Why Firms Lease Short-Lived Assets: A Tax-Based Explanation · 2019-02-13 · why firms lease...

canadian tax journal / revue fiscale canadienne (2008) vol. 56, no 3, 639 - 60

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Why Firms Lease Short-Lived Assets: A Tax-Based Explanation

Ling Chu, Robert Mathieu, and Ping Zhang*

P r é c i s

Les auteurs étudient l’impact de la vie utile des biens utilisés par les entreprises au Canada sur leurs décisions de les louer ou non. Leur analyse théorique fait voir que les entreprises sont d’autant plus enclines à louer des biens qui ont une vie utile brève. En particulier, ils montrent que dans un marché de capitaux concurrentiel, il existe une relation directe entre la baisse des paiements de location et la hausse des taux d’impôt du locateur. En conséquence, la vie utile d’un bien est un facteur pertinent dans la décision de le louer ou non, puisque les taux d’impôt du locateur sont moins susceptibles d’être élevés à long terme, ce qui donne lieu à des frais de location plus élevés et à une réduction des activités de location. À l’aide d’un échantillon de sociétés canadiennes cotées en bourse, les auteurs présentent également une preuve empirique que la vie d’un bien est négativement liée à la quantité de biens qui sont loués par une entreprise.

A b s t r A c t

The authors examine the impact of assets’ useful lives on firms’ leasing decisions in Canada. Their theoretical analysis demonstrates that firms are more likely to lease assets with shorter useful lives. More specifically, they show that in a competitive financing market, lease payments are a decreasing function of lessors’ tax rates. Therefore, the useful life of an asset is relevant in leasing decisions because lessors’ tax rates are less likely to remain at the highest level over a longer horizon, leading to higher leasing costs and less leasing activity. Using a sample of publicly traded Canadian companies, the authors also provide empirical evidence that the useful life of an asset is negatively associated with the proportion of assets leased by a firm.

Keywords: Leases n capitaL cost aLLowance n cca n capitaL investments

* LingChuandRobertMathieuareoftheSchoolofBusiness&EconomicsatWilfridLaurierUniversity,Waterloo,Ontario;PingZhangisoftheRotmanSchoolofManagementattheUniversityofToronto.TheauthorswouldliketothankTheresaLibby,AlanMacnaughton,threeanonymousreferees,andparticipantsattheEuropeanAccountingAssociation2008annualconferencefortheirhelpfulcomments.FinancialsupportforthisprojectwasprovidedbytheCA/LaurierCentrefortheAdvancementofAccountingResearchandEducationandbytheSocialSciencesandHumanitiesResearchCouncilofCanada.

640 n canadian tax journal / revue fiscale canadienne (2008) vol. 56, no 3

intro duc tio n

Formostfirms,leaseliabilitiesaccountforasignificantportionoftotalliabilities.TheEquipmentLeasingAssociationstatesinarecentsurveythat8outof10companiesleasesomeoralloftheirequipment.Infact,theleaseliabilityhasbeendeterminedtorepresentmorethan40percentofallfixedclaims for theaveragefirmwherefixedclaimsaredefinedasthesumofthebookvalueofalllong-termdebt,thebookvalueofallcapitalleases,andthepresentvalueofallfutureoperatingleaseobliga-tions.1Therefore,itisimportanttounderstandinwhatsituationsleasingisacheaperformoffinancingthandirectborrowing.Inthisarticle,weinvestigatetherelation-shipbetweentax-relatedleasingcostsandassets’usefullivesboththeoreticallyandempirically.

PrevioustheoreticalandempiricalstudiesconsideringtheeffectoftaxesonleasingdecisionsincludeMillerandUpton;2Myers,Dill,andBautista;3AngandPeterson;4

c o n t e n t s

Introduction 640Tax Treatment of Leases in Canada 642

Specified Leasing Property Rules 644The Theoretical Analysis 645

The Setting 645The Empirical Analysis 648

The Methodology 648The Results 652

Conclusion 656Appendix 657

Basic Assumptions 657Interest on a Loan 657The Tax Shield (CCA) from an Owned Asset 659Present Value of the Lease After Tax for the Lessor 659The Costs of Financing a Purchase Versus Leasing the Asset for the User 660

1 SeeWeiliGe,“Off-Balance-SheetActivities,EarningsPersistenceandStockPrices:EvidencefromOperatingLeases,”AmericanAccountingAssociation,2006FinancialAccountingandReportingSectionMeetingPaper(online:http://www.ssrn.com/abstract=816044).

2 MertonH.MillerandCharlesW.Upton,“Leasing,Buying,andtheCostofCapitalServices”(1976)vol.31,no.3The Journal of Finance761-86.

3 StewartC.Myers,DavidA.Dill,andAlbertoJ.Bautista,“ValuationofFinancialLeaseContracts”(1976)vol.31,no.3The Journal of Finance799-819.

4 JamesAngandPamelaP.Peterson,“TheLeasingPuzzle”(1984)vol.39,no.4The Journal of Finance1055-65.

why firms lease short-lived assets: a tax-based explanation n 641

KrishnanandMoyer;5Shanker;6andGraham,Lemmon,andSchallheim.7However,thesestudiesdonotconsidertheimpactofassets’usefullivesonfirms’leasingdeci-sions.Themainobjectiveofthisarticleistoexaminetheimpactofassets’usefullivesontheleasingdecisionsunderthecurrentCanadianincometaxlaw.Inouranalysis,werelatetaxrateuncertaintyinfutureperiodstothecostsandbenefitsofleasing.WethenempiricallytestourpredictionsusingasampleoffirmstradedontheTorontoStockExchange(TSx)inthe2005fiscalyear.Thisanalysisisparticularlyusefulfortaxpractitionerswhoassisttheirclientswiththedecisionsonwhethertoleaseorbuyassets.

Empiricalstudieshavetestedearliermodelsthatpredictedagreateruseofleasesbyfirmswithlowtaxrates.Evidenceonthistopicismixed.Whilesomestudiesfailtosupporttheexistenceofanegativerelationshipbetweenthetaxrateandtheuseofleases,8morerecentworkdocumentsevidenceconsistentwithearliermodels.Forexample,SharpeandNguyen9usethepresenceofoperatinglosscarryforwardstoproxyforfirms’marginaltaxrates.Theirresultsindicatethatfirmswithlosscarry-forwards(thatis,lowtaxrate)havemoreleases.Graham,Lemmon,andSchallheim10avoidendogeneityproblemsinmeasuringtaxbyusingtaxratesbeforeconsideringthefinancingeffects.Usingthismeasure,theyprovideevidenceofanegativeasso-ciationbetweentheuseofleasesandtaxrates.UsingCanadiandata,Shanker11alsoexaminestheassociationbetweentaxratesandtheuseofleases.Shefindsthatfirmswithhighermarginaltaxratesarelesslikelytouseleases.

Ourstudycontributestotheliteratureinseveralways.First,wedevelopamulti-periodmodelthatallowsforuncertaintyinthelessors’futuretaxrates.Thus,weareable topredict that leasingdecisionsarenegativelyaffectedbyassets’usefullives.Wethenempiricallytestourprediction.Toourknowledge,thisisthefirstarticletostudytherelationshipbetweenassets’usefullivesandtheleasedecisions.Theempiricalanalysisprovidesevidencethattheusefullivesofassetsarenegativelyassociatedwiththeproportionofleasesheldbyfirmsinoursample.Theseresultssuggestthatassetswithlongerusefullivesarelesslikelytobeleased.Thecoefficientonthediscountrateisinsignificantlyconsistentwithourexpectationthattheimpact

5 V.SivaramaKrishnanandR.CharlesMoyer,“BankruptcyCostsandtheFinancialLeasingDecision”(1994)vol.23,no.2Financial Management31-42.

6 L.Shanker,“TaxEffectsandtheLeasingDecisionsofCanadianCorporations”(1997)vol.14,no.2Canadian Journal of Administrative Sciences195-205.

7 JohnR.Graham,MichaelL.Lemmon,andJimS.Schallheim,“Debt,Leases,TaxesandtheEndogeneityofCorporateTaxStatus”(1998)vol.53,no.1The Journal of Finance131-62.

8 See,forexample,AngandPeterson,supranote4,andKrishnanandMoyer,supranote5.

9 StevenA.SharpeandHienH.Nguyen,“CapitalMarketImperfectionsandtheIncentiveToLease”(1995)vol.39,no.2-3Journal of Financial Economics271-94.

10 Supranote7.

11 Supranote6.


ofthisvariableinthedecisionismarginal.Alsoconsistentwithourexpectation,thetaxvariablesareinsignificant.Finally,othervariablessuchasleverageratio,workingcapital,proportionofcapitalassets,andsizeofthefirmaffectthedecisiontoleaseassets.

Thearticleproceedsasfollows.Wediscussthetaxtreatmentsofleasesinthenextsectionandthenweintroduceourmodel.Wepresenttheempiricaltestsofourtheoreticalpredictionandfinallywemakeconcludingremarks.

tA x tre Atment o f Le A se s in c A n A dA

Aleaseisacontractallowingafirm(thelessee)touseanassetthatisthepropertyofanotherparty(thelessor)inexchangeforleasepayments.Attheendoftheleaseterm,theassetcanbereturnedtothelessor,andthelesseemayormaynotguaran-teetheresidualvalue.Alternatively,theownershipoftheassetcanbetransferredtothelesseeattheendoftheleasetermthroughabargainpurchaseoptionorwithoutconditions.Althoughthelessorretainsthelegalownershipoftheassetthroughouttheleaseterm,theleaseconditionscouldbesuchthatthelesseeenjoysmostofthebenefitsassociatedwiththeownershipoftheasset.

Acontractcanbetreatedasatrueleaseorapurchasefortaxpurposes,depend-ingonthetermsofthecontract.Thedistinctionbetweenleaseandpurchasehasadirectimpactonthetaxtreatment.Ingeneral,theCanadiantaxtreatmentforatrueleaseisasfollows:thelesseedeductstheleasepaymentsasleaseexpenses,andthelessorrecognizestherentalincomeanddeductsfromitthecapitalcostallowance(CCA)andotherrelatedexpenses.Ifthelegalrelationshipinthecontractisapur-chase,theacquiringfirmdeductstheCCAandtheinterestexpense,andthesellingfirmrecognizesagainorloss,whichmaybeacapitalgainorbusinessincomede-pendingonthenatureoftheassetandotherfactors.

Thedeterminationofatransactionas“leaseorpurchase”fortaxpurposeshasevolvedovermanyyears.TheCanadaRevenueAgency’s(CRA’s)Interpretation BulletinIT-233R12wasintendedtostopabusesinleasearrangementsituationswheretheeconomicsubstanceofthetransactionsbetweenthepartiesreflectedasale,butthelegalformwasalease.IT-233Rclearlysuggestedasubstance-over-formdoctrine,whichhasalsobeenusedintheCanadianaccountingstandardsfortheclassificationofleases.Inparticular,theinterpretationbulletinsetoutfoursituationsthatwouldbeconsideredcapitalleasesratherthanoperatingleases:

1. thelesseeautomaticallyacquirestitleafterpaymentofaspecifiedamountintheformofrentals;

2. thelesseeisrequiredtobuythepropertybeforeoratlease-endorattheter-minationofthelease,orisrequiredtoguaranteethatthelessorwillreceive

12 Interpretation BulletinIT-233R,“Lease-OptionAgreements;Sale-LeasebackAgreements,”February11,1983.


thefulloptionpricefromthelesseeorthirdparty(exceptwheresuchguar-anteeisgivenonlyinrespectofexcesswearandtearinflictedbythelessee);

3. thelesseehastherightduringoratlease-endtobuythepropertyatanoptionpricethatattheinceptionoftheleaseissubstantiallylessthantheprobablefairmarketvalueattheoptiondate;or

4. thelesseehastherightduringoratlease-endtobuythepropertyatanoptionpriceorundertermsandconditionsthatatthelease’sinceptionaresuchthatnoreasonablepersonwouldfailtoexercisesuchoption.13

Onthebasisoftheabove,iftheeconomicsubstanceofaleasecontractisnotatrueleasebutapurchasefromthelessee’sperspective,thenitistreatedasacapitallease.Thetaxconsequencesarethesameaswithanyotherpurchaseoncreditorin-stalmentsales.Thesesituationsshowthatthelegalrelationshipofacontractisnottheonlyfactortodifferentiateoperatingleasesandcapitalleasesfortaxpurposes.

PrinciplesusedinthedeterminationofleaseorpurchasestatusevolvedfurtheraftertheShellcase.14InShell,theSupremeCourtofCanadastated,

[T]hisCourthasneverheldthattheeconomicrealitiesofasituationcanbeusedtorecharacterizeataxpayer’sbona fidelegalrelationships.Tothecontrary,wehaveheldthat,absentaspecificprovisionoftheActtothecontraryorafindingthattheyareasham,thetaxpayer’slegalrelationshipmustberespectedintaxcases.Recharacterizationisonlypermissibleifthelabelattachedbythetaxpayertotheparticulartransactiondoesnotproperlyreflectitsactuallegaleffect.15

AsaresultoftheShellcase,IT-233RwascancelledonJune14,2001.16TheCRAstatedthatthedeterminationofwhetheracontractisaleaseorapurchaseisbasedonthelegalrelationshipscreatedbythetermsoftheparticularagreement,ratherthanonanyattempttoascertaintheunderlyingeconomicreality.Inaddition,attheCanadianTaxFoundation’s2000annualconference,CRAofficialsstatedthatthelegalrelationshipbetweenthepartiestothecontractdistinguishesbetweenatrueleaseandapurchase,notsimplythedocument’sself-referencingasaleaseorabuy.17Auto-maticownershipofpropertyaftersomerentispaidisviewedasaconditionalorinstalmentpurchaseandnotasalease.TheCRAfurtherstatedthatitspolicyonthegeneralanti-avoidancerule(GAAR)18remainsunchanged:itwillcontinuetoapply

13 Ibid.,atparagraph3.

14 Shell Canada Limited v. The Queen et al.,99DTC5669(SCC).

15 Ibid.,atparagraph39.

16 CanadaRevenueAgency,Income Tax Technical Newsno.21,June14,2001.

17 RoyShultis,MichaelHiltz,VanceSider,andJudithWoods,“JudicialandAdministrativeDevelopments,”inReport of Proceedings of the FiftySecond Tax Conference,2000ConferenceReport(Toronto:CanadianTaxFoundation,2001),36:1-21,at36:8-10.

18 Section245oftheIncomeTaxAct,RSC1985,c.1(5thSupp.),asamended(hereinreferredtoas“theAct”).Unlessotherwiseindicated,statutoryreferencesinthisarticlearetotheAct.


GAARinabusiveavoidancetransactions.Itseemsclearthatarecharacterizationisonlypermittediftheparticulartransactiondoesnotproperlyreflectitsactuallegalsubstance.

Inrecentyears,theCRAhasfollowedtheprinciplesestablishedinShellinitsas-sessments.Forexample,initsrulingdatedJuly10,2002,19oneoftheissuestobedeterminedwaswhetheraparticularagreementwillbeconsideredaleasesuchthatthepaymentsmadeunderthetermsoftheagreementwillbedeductiblefortaxpur-poses.Usingcaselaw,20theCRAlookedatwhethertherehadbeenapurchaseunderthelaw;inotherwords,doesthetaxpayerhavetitleto,ortheincidentsoftitleandrightsin,theasset,notjustrightsinacontractrelatingtotheasset.

DuetotheoutcomeoftheShellcaseandthecancellationofIT-233R,therearenolongeranycapitalleasesfortaxpurposesonthebasisofeconomicsubstance.Legalrelationshipistheonlydeterminingfactorfortheleaseversuspurchasedeci-sion.Specifically,wherethereisnotransferoflegaltitleofthepropertyintheleaseagreement,theleaseistreatedasanoperatinglease.Ontheotherhand,ifatanytimethe legal titlehasbeentransferredduringthe lease term,thetransaction istreatedasapurchaseatthetimeofthetransfer.

Specified Leasing Property Rules

In1989,CanadaadoptedthespecifiedleasingpropertyrulestoeliminatetheCCAbenefitstolessorsoncertaintypesofassets.Theseruleseffectivelybifurcatetheleasemarketintotwomainsegments:exemptandnon-exemptassets.Exemptassetsincludegeneralpurposeofficefurnitureandofficeequipment,suchascomputers,residentialequipments,passengervehicles,vans,trucks,andrailcars.Non-exemptassetsconstitutetheremainder,suchasindustrialmachinery,vessels,energygenera-tionassets,oilandgasequipment,flightsimulators,andtelephoneswitchingassets.

AlessorofexemptassetsisentitledtofullCCA.Alessorofnon-exemptassetsislimitedtoaCCAdeductionequaltothelesserof(1)fullCCAand(2)thenotionalamountofprincipalitwouldreceiveiftheleaseweretreatedasaloanofanamountequaltothefairvalueoftheleasedproperty,withinterestataprescribedratebasedonlong-termgovernmentofCanadabondrates.Therefore,theCCAdeductiblefornon-exemptassetscouldbelowerthantheprescribedCCA.

Thelesseeistreatedaspayingrentandisnotaffectedbythespecifiedleasingpropertyrules.However,ifthelesseeandlessormakeanelectionundersection16.1,thelesseeistreatedastheowneroftheequipmentforthepurposeofcalculatingitsincomefortaxpurposesandisentitledtotreattherentpaymentasablendofprin-cipalanddeductibleinterest.Tomakeavalidsection16.1election,thelessorandlesseemustdealatarm’slength,andthelessormustbearesidentofCanadaoranon-residentcarryingonbusinessthroughapermanentestablishmentinCanadathatisnottax-exempt.

19 CRAdocumentno.2001-0115657,July10,2002.

20 MNR v. Wardean Drilling Ltd.,69DTC5194(Ex.Ct.).


Itwouldbeinterestingtocontrolforassetsleasedunderspecifiedleasingprop-ertyinourempiricalanalysis.Weusedarandomsampleof30firms(27percentofoursample) indifferent industriestosearchforthis informationinthenotesonoperatingandcapitalleases,notesonotheritemsinthefinancialstatements,andtheremainingpartoftheannualreports.Wefindnoevidenceofanydiscussionbyfirmsonspecifiedleasingpropertyintheannualreports.Therefore,empiricallywecannotidentifyandcontrolforspecifiedleasingproperty.Similarly,ourtheoreticalmodel developed in the following section does not apply to assets leased underspecifiedleasingproperty.

the theo re tic A L A n A Lysis

The Setting

Inouranalysis,weassumethefollowingsimplifiedsetting.First,assumethatafirmneedsanassettoundertakeaproject.Thefirm(referredtoastheuseroftheasset)hastwoalternativefinancingmethodstoobtaintheasset:leasingtheassetorbor-rowingfundstopurchasetheasset.Iftheassetispurchasedwithborrowedfunds,thenetpresentvalueoftheproject,NPvP,is

NPvPPv(net cash flows from the project before considering the cash flows related to the purchase) Pv(net cash flows impact of buying the asset) Pv(residual value of the asset).

Thenetcashflowimpactofbuyingtheasset(thesecondcomponent)iscomposedofthreeelements:(1)thebefore-taxpresentvalueofcashoutflowsfrombuyingtheasset(thecostoftheasset),(2)thepresentvalueofthetaxsavingsfromthededuc-tionoftheinterestexpense,and(3)thetaxshieldfromCCAdeductionsassociatedwiththepurchaseoftheasset.

Alternatively,whenthefirmleasestheasset,thenetpresentvalueoftheproject,NPvL,is

NPvLPv(net cash flows from the project before considering the impact of leasing the asset) Pv(net cash flows impact of leasing the asset).

Thenetcashflowimpactofleasingtheasset(thesecondcomponent)iscom-posedoftwoelements:(1)thebefore-taxpresentvalueofcashoutflowsfromleasingtheasset(thepresentvalueoftheminimumleasepayments);and(2)thepresentvalueofthetaxsavingsfromleasepayment.

Assumethattheuseoftheassetisindependentofthedecisiontobuyorlease.Therefore,thenetcashflowsgeneratedfromtheprojectarethesameunderbothalternatives.Furthermore,thebefore-taxpresentvalueofcashoutflowsfrombuy-ingtheasset(thecostoftheasset)lessthepresentvalueoftheresidualvalueoftheassetshouldbeveryclosetoorequaltothebefore-taxpresentvalueofcashout-flows fromleasing theasset (thepresentvalueof theminimumleasepayments).Consequently,tocomparethebenefitsofleasingandbuyingtheasset,wecanfocus


onthetaxconsequencesofbuying(deductibilityofinterestexpenseandtheCCAtaxshield)andleasingtheasset(deductibilityofleaseexpenses).21

Tocomparebothalternatives,wemakethefollowingassumptions:

1. Thefirmhasaprojectthatrequirestheacquisitionofaspecificasset.Theassetwillbeusedfornperiods,anditsresidualvalueattheendofthenthperiodisR.

2. TheusercanpurchasetheassetatapriceofCwithborrowedfunds.Thebor-rowedfundsarerepaidwithequalpaymentsovernperiods,andthedebtissecuredbythepurchasedasset.Theinterestrateonthedebtisdenotedas,whichreflectstheriskoftheprojectandthecollateralprovidedbythefirm.

3. Theusercanalsoleasetheassetwithequalleasepaymentsovernperiods.Theimplicitinterestrateforcalculatingleasepaymentisalso.

4. Theuser’staxrateistu.TheCCAratefortheparticularassetis,andtheloanpaymentsorleasepaymentsaremadeattheendofeachperiod.

5. Thefinancingmarketiscompetitive,andthelessorsandlendersearnzeroeconomicprofit.Weuselessortorepresentbothlessorandlender.Theles-sor’staxrateisrepresentedbytl.

Theanalysisofourmodelisdetailedintheappendix.Themainresultsaresum-marizedbelow.

Result1:Theinstalmentpaymentfortheloanineachperiodisnotafunctionofthelessor’staxrate.

Result2:Theinstalmentpaymentforthelease ineachperiodisadecreasingfunctionofthelessor’staxrate.

Result3: Ifthelessorandthefirmhavethesametaxrate,thenthefirmisindif-ferentbetweenleasingandfinancingapurchaseoftheneededasset.

Result4:Thefirmwillleaseifitstaxrate(tu)islowerthanthelessor’staxrate(tl).

Result5:Thebenefitofleasingisanincreasingfunctionofthegapbetweentuandtl.

21 Werecognizethatotherreasonsmayaffectthedecisiontobuyorleaseanasset.Forexample,whenafirmacquiresanasset,itmayhavetoprovideasignificantproportion(perhapsupto40percent)ofthevalueoftheassetasanupfrontcashdownpayment(seeJoselitoGallardo,Leasing To Support Micro and Small Enterprises,PolicyResearchWorkingPaperno.1857(Washington,DC:WorldBank,1997)).Furthermore,thefirmmayhavetoprovidecollateralandmaylackthecredithistorytoobtainaloan,mostlyinthecaseofassetsthatincreaseproductionlevels.Toavoidtheseconstraints,smallprivatefirmsmaypreferleasing.Intheirtheoreticalmodel,EisfeldandRampinishowthatfirmswithcreditconstraintsaremorelikelytoenterintoleases:AndreaL.EisfeldandAdrianoA.Rampini,“Leasing,AbilityToRepossess,andDebtCapacity,”The Review of Financial Studies(forthcoming).


Toanalyzethedecisiontoleaseorpurchasetheasset,weexaminetwoscenarios.First,assumethatthereisasingle-periodmodel(orequally,multipleperiodswithconstanttaxrates).IfthehighestcorporatetaxrateisdenotedbyT,thenboththelessors’andthefirms’taxratesrangefrom0toT.Underacompetitivefinancingmarket,theleasepaymentisadecreasingfunctionofthelessor’staxrate(result2),andthebenefitofleasing(comparedwithpurchasing)isanincreasingfunctionofthegapbetweenthetaxrateofthefirmandthelessor(result5).Thisimpliesthatallfirmswillleasefromlessorshavingthehighesttaxrates,andonlytheselessorssurviveintheleasingmarket.Inotherwords,firmsleasefromlessorswhosetaxrateisTtominimizeleasepayments.Therefore,underthisscenarioandassumingthattaxistheonlyconsideration,becauseonlylessorswiththemaximumtaxratewillremaininthemarket,thefirmsareeitherindifferentbetweenleasingtheassetandpurchasingitiftheirtaxrateisalsoT(result3),ortheyalwayspreferleasingiftheirtaxrateislowerthanT(result4).Consequently,firms’taxratesdonotdirectlyaf-fectleasingdecisionsbecausealessor’staxratewillbeatleastashighasthefirms’taxrate.Similarly,theleveloftheinterestratedoesnotdirectlyaffectfirms’leasingdecisionsbecausethebenefitofleasingisnon-negativeatanyinterestlevelwhenlessors’taxratesarehigherthanthefirms’taxrates.However,thesizeofthebenefitofleasingisaffectedbythefirms’taxrateandinterestrate,whichmayindirectlyaf-fectfirms’leasingdecisions.22

Second, assume that there is a multiperiod model where the lessor’s tax rateacrossperiodsisnotnecessarilyconstant.Inthiscase,thelessor’staxratemaynotremain at T in all periods due to fluctuations in the lessor’s profitability. Con-sequently,ifthelessor’staxratecouldbelowerthanTinsomeperiodsduringtheleaseterm,result2impliesthattheleasepaymentsrequiredbythelessorwouldbehigherthanthepaymentrequiredunderaconstanttaxrateT.Inotherwords,be-causethelessor’soperationisnotrisk-free,thereareextracoststhatmaybepassedontothefirmifitleasesanassetwithausefullifegreaterthanoneperiod.

Togainfurtherintuition,supposethatthelessorhasataxrateTatthebeginningofperiod1andhasanassetwithamultiperiodlifeavailableforleasing.Iftheleasetermcoversthelifeoftheasset,thentocalculatetheleasepaymentrequiredineachperiod,thelessormustconsidertheexpectedtaxrateoverallperiodsofthelease.More specifically, toobtain theexpectedreturn fromthe leasedasset, the lessorcannotusethetaxrateTinthecalculationtodeterminetheleasepaymentsbecause,insomeperiods,itispossiblethatthetaxratecouldbelowerthanT.ThiswillleadtoahigherleasepaymentineachperiodthantheleasepaymentunderascenariowherethetaxrateisconstantatT.Toeliminatetheuncertaintyrelatedtofuturetaxratesforthelessorandtodecreasetheleasepayments,thefirmmayprefertosignaseriesofleaseshavingonlyoneperiodwithalessorwhosetaxrateisTinthatperiod.

22 Firms’leasingdecisionsareaffectedbyotherfactorsinadditiontotaxconsiderations.Thisarticlefocusesonthetax-relatedissue,whichcanexplainsomecausalrelationshipbetweentheassets’lifeandleasingdecisions.However,thefullleasingdecisioncanbeexplainedonlyifallrelevantfactorsareconsidered,whichisbeyondthescopeofthisarticle.


Lessorsmayalsoengageinsophisticatedtransactionstomaximizethetax-relatedbenefits,suchasinThe Queen v. Canada Trustco Mortgage Co.case.23However,relatedtransactionandcontractingcostsmaynotbetrivial,preventingsuchstrategicbehav-iour.Furthermore,lessorswhohaveassetswithmultiperiodlivesonhandcannotaffordtoreceivetheminimumleasepayments inonlysomeperiods if there isapossibilitythattheirassetsinsomeotherperiodsarenotleasedwhentheirtaxratesgodown.

Givenacertainlevelofoperationalrisk,thenumberofperiodswherethelessor’sfuturetaxrateislowerthanTincreaseswiththeleaseterm.Thisimpliesthatthedefactotaxrateinthecalculationoftheleasepaymentislowerforassetswithlong-erlivesand,hence,theleasepaymentswillbehigher.Consideringthatfirmswithataxratehigherthanthedefactotaxrateusedbythelessorwillnotleasetheassets(result4), longer-lived assets will be leased less often than shorter-lived assets.24Furthermore,ifleasedassetsfallintothenon-exemptcategoryunderthespecifiedleasingpropertyrules,theleasebenefitsresultingfromtaxsavingscouldbefurtherreducedbecausetheassets’useful livesare longerforagivenCCArate.Asmen-tionedbyJog,25the1989taxreformadverselyaffectstheleasesofequipmentwithCCA rates that are higher than their economic depreciation rates. This effect isgreateriftheassets’usefullivesarelonger.Theaboveanalysesleadtothefollowinghypothesis:

Hypothesis:Theportionofleasedassetstototalassetsheldbyafirmisadecreasingfunctionoftheexpectedusefullivesoftheassets.

the emPiric A L A n A Lysis

The Methodology

WetestthepredictionsofouranalysisfromtheprevioussectionofthisarticleusingdatafromasampleofCanadianpubliclytradedfirms.Wemanuallycollecttheinfor-mationneededforthetestsfromfirms’annualreportspostedontheSEDARWebsite.26

23 2005DTC5523(SCC).

24 Notethattheuncertaintyinafirm’sfuturetaxratedoesnothaveasimilarimpactonleasingdecisionsasdoesthetaxrateofthelessor.Thelessor’sfuturetaxratecanmoveinonedirectiononly(itgoesdownfromthecurrenthighlevelT ):theexpectedtaxrateisthenlowerandthecorrespondinglycalculatedleasepaymentishigher.Afirm’sfuturetaxratecanmoveineitherdirection,whichresultsinasmall,orno,changeintheexpectedtaxrate(thatis,theymaycanceloutinexpectation).Asaresult,theexpectedimpactonthebenefitofaleaseisminimal.

25 VijayM.Jog,“Leasing,PreferredShares,FinancialInnovations,andTax-LossUtilization,”inPolicy Options for the Treatment of Tax Losses in Canada(Toronto:ClarksonGordonFoundation,1991),6:1-41.

26 Thesystemforelectronicdocumentaccessandretrieval(SEDAR)isaWebsitedevelopedforCanadiansecuritiesadministrators.AllinformationfiledundertherequirementsofthesecuritiesregulatoryagenciesinCanadaispubliclyavailableonthisWebsite(http://www.sedar.com).


ThefirmsselectedforanalysisrepresenttheTSx270forthefiscalyear2005,allow-ingustoidentifyabroadsampleoffirmsacrossmostindustries.Fromthissample,we eliminate financial institutions and real estate companies that are mostly in-volvedinleasetransactionsaslessors.Thisresultsinasampleof253firms.Wealsoeliminatenaturalresourcecompanies(99firms)andincometrusts(32trusts)be-causethemodelwedevelopeddoesnotapplytothesetwocategoriesoffirms.27Weloseanadditional11observationsduetomissingdata.28Thefinalsampleiscom-posedof111firms.

Themodelincludesthediscountedvalueofoperatingleases,deflatedbytotalassets,asthedependentvariable.However,futureobligationsunderoperatingleasesarenotrecognizedinthebodyofthefinancialstatements.Therefore,weneedtodeterminethepresentvalueoftheminimumleasepaymentstoobtaintheoperatingleaseobligationsasiftheywererecognizedinthebodyofthefinancialstatements.Therefore,wecollectallavailable informationtomakethiscalculationfromthenotestothefinancialstatements.

Twobasicassumptionsareneededtocalculatethediscountedvalueofoperatingleases.First,weneedadiscountrate.Asdiscussedinsection3065oftheHandbookoftheCanadianInstituteofCharteredAccountants,“thediscountrateusedbytheles-seeindeterminingthepresentvalueofminimumleasepaymentswouldbethelowerofthelessee’srateforincrementalborrowingandtheinterestrateimplicitinthelease,ifpracticabletodetermine.”29AsdiscussedbyImhoff,Lipe,andWright,30thediscountrateshouldbetheweightedaverageimplicitrateforeachportfolioofoperatingleases.However,thisrateisnotalwaysavailableduetolimitedinformationprovidedinthenotes.31Therefore,Imhoffetal.discusstwoalternativewaystode-terminethediscountrate.Theimplicitrateonacapitalleasecanbedeterminedonthebasisoftheinformationprovidedinthenotes.Alternatively,onthebasisoftheinformationprovidedinthenoteonlong-termdebt,anaverageinterestratecanbecalculated.Giventhattheinformationneededtocalculatetheimplicitinterestrateoncapitalleasesisalmostneverprovided,weusetheaverageinterestrate.There-fore,thediscountrateisdefinedastheaverageimplicitrateonoperatingleaseswhenitisprovided;otherwise,wetaketheaverageinterestrateonlong-termdebt.

27 Theleasingactivitiesofnaturalresourcefirmstypicallyinvolvelong-termrightstoexploitaresourceonapropertyratherthanleasingamortizablecapitalassets.Incometrustsareeliminatedbecausethemodeldealswiththetaxconsequencesofleasingorbuyinganasset,andthesefirmsdonotpayincometax.

28 Themissinginformationwaseithertheabsenceofinformationonfirms’costofcapitalthatwecouldusetocapitalizeoperatingleasesorotherspecificvariablesusedinourtests.

29 CanadianInstituteofCharteredAccountants,CICA Handbook(Toronto:CICA)(looseleaf ),section3065,paragraph16.

30 E.A.Imhoff,R.C.Lipe,andD.W.Wright,“OperatingLeases:IncomeEffectsofConstructiveCapitalization”(1997)vol.11,no.2Accounting Horizons12-32.

31 Lessthan25percentofthefirmsdisclosedtheimplicitrateinthenotestothefinancialstatements.


Thesecondassumptiondealswiththedurationofcashflows.TheCanadianac-countingstandardsrequirefirmstoprovidethefutureminimumleasepaymentsforthenextfiveyearsandtheaggregateamountfortheremainingyears.Alsoconsist-entwithImhoffetal.,wedividethe“beyondfiveyears”obligationbytheamountofobligationinthefifthyeartoapproximatetheannualminimumleasepaymentintheyearsfollowingthefifthyear.Wethendiscounttheannualleasepaymenttoobtainthediscountedvalueofoperatingleases.

Weusethefollowingmodeltotestourpredictions:

Leases 01Useful_life2HMTR3MMTR4Discount5Leverage6ROA7Working_cap8CFO_CL9Size10Capital_assets11Market_book12Merchandising13Manufacture.

Wefirstusetotalleasesdeflatedbytotalassetsasthedependentvariablebecausethemodel categorizes all leases asoperating leases tobeconsistentwith the taxtreatment. However, because of the difference between the tax and accountingtreatment,wealsoconducttheanalysisexcludingcapitalleasesfromtheleft-handside.Whenoperatingleasesareusedontheleft-handside,weincludetheobliga-tionsundercapitalleasesasanindependentvariable.32

Weincludefourcategoriesofindependentvariables.First,weincludevariablesto test thegeneralpredictionsofour theoretical analysis.Recall that the theorypredictsthatfirmsaremorelikelytobuyassetswithlongerusefullives.Becausetheusefullife(identifiedasUseful_lifeintheregression)ofassetsforoperatingleasesisnotdisclosedinthenotestothefinancialstatements,toproxyfortheusefullivesofunrecognizedassets(underoperatingleases),weassumethattheusefullivesoftherecognizedassetsinthebalancesheetarehighlycorrelatedtotheusefullivesofthosethatarenotrecognized.33Onthebasisofthisassumption,wecanproxyfortheusefullivesbytakingthegrossvalueofcapitalassetsdividedbytheamortizationexpenses.However,severalfirmsdonotdisclosetheamortizationexpenseor,whenitisdis-closed,firmsoftencombinetheamortizationexpenseoftangibleandintangibleassets.Toproxyfortheusefullife,weusecapitalexpendituresinsteadofamortiza-tionexpensesduetothelimitationsassociatedwiththedisclosureoftheamortizationexpenses.Totheextentthatmostfirmsmaintaintheirproductioncapacity(oralargecomponentoftheircapitalexpendituresistomaintaintheirproductiveactivities),

32 Webelievethatpresentingtheresultsforbothtotalleasesandoperatingleasesprovidesstrongerevidenceinsupportingthepredictionsofthemodel.Wealsoattemptedtoexaminetheresultsusingcapitalleaseobligationsasthedependentvariable,butthenumberofobservationswastoosmalltoobtainmeaningfulresults.

33 ThereisapossibilitythatourproxyforUseful_lifeisbiasedbecauseitisbasedonanapproximationusingcapitalexpenditures.Becausethedecisiontoleaseorpurchaseisaffectedbytheusefullifeoftheasset,weprobablyoverestimatetheusefullifeofaleasedasset.Althoughthisbiascannotbeavoided,itsdirectionisagainstourpredictions.


theratioofthegrossvalueofcapitalassetsoverannualcapitalexpendituresshouldprovideareasonableproxyfortheusefullivesoftheassets.34Becausethemodelpredictsthatbuyingtheassetismoreadvantageousforthoseassetswithlongeruse-fullives,weexpectanegativesignonthisvariable.35

Wealsoincludethemarginaltaxrateintheregression.FollowingKlassenandMawani,36wecalculatethemarginaltaxrateonthebasisofestimatedtaxableincomeandwhetherornotthefirmhasoperatinglosscarryforwards.Thepresenceoflosscarryforwardsisdeterminedfromthenotestothefinancialstatements.Taxablein-comeisestimatedasnetincomebeforetaxeslessthechangeinfuturetaxliabilitiesfromthebalancesheet,grossedupbythestatutorytaxrate.37

Usingtheoperatinglosscarryforwardandtheestimatedtaxableincome,wecreateatrichotomousvariabledefinedasfollows.Ifestimatedtaxableincomeispositiveandthefirmhasnooperatinglosscarryforward,thenthefirmisassumedtohaveahighmarginaltaxrate.Ifestimatedtaxableincomeispositiveandthefirmhasanoperatinglosscarryforwardorifthefirmhascurrentlossesbutnolosscarryforward,thenthefirmisassumedtohaveamoderatemarginaltaxrate.Finally,ifthefirmhascurrentlossesandalosscarryforward,thenthefirmisassumedtohavealowmarginaltaxrate.38Tocapturethemarginaltaxrate,twodummyvariablesareinclud-edintheregression.HMTRtakesthevalueof1ifthefirmisassumedtohaveahighmarginaltaxrateand0otherwise.MMTRtakesthevalueof1ifthefirmhasamod-eratemarginaltaxrateandthevalueof0otherwise.Firmswithalowmarginaltaxratearecapturedbytheintercept.

Wealsoincludethediscountrate(Discount)intheregression.Asdiscussedabove,thediscountrateisdefinedastheaverageimplicitrateonoperatingleaseswhenitisprovided;otherwise,wetaketheaverageinterestrateonlong-termdebt.Onthebasisofthepredictionsofourmodel,wedonotexpectthecoefficientsonthetwotaxvariablesandonthediscountratevariabletobesignificant.

34 Theratioofthegrossvalueofcapitalassetsdividedbycapitalexpenditureimpliesthatfirmsmainlyusestraightlinedepreciation.Furthermore,itassumesthattheresidualvalueisnotguaranteedorthatitissmallrelativetothetotalvalueoftheleasedassets.Inaddition,firms’capitalizationpolicieswillaffectthenumeratorandmayaffecttheproxyfortheusefullifeoftheassets.

35 Theamountofcapitalexpendituresinvestedbyafirmcanvaryfromyeartoyear.Toexaminetherobustnessofourresults,weusedaveragecapitalexpendituresoveratwo-yearandathree-yearperiod.Theresultsarerobusttothesealternativespecifications.

36 KennethJ.KlassenandAminMawani,“TheImpactofFinancialandTaxReportingIncentivesonOptionsGrantstoCanadianCEOs”(2000)vol.17,no.2Contemporary Accounting Research227-62.

37 AssumingthatfirmspayincometaxinOntario,weuseastatutorytaxrateof36percentfor2005.

38 SeeKlassenandMawani,supranote36;GeorgeA.Plesko,“AnEvaluationofAlternativeMeasuresofCorporateTaxRates”(2003)vol.35,no.2Journal of Accounting and Economics201-26;andJohnR.GrahamandLillianF.Mills,Using Tax Return Data To Simulate Corporate Marginal Tax Rates,NBERWorkingPaperno.W13709(Cambridge,MA:NationalBureauofEconomicResearch,December2007).


Second,weintroducetwoaccountingvariables:financialleverage(Leverage)andreturnonassets(ROA).Consideringthatoperatingleasesareviewedasoff-balance-sheetliabilities,weexpectapositiveassociationbetweentheleverageratioandtheuseofoperatingleases.Theeconomicimpactofoperatingleasesversusbuyingtheassetswillbethesameattheendoftheusefullivesoftheassets.However,thetimingoftheexpenserecognitionwilldiffer.Atthebeginningoftheusefullifeoftheasset,netincomewillbelowerwhenthefirmacquirestheassetbecausethecombinationofamortizationandinterestexpensewillbegreaterthantheleaseexpense.There-fore,weexpectthatfirmswithalowlevelofprofitabilitywillpreferoperatingleasesand,hence,weexpectanegativesignonthevariableROA.

Third,weincludetwodebtcapacityvariables.Thefirstvariable(Working_cap)ismeasuredasworkingcapital(currentassetsminuscurrentliabilities)deflatedbytotalassets.Weexpectapositivesignonthisvariablebecauseoperatingleasesarenotrecognizedinthebalancesheetand,hence,theamountofcurrentliabilitiesis not increasedbyoperating leases.The secondvariable is the cashflows fromoperationsdividedbycurrentliabilities(CFO_CL).Thisvariablecapturestheabilityofthefirmtogenerateenoughcashflowsfromoperationstomeetitscurrentobli-gations.Firmsthatdonothaveenoughdebtcapacitytomakeaninitialpaymentfortheacquisitionofanassetwilllikelyenterintoanoperatingleaseagreementand,hence,wepredictanegativesignonthesevariables.39

Fourth,weincludeseveralcontrolvariables.Leasedassetsmaybedirectlylinkedtocapitalassets.Thatis,whencapitalassetsincrease,leasedassetsmayalsoincreaserelativetototalassets.Tocontrolforthispotentialeffect,weincludecapitalassets(Capital_assets)asacontrolvariable.Wepredictapositivesignonthecoefficientofthisvariable.Weincludethefirm’ssize(Size)tocontrolforsize-relatedfactorssuchasthestabilitylevelofoperationandextentofinformationasymmetry,definedasthenaturallogarithmoftotalassets.Wehavenopredictiononthesignofthisvariable.Wecontrol forgrowthby including theratioofmarket-to-bookvalueofequity(Market_book).40Growthfirmsareexpectedtoacquiremoreassetsand,hence,weexpectapositivesignonthisvariable.Finally,wecontrolforindustry.

The Results

Table1providessomedescriptivestatisticsonthevariablesusedinthemodel,andtable2providesthecorrelationsofthevariables.Asindicatedintable1,unrecog-nizedoperatingleasesrepresent,onaverage,9.8percentofthevalueoftotalassets,whilecapitalleases(recognizedleases)accountforlessthan1percentofthetotalassets.Onaverage,firmsinoursampleareprofitable,asindicatedbytheaverageROAof9.3percent,andhaveameanleveragevalueof58.8percent.Thevolatilityintheleverageratioisconsistentwithasimilarfluctuationobservedonthediscountrate.

39 SeeGallardo,supranote21.

40 Weobtainsimilarresultswhenthegrowthinsalesisusedinsteadofthemarket-to-bookratioofequity.


tAbLe 1 Descriptive Statistics (111 Observations)

Mean Standarddeviation 25% 50% 75%

Operating . . . . . . . . . . . . . . . . . . . 0.098 0.157 0.013 0.040 0.097Useful_life . . . . . . . . . . . . . . . . . . 8.5 7.8 4.3 6.2 10.2Discount . . . . . . . . . . . . . . . . . . . . 0.066 0.020 0.050 0.063 0.079Leverage. . . . . . . . . . . . . . . . . . . . 0.588 0.195 0.468 0.579 0.695ROA . . . . . . . . . . . . . . . . . . . . . . 0.093 0.194 0.049 0.081 0.108Working_cap. . . . . . . . . . . . . . . . . 0.110 0.384 −0.010 0.095 0.197CFO_CL. . . . . . . . . . . . . . . . . . . 0.568 0.671 0.202 0.431 0.721Size . . . . . . . . . . . . . . . . . . . . . . . 14.832 1.192 13.989 14.801 15.621Capital_lease. . . . . . . . . . . . . . . . . 0.006 0.017 0.000 0.000 0.013Capital_assets. . . . . . . . . . . . . . . . 0.365 0.245 0.133 0.358 0.507Market_book. . . . . . . . . . . . . . . . . 2.722 2.587 1.534 2.123 2.970Estimated tax rate . . . . . . . . . . . . . 0.271 0.156 0.185 0.310 0.352

Thevariablesaredefinedasfollows:

Operating discountedvalueofoperatingleasesdeflatedbytotalassets.

Useful_life estimatedusefullifeofassetsrecognizedasoperatingleases,calculatedasthefirm’scapitalassetsdividedbycapitalexpenditures.

Discount discountratecalculatedastheaverageimplicitrateonoperatingleases,whendisclosed,orastheaverageinterestratecalculatedasinterestexpensedividedbytotaldebt.

Leverage financialleveragecalculatedastotalliabilitiesdividedbytotalassets.

ROA returnonassetsdefinedasoperatingincomeovertotalassets.

Working_cap workingcapital(currentassetsminuscurrentliabilities)deflatedbytotalassets.

CFO_CL cashflowsfromoperationsovercurrentliabilities.

Size thenaturallogarithmoftotalassets.

Capital_leases obligationsundercapitalleasedeflatedbytotalassets.

Capital_assets capitalassetsdeflatedbytotalassets.

Market_book theratioofthemarket-to-bookvalueofequityattheendofthefiscalyear2005.

Estimated tax rate incometaxdividedbyincomebeforetax.

Ourproxyforusefullifeindicatesanaveragevalueof8.5yearswithastandarddevi-ationof7.8years.Theaveragefirmhasapositiveliquiditysituationandexhibitsalargevolatilityintheproportionofcapitalassetsovertotalassets.Also,byusingtheTSx270,oursampleiscomposedmainlyoflargeCanadianfirms.

Resultsoftheregressionarepresentedintable3.41Thefirstregressionusestotalleasesasthedependentvariableandthesecondregressionusesthediscountedvalueofoperatingleases.Thefirstsetofindependentvariablesisderivedfromthemodeldevelopedintheprevioussection.Consistentwiththemodel,thecoefficientofthe

41 Theresultsarepresentedusingordinaryleastsquaresregressions.Similarconclusionsholdwhenweusecensoredtobitmethodology.

654 n canadian tax journal / revue fiscale canadienne (2008) vol. 56, no 3tA

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tAbLe 3 Regression Analysis (Regression 1 Uses Total Leases as the Dependent Variable and Regression 2 Uses Operating Leases as the Dependent Variable)

Regression1 Regression2a

Expectedsign Coefficient t-statisticb Coefficient t-statistic

Predictions(model)Useful_life . . . . . . . . . . 0.0047 2.51c 0.0043 2.46c

HMTR. . . . . . . . . . . . . ? 0.0305 0.61 0.0229 0.48MMTR . . . . . . . . . . . . ? 0.0070 0.19 0.0041 0.12Discount . . . . . . . . . . . . ? 0.3424 0.54 0.6442 1.06

AccountingvariablesLeverage. . . . . . . . . . . . 0.2512 3.23c 0.2399 3.25c

ROA . . . . . . . . . . . . . . 0.0708 0.97 0.0718 1.03

DebtcapacityvariablesWorking_cap . . . . . . . . . 0.0768 2.33c 0.0787 2.52c

CFO_CL . . . . . . . . . . . 0.0020 0.10 0.0045 0.23

ControlvariablesSize. . . . . . . . . . . . . . . ? 0.0461 3.77c 0.0461 3.97c

Capital_assets . . . . . . . . 0.0974 1.52e 0.0823 1.35e

Capital_leases. . . . . . . . na / 1.3426 1.98d

Market_book. . . . . . . . . 0.0055 1.10 0.0050 1.06Merchandising . . . . . . . ? 0.1923 4.79c 0.2118 5.50c

Manufacture . . . . . . . . . ? 0.0292 1.10 0.0143 0.56

Intercept. . . . . . . . . . . . . . ? 0.6754 4.04c 0.6685 4.24c

No.ofobservations . . . . . 111 107F-value . . . . . . . . . . . . . . . 6.44 6.97AdjustedR2 . . . . . . . . . . . 39.14% 43.19%

Thevariablesaredefinedasfollows:

HMTR adummyvariablethatequals1whenthefirmhasahighmarginaltaxrateand0otherwise.

MMTR adummyvariablethatequals1whenthefirmhasamoderatemarginaltaxrateand0otherwise.

Merchandising adummyvariablethatequals1ifthefirmisamerchandisingcompany(StandardIndustrialClassification(SIC)codebetween5000and6000)and0otherwise.

Manufacture adummyvariablethatequals1ifthefirmisamanufacturer(SICcodebetween2000and4000)and0otherwise.

a Fourfirmsdonothaveoperatingleasesinourfinalsample.bAlltestswithpredictedsignsareofone-sidednullhypotheses.Thecriticalvaluesforone-

sidedtestsare1.28,1.64,and2.33for10percent,5percent,and1percenttests,respectively.c Significantlydifferentfrom0atthe1percentlevel.dSignificantlydifferentfrom0atthe5percentlevel.eSignificantlydifferentfrom0atthe10percentlevel.


variableUseful_lifeisnegative,asexpected,andsignificantatthe1percentlevelinbothregressions.Therefore,assetswithlongerusefullivesarelesslikelytobeleased.Ourresultsareconsistentwithourmodelbecausethecoefficientonthediscountrate(Discount)andthecoefficientsonthetwotaxvariables(HMTRandMMTR)areinsignificantinbothregressions.

Thesignsonthecoefficientsoftheaccountingvariablesareconsistentwithourprediction,butonlyoneissignificant.Thatis,thecoefficientonfinancialleverage(Leverage)ispositiveandsignificantatthe1percentlevelinbothregressions.Thissuggeststhatfirmsaremorelikelytoleaseassetsastheirleverageratioincreases.ThecoefficientofthevariableROAisnegative,asexpected,butitisinsignificant.

Regardingthedebtcapacityvariables,thecoefficientofWorking_capispositive,asexpected,andsignificantatthe1percentlevelinbothregressions.Thisresultisindicativeoflowercurrentliabilitieswhentheobligationisnotrecognizedinthefinancialstatements.Thesecondliquidityvariable,CFO_CL,hasanegativecoeffi-cient, asexpected,but it is insignificant.For thecontrolvariables,weobserveanegativeassociationbetweenthesizeoftheleaseobligationandfirmsizeandapositiveassociationbetweenthesizeoftheleaseobligationandthevalueofcapitalassets.Thegrowthvariable,market-to-bookvalueofequity,isinsignificant.Finally,oneof the industry dummy variables, Merchandising, is significant because retailersmainlyleasetheirstoresandotherequipment.Inthesecondregression,thecoeffi-cientonCapital_leasesissignificantat5percent.TheadjustedR2ofeachregressionis39.14percentand43.19percentrespectively.

Wealsoconductseveralrobustnessanalyses.First,weincludethecurrentratioinsteadofthevariableWorking_cap.Second,weusethereturnonequityandprofitmargininsteadofthereturnonassets.Third,weusetheaveragetaxrate,definedastaxoverincomebeforetaxes,insteadofthemarginaltaxrate.Fourth,wereplacethemarket-to-bookvalueofequityvariablebythegrowthinsalesvariable.Theresultsoftheseadditionalempiricalanalysesareunaffectedbythesechangesinspecifica-tions(theresultsarenotpresentedintable3forthesakeofbrevity).

co ncLusio n

Inthisarticle,wedevelopatheoreticalanalysisofthetaxconsequencesofbuyingorleasinganasset.Ourstudyhasboththeoreticalandpracticalimplications.Ourstudyshowsthatuncertaintyinthelessor’sfuturetaxrateisanimportantdetermin-ant infirms’ leasingorbuyingdecisions.Wedevelopamodelthatdemonstratesthatassetswithshorterusefullivesaremorelikelytobeleasedthanassetswithlong-erusefullives.Morespecifically,weshowthat,inacompetitivefinancingmarket,leasepaymentsareadecreasingfunctionoflessors’taxrates.Asaconsequence,be-causelessors’taxratesarelesslikelytoremainatthehighestlevelduringalongerhorizon,higherleasingcostsandlessleasingactivitiesareexpectedastheexpectedusefullifeoftheassetincreases.Therefore,wepredictthatassetswithshorterex-pectedusefullivesaremorelikelytobeleased.

WethenempiricallytestthepredictionsofourmodelusingtheTSx270asoursample.Consistentwithourmodel,theusefullifeoftheassetisnegativelyassociated


withtheproportionofleasesheldbyfirmsinoursample.Theresultsalsoindicatethattheproportionofleasesispositivelyassociatedwithfinancialleverage,workingcapital,andtheproportionofcapitalassets.Anegativecorrelationisobservedbe-tweenthepresenceofleasesandfirmsize.Ourtheoreticalanalysisandempiricaltestscanhelppractitionerstoprovidebetteradvicetotheirclientsformakingfi-nancingdecisionsrelatedtocapitalassets.

WewouldliketopointoutthatoursamplefromtheTSx270consistsofmajorCanadianfirms.Therefore,itisnotclearwhetherourresultscanbegeneralizedtosmallerfirms.Becausethecomparisonoflargeandsmallfirmsisbeyondthescopeofthisarticle,itisapotentialfutureresearchtopic.Weusethedepreciationexpensesandthecapitalassetstoestimatetheusefullifeofleasedassets.Thisproxyhassomeweaknesses.First,itmaynotbethecasethatpurchasedandleasedassetshavethesameusefullives.Second,itispossiblethattheusefullifemightbeadeterminantofleasingdecisionsfornon-taxreasons,whichisnotexploredinthisarticle.There-fore,afuturestudycouldsurveycompaniestogatherinformationonthetypeofleasedassetsandtheusefullives.Otherfutureresearchcouldincludebothlesseesandlessorsintheanalysis.Further,duetothelowtaxrateforpensionfunds,astudyoftherelationshipbetweenpensionfundsandleaseswouldbeinteresting.

A PPendi x

Basic Assumptions

1. Thefirmhasaprojectthatrequirestheacquisitionofaspecificasset.Theassetwillbeusedfornperiods,anditsresidualvalueattheendofthenthperiodisR.

2. TheusercanpurchasetheassetatapriceofCwithborrowedfunds.Theborrowedfundsarerepaidwithequalpaymentsovernperiods,andthedebtissecuredbythepurchasedasset.Theinterestrateonthedebtisdenotedas,whichreflectstheriskoftheprojectandthecollateralprovidedbythefirm.Therefore,isthepre-taxdiscountrate.

3. Theusercanalsoleasetheassetwithequalleasepaymentsovernperiods.Theimplicitinterestrateforcalculatingleasepaymentisalso.

4. Theuser’staxrateistu.TheCCAratefortheparticularassetis,andtheloanpaymentsorleasepaymentsaremadeattheendofeachperiod.

5. Thefinancingmarketiscompetitiveandthelessorsandlendersearnzeroeconomicprofit.Thelessor’staxrateistl.

Interest on a Loan

AssumingthattheequalpaymenteachperiodisdenotedbyP,thentheinterestattheendofeachperiodis:

Firstperiod: C;

Secondperiod: (C (1)P);

Thirdperiod: (C (1)2P (1)P);


Fourthperiod: (C (1)3P (1)2P (1)P);

...

nthperiod: (C (1)n 1P (1)n 2...P (1)P).

LetIEkbetheinterestpaidbytheuserattheendofperiodk,andlettbethetaxrate(t=tlforthelessorandt=tufortheuser).Therefore,thepresentvalueoftheinterestis:

Pv(The interest)

=+ −

++ −

++ −

IEt

IEt

IEt

1 22

3

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+ −. . .

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γ[

( )

( ( ) ( ) )

(C

t

C Pk j

j

k

1 1

1 1

1

1

0

2

(( ))]

12 −=∑ t kk

n

=

++ −

−−

++ −

−C t

tP t

n

n

n

n( )

( ( )) (

( )( ( ))

11 1

1 11 1

γγ

γγ

111 1

11 1

11 1

1

++ − − + −

−+ −−

γγ

γγ γ

γ( ) ( ) ( ( ))

( )t

tt t

t

n

))

(1).

Thenthepresentvalueofaloanaftertaxforthelender(valueoftistl )is:

Pv(Loan, t tl) Pt

tC

t

n n

n

1 1 11

11 1

1− + −−

−+

+ −−

−( ( ))( )

( ( )( ( ))

γγ

γγ

))

+

++ −

−+

+ − − + −Pt t tt

n

n

(

( )( ( )) ( ) (

11 1

11 1

11 1

γγ

γγ

γγ tt t

t

n) ( ( ))( )

)−+ −−

11 1

1γ

γ (2).

Becausethefinancingmarketiscompetitive(basicassumption5),thenthelessormakestheexpectedreturnand,hence,Pv (Loan,t=tl)=Cor

PC n

n=+

+ −γ γγ

( )( )

11 1 (3).

Result1:Theinstalmentpaymentfortheloanineachperiodisnotafunctionofthelessor’staxrate.


The Tax Shield (CCA) from an Owned Asset

ThetaximpactoftheCCAisobtainedasfollows.Thepresentvalueofthetaxshieldatthebeginningofperiodoneis:

Firstperiod: CCAC

1 2=θ ,

UCC C CCA C1 1 12

= − = −( )θ ,

whereUCCrepresentstheundepreciatedcapitalcost.Applyingthesamelogictothefollowingperiodsgives:

Secondperiod: CCA UCC C2 1 12

= = −θθθ( ) ,

UCC UCC CCA C2 1 2 12

1= − = − −( )( )θθ ;

Thirdperiod: CCA UCC C3 2 12

1= = − −θθ

θ θ( )( ) ,

UCC UCC CCA C3 2 321

21= − = − −( )( )θθ ;

Fourthperiod: CCA UCC C4 321

21= = − −θ

θθ θ( )( ) ,

UCC UCC CCA C4 3 431

21= − = − −( )( )θθ ;

...

nthperiod: CCA UCC Cn nn= = − −−−

121

21θ

θθ θ( )( ) ,

UCC UCC CCA Cn n nn= − = − −−−

111

21( )( )θθ .

Thepresentvalueofthetaxshieldattimezerois:

Pv (Taxshield of owning the asset)

=+ −

++ −

++

tCCA

tCCA

tCCA

(( ( )) ( ( )) ( (

1 22

3

1 1 1 1 1γ γ γ 11 1 1 1 13−+ +

+ −+

−+ −t

CCAt

UCC Rnn

n

)) ( ( )) ( (. . .

γ γ tt n)))

=+ −

+−− + + −

−C tt t t

θγ γ θ γ

θ

[( ( )) ( )

(( )

(12 1 1

11

11 1

12 −−+ −

+− − −+

− −θγ

θγ

θ)( ( ))

)]( )( )

( (

n

n

n

tC R1

21

1 11 1

1 11−ttn))

=− +

+ − − ++

−Ct

tt t

Ctt( ( ) )

( ( ))( ( ) )(γ θ

γ γ θγ1 2

2 1 1 11 ))( )( )

( ( ) )( ( )) (1 1

1 1 1 12

1− −− + + −

−+

−θ θγ θ γ γ

n

nt tR(( ))1−t

tn (4).

Present Value of the Lease After Tax for the Lessor

Pv (Lease, t tl ) Lt

Ctt

t

n1 1 1 1 22 1 1

− + −+

− ++ −

−( ( )) ( ( ) )( ( ))(

γγ

γ θγ γ(( ) )1− +t θ

+− − −− + + −

−

Ctt

t t

nγ θγ θ γ

θ( )( )( )( ( ) )( ( ))

1 1 11 1 1

21

nn n

R tt

+−

+ −( )

( ( ))1

1 1γ (5).


LetLbetheleasepaymentforeachperiod.Becausethefinancingmarketisas-sumedtobecompetitive,thenPv (Lease,t=tl)=Cor

L t tC Ct t

t tl( )

( ( ) )( ( ))( ( )= =

−− +

+ − − +γ θγ γ θ

1 22 1 1 1 ))

( )( )( )( ( ) )( (

−− − −− + + −

−

Ctt

t t

nγ θγ θ γ

θ1 1 11 1 1

21

)))( )

( ( ))( ( ))

n n

n

R tt

t

−−

+ −− + − −

11 1

1 1 1γ

γγ

(6).

Result2:Theinstalmentpaymentfortheleaseineachperiodisadecreasingfunctionofthelessor’staxrate.Result2isadirectconclusionthatthelessor’s market is competitive and that the present value of the taxshieldisanincreasingfunctionofthelessor’staxrate.

The Costs of Financing a Purchase Versus Leasing the Asset for the User

Pv (Cost of owning, t tu ) Pt

tCt tn

n

n1 1 11

11 1− + −

−−

++ −

−−( ( ))( )

( )( ( ))γ

γγ

γγ

11

γt

+

++ −

−+

+ − − + −Pt t tt

n

n

(

( )( ( )) ( ) (

11 1

11 1

11 1

γγ

γγ

γγ tt t

t

n) ( ( ))( )

)−+ −

+ −

11 1

1 1γ

γ

−− +

+ − − +−

−Ct

tt t

Ctt( ( ) )

( ( ))( ( ) )(γ θ

γ γ θγ1 2

2 1 1 11 ))( )( )

( ( ) )( ( ))1 1

1 1 12

1− −− + + −

−θ θγ θ γ

n

nt t

−−

+ −R t

t n

( )( ( ))

11 1γ (7).

Pv (Cost of leasing, t tu ) Lt n1 1 1− + − −( ( ))γ

γ (8).

Result3:Ifthetaxratesoftheuserandthelessorareequal(tu=tl),thenthepresentvalueofleasingorpurchasingtheassetisthesame(Pv (Cost of owning)Pv (Cost of leasing)),andtheuserisindifferentbetweenbuy-ingandpurchasingtheasset(directlyfromequations2,3,and6).

Result4:Theuserwillleasetheassetifitstaxrateislowerthanthelessor’staxrate(thatis,iftutlthenPv (Cost of owning)Pv (Cost of leasing))andviceversa(fromresult2andresult3).

Result5:Thebenefitofleasingisanincreasingfunctionofthegapbetweentuandtl(fromresult2andresult4).

Why Firms Lease Short-Lived Assets: A Tax-Based Explanation · 2019-02-13 · why firms lease...

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Transcript of Why Firms Lease Short-Lived Assets: A Tax-Based Explanation · 2019-02-13 · why firms lease...