Finance Lease

How a Finance Lease Works

A finance lease sits between an operating lease and an outright purchase in terms of economic substance. The leasing company (lessor) purchases the equipment and leases it to you (lessee) for a significant portion of the equipment's useful life. Unlike an operating lease where the lessor retains the residual value risk, a finance lease passes substantially all the risks and rewards of ownership to you.

In practice, this means the equipment appears on your balance sheet as an asset (with a corresponding lease liability), you are responsible for maintenance, insurance, and all costs of operating the equipment, and you are expected to purchase the equipment at the end of the lease by paying the pre-agreed residual value.

The key advantage of a finance lease over a chattel mortgage or hire purchase is the residual value. By deferring a portion of the cost to the end of the term, your regular payments during the lease are lower. This preserves cash flow during the lease period while still giving you the benefit of using the equipment from day one.

Understanding Residual Values

The residual value is the cornerstone of a finance lease. It represents the amount you will pay at the end of the lease to take outright ownership of the equipment. The residual is set at the beginning of the lease and does not change, regardless of the equipment's actual market value at lease end.

Higher residual values mean lower regular payments but a larger final payment. Lower residual values mean higher regular payments but a smaller final payment. The optimal residual depends on your cash flow priorities, the expected depreciation of the equipment, and your intentions at lease end.

For example, on a $100,000 finance lease over 5 years at 6% p.a., a 30% residual ($30,000) would give monthly payments of approximately $1,503. Without a residual, payments would be approximately $1,933. At the end, you pay $30,000 to own the equipment outright, or you could refinance the residual, trade the equipment, or sell it.

Tax Treatment of Finance Leases

Finance lease payments are tax deductible as a business expense. The entire rental payment, including the capital and interest components, is deductible against your business income. For GST-registered businesses, the GST included in each lease payment is claimable as an input credit on your BAS returns.

The accounting treatment requires the leased asset and the lease liability to be recorded on your balance sheet. The asset is depreciated over the lease term (or the asset's useful life, whichever is shorter), and the lease liability is reduced with each payment. Your accountant will handle this treatment and can advise on the optimal approach for your reporting requirements.

Comparing Finance Structures: Which Is Right for You?

The choice between a chattel mortgage, hire purchase, finance lease, and operating lease depends on your specific priorities. If your primary goal is lower regular payments with ownership at the end, a finance lease with a moderate residual is often the best choice. If you want to own the equipment immediately and claim GST upfront, a chattel mortgage is preferred.

If you want equipment purely as a business tool with flexibility to return or upgrade, an operating lease gives the most flexibility. If you prefer the simplicity of paying off the equipment with ownership as the end goal, hire purchase is straightforward.

In practice, the decision should be driven by tax considerations, cash flow preferences, balance sheet strategy, and your equipment lifecycle plans rather than the rate alone. A broker can model all options side by side to help you decide.