Leasing: Operating and Finance Leases

The two basic forms are finance and operating leases. The major differences between them are set out in IAS 17.

A finance lease is a form of financing that transfers substantially all the risks and rewards incidental to ownership over a leased asset from the lessor to the lessee. By signing the contract and delivering the leased asset, the lessor transfers economic ownership over the leased asset, while legal ownership is transferred only upon the expiration of lease, on payment of the final instalment. In a finance lease, the lessee uses the leased asset for most of its lifecycle, as with loans.

An operating lease is a lease whereby all the risks and rewards incidental to ownership over the leased asset remain with the lessor. In this case, the lessor retains the economic and legal ownership over the leased asset, while the lessee has only right of use. Upon the expiration of contract, the leased asset is returned to the lessor. Under an operating lease, the lessee uses the leased asset for less than its useful life.

The difference between the finance and operating leases is visible in their tax treatment. The finance lease provider issues an invoice to the lessee immediately upon contract activation. The invoice contains the full obligation: principal + rent per contract (compound interest for the entire duration of the contract period) + all VAT (VAT on the leased asset, invoicing VAT, and VAT on the interest). Based on this, the lessee will include the piece of equipment in their Balance Sheet. Accordingly, the equipment will be recorded in assets, while the long-term commitment to lease will be recorded in liabilities. This piece of equipment is subject to depreciation. If it is a fixed asset for which the user is entitled to tax deduction, the invoice will be the basis for the deduction of the full amount of VAT.

With an operating lease, the lessee receives a monthly invoice for their lease obligation. The invoice shows the net value + VAT. The net value includes repayment of principal + interest for the associated period. In this type of lease, there is no change in the lessee's balance sheet. Monthly invoices for the lease are recorded as an expense and are reflected in the income statement. The leased asset is present in the lessor's books. If it is an item for which the user is entitled to VAT deduction, the deduction will be made based on monthly invoices, where VAT is calculated for each monthly instalment.

The following table gives an overview of the basic differences between the finance and the operating lease:

Table 1. Basic differences between the finance and the operating lease

6.

No.	Characteristics	Finance Lease	Operating Lease
1.	Tax treatment	As trade of goods	As trade of services
2	Financial aspect	Long-term loans	Long-term lease
3.	Legal ownership	Lessor	Lessee
4.	Economic ownership	Lessee	Lessor
5.	Tax savings for the user	Depreciation and interest	Rent
6.	Risks of using good	Lessee	Lessor
7.	Lease period	Optional	Up to 75% of the asset's economic life
8.	VAT invoicing	At the inception of lease transaction, on the total value of the financed asset + VAT on interest	On the individual rental, each rental being taxed, net rental + VAT
9.	Transfer of ownership after expiry of the lease contract	Upon payment of the final instalment, the lessee becomes owner	Upon expiry of the contract, the lessee has a right to purchase the asset at market value
10.	Suitable form of leasing	Where the user wants to become the owner of the asset	Where the user does not want to own the leased asset, the lessor bears the entire risk

Source: IAS