A guide to long funding leases
The significance of Long Funding Leases is that they potentially deny Capital Allowances to lessors, including Landlords, who lease certain items of plant or machinery. It is important, therefore, to understand exactly what Long Funding Leases are and when they might apply.
The concept of Long Funding Leases was introduced by Schedules 8 & 9 of The Finance Act 2006 and is now contained in Capital Allowances Act 2001 s70A to s70YJ.
The reason behind its introduction was to correct a perceived long-standing distortion in the tax system which meant those who acquired assets under certain kinds of leases were treated differently from those who financed their acquisitions with debt.
As an introduction, there are two types of lease recognised for accounting purposes: finance leases and operating leases.
Finance leases are typically leases for most or all of an asset’s useful life and in commercial terms they are equivalent to a loan. Operating leases on the other hand are usually the simple hiring of an asset for a short period of its useful life.
To understand the reality of finance leases (and some operating leases) the rental payments should be thought of as a matter of economic and commercial substance, namely a combination of
- Interest on a “loan”, and
- Repayment of the “loan”
Essentially, long funding leases are taxed by reference to this commercial substance. Therefore:
- Long funding lessors are taxed in a similar way to which they would have been taxed had they made a loan.
- Long funding lessees are taxed in a way that is similar to the way in which they would be taxed had they purchased the asset.
Any derived lease of background plant or machinery for a building is an excluded lease. As a result, the long funding lease rules do not apply.
It is therefore important to understand what exactly background plant and machinery is.
Background plant and machinery for a building is:
- plant or machinery of a type that might reasonably be expected to be installed in various types of buildings of different descriptions, and
- whose sole or main purpose is to contribute to the functionality of the building within which activities can be carried on.
CAA2001 s70T provides for the Treasury to make specific orders relating to the further clarification of background plant and machinery. This order, SI 2007/303 - The Capital Allowances (Leases of Background Plant or Machinery for a Building) Order 2007 -, sets out three lists of plant and machinery.
The first list sets out prescribed examples of background plant and machinery, the second contains items that are deemed to be background plant and machinery and the third list sets out items that are deemed not to be background plant and machinery.
The first and second lists are made up of specific items, whilst the third list sets out items used for certain specific purposes for which the plant and machinery is installed – primarily manufacturing, storage or retail uses.
Even where plant and machinery is not background plant and machinery, but is affixed to land and is leased with the land under a mixed lease (i.e. a fixture under CAA2001 s173), it may still be excluded from the long funding lease rules and so Capital Allowances could still be available.
For this to be the case the plant and machinery must be less than the following set values:
- 10% of the aggregate market value of all the background plant and machinery leased with the land, and
- 5% of the market value of the land including buildings and fixtures.
Where, exceptionally, a lease is accounted for as a loan the lessor is taxed on the amount that is, or should be, shown as interest in accounts prepared under GAAP
If, on the other hand, the lease is an operating lease then the lessor will be taxed all of the rental receipts, but will be allowed, in lieu of Capital Allowances, a deduction for any expected loss in the value of the leased plant or machinery over the term of the lease. This is subject to any further adjustments that may need to be made for additional expenditure by the lessor during the lease or any terminal adjustments at the end.
No requirement for symmetry between lessor and lessee
The tests for a long funding lease are carried out independently by lessors and lessees. So a long funding lease for a lessor need not be a long funding lease for the corresponding lessee.
To prevent both parties claiming Capital Allowances CAA2001 s70Q gives priority to the lessor, so if the lessor can claim Capital Allowances then the lessee cannot.
CAA2001 s70H further requires that a lessee who wants a lease to be treated as a long funding lease must make a return for the ‘initial period’ to that effect and this sets the treatment of the lease for its duration. The requirement for the lessee to decide the treatment does also however allow lessees to stay outside the long funding lease regime if they wish.
If the lessee chooses not to treat the lease as a Long Funding Lease it may claim a deduction for any lease rental payments in the normal way.
Whilst Long Funding Leases add another layer of complexity to leasing, the existence of background plant and machinery means it should have no impact on the majority of property leases.
Landlords do, however, however need to be careful where they are leasing property that contains assets that are not regarded as background plant or machinery, particularly properties where loose chattels are also leased along with the property, as this could significantly change the income that needs to be recognised for tax purposes or any deductions allowed against that income.
For lease of plant or machinery where Capital Allowances would normally be given (including plant or machinery that is leased with land), it is therefore necessary for the Landlord to now establish whether the lease is a Long Funding Lease.
In broad terms, long funding leases are leases of plant or machinery entered into after 1 April 2006, which are:
- Finance leases with a term of more than 5 years (sometimes more than 7 years), or
- Operating leases with a term of more than 5 years which meets certain tests (set out below) intended to identify those operating leases that serve a financing function (a funding lease).
The tests are
- is the present value of the minimum lease payments 80% or more of the fair value of the plant and machinery, or
- is the term of the lease more than 65% of the remaining useful economic life of the leased plant and machinery
Specifically excluded from being a Long Funding Lease are:
- an excluded lease of background plant or machinery for a building, and
- an excluded derived lease of plant with land where the plant has a low percentage value
Plant and machinery may be leased along with other assets. For example, an office building will be leased along with its lighting, air-conditioning, lifts etc.
When this is the case, the leases are referred to as mixed leases. Here the different groups of similar assets leased, such as the property and the qualifying fixtures, need to be treated as two or more separate notional leases with these notional leases in turn being referred to as derived leases
For each derived lease it is necessary to make a just and reasonable apportionment of the total rents between them. Each derived lease must then be analysed separately for income and tax purposes.
If a fixture is not background plant and machinery, or falls outside of the low percentage value rules, then it is necessary to establish whether the terms of the lease means that lease is to be regarded as a funding lease by the economic value and minimum lease payment tests previously outlined.
As previously mentioned, the purpose of the Long Funding Lease rules is to align the tax treatment more closely with the economic reality of a transaction. As a result:
- capital allowances are not available to the finance provider (the lessor); instead they are usually available to the lessee as the person who bears most of the economic risk of ownership
- the finance provider (the lessor) is taxed only on that proportion of the rental income that represents interest – a figure that is closely related to its accounting profit, period by period.
- where capital allowances are claimed by a lessee, the lessee is entitled to relief for only part of the lease rentals because the balance is relieved under the capital allowances rules.
Where a lease is not a long funding lease then the lessor is taxed on the full amount of any rents receivable under the lease. Where the assets leased are plant or machinery the availability of Capital Allowances means that, over the life of the lease, the lessor is taxed on its commercial profit.
As Capital Allowances are not available to Lessors under a long funding lease an adjustment of the rentals is needed to reflect the commercial reality of the lease.
This adjustment will depend on whether the lease is a finance lease or an operating lease.
Where the lease is a funding lease then the lessor is taxed on the rental earnings that are shown in the accounts, or would be shown if accounts were prepared in accordance with GAAP.
The rental earnings may include such items as any profit retained on selling the asset when the lease comes to an end.