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This section is applicableÌýto entities applying FRS 102 pre 2024 amendments or FRS 105, and for lessors onlyÌýunder IFRS 16 and FRS 102 (2024 amendments).Ìý

See BLM17000Ìýfor lessee accounting under the on-balance sheet model under IFRS 16 and FRS 102 (2024 amendments)Ìý

This page provides further commentary on a range of topics relating to commercial substance and risks and rewards.Ìý

Commercial SubstanceÌý

To understand the reality of finance leasing,Ìýyou may find it helpful to think of the rentals under a finance lease in terms of theirÌýeconomic and commercial substance – that is a combination of:Ìý

But as a matter of general law the rentals are simply the hire charge for an asset.Ìý

A simple example illustrates how a finance lease resembles a loan.Ìý

A trader who wants an asset costing £10,000 could borrow £10,000 at (say) 10% from a bank and use the money to buy the asset. The trader will pay the bank the interest and the capital. The capital could either be repaid in one lump sum at the end of the loan periodÌýor it could be structured like a repayment mortgage, with small capital payments and large interest payments at first and, towards the end, large capital payments and small interest payments.Ìý

The same commercial result can be achieved with a finance lease. The finance lessor (often a subsidiary of a bank) buys the asset for £10,000 and leases it to the lessee. The lessee is the one who uses the asset. The lessor charges the lessee rentals which, over the term of the lease, will repay the capital with a commercial rate of ‘interest’.Ìý

TypicallyÌýa finance lease is structured like a repayment mortgage. That is, in substance, the rentals in the early years are mostly ‘interest’ while towards the end they are mostly loan’ repayment. The following simple example shows a typical profile for a ten-yearÌýlease.Ìý

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The ‘interest’ charges included in a finance lease agreement may fluctuate with base rate orÌýother changes (such as tax rate or other tax regime changes) and often provisions in the leaseÌýspell out the consequences. The lease is usually designed to leave the finance lessor making a desired return on the finance element whatever happens.Ìý Meanwhile,Ìýthe lessee picks up any resulting increased costs or benefits from any reduced cost.Ìý

In a basic finance lease, the economic risks and rewards of ownership sit with theÌýlessee although, as a matter of law, it is the lessor who owns the asset. As with any lease, the terms of the lease give the lessee the right to use the asset in return for the rental payments. However, finance leases mayÌýcontainÌýprovisions which ensure that the lessee can either:Ìý

If the asset is in poor condition at the end of the leaseÌýit will be worth less than an asset that has been looked after well. ÌýThe lesseeÌýloses out if they »å´Ç²Ô’tÌýlook after the asset because they haveÌýhad toÌýpayÌýall the rentalsÌýrepresentingÌýthe full cost of the asset, plus the lessor’s profit, regardless.ÌýÌýIf the asset is well looked after by the lessee and remainsÌýin good condition itÌýwill usually beÌýworth more than expected when the 'loan' has all been repaid, and the lessee reaps the benefit.Ìý

Rental ProfilesÌý

Finance lease rental schedules can be structured in all kinds of ways; for example, the initialÌýrentals could be nilÌýor much lower than the amount needed to pay off the debt. SubsequentÌýrentals are then correspondingly higher.Ìý

Where the initialÌýrentals are nil (or set at an amount less than the ‘interest’ which is accruingÌýon the ‘loan’) the lessee’s debt to the lessor increases. This led to tax planning opportunities where ‘interest’ earnings could be recognised for accounts purposes much sooner than they were taxable. Schemes which used deferred rental structures to avoid or defer tax, and the legislation enacted to counter them are described at BLM70000Ìýonwards.Ìý

Where the rentals are set at an amount equal to the ‘interest’ on the ‘loan’ the lessee’s debt remainsÌýstatic and the lease is equivalent to an interest-only loan. Such a lease is likely toÌýcontainÌýa requirement to pay a terminal rental at the end of the lease term which will, in effect, repay the ‘loan’.Ìý

Various combinations are possible. For example, the lease might be equivalent to an interest-only loan for a few years and then become equivalent to a repayment loan for the rest of the lease term.Ìý

Primary and secondary periodsÌý

A finance lease is usually split into ‘primary’ and ‘secondary’ periods. The ‘loan’ (with the ‘interest’) is repaid during the primary period. Once that period is complete,Ìýthe lessee usually has the option to continue to hire the asset for a nominal rent during the secondary period, whetherÌýindefinitely or for at least the remaining useful life of the asset.Ìý

The structure of the lease is crucial to the nature of a finance lease.Ìý

It should be noted that leases are often structured in this way because the parties wish to avoid any provision under which the lessee might become the owner of plant or machinery (and so the lessee ³¦²¹²Ô’tÌýsimply acquireÌýthe asset at the end of the primary period). If they are not, CAA2001/S67 may apply and treat the lessee (not the lessor) as the owner for capital allowances purposes. The effect of section 67 CAA 2001 is discussed in detail at BLM39000Ìýonwards.Ìý

Rental rebates and termination paymentsÌýÌý

At any time from the end of the primary period (and sometimes from an earlier point) the lessee is oftenÌýentitled to require the lessor to sell the asset and pay the majority (often over 99%) of the net sale proceedsÌýto the lessee by way of rental rebate. The net sale proceeds are the sale proceedsÌýless any amount that might be due by way of rent.Ìý

The lessor is usually entitled to retainÌýonly a trivial proportion of the net sale proceeds. In addition to this, the lessor isÌýentitledÌýto ensure that, where needed, it recoups its capital investment plus interest on the outlay, whether that comes out of the sale proceeds or by way of a further ‘termination rental’.ÌýThe objectiveÌýis to ensure that the lessor recoups its net cost plus an amount that is equivalent to interest on the loan.Ìý

Exceptionally, the lessor might seek additionalÌýpayments where a lease is terminatedÌýearly.Ìý

Long-funding leasesÌý