Though not very entrenched in Uganda, leasing is popular in the developed world. As an alternative means of financing, leasing enables businesses to possess and use assets without necessarily legally owning them releasing capital that would be incurred as a one off payment for outright purchase.
To enlighten the business community on how asset leasing functions, this article sets out the key attendant legal, tax and commercial considerations.
What is leasing?
Leasing is an arrangement where the owner of an asset (“lessor”) allows another party (“lessee”) the temporary possession and use of an asset for an agreed period in exchange for periodical rental payments.
The lessor finances the acquisition of an asset that is let out to the lessee who takes possession but legal title remains with the lessor.
Sometimes, a lessee may be asked to make an upfront deposit payment known as a premium on entering into a lease arrangement but most times will remit periodic payments to the lessor for the duration of the lease arrangement.
Classification of leases
Businesses should pay attention to the type of lease transaction that they enter into given the divergent tax and commercial consequences of each. Leases are divided into two broad categories namely finance and operating.
Finance or capital leases involve the lessee paying for the usage of the asset but with the option of legally owing it at the expiration of the lease term.
It is noteworthy that although the legal title remains with the lessor in a capital lease, the lessee recognises the asset as its own for financial reporting and tax deduction purposes in accordance with the substance over form principle considering that the lease term of a finance lease more- less equals the effective life of the leased property.
An operating lease on the other hand allows for the use of an asset but does not convey ownership rights of the asset to the lessee who only books as an expense the periodic rental payments expended both for accounting and tax purposes.
Is asset leasing a commercially viable option?
In comparison to traditional means of financing like a term loan, leasing is easier with lesser costs and paperwork involved. Other types of borrowings may impose restrictive debt- equity ratio margins or special conditions on the declaration of dividends on the borrower which is not the case with asset leasing.
Asset leasing also enables businesses finance the acquisition of equipment through the payment of periodic lease rentals that they would otherwise not be able to buy if they were to make one upfront payment. Leasing allows the lessee to stagger the periodic lease payments in accordance with their ability to pay. This frees up the much needed capital for investment in other areas of the business. Lease payments also enjoy tax deductions, lowering overall commercial costs.
There is no collateral required to lease an asset and the inability to pay up the periodic rental payments would only result in the forfeiture of the asset.
A business can be able to pay the routine rental payments from the cashflows earned from its use during the lease arrangement. In view of changing technology trends, leasing also enables the lessee to avoid the asset technology obsolescence risk. A lessee would simply acquire another asset matching their current technology needs.
The downside to asset leasing is that it is usually more expensive than buying the asset outright. Some long term contracts are also only cancellable with the payment of a hefty penalty. Sometimes, the lessee can be asked to make a deposit or a payment in advance which can be substantial.
Asset leasing literature widely cites the quote of Donald Grant that succinctly sums up the notion of asset leasing.“Why own a cow when the milk is so cheap? All you really need is milk and not the cow.” The cow is the asset and the milk is the right of using the asset.
This, therefore, means that a person requiring an asset for productive activities can obtain it through leasing without necessarily being the owner. As illustrated, small and medium enterprises are able, through asset leasing, to obtain asset financing that they would be unable to obtain via traditional financing for lack of collateral or business track record.
Asset financing does not require collateral and the lessee is able to pay off the periodic rental payments from the cash flows derived from the use of the leased equipment.
The author is the managing partner at Cristal Advocates.