To Lease or Buy?

t some point as you grow your firm’s business and need to invest in new equipment, you’ll no doubt ask yourself: should I lease or should I buy?

There’s no clear cut answer. Lease or purchase decisions depend on your current cash flow situation, the length of time the equipment is needed, and other business factors and tax considerations.

Leasing might be the best option if you simply don’t have the cash on hand, since many leases require little or no down-payment. Likewise, leasing may be the best option if the equipment is only needed for a relatively short term, such as for a specific project, or if the equipment could become obsolete relatively quickly (such as computers or other high-tech equipment). If you are considering leasing, though, talk to your banker and accountant about whether or not the lease obligations could adversely impact any pre-existing financial covenants or restrictions you may have.

You may prefer to purchase equipment if your firm has the upfront cash to pay in full, since the interest charges on a lease can ultimately drive up the cost.

However, it’s not all about the price. Let’s consider some of the main tax considerations as well.

How capital cost allowance
deductions work

While an equipment purchase itself isn’t a deductible expense for tax purposes, you can deduct depreciation on the equipment for each year that it is available for use in the business. Depreciation for tax purposes is called “capital cost allowance” (CCA).

Under Canada’s Income Tax Act, depreciable assets are grouped into more than 50 classes according to their type and use, and each has its own rate of depreciation. To give some examples, furniture, photocopiers, and telephone equipment are placed into Class 8, which has a maximum annual rate of depreciation of 20%. Application software, such as specialized design software or Microsoft Office Suite, go into Class 12, which has a 100% CCA rate.

The CCA rate for computer hardware and systems software (such as Microsoft Windows 8) has gradually increased from 30% (before March 2004) to 55%. These are now placed into Class 50. Data network infrastructure equipment (servers, data switches and routers), operating to support telecommunication applications such as e-mail, instant messaging, web hosting and browsing, are placed into Class 46, which has a 30% CCA rate.

Although there are many different rates of depreciation for tax purposes, most classes of assets are depreciated on what we call a declining-balance basis. This rule means the rate is applied to the depreciated value of the item (not the price you paid when you first bought it) each year. Also, for most classes, the maximum amount of CCA that can be claimed in the year the asset is acquired is half of the normal CCA rate. This is known as the “half-year” rule.

If you borrowed money to finance the purchase of equipment used by your firm in its business, you can generally deduct the related interest expenses, but make sure that the terms of the loan are eligible for the interest deduction. The terms will almost certainly be eligible if you borrow from your bank, but if you borrow from friends or family, get your lawyer to draw up a legal agreement that meets the criteria for interest deductibility.

Tax rules for leasing

If you decide to lease equipment instead of buying it, be aware that the tax treatment depends on how the lease is treated — either as an “operating lease” or as a “financing lease.” For tax purposes a “financing lease” is considered a sale. The difference is in the legal relationship created by the terms of the lease agreement, not the underlying economic reality. In other words, if the legal agreement is clear that it is a lease — and not a purchase and sale agreement — it will be treated as an operating lease for tax purposes.

Under an operating lease arrangement, lease payments (both principal and interest components) are fully deductible in the same way you’d deduct, say, rental expenses. However, you cannot claim any CCA since you don’t own the asset. As soon as the legal title of the asset has been transferred (at any time during the lease term), the transaction is then treated as a purchase and as the owner you can claim CCA. Under a financing lease arrangement, you cannot deduct the lease payments, but you can claim CCA on the asset on Schedule 8 of the corporate tax return. You are also allowed to deduct the interest portion of the lease payments. This treatment of leases from a tax perspective may not be the same treatment for financial accounting purposes.

As you can see, there’s no one-size-fits-all solution, so professional advice is recommended before you make a final decision to lease or buy. cce

 Kelly Kolke, C.A. is a partner with Grant Thornton LLP. He is based in Nova Scotia. E-mail Kelly.kolke@ca.gt.com.