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Purchase vs. Capital Lease - What's the better deal?
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For starters, these two types of financing instruments are treated exactly the same for income tax purposes. You deduct the interest paid on the financing each year and the capital cost allowance (CCA) for that asset class. We will further touch on the income tax implications after we analyze the total cost to finance a truck under the 2 separate options - purchase and capital lease.
To illustrate an exact apples to apples comparison we will use the following example:
John Smith, a sole proprietor Owner Operator, has exactly $20,000.00 to put down on a new 1999 truck. The selling price is $120,000.00 and in both cases he is able to finance it over 60 months at a rate of 8.95%.
Let's run the numbers on the purchase/loan option first. If he buys the truck for $120,000.00 we must add $8400.00 GST and $9600.00 PST (this is an Ontario example). Total purchase price is $138,000.00 less $20,000.00 down payment = $118,000.00 to finance. At 8.95% for 60 months the monthly payments work out to $2,446.62. Therefore the total out of pocket cost for this truck over the 60 months would be $20,000.00 down payment + 60 x $2,446.62 monthly payments - $8400.00 GST refund = $158,397.20.
Now, if John takes that $8,400.00 GST refund and lumps it as a additional payment in the 6th month, his monthly payments would drop to $2,280.05. The total out of pocket cost for this truck now becomes $20,000.00 down payment + 60 x $2,280.05 monthly payments = $156,803.00. John would save an additional $1,594.20 in financing charges by lumping his GST refund into the contract in the 6th month. That's almost ¾ of a monthly payment.
Let's now take a look at the same scenario but as a capital lease with a $100.00 buy out.
John still has $20,000.00 to put down, but as a lease we must back the taxes out. Therefore, his down payment would look like this: $17,391.31 + $1,217.39 (GST) + $1,391.30 (PST) = $20,000.00. Based on this he must then finance $120,000.00 - $17,391.31 = $102,608.69 for 60 months at 8.95%. His monthly payments on this lease would be $2,127.50 + $148.93 (GST) + $170.20 (PST) = $2,446.63. The total cost of this lease over the 60 month term would be: 60 payments x $2,446.63 = $146, 797.80 minus 60 GST refunds x $148.93 = $8,935.80 plus $20,000.00 down payment minus down payment GST refund of $1,217.39 = $18,782.61 plus $100.00 buy out. Grand total cost: $156,744.61.
To do a true "fair comparison" we will use scenario 2 (GST lump payment) to compare to the capital lease option. As you can see they virtually cost the same over the 60 month period. Scenarios 2 and 3 have a $59.00 difference. If the overall cost to finance each is virtually identical, what other issues should be addressed to determine which option is right for you?
1. The monthly payment - A cash flow consideration. In the purchase option the monthly payment works out to be $2,208.05 and in the lease option it works out to be $2,446.63 (you would get $148.93 back in GST each month on the lease).
2. PST Refund - Another cash flow consideration. With a purchase you would receive the PST refund back (if eligible) all at once, usually within 3 to 6 months of the purchase. With a lease, you must apply every 12 months to obtain your PST refund based on that 12 months of activity.
3. Balance owing/pay out at critical trade years - in any finance deal this should be considered. You don't want the pay out to be more than what the "street value" of the equipment will be. Remember that the taxes (GST & PST) will have to be paid on a pay out in the lease option.
4. Income Taxes - From an overall tax deduction standpoint (CCA and interest) there is virtually no difference between the purchase scenario and the capital lease. In our example, the purchase scenario would have an additional write off of $158.12. At a marginal tax rate of 40% this would equate to a tax savings of $63.25. This amount would offset the $59.00 that was in favour of the capital lease for the overall cost of the financing.
5. Legality of the finance contract - be sure to review any finance contract to be certain of all clauses. In particular, pay out penalties, late payment penalties, remedies, etc. The key to these two financing scenarios being identical, with respect to total cost of financing, is the term (60 months) and the rate (8.95%) are exactly the same. If these two variables change, then the overall costs will change. In the final analysis, it should come down to "what is the total cost of the financing over the life of the deal" and "the tax implications", which would vary on an individual basis. With a little bit of homework, some amortization tables and consultation with your accountant, you can determine what is the best deal for you.
The key to these two financing scenarios being identical, with respect to total cost of financing, is the term (60months) and the rate (8.95%) are exactly the same. If these two variables change, then the overall costs will change. In the final analysis, it should come down to "what is the total cost of the financing over the life of the deal" and "the tax implications", which would vary on an individual basis. With a little bit of homework, some amortization tables and consultation with your accountant, you can determine what is the best deal for you.
What is a Capital Lease?
From Revenue Canada's stand point, a capital lease is just a different method of financing a piece of equipment you intend to own in the end. For income tax purposes, Revenue Canada treats a capital lease the same as a purchase. When is a lease considered a capital lease? When one of the following exists:
1. Title automatically passes after a certain number of payments
2. The Lesee is required to buy the asset at some point or guarantee full option price
3. The option to buy is at less than fair market value (FMV)
4. The option to buy is at a price or under conditions such that no responsible party would fail to exercise that option. In our John Smith example it is a capital lease because the buy out was for a nominal amount, $100.00, and this is at less than fair market value.
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