You should be familiar with my views on the continuing erosion of the tax incentives available for leasing in the US. Now we are beginning to see some of the same things occurring in the UK. As an example, certain provisions of the UK’s Finance Act of 2006 limit the availability to lessors of writing down allowances/depreciation. Under these provisions, certain leases, previously treated as tax leases and now referred to as ‘long funding leases,’ will be viewed as nontax leases by the tax authorities. The intent, and effect, is to reduce the ability of lessors to transfer tax benefits to loss making lessees by shifting the tax ownership of these transactions to the lessee.
What I am sure is an unintended effect of the regulation, however, is to raise the possibility of UK lessors now being able, with the right structure, to provide lessees a synthetic lease product. For those of you not familiar with synthetic leases, a synthetic is a lease that, for financial accounting purposes, is off balance sheet (i.e., an operating lease) to the lessee. For tax purposes, however, the lessee is viewed as being the owner and deducts the tax depreciation, making the transaction, in essence, an off balance sheet loan. Kind of crazy, but it works and is fairly common in the US, particularly in corporate aircraft.
The new UK tax regime applies to certain leases of plant and machinery that are presumed to function as financing transactions. These leases are referred to as funding leases. A funding lease is any lease classified as a finance/capital lease for accounting purposes. A lease classified as an operating lease for accounting purposes also may be a funding lease if either (1) the net present value of the payments is greater than 80% of the fair market value, or (2) the term of the lease is more than 65% of the remaining economic life of the asset. It is these two secondary tests for operating leases that opens the door to offering synthetic leases.
Under the 2006 Act, lessors in transactions referred to as long funding leases will no longer be able to deduct the tax depreciation. This depreciation will, instead, now go to the lessee. A long funding lease, in general, is any funding lease (as roughly defined above) longer than 7 years. So, now you have one component of the synthetic lease – tax ownership by the lessee. The missing piece is the operating lease classification. If, however, the lease is an operating lease, and qualifies as a funding lease due to either the NPV or economic life test discussed earlier, you also have the off balance sheet piece. Voila – a synthetic lease!
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