MANUFACTURING FACILITIES EQUIPMENT PURCHASE & LEASE

Introduction

Facility leasing or equipment leasing offers an interesting alternative for startup or established companies to acquire manufacturing facilities. The reasons for choosing leasing over purchasing are numerous, and not entirely related to tax planning. Non-tax considerations include the ability to acquire needed equipment without large capital outlays and the opportunity to effectively finance equipment acquisition off the balance sheet. Furthermore, leasing may help the company avoid risks of obsolescence. Generally, equipment leases fall into two types. A simple operating lease generally involves only the lessee/user and the equipment manufacturer, retailer or equipment leasing company that acts as the lessor. A second type of equipment lease, used primarily for large equipment or facility transactions, is a leveraged lease. A leveraged lease typically involves multiple parties, including the manufacturer, one or more lenders who furnish generally 60% to 80% of the purchase price, an equity participant who acts as the actual owner of the lease, one or more trusts to hold title to the equipment and hold the security for the lenders and the end user or lessee.

Defining Leases

Regardless of the form of the lease transaction, it is critical for tax purposes that the lease be actually classified as a lease and not as a sale. If a transaction structured as a lease is reclassified as a sale, the lessee will be treated as the owner of the equipment, the lessor will lose cost recovery deductions, the rental payments will be treated partially as a return of principal and partially as interest and any gain with respect to the property will be recognized at the inception of the transaction. The Revenue Canada has announced that it will generally treat a lease as a conditional sale if any of the following factors are present: (a) A portion of the rental payments are applied to a purchase price of the property; (b) Title passes to the lessee on termination of the lease; (c) Some portion of the rentals are interest payments; (d) The lease payments substantially exceed fair rental value; (e) Total rentals approximate the purchase price of the equipment plus interest over the term of the lease; (f) Rentals are substantially higher at the beginning of the lease than at the end; (g) Front-end rentals approximate the purchase price of the equipment plus interest; or (h) The lessee has a nominal purchase price option.

These criteria are somewhat dated based upon subsequent developments in case law regarding the status of leasing transactions. The criteria now focus primarily on whether the lessor expects an economic profit other than tax benefits, whether there is a reasonable expectation of a significant residual value, whether the lessee has made a substantial equity investment in the equipment and whether the lessor has retained profit and loss potential. The Revenue Canada has also adopted certain specific criteria for ruling purposes in determining whether a leveraged lease transaction will be treated as a lease. These requirements include the following: (a) The lessor must have an equity investment at risk equal to at least 20% of the cost of the equipment; (b) The equipment must be reasonably expected to have a value equal to at least 20% of its original cost at the end of the lease; (c) The equipment must be reasonably expected to have a remaining useful life at the end of the lease equal to the greater of one year or 20% of its original estimated useful life; (d) The lessee may not have the right to purchase the equipment for less than its fair market value; (e) The lessee may not provide any portion of the original cost of the equipment or of any improvements or additions that cannot be removed; (f) The lessee may not participate in the loan to purchase the equipment; (g) The lessor must demonstrate a profit other than from tax benefits; (h) The ability to use uneven rentals is limited; and (i) The property cannot be limited-use property.

The determination by a lessee of whether to lease or purchase equipment will likely depend on an economic analysis of the cost of leasing versus the cost of purchasing the equipment. The analysis should focus primarily on examination of the discounted cash flow from a leasing structure against the cost of buying. The costs in either event must include tax benefits such as deductible rentals or cost recovery deductions, and other costs such as debt service and interest on a financed purchase. Equipment leases that contain options to purchase by the lessee are risky if the option is at other than fair market value. A fixed price purchase option could cause the lease to be treated as a financing if the fixed price is not based upon the reasonably estimated market value at the time the option is exercisable.