Putting the tax brakes on company cars

Company cars used to be a great perk: every three years you'd get a new, bigger model and could hammer it up and down the motorway without a thought to either the financial or environmental cost. Not any more, though. As director of AA Loans, Lloyd East, says: "The cost of company cars is becoming increasingly high."

Company cars are now considered to be a taxable benefit. You pay tax on a proportion of the new list-price of your car at your standard rate, that's 40% for higher tax-rate payers, 22% for lower tax-rate payers. And the way company cars are taxed means that the proportion on which you pay tax is higher for the least fuel-efficient motors; it is much more expensive tax-wise to drive a large gas-guzzler than a smaller car.

This is because in 2002 the chancellor, Gordon Brown, changed the way company cars were taxed in an effort to cut UK carbon dioxide emissions. He decreed that those cars that emit a relatively high proportion of damaging CO2 should be taxed at 35% of the list-price of the car, while eco-friendly vehicles would be taxed at only 15%. In between there is a stepped table of emissions and tax, which increases at 1% increments for every extra five grams of CO2 per kilometre that your car emits.

Confusing? Yes, it is, but the table on the Society of Motor Manufacturers and Traders' website can help make sense of it and explains what rate different cars are taxed at. If you already drive a company car you probably know its CO2 emission rate - indeed emission rates are a big selling point now and most car adverts feature them.

Green targets
The decision to tax only company cars on their emission rates and not all cars was made because most company cars end up in the used-car market. In this way the government hoped to eventually influence the cars everyone bought. Although it is committed to taxing company cars in this way for the foreseeable future, it is moving the goalposts a little. But a slight tweak to the rules is enough to cost some drivers hundreds of extra pounds in tax.

When the new tax regime was introduced, an extra 3% "environmental tax" was added to diesel cars. This was because while diesels actually produce less CO2 than petrol cars, they pump out some pretty nasty particulates. The lowest tax rate for a diesel car was 18% instead of 15%, although the top rate was capped, as on petrol cars, at 35%.

However, at the time a new European standard for diesel cars called Euro IV was being rolled out. Cleaner than conventional diesels, Euro IV cars co-existed for a time with ordinary diesel cars. And to encourage companies to buy these cleaner diesel vehicles, the government knocked off the 3% environmental tax, bringing them in line with petrol cars.

Because diesel cars usually have better fuel efficiency than petrol cars and also have a stronger resale value, Euro IV diesels became very attractive as company cars and their sales went up - from 26% of sales in 1999 to 50-60% in 2005. Now all diesel cars in Europe conform to the Euro IV standard and the government is taking the tax-incentive away. As of January 1 2006 the minimum tax payable on a diesel car will be 18%.

However, employees who register their new diesel car before December 31 2005 will still be able to take advantage of the tax break for as long as they own the car, potentially saving themselves hundreds of pounds. For example, an employee who spends £15,000 on a new low-emissions diesel car and registers it before the end of the year will pay tax on 15% of the vehicle. If he is a basic-rate taxpayer, paying a rate of 22%, his annual tax bill for the car will be £495. If, however, he registers the same car after January 1 next year he will pay 22% on 18% of its value - £594 a year. That's a difference of almost £100 every year he owns the car.

The potential saving is much greater for high-rate taxpayers, and those who buy more expensive and less fuel-efficient cars. A high-rate taxpayer who buys a £25,000 diesel car with CO2 emissions of 200g/km would be taxed at 40% on 27% of the value of the car if she registered it before the end of the year. This would mean an annual tax charge of £2,700. After January 1, tax would be charged on 30% of the car's price, increasing her tax bill to £3,000 a year.

Tax points
So as another tax break on company cars is removed, it's worth asking if they are still the perk they once were. With many companies offering cash in place of a motor, how do you know what is best for you? As with most things which involve money, each individual case will be different - and it pays to do your research.

Lloyd East from the AA says the most important thing is to "understand the scheme on offer". He says: "Speak to your HR department and ask them to explain the scheme's structure and benefits." Many company car schemes allow employees to contribute cash (up to £5,000 for tax purposes) so they can get a better car. But many companies also offer cash instead of the car and let you claim a mileage rate for using your own vehicle.

East says: "A general rule of thumb is that the more miles you drive, the better value it will be for you to participate in a company car or fuel scheme. Work out the number of miles you drive, both for business and in your personal life. Take into consideration the personal costs of being on the road and offset this against the scheme to make sure you pick the right deal."

It's not just the purchase price of the car that you should worry about, he says. "Company cars will usually come with free repairs, servicing and road tax, the cost of which will be charged to your company. This can often save you thousands of pounds."

Useful links

How much tax will I pay on a company car?
Company car tax benefit-in-kind calculator

Cash or car, what's best for me?
Cash or car calculator