Leasing and Financial Intermediation: Comparative Tax Advantages

Abstract

In the past two decades, leasing has developed into an important method of asset-based financing. Spurred by the tax concessions granted in the early 1980s, operating leases have become prime vehicles for financial intermediation. As a result, legal owners of assets may in fact be pure financial agents intermediating between manufacturers and operators of assets. In the past, the academic literature focused primarily on the question of valuation assuming a two party transaction namely, the lessor and the lessee. No distinction was made between the manufacturer and the pure leasing intermediary. (See, for example, [1], [2], [7], and [8].) It is, therefore, unclear if the same analysis holds for both types of lessor. Broadly speaking, the advantages of leasing as a form of financial intermediation stem from two sources reduction in taxes and lower financing costs. Many large leasing transactions have elements of both. The former arises primarily due to differences between the marginal tax rates of the lessor and the lessee. There are many aspects of the latter, but the most important one is related to the transactions cost of adjusting the debt-equity mix of a firm. In this paper, we concentrate on tax considerations. In particular, we examine the conditions under which a pure financial intermediary benefits from entering the leasi g business as a lessor. Obviously, in order to justify the creation of a leasing financial intermediary, between an equipment manufacturer and the user, base on a tax rationale, it must be demonstrated that the tax benefits of the arrangement exceed those when the manufacturer serves directly as the lessor. This may be true because the base for depreciation differs depending on whether the lessor is an intermediary or is the manufacturer of the asset. In a competitive market, it may pay a manufacturer to share the benefits of a higher depreciation base through selling the asset to an intermediary who, in turn, can act as the lessor. Note that in an otherwise identical lease contract, the manuAn earlier version of this paper was presented at the Financial Management Association meetings in Toronto, Canada, 1984. The first author acknowledges the financial support he received from Rutgers. The authors gratefully acknowledge the comments of Robert Taggart, Charles Upton, and the anonymous referees.