What is Combination Lease?
Combination lease offers features of both financing or capital lease and Operating Lease. This is a customizable form of leasing. One of the simple examples of combination lease is a capital lease that carries a clause for cancellation. This is different as it is usually found in operating leases.
Operating lease is a service lease where the contract term is short. Short and long terms of the lease are determined by the life of the asset. Under this, the lessor (the owner of the asset) provides for the maintenance and financing. This type of lease can be canceled anytime. On the contrary, a financial lease is usually fully amortized. It simply means that it can be leased out for the entire life of the asset and cannot be canceled. Even sale and leaseback of assets (such as airplanes) is a type of financial lease.
Reasons for Combining
Combined leases are created to have different types of obligations from suppliers. The combinations can include components of the lease and even non-lease components. There are specific conditions which do not allow a simple lease to exist but create different components.
An example is the lease of an industrial area which in turn has the lease of land, buildings, equipment, or contract for car lease combined with maintenance.
It happens in large projects with a requirement for many contracts to be entered into with the same counterparty. This is also required to be done at almost the same time for conducting work of one contract as it is dependent on the next one. By law under IFRS (International Financial Reporting Standards), an entity is required to combine contracts with leases under specific conditions. If the assets involved are a single lease component, the contracts are negotiated as a package with the overall commercial objective.
Under the United States tax laws, IFRS 16 is the all-encompassing statute for all lease-related agreements and issues. However, the non-lease components of a combined lease are covered by the respective standards. Hence, combined leases are very complex in nature for tax treatments.
Combination lease is a smart way for companies to integrate different requirements of a project. Under normal circumstances, these majority components would classify a lease as a finance lease or operating lease. The substance of the lease determines this distinction rather than the form of the contract. A combined lease requires this distinction to be created between operating and financial lease finally to ensure the right tax treatment. These steps are important to records the income correctly for the lessor and also for the lessees to record the lease rentals in a correct manner. Leases are now part of the financial statements and do affect the cash flow in a major way.1,2