Most local authorities no longer rely solely on ‘in-house’ operations to deliver either public services or their own internal functions. This insights article provides an introduction to some of the alternative approaches being used by local authorities and highlights some of the implications for asset financing choices and related risks.
Alternative service delivery models include the use of ‘shared services’, between multiple local authorities and also between local authorities and other public bodies; joint ventures, outsourcing to private or voluntary providers, and also, ‘insourcing’ where previously outsourced services are brought back ‘in house. Alternative service delivery models now involve the increasing use of Local Authority Trading Companies (LATCs) to trade for profit, providing a revenue stream for Local Authorities.
Historically, many Local Authorities have typically always relied on and used operating leasing to finance and acquire assets. Operating leasing has often been seen as convenient and simple source of financing albeit with ‘strings attached’ in terms of expensive end of lease risks and charges. However, the newly formed LATCs (limited companies) now have a wider choice of leasing options to consider when deciding how to finance capital expenditure to acquire assets. Finance leasing, hire purchase and contract hire are some of the variants of asset finance which need to be considered as part of any options appraisal exercise to determine the most optimum financing solution. This article considers and discusses some of the characteristics and key differences of these variants.
• Finance Leases
Finance leases are mainly fully amortising leases (sometimes referred to as full payout) and are the most common type of lease used by corporates in the UK. Here the lessor recovers the original capital cost and interest over the primary term of the lease and has no material risk in the residual value of the asset. At the end of the primary lease term the lessor may permit the lessee to continue leasing the assets in perpetuity for payment of a nominal peppercorn rent. Alternatively, the lessor may grant the lessee a sales agency to sell the assets and between 95% and 99% of the sales proceeds are refunded back to the lessee as rebate of rentals. Finance leasing is basically similar to a loan secured on an asset.
• Operating Leasing
Operating leasing is an accounting term used to describe all leases that are not finance leases. As such operating leasing embraces a wide variety of different types of leases in which a substantial proportion of the risks and rewards associated with asset ownership remain with the lessor. The lessor makes a significant investment in the assets residual value which means the lessee has reduced rental repayments over the initial term of the lease. However, as the lessor is exposed to significant asset market value risk at the end of lease this means the lessee will, to avoid additional charges, need to comply with contractual asset return conditions to protect the lessor from losses and to guarantee the lessor recovers the original residual investment.
• Contract Hire
Contract hire is term commonly associated with vehicle hire and rental usually refers to a short term (usually 2 or 3 year fixed term) contract for the hire of vehicles where the lessee simply returns the vehicles at the end of the contract period. Such agreements usually entail the lessor taking substantial residual risk on the sale of the vehicle at the end of the lease contract and would normally be classified as an operating lease. Contract hire arrangements are usually, but not always, with full maintenance provision.
• Hire Purchase
Contracts of this kind are contracts of bailment where the ‘hirer’ has an option to purchase the assets for a nominal sum at the end of the hire term. The option to purchase is exercised in most cases. Hire purchase, (also sometimes referred to as ‘lease purchase’) ‘does what it says on the tin’; it’s a contract for the hire and purchase of an asset and the hirer; on payment of the option sum and on completion of all the terms and conditions of contract, obtains legal title to the asset. There are no issues and risks with asset return and secondary lease term conditions and additional charges.
There are also important and significant differences with tax, vat and accounting rules to consider when selecting the appropriate asset financing solutions described above; and not least, due consideration to the legal contractual terms and conditions to ensure the correct master lease and hire contract reflects the different lease classifications and risk variations.
Arlingclose leasing advisory services team can assist clients navigate the landscape of asset financing choices for both newly formed LATCs and their own capital financing objectives to guarantee optimum financing decisions, minimizing risks and reducing costs. For more details contact SKelly@arlingclose.com, GReadings@arlingclose.com and NHodges@arlingclose.com
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