For all firms of solicitors considering purchases of capital equipment, such as computer systems, the tax treatment of the equipment costs has once again changed.As most established unincorporated businesses such as law firms are now entering their 'transitional year' between the old and new schedule D tax regimes, solicitors should consider the available tax relief when considering the method of purchase for capital equipment.

The 1996/97 transitional year rules - for which, in simple terms, the basis period will be the two accounting periods commencing after 6 April 1994 - will, in most cases, result in revenue expenditure in these two years receiving only 50% relief.

Any income received in the transitional year basis period will likewise only be 50% taxable.During the transitional period, businesses will still qualify for capital allowances with all assets acquired during the transitional year period being eligible for a 25% writing down allowance.

This allowance will be given as a deduction from the averaged profit for the transitional year.Also in 1993 the position concerning the tax treatment of so-called 'balloon leases', where rental payments were front-end loaded, was tested before the courts in Gallagher v Jones.

In this case, the tax-payer argued that the large initial rental paid on obtaining the lease constituted a revenue expense at that time, thus creating a trading loss.

The Revenue contended that the initial rent al should be spread over the life of the asset in accordance with generally accepted principles of commercial accountancy.

The taxpayer successfully argued before the High Court ((1993) STC 199) that statement of standard accounting practice 21 (SSAP 21) did not apply to an unincorporated business.

However, the Court of Appeal ((1993) STC 537) overturned this judgment, finding that the correct way to ascertain the profits or losses of a business for tax purposes was to apply generally accepted principles of commercial accountancy unless these were inconsistent with the true facts of the case.

Here, there was no inconsistency between tax law and the relevant accountancy principles as set out in SSAP 21.

It is understood that this case will not be appealed further and the Court of Appeal's judgment therefore stands.For tax purposes, there are in effect four different methods of purchasing capital equipment, namely hire purchase, finance leases, operating leases and outright purchase.

It should be noted that the method of purchase of such equipment is essentially a commercial decision and whilst the tax position may have an impact on the decision process, the decision should not be taken looking at the tax position in isolation.-- Hire purchase.

A hire purchase contract enables a business to obtain the right to use an asset for a period of time.

The hirer will also be able to acquire in the future the legal title to the asset by exercising an option to purchase the asset subject to certain conditions, typically the payment of an agreed number of instalments.Under a hire-purchase agreement, the asset is accounted for as if it belonged to the hirer at the outset of the contract.

All capital expenditure incurred in respect of the asset is treated as having been incurred when the asset is first brought into use in the business.Accordingly, the hire purchase contract consists of two elements of expenditure for tax purposes.

The element relating to the capital cost of the asset falls to be treated under the capital allowance regime, being written off against profits at the rate of 25% per annum on the reducing balance.

The interest element is treated as a revenue expense and, in the transitional year basis period, will be averaged.The above is best illustrated by way of a graph (this graph cannot be reproduced on the database.

Please see original), the basic facts of which will be used throughout to provide a simple comparison of the differing methods of purchase.A computer originally costing ��10,000 is acquired on a three-year hire purchase contract by the LSG Partnership on 1 May 1994.

The LSG Partnership makes up its accounts to 30 April each year and is currently assessed under the old schedule D regime on the prior year basis.

On 30 April 1999 the computer is to be scrapped.

Interest charges for the three years of the hire purchase agreement are £1000 in year one, £660 in year two and £250 in year three.-- Finance lease.

A finance lease is a lease which transfers substantially all the risks and rewards of ownership of an asset to the lessee.

For accountancy purposes, under SSAP 21, a finance lease should be presumed to exist if, at commencement of the lease, the current value of the minimum lease payments, including any initial payment, amounts to substantially all (normally 90% or more) of the fair value of the leased asset.Under a lease purchase agreement the asset is again treated as belonging to the lessee although capital allowances will not in this case apply.

However, for such leases entered into after 11 April 1991, the Inland Revenue will normally accept that the properly computed commercial depreciation of the assets, which is charged to the profit and loss account of the business, represents the appropriate relief.

This relief is accordingly given as a revenue deduction in addition to the interest element of the lease payments.Where the depreciation policy of the business does not, in the inspector's view, use a properly computed commercial rate, the inspector will allow only such part of the lease payments in the period which represent the capital repayment element, in accordance with the accruals concept (SSAP 2).This is again illustrated in the graph using similar facts as above.

In this instance, the depreciation policy applied is to write off the capital element of the expenditure over the term of the lease (ie three years).-- Operating lease.

An operating lease is simply defined as any lease other than a finance lease.

The accounting standard defines an operating lease as one where the lessee pays a rental for the hire of the asset for a period of time which is normally substantially less than its useful economic life.

Accordingly, any payment under an operating lease is treated in its entirety as a revenue deduction with no distinction being made between capital and interest elements within each payment.The graph again assumes similar facts as above.

However, the annual rental for the computer is £2000 per annum.

For comparative purposes I have assumed that a new lease for a new computer is obtained at the end of the first lease.-- Outright purchase.

The final alternative is for the business to purchase the asset outright.

In this instance, the capital cost of the asset will be available for capital allowances as set out in the section on hire purchase.

In addition, since the business has had to borrow funds for the purchase, relief may be available on the interest suffered in connection with such borrowings.

This would therefore produce an identical tax position to that as for hire purchase, subject to the commercial terms being identical.However, if the funds were to be provided by way of new capital or loans to the firm by the partners, then interest relief on money borrowed to fund such investment may qualify for relief outside the business, against the total income of the borrower.

This could prevent the transitional year rules applying to such interest payments, with the effect that relief is given in the tax year in which the interest is actually paid.

This again is illustrated in the graph, where it will be seen that permanent income tax relief for the interest starts in 1994/95: under the other methods, no tax relief is obtained before 1996/97.One word of caution must be noted in that the Inland Revenue issued a press release on 31 March 1994 detailing the scope of the proposed anti-avoidance provisions in respect of the transitional year basis period.

These may be capable, inter alia, of reducing the interest relief available to an individual borrowing to provide finance to a business as described above.

It is therefore essential to seek professional advice in this respect before entering into such arrangements.The tax position relating to the various options will change again when businesses come out of the transitional year basis period improving the tax position of finance leases.q