EQUIPMENT LEASES: OPERATING VS. FINANCE

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The two principal forms of commercial equipment leases are operating leases and finance leases, with an operating lease being essentially a rental agreement, which provides the lessee with the right to use the specified equipment for a period of time, but the lessor retains the risks and rewards of ownership, while a finance lease is more akin to purchasing an asset with a loan, such that legal title often remains with the lessor during the lease term, while the lessee effectively assumes most of the risks and rewards of ownership.

Operating Lease (True Lease / Off-Balance Sheet Lease - under ASPE)

An operating lease is essentially a rental agreement. The lessee gains the right to use an asset for a period of time, but the lessor retains the risks and rewards of ownership.

• Ownership: The lessor (leasing company) retains legal ownership of the equipment.

• Accounting Treatment (Under ASPE / Traditional View):

  • Balance Sheet: The leased asset and the corresponding lease liability generally do not appear on the lessee's balance sheet. This is why they were often called "off-balance sheet" financing.

  • Income Statement: Lease payments are expensed on the income statement as a rental expense, usually on a straight-line basis over the lease term.

  • Financial Ratios: Operating leases typically didn't impact debt-to-equity ratios because no liability was recorded. They would affect profitability ratios due to the expense.

• End-of-Lease Options:

  • Return the equipment to the lessor.

  • Renew the lease, often at a lower rate.

  • Purchase the equipment at its then-current Fair Market Value (FMV). There's no pre-determined bargain purchase option.

• Risks and Rewards: The lessor bears most of the risks and rewards of ownership, such as obsolescence and residual value risk.

• Useful For: Equipment that rapidly depreciates, is needed for a short period, or for businesses that prefer not to show the asset and liability on their balance sheet (where ASPE allows).

• Tax Implications: Lease payments (the full amount) are generally deductible as a business expense for tax purposes. You cannot claim Capital Cost Allowance (depreciation) because you don't own the asset.

Finance Lease (Capital Lease / On-Balance Sheet Lease)

A finance lease is more akin to purchasing an asset with a loan. While legal title often remains with the lessor during the lease term, the lessee effectively assumes most of the risks and rewards of ownership.

• Ownership: While legal title might stay with the lessor, for accounting purposes, the lessee is considered the "owner" because they bear the substantial risks and rewards of ownership. Often includes a nominal ($1) buyout option at the end.

• Accounting Treatment (Under IFRS 16 for all leases / Under ASPE for qualifying leases):

  • Balance Sheet: The leased asset (recorded as a "Right-of-Use" asset under IFRS 16) and a corresponding lease liability (debt) are recognized on the lessee's balance sheet. Income Statement: Instead of a single lease expense, you'll see two components:

    • Depreciation Expense: On the Right-of-Use asset over its useful life or the lease term.

    • Interest Expense: On the lease liability.

  • Financial Ratios: Finance leases increase both assets and liabilities on the balance sheet, which can impact financial ratios like debt-to-equity and return on assets. EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) will typically be higher under a finance lease as lease payments are broken down into interest and depreciation, which are added back to calculate EBITDA.

• Criteria for Classification as a Finance Lease (Under ASPE): A lease is typically classified as a finance lease if it meets any one of the following criteria (often referred to as "bright lines"):

  • Transfer of Ownership: The lease transfers ownership of the asset to the lessee by the end of the lease term (e.g., a $1 buyout option).

  • Bargain Purchase Option (BPO): The lease contains a bargain purchase option, allowing the lessee to buy the asset at a price significantly lower than its expected fair market value at the end of the lease.

  • Lease Term Test: The lease term is for the major part of the economic life of the asset (generally 75% or more).

  • Present Value Test: The present value of the minimum lease payments (excluding executory costs like maintenance) amounts to at least substantially all of the fair value of the leased asset (generally 90% or more).

  • Specialized Nature: The leased asset is of such a specialized nature that only the lessee can use it without major modifications.

• Risks and Rewards: The lessee assumes most of the risks and rewards of ownership, including obsolescence risk and generally responsibility for maintenance and insurance.

• Useful For: Equipment expected to be used for its full economic life, where the business intends to own the asset, or for businesses seeking to leverage depreciation for tax benefits.

• Tax Implications: For tax purposes, the CRA may treat a finance lease as if you purchased the property. This means: You can deduct the interest portion of the lease payments. You can claim Capital Cost Allowance (CCA), which is the tax depreciation on the equipment, as if you owned it.

For knowledgeable and experienced legal representation when undertaking equipment-related transactions, contact corporate business lawyer Christopher Neufeld at Chris@NeufeldLegal.com or 403-400-4092 / 905-616-8864.

Key Aspects of a Commercial Equipment Lease A commercial equipment lease is a legally binding contract that allows a business (the Lessee) to use equipment owned by another party (the Lessor) for a specific period of time in exchange for regular lease payments (and other legal conditions set out in the lease agreement), thereby preserving the business' cash flow to advance the business enterprise. Read more.

 

Common Errors by Lessees with Equipment Lease Agreements Lessees often make several common errors when entering into equipment lease agreements, which can lead to unexpected costs, legal complications, and operational inefficiencies. As such, in advance of leasing equipment, it is important to understand some of the most frequent mistakes made by lessees when leasing commercial equipment. Read more.

 

Operating Lease vs. Finance Lease for Commercial Equipment The two principal forms of commercial equipment leases are operating leases and finance leases, with an operating lease being essentially a rental agreement, which provides the lessee with the right to use the specified equipment for a period of time, but the lessor retains the risks and rewards of ownership, while a finance lease is more akin to purchasing an asset with a loan, such that legal title often remains with the lessor during the lease term, while the lessee effectively assumes most of the risks and rewards of ownership. Read more.