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Tata Capital > Blog > Operating Lease vs. Financial Lease: Which one suits your business?

Equipment Lease

Operating Lease vs. Financial Lease: Which one suits your business?

Operating Lease vs. Financial Lease: Which one suits your business?

Every business needs state-of-the-art equipment to enhance productivity, efficiency and accelerate business growth. Upgraded machinery is crucial for the smooth functioning of operations and enables enterprises to stay ahead of the curve and cater to evolving needs of the customer.

As the pandemic prolongs, the decision to invest in machinery could become challenging due to the massive strain on the company’s cash flows. Equipment leasing could be a lucrative option for businesses with limited upfront capital to invest in the latest machinery. 

Equipment leasing is a type of financing option wherein the lessor, the owner of the equipment, allows the lessee to use the equipment for a specified period in exchange for lease rentals. Equipment such as high-tech machinery, computers, vehicles, and industrial equipment, can be financed through leasing.

Equipment leasing has been classified into the following two categories:

Finance lease

A finance lease is usually a long-term agreement wherein the lessor rents the equipment to the lessee with an option to purchase the equipment at the end of the lease period. 

In this option, the lessee bears all the risks and rewards associated with the equipment. The lessee is responsible for maintaining the asset and pay insurance and taxes. The lessee can claim the depreciation and interest expense. 

Businesses prefer financial leases for expensive capital assets when they cannot make the upfront capital investment in procuring the equipment.  

Operating lease.

An operating lease is usually short-term in nature and cancellable at any time before the lease period. It involves lower monthly payments with higher residual value. The lessee can claim a deduction of the lease rentals. 

In this option, the lessor retains the ownership and also bears the risk of obsolescence. The lessor can claim the depreciation to reduce the taxable income.

Businesses resort to operating leases for high-tech assets or those subject to frequent technological upgrades such as computers, office equipment, furniture, and fixtures.

Additional Read: Role of Construction Equipment Finance in growing your business

Choosing between the Operating and Finance lease

It’s essential to select the appropriate leasing option to meet the requirements of the business. Here are a few deciding factors in evaluating before making the right choice.

Frequent Equipment Upgrade.

Is the underlying equipment subject to frequent technological advancements? If yes, then an operating lease might be more favorable than a financial lease. 

The operating lease offers an option to replace obsolete equipment with new ones without high penalties. It is beneficial for asset classes that are subject to regular upgrades. 

Ownership

How important is the ownership of the asset?

Suppose ownership is critical, as is in cases of core manufacturing equipment. It is recommended to go for a finance lease. In a finance lease, the ownership resides with the lessee. It is a less risky option, and owning equipment offers complete control to business owners. Additionally, it is reflected as an asset on the balance sheet, making companies look stronger and demonstrate financial credibility. 

Tax Implications.

The type of lease chosen impacts the tax treatment of related leasing costs.

The finance lease offers the benefit to claim depreciation and interest expense which are reduced from the taxable income. Upkeep, maintenance, and insurance of plant and machinery can also be claimed as a deduction.

In an operational lease, the monthly outflow of lease rentals can be claimed as business expenses. It is tax-deductible and reduced from the overall taxable income.

Reach out to our experts at Tata Capital to access step-by-step guidance on the tax planning for your equipment leasing solutions.

Additional Read: 7 Reasons to Get Equipment Finance for Your Business

Lease Duration.

An operational lease is a contract where the lessor permits the lessee to use the asset for a period shorter than the asset’s economic life without the transfer of ownership rights. It is majorly undertaken for the assets that are high-tech or prone to technological changes like computers and office equipment. 

However, the financial lease is a long-term lease where the tenure of the lease must be 75% or greater of the asset’s useful life.     

Conclusion 

Investing in new equipment and machinery is essential for the growth of any business. Equipment leasing is an excellent option to upgrade machinery regularly. 

Financial and Operational lease each have their own merits. Depending upon the long-term and short-term requirements, a business may opt for the most suitable leasing solution.

To make the right choice between the leasing options available, reach out to Tata Capital’s expert leasing team.

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