Financial vs. operational leasing - Understanding the fundamental differences

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When it comes to asset financing, the distinction between financial and operational leasing raises crucial legal, accounting and tax issues. This differentiation determines how transactions are handled and structures contractual relations. Contrary to the traditionally narrow French view of leasingThe European approach reveals a notable complexity.

Fundamental distinction criteria

The separation between these two forms is based on a number of structuring criteria, applicable to a wide range of products. property, whether movable or immovable :

• Economic property Beyond the legal title, who really bears the economic risk of the investment?
• Residual value the way it is handled often determines its legal status
• Contract duration its correlation with the economic life of the asset influences its qualification
• Purchase option its presence or amount reveals the economic intention of the parties

According to "Crédit-bail international et leasing en Europe" (Fasc. 643, JurisClasseur Droit bancaire et financier), "If the economic risk of the investment falls substantially on the lessee, the transaction is considered a financial lease. If the risk is borne by the lessor, i.e. the investor, then it is an operating lease.

This assessment of residual risk is the cornerstone of the analysis.

Economic ownership and the reality of risk

The economic approach now prevails over the legalist approach. The economic owner is not necessarily the holder of the legal title.

In practice:

• In a finance lease: the lessee bears the economic risk even if he only obtains legal ownership at the end of the contract.
• In an operating lease, the lessor retains the residual value risk and remains the economic owner.

IAS 17 summarises this approach by defining finance leases as those which "transfers substantially all risks and rewards to the owner of the property".. Operational is defined by opposition.

Diversity of European treatments

Qualification has a direct impact on accounting and tax treatment, which varies from country to country.

Germany: a dual approach

In Germany, legal ownership belongs to the lessor, but economic ownership can pass to the lessee depending on certain criteria:

• Duration of the contract in relation to the economic life of the asset
• Existence of advantageous purchase or extension options

The tax consequences vary radically:

• If the lessee is the economic owner: he depreciates the asset but only the portion of the rent representing interest is deductible.
• If the lessor retains economic ownership: he depreciates and the lease payments are fully deductible for the lessee.

Italy: a more unitary system

In Italy, the system essentially recognises leasing contracts for furniture or real estate that are similar to French crédit-bail:

• The asset retains a residual value
• A purchase option exists for the lessee
• During the term of the contract, the lessor remains the owner and depreciates the asset

The deductibility of rental income varies according to the nature of the property:

• For movable property: rental payments are deductible if the rental period is at least half the normal depreciation period.
• For the real estate the minimum term is eight years for contracts concluded since 1989

United Kingdom: a more complex distinction

The British system is different:

• Finance leases, where the lessee generally pays the full cost of the lease
• Operating leases, where the asset retains a residual value
• Hire purchase, where the lessee necessarily becomes the owner

On the tax front, there are major differences:

• In leasing (financial or operational), depreciation is charged by the lessor.
• In hire purchase, it is the lessee who depreciates the asset as soon as it is brought into service.

Impact on the structuring of operations

The choice between these formulas has a direct influence:

• Balance sheet structure (optimisation of off-balance sheet items)
• The tax burden and its distribution over time
• Financial flows and their accounting treatment
• Operational flexibility (particularly for technological renewal)

Some countries do not make this distinction. France differentiates between leasing and long-term rental. Denmark, Germany, Greece, Ireland and Luxembourg apply their own distinctive criteria.

Heterogeneous legal systems complicate cross-border transactions. Despite harmonisation efforts, such as those of the Ottawa Convention on International Financial LeasingFor example, an arrangement classified as financial leasing in one country could be treated as operational in another.

Each transaction therefore needs to be analysed on a case-by-case basis. Recent tax developments in the UK, which are unfavourable to financial leasing, illustrate the importance of constantly monitoring these issues.

All international leasing finance projects require an appropriate in-depth legal expertise to avoid qualification pitfalls and optimise tax treatment.

Sources

• Fasc. 643: MOVABLE LEASING. - Crédit-bail international et " leasing " en Europe, JurisClasseur Droit bancaire et financier, First publication: 16 June 2001, authors: Christian Gavalda, Professor Emeritus at the University of Paris-I, Panthéon-Sorbonne and Danièle Crémieux-Israël, Doctor of State Law.
• Ottawa Convention on International Financial Leasing, 28 May 1988, entered into force on 1 May 1995
• Directive 2000/31/EC of 8 June 2000 on certain legal aspects of electronic commerce in the internal market
• International accounting standard IAS 17 on the treatment of leases
• Work of LEASEUROPE, the European Leasing Federation

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