Leasing
What is Leasing?
Leasing is a process by which a firm can obtain the use of a certain fixed assets for which it must pay a series of contractual, periodic, tax deductable payments. The lessee is the receiver of the services or the assets under the lease contract and the lessor is the owner of the assets. The relationship between the tenant and the landlord is called a tenancy, and can be for a fixed or an indefinite period of time (called the term of the lease). The consideration for the lease is called rent.
Term of a lease
The term of the lease may be fixed, periodic or of indefinite duration.
If it is for a specified period of time, the term ends automatically when the period expires, and no notice needs to be given, in the absence of legal requirements.
The term's duration may be conditional, in which case it lasts until some specified event occurs, such as the death of a specified individual.
A periodic tenancy is one which is renewed automatically, usually on a monthly or weekly basis.
A tenancy at will lasts only as long as the parties wish it to, and be terminated without penalty by either party.
It is common for a lease to be extended on a "holding over" basis, which normally converts the tenancy to a periodic tenancy on a month by month basis.
Advantages of commercial leasing
For businesses, leasing property may have significant financial benefits:
- Leasing is less capital-intensive than purchasing, so if a business has constraints on its capital, it can grow more rapidly by leasing property than it could by purchasing the property outright.
- Capital assets may fluctuate in value. Leasing shifts risks to the lessor, but if the property market has shown steady growth over time, a business that depends on leased property is sacrificing capital gains.
- Because of investments which are done with leasing, new businesses are formed. Furthermore, unemployment in that country is decreased.
- Leasing may provide more flexibility to a business which expects to grow or move in the relatively short term, because a lessee is not usually obliged to renew a lease at the end of its term.
- In some cases a lease may be the only practical option; such as for a small business that wishes to locate in a large office building within tight locational parameters.
- Depreciation of capital assets has different tax and financial reporting treatment from ordinary business expenses. Lease payments are considered expenses, which can be set off against revenue when calculating taxable profit at the end of the relevant tax accounting period.
Disadvantages of commercial leasing
For businesses, leasing property may have significant drawbacks:
- A net lease may shift some or all of the maintenance costs onto the tenant.
- If circumstances dictate that a business must change its operations significantly, it may be expensive or otherwise difficult to terminate a lease before the end of the term. In some cases, a business may be able to sublet property no longer required, but this may not recoup the costs of the original lease, and, in any event, usually requires the consent of the original lessor. Tactical legal considerations usually make it expedient for lessees to default on their leases. The loss of book value is small and any litigation can usually be settled on advantageous terms. This is an improvement on the position for those companies owning their own property. Although it can be easier for a business to sell property if it has the time, forced sales frequently realise lower prices and can seriously affect book value.
- If the business is successful, lessors may demand higher rental payments when leases come up for renewal. If the value of the business is tied to the use of that particular property, the lessor has a significant advantage over the lessee in negotiations.
The History of Leasing
Leasing is corporate America's biggest external source of equipment finance. It's bigger than bank loans, bigger than bonds, bigger than stocks, bigger than commercial mortgages. And it's the fastest growing form of business investment. This year alone, over $220 billion dollars of equipment will be leased in the United States and $550 billion throughout the world. Overall, worldwide leasing volume continues to grow. Unfortunately, several country volumes have dropped precipitously, thus making it more difficult to expand their leasing markets.
U.S. companies lease everything from printing presses to power plants, hay balers to helicopters, office copiers to offshore drilling rigs, telecom equipment to large-scale computer networks.
Over 35% of all capital equipment is financed through some form of leasing. Eight out of ten companies - from mom and pop proprietorships to the Fortune 500 - have turned to leasing to get ahead and stay ahead.
How did we get here? How did leasing become the most popular financing alternative in the world? Let's explore its rich history.
In 1984, while the leasing industry was reeling from the third major tax change in four years, archaeologists found clay tablets from the ancient Samarian city of Ur. They discovered that these tablets documented farm equipment leases from the year 2010 BC.
Fifty years later, the king of Babylonia in his famous Code of Hammurabi enacted the first leasing laws. The ancient civilizations of Egypt, Greece and Rome engaged in leasing transactions of real and personal property, while the Phoenicians actively promoted leasing by chartering ships to local merchants.
Leasing first appeared in the United States in the 1700's to finance the use of horse-drawn wagons. By the mid-1800's, railroad tycoons, battling to extend their private railroads across the country, required tremendous amounts of new capital. Most banks, however, considered railroad financing risky and refused to lend to the emerging transportation industry. Locomotives, cars and other railroad equipment had to be financed using new and creative methods - the forerunners of the equipment lease.
This new scheme involved third-party investors who would pool their funds, purchase railroad cars from a manufacturer, then lease the cars to the railroad in the form of "equipment trust certificates". The railroad would receive title to the equipment after making periodic payments to cover the purchase price plus interest. This method of financing resembles the modern-day conditional sale.
In the early 1900's, companies began to act as lessors for this equipment by leasing it out while maintaining title to it. Often, the lessees would be shippers who wanted control over their shipments without the responsibilities of ownership. This method introduced the operating or true lease concept. Meanwhile, other manufacturers were looking for additional ways to sell their merchandise. They created the installment sale, which allowed consumers and commercial markets to increase their purchasing power by paying for equipment over time.
By the mid-1920's, manufacturers were basing too many major investment decisions on credit sales. Their failure to recognize this danger helped bring about the Great Depression in the 1930's. As many businesses suffered, they became wary of "creative" financing and leasing was placed on hold.
Leasing returned to popularity during World War II. Manufacturers entered into cost-plus contracts with the government. These contracts allowed the manufacturer to recover actual costs plus a guaranteed profit. In order to minimize costs, many of these companies leased special-purpose machinery from the government. Companies discovered that they could return the equipment to the government at the end of the lease, thus protecting themselves against owning technically obsolete equipment when the war ended.
In the 1950's, consumers started to demand a vast array of goods. They wanted speed, convenience and mobility. Manufacturers utilized leasing to help overhaul old operations quickly and create new facilities for the production of new products like televisions, advanced communications equipment and airplanes.
This rapid growth provided an ideal backdrop for the creation of a formal equipment leasing industry.
The leasing industry has experienced phenomenal growth over the years. In spite of a strong US dollar, volatile exchange rates and unpredictable interest rates, the leasing industry continues to survive and expand. Today, all over the world, you can see banks, insurance companies, captive finance companies, third-party vendors, brokers, and independent leasing companies all competing to serve lessees.
What were the major factors that helped make leasing the popular financial alternative that it is today?
The volatility of the general economy was one factor. Leasing, once considered to be aggressive financing used only by those unable to get conventional terms, is now regarded as a stable alternative to wildly-fluctuating interest and inflation rates. For example:
- In December 1980, the prime lending rate reached 21.5% and low-risk instruments like U.S. Treasury bonds stood at 17%.
- Double-digit inflation became common in the 1970's, causing many assets to be priced out of reach without financing.
- Annual federal budget deficits climbed continuously, from $25 billion in 1968 to a staggering amount of $230 billion in 1990, causing the national debt to reach a mind-boggling $2.7 trillion.
This financial roller coaster caused many traditional funding sources to tighten their credit requirements, opening the door to new methods. At the same time favourable tax laws and other regulations were bolstering leasing. Let's return to the 1950's to see why some of these favourable changes were brought about.
By increasing tax deductions in the early life of the asset and deferring taxable income to the later years, the Code was intended to enhance the benefits of ownership and encourage capital spending. However, many companies like railroads and airlines that needed the use of large and costly equipment couldn't afford to purchase it outright and couldn't take advantage of these new tax benefits.
For the first time, a real distinction could be made between the benefits of ownership and the benefits of use.
U.S. Leasing Corporation was the first general equipment leasing company formed to take advantage of these tax benefits of ownership while passing the right to use the equipment and the expense of maintenance to another party. In these transactions, title usually passed to lessees upon their exercise of a nominal purchase option.
By 1955 the use of leasing had spread, and several more leasing companies entered the market. While they were bringing new products into the leasing arena at a rapid rate, a major tax issue was surfacing. The tax code, which had been issued by the IRS the previous year, had not distinguished clearly between a true lease and a conditional sale agreement. Since leasing companies didn't want to lose any of these newfound tax benefits, they were reluctant to pursue situations, which would be questioned by the IRS.
With the intention of defining a true lease for tax purposes, the IRS issued Revenue Ruling 55-540 in 1955. This ruling classified a transaction as a true lease only if none of the following conditions were true:
1.Any portion of the lease payments was applied to an equity position in the asset
2.Ownership automatically passed to the lessee at the end of the term
3.The amount paid under a short-term lease was a significant portion of the purchase price
4.Rental payments were substantially higher than fair market
5.The transaction contained a nominal purchase option
6.Any portion of the lease payment was characterized as interest.
If any one of these conditions were true, the transaction was considered a conditional sale, and only the lessee received the tax benefits.
During the remainder of the 1950's, the economy remained somewhat flat. A mild recession in 1960-61 once again spurred Congress to action, resulting in dramatic changes in the leasing industry.
In another effort to pump up capital expenditures, Congress introduced in 1962 a new tax benefit, which would provide the leasing industry with its biggest boost. The Investment Tax Credit (ITC) provided purchasers of capital equipment with a tax credit they could use to offset their total tax liability to the government. The purchaser could determine the amount of this credit by taking 7% of the original equipment cost.
Lessors who could establish true leases were also entitled to the ITC. Therefore, a smart lessor would keep the ITC, reduce the monthly rental payments from the lessee, and still show higher after-tax yields.
Another significant event occurred in 1963, when the Comptroller of the Currency issued a ruling permitting banks to get into the leasing business. Before this, national banks were not allowed to own or lease personal property since their business was restricted to lending money. Previous involvement in leasing had been limited mainly
to the trustee function involving equipment trust certificates. As soon as banks began to take an active role in equipment leasing, the use of equipment trust certificates began to fade.
1970 ushered in a turbulent decade for the economy. The continued emphasis on defense spending and the push for technological advancement left the government with an increasing budget deficit, declining GNP and growing unemployment.
In August of 1971, President Nixon imposed the first peacetime wage and price controls. This resulted in companies jacking up their prices and then discounting them for selected customers in order to stay within the confines of the law. By 1973 the Watergate scandal and the Arab oil embargo had caused the U.S. dollar to be devalued twice.
The prime rate steadily increased during this decade, from 6% to 15.75%. Inflation rose to 12%, discouraging savings and reducing capital available for investment. Corporate profits were sharply reduced, and the economy slid deeper into recession. Research and development, investment in new equipment and the planned replacement of aging assets were usually the first budget items to be cut.
Banks were given a stronger foothold in the leasing industry when Congress amended the Bank Holding Company Act in 1970. This amendment allowed banks to form holding companies and bank subsidiaries. As subsidiaries, bank leasing companies were no longer subject to the stringent reserve requirements of their parent banks, providing them with more financial leverage and a greater profits.
Companies like IBM and Xerox began to use leasing more widely to finance the distribution of their products. They maintained equipment title, offered shorter terms, and remarketed the equipment after the lease. These benefits attracted many customers who wanted to avoid the risk of computer and copier technical obsolescence. Vendor leasing quickly spread to other types of equipment,including office machinery and furniture,cash registers,and restaurant equipment.
The marketplace also created new types of products. One example is the leveraged lease, a highly sophisticated product that combines three parties -- lessor, lessee and lender. In this type of transaction, the lessor finances the equipment by putting in 20% equity and borrowing 80% from a lender on a non-recourse basis. The lessor then keeps all of the tax benefits as well as deducting the loan interest. The leveraged tax benefits allow the lessor to offer the lessee extremely low rentals while maintaining a high yield.
Since the complex structuring of leveraged leases was not foreseen in 1955, many lessors required private tax rulings from the IRS. In 1975, the IRS responded by issuing Revenue Procedure 75-21. This procedure amplified its 1955 ruling and specified in more detail what criteria would be used to govern leasing transactions for tax purposes.
While the IRS was dealing with the tax aspects of lessors, the Securities and Exchange Commission (SEC) was concerned with inconsistent lessor balance sheets and income statements. They wanted to standardize the financial statement reporting methods of both lessors and lessees in order to help investors make better-informed investment decisions. In 1976, the Financial Accounting Standards Board (FASB), under pressure by
the SEC, issued a comprehensive lease accounting document entitled Financial Accounting Statement No. 13 (FAS 13).
This statement classifies a lease as either a capital lease or an operating lease from the lessee's viewpoint. If the lease is determined to be a capital lease, the lessee must account for it as an outright purchase and show the asset on their financial statements. An operating lease, on the other hand, is not reflected on the balance sheet and future rentals are disclosed only in the footnotes.
Lessors are subjected to similar tests designed to create accounting symmetry, but these criteria leave some loopholes that can enable both parties to leave the asset off the balance sheet.
In the 80’s, the leasing industry witnessed five major tax laws in a very short period of time:
- Economic Recovery and Tax Act of 1981 (ERTA)
- Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA)
- Deficit Reduction Act of 1984 (DRA)
- Tax Reform Act of 1986 (TRA)
- Competitive Bank Equality Act of 1987
In August of 1981, Congress passed ERTA, an extensive revision of the1954 Internal Revenue Code. Led by a Republican majority in the Senate, Congress believed that the private sector would spend and invest more money and stimulate the economy if its tax burdens could be sharply reduced.
Two features of this law had major impacts on leasing (1) ACRS - Accelerated Cost Recovery System and (2)Safe Harbor Leasing.
ACRS replaced the complex ADR depreciation system with a simpler and faster cost recovery system. This new system contained only five classes of assets ranging from 3-year to 15-year life spans and specified the percentage of cost to be written off in each year. This enabled an owner/lessor to fully depreciate an asset without having to estimate useful life and salvage value.
Safe harbor leasing had a major impact on the entire business community. Tax benefits were made available to lessors other than those complying with "true lease" guidelines. Only three tests had to be met to qualify for the tax benefits of ownership:
- Lessor is a corporation (excluding subchapter S and personal holding companies)
- Lessor’s minimum investment in the leased asset is never less than 10% (reduced from 20%)
- The term of the lease does not exceed 90% of the useful life of the asset or 150% of the present class life of the asset.
If all of these requirements were satisfied, the transaction would qualify as a lease for tax purposes regardless of other factors previously disallowed, like bargain purchase options and limited-use property.
Another new feature of safe harbor leasing was the tax benefit transfer (TBT) lease. This enabled lessors to structure a lease with direct matching of incoming rentals and debt payments to make a single payment to the lessee for the tax benefits. This aspect of the law led quickly to major sales of tax shelters to "nominal lessors" who were not normally in the leasing business. Several major companies, General Electric, for example, did not pay taxes that year due to their tremendous participation in the TBT marketplace.
As soon as it was enacted in 1981, ERTA became a scapegoat for the continually rising federal budget deficit. The volume of leases written jumped from $32.8 billion in 1979 to $57.6 billion in 1982, creating an unforeseen loss of tax revenues.
Congress passed TEFRA in August of 1982 to increase tax revenues lost under ERTA. This new act repealed safe harbor leasing and replaced it with the "finance lease", along with a complicated phase-in schedule. It also introduced the "90-day window", allowing leases to be written on new equipment already in service.
The finance lease liberalized the "true lease" guidelines of Revenue Procedure 75-21 in one major respect - fixed price purchase options of at least 10% would qualify for lease consideration. It also contained some unfavorable requirements - spreading the ITC benefits over 5 years and limiting the amount of tax liability that could be offset by ITC.
Although interest and inflation rates had returned to acceptable ranges by 1984, the budget deficit was growing enormously and became a political hot potato. In June of 1984, Congress passed the Deficit Reduction Act, the third major tax law in four years, to reduce the size of the budget deficit by raising tax revenues.
This new act postponed the introduction of finance leases from January 1984 until January 1988, as Congress recognized the impact on the Treasury of the rapidly growing leasing industry.
The Deficit Reduction Act of 1984 affected the leasing industry in several other ways:
- Time value of money was introduced by requiring lessors to adjust uneven rental streams for tax purposes
- Depreciation benefits on real property were reduced
- True-tax treatment was disallowed for leases to foreign corporations not subject to U.S. income tax
- TRAC leases, primarily affecting the vehicle leasing industry, were recognized as true-tax leases
In December 1984, President Reagan submitted a proposal to Congress for tax simplification. Some of the aspects of this proposal, especially the elimination of investment tax credit, caused some concern within the leasing industry. That concern finally came to past with the signing of the Tax Reform Act in October of 1986.
This tax change was so complicated that it required 2000 pages to document it. Major changes affecting leasing included:
- Repeal the Investment Tax Credit
- Lengthening equipment useful lives
- Introducing an alternative minimum tax
- Reducing depreciable amounts in the earlier years.
In 1987, Congress decided to help the banking community compete more effectively against the independent leasing companies in the operating lease market by passing the Competitive Bank Equality Act of 1987. In this legislation, Congress allowed major financial institutions to put up to 10% of their assets into operating leases. Prior to this new law, banks could not provide this type of lease due to the perceived risks and costs of direct ownership.
Nonetheless, few banks took advantage of this opportunity and left the equipment leasing industry altogether. In fact, independent leasing firms began to move into other aspects of structured asset finance to take advantage of the Bank's reluctance to avoid high-risk projects.
FASB 91 required leasing companies to reduce the amount of initial direct costs eligible to be booked at lease inception, FASB 94 required leasing companies to consolidate their leasing subsidiaries activities with the parent company, FASB 95 required leasing companies to produce cash flow statements instead of source and use of funds statements and FAS 96 totally overhauled the area of income tax/deferred tax computations and presentation.
Finally, in the mid 90’s, Wall Street and the business community discovered the Internet and the IPO market. It was almost impossible not to make money. Companies were expanding quickly and Silicon Valley in California, and the high-tech communities in Texas and Massachusetts, supplied talent to automate every process possible. The word E-lease was invented and volume went through the roof. Under President Clinton the economy grew more than 4-5% per year. Companies such as Sun, HP, IBM, Cisco were household names and started their own captive finance companies.
Unfortunately, the party could not last forever. And in 2001, the US recognized its first major recession in decades. Alan Greenspan lowered the federal borrowing rate 9 times to an all-time low of 2.5%. As of this writing, President Bush is still considering altering the alternative minimum tax and lowering corporate tax rates to spur the economy. The ELA would prefer changing the accelerated depreciation rules.
As a result of the World Trade Center bombings, it may take years to rebuild the US infrastructure. Whatever happens, I can assure you, the leasing industry will be there and at the front of the line – a privilege that rarely comes along in life.
Conclusions and the convenience to contract a lease at long term
A long-term lease is simply a lease in which the agreement term is ten years or longer. A long-term lease is typically an option used for commercial real estate rentals - your apartment or home rental should not be subject to a long-term lease, unless under very special circumstances.
A long-term lease has certain advantages and disadvantages. Locking the rent into a stable price can be either good or bad. Rent generally trends upwards, so a long-term lease can potentially save you money by locking you into a set price for years to come. However, if the market crashes and rent drops suddenly, you'll still be responsible for the same amount of rent. Also, if you want to move your business to another location, you may need to choose between waiting out the lease, however long it may be, or breaking the lease and being severely penalized.
When leasing property, it's a good idea to know the language used, financial or lease-related terms, and what they mean. A long-term lease is only one of many different types of leases defined by the length of the lease term. A pure lease or true lease is typically a very short-term lease; it's considered a "real" lease because once it's over, it's over - the renter cannot renew the lease or purchase the property. The property covered by a pure lease is typically some kind of equipment.
Leases are also categorized in terms of the percentage of the property's life for which they are leased. A capital lease can be a purchase, such as with a rent-to-own lease, or simply a lease that spans the majority of the property's expected life; the opposite is an operating lease, in which the lease term is only a fraction of the property's life. For instance, most residential properties are rented under operating leases, as the lease terms are typically six months to a year long.
Some leases may take into account rises or falls in the market. A step-down lease contains a provision in the contract for decreases in rent, while a step-up lease contains a provision in the contract for increases in rent. These types of leases may be combined with other types of leases, such as the long-term lease, to ensure that the rent amount remains fair over time.
Different types of leases place different levels of responsibility on the landlord and tenant. The gross lease is the most common form of residential leased property, requiring that the landlord take care of any maintenance, property insurance, or taxes on the property. A double net lease requires the tenant to pay all insurance and taxes related to the use of the property, while the landlord is still responsible for any maintenance that needs to be done to the property. A triple net lease makes the tenant responsible for the maintenance as well as the insurance and taxes. In a net lease or closed-end lease, the tenant is responsible for virtually every expense associated with the property.
Another kind of lease is the sandwich lease, also known as "sub-letting." A sandwich lease occurs when the tenant leases the property to another individual. The tenant becomes both the lessee and the lessor, acting as a sort of "middle man."
Whether you want to lease property for business or personal needs, for a short time or an extended period, it's important to know the language used in the business. A long-term lease may or may not be right for you, and could easily be combined with other types of leases, so it's important to be familiar with all of the terms you could encounter.
Bibliography
*Leasing from Wikipedia the free enciclopedia
*The History of Leasing by Jeffrey Taylor
*WiseGeek-What is a Long-Term Lease? Griten by Katharine Swan
Omar Gómez Castañeda "Leasing" [en linea]
Dirección URL: https://www.zonaeconomica.com/leasing (Consultado el 25 de Abr de 2024)
