Leasing practices and classification of leases by lessors and lessees for tax purposes vary widely from country to country and depend primarily on the intended ultimate ownership of the leased asset. Lessors and lessees often negotiate and agree as to which party has asset ownership for tax purposes and, thus, tax benefits of ownership.
Tax Lease = Tax Benefits of Asset Ownership for Lessor
Whether a transaction is considered a true lease or nontax lease – a lease intended as security – determines the tax treatment of the transaction by the parties to the transaction. Where a transaction is treated as a true lease, the lessor receives the tax benefits of ownership, including depreciation and investment tax credits, while the lessee claims the rental payments as operating expense. Where a transaction is a nontax lease, the lessor provides the financing of a capital asset and receives interest income over the lease term while the lessee takes advantage of the tax benefits of ownership of the asset.
A tax benefit is a deduction allowed to reduce a taxpayer’s tax liability while supporting certain types of commercial activity, typically in the form of accelerated tax depreciation and investment tax credits. Tax depreciation is the periodic expensing of an asset’s cost in the owner’s income statement and tax returns based on tax rules, whereby a given percentage of the asset’s cost is annually offset against the company’s taxable income. An amount companies are allowed to deduct directly from their tax liability as a percentage of the amount invested in their own business, to encourage and reward economic growth is an investment tax credit.
When tax rates of the lessor and the lessee differ, the tax benefits of ownership of leased assets are greatest for the party in the higher tax bracket. Therefore, the party that can best utilize the tax benefits of asset ownership generally assumes ownership of the asset. The claiming of tax benefits of ownership by lessors is generally reflected in lower rental payments for the lessees – likewise, the claiming of tax benefits of ownership by the lessee reduces the effective cost of the asset’s financing for the lessee. Leases are often rather complex due to the creative drafting of agreements to shift the tax benefits of asset ownership to the party in the higher tax bracket.