GST TREATMENT OF CHATTEL FINANCE PRODUCTS
- GST trap for small businesses
CASE STUDIES BY AMBRY LEGAL
CASE STUDY
Colin is registered for GST on a cash basis. When he traded in a business motor vehicle he was surprised to be told by the car salesman that he would have to pay GST on the value of the trade-in.
This news was not a deal-breaker because the salesman explained that he would also be entitled to claim back the input tax credit on the new vehicle. The salesman went on to point out that as the trade-in vehicle was worth less than the new vehicle his GST cost would be much less then the value of the input tax credit on his new vehicle. Never one to miss a tax rort, Colin decided to spend more than he had originally contemplated and finance the vehicle by way of hire purchase.
Colin was shocked to learn from his accountant that he was not entitled to claim the GST credit on the hire purchase arrangement. Why is this so, and how should the salesman have advised Colin to finance the vehicle?
INTRODUCTION
One of the most common transactions entered into by a business is the purchase of plant and equipment (including motor vehicles). It is also common to use one of the following products to finance the acquisition: leasing, hire purchase, or a chattel mortgage.
The tax law gives us a clear definition for the term hire purchase however there is no definition of the term lease or chattel mortgage. While most tax practitioners understand the difference between these financial products the Commissioner has had occasion to warn tax agents that the ATO’s audit investigations have found that it is not uncommon for tax payers to be confused between these products and, for example, claim hire purchase rentals as a tax deduction in the mistaken belief that an hire purchase contract was in fact a lease.1
The term "hire purchase agreement" is defined in section 995-1 of ITAA 1997 as:
(a) a contract for the hire of goods where:
(i) the hirer has the right or obligation to buy the goods; and
(ii) the charge that is or may be made for the hire, together with any other amount payable under the contract (including an amount to buy the goods or to exercise an option to do so), exceeds the price of the goods; and
(iii) title in the goods does not pass to the hirer until the option to purchase is exercised; or
(b) an agreement for the purchase of goods by installments where title in the goods does not pass until the final installment is paid.''
There is no general definition of the term "lease" for income tax purposes and while the common law meaning of "lease" probably only applies to real estate transactions the term "lease" is commonly used to describe bailment of chattels for consideration. In practice, the only way to tell the difference between a lease agreement and hire purchase agreement is to read the terms and conditions of the agreement. The ATO considers a finance agreement to be a lease when:
- there is no option to purchase the vehicle written into the agreement; and
- the residual value reflects a bona fide estimate of the vehicle's market value at the end of the lease.
If these 2 conditions are not met, the ATO considers the agreement to be a hire purchase or chattel mortgage agreement and only the interest component of the payments is deductible. Whereas the full lease rental is deductible under section 8-1 if the vehicle is used for income-producing purposes.
For income tax purposes the tax treatment of hire purchase agreements and chattel mortgages products will usually be the same. However, in my opinion this is not true for GST purposes. This conclusion turns on the fact that there is a significant legal distinction between the two products. Title to the goods under a chattel mortgage facility usually passes to the purchaser of the goods when they are delivered to the purchaser. At the same time the financier takes a security interest (chattel mortgage) over the goods. Whereas title to the goods does not pass to the purchaser of goods under hire purchase until the final payment is made. This becomes important when analyzing the GST treatment of these two products.
The following table summarises these differences:
Ownership
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Income Tax Treatments
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Finance Lease
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The financier is the owner of the goods. The lessee guarantees the residual value upon expiry of the lease and will usually make an offer to buy the goods at the residual value upon completion of the lease | Lease rentals are generally deductible under section 8-1 in the period in which the rental is incurred |
Hire Purchase
|
Title remains with the vendor of the goods or the financier until the last rental payment is made. | Div 240 recharacterises the transaction as being a sale of property to the hirer and allows the hirer to claim the interest expense and depreciation (or a trading stock deduction). |
Chattel Mortgage
|
Title passes to the purchaser of the goods (usually) upon delivery. The financier has a charge of the goods to secure a loan made to finance the acquisition. | Interest on the loan is deductible under section 8-1. Depreciation can be claimed under the UCA rules. |
GST Treatment of lease agreement
A lease agreement grants the lessee the use of plant or equipment owned by the financier for the term of the lease agreement. The financier remains the owner of the equipment. The lessee pays the financier a lease rental fee and usually guarantees that that the equipment will be worth the agreed residual value at the end of the lease period.
Where the financier is registered for GST the supply of the equipment by way of lease will usually be a taxable supply. Where the lessee is registered for GST they will be entitled to claim a corresponding input tax credit if the rental agreement is a creditable acquisition. If the lessee purchases the equipment at the end of the lease (usually at a price equal to the residual value), this transaction will also be subject to GST if it is a taxable supply made by the financier.
There are potentially two supplies being made: a one-off grant of the lease and sale of the equipment at the end of the lease
Case study (cont.) Assume Colin chooses to finance the new vehicle by way of a lease agreement. The old vehicle is sold for $16,500 and the new vehicle costs $44,000. The finance company quotes a monthly rental of $1,100 over a term of 5 years with a 30% residual. |
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Cash basis taxpayer
Where a lessee is registered for GST on a cash basis the taxpayer will be entitled to claim an input tax credit on the monthly lease rental in the tax period in which the rental is paid.
On these facts, Colin will have a GST liability of $1,500 in the tax period in which he disposes of the old vehicle (this is true even if the old vehicle was acquired pre-GST) and he will be entitled to claim an input tax credit of $100 per month for 60 months. If Colin purchases the vehicle at the residual value of $13,200 at the end of the lease he will be entitled to a further input tax credit of $1,200 in that tax period.
Non-cash taxpayer
Ordinarily the lessee would be entitled to claim an input tax credit on the whole of the consideration payable on the grant of the lease upfront, however this transaction is caught by the progressive or periodic supplies provisions found in Division 156 of the GST Act. This means that the tax payer who is registered for GST on a non-cash basis will attribute the input tax credit to the period in which the lease rental is due to be paid (note this might be a tax period other than the tax period in which the liability is actually discharged).
GST Treatment of hire purchase contract
Under a hire purchase contract the hirer has the use of the equipment while he is paying for the equipment on an installment plan. The financier owns the equipment until the last installment is paid. At that point in time the hirer becomes the owner of the equipment.
It is not clear to me how a literal interpretation of the law would treat this transaction. Arguably, the supply being made under the hire purchase transaction is similar to that under a lease agreement. That is: the financier first grants the hirer the right to use certain equipment before title passes, but also agrees to transfer ownership of the equipment to the hirer upon payment of the last month’s rental.
However, the Commissioner has said in GSTR 2000/35 that “a hire purchase agreement is in commercial substance a method by which the ‘hirer’ purchases goods on deferred payment terms [therefore] it is not a supply progressively or for a period"2. He goes on to say that this is so because while the transaction is in technically a bailment, with an option to purchase, the intention of the parties is that the goods will never be returned to the financier. While the Commissioner does not go on to draw any conclusions as to what this means about attribution of GST liability in the GST ruling the ATO’s Hire purchase, leasing and GST – Fact Sheet advises that the correct treatment of a hire purchase transaction requires attribution to follow the commercial substance of the transaction rather than its legal form. As this is favourable to the taxpayer, and consistent with the income tax law, it would be churlish of us to disagree with the Commissioner’s interpretation.
Another issue arises in regard to hire purchase. On the commercial substance view of a hire purchase transaction the hire purchase rental amount is a function of the term of the contract and the interest rate payable on the arrangement. This means that we need to consider the GST treatment of the interest component of the rental agreement. Interest payments represent the consideration payable for the supply of money. A supply of money in these circumstances would be an input taxed financial supply therefore GST will not usually be attributable to that part of the hire purchase rental. However, where the amount of interest payable under the hire purchase agreement is not separately identified and disclosed to the hirer the total amount payable under the contract will be subject to GST.
As the hirer ends up owner the equipment there is no residual payment as such, however, the last rental payment may be for a lump sum amount similar to the amount typically payable as the residual value on a lease agreement.
Case study (cont.)
Assume Colin chooses to finance the new vehicle by way of a hire purchase agreement. The old vehicle is sold for $16,500 and this amount is applied as a trade-in against the purchase price of the new vehicle (costing $44,000), therefore Colin has to finance $27,500. The finance company quotes a rental of $550 per month for a term of 5 years. This amount represents repayment of the $27,500 net purchase price plus interest of $5,500.
Cash basis taxpayer
On these facts Colin will be liable for $1,500 GST on the disposal of the vehicle and he will be entitled to claim an input tax credit of approximately $40 on each monthly payment of $550.
As the financier has separately advised the interest component of the monthly rental (20% of the total amount payable under the contract) the input tax credit is reduced by $10 per month. Note: the interest cost of $10 in this example is calculated on a simple straight-line basis. In our opinion if the financier has not separately identified the amount of interest payable on each monthly installment it would be open to Colin to calculate the interest on a credit foncier basis. However, this would have the effect of reducing the input tax credit in the early days of the finance agreement.
Non-cash taxpayer
Because the Commissioner is of the view that GST should be attributed on the basis of the commercial substance of the transaction it follows that if Colin was a non-cash taxpayer he would be entitled to claim an input tax credit on the full purchase price of the equipment. This is because the commercial substance approach assumes that Colin borrowed the purchase price and acquired the property at the beginning of the transaction.
Therefore on the se facts Colin would still be liable for $1,500 in GST but would have the immediate benefit of a $4,000 input tax credit.
GST Treatment of chattel mortgage facility
Under a chattel mortgage facility there is no need for a substance over form analysis. This is because the legal form of the transaction is that the end user arranges a loan from a financier, uses this loan to acquire the goods and then grants the financier a charge over the equipment to secure the loan.
This means that there are two supplies. A financial supply of money by the financier and a supply of the equipment by the vendor of the goods.
Case study (cont)
Assume the same facts as the previous case study but that Colin chooses a chattel mortgage instead of a hire purchase contract.
Cash basis taxpayer
On these amended facts Colin will still be liable for $1,500 in GST but even though he is a cash-based taxpayer he would have the immediate benefit of a $4,000 input tax credit. This is because he has paid for the vehicle in full in the tax period in which he took delivery of the vehicle.
As with other finance facilities made available to Colin’s business the loan supplied by the financier will be an input taxed financial supply.
Non-cash taxpayer
When a chattel mortgage facility is used both a cash and non-cash taxpayer will be treated the same as there is no timing difference that needs to be adjusted for. This conclusion is supported by interpretive decisions ID 2001/728 and 2001/727 support this view. As long as the registered taxpayer hold the tax invoice he will be entitles to claim the input tax credit under section 29 – 10 of the GST Act.
CONCLUSION
Everything else being equal:
- where a client is registered for GST on a cash basis there is an obvious tax benefit in using a chattel mortgage facility over either a hire purchase or lease facility.
- If a client is registered on a non-cash basis they will be better off if they choose to use a hire purchase contract on which the financier does not separately identify the interest cost. This is because this product will allow them to claim an input tax c4redit on the interest component of the transaction.
AMBRY LEGAL
Reference notes
- "The Tax Agent", national ATO tax agent newsletter, Issue 1, September 1998
- GSTR 2000/35 para 66