Background

Taxpayers may not be aware of the differences between an instalment sale agreement and finance lease, with many Taxpayers assuming both contracts are the same since both require regular repayments. Since they are different agreements, both have different regulations and norms when it comes to tax deductions and VAT.

A finance lease arises when the taxpayer is loaned a certain amount of money to purchase an asset (perhaps a car, or machine) and can then claim the repayments made in the tax year as an ‘expense against taxable income.’ Thus, anything paid to the bank can be claimed as a deduction. At the end of the lease agreement, the lessee has the option to purchase the asset.

In instalment sale agreements, the financing company also loan the taxpayer money for an asset, but the taxpayer can only claim wear-and-tear allowance and finance charges, rather than claiming the total repayments as an expense. At the end of an instalment agreement, the lessee gains ownership of the asset.

While both lease agreements allow the lessee the possible ownership of the asset at the end of the stipulated agreement and do not require an upfront deposit, the key difference is how deductions against income tax are claimed.

Income Tax implication for Finance/Operating lease and instalment sale agreement

So what is a finance lease?
In a finance lease, the financial company is legally the owner of the asset during the lease. However, the lessee has the option to acquire ownership of the asset after the last rental. In this lease agreement, the lessee may claim the rental payments incurred as a deduction against taxable income per S24J and S11(a) of the South African Income Tax Act. However, these deductions are only available if the leased asset was used in the production of income. The deduction should be adjusted for any VAT implications.

Tax Implications: For tax purposes, lessees in a financial lease agreement can claim their monthly tax payments excluding VAT.

If the lease agreement extends, it is accepted that the lessee acquires the asset at a cost equal to the cost for the lessor reduced with a tax allowance of 20% per year on the reducing-balance method. However, this equation will not be applicable if the nominal annual rent equals 10% or more of the above calculation.

Instalment sale agreement
In an instalment sale agreement, a financial company also lend the lessee money to purchase an asset but rather than claiming repayments as an expense the lessee can only claim wear-and-tear and finance charges. The lessee may claim the financial charges incurred as a deduction against taxable income per S24J of the Act. In addition to the deduction claim, the lessee may claim wear-and-tear allowance/ capital allowance on the leased asset used due to the vested ownership rights being transferred under the instalment sale at the start of the agreement. These deductions are only available if the asset was used in the production of income.

At the end of the term, the taxpayer will not incur any recoupment on the deductions claimed, as the lessee obtained the ownership rights to the asset at the start of the instalment sale agreement (rather than at the end of it, as is possible with a finance lease).

VAT

VAT implications are the same for both contracts. The lessee may claim 15 % VAT on the total cash value of the leased asset, at the time of delivery or where any payment is made (whichever is earlier). Exclusions to this rule will apply if the lease agreement provides for a “cooling-off” period. In such instances, the time of supply will be when the “cooling-off” period expires. These VAT implications will not apply to the leasing of a
passenger vehicle as defined in the VAT act. The VAT act defines a motor as a motor vehicle having three or more wheels, normally used on public roads and constructed or adapted wholly or mainly for the carriage of passengers.

If you are unsure of what lease agreement is best for you and what the tax implications will be, please contact us for further information:

The Tax Ombud
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