Finance Leasing Manual - FLMAppx3

Schedule 12 FA 1997: published Notes on Clauses in first print of Finance Bill 1997

This Appendix reproduces the Explanatory Note on Clause 80 and Schedule 11, Finance Bill 1997 which were publish with the first print of the Bill. Clause 80 and Schedule 11, after amendments, became Section 82 and Schedule 12, FA 1997.

This Note reflects the view taken at the time the first print of the Bill was published. It does not attempt to deal with any subsequent changes. Later explanations, including those elsewhere in this manual, take priority. However, the Note has been included in case it is cited by others and in case the general background is helpful. The original numbering has been preserved.

Appendix 4 includes the further Note on the amendments made at Report Stage of the Bill.

BOARD OF INLAND REVENUE FINANCE BILL 1997
RESOLUTION 50 CLAUSE 80
SCHEDULE 11
EXPLANATORY NOTE
CLAUSE 80: FINANCE LEASES AND LOANS

SUMMARY

1. Clause 80 and Schedule 11 contain the two proposals on finance leasing.

2. One proposal counters leasing schemes whereby finance lessors try to turn some of their lease rental income into capital receipts. It applies to leases in existence on Budget Day as well as new leases. The other proposal, which applies only to new leases, deals with a possible deferral of tax liability by means of leases under which rentals are concentrated towards the end of the lease term.

3. In both cases the proposal is that from Budget Day the minimum rental income for tax should be the income recognised in lessors' commercial accounts. Schemes intended to turn income into capital are also countered by changes in the capital allowances rules. Allowances will not be due for assets let under new leases of this kind and allowances due under existing leases will be subject to normal disposal computations, even if an indirect disposal method is used.

4. The Government recognises the value of the finance leasing industry in assisting capital investment in British business. Nevertheless, it is necessary to ensure that the beneficial tax rules which finance leasing enjoys are used as Parliament intended and not exploited.

5. The first proposal counters avoidance of tax estimated at about £150 million per annum by the use of finance leasing schemes intended to turn part of the lessor's rental income into a capital receipt (taxed later and at lower effective rates, if at all). The Inland Revenue have identified in total about £3 billion of schemes of this kind.

6. The second proposal is not concerned with tax avoidance schemes but with finance leases where rentals are concentrated into the later years of the lease. These are normally entered into for good commercial reasons. In these circumstances the rental income of the lessor may be recognised under current law more slowly for tax than it is in the lessor's commercial accounts.

7. Consistent with wider Government policy for the taxation of business the proposals align the tax treatment of finance lease rental income more closely with the commercial accounting treatment. The commercial accounts of companies have to be made public and are used for a range of business purposes. The profits they show determine what can be distributed to shareholders by way of dividend. The Government therefore believes that, where possible, they should be used as the measure of earnings for tax.

8. The effect of the second proposal is to tax leasing profits earlier than may be the case under current law.

9. There is a brief explanation of the nature of finance leasing at the end of these notes under 'Background'.

Schemes within Part I of the Schedule

10. Part I schemes involve variations on the following arrangements.

11. Rentals under the finance lease are set low in the early years of the lease. At the end of the desired loan period (say 5 or 10 years) the lessee has an option to buy the asset for capital sum. That sum is calculated to be the amount needed to pay off the balance of the 'loan' with 'interest' after allowing for the (low) actual rents paid already.

12. In the commercial accounts the lessor recognises the interest earned each year up to the option date even where it has not been received (or payable) and even though it may be paid in a capital form. The 'interest' in the capital sum may be a capital gain for tax purposes but any actual tax is avoided or reduced because of the indexation relief and other capital gains reliefs.

13. Another feature of these schemes is that the full 'capital' element in the rentals is often not taxed, as it should be in the normal case. The imposition of tax on the full rentals is necessary to balance the availability of capital allowances on the capital cost to the lessor. But in the case of these schemes the capital element (or some of it) comes in the lump sum paid by the lessee under the option and is not taxed at all.

14. The reason for this is broadly as follows. In the ordinary way the capital allowances disposal computation when the asset is sold should ensure that only the net depreciation is relieved. So, if a lessor buys an asset for £1m, capital allowances will be due on £1m; but if the asset is later sold for £1m the allowances will all be clawed back.

15. This is what should in principle happen for these schemes because the loan repayment (the sale price when the asset goes to the lessee) will usually be equal to the capital cost of the asset. So all the allowances should be recovered, leaving the lessor taxable at the end of the day on his interest earnings.

16. But under these schemes lessors often side-step the capital allowances balancing adjustments by selling something which is in substance the asset but is technically something else. For example, the parent bank may set up a special purpose leasing subsidiary for the deal. That company buys the asset and leases it to the lessee. When the 'loan' comes to be repaid the bank sells the shares in its leasing company to the lessee's parent instead of the leasing company selling the asset to the lessee. The price for the shares will, of course, be the amount needed to repay the loan with interest. There is a capital gain but it is again eliminated or reduced by indexation etc. In practical terms for both the lessor and lessee groups of companies it is just the same as if the asset itself had been sold.

17. A further feature is that the accountancy profit may well appear in no individual company. The lessor company itself gets a small amount of rental income which is all that it shows in its accounts. The parent of the lessor company has a capital gain which, again, is all that it shows in its accounts. The true earnings of the lessor group from the lease only emerge in the results for the whole group - the glossy accounts for the shareholders - which are not the results of any individual company and therefore do not feature in any tax computations. That is why it is necessary to look to the commercial reality of the transactions shown only in the consolidated group accounts.

Leases within Part II of the Schedule

18. Part II is concerned with the deferral of tax generated by back-loaded finance leases. These are leases where the rentals start low and increase over time. At the end of the day the lessor gets back the full capital cost of the asset (the 'loan') plus a commercial rate of interest. The interest will be more than under a conventional 'straight-line' lease where the rental payments are level. This is because the 'loan' is not repaid as fast so there is more interest.

19. The commercial accounts spread the total interest in the rentals over the lease period in proportion to the outstanding debt each year. It does not matter when the cash is actually paid, so long as it eventually comes in.

20. Consider a simple example which ignores the further complication of capital allowances. Suppose a lease lasts two years. At the start of Year 1 the lessor buys a piece of machinery or plant for £50m. The parties agree an interest rate of 10%. The rental payable in Year 1 is nil. The rental payable at the end of Year 2 is £60.5m. This consists of:

• £50m capital repayment;

• £5m interest for Year 1;

• £5.5m interest for Year 2 (that is, £55m debt at the end of Year 1 @ 10%).

21. The accountancy measure of the lessor's earnings is £5m for Year 1 and £5.5m for Year 2. Those are the figures in lessor's commercial accounts. However, at present for tax there is no income in Year 1. In Year 2 the full £10.5m 'interest' in the rental is taxed. So the total amount taxed is the same as the commercial measure but the tax comes in later - a timing loss for the Exchequer.

22. After Year 2 the lessor continues to lease the asset to the lessor but the rent is purely nominal: the lessee has paid the full cost of the asset with interest already. The table below summarises the tax and commercial profit figures for the interest under current law.

£ millions

YEAR 1 Year 2
0 10.5 Taxable profit - when due

5 5.5 Commercial profit

23. The proposal in Part II therefore applies the commercial measure of the interest earnings for tax and eliminates the timing gain.

DETAILS OF THE CLAUSE

24. Clause 80 is very short and just brings Schedule 11 into effect.

25. Schedule 11 is divided into four parts. Part I (covering paragraphs 1 to 15) is concerned with finance leases intended to turn part of the associated rental income into capital receipts. Part II (paragraphs 16 to 18) is concerned with other finance leases. Part III (paragraphs 19 and 20) adapt these provisions for insurance companies. Part IV (paragraphs 21 to 31) contains definitions and other interpretative provisions.

26. Paragraph 1 provides an overview of Part I which deals with finance leases designed to turn part of the associated rental income into capital receipts.

27. Paragraph 1(1)(a) to (c) states that Part I of the Schedule deals with leases which are regarded as finance leases or loans under normal accounting practice as it applies to United Kingdom companies.

28. United Kingdom accounting practice is set out in a series of 'standards' issued or adopted by the Accounting Standards Board, a statutory body. The Companies Act requires any departure from the standards in accounts which have to be prepared under it to be disclosed in the notes to the accounts. There is also a strong legal presumption that accounts drawn up in accordance with the standards will show the true and fair view of a company's affairs required under the Act and that accounts which fail to conform with the standards do not show such a view.

29. Accountancy practice requires that the accounts of a business to reflect the commercial substance of its transactions rather than their legal form, if that is different. Financial Reporting Standard No 5 is concerned with accounting for the substance of transactions generally while Statement of Standard Accounting Practice No 21 deals specifically with the leasing of assets.

30. Under SSAP 21 leases have to be divided into two categories, 'operating leases' and 'finance leases'. An operating lease is one which runs for a period which is usually much shorter than the useful life of the asset concerned. The lessor takes the risk that the asset will depreciate faster than expected and stands to gain if it retains its value better than expected. The lessor is not required to account for operating leases as a financial asset or investment.

31. A finance lease by contrast is in economic substance equivalent to a secured loan. The terms are such that the lessor is insulated from the commercial risks and rewards of the ownership of the leased asset and instead in total gets back his outlay on the leased asset plus a return equivalent to interest at a commercial rate on that asset, neither more nor less. Most finance lessors are companies which are subsidiaries of banks.

32. Paragraph 1(1)(d) makes it clear that Part I of the schedule is not concerned with all finance leases but only with those arranged so that the lessor may receive part of the return on his investment in the form of a lump sum which is not taxed as rent. Such a lump sum is normally taken into account in calculating a lessor's capital gains position but in practice the existence of indexation relief (for price inflation) and other reliefs means that the tax payable is very much less than it would be if part of the lump sum took the form of rents, which would be taxed as income.

33. Paragraph 1(2) sets out the principal purposes of Part I.

34. The first purpose (in paragraph 1(2)(a)) is, from Budget Day, to substitute for the ordinary tax measure of income from the lease the amount recognised in accordance with normal accounting practice (where this is larger than the normal measure: paragraph 5).

35. As a matter of accountancy practice, part of the lump sum mentioned in paragraph 1(1)(d) will be recognised as annual income over the course of the lease and thus taken into account in computing commercial profits. Income is recognised in this way because in substance the lease is tantamount to a loan, the interest on which needs to be matched with the lessor's own borrowing costs in order to properly reflect the lessor's profit.

36. Paragraph 1(2)(a) also states that, in order to take account of the true substance of the leasing arrangements, the income recognised in accordance with normal accountancy practice may be that shown in consolidated accounts of the lessor's group or in those of a company which is a 'connected person' of the lessor. A 'connected person' is defined further in paragraph 28 of the Schedule: it is the usual Taxes Acts definition of a related party. The reason for looking wider than the lessor is that the full earnings from the lease may only be shown in, say, the accounts of the parent or in the consolidated group results.

37. The second purpose of Part I (paragraph 1(2)(b)) is to deny reliefs for capital expenditure, such as capital allowances, on assets leased in this way under leasing arrangements starting after Budget Day.

38. The third purpose (paragraph 1(2)(c)) is to recover appropriately any tax reliefs for capital expenditure already given. In the case of leases in existence on Budget Day this will be when the lessor is paid up by means of a lump sum. These rules reflect the Government's view that leases of this nature take the tax advantages inherent in finance leases to unacceptable extremes.

39. Paragraphs 2 to 15 of the Schedule set out the detailed rules in Part I of the Schedule for leases of this kind.

40. Paragraph 2 introduces the detailed definition of the leases to which Part I of the Schedule applies.

41. Paragraph 2(1) provides that Part I applies if a lease of an asset has been granted (at any time) and all the five conditions set out in paragraph 3 are at some point satisfied, either currently or in the past (a point which may be before Budget Day).

42. 'Asset' is defined in paragraph 31 of the Schedule in wide terms - 'any form of property or right'. This is apt to encompass both physical assets (including land and chattels) and, for example, intellectual property, such as the rights in a film or book. 'Lease' is also widely defined in paragraph 31.

43. Paragraph 2(2) provides that, once a lease has satisfied the five conditions, it remains within the scope of Part I until the asset ceases to be let under the lease in question or until the lease is assigned to a person unconnected with the persons specified in paragraph 2(3).

44. Paragraph 2(3) defines those persons, to include in particular the lessor and connected persons of the lessor. 'Persons' encompass both individuals and companies.

45. Paragraph 2(4) puts it beyond doubt that after a lease has initially ceased to come within the scope of Part I (for example on an assignment to an unconnected person) it may do so again subsequently if the conditions are satisfied.

46. Paragraph 3 then sets out the five conditions which have all to be satisfied before the rules in Part I of the Schedule apply. These are in sub-paragraphs 1 to 5 of the paragraph.

47. Paragraph 3(1) contains the first condition. This that the lease is part of 'leasing arrangements' (defined in paragraph 31 of the Schedule in wide terms) which, for accounting purposes, normal accounting practice treats as a finance lease or a loan either in the hands of the lessor himself, a connected person or in consolidated group accounts reflecting the lessor's transactions. 'Accounting practice' and 'accounting purposes' are defined further in paragraphs 29 and 31 of the Schedule.

48. A finance lease is not further defined but it has a clear meaning in accountancy: it is a lease which in commercial substance is tantamount to a loan made by the lessor to the lessee and secured on the leased asset. Accounting standards require the parties to account for the transaction as a loan: the lessor must show the initial cost of the leased asset in his balance sheet as a loan to the lessee and must treat rentals partly as interest on the loan and partly as repayments of the principal.

49. Note that the Schedule refers to 'leasing arrangements ... such as fall to be treated in accordance with normal accountancy practice as a finance lease or loan'. There are two points here. First, all the circumstances surrounding the lease have to be considered. Second, the actual accounting treatment adopted will not be decisive if it is not in accordance with normal accountancy practice (although it should be rare for any lessor of substance to use accounting methods which do not accord with normal accountancy practice).

50. Paragraph 3(1) also refers to 'consolidated group accounts'. They are defined in paragraph 31 by reference to the definition in the Companies Acts. Consolidation of the accounts of a group of companies involves treating them as if they were a single entity. Transactions between group members are not therefore reflected in these accounts, only those with other parties. The published annual reports and financial statements of most quoted companies will contain consolidated group accounts.

51. The reason for having regard to the treatment of a lease in the consolidated accounts or those of a connected person of the lessor is that there will be occasions where the true economic substance may not be shown in the lessor's accounts. A consolidated group view may be required for the purposes of this Schedule when it would not otherwise be required for other purposes; for example, where a foreign-controlled group is involved.

52. Paragraph 3(2) sets out the second of the five conditions which must be satisfied before the provisions in the Schedule apply. The condition is that under the leasing arrangements the lessor or a connected person may obtain a lump sum (other than rent) the accountancy treatment of which is part repayment of the investment under the finance lease or loan and part payment of the return on that investment (in economic substance interest).

53. This is an essential element in schemes intended to turn rental income into capital. Typically, a company which is a fellow member of the lessee company's group will have the right to exercise an option to buy out the lessor's economic interest in the lease for a lump sum on terms which make it likely that the option will be exercised.

54. Payments to connected persons of the lessor are included because schemes may enable the lessee or fellow group members, instead of paying up a lease (effectively repaying the loan with interest), to achieve the same economic result by making the lump sum payment to a person other than the lessor. For example, where the only business of a lessor is the lease in question, the scheme may provide for the lessee to buy all the shares in the lessor from its intermediate parent for that payment. Here neither the lessor nor its intermediate parent may show the group's full earnings from the lease in their accounts.

55. Paragraph 3(3) sets out the third condition. This condition is satisfied unless the whole of the lump sum referred to in the second condition in paragraph 3(2) would be taxable as rent under the ordinary tax rules, that is apart from the rules in the Schedule. Rent taxable under the ordinary rules in this way is referred to as 'normal rent' (defined in paragraph 21 of the Schedule).

56. To satisfy the condition all the rent must be taxable for periods ending with the latest period in which a particular lump sum may be payable (sub-paragraph 9).

57. Paragraph 3(4) sets out the fourth condition. This condition is satisfied if the 'accountancy rental earnings' exceed the 'normal rent'.. This may be either in the period of account when the tests for whether a lease is caught by the rules in the Schedule are being applied or in an earlier period when the lessor in question was still the lessor. 'Accountancy rental earnings' are defined in paragraphs 22 and 23 of the Schedule but broadly they are the earnings from the lease which accountants recognise when they apply their special rules for finance leases. The group's consolidated results are taken into account.

58. The point of this condition is as follows: if a lessor is consistently being taxed on at least as much income as the commercial accounts show, then the terms of the lease are not ones which are designed to turn rental income into a capital receipt. There is therefore no mischief which needs to be countered.

59. Paragraph 3(5) sets out the fifth condition. This requires that one of two circumstances must exist before the condition is satisfied. These circumstances are set out in paragraph 4 of the Schedule but essentially there must be some likelihood that the lessee or a connected person of the lessee will buy out the lessor's interest in the leased asset for a lump sum of the sort described in paragraph 3(2). That is one containing an amount which under accountancy practice is classified as earnings from the lease.

60. This condition is intended to ensure that a lease does not come within the proposed rules in Part I of the Schedule solely because there is a possibility that a lessor may obtain a 'capital sum' as set out in sub-paragraph 4 above (that is, one containing in substance an interest element) other than from the lessee or a connected person. This might happen for example on the unplanned sale of the leased asset to a third party or on a claim under an insurance policy on the destruction of the asset.

61. Paragraph 3(6) sets out rules to ensure that in applying the fourth condition (in paragraph 3(4)) the special basis on which companies' income from UK land and buildings is recognised for tax (under Schedule A) does not lead to arbitrary results. Schedule A for corporation tax brings in the rents to which the landlord is 'entitled' in the period and this may produce a 'lumpy' or unrepresentative pattern. Hence, for the purposes of the fourth condition only, paragraph 3(6) evens out the flow of rents.

62. Paragraph 3(7) sets out a similar rule for cases where, exceptionally, the lessor's rental income is recognised for tax under Schedule D on a similar basis to that in the Schedule A rules for companies.

63. Paragraph 4 supplements the fifth condition (in paragraph 3(5)) which a lease must satisfy before it is subject to the rules in Part I of the Schedule. The condition is satisfied if either one of two legs of the condition is satisfied.

64. The first leg (in paragraph 2(1)) is that there must be arrangements in place whereby the lessee or a connected person of the lessee may acquire either the leased asset or an asset representing the leased asset and in the process the lessor or a connected person of the lessor may receive a lump sum of the sort referred to in paragraph 4(4). (That is one containing an amount which under accountancy practice is classified as earnings from the lease.) The second leg (in sub-paragraphs 2 and 3) is that it must be more likely that the lessee or a connected person, rather than anybody else, may pay such a sum for that purpose.

65. An 'asset representing the leased asset' is defined in paragraph 27 of the Schedule. Broadly, the effect is to ensure that a lease will satisfy the condition in paragraph 4 if the lessee (or a connected person of the lessee) can buy out his obligations under the lease with a lump sum, no matter in exactly what way this is achieved. For example, the lessor company may be a special purpose company set up for one particular leasing deal. The lessor could sell the asset to the lessee but, instead, the lessor's parent sells the shares in the lessor company to the lessee.

66. The condition applies whether the lessee may acquire the asset 'directly or indirectly' from the lessor. This again is intended to ensure that the test cannot be easily side-stepped. An example of an indirect acquisition would be one where the lessor first sells the leased asset to a nominally independent intermediary who can in fact be relied on to sell the asset on to the lessee.

67. Paragraph 5 sets out the amount of income to be taxed where the lease comes within the definition in paragraph 3.

68. Paragraph 5(1) provides that where the 'normal rent' (the income recognised for tax under the ordinary tax rules) is less than the 'accountancy rental earnings' the amount of rents to be taxed is a sum equal to those earnings. As noted above, 'accountancy rental earnings' are defined in paragraphs 24 and 25 of the Schedule but broadly they are the earnings from the lease which accountants recognise when they apply the special rules for finance leases.

69. This rule applies only in respect of 'periods of account' from Budget Day. A 'period of account' is defined generally in paragraph 31 to exclude periods ending before Budget Day. And paragraph 24 provides that a period of account straddling Budget Day is treated as being divided into two for the purposes of the Schedule. The first part is regarded as ending immediately before Budget Day, so that the taxable rentals referable to it are calculated in the ordinary way, and only those for the second part, starting with Budget Day, are calculated under the rules in Part I of the Schedule.

70. Paragraph 5(2) provides that where under paragraph 5(1) it is a sum equal to the 'accountancy rental earnings' which is taxed as the rent from the lease, that sum is regarded as accruing evenly over the period of account. This is to deal with situations where the period for which accounts are drawn up is different from the period on which the tax assessment is based. The effect is that in those circumstances rents may be apportioned on the (usual) time basis.

71. Paragraph 6 ensures that the rule in paragraph 5, that the accountancy rental earnings or the normal rents (ordinary taxable rents) are taxed, whichever is the higher, does not overall cause more rent to be taxed as income than is actually due to the lessor. This is achieved in a way which gives relief as early as possible so long as not less than the lower of the two measures of rents (accountancy rental earnings and normal rents) are taxed for any period.

72. This is done by requiring running totals to be kept of aggregate differences between accountancy rental earnings and the normal rents. Any aggregate excess of accountancy earnings over normal rents arising in past periods can then be set against any current excess of normal rents over accountancy earnings. Conversely, any aggregate excess of normal rents over accountancy rental earnings arising in past periods can be set against any current excess of accountancy rental earnings over normal rents. Paragraphs 6(1) to (4) define the two types of excess.

73. Paragraph 6(1) defines a 'normal rental excess'. This arises when the normal rent (which is taxable) is greater than the accountancy rental earnings for a period of account in which the lease is regarded as a finance lease.

74. Paragraph 6(2) describes the sum of any 'normal rental excess' for more than one period (after deducting any amount used in working out the double charge relief available) as the 'cumulative normal rental excess'. It is worth noting that the cumulative normal rental excess 'for' a current period means the aggregate of the normal rental excesses for past periods; but this does not include any excess for any period before Budget Day because 'period of account' is defined for this purpose in paragraph 31(1) to mean periods beginning on or after Budget Day.

75. Paragraph 6(3) deals with the opposite case where the accountancy rental earnings for a period are more than the normal rent. Such an excess is called an 'accountancy rental excess'.

76. Paragraph 6(4) calls the total of the 'accountancy rental excesses' for more than one period the 'cumulative accountancy rental excess'. This running total is reduced by any amount given as double charge relief against earnings otherwise taxable under existing law or against capital gains under paragraph 13 and by sums calculated under the bad debt relief rules in paragraph 9. Note that the cumulative accountancy rental excess 'for' a current period is the aggregate of the accountancy rental excesses for past periods; but this does not include any excess for any period before Budget Day because 'period of account' is defined for this purpose in paragraph 31(1) to mean periods beginning on or after Budget Day.

77. Paragraph 6(5) and (6) apply to give relief where the normal rent exceeds the accountancy rental earnings and there is some cumulative accountancy rental excess brought forward. What happens is that the rent taxable under existing law is reduced by the excess brought forward - but only down to the level of the accountancy rental earnings for the period.

78. Consider a much-simplified example. In Year 1 the taxable rent is nil and the accountancy rental earnings are £2m. In Year 2 the taxable rent is £2m and the accountancy rental earnings are nil. The result is that the new rules tax £2m in Year 1 (that is the accountancy earnings) and there is an accountancy rental excess of £2m to go forward. In Year 2 the taxable rent under existing law of £2m is reduced by the excess brought forward of £2m - so nothing is taxed. Over the two years £2m is taxed in all and this equals the £2m earned. The proposal does not, overall, charge any extra income - it merely advances the time at which it is taxed (here from Year 2 to Year 1) and so eliminates an unintended timing gain for the lessor.

79. Paragraph 6(7) and (8) explain what happens for a period where the accountancy rental earnings exceed the normal rent and there is a cumulative normal rental excess. Broadly, the aim is to take account of the fact that the lessor may have been taxed in earlier periods on an existing measure of taxable rents (the normal rent) which is more than the accountancy measure and to give credit for that excess against any extra amount otherwise taxable under the proposal.

80. Consider another much-simplified example. Suppose in Year 1 the ordinary measure of rental earnings under existing law is £5m and the accountancy measure is £3m, while in Year 2 the ordinary measure is £4m and the accountancy measure is £6m. The result here is that £5m is taxed in Year 1 but there is a cumulative normal rental excess of £2m to go forward. In Year 2 the proposed rules will tax the accountancy measure of £6m less £1m = £5m. That is, the cumulative normal rental excess reduces the extra amount otherwise charged by the proposal but only down to the level of the accountancy measure for the year. There remains a cumulative normal rental excess of £1m to go forward to Year 3.

81. The cumulative accountancy rental earnings may nevertheless exceed the total rents actually due by the time the lessor disposes of his interest in the lease for a lump sum. The excess represents the income element in that lump sum. Paragraph 13 therefore provides for the excess to be taken into account for capital gains purposes on receipt of the lump sum except where the lease is assigned on no gain/no loss terms for capital gains purposes. In the latter case paragraph 7 (see below) enables the assignee to stand in the shoes of the lessor.

82. Paragraph 7 deals with the assignment of a lease in circumstances which are regarded for capital gains purposes as giving rise to neither a gain nor a loss. In the context of finance leasing such an assignment is most likely to be to another member of the group of companies to which the lessor belongs. In those circumstances the assignee takes over the assignor's 'cumulative accountancy rental excess' or 'cumulative normal rental excess' and can obtain relief for them against rental income, or against any capital gain within paragraph 13. The computations are made as if the assignee had stepped into the assignor's shoes.

83. Paragraphs 8-10 are concerned with bad debts. Broadly, the aim is to ensure that any bad debts are sensibly taken into account in computing taxable profits and accountancy rental excesses and normal rental excesses. At the end of the day, if the lease runs its course, the net rents taxed should equal the net rents payable after allowing for any bad debts.

84. Paragraph 8 is concerned with relief for bad and doubtful debts in respect of companies' finance lease rentals within Schedule A (from land and buildings in the United Kingdom). Under Schedule A for UK companies, rents are taxed as a company becomes entitled to them. The special bad debt relief rule (in Section 41 of the Taxes Act) works from that basis. It also gives relief by re-opening computations for earlier periods to reduce irrecoverable rents already taxed for those periods, rather than simply by giving a deduction from rents for the bad debt in the period in which the bad debt is charged as an expense in the commercial accounts, as happens in computing trading profits. Neither feature of Section 41 is consistent with the charge to tax on accountancy rental earnings under this Schedule.

85. The purpose of paragraph 8 therefore is to disapply Section 41 and give instead bad debt relief as if the rents from the lease in question were part of a trade carried on by the lessor. (Paragraphs 9 and 10 of the Schedule then set out the interaction of bad debt relief with the relief for cumulative accountancy rental excess and cumulative normal rental excess which paragraph 6 provides for both Schedule A and Schedule D.)

86. Paragraph 8(1) provides that in comparing accountancy rental earnings and normal rents under paragraph 5 of the Schedule any reduction in either figure by virtue of bad debt relief under Section 41 is ignored.

87. Paragraph 8(2) ensures that no deduction under Section 41 is given in respect accountancy rental earnings brought into account for tax in a period of account. It also provides that, for subsequent periods, ending either with the termination of the lease or its assignment on other than 'no gain/no loss' terms (when paragraph 7 applies), no relief under Section 41 is to be given. This rule applies whether or not in those subsequent periods accountancy rental earnings exceed normal rents and are therefore taxed instead.

88. Paragraphs 8(3) and (4) apply instead for these periods the (rather more generous) bad debt relief rules that apply to the computation of trading profits. Under these rules a deduction is usually available at the same time as a deduction for a bad or doubtful debt is made in the commercial accounts. To compute the deduction for bad debts it is assumed that the letting in question is carried on in the course of a trade.

89. Paragraph 8(5) provides that relief for the deduction calculated under sub-paragraph 4 is given as if it were an ordinary expense of the letting in question to which the Schedule A rules for corporation tax apply.

90. Paragraph 8(6) applies the rules for trading profits to any subsequent recovery or credit in respect of a debt for which a deduction was calculated under sub-paragraph 4. Again those rules will normally follow the commercial accounting treatment for the period of account in question. The recovery or credit is treated as further taxable rent for that period of account.

91. Paragraph 8(7) defines taxable rent.

92. Paragraphs 8(8) and (9) ensure that for any period of account for which Section 41 relief for a bad debt is available (that is a period earlier than that in which accountancy rental earnings first exceed normal rents) a deduction is given once and once only. Otherwise, a double deduction might exceptionally arise, once under Section 41 and once under the trading profits rules.

93. Paragraph 8(8) provides that Section 41 claims for bad debt relief cannot be made after the time when the conditions in paragraph 3 become satisfied. Instead relief is available after that time under the trading profits rules.

94. Paragraph 8(9) provides that, if a Section 41 claim for bad debt relief has been made before those conditions are satisfied, the same amount cannot be relieved under the trading profits rules.

95. Paragraphs 8(8) and (9) may apply where the rules in the Schedule for periods before the conditions in paragraph 3 become satisfied are applied under paragraph 14 of the Schedule (where an existing lease is not within Part I of the Schedule at the outset but later comes within Part I).

96. Paragraphs 9 and 10 deal with the interaction of bad debt relief and relief for cumulative accountancy rental excess and cumulative normal rental excess under paragraph 6. Relief for cumulative excesses is only justified where they represent rents taxed in earlier periods. If those rents are also the subject of bad debt relief then that justification disappears. To continue to give relief under paragraph 6 would amount to giving relief twice for the same sum.

97. Paragraph 9 is concerned with the interaction of bad debt relief and cumulative accountancy rental excess. The rationale is that the relief for any rental excess should only represent an excess of accountancy rental earnings over normal rent to the extent it has effectively been brought into account for tax and that the relief should only be given against normal rent similarly brought into account. This calls for adjustments where the lessor cannot obtain some or all of his rent and writes it off as a bad debt.

98. Paragraph 9(1) reduces any cumulative accountancy rental excess for a period where the accountancy rental earnings exceed normal rent and there is a bad debt deduction. The cumulative accountancy rental excess for the period of account is reduced by an amount equal to the excess of the bad debt deduction over the accountancy rental earnings.

99. For example, suppose the facts for a period of account were:

• the accountancy rental earnings are £100;

• the normal rent is £70;

• a bad deduction of £110 falls to be made in respect of rents from the lease for a previous period; and

• there is a cumulative accountancy rental excess for the period of account of £130; this is the total excess for periods before the current period.

100. The effect of paragraph 9(1) is to reduce the cumulative rental excess for the period of account (£130) by the amount by which the bad debt deduction of £110 exceeds the accountancy rental earnings of £100. That is, the cumulative rental excess is reduced by £10 to £120. The taxable earnings for the current period under paragraph 5 are the accountancy rental earnings of £100 but there is a bad debt deduction of £110 and so, before any other expenses, there is a net loss for the period of £10.

101. Paragraph 9(2) deals with the converse situation where for a period of account normal rent is at least equal to accountancy rental earnings (so that it is the normal rent which is taxed). In those circumstances there are two restrictions. These are set out in paragraph 9(3) and (4).

102. Paragraph 9(3) provides that relief otherwise available under paragraph 6 in a period for any cumulative accountancy rental excess brought forward from previous periods is restricted to any excess of the normal rent over any bad debt deduction given in respect of rents from the lease. That is because only the normal rent net of bad debt relief is in effect being brought into account for tax.

103. Paragraph 9(4) deals with the case where the bad debt deduction exceeds the normal rent for a period of account. In such a case any cumulative accountancy rental excess brought forward from previous periods is reduced by the amount by which the bad debt deduction exceeds the normal rent. In such a case the excess of the bad debt deduction over the normal rent for the period of account already represents relief for rents taxed in previous periods. It would be wrong to give relief again via a cumulative accountancy rental excess deduction.

104. Suppose the facts for a period of account are:

• the accountancy rental earnings are £70;

• the normal rent is £100;

• there is a bad debt deduction of £80; and

• there is a cumulative accountancy rental excess of £90 (that is, the aggregate of accountancy rental excesses brought forward from earlier periods).

105. The result is:

• the taxable earnings are the normal rent of £100 and there is a bad debt deduction of £80 (ignoring any other expenses);

• £30 of the cumulative accountancy rental excess of £90 brought forward would ordinarily be deducted from the £100 of taxable normal rent (the deduction cannot reduce the taxable rent below the normal rent: paragraph 6(6)); but paragraph 9(3) restricts the deduction to £20 - see the next bullet below;

• paragraph 9(3) says the amount of cumulative accountancy rental excess which can be deducted from the taxable rent cannot be more than the amount by which the normal rent of £100 exceeds the bad debt deduction of £80 ie £20; the cumulative accountancy rental excess of £90 is reduced to £70 (the amount deductible in the year) and so £70 of cumulative accountancy rental excess remains to be carried forward to next year.

106. If the bad debt had been, say, £120 none could be set off. This is because of the bracketed words at the end of paragraph 9(3) which say that if the bad debt deduction is more than the normal rent the cumulative accountancy rental deduction is nil.

107. Further, if the bad debt deduction had been £120, paragraph 9(4) reduces the cumulative accountancy rental excess by the amount by which the bad debt deduction (£120) exceeds the normal rent of £100; that is by £20. So the cumulative accountancy rental excess for the period of £90 is reduced by £20 to £70 and this is carried forward to the next year.

108. Paragraph 9(5) and (6) reinstate any relief for cumulative accountancy rental excess restricted under this paragraph if the bad deduction is subsequently reversed (because the debt is recovered or prospects for recovery improve).

109. Paragraph 9(7) defines 'bad debt deduction' and 'taxable rent'.

110. Paragraph 10 deals with the interaction of bad debts deductions and relief for cumulative normal rental excess under paragraph 6. Again the rationale is that the relief should only represent an excess of normal rent over accountancy rental earnings which have effectively been brought into account for tax and that the relief should only be given against rents similarly brought into account. The structure of the detailed rules is identical with that in paragraph 9.

111. Paragraph 10(1) reduces any cumulative normal rental excess for a period where the accountancy rental earnings do not exceed the normal rent and there is a bad debt deduction. The cumulative normal rental excess for the period of account is reduced by an amount equal to the excess of the bad debt deduction over the normal rent.

112. Paragraph 10(2) deals with the converse situation where for a period of account accountancy rental earnings exceed normal rent. In those circumstances there are two restrictions. These are set out in paragraphs 10(3) and (4).

113. Paragraph 10(3) provides that relief otherwise available under paragraph 6 in that period for any cumulative normal rental excess brought forward from previous periods is restricted to any excess of the accountancy rental earnings over any bad debt deduction given in respect of rents from the lease. That is because only the accountancy rental earnings net of bad debt relief is in effect being brought into account for tax.

114. Paragraph 10(4) deals with the case where the bad debt deduction exceeds the accountancy rental earnings for a period of account. Here any cumulative normal rental excess brought forward from previous periods is reduced by the amount by which the bad debt deduction exceeds the accountancy rental earnings. In such a case the excess of the bad debt deduction over the accountancy rental earnings for the period of account already represents relief for rents taxed in previous periods. It would be wrong to give relief again via cumulative normal rental excess.

115. Paragraph 10(5) and (6) reinstate any relief for cumulative normal rental excess restricted under this paragraph if the bad deduction is subsequently reversed (because the debt is recovered or prospects for recovery improve).

116. Paragraph 10(7) defines 'bad debt deduction' and 'taxable rent'.

117. Paragraph 11 deals with leases within Part I of the Schedule which are 'new schemes'. 'New schemes' are defined in paragraph 28. The effect of the paragraph is deny capital allowances and other reliefs for capital expenditure on the leased assets concerned. It also provides for the recovery of allowances and reliefs in a case where a lease which is a new scheme does not come within Part I at the outset but subsequently does so.

118. Paragraph 11(1) provides that the paragraph applies to 'new schemes', as defined in paragraph 28. Broadly, they are leases which the lessor becomes committed to granting on or after Budget Day.

119. Paragraph 11(2) and (3) deny capital allowances and other reliefs for capital expenditure (including expenditure on the acquisition of rights in films within Section 68 of the Capital Allowances Act) on assets leased under new schemes to which Part I of the Schedule applies.

120. Where the lease is not within Part I at the outset the allowances and reliefs are denied from the time when the conditions in paragraph 3 of the Schedule (defining a lease within Part I) become satisfied.

121. Paragraph 11(4) to (11) provide the rules for recovering allowances and reliefs already given in a case where Part I does not apply from the outset. The recovery rules apply for the period of account in which the conditions in paragraph 3 become satisfied. The tax computations for previous periods are not re-opened. The precise form of the recovery depends on the detailed rules relating to particular types of allowances.

122. Paragraph 11(4) to (7) deal with capital allowances in respect of machinery and plant (and those in respect of patent rights and mineral extraction).

123. Paragraph 11(5) sets out the basic rule for recovering these allowances: a disposal value equal to the capital expenditure qualifying for allowances is brought into account on the occasion when the lease comes within Part I.

124. For example, suppose machinery and plant of £100 is leased under a lease which comes within Part I in its second year. Here a disposal value of £100 is brought into the lessor's pool of qualifying expenditure for Year 2. Assuming a 25% writing down allowance had been given in Year 1 the value of the pool at the start of the second year will be £75. No more allowances are due for the second or subsequent years by virtue of paragraph 11(2) and a disposal value of £100 is brought into account for Year 2. Assuming there are no other assets in the pool, that will give rise to a balancing charge of £25. This is the excess of the disposal value of £100 over the £75 in the pool at the start of Year 2. Thus the allowance of £25 given for Year 1 is recovered and the remaining expenditure in the pool is eliminated.

125. Paragraph 11(6) and (7) ensure in relation to a leased asset that the disposal value brought to account under sub-paragraph 5, together with disposal values brought into account under the ordinary rules, cannot exceed the original cost of the asset.

126. Paragraph 11(8) ensures that other capital allowances due to the lessor are recovered in the period in which the leases comes within Part I of the Schedule. This is achieved by regarding a sum equal to the reliefs or allowances given as a balancing charge.

127. Paragraph 11(8) and (10) deal with leased films and other assets where capital expenditure on them is relieved as a revenue deduction. The mechanism here is to regard a sum equal to the deductions given as a business receipt.
128. Paragraph 11(11) deals with the recovery of capital allowances given to a contributor to a lessor's capital expenditure.

129. Paragraph 11(12) and (13) deal with minor definitional points.

130. Paragraph 12 concerns capital allowances and other reliefs for capital expenditure on leases which count as 'existing schemes'. 'Existing schemes' are defined in paragraph 28 of the Schedule. Broadly they are leases which the lessor had actually granted, or was committed to granting, before Budget Day. The effect of the paragraph is to ensure that any 'major lump sum' is properly brought into account when it falls due even if it is not paid to the lessor on a direct disposal of the asset.

131. A 'major lump sum' is defined in paragraph 3(2) of the Schedule. Broadly, it is a sum which represents in accountancy terms repayment of the lessor's outlay under the finance lease plus interest. It can include a sum payable to a connected person (for example, where the shares in the lessor company are sold to the lessee).

132. Paragraph 12(1) applies the paragraph to existing schemes where a major lump sums falls due on or after Budget Day.

133. Paragraph 12(2) and 3 apply with modifications the rules in paragraph 11 dealing with the recovery of capital allowances and reliefs to the treatment of major lump sums within this paragraph. The sum to be brought into account for the purposes of this paragraph is the major lump sum rather than disposal values and other sums regarded as brought into account under paragraph 11.

134. Paragraph 12(4) to (7) set out the detailed modifications required.

135. Paragraph 13 deals with disposals of the leased asset and assets representing the leased asset other than no gain/no loss disposals within paragraph 7. In those circumstances any unused 'cumulative accountancy rental excess' is set against the disposal proceeds in calculating the capital gains position on the disposal. This is to ensure the same sum is not taxed twice, once as income and again as a capital gain. It is appropriate that the charge as income should take priority because the cumulative accountancy rental excess represents that part of the proceeds on the disposal which is in substance of an income nature.

136. Paragraph 13(1) sets out the basic rule. On the disposal of the leased asset (or an asset representing the leased asset as defined in paragraph 27 of the Schedule) any unused cumulative accountancy rental excess computed under paragraph 6 is set off against the disposal proceeds.

137. Paragraph 13(2) provides that where the disposal is a part disposal only a proportion of the 'cumulative accountancy rental excess' may be set off against the disposal proceeds. That proportion is the same as the proportion of allowable expenditure which may be set off under the ordinary capital gains rules on such a part disposal.

138. Paragraph 13(3) ensures that simply because relief under this paragraph is available the taxpayer is not prevented from obtaining further relief under the general capital gain rule excluding from the disposal proceeds any sums taken into account as income (Section 37 of the Taxation of Chargeable Gains Act). This is subject to the rule in paragraph 13(4).

139. Paragraph 13(4) ensures that relief for the 'cumulative accountancy rental excess' cannot be duplicated by relief under Section 37 of the Taxation of Chargeable Gains Act, whether on the same disposal or on another disposal of the leased asset or a representative asset.

140. Relief under this paragraph takes priority over relief under Section 37. Relief more than once under this paragraph for the same amount of 'cumulative accountancy rental excess' is prevented by the rule in paragraph 6(4) where the excess carried forward to later periods is reduced by relief given in earlier periods.

141. Paragraph 13(5) deems a period of account to come to an end for the purposes of paragraph 13 immediately before any disposal. This is to ensure that the amount of cumulative accountancy rental excess available for set off against the disposal proceeds can be properly calculated. The cumulative accountancy rental excess for any period of account is, in effect, the aggregate accountancy rental excess for periods before the current period of account (paragraph 6(4)). By deeming a period of account to end before the disposal the accountancy rental excess for the deemed period of account up to the date of disposal can be included in the cumulative accountancy rental excess available to be used in computing the chargeable gain.

142. Paragraph 13(6) deals with simultaneous disposals of the whole or part of the asset or an asset representing the leased asset. Cumulative accountancy rental excess is to be apportioned between them on a just and reasonable basis.

143. Paragraph 13(7) contains a minor definition.

144. Paragraph 14 makes provision for recognising income from some finance leases which count as 'existing schemes' as defined in paragraph 28. The leases affected are those which initially do not satisfy the conditions in paragraph 3 of the Schedule (and so are not caught by the Schedule) but subsequently, at some point after Budget Day, come within those rules for the first time. The leases in question are only existing schemes because Part II of the Schedule will ensure that rents in relation to new scheme finance leases are taxed correctly from the start.

145. The approach, effectively a catching up exercise, is to tax under paragraph 5 in the period when the lease is first subject to the rules in the Schedule the accumulated excess (if any) of the accountancy measure of income from the lease over the income actually taxed in earlier periods. No such excess relating to periods prior to Budget Day can be taxed in this way and nor are the assessments for earlier periods of account actually re-opened: the catching up is done in the period in which the conditions are met.

146. Paragraph 14(1) applies the paragraph to leases which counts as an 'existing scheme' (broadly, a lease which the lessor had granted, or was committed to granting, before Budget Day) where the conditions in paragraph 3 become satisfied at some time after Budget Day.

147. Paragraph 14(2) provides that for the purposes of the Schedule the time when the conditions are satisfied forms its own brief period of account. This is to ensure the computational provisions in paragraph 14(3)3 work correctly.

148. Paragraph 14(3) requires the cumulative accountancy rental excess to be calculated under paragraph 6 for the period from the inception of the lease (but not before Budget Day) to the time the conditions in paragraph 3 are satisfied. For this purpose it is assumed that the provisions in Part I of the Schedule had applied to the lease from the start of the lease (but, again, not before Budget Day).

149. The cumulative accountancy rental excess at any point represents the running total of the amount by which the accountancy rental earnings exceed the normal rent and therefore the extra amount that would have been taxable if the lease had come within Part I of the Schedule from the start. Paragraph 14(3) therefore goes on to treat that excess as additional rent arising immediately before the conditions are satisfied and to provide for it to be carried forward under paragraph 6.

150. Paragraph 14(4) provides that any cumulative normal rental excess is to be calculated, also under paragraph 6, at the time the conditions are satisfied and carried forward.

151. Paragraph 14(5) provides that the rent regarded as arising under paragraph 14(3) is in addition to any current rent and is left out of account in applying the comparison between accountancy rental earnings and normal rent under paragraph 5.

152. Paragraph 14(6) specifies further the time when the rent is deemed to arise.

153. Paragraph 14(7) provides that in the case of rentals subject to tax under the Schedule A rules which apply to companies any relief for bad debts already given under Section 41 of the Taxes Act is to be regarded as if it were given in the same way as bad debt relief in computing trading profits. This is to ensure the cumulative accountancy rental excess can be calculated correctly under paragraph 6 for the periods prior to the time the conditions in paragraph 3 were satisfied as required by paragraph 14(3).

154. Paragraph 15 provides continuity of reliefs when a lease changes status. It applies where a lease initially subject to the rules of Part II of the Schedule comes within those in Part I. Here any cumulative accountancy rental excess or any cumulative normal accountancy rental excess for the purposes of Part II counts for Part I purposes.

155. Paragraph 16 marks the beginning of Part II of the Schedule. It provides an overview of the rules in Part II in the same way that paragraph 1 provides an overview for Part I. It covers cases outside Part I where any assets are leased in such a way that, for accountancy purposes, they are a finance lease.

156. The principal purpose of Part II is to ensure that the taxable measure of earnings from the lease is not less than the accountancy measure. In effect, the rules take as the taxable earnings the measure under the existing law or the accountancy measure, whichever measure is higher. Unlike Part I, Part II contains no special rules relating to reliefs for capital expenditure.

157. Paragraph 17(1) explains that the rules apply to 'new schemes' which are finance leases. 'New schemes' are defined in paragraph 28 but broadly they are leases which the lessor had not granted, or was not committed to granting, on Budget
Day.

158. Paragraph 17(2) provides that the rules continue to apply once the lease is caught until the lease is assigned to a person unconnected with the persons specified in paragraph 17(3).

159. Paragraph 17(3) defines those persons, to include in particular the lessor and connected persons of the lessor. 'Persons' encompass both individuals and companies.

160. Paragraph 17(4) puts it beyond doubt that after a lease has initially ceased to come within the scope of Part II (for example on an assignment to an unconnected person) it may do so again subsequently if the conditions are satisfied.

161. Paragraph 18 applies the rules in a number of paragraphs in Part I for the purposes of Part II. The paragraphs attracted in this way are paragraph 5 (the charge on accountancy rental earnings), 6 (cumulative excesses), paragraph 7 (assignment of a lease on no gain/no loss terms), s 8 to 10 (bad debts) and paragraph 13 (relief for cumulative accountancy rental excess against capital gains disposal proceeds). The paragraphs dealing with capital allowances (11 and 12) are not attracted and nor is the 'catching-up' charge under paragraph 14.

162. Paragraph 19 and 20, constituting Part III of the Schedule, apply the provisions in the Schedule to the special circumstances of insurance companies.

163. Paragraph 19 ensures that the references in the Schedule to accounting purposes do not apply to the accounts which insurance companies are required to draw up under the Insurance Companies Act. Insurance companies are also required to prepare accounts under the Companies Acts, like other companies, and it is to those accounts that the Schedule refers.

164. Paragraph 20 sets out how the main rules in Parts I and II are adapted to meet the case where the lessor is a company carrying on life assurance business. The tax rules relating to such companies are complex, because different parts of a company's business are taxed in different ways.

165. Paragraph 20(1) simply provides that the rest of the paragraph applies where the lessor carries on life assurance business.

166. Paragraph 20(2) overrides the rest of the Schedule where profits of any part of the life assurance business are computed in accordance with the 'life assurance Case I rules'. These provide that where a computation of business is to be carried out in accordance with Case I principles (Case I being the normal way profits from trades are computed) the investment income and increase in value of assets that is to be brought into account in that computation is the amount shown in the revenue account in the return the company makes to the DTI for regulatory purposes. This is done so that there is appropriate matching between the incomings and the outgoings. That matching could be upset if the rules in the rest of the Schedule applied.

167. Paragraph 20(3) ensures that in the cases where the Schedule is to apply, one condition for the operation of the Schedule, namely that the amounts to which the Schedule applies are not already brought into account for tax, is still regarded as applying even if some amounts have been brought into account under the 'life assurance Case I rules'.

168. Paragraph 20(4) applies the normal apportionment rules for dividing income up between different classes of business for their different tax treatments. Amounts within the Schedule are not necessarily on first principles to be regarded as income arising from assets, and since the apportionment rule in Section 432A of the Taxes Act depend on there being such income, the sub-paragraph puts it beyond doubt that those rules apply.

169. Part IV of the Schedule set outs supplementary provisions, mainly defining the terms used earlier.

170. Paragraph 21 defines 'normal rent' as the rent which would be brought into account for tax apart from the rules in this Schedule.

171. Paragraph 22 and 23 between them define 'accountancy rental earnings'.

172. Paragraph 22(1) provides that 'accountancy rental earnings' are the highest of the three figures for a period of account given by paragraph 22(2). The three figures are the rental earnings for the lessor, a connected person of the lessor or consolidated accounts of the group of which the lessor is a member.

173. 'Rental earnings' are defined in paragraph 23 of the Schedule and 'connected person' in paragraph 26. Consolidated group accounts are defined as they are for Companies Acts purposes.

174. Paragraph 22(3) ensures that the period of account to be considered is that of the lessor company. Paragraph 25 of the Schedule provides rules to deal with situations where the period of account of a connected person or of the group as a whole do not coincide with that of the lessor.

175. The purpose of taking the highest of the three figures is to ensure that the earnings fully reflecting the economic substance of the transaction are taxed. This is especially important when the capital sum which is an essential part of Part I leasing schemes may be received not by the lessor but by a related party. In such a case it is only by considering the lessor's position and that of the related party together that the true economic substance of the transaction can be appreciated. That is likely to be in the consolidated accounts of the group as a whole, or possibly in the accounts of the related party, rather than in those of the lessor company itself.

176. In more detail, a lease to which the rules in the Schedule apply will typically provide that the group of companies of which the lessee company is a member can bring their obligations under the lease to a close by buying out the lessor's interest in the leased asset. In those circumstances the measure of income from the lease recognised in the consolidated accounts of the lessor's group is likely to be the same as that shown in the lessor's accounts.

177. But instead of buying out the lessor's interest the arrangement may be that instead the lessee group purchases, at a price calculated in exactly the same way, the lessor company itself, by buying all its issued share capital from the company which owns them. The economic substance of this transaction, which is substantially the same as a purchase of the lease itself, is likely only to be reflected in the consolidated accounts of the lessor group. The lessor's own accounts will just show the rents to which it becomes entitled under the lease and not the receipt for the purchase of its shares, even though in substance that includes part of the return on the investment in the lease. To ensure the economic substance of the transaction is properly reflected for tax the highest of the three figures is taken as the measure of the rental income.

178. Paragraph 23 of the Schedule defines the 'rental earnings' element of the term 'accountancy rental earnings'. The rental earnings for any period are the sums which should be recognised in accounts drawn up in accordance with normal accounting practice as the gross return on the finance lease or loan investment (the 'interest'). The accounts in question are those of the lessor or of a connected person or the consolidated group accounts, as the case may be. Paragraphs 29 and 31(1) of the Schedule contain further provisions on these accounting concepts.

179. Paragraph 24 is part of the machinery for ensuring that the taxable measure of rents is not increased for periods ending before Budget Day even if the lessor's period of account straddles Budget Day. This is achieved by treating that period of account as ending with Budget Day and another period as starting on that day. Rules elsewhere in the Schedule ensure that the Schedule does not apply to periods of account ending before Budget Day.

180. Paragraph 25 deals with situations where the measure of the accountancy rental earnings taxed under the Schedule on the lessor is that shown in the accounts of a connected person or the group as a whole and the period for which those accounts are drawn up is different from the period for which the lessor's accounts are drawn up. In those circumstances the figures are time apportioned as necessary to arrive at the measure of accountancy rental earnings for the lessor's period of account.

181. Paragraph 26 defines 'connected persons' in accordance with the usual Taxes Act definition (including for example all companies which are members of the same corporate group). The paragraph also provides that persons are regarded as connected throughout the period, beginning at the time the leasing arrangements are made and ending with the termination of the current lessor's interest, if they are connected at some point during that period.

182. Paragraph 27 defines assets which represent leased assets. The intention is to identify assets which in economic terms are essentially the same asset, in whole or in part, as the leased asset. The Schedule provides broadly that transactions in such assets are treated as analogous to transactions involving the leased asset itself.

183. The first category of asset which counts as representing the leased asset is any asset derived from or created out of the leased asset. An example would be the sub-lease of a leased asset.

184. The second category is any asset from which the leased asset is derived or created. An example here would be a freehold interest in land out of which a lease is created.

185. Third are assets which are derived from assets out of which the leased asset was created. An example would be a lease created out of the same freehold as the leased asset was created.

186. Finally, there are assets which derive their value to a substantial degree from the leased asset. For example, shares in a lessor company would represent a lease held by the lessor company so long as that lease did not amount to an insubstantial proportion of the assets held by the company. The requirement that an asset must derive at least a substantial part of its value from the leased asset ensures that for example ordinary portfolio investment in, say, the shares of the parent companies of banking group which include leasing subsidiaries are excluded from the definition.

187. Paragraph 28 defines new and existing leasing schemes. The distinction is important for two reasons. First, leases potentially within the rules in Part II of the Schedule are only caught where they are a new scheme. Second, capital allowances for old Part I schemes continue to be given (but subject to new disposal rules) while capital allowances for new Part I schemes are denied altogether from the outset. In essence the paragraph provides that existing schemes are those to which a lessor was substantially committed on Budget Day and which are finalised reasonably quickly thereafter.

188. Paragraph 28(1) provides that a lease forms part of an existing scheme if it satisfies either the tests in sub-paragraph 2 or 3. Otherwise it forms part of a new scheme.

189. Paragraph 28(2) sets out the first test. A lease counts as an existing lease either if a written contract was unconditional before Budget Day and no terms remained to be agreed after that date or, if it was conditional, the conditions were satisfied before Budget Day.

190. Paragraph 28(3) sets out the alternative test. This test is satisfied even if the pre-Budget Day written contract contains conditions not then satisfied and/or terms agreed only subsequently. This is so long as the conditions are satisfied and/or the terms are agreed within the further period set out in paragraph 28(4) (or such longer period as the Board of Inland Revenue may allow) and the contract in its final from is not materially different from the pre Budget Day version. The Board are likely only to grant an extension where every effort has been made to finalise the contract and there are good reasons why the ordinary time limits could not be met.

191. Paragraph 28(4) defines the period mentioned in sub-paragraph 3, namely six months from the date the contract was originally made or 31st January 1997 if that is later. The second (31st January) leg of the definition is to accommodate leases where most of the six month period allowed for finalisation had expired by Budget Day when these measures were first announced.

192. Paragraph 29 sets out what is meant by 'accountancy purposes' and 'normal accountancy practice'. These concepts are important in determining whether a lease counts as a finance lease (or loan) and in measuring the 'accountancy rental earnings' from it. In essence the approach is determine what the accountancy treatment would be under best UK commercial accounting practice.

193. Two particular features of these rules are as follows. Persons who are not companies are not assumed to draw up consolidated group accounts or having their results reflected in such accounts if that is not in fact the case. But lessor companies (and persons connected with them) incorporated outside the UK are treated as if they were incorporated in the UK and thus subject to the Companies Act rules on the preparation of accounts. If they are parent undertakings they are assumed to draw up consolidated group accounts.

194. Paragraph 29(1) provides for this purpose that it must be assumed the lessor and any connected person of the lessor are UK companies. This is because UK companies are required to draw up accounts in accordance with the guidance provided by the Accounting Standards Board.

195. Paragraph 29(2) limits the assumption in sub-paragraph 1 by providing that it cannot require persons who are not companies to be regarded as members of a group of companies. This ensures that the financial results of persons who are not companies cannot by virtue of these rules be reflected in consolidated group accounts.

196. Paragraph 29(3) ensure that persons not actually required to draw up accounts as if they were UK companies are regarded as doing so for the purposes of the provisions in the Schedule. Unincorporated businesses and companies incorporated outside the UK are examples of persons not actually required to draw up the accounts mentioned in sub-paragraph 1 but who must do so to the extent necessary to comply with the Schedule.

197. Paragraph 29(4) limits the provision in the previous sub-paragraph so that such persons are not regarded as drawing up consolidated accounts.

198. Paragraph 29(5) then introduces a more limited assumption about consolidated accounts: companies which would count as 'parent undertakings' for Companies Acts purposes are regarded as having to draw up consolidated accounts whether or not they are actually required to do so under the Companies Act 1985. Thus parent companies incorporated outside the UK are deemed for the purpose of identifying leases within the Schedule and computing the rental income from them to have to draw up consolidated accounts.

199. Paragraph 30 ensures that all assessments and adjustments necessary to give effect to the provisions of the Schedule may be made. This is principally relevant to the provisions dealing with capital allowances.

200. Paragraph 31 provides interpretative rules.

BACKGROUND

Basic features of a finance lease

201. A finance lease in economic and commercial substance is tantamount to a loan. The finance lessor (usually part of a big banking group) is the lender and the lessee is the borrower. The lessor lends money to the lessee by buying an asset needed by the lessee (either a new asset or an asset already owned by the lessee).

202. The finance lease rentals are worked out like the payments due under a house repayment mortgage. They are the amounts which will repay the loan (cost of the asset) to the lessor with a commercial rate of interest over the agreed loan period (the 'primary period' in finance lease terms). But, strictly, as a matter of law, the payments are rentals for the hire of an asset - not interest and loan repayments.

203. Accountancy practice recognises the reality and treats the lessor as having made a loan, just like a bank. And just like a bank the lessor's commercial earnings are the interest element in the finance lease rentals. The capital element in the rentals goes to the balance sheet to reduce the outstanding loan.

204. An important point here is that the lessor is legally the owner of the asset (and so qualifies for any capital allowances on it) but accountancy requires the lessee and not the lessor to show the asset in the balance sheet as if he owned it. This is because the economic reality is that the lessee has the same full use and benefit/risk as an ordinary owner. If the asset is useless the lessee still has to pay the rentals. If the asset grows in value the lessee gets the benefit. Once the 'loan' has been paid off the lessee either continues to rent the asset for a purely nominal sum for as long as he likes or the asset is sold and the lessee keeps the proceeds.

205. For tax the gross rentals ('interest' and 'capital') are charged but capital allowances are given. Where the full capital cost of the asset qualifies for capital allowances (as it does, for example, if the asset is machinery or plant) the net amount taxable is broadly the 'interest'. That is the gross rentals are taxed but capital allowances can be deducted equal over the life of the asset equal to the capital repayment element.