How Does A Capital Lease Work?
What is a capital lease? What’s a sales lease? What’s a true lease? What are the differences and which one is best for me?
These are common questions we receive on a consistent basis. For people who dip their toes into the leasing industry but do not work in it consistently or at all, vernacular can be a challenge. Moreover, different companies have their own names for these products, sometimes confusingly where they overlap but mean different things.
In an effort to alleviate any confusion, in this post I will be outlining the capital lease, one of AmurEF’s core products. AmurEF offers other products, such as Equipment Finance Agreements (EFAs) and Operating Leases (sometimes referred to as true leases), which have their own distinct characteristics, primarily with respect to legal ownership of the equipment and tax treatment, as well as specific advantages and disadvantages. Future entries in this blog will cover these products, too.
The capital lease is a hybrid agreement in a category all its own. It maintains certain characteristics of a lease, but its basic structure is very much like that of a typical loan. In a capital lease, the customer (the lessee) picks out the equipment but the lessor (say, AmurEF) purchases it from the vendor(s) and retains ownership. The customer is allowed full use of the equipment in exchange for paying the lessor a stream of payments according to the lease schedule. The equipment serves as collateral during the lease term.
If all goes well, at the expiration of the lease term, the customer will have made all the payments according to the lease agreement and will (or has the option to) purchase the equipment from the lessor for a nominal fee. In fact, another term for the capital lease is a dollar out lease because at the expiration of the lease term the lessee purchases the equipment from the lessor for $1.00 (or $101.00 in some States), making it almost a certainty that the customer will actually end up owning it. That’s why the basic structure of the agreement is very much like a loan.
Criteria for Capital Leases
The Uniform Commercial Code (the “U.C.C.”) codifies general business practices into criteria to help determine whether a financing agreement represents a capital lease. The facts of each individual agreement matter a great deal in the ultimate determination whether a financing agreement represents a capital lease, true lease, or equipment finance agreement. However, some criteria tend to be common across all State jurisdictions because they are closely based on the U.C.C.:
- The agreement is non-cancellable;
- The original term of the lease is equal to or greater than the remaining economic life of the equipment;
- The lessee is bound to renew the lease for the remaining economic life of the equipment or become its owner;
- The lessee has an option to renew the lease for the remaining economic life of the equipment for no additional consideration or for a nominal additional consideration; or
- The lessee has an option to become the equipment owner for no additional consideration, or for a nominal additional consideration.
Capital Lease Vs. Loan: Understanding The Differences
Given the similarities between a capital lease and a loan, how do they differ? This post is not meant to be all encompassing but I will outline a couple of major differences.
One unique feature of the equipment finance industry, and therefore, capital leases, is the presence of the hell or high water clause. This clause requires all payments to be made according to the lease schedule for the entirety of the lease term regardless of any underlying circumstances the customer may face (i.e., come hell or high water). If the customer chooses to pay early, he or she will still be liable for the entirety of the remaining payment stream. In that way, the payment terms are very much like the customer is leasing/renting the equipment during the entire lease term.
Additionally, there may be a clause that directs a customer to contact the equipment manufacturer in the event of any issues that may fall under any product warranty. That is, the lessor is not in any way responsible for fixing any equipment problems; the equipment quality does not impact the validity of the agreement.
As we have seen, there are many similarities between a capital lease and a basic loan. There are also some similarities between a capital lease and an operating lease. A capital lease is instead a hybrid instrument, with some characteristics of a lease and some of a loan. To better understand the most suitable financing option, customers should feel free to contact us and speak with a sales representative, who will always be happy to understand their equipment needs and discuss specific financing options available!
Notice: This is not legal advice and not, in any way, create an attorney/client relationship. If you have any questions about the information contained in this post, please contact your attorney and/or CPA to discuss the particulars of various lease products as they relate to your specific situation.
Seth Yount is Corporate Counsel at Amur Equipment Finance, Inc. He obtained his law degree and M.B.A. from Creighton University in 2011. He has been with Amur’s legal department for more than 4 years and is also a Certified Lease Finance Professional.