Finance Lease

A lease is a contract outlining the terms under which one party agrees to rent property owned by
another party

The party using the asset is the lessee

The legal owner of the asset is the lessor

A finance lease agreement is a lease agreement where one party uses the asset which is not
legally theirs, for almost its entire useful life in exchange for lease rentals.

A lease can also be treated as a finance lease if;

 The lease term exceeds 75% of the effective life of the asset
 The lessee has an option to purchase the asset at the end of the lease term.
 The estimated residual value of the asset at the end of the lease term is less than 20% of its
market value at the start of the lease term.
 The leased assets are of specialised nature such that only the lessee can use them without
major modifications being made

The effective economic life

An asset can be considered to be a leased asset when the lease term exceeds 75% of the effective
life of an asset. The effective life of an asset for tax purposes is reliant on which group an asset
belongs to. The lessee is also entitled to claim depreciation allowance on the asset which is based on
cost of the leased asset (rates depend on the group the asset belongs to as seen below).

Group One Assets :5 years @ 25%

Automobiles, taxis, light general trucks, tractors for use over the road, special tools and devices

Group Two Assets: 7 years @ 20%

Office furniture, fixtures and equipment, computers, heaving trucks, buses, construction equipment,
trailers

Group Three Assets: 15 years @ 10%

Any depreciable assets not included in other groups

Group Four Assets: 30 years @ 5%

Industrial buildings, land, engines, turbines, rail road cars and equipment

Treatment of finance lease for lessee and lessor

Lessee
Where a lease is classed as a finance lease the lessee will recognise the leased asset similar to an
asset that the lessee has legal ownership of. The lessee will recognise the leased asset as a fixed
asset and can therefore claim depreciation allowances on the asset.

The lease rentals that the payable by the lessee are separable into two components; the principal
repayment and the interest. The interest portion becomes an allowable deduction for the lessee.
Lessor
Interest element of the lease payment is treated as taxable income for the lessor

Calculating the allowable deduction for lessee

The loan amortisation schedule can be used to calculate the interest payable by the lessee each
year.

The principal amount for the commencement of the loan = Present value of the payments to be
made under the lease

Present value where payments are in advance = Annuity factor of the year before the lease ends +1

Present value where payments are in arrears = Annuity factor for the year the lease ends