Question

A lessor and lessee are most able to maximize their financial communities of interest through a lease contract if the lessor's tax rate is very high and the lessee's very low. Explain how this would be true, and the implications for the type of firms who lease their assets and the type of companies who operate as lessors.

Answer 1

Leasing is the process through which a person (called as lessee) obtains the economic use of an asset for a specific period of time without obtaining an ownership interest in the asset. Asset owned by a person (called lessor) who gives it on lease to lessee in return of a monetary consideration (called as lease payments) for a certain period of time. As per the lease agreements executed by lessor and lessee, ownership generally remains with the lessor and lessor calims the depreciation deductions over the life of the asset. Due to depreciation deductions (a non cash expenditure), lessor's net income reduces and beacuse of that lessor need to pay lower amount of tax even if higher tax rates are prevailing.

Thus, we can say that it is true that tax benefits from leasing are straightforward; taxes can be saved by transferring valuable depreciation deductions from low tax rate lessee of asset to high tax rate lessors.

Firms who lease their assets ?are referred to such firms who leases their assets in ordinary course of business to gain from lease payments. Here, assets are assumed to be owned by the firms from their own sources and assets are not bought on financing from any lending institutions. Therefore, no borrowing costs in form of interest is involved. In such a scenario, lease transaction will help such firms take advantage of depreciation tax shield because lessor is high tax payer and lessee is assumed to be low tax payer.

Companies who operate as lessors - ?are referred to the companies whose basic business model is buying the assets on borrower funds and leasing it to other persons. In such a scenario, interest cost is involved. If the interest rates are high, then benefits of depreciation tax shield would be lower or nil. Acquiring the assets only for the purpose of leasing would involve other acquisition costs as well and it will increase the pre tax cash outflow for the lessor. If the lease rents are not deferred then there would be no difference in the pre tax cost for acquisition of the asset and present value of after tax cash inflows from lessee. Therefore, it will not derive as much benefit for the companies who operate as lessor in comparision to firms who lease their assets in normal course of business.

Hope it will clarify. Thanks.