A finance lease is a financing agreement that transfers “substantially all of the risks and rewards of ownership of the asset to the lessee”. In plain English, this means that it puts you, the lessee, in much the same position as you would have been had you bought the asset rather than leased it.
It features some of the elements of contract hire: you pay monthly rentals, you hand back the vehicle at the end of the agreement, you cannot become the owner and the tax treatment is the same as for contract hire.
But it also has elements that make it similar to purchasing a vehicle on, say, lease purchase: you repay the funder the amount they paid for the vehicle (plus interest); the amount you receive on disposal depends on the vehicle’s secondhand value and the vehicle appears on your company’s balance sheet.
A finance lease comprises an initial (“primary”) period (usually three to five years).
Thereafter you are usually allowed to keep the vehicle for as long as you wish, on payment of a small “peppercorn” rental.
The key difference between a finance lease and contract hire is the treatment of the vehicle at the end of the lease.
With contract hire, you hand back the vehicle and, so long as there is no liability for excess mileage or damage to the vehicle, that’s the end of the matter.
With a finance lease the lessor will sell the vehicle and give you the majority (perhaps 95%) of the sale proceeds.
You will not be charged for excess mileage or damage: the lessor has such a small interest in the sales proceeds they are not worried about how these affect the vehicle’s disposal value.
In finance leases a predetermined lump sum (“balloon”) rental is usually payable at the end of the primary period. It will usually be equal to the lessor’s estimate of the residual value of the vehicle at the end of the primary period.
The balloon rental allows the lessor to reduce your monthly rentals during the primary period, so these will often be similar to the rentals in a contract hire agreement.
However, you are obligated to pay the balloon rental in the finance lease but have no such obligation in contract hire. Be wary if quoted a very low monthly rental and a very large balloon payment.
Under a finance lease you will have to maintain the vehicle though if required the lessor will usually add a maintenance package to the agreement (as in contract hire) or they may offer to pay for maintenance and to recharge the cost to you as it is incurred.
Unlike most businesses, leasing companies can recover input VAT when buying cars to lease out.
This reduces the amount of their investment and therefore reduces the overall amount you have to pay.
However, finance lease and contract hire rentals are treated slightly differently for corporation tax purposes.
If uneven rentals are payable – e.g. because of a large initial payment – you will only be allowed to claim corporation tax relief on these on a straight-line basis, taken evenly over the life of the lease.
For leases written by companies on or after April 1, 2009 (or April 5, 2009 for partnerships and sole traders), lessees’ rentals are fully tax deductible for cars emitting less than 160g/km of CO2; otherwise, 15% of the rental is disallowed for tax purposes.
- So, should you consider financing your vehicles using finance leases? There are four issues to consider:
- residual risk.
Operationally there should be little difference between finance leasing, contract hire, outright purchase and a motor finance product such as hire purchase, though the back-end procedures will differ slightly.
On the financial side, as with all lease-versus-buy options, you should make your decision based on a detailed analysis that considers all of the cash flows that will arise under each scenario (a discounted cash flow analysis).
Many leasing companies will undertake this analysis for you.
Residual value risk represents the big difference between finance lease and contract hire. Are you happy taking residual value risk? If so, finance leasing might be an attractive option for you. As you will be bearing the residual value risk the vehicle will have to be shown on your balance sheet. Is that an issue for your business?
Finance leases work well for fleets that don’t mind putting assets on their balance sheets, dislike excess mileage and damage recharges, and have tax positions that favour leasing rather than purchasing.
But most fleets do not use finance leases. They consider that finance leases have few advantages over contract hire.
Finance leases are not available from all leasing companies, so if you want to explore them you might have to do a little shopping around.
- Professor Colin Tourick is a fleet management consultant. For more information go to www.tourick.com
Making the right choice
- Finance leases combine elements of leasing and buying.
- Tax treatment is very similar to contract hire.
- Flexibility to extend at very low cost.
- Usually no excess mileage charges or end-of-lease damage recharges.
- If the used vehicle market tumbles, the lessee bears the loss in disposal value.
- Suitable if you don’t mind showing vehicles as assets on your balance sheet.
- Most fleets don’t use finance leases.
- Shop around to find the best deals.