BLM11201 - Lease accounting: lease classification: finance leases – commercial substance & risks and rewards
Source: gov.uk (2025-11-12)


This manual is being updated to reflect FRS 102 (2024 amendments). For guidance on the tax treatment of accounts prepared under IFRS 16 or the revised FRS 102, please refer to pages within the BLM50000 (https://www.gov.uk/hmrc-internal-manuals/business-leasing-manual/blm50000) chapter.

This section is applicable to entities applying FRS 102 pre 2024 amendments or FRS 105, and for lessors only under IFRS 16 and FRS 102 (2024 amendments).

See BLM17000 (https://www.gov.uk/hmrc-internal-manuals/business-leasing-manual/blm17000) for lessee accounting under the on-balance sheet model under IFRS 16 and FRS 102 (2024 amendments)

This page provides further commentary on a range of topics relating to commercial substance and risks and rewards.

Commercial Substance

To understand the reality of finance leasing, you may find it helpful to think of the rentals under a finance lease in terms of their economic and commercial substance – that is a combination of:

‘interest’ on a ‘loan’, and

repayment of the ‘loan’.

But as a matter of general law the rentals are simply the hire charge for an asset.

A simple example illustrates how a finance lease resembles a loan.

A trader who wants an asset costing £10,000 could borrow £10,000 at (say) 10% from a bank and use the money to buy the asset. The trader will pay the bank the interest and the capital. The capital could either be repaid in one lump sum at the end of the loan period or it could be structured like a repayment mortgage, with small capital payments and large interest payments at first and, towards the end, large capital payments and small interest payments.

The same commercial result can be achieved with a finance lease. The finance lessor (often a subsidiary of a bank) buys the asset for £10,000 and leases it to the lessee. The lessee is the one who uses the asset. The lessor charges the lessee rentals which, over the term of the lease, will repay the capital with a commercial rate of ‘interest’.

Typically a finance lease is structured like a repayment mortgage. That is, in substance, the rentals in the early years are mostly ‘interest’ while towards the end they are mostly loan’ repayment.

The ‘interest’ charges included in a finance lease agreement may fluctuate with base rate or other changes (such as tax rate or other tax regime changes) and often provisions in the lease spell out the consequences. The lease is usually designed to leave the finance lessor making a desired return on the finance element whatever happens. Meanwhile, the lessee picks up any resulting increased costs or benefits from any reduced cost.

Risks and Rewards

In a basic finance lease, the economic risks and rewards of ownership sit with the lessee although, as a matter of law, it is the lessor who owns the asset. As with any lease, the terms of the lease give the lessee the right to use the asset in return for the rental payments. However, finance leases may contain provisions which ensure that the lessee can either:

continue to use the asset for very little payment after the 'loan' has been repaid and all the 'interest' has been paid, and/or;

require the lessor to sell the asset and pay most of the proceeds (after clearing the 'capital' and 'interest' debt) to them (the lessee) by way of a rental rebate (see below).

If the asset is in poor condition at the end of the lease it will be worth less than an asset that has been looked after well. The lessee loses out if they don’t look after the asset because they have had to pay all the rentals representing the full cost of the asset, plus the lessor’s profit, regardless. If the asset is well looked after by the lessee and remains in good condition it will usually be worth more than expected when the 'loan' has all been repaid, and the lessee reaps the benefit.

Rental Profiles

Finance lease rental schedules can be structured in all kinds of ways; for example, the initial rentals could be nil or much lower than the amount needed to pay off the debt. Subsequent rentals are then correspondingly higher.

Where the initial rentals are nil (or set at an amount less than the ‘interest’ which is accruing on the ‘loan’) the lessee’s debt to the lessor increases. This led to tax planning opportunities where ‘interest’ earnings could be recognised for accounts purposes much sooner than they were taxable. Schemes which used deferred rental structures to avoid or defer tax, and the legislation enacted to counter them are described at BLM70000 (https://www.gov.uk/hmrc-internal-manuals/business-leasing-manual/blm70000) onwards.

Where the rentals are set at an amount equal to the ‘interest’ on the ‘loan’ the lessee’s debt remains static and the lease is equivalent to an interest-only loan. Such a lease is likely to contain a requirement to pay a terminal rental at the end of the lease term which will, in effect, repay the ‘loan’.

Various combinations are possible. For example, the lease might be equivalent to an interest-only loan for a few years and then become equivalent to a repayment loan for the rest of the lease term.

Primary and secondary periods

A finance lease is usually split into ‘primary’ and ‘secondary’ periods. The ‘loan’ (with the ‘interest’) is repaid during the primary period. Once that period is complete, the lessee usually has the option to continue to hire the asset for a nominal rent during the secondary period, whether indefinitely or for at least the remaining useful life of the asset.

The structure of the lease is crucial to the nature of a finance lease.

The primary lease period protects the lessor: it ensures that the loan implied in the lease is repaid just as it would be under an actual loan;

The secondary lease period protects the lessee: it recognises that the lessee has acquired economic ownership of the asset and that, without legal title to the asset, the lease must protect the lessee’s right to carry on using the asset.

Rentals payable in the secondary period are usually nominal, reflecting the fact that the lessee has repaid what amounts to the loan. The secondary period rentals are often essentially just sufficient to cover the lessor’s administration costs.

It should be noted that leases are often structured in this way because the parties wish to avoid any provision under which the lessee might become the owner of plant or machinery (and so the lessee can’t simply acquire the asset at the end of the primary period). If they are not, CAA2001/S67 may apply and treat the lessee (not the lessor) as the owner for capital allowances purposes. The effect of section 67 CAA 2001 is discussed in detail at BLM39000 (https://www.gov.uk/hmrc-internal-manuals/business-leasing-manual/blm39000) onwards.

Rental rebates and termination payments

At any time from the end of the primary period (and sometimes from an earlier point) the lessee is often entitled to require the lessor to sell the asset and pay the majority (often over 99%) of the net sale proceeds to the lessee by way of rental rebate. The net sale proceeds are the sale proceeds less any amount that might be due by way of rent.

The lessor is usually entitled to retain only a trivial proportion of the net sale proceeds. In addition to this, the lessor is entitled to ensure that, where needed, it recoups its capital investment plus interest on the outlay, whether that comes out of the sale proceeds or by way of a further ‘termination rental’. The objective is to ensure that the lessor recoups its net cost plus an amount that is equivalent to interest on the loan.

Exceptionally, the lessor might seek additional payments where a lease is terminated early.

Long-funding leases

Long funding leases are taxed differently to other types of lease. See BLM20000 (https://www.gov.uk/hmrc-internal-manuals/business-leasing-manual/blm20000) onwards for guidance on deciding whether a lease is a long funding lease and BLM40000 (https://www.gov.uk/hmrc-internal-manuals/business-leasing-manual/blm40000) onwards for guidance on taxing long funding leases.