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Finance Leases

In the past, finance leases have traditionally been used for many years to finance motor vehicles, office equipment and machinery.

However in recent times, finance leases have fallen out of favour as financiers are reticent to provide funding for motor cars or equipment that has a higher residual value than the market value at the end of the financing arrangements.

With the GFC many financiers preferred to assist with a hire purchase or operating lease product rather than financing under a lease agreement with a large residual value.

Under a lease agreement the finance company (the lessor) owns the equipment and grants you (the lessee) use of the equipment & rents or leases this equipment to you. A finance lease has a pre-determined value left outstanding to pay at the end of the agreement called a residual value which is calculated & displayed on the finance paperwork.. This residual value is a guarantee to the finance company that they will get this amount at the termination of the lease. Many times the residual value is determined by the financier following guidelines set by the Australian Tax Office.

Notes on Finance Leases

• Under a finance lease, the financier will pay for the asset 100% and rent the asset to you. You have no ownership in the asset so if you have paid a deposit at the car yard this deposit will be refunded to you. The financier has title to the equipment.
• The financier calculates the finance on the GST exclusive amount of the purchase and then leases the equipment to you. GST is then levied on the lease instalments.
• Residual Values at the end of the agreement attract GST
• If you use the equipment for business purposes then the payments you make are generally tax deductible (to the extent of your business use)
• Payments are fixed for the agreement so you know with certainty what your commitments are
• Finance Lease liabilities are noted on the Balance Sheet of your accounts
• If you wish to change the equipment you will need to pay the existing agreement out before you can start a new lease
• The lessee guarantees that the lessor will get a pre-determined amount for the equipment at the end of the lease
• You run the risk that the equipment becomes obsolete and you still have the residual liability.

So how do we know how much is the residual value?

There are rules to consider when the residual value is set. There are a number of ways to set the residual value and this residual value should reflect what the equipment is commercially worth at the end of the lease. This can often be hard to estimate and many factors may change this value including technology advances, changes to attitudes towards 2nd hand cars, new tariffs taxes and so on. The Australian Tax Office has a set of guidelines that you can follow if you choose to calculate the residual value using their methods. You should consult with your accountant who can advise you of additional ways to set residual values suitable to your circumstances other than the ATO guidelines.

It should be noted that most financiers will set the residual value following the guidelines from the Australian Tax Office if you chose to finance via a finance lease.

IT28 & Effective lives of depreciating assets

In order to give tax payers some level of certainty about being able to legitimately claim the instalments as tax deductions, the Australian Tax Office made a ruling on 06/07/1960 known as IT28. This taxation ruling concerned the leasing arrangements of plant & machinery. It was devised so that traders could operate without fear of legal argument from the ATO if they followed their procedure of leasing plant and machinery.

This ruling effectively sets out the minimum residual values that can be used in leasing transactions according to the effective life of the equipment. The ATO ruled via IT28 that you could rely on tax deductions from your leasing claims if you set the residual value following their guidelines.

The following table sets out the minimum residual values required according to the effective life of the equipment (Taxation Ruling IT28)...

Minimum Residual Values Table According to Effective Life

	Finance Term (Years)
Effective Life (Years)	1	2	3	4	5
2	37.50%	0.00%	0.00%	0.00%	0.00%
3	50.00%	25.00%	0.00%	0.00%	0.00%
4	56.25%	37.50%	18.75%	0.00%	0.00%
5	60.00%	45.00%	30.00%	15.00%	0.00%
6	62.50%	50.00%	37.50%	25.00%	12.50%
7	64.29%	53.57%	42.86%	32.14%	21.43%
8	65.63%	56.25%	46.88%	37.50%	28.13%
9	66.67%	58.33%	50.00%	41.67%	33.33%
10	67.50%	60.00%	52.50%	45.00%	37.50%
11	68.18%	61.36%	54.55%	47.73%	40.91%
12	68.75%	62.50%	56.25%	50.00%	43.75%
15	70.00%	65.00%	60.00%	55.00%	50.00%
20	71.25%	67.50%	63.75%	60.00%	56.25%

For example if a depreciating asset had an effective life of 10 years then the minimum residual value set after 4 years would be 45% of the original cost.

One of the problems concerning a finance lease is that many lessors are reluctant to lease long effective life equipment to the lessee. This is for 2 reasons. Firstly often the equipment does not hold its value and secondly most financiers prefer the borrower to owe little or nothing at the end of the finance term to reduce the financiers risk in the transaction. This is why a finance lease for equipment that has a long effective life is often unworkable.