The evolution of leasing’s commercial framework
Care must be taken when comparing country statistics as ‘like for like’ comparisons hide different interpretations of leasing.
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Introduction from Executive Producer LINDSAY TOWN
The growth of leasing has resulted in the term being applied to many forms of finance. Derek Soper, Chairman of IAA-Advisory and of the Leasing Foundation, cautions that ‘like for like' comparison is not always available due to different interpretations of leasing in different countries even though the twin features of cash flow and the benefits of use without ownership remain key to leasing's cost effectiveness.
Who should be interested in this?
New entrants to the leasing and asset finance industry, industry commentators, anyone wanting to understand the context of modern-day leasing.
The evolution of leasing's commercial framework
It is appropriate to examine the basic concept and outline of the various forms of leasing that have evolved from the core concept of “use without ownership”.
Definitions of leasing vary slightly from one country to another in line with their own particular regulatory practices, taxation or accounting regimes. A widely used definition of leasing is as follows.
“A lease is a contract between a lessor and lessee for the hire of a specific asset selected from a manufacturer or vendor of such assets by the lessee. During the period of the lease the lessor retains ownership of the asset. The lessee has ‘quiet' possession and use of the asset on payment of specified rentals over a period.”
Within this general definition of a lease, there are two main subfamilies of leasing which are internationally recognised and referred to as “finance leases” and “operating leases”.
A finance lease, often referred to as a “full payout lease” is one which requires payment by the lessee over an obligatory period of specified rentals sufficient in total to repay the capital outlay of the lessor and give a profit margin after the deduction of interest costs.
An operating lease is generally regarded as one that does not meet the ‘full payout' criteria of a finance lease and therefore leaves the lessor with a ‘residual value' interest in the equipment at the end of the initial rental period of the lease. However, with the introduction of new International accounting standards for leasing, more precise definitions have been introduced.
The development of these two types of lease have been driven primarily by the fundamental and twin objectives of lessees wishing to have a relatively easy extra ‘line of credit' and / or to leave certain commitments off the balance sheet. The discussion which has been raging for many years is whether the substance of a lease should override its legal form as more and more complex structures are devised to avoid the requirement for lessees to capitalise leased assets.
In addition to the above classifications, in some countries leases will normally be described as either “tax based” or “non-tax based”. The latter are often referred to as “lease with option to purchase” agreements and differ only very slightly from a hire-purchase contract.
Salient features of a lease
Whatever the form, the substance of the most common form of a finance or full pay-out lease is usually evident from the following characteristics:
1. The asset is selected by the lessee, although the actual order for the equipment may often be placed in the lessor’s own name.
2. The lessor retains ownership throughout the period of the lease.
3. The lessee normally carries the risk of obsolescence and has the exclusive rights to use the asset, subject to the conditions of the lease, which includes requirements for the asset to be maintained in good working order, insured, etc.
4. There is a significant non-cancellable period of the lease during which the lessor expects to receive sufficient rentals to recover all, or substantially all, of the capital outlay and to make a profit margin after all costs.
5. At the end of the lease the lessee may continue the lease at a further agreed rental or hand the equipment back to the lessor.
The deductibility in full of lease rentals for tax purposes by the lessee is of fundamental importance in tax-based leasing. The importance of “cash flow” in leasing does, however, remain and, next to the conceptual benefits of “use without ownership” is one of the most salient features of any lease and the key to its cost effectiveness.
Finance leasing is still regarded essentially as a means of financing the use of an asset without acquiring ownership. From this principal feature flow all the characteristics of a lease although, as will be seen from the following definitions, the distinction between one form of finance and another stems from the narrow difference in emphasis of the main features previously described.
- Outright sale. Purchase using own or borrowed funds.
- Unsecured loan. Purchase with borrowed funds but with no security for the lender.
- Mortgage. Purchase with payments made over time and secured by the asset.
- Credit sale. Purchase with extended credit provided by the supplier.
- Conditional sale. Purchase with title passing on payment of the final instalment.
- Hire purchase. Legally a hiring with an option to purchase at a nominal sum at the end of the term.
- Finance lease. Usually a lease with a ‘full payout' profile.
- Lease purchase. A lease which includes an option for the lessee to gain title at the end of the rental period.
- Operating lease. A lease which involves the lessor in taking a residual value position at the end of the lease.
- Short-term lease. A short-term lease with cancellation and renewal options where title remains with the lessor.
- Contract hire. A form of operating lease (mainly for motor vehicles) which incorporates maintenance, local road fund tax, insurance, a residual position at the end of the lease and many other ‘road user features' such as replacement tyres and windscreen.
- Rental. Another form of operating lease often shorter in duration than contract hire.
- Plant hire. Hire for relatively short periods, usually to a number of users – mainly seen with construction equipment.
As will be seen from the facilities described above, there is no clear dividing line between use and ownership and different distinguishing features apply for different purposes. Under an instalment-purchase contract, for example, legal ownership does not normally pass to the hirer until the option to purchase is exercised after the final instalment has been paid, whereas economic ownership has been enjoyed from the outset.
The spread of leasing has resulted in the term being applied to many forms of instalment finance even though upon close examination they will be found to be more akin to instalment purchase. It is for this reason that care must be taken when comparing country statistics – ‘like for like' comparison is not always available due to different interpretations of leasing.