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Jarvis, Collis and Bainbridge 2000

Executive summary

Introduction

Leasing is a significant source of finance for businesses of all sizes in the UK and makes a significant contribution to the economy. This report describes developments in the finance leasing market during the 1990s and focuses on single finance lease contracts for moveable plant and equipment in excess of £500,000 (the medium to big ticket market). The study took the form of a literature search and face-to-face interviews with individuals working in this sector of the market.

Previous research shows that economic and taxation implications are the main concerns of large firms when assessing whether to use leasing as a source of finance. In order to evaluate the economic merits of finance leasing, a firm must compare the cost of leasing with the cost of borrowing and purchasing the asset. Owing to the tax consequences of entering a lease, this should be a post-tax analysis. The tax incentives available for asset investment are an important consideration because the lessee gives up the right to the capital allowance claimed by the lessor as the owner of the asset. This fundamental point distinguishes leasing from other sources of finance.

The growth of the finance leasing market

The real growth in the finance leasing market took place from 1960 onwards, when the bias towards the ownership of assets diminished and the financial benefits of leasing became more widely known. In addition, advances in information technology stimulated the development of a leasing market for computer hardware, which enabled lessees to avoid the risk of the technological obsolescence. Other significant factors were the Bank of England's decision to relax restrictions on bank lending to leasing companies in 1969 and the introduction of Competition and Credit Control in September 1971. These policies stimulated the clearing banks to establish leasing subsidiaries, which helped improve the profile of the providers of leasing finance.

The most important positive influence on the growth of leasing was the replacement of investment grants with 60% first-year allowances (FYAs) in 1970, which by 1972 had risen to 100%. The expansion of front-ended capital allowances and tax relief, in conjunction with other existing relief, made available allowances which were often greater than taxable profits. This affected a relatively large number of companies, particularly those in the manufacturing sector, that become tax-exhausted. Although such firms were able to carry forward unused allowances, the present value of their tax savings declined over time.

The 1980s were a period when interest rates were high and consequently any deferral of tax allowances greatly reduced their present value. This provided a perfect environment for further growth in the finance leasing market. In 1984, however, plans were announced to phase out 100% FYAs, and expenditure incurred since March 1986 has generally qualified for 25% WDAs only. This reduction coincided with a decrease in corporation tax from 50% to 35% and new regulations introduced by SSAP 21 in 1984 that required lessees to record the lease in the balance sheet and spread the rentals in accordance with the accruals concept. The unexpected short-term effect was an upturn in the use of leasing, since the phased reduction in corporation tax meant that the lessor's profit (which arose largely at the back-end of the lease period) was taxed at a lower rate.

The 1990s have been more stable. Capital allowances have been available throughout the period at a rate of 25% on a reducing balance basis (except for the year ended 31 October 1993 when a 40% FYA was available), and corporation tax has fallen gradually from 35% to 30%. However, the lease versus buy evaluation has been complicated by new rules (SI 1998/3175) that require large companies to pay corporation tax in quarterly instalments, rather than nine months after their year-end.

Prior to April 1991, when there was symmetry in the tax positions of the lessor and lessee, the decision to lease rather than buy provided no post-tax benefits. Opportunities for a lessor and lessee to share in taxation advantages through a finance lease contract at the start of the 1990s included situations where:

• the lessee had insufficient taxable profit to shelter capital allowances

• the lessor used a leasing company with a different year-end

• a financing structure was used

• the lessor did not account for tax on an accruals basis.

Developments during the 1990s

In April 1991 a series of regulatory and legislative changes began that eroded the net advantage of leasing. Statement of Practice SP3/91 introduced a new system of relief that followed accruals accounting principles, based on the useful economic life of the asset rather than the time of the payment. This gained statutory force by virtue of two key legal cases. Although the lessor is still taxed on the basis of rental receipts, the lessee receives tax relief on the basis of a capital element and a finance charge. This had a significant effect on the decision to lease or buy assets and caused problems for the leasing of certain assets, particularly those with a long useful life. Its emphasis on the lessee's depreciation policy could be disadvantageous to leasing, but also created opportunities for those structuring tax-efficient finance.

Schedule 12 of the Finance Act 1997 required lessors who had not been required to adopt accruals accounting principle under SP3/91 to do so. The aim was to remove the tax deferral benefits of ordinary finance leases where the rental payments were concentrated towards the end of the lease. It was widely anticipated that the new Labour government would encourage investment in plant and equipment. In fact, the Finance Act (No. 2) 1997 continued the trend towards reducing the net advantage of leasing with new rules aimed at stopping arrangements that accelerated capital allowances and transferred unused allowances, as well as the use of group relief to accelerate relief.

Key findings

There was general consensus among those interviewed in the finance leasing market that SP3/91 was an example of the Revenue's piecemeal approach to the industry. Although it was quickly drawn to the attention of lessors by accountants and lawyers, and by articles in professional journals, most lessees were probably ignorant of SP3/91. The increased complexity of leasing in the medium-to-big ticket market meant that most corporate lessees needed an adviser or packager to advise them on commercial aspects.

Where there was appreciation of SP3/91 by lessees in the medium ticket market, the main effect was for potential lessees to extend the proposed term of the finance lease to be commensurate with the asset's useful life. This made credit approval more difficult to obtain. For lessees with strong credit, however, SP3/91 offered beneficial structuring opportunities.

All those interviewed believed that the market had seen an increasing number of particularly big ticket transactions for long periods with escalating rental profiles. Advisers and packagers tend to be less active in the big ticket market and the size and standardisation of documentation in this market does not often require input by accountants and lawyers.

There was general consensus on the following points.

• The market had responded very quickly to SP3/91 in order to exploit the potential benefits of rental escalation for big ticket deals.
  

• There would be an increased move to operating leases.
  

• The Inland Revenue were correct to move against multi-option property structures.
  

• There were legal tax avoidance structures that could have been pursued, but such action might be detrimental to relations with the Inspector of Taxes.
  

• The Inland Revenue sees leasing as a tax abuse and this perception should be challenged at all levels of government.
  

• The leasing industry had received mixed signals from the government and this made it difficult to assess future Inland Revenue policy.
  

• The Finance and Leasing Association needs to sell the benefits of leasing as a means of addressing the problem of under-investment in the economy.
  

• The leasing industry needs to build alliances at all levels of government with the objective of explaining the overall benefits of leasing, rather than getting drawn into protracted debates on specific tax issues.

Conclusions

Lessors and lessees use tax law and the availability of tax incentives to meet their own ends by altering the terms of lease contracts to minimise the amount and timing of tax payments to the Inland Revenue. This reduces corporate tax revenues or, more often, alters the timing of tax payments. Successive governments have witnessed the growth of leasing without, however, considering its core activities to be tax avoidance.

Historically, governments appear to have encouraged leasing as a tax-efficient mechanism for transferring capital allowances from loss-making companies to profitable companies, thus lowering the after-tax cost of debt to a wide range of companies. Paradoxically, they champion the benefits of leasing when they want to encourage inward investment, yet call it tax avoidance when they want to raise revenue.

The 1990s have been a challenging period for the finance leasing industry, which has attracted many highly-paid professionals, with specialist taxation knowledge. This study illustrates a number of examples of how finance leasing has been used as a tax-efficient means of financing plant and equipment during the decade. As regulatory changes have put an end to one type of tax structure, new products have been developed and this has tended to be the pattern in the industry. In the three-month period following the 1997 Budget, however, the value of new leases declined by 60%, as many of the financing structures developed by the leasing industry were by then prohibited.

With the recent reduction in the rate of corporation tax and lower interest rates, it would appear that the tax advantages of leasing have been considerably reduced. It seems likely that at the end of the 1990s the focus will change from finance leases to tax planning in the context of operating leases and cross-border structures using the Euro, although these may be short-lived if the regulatory trend to close what are perceived as tax loopholes continues. If the significant contribution made by leasing to the economy is to be sustained, it is critical that the different government departments adopt complementary policies that will enable the leasing industry to plan and develop its products.

Implications

The findings of the study, that have implications for the government, practitioners and the leasing industry are as follows.

• The government needs to provide a definition of tax avoidance that is acceptable to the Inland Revenue, so that companies can plan capital investment with greater certainty than at present.
  

• The government must consider carefully how its policies relating to capital investment and taxation affect the market and the overall level of capital expenditure in the economy.
  

• The government needs to co-ordinate and communicate future policies that affect the leasing industry.
  

• Tax practitioners should keep up to date with developments in accounting legislation and practice.
  

• The FLA should be more proactive in representing to the government the important role played by leasing in the economy.
  

• The leasing industry needs to be more innovative and international in its outlook if the industry is to survive in the 21^st century.

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