Fundamentally, the new regime gives capital allowances to the economic owner of plant or machinery rather than, under the current system, to the legal owner. There are exceptions for ‘short term leases’ where the legal owner will continue to be entitled to capital allowances.

Under the new regime, the UK’s arguably discriminatory overseas leasing rules will be abolished and this will open up a new market for UK lessors. The changes will generally adversely affect the cost of finance provided to businesses in the UK that use medium and long term leases to lease business assets.

The ‘funding lease’
A lease is a funding lease if, at the start of the lease, any one of the following criteria are met:

• It is treated as a finance lease under generally accepted accounting practice;
• The net present value of the minimum lease rentals (ignoring payments for ancillary services) is 80% or more of the market value of the asset; or
• The minimum term of the lease is more than 65% of the expected remaining useful economic life of the asset.

The ‘long funding lease’

A funding lease will be a long funding lease unless it is a ‘short lease’. A short lease is a funding lease which meets either exception below.

1. Lease term no more than 5 years
   Where the lease term is less than or equal to 5 years, such leases will be excluded from being treated as a long funding lease so that both the lessor and the lessee will be treated in line with the current rules (i.e. capital allowances available to the legal owner of the asset).
2. Lease term is between 5 years and less than 7 years.
   
   Where the lease term is between 5 and 7 years in length, such leases will also be excluded from being treated as a long funding lease provided:

• the total rentals payable in any year is not more than 8% of the average amount of rentals payable in the preceding years; and
• the implied residual value of the plant and machinery in the lease terms is not more than 5%.

Where the lease is a long funding lease the new regime treats the lessee as the owner of the equipment for capital allowances purposes. The lessee is also entitled to deduct the finance charge included in the lease rents. The lessor is treated as though the lease is a loan and taxed on the finance element of the rents only. Special adjustments apply where a long funding lease is accounted for as an operating lease.

The requirement to consider the above tests for every lease a company writes, and for every lease a business undertakes in order to finance the cost of equipment means that many lessors in the UK will have to change their systems to capture the information required to comply with the new regime. As the complete legislation is still not available, a number of lessors may have difficulties in changing their systems and procedures in time to capture the relevant information which will be required for tax purposes when the new regime fully applies from 1 April.

Transitional rules
Generally, the new regime will not apply to leases where there is a written contract in place before 1 April 2006, as a result of which the completed asset is made available to the lessee before 1 April 2006. The transitional rules apply so that where there is both a written agreement in place before 21 July 2005 and the asset is under construction and not made available to the lessee before 1 April 2006, as long as the asset is made available before 1 April 2007 (or in special circumstances 1 April 2009), and certain other conditions are met, the lease will fall within the current regime. Additionally, where some expenditure is incurred before Royal Assent to FA 2006 and a written lease agreement was in place before 21 July 2005 but the transitional provisions described above are not met, then expenditure incurred before Royal Assent will be taxed under the current regime. Any expenditure incurred after Royal Assent on the same asset will be dealt with under the new regime if the criteria are met.

Election
Deloitte initiated the call for an election to be available to allow lessors to elect for all leases to be taxed on the same basis. This would avoid lessors having to consider the above tests every time they enter into a lease. HMRC have consequently announced that an election will be introduced which will allow lessors to elect for all leases (other than car leases) to be taxed under the new regime where the value of the leased assets does not exceed £10 million (it has not yet been made clear whether this is on a company or group basis). The election itself may be made on a company by company basis and will be available for leases finalised on or after 1 April 2006, where the asset has not been leased before or has only previously been leased under a long funding lease. The effect of the election is that lessors should be taxed on their accounting profit as long as the accounting profit reflects the profits that would be taxed on a statutory basis under the new regime.

Anti-avoidance

Double Benefit leasing
HMRC will introduce rules which are intended to prevent companies achieving a double benefit, i.e. both the lessor and the lessee claiming capital allowances.

The Government is concerned that independent decisions by the lessor and lessee on whether a lease is a funding lease or not could lead to double allowances so they have stated that a lessor’s right to claim allowances should take precedence over the lessee’s right to claim allowances. The entitlement to claim capital allowances will rest with the superior lessor in the chain, whether or not they are within the charge to UK tax. In circumstances where the lessee cannot establish entitlement to capital allowances, the lessee will receive a deduction for the lease rentals payable.

Lease term
The length of a lease term is essential in determining whether a lease is a long funding lease or not. HMRC are therefore understandably concerned that this is an area which may be exploited. The lease term will therefore include the term of any extension option where it is “reasonably certain” at the lease term that the option will be exercised.