When Michael Kennedy came to see me about a week ago, he told me his firm was thinking of moving its office to a new site. "We've grown substantially over the last few years," he said, "and our existi...
When Michael Kennedy came to see me about a week ago, he told me his firm was thinking of moving its office to a new site. “We’ve grown substantially over the last few years,” he said, “and our existing space no longer works very well for us. When we move we plan to invest in a fair amount of new equipment.”
“What kind of equipment?” I asked.
“Computers mostly, but we’ll also be buying some basic office equipment, desks and chairs and the like. Our budget is $120,000 in total and computers take up about two-thirds of that amount.”
“That’s a lot of money for a firm your size,” I said.
“True, and for that reason we’re considering leasing. Our space consultant suggested that there’s a tax advantage in leasing fixed assets. Is that correct?”
“The only way to decide is to compare the two alternatives. For example, assume that you want to obtain a computer that costs $1,000 plus tax. At current rates the supplier offers to lease it to you for a monthly cost of $32 plus tax for 36 months, with a buyout at the end of the period of 10% of the original purchase price, or $100. Alternatively, you can finance the purchase over a three-year term with your bank at an 8% interest rate. Which is the better deal?”
“I guess that depends on the total cash outlay under each alternative,” Michael suggested.
“The payments under the leasing arrangement total $1,252, ignoring provincial sales tax and GST. Going with the bank loan, you make 36 payments of $31.11 each. At the end of the period, the loan is fully repaid. Your payments to the bank over the three-year period total $1,120.
“The bank loan looks better,” Michael said.
“That’s right, and the most likely reason is that the bank is able to lend you money at a cheaper rate than the lessor. On a pretax basis, the bank loan is about 12% less than the leasing alternative.”
“What about after tax?” he asked.
“When you lease an asset, generally you can deduct lease payments as a business expense. For that reason, over the course of the lease the timing of your tax deductions will correspond exactly to the timing of your lease payments. When you buy an asset, its value goes into a class that allows depreciation at a specified rate. For example, computers normally go into Capital Cost Allowance Class 10, which allows depreciation on the value at 30% per year. However, in the year of acquisition of an asset, you are allowed only half the normal depreciation amount.”
“Now I’m getting confused,” Michael said.
“Typically, when you buy a computer you can depreciate its value at 15% in the year of purchase (one half the normal 30% rate) and at 30% on a declining balance thereafter. So in year one you take 15% depreciation which is $150 (15% of $1,000). The next year you take depreciation of 30% off the remaining $850, or $225. And so on.”
“How long will it take to write the asset off totally with depreciation?”
“Since depreciation is taken on the declining balance, it actually takes about seven years to depreciate 90% of the asset’s value.”
“Advantage to leasing,” Michael said.
“True,” I replied, “although you can benefit from buying if your purchase is made at the end of the year. If you buy an asset in December, you get half a year’s depreciation. If you lease in December, you get to deduct one month’s lease payments.”
“On the other hand, by leasing I don’t have to tie up my bank credit line.”
“That’s right. However, your bank may give you a special term loan for asset purchases in addition to your other borrowing.”
“I can discuss that with my banker,” Michael said. But leasing still looks like a better route to me because of the deductibility of lease payments. I don’t like the idea of depreciating a computer for four years after I’ve already junked it.”
“I want to mention a special income tax provision for computer purchases made to deal with the Y2K problem, ” I said. “Because of the millennium bug, the tax rules have been amended to allow an accelerated capital cost allowance for certain computer purchases. If you are replacing old equipment that is not Y2K compliant, you are allowed to write off 100% of a replacement computer or software in the year of acquisition.”
“That’s an argument in favour of buying.”
“Yes it, is. The accelerated rules apply to purchases made between January 1, 1998 and June 30, 1999.”
“So the choice is not obvious. Leasing is not the absolute best alternative in every circumstance.”
“Correct,” I replied. “Your choice will depend on a number of factors. You have to work out the solution carefully with the actual numbers before you can tell which route to follow.”
HENRY T. BULMASH, MBA, C.A.