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HMRC internal manual

Business Leasing Manual

Taxation of leases that are not long funding leases: finance lessees: importance of lease term: no secondary period: primary period is less than useful life of asset

As mentioned in BLM32505, a finance lease may be for less than the economic life of the asset but not contain an option to extend the lease term into a secondary lease period. Such a lease is likely to take one of two basic forms:

  • regular and fairly even (or sometimes rising) rentals over the primary period,
  • regular rentals followed by a substantial final (or termination) rental at the end of the primary period.

In each case the lease is full payout (because the lessor will be reimbursed for the full cost of the asset, plus ‘interest’ over the term of the lease) with the lessor exposed only to credit risk.

In the first case the finance lessee will pay smaller finance charges than in the second because the capital element (equivalent to a loan) is repaid more quickly over the period of the lease. In the second case there is a large lump-sum payment at the end of the lease term, meaning, in effect, that the loan has been outstanding for longer. Therefore, all else being equal, the total rents payable under the second lease (including the termination rental) are greater than under the first because of the higher finance charges.

Following GAAP, the lease rentals should be apportioned between finance charges and the capital element. These will differ in each case, but the depreciation charged to the profit and loss account should be similar. The depreciation must be written off in a systematic way to reflect how the economic benefit is consumed. In practice it is often written off on a straight-line basis.

See BLM32570 where GAAP is not followed.

In the case of the first lease, and assuming the asset has a high value at the end of the lease term, the total of the depreciation and finance charges will be substantially less than the lease rentals paid. In the second case they might be quite similar until the termination rental is paid. However, in practice, and the termination rental will normally be offset by the rent rebate arising from sale of the asset.

Further guidance is at BLM32530 onwards.