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HMRC internal manual

Business Leasing Manual

The tax benefits of operating leasing: operating leases that function as loans: calculating rentals: example, part 1 of 2

Example

Assume that a ship costs £50m and has a useful life of 30 years. A ship operator does not want to buy the ship but wants to use it for at least 10 years. It therefore approaches a lessor bank and it is agreed that after 10 years there is a high probability that the value of the ship will be at least £35m.

The lessor bank approaches the arrangement by assuming that it will be able to sell the asset for at least £35m at the end of the lease term. On that basis the bank can proceed if, over the 10 years of the lease, it will receive £15m plus sufficient to cover its cost of borrowing and provide it with a profit.

Assume that in this case the lessor needs to charge 6% interest to the lessee. In that case the lessor needs to charge a rental of £4.14 m a year and a very simple analysis of the lease rentals might look like:

Year Annual Rent Interest Capital Element Loan balance
         
1 4.14 3.00 1.14 48.86
2 4.14 2.93 1.21 47.66
3 4.14 2.86 1.28 46.38
4 4.14 2.78 1.36 45.02
5 4.14 2.70 1.44 43.58
6 4.14 2.62 1.52 42.06
7 4.14 2.52 1.61 40.45
8 4.14 2.43 1.71 38.74
9 4.14 2.32 1.81 36.92
10 4.14 2.22 1.92 35.00
Total   26.38    

(An actual analysis would be very much more complex than this.)

On the simple facts outlined here, the lease is clearly an operating lease and the accounting will follow the legal form of the contract. The split into ‘interest’ and ‘capital’ is performed purely for the purpose of calculating the appropriate rentals. The tax consequences are discussed at BLM31215.

The lessor’s profit will increase if it is able to sell the asset for more than £35m and will fall, or even be wiped out, if the market moves adversely and the ship’s value falls further than expected to below £35m.

Clearly this method cannot be used if the asset is leased out on many short leases where the rentals are set by reference to market rates, but it is perfectly appropriate where the operating lease is a long one and is designed to function in much the same way as a loan (albeit a loan where the lessor is taking some residual value risk).