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Taxing issues.

Equipment leasing may again be proving to be an attractive means of raising finance and making investments. Equipment leasing, to put it simply, is the means by which one party, the lessor, lays out a capital sum for the acquisition of an asset, and another person, the lessee, uses that asset and in return pays a fee including rent, to the lessor.

Broadly speaking there are two types of lease, namely, the capital or finance lease, and the operating lease. A capital lease is, in effect, a loan which is paid off over the life of the lease through rent, or with a bullet payment at the end or a combination of the two, and the lessee takes on the asset risk. An operating lease, put simply, is a lease where the lessor takes residual risk on the asset and rent is broadly based on the actual cost (including depreciation) and profit margin to the lessor, with the lessor taking back the asset at the end of the lease.

From the investor's perspective, leasing can be (i) a means of securing income on assets while maintaining an ownership interest and thus a security interest in the asset; (ii) it may be a purely financial business -- e.g. a more secure way to lend money on specific assets that can be used by more than one person; or (iii) it is a means by which the investors sell down their manufactured equipment, so the manufacturers of large equipment will often have leasing arms (iv) a means of supplying finance in a manner which is Shari'ah-compliant.

From the lessee's perspective, leasing is attractive because it is a means of having the use of an important and often expensive asset without the initial or immediate outlay of all the capital expenditure required to acquire that asset. Depending on the nature of the lease, it can be a means to either acquiring the asset or having the asset for a fixed period of, at most, the expected useful life of the asset or assets. Furthermore, it can be a means of raising finance in a manner that is Shari'ah-compliant.

The lease or the Ijarah has long been an acceptable way for Shari'ah-compliant lenders and borrowers to arrange finance. As with all financing structures, compliance with Shari'ah will depend on the detail of the arrangements, but the basic requirements are that the duration of the lease and the rental payments are agreed in advance of each rental period and the lessor retains certain rights of ownership, e.g. insurance. The Ijarah can be an operating lease or a lease with a separate option to purchase, so very like the distinction referred to above.

When combining the tax requirements with the Shari'ah requirements, some level of ingenuity may be required to ensure that both sets of requirements are satisfied, e.g. who bears the depreciation risk, what if the rent is benchmarked to a floating rate (e.g. LIBOR) rather than fixed rate etc.

From an accounting perspective a finance lease will often appear in the lessor's accounts as a loan owed by the lessee to the lessor, and in the lessee's accounts as an asset and debt due to the lessor for the rental and other payments due. US GAAP and international accounting standards have different detailed criteria for determining whether a lease should be treated as capital lease or not.

On 17 August 2010 the International Accounting Standards Board (IASB) and the US Financial Accounting Standards Board (FASB) published an exposure draft of a new standard on how leases will be treated for accounting purposes. The proposal is that most leases would be shown the accounts of the lessee as assets with corresponding liabilities and as debt assets in the accounts of the lessors. If the draft is adopted it is expected it will have effect from 2011.

In considering the tax treatment we have considered the tax treatment of the lessors assuming that the lessor is not in the same jurisdiction of the lessee. With regards to the lessee, we have considered the tax treatment of lessees in Germany, the UK and the US. Special rules apply to sale and lease-backed transactions.

In respect of operating leases, the lessor should not be liable to German tax on the rental income provided it is not carrying on a business in Germany through a permanent establishment (PE). In respect of a finance lease (as determined under German tax law), the lessor may not be subject to tax if the income is regarded as investment income and the lessor is not operating in Germany through a permanent establishment.

Provided the non-UK resident lessor is not carrying on a business in the UK through a PE, it should not be liable to UK corporation tax on the rental income arising from a UK lessee, however one also has to consider the UK income tax position.

UK income tax is chargeable on income arising from a trade carried on in the UK. A distinction can be made, for these purposes between a trade carried on in the UK and with the UK, and in the latter case no UK income tax on trading income should arise. Ultimately it is a question of fact whether a person is trading in the UK or with the UK, but the lessor should be able to arrange itself such that it is not carrying on a trade in the UK.

Furthermore, most UK double tax treaties provide that a non-UK resident person who is carrying on a trade in the UK otherwise than through a PE, should not be liable to UK income tax on their trading income. Of course one would also have to consider whether the rental income from the lessees could be taxed under another charge to UK tax, e.g. interest or property income or miscellaneous income. It is thought that the UK tax authorities do not seek to impose tax on non-resident lessors who have no PE in the UK under the miscellaneous charge.

Where the lessor is not resident in the US and is not carrying on a trade or business in the US through a PE, then it should not generally be liable to US federal net income tax on its rental income. Such income may, however, be subject to a gross withholding tax. The nature of the lease will determine the withholding tax position.

DEDUCTIBILITY OF RENTAL PAYMENTS

The German tax code makes a distinction between operating leases and finance leases. But the rules are set out in the German tax code and do not follow the accounting treatment. For an operating lease, the lessee should be entitled to a full deduction for the rental payments, subject to the usual rules on deduction. In the case of a capital lease, it is the finance element of the rental payment that is generally deductible, but with the lessee claiming the tax depreciation.

For a UK lessee in respect of a non-long funding lease carrying on a trade, profession or vocation the rental payments are of a revenue nature and subject to the usual rules regarding purpose and specific disallowance rules, the rental payments should be allowed as a deduction. If the lease is a "long funding lease" (as defined in the UK tax code), then there are restrictions on the deductions. Different restrictions apply for long funding finance leases and long funding operating leases. However, under long funding leases, the lessee should be allowed to claim the capital allowances -- the UK's tax equivalent for depreciation (as depreciation is disallowed as a UK tax deduction).

For US federal tax purposes it is essential to determine whether arrangements will be treated as a lease or a finance transaction. The basis for so determining are set by the tax code, judicial decisions and IRS (Inland Revenue Services) guidance but not US GAAP (Generally Accepted Accounting Principals). At a very basic level, a lease will be respected as such if the economic ownership remains with the lessor. In such instances, the lessor, subject to normal rules on deduction, should be able to claim a deduction for the rental payments, but not a deduction for depreciation.

If the lease is treated as a finance lease under US federal income tax principles, then the lessee, subject to normal rules, will only be allowed a deduction for the finance element of rent, which will be regarded for all US federal tax purposes as interest. In addition, the lessee should be allowed a deduction for depreciation in respect of its US federal income tax.

TAX DEPRECIATION

Broadly speaking a lessor in respect of an operating lease and a lessee in respect of a capital or finance lease, will have to take into account the appropriate level of depreciation when computing its accounting profit. The tax codes, however, vary in how such depreciation should be treated for tax purposes.

Again the rules differ according to how the lease is classified for German tax purposes. The lessor in respect of an operating lease should be allowed to claim tax depreciation in respect of the leased equipment. If in respect of a finance lease, the lessor is regarded as the economic owner, as determined under German tax rules, then it will be entitled to the tax depreciation. However, if the lessee is regarded as the economic owner under these rules, it is the lessee who will be entitled to claim the tax depreciation.

The UK's tax code has its own system for allowing the tax deduction in place of depreciation and it is very prescriptive. Broadly speaking, the lessor is only entitled to claim the tax depreciation in respect of non long funding leases, whereas the lessee is generally entitled to claim tax depreciation in respect of long funding leases, and thus the lessee gets the benefit otherwise denied with the disallowance of the portion of the rents paid under long funding leases.

In the US, the "owner" of the asset as determined for federal income tax purposes (and not accounting purposes) is the person who is allowed to claim tax depreciation for US federal tax purposes. Thus in the case of a finance lease, the lessee should be able to claim such a deduction. This will be important to the lessee, especially if it is only entitled to claim a federal income tax deduction for the element of the rent.

WITHHOLDING TAXES

The withholding tax position will depend on (i) the jurisdiction, (ii) the lease classification and (iii) the equipment classification. Very broadly, the withholding tax position is set out below for equipment (not fixtures):

There may be domestic or treaty reliefs available in respect of the rental/interest payments depending on the exact circumstances. Under the US rules, the interest element of the rent could be relieved from US federal withholding under the "portfolio interest" exemption.

Equipment leasing can provide opportunities for the conventional and Shari'ah-compliant lessor and the lessee, but in order to maximise those opportunities, care has to be taken to ensure that each of the commercial, Shari'ah, accounting and tax angles are working together.

2009 CPI Financial. All rights reserved.

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Publication:Islamic Business & Finance
Geographic Code:4EUGE
Date:Oct 14, 2010
Words:1867
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