Operating lease to finance a standard investment project

This page was last modified on 08-01-2013

Operating leasing is a contractual technique used to obtain medium-term credit whereby a leasing company (the lessor), at the request and according to the specifications of its client (the lessee), acquires full ownership of movable assets for business use with a view to leasing them for a specific period in exchange for fees or rental payments. The lessee, which, by this means of financing, keeps its financial independence, must maintain the asset in a prudent and responsible manner and ensure that it is adequately insured. At the end of the lease contract, the lessee can:

  • return the asset to the lessor, thereby ending its obligations;
  • ask for the lease contract to be renewed;
  • purchase the asset at the agreed price at the end of the lease contract.

During the term of the operating lease, the business is only the lessee of the asset and only pays a certain difference between the initial value of the asset and the residual value at the end of the lease contract. Since the lessee does not intend to become the owner of the asset, the lease contract does not generally provide for a purchase option. Because of this, any purchase of the asset by the lessee is negotiated at the end of the lease contract. The lessor therefore keeps all or almost all of the rights, obligations, advantages, disadvantages and risks attached to the right of ownership of the asset financed.

Operating leasing is generally offered by sector specialists as it requires in-depth knowledge of the market. It also often contains a service or maintenance component, i.e. additional services, such as the maintenance of the asset, insurance and repairs, etc., are included.

Objective: operating leasing is used to finance the vehicle fleet (cars, vans, trucks, boats and planes), production tools or various machinery and movable assets (computers, printers, photocopiers, etc.).

Who is concerned

Available to the self-employed and any type of business, operating leasing applies in the following cases:

  • acquisition of movable assets when a business is being set up;
  • refinancing of movable assets by leasing to free up capital for other investments;
  • modernisation of production tools, IT system, etc.;
  • improvement of the balance sheet structure by replacing bank debt with off-balance sheet operating leases;
  • tax optimisation.

Prerequisites

Documentation or description of the business

  • copy of the company’s articles of association;
  • group structure if the company is part of a more complex group;
  • last 3 audited balance sheets of the borrower and, if applicable, the latest available trial balance;
  • order book (where applicable);
  • list of customers and their relative contribution to turnover;
  • list of suppliers.
  • forecast balance sheet or business plan in the case of a new business activity or a major expansion plan.

Presentation of the project

  • detailed description (including figures) of the planned investment;
  • financing plan;
  • calculation of feasibility and return and calculation of the breakeven point;
  • appendices:
    • machinery: list of investments, replacement of existing equipment, additional equipment, purchase orders or invoices;
    • supplier: contact details, references, brands.

Guarantees

A significant guarantee for the lessor is that it maintains legal ownership of the asset and so the risk incurred is reduced. It may, however, request the following additional guarantees:

  • a pledge of a certain amount representing the proportion of shareholders' equity of the investment;
  • the payment of a higher first rental payment, also representing the proportion of shareholders' equity of the investment and allowing the leasing company to reduce the level of risk from the start. This first rental payment is generally tax deductible by the lessee;
  • a commitment by the supplier of the asset or by the customer to take back or purchase the equipment at the end of the lease contract;
  • surety of the parent company or partners/shareholders;
  • various other tangible and moral guarantees.

When the partners/shareholders of a business have to stand surety for the company, the details of their financial situation must be provided to the lessor.

How to proceed

Duration and amount

Duration

The term of the operating lease is greatly limited by accounting and tax requirements. Indeed, it must correspond to at least 40 % and no more than 90 % of the amortisation period in order to be treated as off-balance sheet financing.

Considering the nature of the objects to be financed by operating leasing, a short to medium-term period is the most common (between one and 5 years for movable assets).

Amount

Financing of up to 100 % of the asset’s value.

Rental payments

  • the rental payments depend on different criteria, including, for example, the quality of the lessee, the amount, the rate, the amortisation period of the asset to be financed, etc.;
  • equal rental payments, depending on:
    • a fixed or variable interest rate;
    • the asset’s residual value;
    • administrative charges.
  • monthly, quarterly, semi-annual or annual rental payments.

Repurchase value

Varies, generally between one and more than 50 % of the initial value. The difference between the residual value and the initial value of the asset is paid in the form of rental payments.

Accounting and tax information

Legal ownership

The lessor is the legal owner of the asset during the full lease term.

Economic and tax ownership

When the conditions required for an operating leasing are not met, ownership of the asset is allocated to the lessor, unless the possibility of both increases and decreases in the value of the asset is assumed by the lessee.

Therefore, if the lessee only benefits from the chances of an increase in value or only bears the risks of depreciation, legal ownership should not be separated from economic ownership and so the asset is allocated to the lessor and the contract is deemed to be a rental contract.

Accounting treatment of the asset

The accounting treatment of the asset depends on the economic and tax ownership:

  • if the lessor is considered to be the owner: the fixed asset does not appear in the lessee’s commercial balance sheet; only the rental payments are entered in the accounts and are tax deductible as operating expenses;
  • if the lessee is considered to be the owner: the fixed asset is recorded on the asset side of the business’ balance sheet. Consequently, it is also the lessee who depreciates the asset. The depreciation and financial interest are tax deductible as operating expenses.

VAT

The payment of VAT is spread over the full lease term, with the VAT being pre-financed by the lessor.

Set-up times

The reviewing and processing times depend on the complexity, size and urgency of the case.

Advantages, disadvantages and risks

Advantages

  • can make it easier to obtain financing and thus represents a swift and flexible solution to investment problems without affecting the business’ credit lines or specific guarantees with banks;
  • financial costs are spread over the economic life of the investment;
  • VAT (calculated on the rental payments) is fully refundable.
  • rental payments are fully deductible from the lessee’s taxable profit as an operating expense;
  • leased assets are not entered in the accounts as fixed assets, thus making budgeting easier.

Disadvantages

  • higher cost because operating leasing is a comprehensive solution that very often includes other services, such as the maintenance of the asset;
  • special contract with specific conditions (e.g. mileage for cars);
  • expenses for making the asset fully operational at the end of the lease contract when the asset is returned;
  • the rental payments are not flexible and cannot be reduced over time;
  • payment of a penalty if the lessee ends the lease contract early.

Risks

The main risk with operating leasing is the risk of accounting and tax reclassification. There is no specific legislation in Luxembourg regarding leasing. It is therefore necessary to follow the standards established by the German tax authorities (and which are used as a basis by the Luxembourg tax authorities) or international accounting standards and request the prior approval of the Luxembourg tax authorities in order to avoid a reclassification.