BLM32305 - Taxation of leases that are not long funding leases: finance lessees: termination adjustments: introduction

The economics of a finance lease are explained at BLM00600 onwards. The risks and rewards of ownership of the leased asset rest with the lessee. If the asset is sold the benefits of ownership are largely enjoyed by the lessee; likewise the obligations of ownership. But as the asset belongs to the lessor it is the lessor who, in the first instance, is entitled to the sale proceeds (although in practice the lessee may conduct the sale negotiations as the lessor’s agent).

Therefore, when the lessee no longer wants the use of the leased asset, the lease agreement is likely to provide that the lessee sells the asset as agent for the lessor. Although legal ownership rests with the lessor - and the lessor will receive the sale proceeds - economically speaking the leased asset is ‘owned’ by the lessee. If the asset is sold it is reasonable to expect that substantially all of the benefit of the sale proceeds ends up with the lessee.

Under a finance lease the rentals payable are usually intended to give the lessor only a financier’s return on his investment in the leased asset. (In the case of smaller leases, with less credit-worthy lessees, this includes the need to make sufficient margin to cover bad debts as well as operating costs, just as is the case with loans.)

In order to ensure that this is the case finance leases contain provisions for terminal adjustments. These adjustments consist of provision for a rebate or a further payment of rent. This, together with the lessee’s right to receive all, or almost all, the sale proceeds from the leased asset will ensure that the lessor makes his expected turn, and the lessee enjoys (or suffers) the risks and rewards of ownership.

If the lease is terminated during the secondary lease period (and assuming that the lessor has received sufficient rentals to recover the cost of the leased asset) the lessee will receive, from the lessor, a terminal rebate of rent representing substantially all of the sale proceeds. If the sale occurs during the primary lease period the sale proceeds will be set against the outstanding liabilities under the lease. This may result in the lessee paying the lessor a terminal rental, or the lessor paying the lessee a terminal rebate.