Introduction: Leasing: Introduction to operating leases and off balance sheet finance
Operating leases, particularly on expensive assets, are often simply another form of finance. In these cases the lessor takes some equity risk, but in substance it is still making a loan to the lessee.
Leases that function as financing transactions may be properly classified as operating leases, but the lessor is likely to sell the asset at the end of the lease and so, as with finance leases, there may only be a single lessee. The difference is that, because the rentals do not fully cover the cost of the asset (plus interest), the lessor has to take some risk that the value of the asset at the end of the lease (the ‘residual value’) will not pay off that part of the ‘loan’ that is not, in effect, repaid via the rental stream.
The advantages for the lessee include not having to pay for the full cost of the asset over the term of the lease and the fact that borrowing remains off balance sheet - hence operating leases may be a form of off balance sheet finance. The latter is important for some businesses for commercial reasons. The lessee may, however, have to pay what amounts to a higher rate of interest on what amounts to the loan, as well as losing any upside on the expected residual value at the end of the lease term.
It is worth noting that although the lessor takes equity risk it is, in practice, often a very low risk, see BLM00065.
The introduction of the long funding lease rules by FA 2006 brought in a new regime for taxing longer leases that perform a financing function (see BLM20000 onwards). This includes some operating leases.