by the number you got at (ii) above. This gives you the interest charge within that instalment.
Using this method the interest charge within the first instalment is: £3,000 x 36/666 = £162.16
The interest charge within the second instalment is: £3,000 x 35/666 = £157.66
Continuing in this way for the first twelve instalments, we get total interest charges of £1,648.65 in the first year of the agreement. In other words, using the ‘rule of 78’ provides 65% more tax relief for interest arising in the first year than the simple straight line method.
(Just in case you’re wondering why it’s called the ‘rule of 78’, it’s because the numbers 1 to 12 add up to 78. It’s not, as I thought when I was a student, because it was invented in 1978!)
Most businesses remember to claim the interest charges within the HP instalments paid during the period but it is also perfectly legitimate to claim a further amount for accrued interest within the next instalment. I will explain this further by returning to our example.
Moffat Ltd has a 31st March year end and actually purchased its new machine on 4th April 2011. Its HP payments are due on the 4th of each month, commencing 4th May 2011. For the year ending 31st March 2012, it therefore claims all of the interest within its first 11 instalments (total £1,536.04 using the ‘rule of 78’).
The company can also claim accrued interest of £98.08, representing 27/31sts of the interest charge within its twelfth instalment due on 4th April 2012.
In summary, Moffat Ltd is able to claim the following amounts in the year ending 31st March 2012:
Annual investment allowance - £12,300 (purchase price*)
Interest paid - £1,536.04
Interest accrued - £98.08
Finance charge - £50.00
Total - £13,984.12
* - Assuming sufficient allowance is available
It has to be admitted that the above example includes some messy calculations. Another company might prefer to keep life simple and just claim all the interest and other finance charges on a straight line basis as the instalments are paid. In this example, that would produce a total deduction of £947.22 for the first 11 instalments paid during the year (plus capital allowances on the purchase price).
But Moffat Ltd was able to claim an extra £736.90: surely that’s worth a little bit of effort? Furthermore, for most business owners, their accountant should be doing the work – so you might want to check if they’re using the ‘rule of 78’ or claiming accrued interest.
HP and Capital Allowances
One critical point about an asset acquired under HP is that it is only eligible for capital allowances if it is brought into use in the business before its accounting date. In one case a few years ago, a haulage firm with a 31st March year end purchased some new trucks on HP just before its year end but only bought road fund licences (tax discs) for them from 1st April. HMRC pounced on this apparent error and stated that capital allowances could not be claimed in the year of purchase as the trucks were clearly not yet in use in the business as at 31st March.
Fortunately, however, the firm’s accountant was able to point out that the trucks had been used internally, within the firm’s own site, on 31st March, so the capital allowances were due in the earlier year after all.The lesson is clear – make sure you bring HP assets into use before your year end.