In today’s rapidly changing business environment many companies are looking for alternative ways to fund equipment purchases. Leasing has become a popular equipment financing option, but a recent discussion with the CFO of a very large semiconductor manufacturer points out that there are still some skeptics when it comes to leasing.

"Leasing is for companies who can’t afford to do business in cash," said the CFO. "Why should I pay a fee to use someone else’s money when we have plenty of our own?"

My question to the CFO was: "Why waste cash on assets that may quickly become obsolete and could be losing value for your business the minute you turn on the switch?"

Leasing companies sometimes make the mistake of dazzling clients with their ability to create elaborate and complex leasing solutions that, frankly clients just don’t understand and don’t trust, leading to skepticism about leasing. The truth is that leasing is not as complex as you might think and if you remove all the jargon, there are really three basic types of leases:

• True Lease/Tax Oriented Lease
• Conditional Lease/Non-tax Oriented Lease
• Leveraged Lease

True Lease/Tax Oriented Lease

In a tax, or true lease, the finance company, called the lessor, is considered to be the owner of the equipment and takes the depreciation. As a result, the company using the equipment, the lessee is likely to receive lower monthly payments because the lessor receives the benefits of depreciation. All payments on a tax lease, not just the interest portion, are tax deductible as operating expenses for the lessee.

To qualify as a tax lease, certain guidelines established by must be met:

The estimated value of the equipment at the end of the lease must equal or exceed 20% of the original cost of the equipment. This value, called the estimated fair market value is set at lease inception.

• The length of the lease cannot exceed 80% of the estimated useful life of the equipment.
• The remaining economic life must be at least one year or 20% of its original estimated useful life, whichever is greater.
• The lessee cannot have the option to purchase or re-lease the equipment at the end of the lease at a price below fair market value.
• The lessor must be the owner of the equipment; therefore, the lessee cannot make investments in the equipment.
• The equipment cannot be one-of-a-kind, limited-use equipment that only the lessee could use.

Conditional Lease/Non-tax Oriented Lease

The conditional or non-tax oriented lease is basically a structured loan where the lease transfers all the tax and depreciation benefits to the lessee. This type of leasing arrangement is similar to a conditional sales contract, in which the title to the equipment does not pass to the customer until all required payments have been made. The lessee can also have an "Early Buy Out" (EBO) option or a renewal option which allows for some flexibility at the end of the lease term.

Under the conditional lease, the lessee treats the equipment as owned, claiming any investment tax credits, depreciating the equipment for tax purposes and can deduct the only interest portion of the lease payments from operating expenses. At the end of the lease, the lessee can purchase the equipment at the price established at the beginning of the lease that is below fair market value.

Leveraged Lease

A leveraged lease has a similar structure to the true lease, but is a bit more complex from a legal and tax standpoint. There are three parties involved in a leveraged lease:

• the lessee
• the lessor, called the equity participant
• a long-term lender, called the debt participant

In this lease, the lessor retains only contributes a portion of the funds needed to purchase the equipment, usually between 20-40%, but still retains ownership of the equipment. The long-term lender provides the balance of the funds needed to purchase the equipment.

What does this mean to the lessee? Since the lessor gains additional tax benefits from this leasing/funding structure, the savings can be passed on to the lessee in the form of lower payments, just as in a tax lease structure.

The Benefits of Leasing

Leasing is a popular choice because it can have a positive impact in several areas: cash flow, cash management, income tax liability and equipment obsolescence. Leasing prevents cash from being tied up in equity; it can keep debt lines free and credit lines open. Also, since leasing offers 100% financing, companies can avoid making large downpayments and are in a better position to afford costly new equipment.

When reviewing equipment financing options, companies should consider the following benefits of leasing:

1. Provides companies with a way to manage equipment they may not want long term
2. Gives companies financial access to newer technologies when they need it
3. Leasing can be classified as an operating expense and not as debt on financial statements, reducing the impact on debt-to-equity ratios and liabilities, which can enhance a company’s borrowing capability
4. Cash can be reserved for other uses such as R&D and acquisitions
5. Income taxes may be reduced

No matter how skeptical you may be about equipment leasing, when you consider the potential benefits it pays to explore this valuable financing option. When you do consider leasing, be sure to select a lessor that has experience leasing to the semiconductor industry. The lessor should be familiar with the types of equipment and their general and specific uses. A finance company that has this expertise will be able to present you with a number of alternative financing structures, clearly outlining the benefits of each to help you make the right equipment financing decisions.