Introduction: Commercial substance and structure: Finance leases: commercial substance
In order to understand the reality of finance leasing you may find it helpful to think of the rentals under a finance lease for what they are as a matter of economic and commercial substance – that is a combination of
- ‘interest’ on a ‘loan’, and
- repayment of the ‘loan’.
But as a matter of general law the rentals are simply the hire charge for an asset. The distinction is important because, before FA 2006, the tax treatment tended to follow the legal form rather than the economic substance.
FA 2006 introduced a new regime for ‘long funding leases’ which taxes certain leases, particularly longer finance leases, in accordance with their economic substance. See BLM20000 onwards for guidance on deciding whether a leaseis a long funding lease and BLM40000 onwards for guidance on taxing long funding leases.
Example of how a finance lease resembles a loan
A simple example illustrates how a finance lease resembles a loan.
A trader who wants an asset costing £10,000 could borrow £10,000 at (say) 10% from a bank and use the money to buy the asset. The trader will pay the bank the interest and also repay the capital. The capital could either be repaid in one lump sum at the end of the loan period or it could be structured like a repayment mortgage, with small capital payments and large interest payments at first and, towards the end, large capital payments and small interest payments.
The same commercial result can be achieved with a finance lease. The finance lessor (often a subsidiary of a bank) buys the asset for £10,000 and leases it to the lessee. The lessee is the one who uses the asset. The lessor charges the lessee rentals which, over the term of the lease, will repay the capital with a commercial rate of ‘interest’.
The ‘interest’ charges included in a finance lease agreement may fluctuate with base rate or with other changes (such as tax rate or other tax regime changes) and so there are often provisions in the lease which spell out the consequences. Usually, the aim is to leave the finance lessor making its desired turn on the finance whatever happens: the lessee picks up any increased costs and benefits from any reduced cost.