BIM61165 - Leasing: Finance lessees: sale and leaseback

A sale followed by a leaseback in the form of a finance lease can result in a profit if the capital value attributed to the asset for the purposes of the lease is higher than the carrying value of the asset in the books of the vendor/lessee up to the time of sale. The Guidance Notes on SSAP 21 suggest that the situation can be dealt with in one of two ways in the accounts of the vendor / lessee.

Under the first accounting method in SSAP 21 the asset (which is a capital asset of the vendor) is treated as sold and the profit amortised over the lease term.

The second accounting method in SSAP 21 regards the sale and leaseback transaction as a refinancing exercise. As this reflects the substance of the transaction, it is the ONLY METHOD now acceptable under FRS 5, which is mandatory for periods of account ending on or after 22 September 1994.

FRS 5 accounting treatment

The transaction is regarded purely as a refinancing exercise. The asset is not treated as if it has been sold and the profit on sale is not taken. The asset stays in the vendor's balance sheet at its book value and the sale proceeds is shown as a creditor. Where this treatment is adopted and the asset remains in the balance sheet at book value the following tax adjustments are required.

• Depreciation charge: for the purpose of computing the lessee's rental deductions, the sale and lease-back of the asset is recognised. That is, there is a new finance lease and the rental payments are, in principle, allowable for tax purposes in the same way as for any other finance lease. But the actual depreciation charge in the accounts will reflect the old book value of the asset and so the accounts alone do not provide the right answer. The appropriate deduction for the capital element of the lease rentals will be an amount equal to the depreciation which would have been debited in the profit and loss account had the lease been dealt with under the first method described above and not the depreciation actually charged. But the RATE of depreciation actually applied to the asset in the accounts will normally indicate the rate to be applied to the asset in this computation.
• Profit on sale of owned asset: the profit on the sale of the owned asset is a capital matter, so is not charged as income. As the profit is not taken to the profit and loss account no tax adjustment will be needed.
• Capital allowances: there will be the usual capital allowances balancing adjustment consequences on the sale of the owned asset.
• Capital gains: there may also be a capital gains charge on the profit on the sale of the asset.

Example

Facts

Asset purchased for £50,000; this is an ordinary purchase and not a finance lease.

Useful life: ten years.

Depreciation rate: 10% per annum straight-line.

At the end of year 5 the owner sells the asset for £30,000 and leases it back under a five year finance lease. The asset is still expected to have a total life of ten years and so must be written down to nil by the end of Year 10. Rentals (excluding the finance charge element) are £6,000 p.a. payable in arrear.

Accounting treatment: sale not recognised - treated as refinancing

END OF YEAR 5:

• Sale proceeds: Dr. bank a/c £30,000; Cr. lease creditor a/c £30,000.
• The asset remains in the balance sheet at its written down value of £25,000 (cost £50,000 less depreciation £25,000).

YEARS 6-10:

• Depreciation of asset as before (10% x original cost of £50,000) = £5,000 each year.

Tax treatment

Under the new finance lease, the capital repayment element in the rentals total £30,000 and this is payable over five years (Years 6 to 10 inclusive). The asset will be worth nothing at the end of ten years and so the full amount of these rentals has to be written off over this period. But, because the asset has stayed in the balance sheet at its existing written down value of £25,000, the actual depreciation charge will only write off £25,000 by the end of year ten - a shortfall of £5,000.

The additional revenue rental deduction (£5,000) should be spread over years 6-10 using the actual rate of depreciation in the accounts as a guide. That is, in this case:

• 20% of the total capital element in the rentals is allowable for tax purposes each year, namely, £30,000 @ 20% = £6,000.
• Depreciation of £5,000 is actually charged in arriving at the commercial profits each year. So a further £1,000 a year must be deducted in the tax computation.
• There has actually been a sale and so there may be a capital allowances balancing event and also a gain subject to a capital gains charge.