Contents
- What is a hire purchase agreement?
- Tax treatment
- Hire purchase v leasing v outright purchase
- Limitations under division 240
What is a hire purchase agreement?
A hire purchase agreement commonly refers to a contractual arrangement whereby a person or entity (the lessee) acquires from another person or entity (the lessor), the right to use an asset and a subsequent right or obligation to purchase the asset. For example, Person A providing Person B with a car for hire and at some future point in time the right or obligation to purchase that car.
According to tax legislation, a Hire Purchase Agreement is constituted by the following:
- A contract for the hire of goods.
- The hirer has the right or obligation to buy the goods.
- The charge that is or may be made for the hire, together with any other amount payable under the contract exceeds the price of the goods.
- Title to the goods does not pass to the hirer until the option to purchase is exercised or an agreement for the purchase of goods by instalment where title in the goods does not pass until the final instalment is paid.
You will note from this definition that the totality of instalment payments and any other associated charges must exceed the sale value of the goods. The excess represents the charge imposed by the lessor for providing the lessee with flexible terms to use and then purchase the goods (i.e. the lessor is providing favourable terms to the hirer by not requiring upfront payment to acquire the goods).
You will also note from the above definition that ownership of the goods does not pass to the lessee until the instalments are paid and/or an option to purchase is exercised.
Tax treatment
The taxation rules related to hire purchase agreements are set out in Division 240 of the Income Tax Assessment Act.
Under Division 240, the taxation treatment of the hire purchase arrangement with equated with the taxation treatment of a normal sale/purchase of the underlying goods subject to the agreement. That is, the hire purchase arrangement is treated as a theoretical sale of goods by the financier (the notional seller) to the hirer (the notional buyer) financed by a loan provided by the notional seller to the notional buyer. The sale/purchase is deemed to occur at the commencement of the arrangement.
For the notional seller, the proceeds attributed to the notional sale is the agreed cost or market value.
For the notional buyer, the acquisition cost is the agreed cost or market value. The notional buyer will be entitled to a capital allowance deduction (to the extent the asset is used for an income producing purposes) which is based on the deemed acquisition cost. The various depreciation incentives may also be available to small business taxpayers. This includes the instant asset write off to accelerate/front load the claim for depreciation.
The excess of the notional sale/purchase amount is considered the finance charge component. Part of this finance charge component represents a notional interest (subject to adjustment at the end of the arrangement) that is assessable income to the notional seller and deductible to the notional buyer (to the extent the asset is used for income producing purposes). Note that the notional interest component of each instalment payment (not the full instalment payment) is deductible. The finance charge likely also consists of a fee component. The fee is generally added to the cost of the depreciating asset.
Because the hire purchase agreement is treated in the same way as a sale/purchase transaction, the balancing adjustment provisions may apply if the goods subject to the hire purchase are depreciable assets (e.g. a motor vehicle). A reminder that a balancing adjustment event results in assessable income to the taxpayer where the termination value of the asset (i.e. the sale proceeds) exceeds the adjustable value of the asset. In the reverse situation, the taxpayer is entitled to a deduction.
Note if the goods subject to the hire purchase agreement are trading stock, the normal trading stock rules apply. That is, the notional buyer will be entitled to a deduction for the price of the stock acquired and on hand.
The commercial alternatives to hire purchase arrangements obviously includes leasing the relevant asset or outright purchasing the asset. The remainder of this article highlights some the benefits and cons of entering into a hire purchase agreements compared with these alternatives.
Hire purchase v leasing v outright purchase
Hire purchase
The major drawcards for hire purchase agreements include the flexibility to acquire the goods by instalment payments rather than by repayments under a finance arrangement. This is obviously favourable where the taxpayer has a lower credit rating and would otherwise struggle to obtain finance.
The hire purchase also enables the taxpayer to claim a depreciation deduction for the underlying asset. If eligible, the taxpayer may also be in a position to immediately write off the assets value in the first instalment period. GST credits on the underlying goods may also be claimed in full in the period the first instalment is paid (if the taxpayer collects GST on an accruals basis). Under the lease agreement, GST credits can only be claimed as lease payments are made. As you can observe, the hire purchase arrangement allows the taxpayer to potentially claim tax benefits up front. This may be preferred instead of drawing out tax benefits over a period of time (as is the case with respect to a lease arrangement).
There are obviously circumstances where the immediate claim of depreciation is not ideal for the taxpayer and where the timing of deductions presented under a lease is preferrable.
Leasing
Leasing involves a party having the right to use an asset over the term of a lease in exchange for regular payment.
The major commercial drawcards for leasing include lower short term costs (as the underlying asset is not being acquired) and cash flow advantages. Generally, no burdensome debt will be taken on to finance lease repayments. The other advantage of the lease is that the taxpayer does not bear the burden of wear and tear on the asset. Rather, the lessor wears this burden.
From a tax perspective, the lease asset repayments will be deductible when incurred/paid as a usual business outgoing under section 8 1 (limited by any private use component). This is different from a hire purchase arrangement, whereby the instalment payments (except any interest component) are not deductible as incurred. Instead, as mentioned, the taxpayer gets their deduction from depreciation on the hire purchase asset. Because depreciation deductions are subject to the complexity and rigidity of the capital allowance regime and the simplified depreciation rules, leasing will often be preferred by taxpayers to better manage deduction outcomes in respect of the relevant business asset.
To demonstrate this point, take Thomas who owns a small business through a trust that has opted into the simplified depreciation rules which require depreciating assets under the relevant threshold to be immediately depreciated in full. Thomas had no other income during the 2022 23 financial year and has only commenced business on 1 June 2023. At 30 June 2023, he has made $10,000 in business income and becomes entitled a deduction of $10,000 for depreciation on an asset acquired under a hire purchase agreement. He has no other deductions for the 2022 23 financial year. In this example, Thomas has taxable income of $0. Because he was under the tax free threshold for 2022 23, he essentially receives no tax benefit from the immediately deducted hire purchase asset. From a tax perspective, it would have been preferrable to defer the hire purchase or lease the asset (or depreciate the asset over its effective life) to draw out the deduction and apply it against future income years where taxable income was higher. Assume the business really took off in 2023 24 and Thomas had assessable income of $200,000 with no other deductions. The $10,000 depreciation deduction would reduce his taxation liability by $4,500 (compared with $0 where the immediate write off occurs in 2022 23).
As another example, assume Thomas runs his business through a trust and is looking to wind down the business in the coming 2 3 years. The trust has accumulated losses which will remain trapped in the trust once the business concludes. There is arguably little benefit to claiming large up front deductions for assets purchased under a hire purchase agreement in this instance as future profits are not likely to soak up accumulated losses. Thomas may prefer to simply hire an asset until the business concludes.
Similarly, the tax benefit of leasing includes a potentially accelerated claim of depreciation. For example, the effective life of a motor vehicle is generally considered to be 8 years. Therefore, any motor vehicle depreciation if spread over useful life is generally 8 years. This provides the taxpayer with a 12.5% annual deduction (assuming the prime cost method is used). However, under a leasing arrangement, a taxpayer could make lease payments that exceed that value to maximise deductions.
As you can see, the benefits of a hire purchase versus lease arrangement is highly circumstance dependant. There is no clear winner in every circumstance. The ability to utilise the capital allowance regime with a hire purchase agreement can be favourable to bring forward deductions e.g. by utilising the instant asset write off. In other cases, immediate depreciation will be less favourable.
Note that because the underlying asset is likely being purchased, there may be greater total outgoings and deductions available to the taxpayer who acquires an asset under a hire purchase agreement as opposed to merely hiring the asset.
Outright purchase
The taxation of hire purchase agreements is identical to an outright purchase. However, a hire purchase arrangement does have the benefit of purchasing an asset by instalments rather than being an upfront or finance funded acquisition.
The risk with the hire purchase agreement is that the value of the asset at the point in time the option to purchase is available (if pre determined and agreed in advance) may be lower than anticipated. This means the hirer may be locked in to purchase an overvalued asset. This risk is not present where there an outright purchase.
Under a hire purchase arrangement, there is limited flexibility to sell the asset as the title to the asset does not pass until the final instalment is paid. However, there is no such limitation in respect of an outfight purchase.
Importantly, if the hire purchase arrangement is extended or renewed, the notional buyer will continue to be treated as the notional owner of the asset. Division 240 apply as if there is a new arrangement.
If the notional buyer actually acquires the property, the notional buyer continues to be treated as the buyer and there is taken not be a disposal of the asset. Obviously, therefore, the buyer is not entitled to a further deduction once the asset is actually purchased. However, if the arrangement ceases and the notional buyer does not proceed to purchase the property (or the right to use the property ceases), the notional buyer is deemed to have sold the asset to the notional seller at the asset’s market value.
For a notional seller, the consideration for the notional sale is the agreed cost or arm’s length value. The seller may not claim a capital allowance deduction for the property as the property is deemed to have been disposed.
Where the hire purchase lease term ends and the notional buyer acquires the hired goods, the transfer of the asset is not treated as a disposal/acquisition for taxation purposes. That is, there is no consequence for the buyer or seller upon sale/purchase.
However, if the agreement ceases and the notional buyer does not acquire or maintain a right to use the property, the notional seller is deemed to have re acquired the property from the notional buyer at market value. This will trigger a balancing adjustment event for the buyer and constitute the acquisition of a depreciable asset for the seller.
Limitations under division 240
Division 240 will not apply where the finance charge is merely a trivial sum. The mark up must be enough to reasonably be regarded as an authentic finance charge.
Division 240 is not applicable where there is no notional seller. This might occur where the party hiring the asset does not actually own the asset e.g. where the supplier is a lessee of the asset under a head lease and the asset is being sub leased to the hirer.
Division 240 does not apply in respect of goods which are dealt with under the capital gains tax regime or withholding tax regime. For example, a hire purchase over a non depreciable asset. This article does not address the tax consequences of a hire purchase agreement over non depreciable capital assets.
The ATO may apply general anti avoidance powers to cancel any tax benefit received from a contrived arrangement designed to bypass Division 240.
This article is general information only and does not provide advice to address your personal circumstances. To make an informed decision you should contact an appropriately qualified professional.