BLM32535 | Taxation of leases that are not long funding leases: finance lessees: importance of lease term: no secondary period: assets with residual values - depreciation charge

Both UK GAAP and IFRS require assets leased under a finance lease to be depreciated by the lessee. The amount to be depreciated is the cost of the assets less any expected residual value. The term over which the cost less expected residual value is allocated must also be considered. If it is reasonably certain that the lessee will obtain ownership the cost is allocated over the useful life of the asset. Otherwise the cost less expected residual value is allocated over the shorter of either the lease term (including the secondary period if this is likely to be taken up) or the useful economic life of the asset.

For example, suppose a ship that costs £1 million is leased for 10 years (no secondary period) and is expected to fall in value to £550,000 after 10 years. Assuming the depreciation is evenly spread, £45,000 depreciation will be written off each year. It is this depreciation charge that we take for tax purposes, not the £1m cost of the asset, even if the rentals fully compensate the lessor for the original £1m cost of the ship (with a rental rebate on sale after 10 years).

Of course, in practice, the depreciation charge may vary from year to year. The value of ships can be particularly volatile. So the figures would not necessarily work out neatly; but the principle is clear.