BLM00605 - Introduction: Commercial substance and structure: Finance leases: commercial substance
This manual is being updated to reflect FRS 102 (2024 amendments). For guidance on the tax treatment of accounts prepared under IFRS 16 or the revised FRS 102, please refer to pages within the BLM50000 chapter.
This section is applicable to entities applying FRS 102 pre 2024 amendments or FRS 105, and for lessors only under IFRS 16 and FRS 102 (2024 amendments).
See BLM17000 for lessee accounting under the on-balance sheet model under IFRS 16 and FRS 102 (2024 amendments)
To understand the reality of finance leasing you may find it helpful to think of the rentals under a finance lease in terms of their 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. 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’.
Typically a finance lease is structured like a repayment mortgage. That is, in substance, the rentals in the early years are mostly ‘interest’ while towards the end they are mostly loan’ repayment.
See BLM00630 for a brief description of alternative profiles.
The ‘interest’ charges included in a finance lease agreement may fluctuate with base rate or other changes (such as tax rate or other tax regime changes) and often provisions in the lease spell out the consequences. The lease is usually designed to leave the finance lessor making a desired return on the finance element whatever happens. Meanwhile, the lessee picks up any resulting increased costs or benefits from any reduced cost.
Long-funding leases