What is a finance lease?

The lessor buys the asset your business has chosen and leases it to you for a fixed term, typically two to five years. You make regular rental payments that recover most of the asset's cost plus the lessor's finance charge. A residual value is set at the start, based on the asset's expected worth at the end of the term and the ATO's minimum residual guidelines. Some equipment leases are instead priced so the rentals cover almost the whole cost, leaving only a nominal residual, and that variant is sold as a full payout lease.

At the end of the lease you are responsible for the residual. In practice most lessees either make an offer to buy the asset for its residual value, refinance the residual into a new arrangement, or return the asset for sale and cover any shortfall between the sale price and the residual.

For tax, the lessor owns the asset and claims the depreciation. Your business claims the rental payments as a deduction to the extent the asset is used for business, and claims the GST credit on each rental if registered. Because you never take ownership during the term, there is no upfront GST credit as there would be with a chattel mortgage. Leases of cars above the ATO car limit are treated differently for tax, as a notional sale and loan, so check the luxury car leasing rules before relying on the deduction.

For accounting, AASB 16 requires most lessees to bring leases onto the balance sheet as a right-of-use asset and a matching lease liability, with depreciation and interest recognised instead of a single rental expense.

Finance leases suit businesses that want to preserve working capital, prefer fully deductible payments, and expect to keep the asset for most of its useful life. Vehicles, plant, medical and manufacturing equipment are common examples.

If you would rather own the asset outright from day one, a chattel mortgage is the usual alternative. If you want the financier to carry the end-of-term value risk and hand the asset back, look at an operating lease. A novated lease is the salary-packaged version used for employee cars.