A finance lease, by contrast to an operating lease, is in economic substance very close to a loan to purchase an asset, secured on that asset. Hence, finance lessors are usually members of major banking groups. The lease rentals are calculated to ensure that the lessor recoups an amount equal to its capital outlay in purchasing the asset (on which it may be entitled to capital allowances) plus interest at a rate sufficient to ensure a profit after deducting its own costs of raising finance. The insurance and running costs of the asset are borne by the lessee. So is the depreciation risk.
As a matter of law, the payments made under a finance lease are rental payments for the hire of the asset. This basic point must not be overlooked although, in practice, it may be convenient to focus on the substance and analyse the rentals between:
Large-scale finance leasing in the United Kingdom gained a substantial boost during the period of high first year capital allowances beginning about 1970 and ending, for most types of asset, in 1984. This investment incentive through the tax system, coupled on occasion with economic recession, meant that capital intensive businesses often found themselves tax exhausted and unable to benefit from the first year and other `incentive' allowances due on their investment in fixed assets. Stock relief later accentuated the effects of first year allowances. At the same time financial businesses like banks did not enjoy these reliefs.
Finance leasing offered a means for the surplus first year allowances to be transferred away from businesses without current taxable profits, to banks and others able to use them. In the process the users of the equipment obtained a significant part of the benefit of the tax allowances they could not use directly. This was achieved by leasing rates which reflected, often explicitly, the fact that the lessors could use the first year allowances. This was achieved by having companies trading as finance lessors surrender their tax losses under the group relief rules to fellow group members with trading profits, typically banking profits, which would otherwise have been exposed to tax.
Even after the abolition of stock relief and most first year allowances in the mid-eighties finance leasing is still frequently adopted as a means of funding capital investment. It remains especially attractive to businesses which, for whatever reason, are `tax-exhausted'. Particularly in capital intensive businesses the cost of financing the purchase of equipment by leasing may remain less than, say, the cost of purchasing the assets concerned with the aid of bank loans, even where the lessee is not tax-exhausted. Leasing may also be cheaper (or even the only available finance) because the finance lessor feels it is in a stronger position. If the lessee defaults the lessor continues to be the legal owner of the asset, unlike an ordinary lender.
The sensitivity of finance lease rental rates to the tax regime, especially the capital allowances rules, is illustrated by the provision usually found in leases for expensive items of equipment (known as `big ticket' leases) whereby the lessor is able to re-negotiate rentals if there are changes in the tax rules affecting the lessor or if the lessor fails to obtain the expected capital allowances.
Finance leases are most commonly associated with the funding of machinery and plant, including fixed machinery and plant for which there is a special election available in the capital allowances fixtures code (CA26025 onwards). However, chattels which are not machinery and plant can be finance leased and so can buildings and structures. For example a landlord may grant a Schedule A lease on terms which are essentially the same as a repayment mortgage. Buildings and structures have been leased in this way, in particular where the 100% initial allowance for enterprise zone investment is available.
