Historical Development
Lease finance in Australia is a mature financial product having been offered as part of a portfolio of financing techniques for over five decades. The predominant lessor groups are finance companies and banks; lessees include all private and public industry sectors with around 20% of the economy’s capital equipment being leased. Leasing and other equipment finance offered by members together account for around 40% of equipment capital expenditure.
The wider use of leasing was pioneered by finance companies in the late 1950s and early 1960s. Since that time most financial institutions have moved to include leasing in their product range.
Lease finance utilisation rose strongly as the acceptance of the philosophy of leasing broke down earlier attitudes against this non-equity form of financing. The current level of utilisation reflects this wide acceptance.
Generally speaking leasing is offered as part of a range of financing products. This allows its particular merits vis-a-vis other finance methods to be weighed and tailored to the customer’s particular needs and financial position.
Applicants can usually choose between a number of sources including financiers/lessors with whom they have an existing relationship, those which may be offering leasing at the point of sale and those independently operating in the market.
Lease packagers are involved in structuring some of the more complex transactions. Lease brokers also play a role in promoting the product.
In terms of general market functioning, leases are written for most capital equipment items (provided they are used for commercial purposes) and for periods ranging between two and five years; implicit rates are competitive and are usually fixed for the period of the lease. Providing the commercial use test is met, lessees claim the full amount of the lease rentals as a tax deduction; the lessor, as owner, usually claims the depreciation and any investment incentives – the latter in the case of the Investment Allowance (when applicable) can be claimed by either the lessee or the lessor as appropriate, with leasing’s tax benefit transfer capacity reflecting the incentive of the Allowance in the amount of the lease rentals. Until mid-1990 lessors may have elected to tax account and price on the finance or receivables method (on the implicit interest income stream); IT2594 however removed this election ability. Equipment acquisitions better priced through financing via the finance method (longer depreciating items of plant), are now in many instances financed via commercial hire-purchase or chattel mortgage.
There can be no option during the lease contract to purchase the leased goods at the end of the term. The lessee may however re-lease the goods at the end or make an offer for them. In any event the finance lease will provide for the lessee to indemnify the lessor for any loss on sale for less than the residual value; this provision aims at ensuring that the lessee properly maintains and uses the equipment and, from a pricing point of view, keeps any equipment technological risk implicit in the credit risk.
In the early years most leases were motor vehicle-related and even today around one half of lease volumes is for motor cars, trucks, vans, motor buses and coaches; aircraft, ships and heavy earthmoving vehicles comprise another sizeable end-use, and in recent years EDP and office equipment have grown strongly.
For most part, the national taxation system has been relatively neutral as between the various financing options with each alternative able to compete on the basis of its appropriateness and flexibility for the particular investment and financing need. Paradoxically the long history and high utilisation of leasing in Australia has sometimes led to a misunderstanding of its attributes; however, it is now generally accepted that leasing’s tax benefit transfer capacity provides real benefits for industry, particularly small businesses and start-up operations.
In terms of taxation, leasing captures and crystallises taxation deductions and incentives available within the system and within government policy, focusing their effect on the area where it will have the most impact: reduced cash outflow for the lessee. When Government inquiries urge action to develop ‘sunrise’ industries or to smooth the restructuring of other sectors or industries, it is ironic that the financing technique best suited to achieving both these objects (leasing), has sometimes been inappropriately and disparagingly described as ‘tax shelter’.
A business just starting out or one in the process of restructuring is unlikely to be generating current year taxable income. In these circumstances tax deductions for depreciation or investment incentives do not achieve their desired policy effect – rather they simply add to carry-forward losses. Through leasing, the lessor can claim these deductions against its taxable income, crystallise the benefit and pass it on to the lessee in the form of the tangible incentive of reduced cash repayments.
Unfortunately, the aggregation of such deductions in the books of a relatively few lessors can be misunderstood and can result in the contemplation of restrictions. This occurred in the area of financing unit trusts for property and construction projects when the Tax Commissioner issued tax ruling IT2512 which restricted the ability of such trusts to transfer the benefit of certain deductions. The broader question of tax benefit transfer was also raised in the debate which surrounded the ruling; equipment leasing was however exempted from the Government’s general policy to restrict such tax effective financing. The rationality of this exception was highlighted in the Bureau of Industry Economics’ paper ‘Tax Losses and Tax Benefit Transfer.’
Leasing is an essential financing tool for a dynamic and competitive economy. If from time-to-time a new application or lease product development tests the legislative or taxation framework, this should be seen as a healthy and necessary sign of an innovative financial system. An on-going role for groups such as AELA is to ensure that policy or administrative responses proceed on an informed basis with due regard to any wider consequences.
A development in the lease market over the years has been the offering of variously structured operating leases. These were in part a response to the move to Accounting Standards which require lessees, for corporate disclosure purposes, to capitalise their finance leases onto their balance sheets; operating lease commitments on the other hand, are expensed in the usual way and need only be disclosed by way of footnote to the published accounts.
Initially demand for the operating lease product was limited to the larger corporations and companies with overseas, especially US parents. Over the years this has changed, with a wider spectrum of private and public sector lessees now utilising the product.
From a lessor viewpoint, for the lessor to retain the advantages and disadvantages of economic ownership of the equipment (as the Standard requires of an operating lease) it is necessary to be confident that the value of the equipment when returned by the lessee will achieve a resale price which is predictable. This ‘equipment’ risk is reduced where there is a sufficiently deep second hand market for the particular equipment to allow reliance on reasonable estimates of sale values. Given the general lack of depth of Australian equipment markets (compared, say to the US or Europe), operating leases to-date have been largely limited to motor vehicles, computers and multi-purpose industrial equipment (e.g. forklifts). As the same resale market questions will affect residual value insurance premiums, such insurance can be expensive especially for specialised equipment.
When this equipment resale value risk is added to the credit/client risk (will the lessee meet the commitments) and indeed the manufacturer and goods risk (will the manufacturer/supplier continue to provide servicing, will the goods prove reliable), it is obvious that compared with a traditional finance lease, operating leases are more complex. Any legislative or other regulatory measure which results in a move to operating leases out of balance with the market’s capacity to cover underlying equipment risk will have prudential consequences, as well as forcing that risk, currently implicit in a finance lease, to be explicitly priced in the operating lease. Nonetheless, these problems are being addressed and the product advanced, with some lessors specialising in this market segment.
In addition to finance and operating leases, most AELA members also provide two other products to fund the purchase of capital equipment: hire purchase and chattel mortgage. The Australian Bureau of Statistics (ABS) provides separate monthly statistical series for finance and operating leases, whereas hire purchase and chattel mortgage are included within the one category, classified as ‘non-lease equipment finance’ within its wider Commercial Finance series. Unless otherwise indicated, graphs and statistics utilised in this Review are derived from ABS data. Over recent periods, a discrepancy between the ABS numbers and those derived from an internal AELA sample survey of members, has developed with the ABS series seeming to understate equipment finance activity. For example, the ABS statistics for 2007-08 show total equipment finance volumes of some $26 billion, whereas AELA estimates that total new business for the Industry exceeds $40 billion. AELA has been attempting to reconcile the two statistical sources and as this discrepancy appears to be increasing, is now contemplating producing our own industry-wide equipment finance statistics.
The introduction of GST on 1 July 2000 added somewhat to the complexity of leasing and equipment finance transactions, but at the same time this framework has provided a fair degree of flexibility in meeting the needs of customers. More recently, the introduction in July 2007 of Division 250 to replace the former framework governing leasing to tax preferred entities focused attention on the appropriate income tax treatment for leases to tax exempts. In a similar vein, the proposals for a new regime for the Taxation of Financial Arrangements (TOFA) have focused this attention on leasing to taxables. The detail of these developments is covered elsewhere in this Review, but it is important to note that for leasing to continue to provide a dynamic and creative solution to the equipment finance needs of businesses, it cannot be placed within the conventional homogeneous ‘sale and loan’ approach. The proposal to introduce the Tax Value Method for determining taxable income could have had important implications for the equipment finance industry, and AELA was one of the many groups that welcomed the Government’s decision not to proceed.
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