Construction plant and machinery are a major cost, the management of which can be crucial to the success of many companies.
Selecting the right type of funding for plant can be as important as choosing the right equipment.
Apart from the obvious desire to lock into today’s low interest rates, what other recent trends or changes in taxation might influence the decision over choice of funding method?
There are two main reasons a change might be considered.
1. A quicker way to write-off plant and machinery against tax.
The current £100,000 Annual Investment Allowance (AIA) has the considerable appeal of allowing 100% of eligible expenditure on plant and machinery to be written off against tax in one year. However, its appeal is likely to diminish, from April 2012 onwards, with the reduction in the AIA to £25,000.
To put this into perspective a partnership potentially facing a tax bill of £40,000 could see this reduced to zero but after April 2012 will face a tax bill of £24,600.
Either way, users of modern construction plant may regard £100,000 as a drop in the ocean and would prefer an alternative method of writing off machinery expenditure against tax – especially as it takes about 10 years to write off 90% of the asset’s cost against tax under the current 20% writing down allowance (WDA) rules.
To make matters worse the WDA reduces to 18% after April 2012 which extends the write-off period to about 12 years!
Faced with these dramatic changes to the tax rules is there a more tax efficient alternative funding method that will allow faster write-off against taxable profits?
The short answer is 'yes' and it is called 'operating leasing'. It certainly warrants further investigation because it does not have to be all or nothing, black or white – a blend of hire purchase and operating leasing is possible and this may give just the right shade of grey to suit individual business’ circumstances.
2. Ownership and the impact on the balance sheet.
Depending on the nature of a business, ultimate ownership of the plant and its position as an asset on the balance sheet may not be very important – traditionally this is the case if the plant is part of a production process.
In these circumstances it is often more important to know how much each piece of plant contributes to the overall cost of the process. In the waste/recycling, mining and quarrying sectors, operating leases and contract hire are very popular forms of plant funding.
In the construction industry, while hire purchase remains the most popular form of funding, a number of companies have realised that they have a core group of machines that they plan to operate for a set period which are unlikely to be changed or disposed of before that period has expired.
This core fleet of machines could be written-off against tax far quicker because, with an operating lease, 100% of the monthly rentals can be offset against taxable profits.
Run the machine for three years and 100% could be written off. Consider that from April 2012 the annual writing down allowance will decrease to 18% and it will take 12 years to write off 90.76% of the original capital cost against tax.
The example below shows the tax treatment of an additional £100,000 expenditure on plant, financed over 3 years, which will only be eligible for the 18% WDA tax write-off. It compares cash/hire purchase against an operating lease.
Comparisons for £100,000 expenditure financed over three years
1st Year Tax write off: Cash/hire purchase: £18,000 Operating lease: £28,320
2nd Year Tax write off: Cash/hire purchase: £14,760 Operating lease: £28,320
3rd Year Tax write off: Cash/hire purchase: £12,103 Operating lease: £28,320
Total tax write off in 3 years: Cash/hire purchase: £44,863 Operating lease: £84,960
The operating lease offers 89.38% better tax write-off in as little as three years.
The figures will vary depending on the make and model of machine and its respective residual value but multiply these figures for a fleet of machines and the figures can become eye watering!
There is still another reason to consider an operating lease, which for many companies may be just as important as the speed of tax write-off.
Increasingly a number of plant hire companies are turning to operating leases to reduce the level of debt carried on their balance sheet. This focus on the balance sheet has been exacerbated by the continuing caution being exercised by the major banks.
With an operating lease or contract hire agreement, the plant will not appear as an asset on the customer’s balance sheet (the asset is owned by the leasing company). This in turn can dramatically improve such key accounting ratios as return on capital employed because the same turnover and profit is effectively measured against a smaller asset base.
Operating lease features and benefits
Off balance sheet funding with fixed low cost lease rentals reflecting a predicted future residual value which remains unconnected to the customer (lessee). This residual risk is taken by the leasing company which recovers the machine at the end of the period and sells it in order to realise this unpaid amount.
Benefits include:
- Low capital outlay.
- Spreads the impact of VAT which is collected on each rental as it falls due.
- Low fixed repayments.
- Tax efficient
- Preserves working capital reserves.
- Removes residual value risk.
- Off balance sheet funding.
- Easily combined with repair and maintenance contracts to offer total peace of mind.
Nigel Greenaway is the general manager of marketing at JCB Finance and has over 26 years experience in the finance industry.
Disclaimer: JCB Finance are not financial advisers. Always seek advice from your financial advisor, be it your accountant or finance director, because every business’ circumstances are different with different tax rates and income and expenditure patterns. Businesses should not make investment decisions purely on a tax basis - there should be a compelling business case for the investment in the first place.
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