Taxation of long funding leases: basic principles: introduction
Finance leases (and some operating leases) are commercially very similar to loans and yet prior to FA 2006 the tax treatments were very different. This meant that in some cases commercial decisions - whether to borrow or lease - were affected by the tax treatment of the transaction. That is, some commercial decisions were distorted as a result of the tax regime.
The rules introduced by FA06 reduce this distortion by taxing longer leases that function as financing transactions (‘long funding leases’) by reference to their commercial substance rather than their legal form. In short, and in very broad terms, the rules introduced by FA06 tax such leases in a similar way to a loan, though they are not loans and so are not taxed as loans under the loan relationship rules.
Guidance on whether a lease is, or is not, a long funding lease is at BLM20000 onwards.
The effect of the legislation is to align the tax treatment more closely with the economic reality of the transaction. Thus
- capital allowances are not available to the finance provider (the lessor); instead they are usually available to the person who bears most of the economic risks of ownership (the lessee);
- the finance provider (the lessor) is taxed only on that proportion of the rental income that represents interest - a figure that is closely related to its accounting profit, period by period;
- where capital allowances are available to a lessee, the lessee is entitled to relief for only part of the lease rentals because the balance is relieved under the capital allowances rules.