Finance leases and operating leases have different tax treatments in Canada. While many of us might assume that it doesn’t matter how you lease a piece of equipment for your business, the type of lease you choose could have very different implications for your business taxes. In this blog we’ll uncover the differences between finance leases and operating leases and what they could mean for your bottom line.
What to talk to one of our accountants instead? Our team of experienced accountants have the financial knowledge necessary to help you make the best decision for your business. Call now!
What is a Finance Lease?
A finance lease, also known as a capital lease, is a type of lease agreement where for accounting purposes the lessee (you or your business) is considered an owner of the asset, and it’s recorded on your balance sheet that you own the piece of equipment. Even though as a lease you’re technically renting the piece of equipment, with a finance lease you assume many of the risks (and rewards) of ownership of the asset. This type of lease can have an impact on your financial statements as with a finance lease you have to take the interest expenses, asset worth, depreciation expenses, and liabilities all under your own business umbrella.
In essence, a finance lease is treated as though the lessee is purchasing the asset, with the lease payments spread out over time. At the end of the lease term, you actually gain ownership of the asset in full. This is because finance leases are required to be for 75% or more of the lifespan of the asset. For example, if a tractor has a useful life of 20 years, the finance lease would be for at least 15 years, and you would own the tractor at the end of the lease.
What is an Operating Lease?
An operating lease, on the other hand, is what most people would consider a traditional lease agreement. With an operating lease, the lessor (the owner of the asset) retains the majority of the risks and rewards of ownership. You, as the lessee, are essentially renting the asset for a specific period, and at the end of the lease term, the asset is returned to the owner. Operating leases are typically used for short-term leasing or when the lessee does not intend to keep the asset. From a tax perspective, operating leases are considered a business expense rather than an asset on your financial documents, giving you none of the benefits of boosted assets, but also meaning you need to take on none of the liability expenses.
How Does Lease Type Impact Accounting?
The type of lease you choose will affect how it’s recorded in your financial statements. For finance leases, the asset you’re leasing is recorded on your balance sheet as if it were purchased, along with a corresponding liability representing the obligation to make future lease payments. The depreciation and interest expenses of the asset are recognized over time, so it’s important to know that if you choose a finance lease you’ll have to track the asset as if it belongs to you. While holding the liability can be a risk, the reward of this type of lease is that you own the asset at the end.
In contrast, operating leases do not appear on the balance sheet as an asset or liability. Instead, lease payments are treated as operating expenses and are recognized on the income statement as they are paid. While not having to take on the liability can be a benefit, operating leases do not end in ownership, meaning if you continue to need the asset you’re leasing, you’ll need to continue renting it. This distinction can significantly impact key financial ratios and metrics, such as debt-to-equity ratio and return on assets.
Is it Better to Finance or Lease?
The decision to finance or lease an asset depends on several factors, including your business’s financial goals, cash flow, and the intended use of the asset. Finance leases might be more advantageous if you plan to keep the asset long-term and want to claim depreciation. On the other hand, operating leases might be preferable if you want to keep the asset off your balance sheet and avoid the responsibilities of ownership. If you seek to buy the asset outright and instead get financing to purchase the asset, that can also be a beneficial option if your business has the capital and ability to handle the debt load.
Read More: Should I lease or buy business equipment?
When thinking about financing, finance leases, or operating leases, you can compare them to the idea of getting a mortgage, rent to own home ownership, and renting. Each has their own benefits and risks depending on where you are in your business. Renting might be beneficial if you aren’t sure about the asset itself or if you’ll want it in the future, and sometimes it’s the only option at the time based on your finances. That’s where Gallo LLP comes in! Our team will look at your finances and recommend the best option that will help your business in the long run.
What Are the Tax Treatments of Finance Leases vs Operating Leases?
In Canada, the tax treatment of finance and operating leases differs slightly. When you purchase an asset, either through financing or outright, the cost of this asset is calculated as a part of a business’ Capital Cost Allowance (CCA). Your CCA is calculated to understand how much your business is allowed to expense for each type of asset, and when you are financing equipment you are only able to deduct the CCA as well as the interest on repayments. Because you take on the risks and rewards of the asset, it’s a common misconception that with a finance lease you impact your CCA. While you must still add the asset to your balance sheet with a finance lease, it is not calculated as a CCA. Instead, you can deduct the leasing fees from your taxes. Operating leases also allow you to deduct the entire leasing expenses, but they do not increase your net assets.
How Can Gallo LLP Help?
Choosing the right type of lease for your business can be complex, with significant implications for your financial statements and tax liabilities. At Gallo LLP, our team of experienced accountants has the financial knowledge necessary to help you make the best decision for your business. Whether you’re considering a finance lease or an operating lease, we can provide personalized advice tailored to your specific situation. Call us now to discuss your options and ensure you’re making the most tax-efficient decision for your business.