Working Capital Financing^375
- Assets involved can be either old or new. A firm could sell an old fully depreciated
plant and then lease it back. Another firm could buy a new IBM computer, sell it
to a finance company, and then lease it right back. - Assets are sold at or close to appraised market value.
- The leaseback arrangement calls for lease payments that return all costs plus a
fair return to the lessor. That it, the lease is fully amortised.
Sale and leaseback arrangements and financial leases are identical. The practical
distinction is that financial leases involve assets new to the firm whereas sale and
leasebacks typically involve assets that the firm is already using.
Internal Revenue Service Lease Requirements
The total amount of a lease payment is tax deductible, provided that the lease qualifies
as a bonfire lease. Without this IRS safeguard some firms would have a tendency to
call an installment sale a lease, say an equipment has a useful life of 20 years and is
being purchased on a 10-year installment loan plan. The company conceivably could
write up the sale as a lease with the installment loan payments being called lease
payments. When the installment loan is fully paidñthat is, when the ìleaseî obligations
are metñthe buyer could buy the residual rights to the equipment for a nominal amount
of Re. 1. If the IRS were to let this installment sale qualify as a lease, it would put other
firms at a competitive disadvantage. The reason is that while other firms are writing off
the asset over 20 years, this firm by expensing the ìleaseî payments would be
depreciating the asset over 10 veers. It would be underpaying its taxes and increasing
its net cash flows. To prevent this type of abuse, the IRS requires that the following
criteria be met before a ìleaseî qualifies as a lease and not an installment loan:
- Lease obligation must be for less than 30 years.
- The lease must provide a fair return to the lessor.
- Any lease renewal option granted to the lessee must not be different than one that
would be provided to a third party. - Any purchase option granted to the lessee must not be different than one that
would be provided to a firm not a party to the lease.
If these criteria are not met, the lease does not qualify as a bonfire lease and the lease
payments are not fully tax deductible. A leasing arrangement that does not meet IRS
criteria for a lease is treated as a purchase financed through an installment loan. The
tax deductions are the same as for any other equipment purchase, that is, depreciation,
interest expanse, and so forth.