Defining long funding leases: miscellaneous definitions: term of a lease: 'reasonably certain': example 4 - lessee intention
Lessor N Ltd leases lorries to haulage firm P & Co. P & Co states that it wants to lease some lorries for 10 years. The lorries are expected to have a useful life of at least 10 years but N Ltd is only willing to lease on the basis of
- broadly even payments
- full payout over 5 years.
Thereafter the lessee may exercise an option to continue to lease the lorries at a peppercorn or sell the lorries on behalf of the lessor, retaining 99% of the proceeds as a refund of rentals.
This is very similar to example 2, except that N Ltd has been made aware that P & Co wants to lease the lorries for 10 years. As the lessor is aware that P & Co want to lease the lorries for more than 5 years it is ‘reasonably certain’ the lease term will be 10 years.
In most, if not all, cases it is unlikely that a lessee will approach a lessor with such definite intentions, but if it does, than the lease will not be a short lease.
In practice, only rarely will it be worth enquiring into this issue where a lease has even payments and is full payout over 5 years because the lessor does not gain a substantial tax-timing benefit and, over the 5 years of the lease the tax effect, year by year, is relatively small.
It may be worth looking at the circumstances carefully where the lease rentals are back-loaded, perhaps to the extent the lease is equivalent to an interest-only loan over 5 years, because the tax-timing benefits are greater. However if a lessor enters into such arrangements it is likely the lessee will not have an option to extend the lease beyond 5 years.
In addition, it is worth noting that a big ticket lessor is likely to have far more information about the lessee’s expected behaviour than would be available in a small or medium ticket case. Therefore a big ticket lessor is likely to know more about the lessee’s likelihood of exercising an option. As a consequence the lessor in a big ticket lease is more likely to need to make appropriate value-judgements in respect of a single lease.