Operating leases, particularly on expensive assets, are often
simply another form of finance. In these cases the lessor takes
some equity risk, but in substance it is still making a loan to the
lessee.
Leases that function as financing transactions may be
properly classified as operating leases, but the lessor is likely
to sell the asset at the end of the lease and so, as with finance
leases, there may only be a single lessee. The difference is that,
because the rentals do not fully cover the cost of the asset (plus
interest), the lessor has to take some risk that the value of the
asset at the end of the lease (the 'residual value') will not pay
off that part of the 'loan' that is not, in effect, repaid via the
rental stream.
The advantages for the lessee include not having to pay for
the full cost of the asset over the term of the lease and the fact
that borrowing remains off balance sheet – hence operating
leases may be a form of off balance sheet finance. The latter is
important for some businesses for commercial reasons. The lessee
may, however, have to pay what amounts to a higher rate of interest
on what amounts to the loan, as well as losing any upside on the
expected residual value at the end of the lease term.
It is worth noting that although the lessor takes equity risk
it is, in practice, often a very low risk, see
BLM00065.
The introduction of the long funding lease rules by FA 2006
brought in a new regime for taxing longer leases that perform a
financing function (see
BLM20000 onwards). This includes some
operating leases.
