Leasing Farm Equipment

Agdex#:	831
Publication Date:	02/01
Order#:	01-003
Last Reviewed:	02/01
History:	Original Factsheet
Written by:	R. W. Gamble - Finance and Business Structures Program Lead/OMAFRA

Table of Contents

1. The Lease Quiz
2. The Basics of Leasing
3. Types of Leases
4. Pros and Cons
5. Leasing Terminology
6. Lease vs Purchase Option
7. Timing of Cash Flow
8. Lease Clauses
9. Negotiation Points
10. Leasing Terms
11. Leasing verses Buying Worksheet

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During the past 10 years, it has become more popular to lease farm equipment as a method of acquiring new equipment for farm businesses. This increased popularity is due in part to the increasing cost of farm equipment. The large outlays of capital, particularly down payments, make leasing more attractive. Farm managers are also becoming more comfortable with controlling and using an asset, instead of owning the asset.

With this popularity comes the need of farm managers to be able to evaluate the cost of leasing verses the other options available.

Are you considering a lease? Find out how much you know. Take the lease quiz in section 1.

The purpose of this Factsheet is to increase farm managers understanding of leasing arrangements.

The Lease Quiz

Which Lease is the Best Deal?

Can you determine which of the following leases is the best deal? The equipment being leased is worth $84,000. Various dealers quote the following:

If you picked "C" you are wrong. That's because the interest rate on "B" is the best deal. But you would only know that if your calculator performed lease calculations. The rates for the above leases are as follows:

While more and more leasing contracts are disclosing all the terms, there is still significant misunderstanding in how a lease is calculated.

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The Basics of Leasing

The most common question asked regarding leasing is "Is it better to lease or purchase equipment?" Unfortunately the answer is not straightforward since it depends on the individual's business situation and preferences. Before you can answer that question for yourself, you must know how a lease is calculated.

How a Lease is Calculated

There is no magic in calculating a lease. The cost is based on five variables:

• cost of the machine
• interest rate
• residual or termination value
• the term and number of payments
• monthly or yearly payment

Some leasing companies disclose all these figures while others do not. Ask for this information so you can compare leases. Remember, as was demonstrated in question 1 of the quiz, the payment alone does not allow you to make a comparison.

What are You Paying for in a Lease?

The concept of leasing can be confusing sometimes. What exactly are you paying for? Figure 1 below illustrates lease payments and residual value.

Text Equivalent of Diagram

Example:

The total value of the machine is $120,000. The gray section on the left of the bar represents the amount of the machine that you are paying for in your lease, in this case $80,000. The black part of the bar on the right represents the residual value of $40,000, the amount of the machine cost you have not paid for.

A lease payment can be less than a loan payment because of how the payment is calculated. The interest portion is calculated on the entire value of the machine. However the principle portion of the lease payment is based on only the value of the machine used. This is the sale price minus the residual value - in other words you are purchasing or using only a part of the machine - in the example $80,000 of the total value of $120,000. When the lease term is completed you usually have the option of purchasing the machine at the residual value. In other words you buy the "rest" of the machine at that time.

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The Leasing Contract

An equipment lease contract specifies the following points:

• the customer and dealer names and information
• the exact piece of equipment being leased
• the beginning and ending dates of the lease
• the base hours (defined as the annual number of hours the equipment is expected to be used)
• the payment due the lessor for use in excess of the base hours
• the dollar amount the farmer must pay to purchase the equipment at the end of the lease if the purchase option is exercised
• the advance payment required
• the periodic payment (monthly, quarterly, semiannually or annually)
• miscellaneous terms of the agreement, including such things as charges for excess wear and tear and evidence of insurance on the equipment

Most businesses distinguish a lease from a rental agreement by the duration of control. Equipment leases typically provide control of the equipment for one or more years; rental agreements typically for less than one year.

Under a typical rental agreement, the farmer agrees to pay a specified rate for every hour registered on the hour meter of the tractor. Frequently a minimum number of hours are also specified. The beginning and ending dates of the rent restrict the duration of the rental period.

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Types of Leases

There are two types of leases: an operating lease and a financing or capital lease. It is important to know what type of lease you are dealing with because the tax treatment of each is different.

Operating Lease

This is sometimes called a true lease or an off balance sheet lease (see definition below) This type is typically what people think of when they use the term lease. In an operating lease, ownership of the equipment stays with the person or company (called the lessor) leasing the equipment to the user (called the lessee). The user of the equipment is able to deduct the entire lease payments as an expense for income tax purposes.

The true operating lease is for less than the useful life of the equipment and allows the user to return the equipment at the end of the lease period without further obligation. If there is any requirement to purchase, then it is not a true lease. If there is a purchase option, it must be estimated at Fair Market Value. See Table 1, Lease Purchase Comparison Chart, for Canada Customs and Revenue Agency definitions.

The Off Balance Sheet Lease

This term is used because if a lease is a capital lease the asset shows up on your balance sheet as a leased asset and the payments as a liability. In a true operating lease the balance sheet is not affected and the payments are recorded as an expense on your income and expense statement.

Financing or Capital Lease

A financing lease is, as its name implies, a method of financing the purchase of an asset. Ownership does not transfer to the user until the end of the lease and only then if the user exercises their option to purchase. Canada Customs and Revenue Agency has specialized rules for determining what is a financing lease (see below). In general any of the following indicates the arrangement is a financial lease.

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• There is a requirement to purchase the equipment at some point in the lease.
• A bargain price is offered at the end of the lease period. (This bargain price concept is used as one indicator to disqualify the use of an operating lease where it is not appropriate. However, this does not mean that a financing lease must have a very low or "bargain price" residual where the user wishes otherwise.)

Canada Customs and Revenue Agency states that a lease, which has the following characteristics, is a financing lease and not an operating lease:

1. The person leasing the property automatically acquires title to the asset after a certain number of payments.
2. The lessee must purchase the property during or at the end of the lease.
3. The lessee has the option to purchase the property at a price that is substantially less than the FMV and within a time, that is less than the useful life of the property. Payments to the lessor will represent a substantial portion of the fair market value.
4. The lessee has the right during or at the expiration of the lease to acquire the property at a price or under terms or conditions which at the inception of the lease is/are such that no reasonable person would fail to exercise the said option.

For further information see Canada Customs and Revenue Agency IT-233R Lease-option agreements-Sale-lease back agreements.

• The equipment is worth less that 10% of it's original value at the end of the lease or
• The equipment has gone beyond 75% of its useful life.

Financial lease payments cannot be written off as an expense for income tax purposes. Instead, a deduction for Capital Cost Allowance (CCA - which is depreciation for tax) and a calculated interest expense is used. This is the same as if you owned the machine and reflects the fact that you are really using the lease to purchase the equipment.

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Lease Purchase Comparison

Operating Lease (True Tax lease)
Definition

• Ownership stays with leasing company
• User can return equipment **
• Purchase option at Fair Market Value (FMV)
• Length of lease is not greater than 75% of the useful life of the asset

** This is usually an option only if you're dealing with an original manufacturer of equipment. If you are leasing through a bank they usually have a clause that allows for the purchase, sale of the equipment to a third party or a re-lease of the equipment.

Finance Lease

• User becomes the owner of equipment, either because the lease requires it, or because a bargain price residual is offered. (The bargain price concept is used as one indicator to disqualify the use of an operating lease where it is not appropriate. However, this does not mean that a financing lease must have a very low or "bargain price" residual where the user wishes otherwise.)
• Purchase option is at below FMV
• The length of the lease is greater than ¾ of the useful life of the asset.
• The present value of all the future payments and the residual value are greater than 90% of the asset value.

Purchase **

• User owns the asset.

** A conditional sales contract (CSC) is used to finance the purchase of the equipment from the manufacturer.

Operating Lease (True Tax lease)
Tax treatment of Payments

• All payments can be claimed as a tax-deductible expense.
• Goods and Services Tax (GST) and any applicable Retail Sales Tax (RST) are combined with each payment.
• Farm equipment is RST exempt.
• GST may be payable on the lease payments and an input tax credit claimed.

Finance Lease

• While there may be some differing treatments for a finance lease, generally the full payments are not claimed as an expense
• Depreciation (Capital Cost Allowance - CCA) and a calculated interest expense can be claimed as a deduction
• GST may be payable on the lease payments and an input tax credit claimed.

Purchase**

• Interest cost on loan and depreciation (CCA) can be deducted
• GST and RST, if applicable, are paid up front.

Operating Lease (True Tax lease)
Typical Length

2-5 years, some leases go to 7 years on larger equipment.

Finance Lease

3-7 years

Purchase**

3-7 years

Operating Lease (True Tax lease)
Down Payment

• Some debate exists as to whether a prepayment or down payment on an operating lease makes it a financing lease.
• Check with your tax advisor on this issue.

Finance Lease

• While some leasing companies accept a down payment that reduces the payments required, the lease is still based on 100% of the asset value. The method of handling a down payment varies between leasing companies.
• Make sure you consider the down payment if you are making a comparison based only on the size of payments.

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Purchase**

• A down payment is often made or a trade in value taken.
• Again consider the down payment when comparing only the payments.

Operating Lease (True Tax lease)
Affect on Cash flow

• Typically the cash flow requirements for leasing are less than purchasing.
• Increasing the residual value or lengthening the term can reduce cash flow.

Finance Lease

• Same as the operating lease. No down payments mean that more cash can be used in other areas.

Purchase**

• Usually cash requirements of servicing the loan are higher. There is flexibility on the term of loan.

Operating Lease (True Tax lease)
Affect on Financial Statements and Ratios

• Called an "off balance sheet lease" because the asset does not appear on your balance sheet.
• If your lender is concerned about your working capital, this type of lease would be preferable.
• This advantage may be overstated since most lenders require full disclosure of all liabilities.

Financial Lease

• The equipment would appear on your balance sheet as a leased asset and the payments as a liability.

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Purchase**

• The equipment would appear on your balance sheet as an asset and the loan you obtained to finance it as a liability.

Operating Lease (True Tax lease)
Usage Penalties

• Some leasing companies offer different blocks of base hrs. Penalties are accessed if you exceed the hrs stated in the lease.
• Banks may not have hourly usage penalties.

Finance Lease

Same as operating lease

Operating Lease (True Tax lease)
Early Termination

If you terminate your lease early a pay out to end the lease is required. Following is a typical pay out calculation; however you may be able to negotiate a better deal with your leasing company:

• any current payments
• plus the present value of future payments
• plus the residual value of the equipment
  

Lease agreements will indicate what constitutes a default and termination payment.

Finance Lease

Similar to the operating lease

Purchase**

• Paying off a loan early is usually permitted
• A conditional sales contract may have pay out clauses similar to leases.

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Operating Lease (True Tax lease)
Insurance

• Lessors require that you have insurance on the equipment. Insurance is available through many equipment leasing companies or through your own insurance company. Banks generally do not offer insurance on the equipment.
• Be sure to discuss the availability and benefits of replacement value insurance vs. market value.

Finance Lease

Similar to the operating lease

Purchase**

• Insurance is advised but not required to obtain the loan.
• It is required in a conditional sales contract.

Pros and Cons of Leasing

Although each business situation is different, there are some general points regarding leasing. Discuss any lease arrangements with your tax advisor early in the process. Your tax situation can have a significant impact on the lease or buy decision. Some key considerations follow.

Cash Flow

Generally leasing reduces cash flow requirements of a business. This is largely due to the flexibility that lessors can provide. Lease payments are usually lower than loan payments for the same asset. If your business is at a stage where cash flow is tight then leasing may be more attractive. This is especially true if investment elsewhere in the business can return a higher rate than the cost of the lease.

Tax

As mentioned earlier, consider your current tax situation. An attractive aspect of leasing is that the entire lease payment can be a tax deduction. This is more advantageous to a business in a high tax bracket than to one in a lower bracket because a greater tax reduction results.

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High Equipment Turnover or Requirements

Businesses that need to replace their equipment more often can benefit from leasing. This requirement might stem from the need to have reliable equipment such as a custom operator or a farm business with a very large land base.

Balance Sheet Financials

One feature that can make leasing more attractive is that the asset is not owned and therefore does not show up on the balance sheet. In a normal purchase the asset value is listed on the asset side of the balance sheet, while the loan is a liability. The current year's payment is a current liability, which affects the ratio called current ratio or working capital. Lenders like to see this ratio maintained within certain limits. While a loan affects this ratio, a true lease does not.

Leasing Terminology

The terminology used in leasing can make it difficult to understand. Also not all lease agreements use the same terminology. The following are the essential terms that you need to know. A more complete listing of leasing terminology can be found in Section 10 on page 7-8 of this Factsheet.

Lessee — the user of the equipment being leased.

Lessor — the party to a lease agreement who has legal or tax title to the equipment, grants the lessee the right to use the equipment for the lease term, and is entitled to the rentals.

Initial Value or purchase price — also called the lease value, this is the cost of the lease. This does not always appear on the lease contract as a lump sum. Usually the total payments are listed, which would include the interest charged.

Interest Rate —This is the rate of interest used to calculate your lease payments. Sometimes an interest factor or lease factor is used, which is based on the interest rate and is just another method of calculating the interest cost

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Termination or Residual Value — the value of the leased asset at the end of a lease. You can calculate the cost of your lease by subtracting the termination value from the total lease payments.

Lease Vs Purchase Option?

Making a decision about the best option for your business can sometimes be decided with limited calculations. If your business has large cash flow requirements you may decide that a lease is the most appropriate.

A second question should also be asked. Can the extra cash flow from leasing be used to generate more money than the cost saving from purchasing? Knowing the return on assets that your business is generating is important in answering this question.

How do you /Compare?

The most straightforward method is a simple cash basis comparison. It is outlined below. Another method, the net present value cash flow method allows you to compare the timing of the cash flows. While it is more complex, it is important to understand the cash flow differences between a lease and a purchase option. This is covered in the Section 7, Timing of Cash Flow on page 6.

CCA and Interest vs. Lease Payments

After tax cost must be considered when comparing leasing to purchasing. If the lease is an operating lease then the entire lease payments can be deducted as an expense. If the business purchases that same asset, it can claim Capital Cost Allowance (CCA) and the interest on any borrowed money.

Machinery and other depreciable assets are placed in classes; each with specific depreciation rates. For example, tractors are in class 10, with a depreciation rate of 30% per year, except for the year of purchase when only half the prescribed rate can be used. Table 1, Depreciation Rates, is one example.

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Table 1. Depreciation Rates

A simple cash method compares the after tax cost of the lease verses the purchase. You need to know:

Lease

• Lease payments
• Termination or residual value

Purchase

• Loan payments
• Purchase price
• Depreciation rates of purchased machinery
• Estimate of fair market value on a future sale

In addition to information above, you need to know your tax rate to make the calculation. Table 3 shows how a comparison can be made.

The example above shows that the lease option requires less cash per year but the purchase option is less costly overall.

Note that to compare the two options the length of the loan and the lease is the same. The assumption is the purchased asset is sold at the end of the loan period that coincides with the lease period.

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Timing of Cash Flow

Net Present Value Cash Flow Method

The simple cash method of comparison does not address the timing of the cash flows. Most leases require payments in advance; loan payments are made at the end of the payment period. On the other hand some loans require a down payment or money from a trade in.

The only way to take into account the timing of cash flow is to use a method called the net present value cash flow method. The concept is described below.

Table 2. Leasing vs. Buying Cash Method Comparison

^{1 Some leasing companies will accept a down payment for operating lease. Consult your tax advisor to determine if this indicates it is a finance lease and not an operating lease.}

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The Time - Value Concept of Money

The net present value cash flow method is based on the time-value concept of money. This concept recognizes that money spent or received in the future is less valuable than money received or spent today. The value of a future expenditure or income in today's dollars is said to be its present value. For example if you could receive a dollar today or a dollar in a year from now, which would you choose? If you received it today it could be invested or used. It is therefore more valuable than a dollar received a year from now. If however you were offered $1.05 in a year from now and the interest rates were 5% these two offers would be equal. The present value of the future payment would be equal to the $1.00. The term discount rate is used to describe the percentage used to convert future values to present values.

Present value calculations allow you to determine the least expensive alternative. Using our dollar example, if you had to pay $1.10 a year from now, or $1.00 today, which would be cheaper? Using a discount rate of 5% the present value of the $1.10 would be $1.047. That means it would be less expensive to pay the $1.00 today as opposed to the $1.10 in a year from now. This same principle is used in calculating the present value of the series of payments that must be made on a loan or a lease. These are added together and discounted and the result allows a comparison to be made between the two alternatives. This is called the net present value cash flow method.

Decision Making Aids

While the net present value cash flow can be calculated using present value tables, it is easier to use the "Equipment Lease Analyzer" spreadsheet available from the OMAFRA Web site.

It is a decision-making aid to help evaluate the economic differences between leasing and purchasing equipment. The spreadsheet numerically and graphically compares the alternatives on the basis of cash flow and profitability. Usually a lease is better or worse than a purchase on both criteria, but occasionally one option offers better cash flow while the other offers lower cost.

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Leasing Clauses

Usage penalties — Usage penalties or excess hr rates are clearly stated on your lease contract. The base amount is the number of hours you can use without penalty. Once this number is exceeded the penalties per hour begin. The higher the number of hours on the base rate the higher the cost of the lease. There is a breakeven point at which you would be better to choose a higher number of hours and pay more as compared to paying excess hour rate penalties. See Section 8 for an example calculation.

Insurance — All lease agreements require you have insurance on leased equipment. Discuss with your insurance agent the best options available. There can be situations where the calculations of the amount owing in the termination clause result in more being owed than what your insurance will cover.

Fees — Any fees associated with setting up your lease should be indicated on your agreement.

Taxes — Taxes on a lease are blended with the payments as you make them. On farm equipment this is usually not a great advantage since the GST paid on leases can be used as an input tax credit and the PST is generally not payable.

Consult a tax advisor on the specifics of your situation.

Normal maintenance — as the user of the equipment you are responsible for normal maintenance of the equipment.

Damage due to abuse or neglect — any damages because of abuse or neglect are not considered to be normal wear and tear; you will be responsible for those items.

Early Termination Clauses -all lease contracts indicate the payments required on a premature termination of the lease. A pay out is required if you default on your payments or the equipment was stolen or damaged beyond repair.

While you may be able to negotiate a lower pay out with the leasing company, a typical contract contains a pay out calculation as follows:

• any current payments
• plus the present value of future payments
• plus the residual value of the equipment

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Table 3. Termination of an Equipment Lease

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Negotiation Points

There are several areas that are potential items for negotiation when considering an equipment lease.

Sale Price

Negotiating a lower sales price reduces the annual lease payment and the end-of-lease purchase option price.

Lease term

The term of a lease is probably the easiest area to negotiate. Select the lease duration that fits your farming plans for the next several years. If there is no known need to change equipment in 3 or 4 years, and if controlling an asset outside of its warranty period is no problem, consider a longer lease. Ask the dealer to give you a comparison on the different lease terms.

Number of hours of use per year

Select the number of hours that minimizes the total equipment cost over the life of the lease. While you will not be reimbursed for "unused" hours, it is best not to overestimate the hours of use. However, if you underestimate the hours, an hourly charge is assessed for every hour in excess of the agreed upon annual use. Because leases have limited hourly choices (e.g., 400, 600 and 800 hr/yr.), it is important to evaluate which option is east expensive. For example, if a tractor is needed for 475 hr/yr., it might be cheaper to pay for a 600-hr lease than to choose the 400-hr lease and pay the extra charge for the additional 75 hrs.

Table 4. Calculating Optimum Lease Hours

Implications

If you think you will use the equipment for less than 444 hr/yr. the 400-hr lease is less expensive than the 600 lease.

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The "Equipment Lease Analyzer" spreadsheet calculates the optimum hours to choose. It can be downloaded from the OMAFRA Web site

A Negotiation Plan

A plan for negotiation might include the following steps:

• Make your best deal on the purchase of the piece of equipment you are interested in controlling.
• Ask dealers about equipment leases they offer. Obtain copies of their lease contracts along with quotes of annual lease payments for various lease lengths and annual use. Note that the best purchase deal might include trade-in of used equipment, whereas a lease may not allow trade-ins.
• Ask dealers about options for financing purchases, including interest rate and length of loan.
• · Ask your local banker how the purchase would affect your financial status and what interest rate would be charged for a loan, if needed.
• Ask your local banker or a national finance company if they are interested in purchasing the equipment and leasing it to you. If so, obtain their lease contract and annual payment estimates for various lease durations and annual use.
• Analyze the alternatives (purchase financed by either the dealer or a financial institution or lease financed by either the dealer or a financial institution) for cash flow and profitability.
• Before signing any lease, discuss the terms of the arrangement with your banker and tax adviser and ask how the lease will affect your financial and tax situation.

Conclusion

Although leasing of land has been well accepted in agriculture for generations, leasing of equipment has become widespread only in the last few decades. The cost of equipment, together with the cost of land, has become a significant barrier to entry and longevity in farming. Leasing allows farmers to control productive assets without owning them.

Leases fit into the business activity of some farmers and not others. The many decisions that go into evaluating a lease versus a purchase are difficult. But to maximize profit, the time and effort spent in comparing the two options is worthwhile.

Understanding the points of negotiation and potential effects of each decision along the way will allow farmers to make the decisions that best fit their situation.

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Leasing Terms

Bargain Purchase Option — a lease provision allowing the lessee the option to purchase the equipment for a predetermined price that is substantially lower than the expected fair market value at the date the option can be exercised. i.e. $1.00!

Capital Cost Allowance — an amount (expressed as a %) allowed to be expensed for tax purposes against the cost of capital assets acquired by a business. Different types of assets attract different percentages.

Capital Lease — type of lease classified and accounted for by a lessee as a purchase and by the lessor as a sale or financing, if it meets any one of the following criteria: (a) the lessor transfers ownership to the lessee at the end of the lease term; (b) the lease contains an option to purchase the asset at a bargain price; (c) the lease term is equal to 75% or more of the estimated economic life of the property (exceptions for used property leased toward the end of its useful life); or (d) the present value of minimum lease rental payments is equal to 90% or more of the fair market value of the leased asset less related investment tax credits retained by the lessor.

Economic Life (Useful Life) — the period of time during which an asset has economic value and is usable.

Effective Lease Rate — the effective rate (to the lessee) of cash flows resulting from a lease transaction. To compare this rate with a loan interest rate, a company must include in the cash flows any effect the transactions have on federal tax liabilities.

Equipment Schedule — a document that describes in detail the equipment being leased. It may also state the lease term, commencement date, repayment schedule and location of the equipment.

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Fair Market Purchase Option — an option to purchase leased property at the end of the lease term at its then fair market value. The lessor does not have the ability to retain title to the equipment if the lessee chooses to exercise the purchase option.

Lease — a contract in which one party conveys the use of an asset to another party for a specific period of time at a predetermined rate

Operating Lease — any lease that is not a capital lease. These are generally used for short-term leases of equipment. The lessee can acquire the use of equipment for just a fraction of the useful life of the asset. The lessor may provide additional services such as maintenance and insurance.

Present Value — the current equivalent of payments or a stream of payments to be received at various times in the future. The present value will vary with the discount interest factor applied to future payments.

Purchase Option — a provision by which a lessee has the right to purchase the equipment (usually at the end of, or close to, the end of the lease). The purchase option may be stated at a specified amount or at fair market value.

True Lease — a type of transaction that qualifies as a lease under Canada Customs and Revenue Agency IT233R Guidelines. It allows the lessor to claim ownership and the lessee to claim rental payments as tax deductions.

Vendor Leasing —a working relationship between a financing source and a vendor to provide financing to stimulate the vendor's sales. The financing source offers leases or conditional sales contracts to the vendor's customers. The vendor leasing firm substitutes as the captive finance company of a manufacturer or distributor through the extension of leasing to customers, provisions of credit checking, and performance of collections and operational administration. Also known as lease asset servicing or vendor programs.

Table 5. Leasing verses Buying Worksheet

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