14.10Are There Tax Advantages to Leasing?

Up to this point, we have assumed that firms finance their capital assets by raising

either debt or equity capital. This section considers the tax advantages and disadvan-

tages associated with a third financing possibility: leasing the capital assets.

Operating Leases and Capital Leases

As Chapter 2 discussed, an operating leaseis an agreement to obtain the services of

an asset for a period that generally represents only a small part of the asset’s useful

life. For example, one might lease a car for three years. At the end of this period, the

lease may or may not be extended. In a financial lease(also known as a capital lease),

the lease agreement extends over most of the asset’s useful life.

The decision to enter into an operating lease generally relates to the transaction

costs associated with buying and selling the assets. For example, leasing rather than

buying a car makes sense if you need a car for only two months. Other issues relevant

to the “lease versus buy” decision include information about the resale value of an asset,

potential renegotiation problems at the end of the lease (for example, you might want

to keep the asset longer), and incentive problems (for example, you might be likely to

drive a car differently if you leased rather than bought it).

The above considerations are much less relevant for financial leases, which should

be considered more or less as a financing alternative that is equivalent to buying the

asset with borrowed funds. The major difference between buying an asset with bor-

rowed funds and leasing the equipment relates to the timing of payments, which in turn

affects the tax treatment of the two alternatives.

The After-Tax Costs of Leasing and Buying Capital Assets

In general, an organization in a low tax bracket has an incentive to lease equipment

from organizations in higher tax brackets. To understand this, consider the issues faced

by the University of California, Los Angeles (UCLA) when its business school moved

into a new building in 1995. Although the university did not consider the option of

leasing the building rather than buying it, examining the tax advantages of this alter-

native is instructive. We will assume that if the building is owned, it is funded with an

amortizing mortgage over the 50-year life of the building, which we assume is worth-

less after 50 years. To simplify the illustration, the amortization of the mortgage (that

is, its schedule of debt repayments) is assumed to be identical to the economic depre-

ciationof the building, the sum of the building’s loss in market value as it ages plus

the cost of maintaining the building. Because UCLAis a tax-exempt institution, cal-

culating its costs of renting versus owning the building is straightforward. Its yearly

costs of owning the building are

Cost of owning debt repayment interest

(14.10)

Leasing Costs in a Competitive Market.If the leasing market is competitive, the

costs of the lessor, who owns the building, must be passed on to the lessee, who rents

the building, in this case, UCLA. To calculate the cost of leasing the building, assume

that the lessor pays taxes at a rate Tand charges a lease rate that just compensates

c

for these costs, so that each year its after-tax lease revenues equal its after-tax costs.

(Lease payment)

(1 T) debt repayment interest

(1 T)

cc

(depreciation deduction)

T

c

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524Part IVCapital Structure

This equation can be solved to determine the yearly lease payments that allow the les-

sor to break even in each year:

debt repayment(depreciation deduction)

T

Lease payment^c interest(14.11)

1T

c

When Is Leasing CheaperThan Buying?Earlier, we assumed for simplicity that

the mortgage has an amortization schedule for which debt repayment always equals

economic depreciation. Hence, if the building is depreciated for tax purposesat the

same rate that the mortgage amortizes—that is, the depreciation deductionalso equals

economic depreciation—the depreciation deduction and debt repayment are equal. In

this case, equation (14.11) can be rewritten as

Lease payment debt repayment interest

(14.12)

Acomparison of equations (14.10) and (14.12) implies that each annual lease pay-

ment equals the annual cost of owning the building in this case. This implies that a les-

sor who can take advantage of accelerated depreciation—depreciation for tax pur-

poses at a rate that initially occurs faster than economic depreciation (and accordingly,

faster than the debt repayment in the lease’s early years) would profit from the lease

payment stream given in equation (14.12). This is because, holding the sum of an undis-

counted stream of tax benefits constant, the sooner the tax benefits occur, the greater

is their present value. Hence, if the lease payments specified in equation (14.12) make

the asset purchase and attached lease a zero NPVinvestment for an investor who can-

not enjoy accelerated depreciation, the hastened tax benefits from accelerated depreci-

ation must make the same investment a positive NPVone.

Such an investor could easily afford to lower UCLA’s lease payments on the build-

ing and still turn a profit. UCLA, being tax-exempt, and thus unable to enjoy the tax

benefits from depreciating the building, would thus find it cheaper to lease from such

an investor rather than to buy the building outright. The lesson is as follows:

Result 14.8For low tax bracket investors, it is often cheaper to lease an asset than to buy it.

The tax advantage of leasing instead of buying applies not only to tax-exempt insti-

tutions, but also to any institution or corporation that is taxed at a rate less than the

full corporate tax rate. Corporations that are temporarily in a zero marginal tax bracket

often use leases for exactly this reason. Earlier, we suggested that such firms should

use a higher portion of equity financing to minimize the unused tax benefits. Abetter

solution, however, may be to lease equipment which might allow some of the tax ben-

efits, in essence, to be sold to other tax-paying corporations.

Graham, Lemmon, and Schallheim (1998) find that this is indeed the case; firms

with low effective marginal tax rates use fewer operating leases than firms with high

marginal tax rates. Controlling for nontax influences, they conclude that a nontaxed

firm will have an operating lease to value ratio that is 20 percent larger than a firm

that is taxed at the highest marginal tax rate.

Given this analysis, why did UCLAbuy rather than lease its new building? In the-

ory, UCLAcan sell its new building to a taxable investor, invest the proceeds in bonds,

and lease the building back at a rate that is less than the amount it receives in interest

payments. The difference between the lease payments and the interest proceeds would

come from the tax benefits that UCLAwould in effect be selling to the lessor.

Since most of the money for the UCLAbuilding was donated, it might be difficult

to structure a deal that involved a lease. In addition, the IRS might not recognize this

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Markets and Corporate		Financing Choices	Companies, 2002
Strategy, Second Edition

Chapter 14

How Taxes Affect Financing Choices

525

transaction as a true leasefor tax purposes and might disallow the lessor’s tax deduc-

tions. Whether a lease is considered a true lease for tax purposes depends on the intent

of the parties. Specifically, if the IRS rules that UCLA, in effect, owns the building—

that is, it receives all the benefits and takes all the risks associated with ownership—

then the lessor’s depreciation benefits may not be allowed.

To qualify for the tax advantages of leasing, the lessor must take on some of the

risk associated with the appreciation or the depreciation of the asset being leased. As

noted earlier, however, incentive problems can arise when the lessee’s behavior affects

the asset’s value. The lessor will charge the lessee for the costs arising from these incen-

tive problems, which may offset the tax advantages of leasing.