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HMRC internal manual

Business Leasing Manual

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HM Revenue & Customs
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Plant and machinery leasing - Anti-avoidance: Long funding lease rules: Disposal values: Lessee disposal value at the end of a long funding lease with residual value guarantees

In some cases the lease rentals received may not cover all of the lessor’s capital expenditure, for instance where the asset is expected to retain value at the end of the lease and the lease payments have only covered the depreciation over the period. The lessor may then need to recover some of their expenditure by selling the asset after the lease ends.

This method of recouping expenditure by selling the asset after the lease ends carries with it the ‘residual value risk’ inherent in the asset. This is the risk that the market for the used asset will fall below expectation, and that the residual value of the asset will not be sufficient to make up the difference between the cost to the lessor and the capital receipts from the lease rentals. Where the lessor is commercially only providing finance, this is not a risk they are often willing to bear. To mitigate the risk to the lessor the lease will often contain a ‘residual value guarantee’.

A residual value guarantee ensures that the lessor suffers no shortfall between the value of the asset at the end of the lease and the amount of the lessor’s capital expenditure not recovered via lease rentals. If there is such a shortfall then a guarantee is made for a person, usually the lessee or a person connected with them, to pay the difference to the lessor, thereby shouldering the risk.

Disposal events on or after 1 April 2006

In the case of a long funding finance lease the qualifying expenditure (section 70C CAA 2001) is calculated with reference to the minimum payments under that lease and these will include any residual amount guaranteed (section 70YE CAA 2001).

Note: In a situation where a residual value guarantee has been made the lease is likely to be a finance lease rather than an operating lease, but the classification of each lease is an accountancy point and will depend on the individual facts and circumstances.

Prior to the changes made with effect from 13 November 2008 the disposal value given by section 70E CAA 2001 to the lessee on the expiry of a long funding lease did not have regard to the fact that the guarantee, although made, may not have been used.

The lessee claimed qualifying expenditure based on the ‘minimum lease payments’ within the terms of section 70YE CAA 2001, including any guarantees that may be payable. But unless the lease then terminated early the lessees disposal value was limited to any amounts calculated by reference to the termination value that were payable to the lessee, and this was then reduced by any sum payable by them, to the lessor, on termination.

This gave an inappropriately low result where the lease contained a residual value guarantee that was not called upon and left the lessee with relief in excess of the capital cost of the asset to them.

Example 1

  • the cost of the assets is £100 and rentals over the lease term are £60 (made up of £20 capital repayment and £40 finance charges), and
  • the lessee provides a residual value guarantee of £80 (being £100 - £20)
  • at the end of the lease term the lessor sells the assets to a third party for the expected residual value (£80).

At the commencement of the lease the lessee claims capital allowances on £100 of the minimum lease payments, made up of the £20 capital repayment element of the rentals and the £80 of residual value guaranteed.

At the expiry of the lease the lessor sells the asset for £80.

The lessor has recovered their £100 capital cost of the asset, by the capital lease payments from the lessee of £20 and the third party sale proceeds of £80.

However the lessee obtains an unintended capital allowances tax benefit. The correct result would be for the lessee to have the £100 as qualifying expenditure for capital allowances, as they have done, but then to bring in a disposal value equal to the £80 for the guarantee under the lease which they have not had to pay. This would leave them overall capital relief of £20, equivalent to the capital payments made under the lease, and the capital depreciation of the asset whilst in their use. The legislation as written did not produce this result.

The residual value guarantee at the end of the lease term was not taxed under section 70E(7)(a) CAA 2001, and subsection (7)(b) (which did consider the balance of the minimum lease payments unpaid) was not in point as ‘the lease was terminated on expiry’ rather than before the end of the term. The lessee was therefore not required to bring the balance of £80 into account for CAA purposes. They have also not paid any termination sum or received any rent rebate. Hence the disposal value in accordance with section 70E CAA 2001 would be £0 and the lessee would obtain capital allowances on £100 for capital costs incurred of £20.

Example 2

The same unintended benefit also arose if the sale of the asset did not achieve the amount guaranteed by the residual value guarantee. In those circumstances the residual value guarantor (either the lessee or another party who may or may not be connected to the lessee), paid an amount to the lessor to make up the deficiency.

For instance, in the example above if the asset had realised £60 in the open market rather than £80 then under the guarantee the lessee would have had to pay £20 to the lessor to cover the shortfall. This payment would be covered by section 70E CAA 2001 because it is “any amount payable by the person (the lessee) to the lessor for or in consequence of the termination”.

Where a lessee guarantor had to make a residual value guarantee payment then, in theory, the amount paid could be deducted from the disposal value given by section 70E(7)(a) CAA 2001. In practice, if there was a shortfall below the residual value guaranteed that required a guarantee payment to be made then there would not be a rental rebate paid from the lessor to the lessee, so there would be no disposal value brought in to deduct the guarantee payment from - and the disposal value cannot be reduced below nil.

So where there was a residual value guarantee, regardless of whether the asset was sold for the guaranteed sum or below it, the residual value of the asset, the amount that did not need to be covered by the guarantee, was never brought in as part of the disposal proceeds.

This was not the intention of the legislation.

Disposal events on or after 13 November 2008

From 13 November 2008 section 70E CAA 2001 was amended. For disposal events occurring on or after this date the disposal value is determined by the formula

(QE - QA) + R

where—

QE is the person’s qualifying expenditure on the provision of the plant or machinery;

QA is the qualifying amount - representing the capital payments made; and

R is any relevant rebate