Concept & Characteristics Hire purchase v/s Lease Conditions & Warranties in lease Financing & its implications

Tax implications of hire purchasing Evaluation of hire purchasing from hirer and hiree s angle

Is a peculiar kind of transaction under which the goods are let on hire with the option, to the hirer, to purchase them. Two important aspects are:
 Aspect of bailment of goods subject to hire

purchase agreement.  Element of sale which fructifies when the option of purchase is exercised by the intending purchaser.

Payments are to be made in installments over the period. Possession is delivered to the hirer at the time of entering into the contract. The property in goods passes to the hirer on the payment of last installment. Each installment is treated as hire charge so that in case of default of payments seller is entitled to take away the goods. Hirer/purchaser is free to return the goods without being required to pay any further installment falling due after the return.

LEASE FINANCING

HIRE PURCHASE

Ownership lies with the lessor. Lessor, not lessee, is entitled for depreciation tax shield. Capitalization of the asset is done in books of lessor. Entire lease payment is eligible for tax computation in books of lessee. The lessor, not the lessee, has the right to claim the benefit of salvage value.

Ownership is transferred on payment of last installment. Hirer (owner) is entitled to claim depreciation tax shield. Capitalization of the asset is done in the books of hirer. Only hire interest is eligible for computation of tax in books of the hirer. The hirer can claim the salvage value as perspective owner of the asset..

LEASE FINANCING

HIRE PURCHASE

Usually a source of finance for high cost assets viz. airplanes, machinery. It is not suitable for the low capital enterprises which desire to show a strong asset position in their balance sheet. Whereas the lessee has to maintain the asset in financial lease, it is the responsibility of lessor in an operating lease.

Usually a source of finance for low cost assets viz. office equipments. It is highly suitable for low capital enterprises which need to show a strong asset position in their balance sheet. It is hirer s responsibility to ensure the maintenance of the asset bought.

Condition:
 It is the stipulation which is essential to the main

purpose of the contract.  In case of breach, the aggrieved party has the right to repudiate the contract

Warranty:
 It is the stipulation which is subsidiary to the main

purpose of the contract.  In case of breach, the aggrieved party cannot repudiate the contract, but only can claim damages.

Taxation of hire purchase can be divided into three parts:

 Income Tax  Sales Tax  Interest Tax

Hire Purchaser s Perspective:

 Entitled to tax shield on depreciation, calculated

with reference to the cash purchase price.  Entitled to tax shield on the consideration for hire i.e the finance charge (difference between hire purchase price and cash price).  No deduction of tax at source if the agreement expressly provides for option of purchasing the goods at any time or of returning the same before total amount paid.

Hire Vendor Perspective:

 The consideration for hire/ hire charge/ income

received by the vendor is liable to tax under head, profit and gains of business and profession.  The hire income from house property is taxed as income from house property.  Normal deduction, except depreciation, are allowed while calculating the taxable income.

Hire-Purchase as Sale:
 Sales tax is payable once the goods are delivered by

the hire-vendor to hire-purchaser.  There is no provision for refund of the sales tax paid in case of unpaid installment.

Delivery of goods, not ownership, is taxable event. Taxable Quantum is related to sales price. State, where transaction is entered, is entitled to impose tax. Rate of tax varies from state to state.

The hire purchase companies have to pay interest tax under the Interest Tax Act, 1974.
 According to this Act, interest tax is payable on

the total amount of interest earned, less bad debts in the previous year @ 2%.  The tax is treated as tax-deductible expense for the purpose of computing the taxable income under the Income-Tax Act.

Hire Purchaser:
 The decision criterion is the cost of hiring vis--vis cost

of leasing:

Cost of hire purchase:

Down Payment Plus: Service Charges Plus : PV of payments discounted by cost of debt (Kd) Minus: PV of depreciation tax shield discounted by cost of capital (Kc) Minus: PV of net salvage value discounted by cost of capital (Kc)

Cost of leasing:
Lease management fee Plus: PV of lease payments discounted by Kd Minus: PV of tax shield on lease payment and lease management fee discounted by Kc Plus: PV of interest tax shield on hire purchase discounted by Kc

Hire Vendor:

The decision criterion is based on comparison between NPV of hire purchase and lease financing.

NPV of Hire Purchase:

PV of hire purchase installments. Plus: Documentation and service fee Plus: PV of tax shield on initial direct cost Minus: Loan Amount Minus: Initial Cost Minus: PV of interest tax on finance income (interest) Minus: PV of income tax on finance income (interest) Minus: PV of income tax on documentation and service fee.

NPV of Lease Plan:

PV of lease rentals Plus: Lease management fee Plus: PV of tax shield on initial direct cost and depreciation Plus: PV of net salvage value Minus: Initial Investment Minus: Initial direct costs Minus: PV of tax liability on lease rentals and management fee

Higher NPV option is selected.