Reform of Corporation Tax: The impact on leasing

As part of its program of Corporation Tax reform the Inland Revenue has issued a technical note setting out its proposals for legislation to reform the tax treatment of finance leasing. The objective of the proposed reform is to equate the tax treatment of finance leasing with that of other forms of finance, in particular borrowing. In economic or commercial terms finance leasing and borrowing to purchase are perceived as being very similar; however, different tax treatments apply particularly in relation to the availability of capital allowances.

Leases and capital allowances made simple

Leases are broadly categorised as 'finance leases' or 'operating leases'.

• In accounting terms a finance lease (sometimes referred to as a 'full pay out' lease) is a lease that transfers substantially all the risks and rewards of ownership to the lessee, so whilst the lessor retains legal ownership the lessee assumes 'economic ownership' of the asset.
• An operating lease is a lease under which the lessor at all times retains ownership of the asset and where, at the end of each lease period, the lessee returns the asset and where the lessor carries some residual value risk.

At the heart of any leasing transaction is the availability of capital allowances which enable the cost of the asset to be taken as a deduction in computing tax liabilities and which were originally introduced to encourage investment in industry. To take advantage of capital allowances, the purchaser of the asset must have "tax capacity," that is to say, sufficient taxable profits against which the allowances can be fully offset.

Banking groups and other financial institutions tend to earn high levels of taxable profit on a year on year basis, so consequently carry excess tax capacity. Leasing has evolved into an extremely effective financing tool where banks and financial institutions purchase the asset, claim the capital allowances and lease the asset on to the end user. The rents payable under the lease will, to some extent, reflect the benefit of the capital allowances claimed so that the arrangement benefits both the lessor (in reducing its taxable profits) and the lessee with cheaper finance. This is particularly effective where the end user does not have tax capacity and so is unable to take advantage of the allowances itself, for example, companies with tax losses or exempt bodies.

What's driving the change?

The current policy objective is that where a lease functions as a financing transaction it should be taxed in a similar way to a loan and the Inland Revenue anticipates that this can be achieved by making capital allowances available to the lessee as the 'economic owner' of the asset whilst taxing the lessor on the basis of the substance of the transaction, ie the making of a loan.

The reforms are directed towards transactions that the Revenue perceives as financing. The new regime will introduce the concept of a 'funding lease.' A funding lease will be a lease with at least one of the following attributes:

1. it is a finance lease under GAAP; or
2. the net present value of the minimum lease rentals is more than 75% of the market value of the asset; or
3. the minimum term of the lease is more than 50% of the expected remaining useful economic life of the asset; or
4. the asset is of such a specialized nature that no other user of the asset could reasonably be expected.

It is intended that only funding leases of more than 4 to 6 years will fall within the new regime (the length of term is still to be finally decided). For non-funding leases and shorter funding leases both lessors and lessees will continue to receive the same tax treatment as they do now. For long funding leases the lessee will be entitled to the capital allowances but may not have the tax capacity to take advantage of them. Where the funding lease is accounted for as a finance lease the lessor will be taxed on, and the lessee will deduct, the finance element of the rentals shown in their respective accounts. Where the funding lease is accounted for as an operating lease the lessor will be taxed on, and the lessee will deduct, an amount estimated to be equal to the finance element of the rentals.

What's the impact?

The Revenue anticipate that whilst the reform will apply to a significant number of 'high value leases' most leases will be excluded from the new regime either by virtue of the definition of 'funding leases' or the rule to exempt shorter leases (potentially of up to 6 years). However, the proposals in their current form would appear to put in doubt the future of big-ticket leasing (currently such leases would inevitably be treated as long funding leases).

Impact on specific industry sectors:

• PFI and Local Authorities
• Oil and gas extraction activities
• Manufacturing
• Air
• Rail

Comments are however invited on specific impacts and considerations that may need to be taken into account in relation to the above sectors. Legislation will be introduced in the Finance Bill 2006, but no specific commencement date for the new provisions is specified which means that it is possible that the date could be before royal assent of the Finance Bill 2006. Assuming that the provisions take effect from royal assent this gives the industry about 18 months in which to lobby Government. In the meantime the proposal itself could result in the bringing forward of planned transactions.

Shipping and tonnage tax companies do not qualify for capital allowances, although they can benefit indirectly where ships are leased, therefore the Government has decided that the reforms will not affect existing arrangements for leasing into tonnage tax.

Should you require further details or advice please contact Keith Gregory on +44 (0)20 7367 2898 or at

[email protected], Peter Hewes on +44(0) 20 7367 3670 or at [email protected] or Mary Selby on +44(0) 20 7367 2689 or at [email protected]