Equipment finance in Australia consists of three broad product groupings; leasing (both finance and operating leases), hire purchase and chattel mortgage. Hire purchase was introduced on a widespread basis in Australia in the 1920s, initially for the financing of motor vehicles. Lease finance utilisation rose strongly from the late 1950s as the acceptance of the philosophy of leasing broke down earlier attitudes against this non-equity form of financing, and leasing is now a mature financial product having been offered as part of a portfolio of financing techniques for over five decades. Chattel mortgage has developed as a major form of equipment finance only in the last decade initially as a consequence of a GST anomaly which has been rectified.
The wider use of hire purchase and leasing was undertaken by finance companies in the 1950s and early 1960s. Since that time, a broad range of financial institutions moved to include equipment finance in their product range. Today the predominant equipment financier groups are domestic and international banks, captive financiers, finance companies, fleet leasing companies and rental companies; lessees/borrowers include all private and public industry sectors. An accompanying section provides a statistical profile of the Australian equipment finance market.
Applicants can usually choose between a number of sources including financiers with whom they have an existing relationship, those which may be offering equipment finance at the point of sale and those independently operating in the market. Packagers are involved in structuring some of the more complex transactions. Equipment finance brokers also play a role in promoting the products.
Equipment finance is provided for most capital equipment items (provided they are used for commercial purposes) and for periods typically ranging between two and five years, and longer for higher value equipment; interest rates are competitive and are usually fixed for the period of the contract. Providing the commercial use test is met, lessees can usually claim the full amount of the lease rentals as a tax deduction; the lessor, as owner, usually claims the depreciation and any investment incentives – the latter in the case of the Investment Allowance (when applicable) is claimed by the lessor. For hire purchase and chattel mortgage, the borrower is the party entitled to claim capital allowances and interest costs where allowable.
For income tax purposes there can be no option in a lease contract to enable the lessee to purchase the leased goods at the end of the term. The lessee may however re-lease the goods at the end or make an offer for them. In any event the finance lease will provide for the lessee to indemnify the lessor for any loss on sale for less than the residual value; this provision aims at ensuring that the lessee properly maintains and uses the equipment and, from a pricing point of view, keeps any equipment technological risk implicit in the credit risk.
In the early years most equipment finance was motor vehicle-related and even today around one half of business is for motor cars, trucks, vans, motor buses and coaches; aircraft, ships and heavy earthmoving vehicles comprise another sizeable end-use, and in recent years EDP and office equipment have grown strongly.
For most part, the national taxation system has been relatively neutral as between the various equipment financing options, with each alternative able to compete on the basis of its appropriateness and flexibility for the particular investment and financing need. Paradoxically the long history and high utilisation of leasing in Australia has sometimes led to a misunderstanding of its attributes; however, it is now generally accepted that leasing’s tax benefit transfer capacity provides real benefits for industry, particularly small businesses and start-up operations.
In terms of taxation, leasing captures and crystallises taxation deductions and incentives available within the system and within government policy, focusing their effect on the area where it will have the most impact: reduced cash outflow for the lessee. When Government inquiries urge action to develop ‘sunrise’ industries or to smooth the restructuring of other sectors or industries, it is ironic that the financing technique best suited to achieving both these objects (leasing), has sometimes been inappropriately and disparagingly described as ‘tax shelter’.
A business just starting out or one in the process of restructuring is unlikely to be generating current year taxable income. In these circumstances tax deductions for depreciation or investment incentives do not achieve their desired policy effect – rather they simply add to carry-forward losses. Through leasing, the lessor can claim these deductions against its taxable income, crystallise the benefit and pass it on to the lessee in the form of the tangible incentive of reduced cash repayments.
Unfortunately, the aggregation of such deductions in the books of a relatively few lessors can be misunderstood and can result in the contemplation of restrictions. This occurred in the area of financing unit trusts for property and construction projects when the Tax Commissioner issued tax ruling IT2512 which restricted the ability of such trusts to transfer the benefit of certain deductions. The broader question of tax benefit transfer was also raised in the debate which surrounded the ruling; equipment leasing was however exempted from the Government’s general policy to restrict such tax effective financing. The rationality of this exception was highlighted in the Bureau of Industry Economics’ paper ‘Tax Losses and Tax Benefit Transfer.’
Leasing is an essential financing tool for a dynamic and competitive economy. If from time-to-time a new application or lease product development tests the legislative or taxation framework, this should be seen as a healthy and necessary sign of an innovative financial system. An on-going role for groups such as AELA is to ensure that policy or administrative responses proceed on an informed basis with due regard to any wider consequences.
A development in the lease market over the years has been the offering of variously structured operating leases. These were in part a response to Accounting Standards which require lessees, for corporate disclosure purposes, to capitalise their finance leases onto their balance sheets; operating lease commitments on the other hand, are expensed in the usual way and need only be disclosed by way of footnote to the published accounts. As noted elsewhere, the proposed new lease accounting standard would require all leases be capitalised on the lessee’s balance sheet.
Initially demand for the operating lease product was limited to the larger corporations and companies with overseas, especially US parents. Over the years this has changed, with a wider spectrum of private and public sector lessees now utilising the product. Operating leases are a prominent feature of the fleet leasing industry, often accompanied with fleet management services.
From a lessor viewpoint, for the lessor to retain the advantages and disadvantages of economic ownership of the equipment (as the present Standard requires of an operating lease) it is necessary to be confident that the value of the equipment when returned by the lessee will achieve a resale price which is predictable. This ‘equipment’ risk is reduced where there is a sufficiently deep second hand market for the particular equipment to allow reliance on reasonable estimates of sale values. Given the general lack of depth of Australian equipment markets (compared, say to the US or Europe), operating leases have been largely limited to motor vehicles, computers and multi-purpose industrial equipment (e.g. forklifts). As the same resale market questions will affect residual value insurance premiums, such insurance can be expensive especially for specialised equipment.
When this equipment resale value risk is added to the credit/client risk (will the lessee meet the commitments) and indeed the manufacturer and goods risk (will the manufacturer/supplier continue to provide servicing, will the goods prove reliable), it is obvious that compared with a traditional finance lease, operating leases are more complex. Any legislative or other regulatory measure which results in a move to operating leases out of balance with the market’s capacity to cover underlying equipment risk will have prudential consequences, as well as forcing that risk, currently implicit in a finance lease, to be explicitly priced in the operating lease. Operating leases provide unique benefits to lessees, and constitute a vibrant segment of the Australian equipment finance market.
The introduction of GST on 1 July 2000 added somewhat to the complexity of equipment finance transactions, but at the same time this framework has provided a fair degree of flexibility in meeting the needs of customers. The introduction in July 2007 of Division 250 to replace the former framework governing leasing to tax preferred entities focused attention on the appropriate income tax treatment for leases to tax exempts. In a similar vein, the proposals for the new regime for the Taxation of Financial Arrangements (TOFA) focused this attention on leasing to taxables. The detail of these developments is covered elsewhere, but it is important to note that for leasing to continue to provide a dynamic and creative solution to the equipment finance needs of businesses, it cannot be placed within the conventional homogeneous ‘sale and loan’ approach. The proposal some years ago to introduce the Tax Value Method for determining taxable income could have had important implications for the equipment finance industry, and AELA was one of the many groups that welcomed the Government’s decision not to proceed.
A major recent development has been the commencement of the Personal Property Securities (PPS) regime on 30 January 2012. This is intended to be a simplified regime for recording of financial interests un all tangible and intangible non-real estate assets. This reform has significant implications for all equipment finance products, and is covered in a separate section.