History of Equipment Leasing

The History of Leasing by Canadian Finance & Lease Association (CFLA), Source Article Click Here

Selected by: John Elliott of Jocova Financial

The idea of equipment leasing was born thousands of years ago and is one of the oldest professions. The following is a detailed account of the history of equipment leasing sourced from the CFLA. The piece is organized to guide you through all the major era’s in equipment leasing, markets, types of leasing companies that have developed, regulation, and roles of government. It also details how the industry has evolved into modern day equipment leasing products that businesses and equipment dealers use every day.

Leasing: An Industry in Transition

Corporate Canada’s largest external source of financing equipment acquisitions is, after banks and credit unions, leasing. It is the fastest growing form of business investment. The Task Force on the Future of the Canadian Financial Services Sector reported that in December 2004 the equipment and vehicle leasing industry’s portfolio was estimated to be worth $103.1 billion.

Companies lease everything from printing presses to power plants, hay balers to helicopters and office copiers to offshore drilling rigs. Eight out of ten companies, from mom and pop proprietorships to the Fortune 100, have turned to leasing.

How did we get here? Let us explore its rich history. As we review this history, we’ll refer to many of the legal, accounting and Canadian Revenue Agency rulings pertaining to the leasing industry. While we won’t get in to specific details, we’ll outline the myriad of ever-changing regulations to help you understand where the industry has been and where it may be going.

Early Background

Equipment leasing is one of the world’s oldest professions. The ancient Sumerians evidently produced leases on clay tablets for agricultural tools, land and water rights, oxen and other animals. The City of Ur clay tablets pre-date 2000 BC and, although leasing may have been transacted earlier, these are the oldest “hard evidences” found. According to the research there is a record of Babylonian leasing law, by King Hammurabi, dating back to 1700 BC (Code of Hammurabi).

Many ancient civilizations used leasing as a financing tool, including the Greeks, Romans, Egyptians and Phoenicians. According to manuscripts and historical data, these societies found leasing to be the only viable and affordable way to finance equipment, land and livestock. The Phoenicians used a “ship charter”, which closely resembled today’s pure equipment lease. The Phoenicians were shipping and trading experts who used the ship charters for obtaining the use of a crew and ship. As a matter of fact, the longer-term ship charters covered the economic life of the ship and required the lessee to assume the benefits and obligations of ownership. Today, in negotiating leases, we wrestle with many of the same issues that were dealt with in these ancient ship charters.

At the beginning of the Medieval Ages, various types of agricultural, industrial and even military equipment were leased. In 1066 AD two invasion fleets, sent to England by the Norwegians and the Normans, were both leased. They utilized forms of lease financing to gain the use of the ships and crews. As this historical age moved on, leasing was limited to mostly horses and farming equipment. The leasing of personal property in England was not recognized under English common law, but long-term leasing of real property was allowed. However, in 1284 AD, the Statute of Wales was written and this law dealt directly with the leasing of personal property. It was further clarified in 1571 by a statute that defined who actually owned the leased equipment.

The Railroad Era

With the onset of the Industrial Revolution in the UK and North America came more opportunities for leasing, particularly for railroads. All of these opportunities followed the same pattern. Brand new equipment was needed for manufacturing or transportation and investors provided the capital. Most of the early railroad companies were only able to afford the laying of the track, so they sought financing from private entrepreneurs for the locomotives and railcars. In the 1700’s in the United States, liverymen leased horses, buggies and wagons. However, the railroad industry brought the first real growth of leasing to Canada and the United States as it did in Europe.

Investors provided financing for locomotives and railcars through equipment trusts. Banks or trust companies set up and administered these trusts, issuing an equipment trust certificate. The certificate represented the right of the holder to receive a return of principal and interest on their invested funds. The trust administrator would pay the manufacturer for the equipment and then sell these trust certificates to investors. The administrator collected the rentals from the railroad company, which covered the cost of the equipment and the interest; the most common form of the trust certificate provided for the transfer of ownership of the equipment to the railroad company at the end of the term. The most well known of these railroad finance plans was the Philadelphia Plan and it is considered to be the precursor of today’s conditional sales contract and money-over-money leases.

The Recent Years

While leasing can be traced back thousands of years, it has evolved considerably over the last fifty or so. The industry has grown from being a manufacturer-selling technique into a specialized financial service with the formation of the first independent leasing company in 1952 in the United States. The industry extended to Europe and Japan in the 1960s, then to Canada, and has been spreading throughout developing countries since the mid-1970s. By 1994, leasing had been established in over 80 countries.

More recently, we have witnessed the significant growth of independent financing companies of all size from the very large operating in dozens of countries, to a myriad of small and medium-sized businesses specializing in the financing of particular kinds of equipment and vehicles.

Leasing companies in Canada are pioneering joint venturing, out-sourcing, partnering other services out or creating alliances for financing risk sharing. In many ways, they are symbolic of changes the financial services sector is undergoing. Their innovative products and services are a driver of change in financial services.

The International Market

To put this industry’s growth in some perspective, just over twenty-five years ago, in 1978, annual plant and equipment leasing volumes worldwide (excluding vehicles and real estate) were about US$40 billion. By 1986, plant and equipment leasing had grown to almost US$175 billion and by 2004; worldwide annual plant and equipment leasing volumes had grown to US$511.66 billion. In 2004, Canada ranged seventh in the world in annual plant and equipment leasing.i

Assets leased range from office photocopiers and printers to airplanes, construction equipment, rail cars, agricultural equipment and grain bins and commercial vehicles.

According to both the United Nations and the World Bank, in 1994 an eighth of the world’s private investment was financed through leasing; a third of the OECD countriesii, private investment is financed through leasing; in both middle and low-income countries, leasing doubled between 1988 and 1994.iii

The Canadian Market

In 1998, the federal (MacKay) Task Force on the Future of the Canadian Financial Services Sector reported that the assets of the asset-based financing and leasing industry in 1997 totaled $50 billioni. By 2004, the value of the assets of the industry had increased over 100% to $103.1 billion.

At December 31, 2004, the industry’s portfolio of assets (owned and managed) was estimated to be worth $103.1 billion .

• Equipment financing companies = $48.4 billion

• Business vehicle fleet financing companies = $8.0 billion

• Consumer vehicle financing companies = $46.9 billion

Around 25% of annual new business investment in machinery, equipment and commercial vehicles is financed through leasing, which is a significant advance from only 5%, just 15 years ago.

On the vehicle financing side, over the five years 1998-2003 nearly 8 million new passenger and light trucks were sold in Canadavi of which over 40% were leased. In 2004, of the 1,534,400 total passenger and light vehicles sales in Canada, vii approximately 43% (about 660,000) were acquired by way of lease (88% by consumers and 12% by business customers – vehicles for management, sales forces, maintenance/repair services, general transportation and deliveries.)viii

Independent Leasing Companies

Independent leasing companies formed in the early 1900’s. These companies recognized that many railroad companies and other types of end users were not interested in long-term control or ownership of the leased asset, which was an inherent part of the equipment trust (bank) program. They began to offer more short-term contracts or leases, with which, at the expiration of the term, they would retain title and control of the equipment. At the end of the term, the railcar was to be returned to the leasing company; this type of lease financing was the beginning of the true or operating leases, which are still common today.

Other manufacturers, because of capital limitations, had to work with independent financial concerns to set up vendor finance programs, if they wanted to retain control of their customer or equipment. The independent companies, which were formed to provide vendor financing were, and are today called third-party leasing companies. They earned that categorization, as they were not related to either the manufacturer or the end-user. After World War II, as manufacturers sought to upgrade and modernize their operations, leasing as a viable financing tool continued to grow, leading us into the “modern” era of equipment leasing.

More recently, there has been significant growth of independent financing companies of all sizes from the very large operating in dozens of countries, to a myriad of small and medium-sized businesses specializing in the financing of particular kinds of equipment and vehicles.

Captives

Many manufacturers saw the benefits of providing financing for their products, going so far as to set up their own finance companies, today called captives. Some companies felt leasing was a method of retaining control of their proprietary equipment. Companies such as Caterpillar Financial, Ford Credit and John Deere Credit are examples of captive leasing companies.

During the early 1900’s, the economy was experiencing real growth and there was a surge of installment credit borrowing. Manufacturers wanted to sell more equipment and they felt by offering affordable payment plans they would be able to do so. Ford had already begun offering automobile loans for people wanting to buy cars and other manufacturers selling to companies used equipment leasing to move their products. This was the start of “vendor” leasing programs, as we know them today. Manufacturers were not only able to offer financing; they also felt that they could protect proprietary product information by retaining ownership of the equipment.

These captive finance companies are an integral part of the production and sales cycle of their manufacturer parent. They are a key part of the relationship linking the manufacturer to the dealer and distributor to the customer. Interestingly, captives start off offering to finance their parents’ products but once they understand the business, many expand their horizons to finance not only similar products made by other manufacturers but to finance products their parent company does not manufacture at all.

Tax and Accounting for Leasing

The leasing industry has matured in Canada; leasing is now an accepted financial alternative to purchases for many kinds of assets. One sign of this maturity is the accounting profession’s highly developed guidance on how different forms are leases are treated for tax purposes.

In Canada the Canadian Institute of Chartered Accountants (CICA) governs the accounting of leases, from both the perspective of the lessee and the lessor. The CICA produced a Handbook with guidance for all aspects of accounting; the section that is relevant to leasing is section 3065. In the United States, the equivalent to the CICA standards is the Financial Accounting Standards Board (FASB) which is a board established by the American accountants to set accounting standards. Statement No. 13 of the Financial Accounting Standards Board (FASB 13) set forth comprehensive guidelines for both lessor and lessee book accounting, giving greater uniformity to the financial reporting of equipment leases. Both CICA section 3065 and FASB 13 are updated to provide further clarification and guidance and to adjust to the new forms of leasing.

Under CICA section 3065, there are two primary types of leases: operating leases and capital leases. An operating lease does not transfer substantially all the benefits and risks incident to ownership of property; therefore the lessee can generally expense the lease rental payments. On the other hand, a capital lease transfers substantially all of the risks and benefits of ownership of the leased property to the lessee. In the case of a capital lease, the lease is generally amortized over a specific period and the lease rental payments are not expensed, but the accumulated amortization is expensed. A capital lease, as defined by the CICA, can take several forms. It could include a full-payout lease, also known as a full-term lease, which is a lease in which the lessor recovers, through the lease payments, all costs incurred in the lease plus an acceptable rate of return, without any reliance on the leased property’s future residual value. A capital lease can also refer to the auto industry’s “open-end lease”. This refers to an auto lease where the lessee guarantees the residual or “end value” of the vehicle at the termination of the lease. The lessor receives the periodic rentals plus the end value to provide the return on capital investing in the automobileix.

For tax guidance in Canada, the Income Tax Act, R.S.C. 1985, c. 1 (5th Supp.) referred to as the “ITA”, provides details on all tax related issues, and more specifically permits the deduction of the cost of a fixed asset, in the form of annual capital cost allowances (CCA), at a variety of rates.

More specifics of current accounting and tax issues in Canadian leasing are explored in the chapter titled “Financial and Tax Accounting for Leases”.

As a comment on the current government policy in Canada pertaining to tax, it does not encourage investment in machinery and equipment to the degree that economic research suggests would be optimal.

Modern Day Leasing

With the maturity of the leasing market, the industry has consolidated. During the 1990s, the larger companies had an advantage over the smaller niche or boutique players. The larger companies achieved economies of scale and service broad segments of the industry. These large, well-capitalized lessors had good access to funding while the small, niche participants were either regionally based or focused on a particular sector. Mid-sized companies have almost disappeared as a result of this consolidation.

With large players controlling more of the leasing market, there has been a shift toward a more disciplined approach to leasing. The downturn in the leasing cycle has made this back-to-basics approach all the more important. With the maturing of the industry, there is unlikely to be a return to the free wheeling practices of the 1990s. There are now more parallels between leasing as a financial instrument and other debt instruments. As a result, leasing credit policies and procedures are increasingly similar to those in place for traditional lending.x

Modern Day Banks

Banks that want to enter the leasing business face significant hurdles. The most significant one is a restriction on the size of the residual position. (That refers to the amount of the original asset cost that the lessor does not finance and instead hopes to recover at the termination of the lease. It can be taken both on a single transaction basis and as a percentage of the portfolio.) The Bank Act of Canada, which governs Canadian banks, limits residuals to 25% on any one transaction and a 10% residual on a portfolio as a whole. In addition, Canadian banks are prohibited from leasing automobiles.

Growth of Regulation Continues Capital tax repeal

Government regulation is very important for the future of the Canadian leasing industry. One key issue is the federal Large Corporation Tax and provincial capital taxes. Capital taxes are undoubtedly a factor inhibiting investment in productive assets. If they were lowered or eliminated, companies would buy more assets for their business, and many would be financed through leasing. After years of debate, there has been some significant progress. In September 2002, British Columbia eliminated its capital tax. In their 2003 spring budgets, both the federal and Ontario governments provided for the gradual elimination of their capital taxes over the next five years. In Quebec, however, the previously approved gradual reduction in provincial capital tax by January 1, 2007 was suspended in June 2003.

Federal government demands under the “super-priority” interrupted

Several years ago, the federal government amended the Income Tax Act to give itself legal authority to seize leased assets or to demand from lessors the proceeds of sale of repossessed leased assets. The purpose was to compensate the government for employee federal income tax deductions and federal sales tax not remitted by a customer. In 2002, several successful Court of Appeal decisions favoring lessors, together with continuing negotiations between the Canadian Finance & Leasing Association and the federal Department of Finance, seem to have caused the federal government to interrupt its activities – at least temporarily.

Toward elimination of vehicle lessor “vicarious liability”

The Canadian Finance & Leasing Association has undertaken an initiative to eliminate or limit the statutory obligation of vehicle lessors under provincial “vicarious liability” legislation. These are laws that make the vehicle’s “owners” – that is the lessors – legally liable for the operation of their vehicles. In The History of Leasing several Canadian jurisdictions (British Columbia, Newfoundland, New Brunswick, Nova Scotia, Prince Edward Island and Quebec), lessors do not have to worry for the moment; vehicle vicarious liability is either limited or non-existent. Elsewhere, however, vehicle lessors are receiving an increasing number of claims every month, most in excess of C$1 million each. This issue is currently being challenged in many courts across Canada and remains one of the most important issues in Canadian leasing.

Federal government pilot project to guarantee small business capital leases

In 2002, after almost eight years of lobbying by the Canadian Finance & Leasing Association, the federal government launched a five-year pilot project to guarantee qualifying capital leases up to C$250,000 for eligible small business customers under the Canada Small Business Financing Act (SBLA). The pilot guarantees up to 85% of a lessor’s eligible losses on capital leases in the event of default. This program is the first of its kind in the world. While a few members are offering the program, a much larger number have been prevented from doing so because of unanticipated regulatory obstacles. The Canadian Finance & Leasing Association continues to work with Industry Canada to address these problems.xi

Summary

The technological revolution had a major impact upon the growth of leasing, as we know it today. Firms began to recognize the value of having the use of equipment or vehicles, rather than owning it. Also, with continuing advances in technology, leasing has become a flexible way to hedge against obsolescence, while allowing a firm to gain the use of the most up-to-date technology. Computers, telecommunications and office equipment spurred the growth of leasing. Manufacturers in these industries realized the benefits of leasing equipment. It was not only a convenience for the end-user but also an effective sales tool for the manufacturers seeking to increase their markets.

In the early part of the “modern era”, manufacturers used leasing to keep control of their products and limit others from learning proprietary information about their products by retaining ownership. Many manufacturers created in-house leasing companies, captives, to handle the leasing needs of their customers and gain additional profits, not for control of technological information. The independent leasing companies inching into these new markets also fared very well and grew rapidly.

The Equipment and Vehicle Leasing Industries have proven to be one of the most resilient financial services. Despite struggling with varying economic conditions, leasing is still a predominant force in capital asset financing. Leasing has shown a unique ability to adapt and thrive in an ever-changing economic and regulatory environment, producing new and innovative financial products. While many companies have disappeared, new companies have formed and gained market share.

The leasing industry is now mature and represents a stable percentage of total equipment and vehicle purchases. But to stay competitive, leasing companies must continue to differentiate themselves, their products and services.

Interested in Getting the Best Equipment Leasing & Financing Rates

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i According to the London Financial Group Leasing Report, published in the World Leasing Yearbook 2005 (Euromoney Publications, Colchester, U.K.), the global annual (2004) leasing volume for plant and equipment (excluding vehicles and real estate) was US$511.66 billion. On the basis of annual lease volume, the top ten countries are the United States, Japan, Germany, France, Italy, the United Kingdom, Canada, Spain, Australia and Switzerland ii The 30 member states of the OECD (Organization for Economic Co-operation) include Canada, the United States, the member countries of European Union, Japan, Korea, Australia, the Czech Republic, Poland, Hungary and Mexico The History of Leasing 7 ©Canadian Finance & Leasing Association – December 2007 iii Leasing – Lessons of Experiences, The United Nations Economic Commission for Europe. A conference room paper prepared within the framework of the Regional Advisory Services Programme of the Coordinating Unit for Operational Activities of the United Nations Economic Commission for Europe for the Project Group on Financial Policies for Strengthening SMEs through Microcredit and Credit Guarantee Schemes of the Southeast European Cooperative Initiative (SECI), Geneva, June 1997, at page 4 iv Report of the Task Force on the Future of the Canadian Financial Services Sector, September 1998, at page 43 v Annual Survey of Asset-based Financing and Leasing in Canada, The Centre for Spatial Economics, Milton, Ontario, 2005, at page 11 vi Desrosiers Automotive Consultants Inc., Richmond Hill, Ontario vii Desrosiers Automotive Reports, Market Snapshots, Richmond Hill, Ontario, November 2005 viii Report of the Task Force on the Future of the Canadian Financial Services Sector, September 1998, at pages 25- 26 ix Leasing In Canada – A Business Guide, Third Edition, Ralph F. Selby, PricewaterhouseCoopers LLP, 1999, page 1 x Asset-based Financing and Leasing in Canada – An Overview, 2004, by David Powell, President of the CFLA xi Asset-based Financing and Leasing in Canada – An Overview, 2004, by David Powell, President of the CFLA

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