Globally, leasing is a core part of the economic landscape.
 
 
Globally, leasing is a core part of the economic landscape.

Leasing 101

The modern version of the term ‘leasing’ can have a number of meanings. All are concerned, however, with the use of an asset of some sort by a party who does not own that asset in the full sense.


Derek Soper

Derek Soper

Derek Soper is a long-standing member of the Leasing Industry having entered the business in 1960 with the first leasing company established in the UK. He has served as Chairman of the UK Equipment Leasing Association (now the Finance & Leasing Association) and was a member of the Industry Future Council of the Equipment Leasing and Finance Association of America and the Finance House Association of Hong Kong, having also chaired a European integration committee for Leaseurope. Derek is a Fellow of the UK Institute of Directors and a Freeman of the City of London. Latterly Derek chaired AT&T Capital in both Europe and Asia returning to the UK from Hong Kong in 1998 and established International Advisory Associates and The Alta Group consultancy in Europe where he served as Principal and Chairman. Currently Chairman of IAA-Advisory he continues with close associations across the industry and throughout the world.
Derek Soper

Introduction from Executive Producer LINDSAY TOWN
In the first of a series of pieces in our Leasing Fundamentals series Derek Soper, Chairman of IAA-Advisory and of the Leasing Foundation unpicks the idea of what leasing is based on some simple and easily-understood concepts. What Derek's series of pieces makes clear is that, globally, the industry is complex, changing and little understood but at 20% and 30% of all capital expenditure, a core part of the economic landscape.

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

 

Leasing 101

The modern version of the term ‘leasing' can have a number of meanings.  All are concerned, however, with the use of an asset of some sort by a party who does not own that asset in the full sense.

But leasing has a more particular meaning, as defined by its industrial and commercial context. There is, across the world, in many industrialised countries, a distinct leasing industry.  It consists mainly of companies operating in the broad financial services section of the economy, particularly within banking, which are the leasing, or lessor companies and who acquire assets in order to lease them to lessees who are a variety of businesses spread across the whole spectrum of industry and commerce.

Because such a distinct leasing industry has been established in various parts of the world, there is a tendency to define leasing in sector or ‘status terms: i.e. that leasing is what leasing companies do, or at any rate some of the things they do.  This is the general perception of leasing within the industry.

However as a definition this is less than satisfactory.  There are too many overlaps within and between leasing companies and between that which is, and that which is not, within the usual concept of leasing.

A possible definition of leasing, which is functional rather than status-based would be:

The leasing of a variety of capital assets for various periods of time to commercial users who do not require, or obtain at least initially, title to the assets.

Such a definition would not be universally accepted.  For example, some leasing companies who are to some degree engaged in the business of land and property leasing as well as asset leasing, might well regard the former as part of their leasing activities. Indeed, many of the Leasing Associations around the world have not attempted an authoritative definition of the concept of leasing and many include property leasing within their aggregate statistics for the leasing activity of member companies.

In many jurisdictions it has been the system of corporate taxation which set the boundaries of the leasing industry.  Where assets are leased by one company to another, without the opportunity for the latter to acquire ownership, many tax systems recognise the lessor as owner of the assets, using them in its trade – i.e. the trade of leasing – and thus entitled to offset the cost of acquisition, by way of capital allowances (tax relief), against its tax liability on the rental income from the lease.  If on the other hand the user can acquire legal title to the assets at some point within a hiring or rental agreement the tax system frequently regards that party as the owner for taxation purposes.

If it is not clear at the outset whether ownership of the assets is to be transferred to the lessee or hirer – i.e. the user, during the course of an agreement or on its termination, the consequent uncertainties  in tax treatment could rule out any capital allowance entitlement for either party thus rendering the cost of the transaction prohibitive when compared with a form of ‘purchase over time'.  Commercial hiring arrangements therefore tend to divide clearly into two categories:

1. The leasing agreement, where the lessor claims capital allowances on the understanding that at no stage will title in the assets pass to the lessee.

2. The conditional purchase agreement, which provides for the user – in this case known as the hirer rather than the lessee – to acquire title.

In the case of some types of agreement, such as hire purchase or conditional sale the passing of title, giving ownership to the user, could well occur only at the end of the agreement, when the hirer has completed the instalment payments representing capital and interest.  However because there is only a nominal option fee for the passing of title  itself, while the hirer is in any event committed to the substantive cost of capital and interest payments, the tax system of many countries frequently recognises at the outset that the structure involves a purchase rather than a lease.  In these cases the hirer is usually entitled to claim capital allowances (tax relief) from the commencement of the agreement, even though the hirer does not have legal title at this stage.

There may be no essential difference in the commercial structure of these two types of asset-based finance arrangements.  For any given asset financed at a particular time, the pattern of instalment payments for capital and interest under the purchase structure may match quite closely those of the rental payments under a lease. However, most tax systems follow the legal principle in recognising a critical distinction between the two – treating the financier or lessor as owner in the leasing case, and the hirer or owner in the case of instalment purchase.

Most of the major leasing companies offer facilities for assets to be leased or hired for business use.  Whether the finance is taken on lease or a form of purchase arrangement may depend largely on which of the two parties, the lessor or hirer, can make the best use of capital allowances at the time, in the light of the current tax position.  In spite of this factor of interchangeability with other forms of finance, leasing is nevertheless regarded as a quite separate form of commercial activity and indeed as a specific industry under the established principles of economic analysis, where the boundaries of category sectors and subsectors cut across those of the large corporate groups.

Because of the taxation factors described above, equipment leases are usually structured so that the lessee never acquires ownership of the assets even where that party wishes to have the use of them for an indefinite period. The agreement is for an initial or primary lease period, at the end of which the equipment will revert to the possession of the lessor if no other arrangements are made.

Beyond these common principles, there are distinct types of leasing structure, the most significant of which are the finance lease and the operating lease.

The finance lease structure is closest in its economic nature to the instalment purchase alternative, though without crossing the dividing line related to the passing of the title, which distinguishes leasing from other forms of finance.  The finance lease effectively transfers to the lessee most of the risks and rewards of ownership of the asset, without making the lessee the legal owner.  The lessor, who will usually be a financial sector company, will expect to recover the full capital cost of the asset from the primary lease rentals and the primary lease period will cover almost the whole expected useful life of the asset. The arrangements for the distribution of sale proceeds at the end of the lease, and early termination or secondary lease periods, where the lessee eventually wishes to have the use of the assets for a shorter or longer period than the primary lease period originally agreed, are all structured to maintain the principle of full recovery of the lessor's costs.

With the operating lease there is a commercial rationale, as well as a possible fiscal reason, for the lessee not to acquire ownership. The asset may be required for a shorter period than its expected useful life. The lessor in this case takes a substantial interest in the residual value of the asset from its sale in the second-hand market at the conclusion of the primary lease period and does not recover the whole of his or her capital investment from the primary lease rentals.

Short-term hiring arrangements, where there is no single extended primary lease period and the owner of the asset relies upon a succession of assignments to a variety of users over the life of the asset, fall outside the accepted definition of leasing. For these types of facility, such as plant hire in the construction industry, the party who owns the assets is much more actively involved in their management than is the case in either the finance or the operating lease, which are both essentially financing facilities.

The operating lease, which is particularly important in respect of such assets as vehicles, computers and aircraft for which there is a viable second-hand market, by its nature owes little to fiscal benefits, though lessors in this sector have been able to take advantage of the features of the taxation system, in certain countries, which have generally assisted leasing. The same could be said of the small-ticket sector of leasing in general – regardless of whether the lease agreements take the finance or operating form – if only because the lessees in this sector have seen other advantages of leasing as more important than any fiscal benefits.

In defining the institutional limits of the leasing industry – confined as it is, in many countries, to agreements between commercial parties rather than private individuals –taxation factors are once again quite critical. The Value Added Tax (VAT) system which is established in many countries under various names generally inhibits the use of leasing, as opposed to instalment purchase, in credit sales of consumer durables for the personal sector. As a generalisation in leasing, the gross lease rentals carry VAT at the current rate, but in instalment purchase only the capital cost of the asset is taxed whilst the financing charges or interest payments are VAT-exempt. For the commercial sector lessee, who will generally be a VAT-registered trader entitled to claim “input tax relief” on all VAT paid on his supplies, the higher VAT liability on leasing compared with hire purchase usually makes no practical difference. However, for the ‘consumer' who cannot redeem VAT paid, the difference is sufficient to ensure that instalment purchase predominates over leasing or hiring agreements except for certain categories of assets that have overriding attractions on other grounds.  Where it does occur – as, for example, in television and video equipment – the leasing of assets to consumers is regarded as essentially a retailing activity, quite outside the commercial leasing industry.

The leasing of property, as distinct from plant and equipment, is usually regarded as a separate activity from that of the leasing industry.  Land and buildings are by nature long-life assets, offering investors a mixture of income and capital growth, while plant and machinery represent depreciating assets offering a limited term exposure, with the lessor able to claim capital allowances that can be set against rental income receivable over the life of the asset.  The latter type of exposure is more attractive to a banking sector both because of the fiscal system and as a result of features of banking supervision. The former is attractive to specialist property companies, and to financial institutions such as pension funds who look for a proportion of longer term investments within their portfolios.

It is therefore probably appropriate in many countries to regard property leasing as outside the general conceptual scope of the leasing industry.  There is, nevertheless, a substantial amount of leasing of fixed plant within buildings, such as lifts and heating systems, which can be subject to leasing agreements independent of the interests in the property itself, and which are treated under the tax system as plant rather than integral parts of buildings. Fixture leasing is very much a part of the equipment-leasing activity. It would be fair to say however that many countries are building up a major leasing activity in the real estate sector. Some leasing Associations in Europe are reporting increases in their real estate activities well ahead, in turnover terms, of the equipment leasing activities.

The net result of all these factors is to set the bounds of an international leasing industry, which has come to play a major role in asset finance and is now of considerable significance within the World economy. It has been estimated that in many of the mature leasing markets around the world, lease finance accounts for between 20% and 30% of all capital expenditure.

CC BY 4.0 Leasing 101 by Derek Soper is licensed under a Creative Commons Attribution 4.0 International License.