How Wrong Can You Be? (Pt III)

In the first of this series of articles, How Wrong Can You Be (Pt I), I set out the four key principles that should direct a business's fleet funding policy; Risk, Affordability, Cash-Flow and Accounting/Taxation.

The concept of Risk was explained in more detail in the first article and Affordability and Cash-Flow were covered in Pt II.

In Pt III of the series we'll look at Accounting and Taxation, concepts that have hidden implications for your choice of vehicle funding. Let's start with Accounting.

Accounting

In order to more accurately reflect both the value of assets owned by a business and the cost of using them, accountants use a concept known as 'amortisation'.

'Amortisation' is the process of writing off the cost of an asset over a period of time according to how long the asset is expected to be used in the business.

This is because writing off the full purchase price of an asset in the accounting year in which it is bought does not accurately reflect how it is used in the business - it ignores the value generated by the machine in the 2nd and subsequent years and therefore distorts the profits made from using the asset in years 2, 3, etc.

For example, let's say a piece of machinery costing ￡10,000 has an expected life of 4 years before it is worn out. The machinery is therefore amortised in the accounts of the business over its 4 year working life at 25%p.a. (a quarter of its cost each year).

In other words, 25% of its cost is charged against profits each year for 4 years.

The 25% charged to the profits is known as 'depreciation' - the cost to the business of the drop in value of the machinery in the accounting year.

Writing off the cost in equal chinks is known as 'straight-line' depreciation. The amount written off stays the same each year, so in our example you have a straight line of 25% write-offs over each year of the asset's life.

How plant and machinery depreciates varies - some assets may have very short working lives (e.g. hand tools) and the cost of purchase might be depreciated very quickly in the accounts. Other assets, such as cars or machinery with a long working life, might be written off over much longer period of time, so the rate at which an item is written off usually reflects it's expected working life.

Now, having written off part of the value of the machinery to profits, the remaining value of the machinery needs to be reflected in the business accounts as it remains an asset to the business.

So, continuing our example above, at the end of the first accounting year our machinery will have an accounting value of 75% of its purchase price (100% - 25%) and this remaining value will appear on the balance sheet of the business as an asset (the balance sheet is the accounting summary that tells others the net value of asses and liabilities in your business).

At the end of the second year another 25% in depreciation is charged to profits and the value on the balance sheet drops to 50% of the purchase price, and so on until the end of the fourth accounting year when the last 25% is charged to profits and the asset is considered to be written off, or 'fully amortised', for accounting purposes (even if it is still being used).

This represents a simple version of amortisation. A more sophisticated version uses a concept know as 'reducing balance'. Under a reducing balance amortisation a portion of the value of the asset is still written off each accounting year, but the amount written off is based on a percentage of the asset's value at the end of the last accounting year.

For example, an asset is bought for ￡10,000 at the start of the accounting year. It is amortised at 25%p.a. over its working life on a reducing balance basis.

At the end of Accounting Year 1 ￡2,500 (￡10,000 x 25%) is written off as depreciation. This leaves a remaining value carried forward of ￡7,500 for Accounting Year 2.

At the end of Accounting Year 2 a further 25% is written off to depreciation, but the amount of the write off is calculated on the value at the end of Year 1 (￡,7500), not the original purchase price (￡10,000).

So, at the end of Year 2, ￡1,875 is written off to depreciation (￡7,500 x 25%).

This leaves a balance of ￡5,625 (￡10,000 - (￡2,500 + ￡1,875)) carried forward to Year 3, and so on each year.

This process continues throughout the life of the asset, which means that depreciation takes a lot longer to account for the total value of the asset than if it were written off on a straight-line basis.

Vehicles such as company cars and vans are considered as assets; admittedly depreciating assets (because typically they are continually dropping in value), but assets nonetheless, and therefore if you buy them they appear in the balance sheet of your business as a 'positive' value, something of worth in your business and reflected as a 'plus' on your balance sheet.

However, the amount shown in the balance sheet drops each year according to the depreciation in the value of the vehicle as explained earlier.

Accounting and Finance

If you finance a vehicle instead of buying it from cash reserves, your obligation to repay the lender the money you have obtained from them to pay for the vehicle sits as a liability, a 'negative', in the balance sheet.

So, for example, if you borrow ￡10,000 over 5 years at an interest rate of 5%p.a. to finance a vehicle then the vehicle will sit on your balance sheet as an asset, but your obligation to repay ￡10,000 plus interest to the lender will also appear on the balance sheet for the next 5 years as a liability.

As the loan starts to be repaid, the liability on the balance sheet will reduce each year, but nevertheless it will still be there as a 'negative'.

At the start of the finance agreement, because the ￡10,000 plus interest is more than the value of the vehicle, this will make the net value of the vehicle shown on the balance sheet look worse than if you had paid cash.

Now, under current accounting conventions, not all types of finance appear on the balance sheet like this, giving some types of finance an advantage in accounting terms compared to others.

However, the rules will be changing under moves to harmonise the global standards for accounting, especially for larger businesses.

For the moment though, the principles are:

1. If someone else owns a car, you borrow it for a fee and you return the car to the owner at the end of the agreement with no risk to you over the final value of the car (e.g. in a typical car contract hire agreement), the car and the finance obligation don't appear on the balance sheet, either as an asset or a liability. This type of finance for a car (or van) is sometimes called an 'operating lease' - you just pay to be allowed to operate the car in your business.
2. If someone else owns a car, you borrow it for a fee and then at the end of the agreement how much you owe will vary according to the value of the car at the end (in other words, you have taken on board the risk of the residual value of the car) then the finance agreement will appear on your balance sheet as a liability, and because someone else owns the car its value won't appear as an asset to your business. This type of agreement is usually called a 'finance lease' - you are just using the lease to finance the use of a car by your business.
3. If you buy a car and you borrow money to finance it then the car will appear as an asset on your balance sheet, albeit the car's value will drop each year as it depreciates. The money you have to repay to the lender until the end of the finance agreement will appear on your balance sheet as a liability, though the amount show in the acounts will reduce each year as you make repayments on the finance agreement.

When the rules change, larger businesses will have to show operating leases on their balance sheets as liabilities to avoid the use of operating leases as a means of 'hiding' liabilities from those looking at a company's financial position, e.g. potential investors.

If the accounting impact of vehicles and funding could be summed up in one sentence it would normally be: Assets on the balance sheet are good, liabilities on the balance sheet are bad.

That's an over-simplification, but one that helps summarise how businesses should view vehicles and vehicle finance from an accounting perspective.

Taxation

There are two key isues to take into account when considering taxation in relation to company cars and vans;

1. tax relief for using a vehicle in your business; and
2. Value Added Tax (VAT) recovery on the vehicle.

For vans the position is straightforward, so let's look at that first.

A business will get tax relief for the cost of buying a van according to how the van is financed. The tax relief is given under a system known as 'capital allowances' - capital allowances were introduced in 1945 as way of encouraging investment in assets by giving tax relief for investment in plant and machinery.

Under the current (2019) capital allowances system, subject to certain requirements, 100% of the purchase price of a new van can be written off against business taxes in the year in which the van is purchased.

If the van is bought on a finance agreement (such as a bank loan) then tax relief is given for the interest charges in the agreement by spreading them over the life of the finance. The way the interest is spread loads (or skews) the amount of the interest charges towards the earlier years of the loan (often referred to as a 'Rule of 78' basis).

This is to acknowledge that interest charges are higher in the earlier years of a loan because a larger proportion of the amount borrowed is outstanding. This can be contrasted with the later years of the loan when a significant proportion of the amount borrowed will have been repaid and so the interest charges will be lower.

The overall effect is that a business tax deduction for the interest charges on a finance agreement is greater in the earlier years of the loan.

If the van is acquired through an operating lease, such as contract hire, then tax relief for the lease rentals is normally given in the tax year in which the rentals are paid. The exception to this is when the rental payments are skewed to distort the overall profile of repayments during the life of the lease.

For example, if a van is rented over 36 months on contract hire with a lease payment plan of 6 months' rentals in advance followed by 35 monthly payments then the 6 months' advance payments must be spread over the life of the lease - they can't be claimed as a tax deduction in the first year.

As far as VAT is concerned for vans, the position is straightforward. If you run a VAT registered business and can recover your input VAT then the VAT you pay on the cost of a van will be recovered by the business in the normal way.

However, if this happens, when you sell the van you must charge VAT on the sale price and account for this to HM Revenue and Customs.

The tax and VAT position for cars is much more complex and depends on whether the car is bought or leased.

Tax relief and VAT recovery for cars bought by businesses is restricted. This is because most company cars have a dual purpose. In addition to business use, they are typically used by employees for private mileage as well. This duality of purpose is recognised by limiting the capital allowances and the amount of VAT that can be recovered. A third environmental factor has also been introduced in recent years.

For capital allowances purposes, cars attract a tax deduction at a standard capital allowances rate of 18%p.a. However, the position is made slightly more complex by sub-dividing this between cars with lower or higher level of CO2 emissions.

New cars with CO2 emissions of 50 grammes per kilometre (GP/Km) or less are eligible for capital allowances of 100% of the purchase price in the tax year of acquisition. This includes all-electric cars.

New cars with CO2 emissions of between 51GP/Km and 110GP/Km are given capital allowances at the 18%p.a rate.

New cars with emissions over 110GP/Km only get capital allowances at 8%p.a.

The effect of this split is further complicated by 'pooling'.

Pooling involves grouping all the cars together according to their CO2 emissions. So, cars in the 51GP/Km and 110GP/Km range are grouped together in one pool and cars with emissions over 110GP/Km are put in another pool.

The pooled value of the cars is then given capital allowances at the appropriate rate.

The effect of pooling is to spread capital allowances further. The cars in the 18% pool are further grouped with all the general assets of the business (e.g. plant and machinery).

As new assets are added to the pool the amount available for 18% allowances increases, but similarly, as assets are sold, the sale value is deducted from the pool to reduce the amount available for allowances.

For cars in the 8% pool, this pool is kept apart for a separate capital allowances deduction and, because the 8% rate is much lower than for other cars, it takes much longer for the cost of these cars to be deducted against profits for tax purposes.

It's beyond the scope of this article to cover the impact of capital allowances for cars in full but, basically, the higher the CO2 emissions, the lower the effective tax deduction each year against profits.

For leased cars, tax relief is given on the rentals rather than via capital allowances. However, to encourage the use of cars with lower CO2 emissions there is a restriction of tax relief on the rentals for cars with a CO2 output of more than 110GP/Km. In such cases, 15% of the lease rentals is disallowed completely for tax deduction purposes.

VAT is also more complex for purchased cars.

If a car is purchased by a business then VAT on the purchase price cannot be recovered, but VAT then doesn't normally need to be charged on the eventual sales proceeds when the car is sold.

The only exception to this is for cars that are used 100% for business purposes, in other words where there is absolutely no employee private use at all. For such cars VAT can be recovered under the normal rules applying to the business and must be charged on the sales proceeds of the cars as well.

If a car is leased then the leasing company can recover the VAT on the purchase price, but it must then charge VAT on the lease rentals. However, VAT registered businesses can then recover half the VAT paid on the rentals for cars with mixed business and personal use and 100% of the VAT for cars used only for business purposes (subject to the normal rules for VAT recoverability).

Putting It All Together

This article has probably been heavy going, but it deals with complex and significant issues for businesses considering how to fund their vehicles.

In the final article of this series I will explain how all of the key concepts of Risk, Affordability, Cash-Flow and Accounting/Taxation come together to create the environment in which you should decide how to fund your business cars or vans.

In the meantime, if you want to see all of this concepts put into action, take a look at our DriveSmart website.