1 Financial and Tax Accounting for Leases INTRODUCTION This chapter will introduce some fundamental Canadian taxation and accounting concepts specific to the leasing industry. How leases are classified for tax purposes as either a capital or an operating lease will be discussed in addition to how a financial statement would record a capital lease from the perspective of both the lessee and the lessor. As well, the capital cost allowance system of tax depreciation will be reviewed. This information is designed to provide a basic overview; applicability to specific situations would need to be determined through consultation with your professional accounting advisors. HISTORY In the early years of leasing, there were no rules to dictate the proper accounting treatment for a lease transaction. CICA Handbook Section 3065 Leases was issued in December 1978, two years after the release of Statement of Financial Accounting Standards (SFAS) No. 13 Accounting for Leases by the US accounting body. The principles set out in Section 3065 make it clear that the details of the lease contract and correspondence related to it can affect the accounting outcome as the substance of the transaction will govern. Between 1978 when the Canadian standard was released and September 1989 when a Study Group commissioned by the CICA Accounting Standards Committee issued its research report Leasing Issues, there was no additional Canadian guidance and instead accountants had to look to the US for interpretive aids as the US accounting body had issued a number of statements, interpretations and technical bulletins to change, interpret or clarify the original accounting standard. Since 1989, the Canadian standard setters have issued a number of pronouncements on specific leasing topics. The Canadian Accounting Standards Board (AcSB) has announced that Canadian generally accepted accounting principles (Canadian GAAP), as we currently know them, will cease to exist for all publicly accountable enterprises as at a target date in From that date onward, publicly accountable enterprises (organizations holding assets in a fiduciary capacity for large or diverse group of users) will be required to report under International Financial Reporting Standards (IFRS). Canada is embracing the position taken by the members of the European Union and other countries around the world that are already requiring the use of IFRSs for publicly listed and certain other entities. The adoption of IFRSs is intended to benefit Canadian enterprises by providing better access to international capital, funding and investment opportunities. There are differences between the accounting treatment for leases under IFRS and existing Canadian GAAP. Key Terms and Concepts Please refer to the CFLA Leasing Glossary for a complete list of terminology relating to this topic.
2 Financial & Tax Accounting for Leases 2 CLASSIFICATION OF LEASES FOR ACCOUNTING PURPOSES In Canada, to determine whether an arrangement is a lease requires an evaluation of whether the arrangement conveys the right to use the underlying tangible assets to a non-owner (the lessee), usually for a specified period of time. The fact that an arrangement is not termed a lease is not determinative of whether such an arrangement is, or is not, a lease. The evaluation of whether an arrangement contains a lease within the scope of lease accounting is to be based on the substance of the arrangement and requires an assessment of whether: Fulfillment of the arrangement is dependent on the use of a specific tangible asset or assets The arrangement conveys a right to use the tangible asset or assets. In general terms, the recommendations require that leases be accounted for according to their economic substance rather than their legal form. The substance is to be determined according to whether the lease transfers substantially all of the benefits and risks of ownership related to the leased property from the lessor to the lessee. Where substantially all of the risks and benefits of ownership are transferred from the lessor to the lessee the lease is considered a capital lease. Leases which do not involve the transfer of substantially all of the benefits and risks of ownership are referred to as operating leases. Lease Classification - Lessee From the perspective of the lessee, at least one of the following conditions must be present at the inception of the lease to lead to the conclusion that a lease transfers substantially all of the benefits and risks of ownership to the lessee: There is reasonable assurance that the lessee will obtain ownership of the leased property by the end of the lease term. Reasonable assurance that the lessee will obtain ownership of the leased property would be present if the terms of the lease would result in ownership being transferred to the lessee by the end of the lease term or when the lease provides for a bargain purchase option; or The lease term is of such duration that the lessee will receive substantially all of the economic benefits expected to be derived from the use of the leased property over its life span. Although the lease term may not be equal to the economic life of the leased property in terms of years, the lessee would normally be expected to receive substantially all of the economic benefits to be derived from the leased property when the lease term is equal to a major portion, usually 75% or more, of the economic life of the leased property; or The lessor is assured of recovering the investment in the leased property and of earning a return on the investment as a result of the lease agreement. This condition would exist if the present value of the minimum lease payments, at the beginning of the lease term, excluding any part of the costs relating to the operation of the leased property, is equal to substantially all, usually 90% or more, of the fair market value of the leased property at the inception of the lease. If at least one of these conditions is met, the lessee would classify the lease as a capital lease. Lease Classification - Lessor In respect of the lessor, leases that do not transfer substantially all the risks and benefits of ownership are considered to be operating leases. If at least one of the three conditions as described above is met, this would indicate a transfer of substantially all of the benefits and risk of ownership to the lessee. Two additional criteria must also be met by the lessor:
3 Financial & Tax Accounting for Leases 3 The credit risk associated with the lease must be normal as compared with the risk of collection of similar receivables; and The amount of any unreimbursable costs likely to be incurred by the lessor under the lease can be reasonably estimated. If the lessor does not have sufficient assurance with respect to these amounts, then the lessor should treat the lease as an operating lease. From the lessor s perspective a capital lease can either be classified as a direct financing lease or a sales type lease. In the case of a direct financing lease, the fair value of the leased property at the inception of the lease is the same as its carrying value to the lessor i.e. no initial profit or loss at inception of the lease. A sales-type lease is one, where, at the inception of the lease, the fair value of the leased property is greater or less than its carrying amount which will result in a profit or loss for the lessor. LEASE ACCOUNTING LESSOR S FINANCIAL STATEMENTS For a lessor, a lease can be classified in one of three ways: as an operating, finance, or sales-type lease. For our purposes, we will concentrate on the booking of direct finance leases and operating leases. Further, we will assume, in the case of direct finance leases, that the lease payments are reasonably assured and that there are no uncertainties surrounding the costs yet to be incurred by the lessor. Finance Leases The amount due to the lessor on a finance lease should be recorded and disclosed as a lease receivable and the amount of finance income (unearned interest) should be deferred and amortized over the term of the lease. A portion of the unearned interest should be taken into income at the inception of the lease to offset any initial direct costs, which are expensed as incurred. In the lessor s financial statements, the investment in the lease shall be recorded at (a) the minimum lease payments receivable, less any executory costs and related profit included therein; plus (b) any unguaranteed residual value of the leased property accruing to the lessor; less (c) unearned finance income remaining to be allocated to income over the lease term. Income from a finance lease is taken to income in such a manner as will produce a constant rate of return on the investment in the lease. A debt incurred by the lessor to acquire the property subject to the direct financing lease remains on the balance sheet as a long-term liability In respect of sales-type and direct financing leases, financial statement disclosure is made of: net investment in leases, segregated between current and long-term portions; method of computing the investment in direct financing or sales-type leases for purposes of recognizing income; the aggregate future minimum lease payments receivable, unearned finance income, unguaranteed residual value, executory costs included in minimum lease payments, contingent rentals taken into income, lease term, and amount of minimum lease payments receivable for each of the five succeeding years
4 Financial & Tax Accounting for Leases 4 Case Study Example The following is an example of a typical lease. The purpose of this example is to explore how the lease would be classified, as either a capital lease or an operating lease, and then how the lease would be accounted for on the lessee and the lessor financial statements. When a lease transfers substantially all the benefits and risks incident to ownership of the leased property: a) the lessee will treat the transaction as an acquisition of an asset and an undertaking of an obligation; and b) the lessor will treat the transaction as a financing when the fair value of the leased property is equivalent to the lessor's carrying value of the property. It also brings out the following points: a) the effect of a guarantee of the residual value on the transaction; and b) the lessee should amortize depreciable property under a capital lease over the lease term unless there is reasonable assurance that the lessee will obtain ownership to the property. In this example the following circumstances are assumed: 1. On January 1, 2007 ABC Lessee Ltd. entered into an agreement to lease a truck from XYZ Lessor Inc.; the details surrounding the agreement are as follows: a. XYZ Lessor Inc.'s carrying value of truck $20,691 b. Fair value of truck $20,691 c. Economic life of truck 5 years d. Lease term 3 years e. Rental payments (at beginning of each month) $620 f. Executory costs and related profit, included in rental payments each month $20 g. Residual value that ABC Lessee Ltd. guarantees XYZ Lessor Inc. will realize at the end of the lease term $3,500 h. Lessee rate for incremental borrowing 12% 2. There are no abnormal risks associated with the collection of lease payments from ABC Lessee Ltd. 3. There are no additional unreimbursable costs to be incurred by XYZ Lessor Inc. in connection with the leased truck. 4. At the end of the lease term, XYZ Lessor Inc. sells the truck for $3, ABC Lessee Ltd. knows the interest rate implicit in the lease. 6. XYZ Lessor Inc. does not take tax factors into consideration when recognizing income from the lease. 7. XYZ Lessor Inc. knows the amount of executory costs and related profit thereon included in the minimum lease payments.
5 Financial & Tax Accounting for Leases 5 Based on the above, ABC Lessee Ltd. would record the lease on their balance sheet as follows: ABC Lessee Ltd. Balance Sheet (extracts) As at December 31st ASSETS Equipment under capital lease (Note X) $14,961 $9,231 LIABILITIES Current: Obligation under capital lease (Note Y) 5,704 9,927 Non-current: Obligation under capital lease (Note Y) 15,631 - Current portion (5,704) - Note X: The following is an analysis of equipment under capital lease: December 31, 2007 December 31, 2008 Equipment (cost) $20,691 $20,691 Accumulated amortization (5,730) (11,460) $14,961 ====== $9,231 ====== Leased property is amortized on a straight-line basis over the lease term to its residual value (i.e. $3,500). The amount of amortization charged to expense: 2007 $5,730 and 2008 $5,730.
6 Financial & Tax Accounting for Leases 6 Note Y: The following is a schedule of future minimum lease payments under a capital lease expiring December 31, 2009, together with the present balance of the obligation under a capital lease. Year ending December 31st $7,440 $ ,940 10,940 18,380 10,940 Amount representing executory costs (480) (240) Amount representing interest (12%) (2,269) (773) Balance of the Obligation $15,631 ====== $9,927 ===== Explanation - ABC Lessee Ltd. ABC Lessee Ltd. would classify the lease as a capital lease since there is evidence that substantially all the risks and benefits incident to ownership of the truck have been transferred from XYZ Lessor Inc. to ABC Lessee Ltd. The terms of the lease provide the following evidence in this regard: a) the present value of the net minimum lease payments covers 100% of the truck s fair value at the inception of the lease. Present Value of Net Minimum Lease Payments Factor for present worth of $1 payable in 35 periodic payments at 1% Factor for initial payment no interest element Periodic payments X $600 $18,245 Factor for present worth of $1 due at the end of the period 1%.6989 Residual value X $3,500 $2,446 $20,691 ======
7 Financial & Tax Accounting for Leases 7 Regarding the lessor s treatment of the same lease, here is how XYZ Lessor Inc. would record this lease: XYZ Lessor Inc. Balance Sheet (extracts) As at December 31st ASSETS Current: Net investment in lease $5,704 $9,927 Non-current: Net investment in lease (Note Y) 15,631 - Current portion (5,704) - Note X: Finance income related to the direct financing lease is recognized in a manner that produces a constant rate of return on the investment in the lease. The investment in the lease for purposes of income recognition is composed of net minimum lease payments and unearned finance income. Note Y: The company s net investment in lease includes the following: December 31, 2007 December 31, 2008 Total minimum lease payments receivable: 2008 $7,440 $ ,940 10,940 18,380 10,940 Unearned income (2,269) (773) Portion of lease payments representing executory costs (480) (240) $15,631 ====== $9,927 ===== Explanation XYZ Lessor Inc.. XYZ Lessor Inc. would classify the lease as a direct financing lease since there is evidence that substantially all the risks and benefits of ownership of the truck have been transferred to ABC Lessee Ltd.
8 Financial & Tax Accounting for Leases 8 LEASE ACCOUNTING - LESSEE FINANCIAL STATEMENTS For a lessee, the payments in respect of operating leases are expensed on a straight-line basis in the determination of net income unless another method is appropriate. In practice, it would be rare for a method other than straight-line to be considered appropriate. If the lease is classified as a capital lease, the lessee should account for the lease as an acquisition of an asset (leased property) and the assumption of a liability (the related rental obligation). The lease is recorded by the lessee at the lower of the fair market value of the asset and the present value of the minimum lease payments, with the latter being calculated using the lower of the lessee s incremental borrowing rate and the rate implicit in the lease. The asset is amortized over the period of its expected use. The period of amortization should be the lease term, unless there is a bargain purchase option or if the terms of the lease allow ownership to pass to the lessee at the end of the lease term, in which case it should be the asset s economic life. Lease payments should be allocated between interest expense and a reduction of the lease obligation, in a manner similar to payments on long-term debt. In respect of capital leases, disclosure is made of: gross amount of assets under capital leases and related accumulated amortization major categories of leased property and accumulated amortization methods and rates of amortization obligations related to leased assets and the particulars of the obligations, including interest rates and expiry dates significant restrictions imposed on the lessee as a result of lease agreements existence and terms of renewal or purchase options not included in the computation of minimum lease payments future minimum lease payments in aggregate and for each of the five succeeding years. A separate deduction is made for the amounts related to executory costs and imputed interest amount of contingent rentals recorded and the basis for determining such rentals amount of future minimum rentals receivable from non-cancelable sub-leases In respect of operating leases, disclosure is made of: future minimum lease payments in the aggregate and for each of the five succeeding years the nature of other commitments under operating leases the basis of determination of any contingent rentals, type of property leased, remaining term of the lease, existence and terms of renewal options and guarantees of the residual value of leased assets KEY CHANGES BETWEEN CANADIAN GAAP AND IFRS Identification of leases Under IFRS, An arrangement that at its inception can be fulfilled only through the use of a specific asset or assets, and which conveys a right to use that asset, may be a lease or contain a lease. Under Canadian GAAP, like IFRSs, an arrangement that at its inception conveys the right to control the use of a specifically identified tangible asset may contain a lease agreement. However, unlike IFRSs, this guidance applies only if the asset is a tangible asset such as property, plant and equipment.
9 Financial & Tax Accounting for Leases 9 Lease classification Under IFRS, A lease is classified as either a finance lease or an operating lease. In respect of lessors, there is a sub-category of finance lease for manufacturer or dealer leases. Lease classification depends on whether substantially all of the risks and rewards incidental to ownership of a leased asset have been transferred from the lessor to the lessee, and is made at inception of the lease. A number of indicators are used to assist in lease classification. Under Canadian GAAP, like IFRSs, a lease is classified as either a capital (finance) lease or an operating lease by a lessee. In respect of lessors, capital leases are categorized as direct financing leases or salestype leases, which differ in certain respects from IFRSs. Like IFRSs, lease classification depends on whether substantially all of the risks and rewards incidental to ownership of a leased asset have been transferred from the lessor to the lessee, and is made at inception of the lease. A number of indicators are used to assist in lease classification, like IFRSs. However, unlike IFRSs, in practice the quantitative thresholds included in certain of the indicators generally are interpreted as "bright lines" and there are fewer indicators to be considered. Measurement Under IFRS, A finance lease is recognized by the lessee at the lower of the fair value of the leased asset and the present value of the minimum lease payments. The discount rate used in determining the present value of the minimum lease payments by the lessee is the interest rate implicit in the lease or, if this is not practicable to determine, the lessee's incremental borrowing rate. The interest rate implicit in the lease is used by lessors. Under Canadian GAAP, like IFRSs, a capital lease is recognized by the lessee at the lower of the fair value of the leased asset and the present value of the minimum lease payments. However, unlike IFRSs, the discount rate used by the lessee in determining the present value of the minimum lease payments is the lower of the lessee s rate for incremental borrowings and the interest rate implicit in the lease. Like IFRSs, the interest rate implicit in the lease is used by lessors. Under IFRS, for a finance lease, the lessor recognizes a finance lease receivable and the lessee recognizes the leased asset and a liability for future lease payments. Under an operating lease, both parties treat the lease as an executory contract. The lessor and lessee recognize the lease payments as income/expense over the lease term. The lessor recognizes the leased asset in its statement of financial position while the lessee does not. Under Canadian GAAP, like IFRSs, under a capital lease, the lessor recognizes a capital lease receivable and the lessee recognizes the leased asset and a liability for future lease payments. For an operating lease, both parties treat the lease as an executory contract. The lessor and lessee recognize the lease payments as income/expense over the lease term, like IFRSs. The lessor recognizes the leased asset in its statement of financial position (balance sheet) while the lessee does not, like IFRSs. EXPECTED CHANGES IN IFRS The IASB and the FASB have issued a joint exposure draft for a new standard on lease accounting for lessees and lessors that would replace IAS 17, Leases, and related interpretations. The new guidance would represent a substantial change from existing IFRS and Canadian or US GAAP guidance. The highlights of the expected changes are as follows: Lessee accounting hasn t really changed much, but some of the key details have and other details are emerging that have not been fully developed. The Boards have now created multiple models that will govern the accounting by lessees and lessors.
10 Financial & Tax Accounting for Leases 10 For lessees, every lease would create an asset (right-of-use asset) and a financial obligation if that asset is not paid for in advance. At a high level this is consistent with what currently happens with finance leases. For lessors, every lease would represent a lending transaction most would apparently involve an executory contract. There are 2 models, it s not a free choice as to which one you apply, and it is a lease by lease assessment. For most leases, lessor would keep leased property on its books, recognize a finance receivable and a lease liability (deferred revenue) for the amount of the non-finance income to be recognized over the lease term, rather than on Day 1. So that makes 2 assets and one liability. This is the Performance Obligation Approach (i.e. used when the significant risks and benefits of the leased asset have been retained (similar to a current operating lease)). For some leases, the lessor will derecognize a portion of the leased property (to reflect the piece given to the lessee and the remainder is reclassified as a residual asset) and potentially recognize non-finance income on Day 1 we ll discuss in more detail later. This is the Derecognition Approach (i.e. used when significant risks and rewards have not been retained (similar to a current finance lease)). From a lessee perspective, the main proposal brings all leases on to the balance sheet. The key impact of this is that there will be an increase in assets and liabilities. This will have an important flow on effect to key ratios, such as debt equity ratios and possibly on compliance with covenants. Its also important to note that bringing extra assets onto the balance sheet will also impact the amount of headroom an entity has in testing for impairment. There will be no increase in cash flows from cash generating units, but there will be an increase in the assets to be covered in the test and the rentals will be removed from the cashflows as they are financing charges. From a profit and loss perspective there will be a front loading of expenses in the early years of a lease, as the lease liability will be amortized similarly to the way a finance lease is amortized today. There is a positive impact on EBITDA, as there will be no more rental expenses above the line and only amortization of the asset and interest expense below the line. It is also important to note that the key changes will also impact existing finance leases, not just operating leases. The new measurement method will require significant judgments, with the contingent rental proposals likely to increase the liability, the residual value changes likely to decrease the liability and the requirement to reassess whenever significant changes occur means there will be more volatility in the profit and loss statement. From a lessor perspective, the following is the impact on profit or loss: Performance obligation approach - front-loading of income in profit or loss, due to amortisation of performance obligation and interest income on lease asset and, no gain recognised on commencement, compared to straight-line lease income for operating lessors and possibility of upfront profit on commencement for finance lessors. Derecognition approach - potential for recognition of gain/loss on commencement of lease, but deferral of income relating to residual asset until underlying is sold or re-let, as residual asset is not re-measured (except for impairment) during the lease term. The final standard is expected to be issued in June 2011; the transition date for this standard is currently unknown.
11 Financial & Tax Accounting for Leases 11 TAX TREATMENT FOR LEASES Classification of Leases for Tax Purposes For Canadian income tax purposes there is no statutory description of what constitutes a lease. Consequently, it is a matter of law as to whether a transaction is considered a lease or a sale. In general, leasing companies and their customers base their determination of whether a lease exists for tax purposes on the legal documents that give effect to the transaction. The courts have generally supported this view except where the documents do not represent the true intentions of the parties to the transaction or the parties conduct themselves otherwise. The courts have made reference to the general case law to determine whether a disposition and acquisition of property has occurred for Canadian tax purposes which will indicate whether a lease or a purchase and sale transaction exists. The Canadian taxation authorities current view is that a taxpayer should follow the legal nature of the transaction, provided that the Canadian Income Tax Act ( the Act ) does not indicate otherwise or where the transaction is considered a sham. Where a sham exists then the Canadian taxation authorities may recharacterize the transaction on the basis that a lease does not exist. While the tax treatment of transactions that are sales for tax purposes is consistent with the accounting result from a lessor s perspective, there can be significant differences in the timing of the recognition of income for tax and financial accounting purposes, particularly in the case of finance leases. Taxation of Lessee The lease payments made by a lessee are generally deductible in computing income for tax purposes to the extent they are incurred for the purpose of earning income from a business or property. As noted above the lessor is entitled to claim tax depreciation since, in the case of a lease, the lessor retains ownership of the property. In certain situations where a lessee leases certain property, it may be advantageous for the lessee to file a joint election with the lessor which deems the lessee to have borrowed an amount equal to the fair market value of the leased property and to have acquired the leased property. Where this election is made, the lessee will be entitled to deduct an amount in respect of the notional interest payment on the notional loan and claim tax depreciation on the leased property in lieu of deducting the lease payments. The filing of this joint election does not impact the ability of the lessor to claim tax depreciation. Where a sale has occurred for tax purposes, the lessee is considered to have acquired ownership of the property. In this case, the payments made by the lessee will not be fully deductible because the payments are considered to be financing payments, which normally consist of a principal portion and an interest portion. For tax purposes, the lessee will be able to deduct the interest portion of any payments. In addition, since the lessee is considered to have acquired the property, Canadian tax depreciation may be claimed. Investment or other tax allowances are generally not available to a lessee. Taxation of Lessor A lessor resident in Canada is required to include, in computing income for Canadian income tax purposes, the gross amount of all lease rentals earned during the taxation year from each of its leases in Canada and abroad. The lessor would be entitled to deduct any outlay or expenditure of a current nature,
12 Financial & Tax Accounting for Leases 12 such as general administration and overhead expenses and certain expenses of a capital nature specifically provided for in the Act. All such expenses are required to be made or incurred for the purpose of gaining or producing income from a business or property and the amounts must be reasonable in the circumstances. With respect to a lessor s finance costs, interest would generally be deductible in determining income for tax purposes provided it can be demonstrated that the borrowed funds were used for the purpose of gaining or producing income; the interest amount was paid pursuant to a legal obligation; and the total interest expense was reasonable in the circumstances. As the beneficial owner of the leased property, the lessor would be entitled to claim tax depreciation on the leased asset for Canadian income tax purposes. Tax Depreciation The capital cost allowance ( CCA ) system is the statutory method for writing off the cost of depreciable assets in determining income for tax purposes. The Canadian government has historically believed that fast write-offs can be major contributor to problems in the tax system, such as the sheltering of income by the use of tax deductions in excess of costs recognized in the financial statements, making many profitable corporations non-taxable. The government has been of the view that the inability of taxpayers to use write-offs generated by tax depreciation claims was a major factor responsible for the phenomenon of the trading of tax deductions and losses. This concern over trading in losses through accelerated tax depreciation claims, the desire to provide fiscal incentives from time to time for both general and specific investments or sectors of the economy, coupled with the intention to reduce corporate and personal tax rates, has led to frequent, often complex changes to the Act and the Regulations in order to protect and stabilize tax revenues. The first set of restrictions affecting equipment leasing were introduced in the 1970 s and were intended to limit the tax benefits of leasing obtained by taxpayers, other than corporations satisfying certain principal business tests. The tax law restricts the amount of tax depreciation which a taxpayer may deduct in computing income for tax purposes in respect of leasing assets to the amount of income earned after deducting all other applicable expenses from the leasing business in the taxation year. Thus, a lessor may not create or increase a loss for income tax purposes from its leasing activities through the use of tax depreciation deductions. However, this tax depreciation restriction does not apply where a corporate lessor is a principal business corporation. A principal business corporation exists when a corporation s principal business throughout the year is the renting or leasing of property; or renting or leasing of property combined with selling and servicing of property of the same general type and description, provided not less than 90 percent of the gross revenue of the corporation for the year is from its leasing business. The next set of restrictions targeting leasing were introduced in the late 80 s and were intended to limit the tax benefits of leasing transactions obtained by principal business corporations. These regulations restrict the amount of tax depreciation that may otherwise be claimed by a lessor to an amount equal to the principal amount of the lease payment, computed under detailed rules, determined on the basis that the lease is recharacterized as a loan. These regulations apply to specified leasing property which includes depreciable property leased for a term of one year or longer provided the property has a fair market value in excess of $25,000 CDN at the time of entry into the lease. Property specifically excluded from this definition includes general-purpose
13 Financial & Tax Accounting for Leases 13 office furniture and equipment or computer equipment costing less than $1 million CDN, motor vehicles, railway cars and real property. These rules require that each specified leasing property be included in a separate tax depreciation class. Consequently, tax depreciation, recapture and terminal losses will be calculated separately for each such property, rather than on a pooled basis. An election is available to a principal business corporation to treat non-specified leasing property in this manner which may be advantageous with short-term leases. Depreciable property acquired by a corporation for use in its business is generally categorized into various classes according to the type of property for Canadian income tax purposes. The tax law prescribes a depreciation rate for each class that establishes the maximum amount of tax depreciation (capital cost allowance) that may be deducted in respect of the particular asset class in a taxation year for income tax purposes. A distinction between the various assets included within a class does not exist; rather, the costs of the individual properties are generally grouped on a pooled basis and tax depreciation is computed by reference to the total undepreciated balance in the class at the relevant time. However, as is described below, where the leased property constitutes specified leasing property, a separate tax depreciation pool is considered to exist for each property. Proceeds received from the disposition of depreciable property are credited to the relevant capital cost allowance class to the extent the proceeds do not exceed the original cost of the assets. Under certain circumstances a recapture of previously deducted tax depreciation may occur or a terminal loss for the undepreciated portion of leased property may arise in the year. In general, the Income Tax Regulations limit the maximum amount of tax depreciation available in the year in which a depreciable property is acquired or is otherwise available for use, to one-half of the amount otherwise available in the taxation year. Within the context of a leasing company, tax depreciation may be claimed at the time the property is first used for the purpose of earning leasing income. An example of the calculation of tax depreciation follows: Example: A lessor leases a telephone system to a customer having a capital cost of $20,000 under a 3 year lease. The asset is a class 8 asset and the tax depreciation rate is 20%. The lessor is a principal business corporation and is entitled to claim tax depreciation in the first year in the amount of $2,000 (20,000 x.2 x 0.5). Tax depreciation in year 2 is $3,600 (18,000 x.2) and year 3 is $2,880(14,400 x.2). Investment or Other Tax Allowances In general terms, a federal Investment Tax Credit is available to a lessor where the lessee uses a leased property in certain economically depressed regions of Canada. The investment tax credit claimed for a year reduces the lessor s taxes payable in the year it is claimed and reduces the undepreciated capital cost of the asset in the following taxation year. SUMMARY Understanding the tax and accounting consequences and treatment of a lease is of primary importance. The leasing professional needs to understand the integral role that accounting and tax treatment have upon the lease and how it affects the parties to the lease. In this chapter we demonstrated how leases are classified, the importance and application of the capital cost allowance for tax depreciation, and we reviewed an example of a lease and how the financial statements would be affected.