Defining long funding leases: miscellaneous definitions: avoidance - term of lease artificially shortened - example
Assume the following facts
- Lessor Plc buys a container ship for £50m,
- after 5 years the ship is expected to have an open market value of £40m,
- the ship is expected to have a useful economic life of no more than 25 years,
- Lessor Plc leases the ship for 5 years to C Ltd at £5.5m a year,
- at the 5-year point, C Ltd has option to extend the lease for a further 10 years at the then market rate for the type of ship, which is expected to be in the region of £5m a year or more. If that option is not taken the lessee must pay the lessor £2m,
- the lease is agreed to be properly accounted for as an operating lease under GAAP.
On the basis of these facts there is no reason to think that the lessee is reasonably certain to exercise its option to extend the lease term. But it is equally true to say that it is not reasonably certain not to exercise the option. Both outcomes are realistic and viable.
On the facts as given in this example it would follow that the lease is not a short lease.
The lease would be a long funding lease if, looking at the 15-year period, the lease met the lease payments test or the useful economic life test. On the face of it, the useful economic life test is not met (as 15 is 60% of 25 years) but it would be worth checking the useful economic life is at least 23.08 years (15 is 65% of 23.08). The finance lease test is not met on the facts in this example.
In reality there may, of course, be facts that support the idea that the lessee is reasonably certain not to extend the lease term.
As with other enquiries involving consideration of the lease term you should establish all the facts and seek advice from CTIS (CT&BIT) before taking a formal view on whether an option is reasonably certain not to be exercised.