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Leveraged leasing of railway rolling stock in Canada : a comparative analysis of the equipment leases… Norman, Terrance James 1975

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LEVERAGED LEASING OF RAILWAY ROILING STOCK IN CANADA A C o m p a r a t i v e A n a l y s i s o f the Fqulpment Leases S i g n e d by C a n a d i a n P a c i f i c and C a n a d i a n N a t i o n a l R a i l w a y s Between 19R9 and 1971* by TERRANCE JAMES NORMAN B.Comm. , M c G i l l U n i v e r s i t y , 1970 A THESIS SUBMITTED IN PARTIAL FULFILMENT OF THE REQUIREMENTS FOR THF DEGREE OF MASTER OF SCIENCE IN BUSINESS ADMINISTRATION i n the Department o f COMMERCE AND BUSINESS ADMINISTRATION We a c c e p t t h i s t h e s i s as c o n f o r m i n g t o the r e q u i r e d s t a n d a r d THE UNIVERSITY OF BRITISH COLUMBIA J a n u a r y , 1975 In p r e s e n t i n g t h i s t h e s i s in p a r t i a l f u l f i l m e n t o f the r e q u i r e m e n t s f o r an advanced d e g r e e at the U n i v e r s i t y o f B r i t i s h C o l u m b i a , I a g r e e that the L i b r a r y s h a l l make i t f r e e l y a v a i l a b l e f o r r e f e r e n c e and s t u d y . I f u r t h e r agree t h a t p e r m i s s i o n f o r e x t e n s i v e c o p y i n g o f t h i s t h e s i s f o r s c h o l a r l y p u r p o s e s may be g r a n t e d by the Head o f my Department o r by h i s r e p r e s e n t a t i v e s . It i s u n d e r s t o o d tha t c o p y i n g o r p u b l i c a t i o n o f t h i s t h e s i s f o r f i n a n c i a l g a i n s h a l l not be a l l o w e d w i t h o u t my w r i t t e n p e r m i s s i o n . Department o f Commerce and Business Administrat ion The U n i v e r s i t y o f B r i t i s h Co lumbia V ancouver 8, Canada Date D S C . Z O ] \<W*+ i i ABSTRACT L e v e r a g e d l e a s i n g o f e q u i p m e n t has become t h e l o w e s t c o s t and most r e a d i l y a v a i l a b l e s o u r c e o f e x t e r n a l f u n d s f o r t r a n s p o r t a t i o n c o m p a n i e s i n N o r t h A m e r i c a . T h i s s t u d y e x a m i n e s t h e e x p e r i e n c e o f t h e p r i n c i p a l C a n a d i a n r a i l -r o a d s w i t h l e v e r a g e d l e a s i n g of; r o l l i n g - s t o c k . I t a l s o e x a m i n e s some r e c e n t c h a n g e s In C a n a d i a n g o v e r n m e n t r e g u l a t i o n s w h i c h w i l l s i g n i f i c a n t l y a f f e c t t h e f u t u r e o f l e v e r a g e d l e a s i n g i n C a n a d a . I t i s e s s e n t i a l t o b e g i n w i t h a b a s i c u n d e r s t a n d i n g o f r a i l -way e q u i p m e n t f i n a n c i n g . C h a p t e r 2 r e v i e w s t h e b a c k g r o u n d o f e q u i p m e n t f i n a n c i n g by N o r t h A m e r i c a n r a i l r o a d s and t h e t y p e s o f e q u i p m e n t o b i i g a t i o n s t h a t h a v e e v o l v e d o v e r t h e y e a r s . C h a p t e r s 3 and 4 e x p l a i n how l e v e r a g e d l e a s i n g w o r k s and s u r v e y t h e t h e o r e t i c a l m o d e l s t h a t a r e a v a i l a b l e ifin f i n a n c i a l l i t e r a t u r e f o r a n a l y z i n g t h e l e a s e - o r - b u y d e c i s i o n . I t i s t h e n p o s s i b l e t o a p p l y t h e t h e o r y t-oipemp<l;nica'iltdataThfhe f i n a n c i a l l e a s e s s i g n e d by C a n a d i a n P a c i f i c a n d C a n a d i a n N a t -i/dnal R a i l w a y s b e t w e e n 1969 and 197k are e x a m i n e d t o a s s e s s t h e i r e c o n o m i c m e r i t s . A p p l i c a t i o n o f two o f t h e most r e c e n t t h e o -r e t i c a l m o d e l s t o t h e l e a s e s s i g n e d by CN and CP c o n f i r m e d i t h a t t h e r a i l w a y s ' d e c i s i o n s t o l e a s e w e re c o r r e c t . H o w e v e r t h e r e w e re s i g n i f i c a n t d i f f e r e n c e s I n t h e ways t h e l e a s e w e r e i i i a n a l y z e d . CN Is a Crown c o r p o r a t i o n and f t does n o t pay f e d e r a l Income t a x . . I t a c h i e v e s l o w e r f i n a n c i n g c o s t s by " s e l l i n g " t h e t a x s h i e l d ( p r i n c i p a l l y d e p r e c i a t i o n w h i c h c a n be d e d u c t e d f r o m t a x a b l e i n c o m e ) ) w h i c h i s n o r m a l l y d e r i v e d f r o m o w n e r s h i p o f an a s s e t t o a n l e s s o r i n r e t u r n f o r a l o w e r l e a s e r a t e . On t h e o t h e r h a n d / CP c a n u s e t h e t a x s h i e l d b u t i t ts r e s t r i c t e d t o a d e p r e c i a t i o n r a t e o f 6% o n d e c l i n i n g b a l a n c e e a n n u a 1 1 y f o r t a x p u r p o s e s . I t a c h i e v e s l o w e r f i n a n c i n g c o s t s i s b y " s e l l i n g " t h e t a x s h i e l d t o a l e s s o r w h i c h c a n d e p r e c i a t e t h e same a s s e t a t 20£ on d e c l i n i n g b a l a n c e i n Canada o r a t a c c e l e r a t e d d e p r e c i a t i o n r a t e s c o u p l e d w i t h t h e i n v e s t m e n t t a x c r e d i t i n t h e U n i t e d S t a t e s . T h e o v e r a l l b e n e f i t s t o CN f r o m l e a s i n g a r e c o m p a r a b l e t o t h e b e n e f i t s t o CP b u t t h e y a r e much more a p p a r e n t i n a b e f o r e - t a x c a l c u l a t i o n . A n a l y s i s o f t h e CP l e a s e - o r - b u y d e c i s i o n i s c o m p l i c a t e d by i n c o r p o r a t t i m g t h e t a x s h i e l d i n t o an a f t e r - t a x c a l c u l a t i o n . The l o w e s t c o s t e x t e r n a l s o u r c e o f c a p i t a l f o r b o t h CN and CP was f o u n d t o be l e v e r a g e d l e a s i n g u s i n g U7ST f i n a n c i a l s o u r c e s f o r e q u i p m e n t t o be u s e d i n i n t e r n a t i o n a l s e r v i c e b e t w e e n Canada and t h e U n i t e d S t a t e s . The n e x t b e s t a l t e r n a t i v e i s l e v e r a g e d l e a s i n g usiimg C a n a d i a n f i n a n c i a l s o u r c e s . iv ) ' ' T h e r e have been two r e c e n t p o l i c y d e c i s i o n s by t h e C a n a d i a n g o v e r n m e n t w h i c h have a l r e a d y s e r i o u s l y a f f e c t e d l e v e r a g e d l e a s i n g o f r o l l i n g s t o c k by t h e C a n a d i a n r a i l r o a d s . The D e p a r t m e n t o f N a t i o n a l Revenue i s s u e d I n t e r p r e t a t i o n B u l l e t i n IT-16U on J u n e 5, 197U. I t s t a t e d t h a t a l e s s o r i n a l e v e r a g e d l e a s e t r a n s a c t i o n i s a l l o w e d t o d e p r e c i a t e t h e a s s e t s o n l y t o t h e e x t e n t o f t h e f u n d s t h a t t h e l e s s o r has p l a c e d a t r i s k . T h i s l e a v e s t h e m a j o r i t y o f t h e c o s t o f t h e a s s e t s u n d e p r e c i a t e d f o r t a x p u r p o s e s and i t means t h a t l e v e r a g e d l e a s i n g i n Canada i s u n e c o n o m i c a l u n d e r t h o s e c i r c u m s t a n c e s . On November 1 8 , 197U, ttebe M i n i s t e r o f F i n a n c e removed t h e e x e m p t i o n o f w i t h h o l d i n g t a x on payments t o f o r e i g n e r s f o r t h e u se o f r a i l w a y r o l 1 I n g s t o c k In C a n a d a . T h i s means t h a t 1 5 | o f t h e e n t i r e r e n t on l e a s e s s i g n e d W i t h f o r e i g n f i n a n c i a l s o u r c e s a f t e r t h a t d a t e must be w i t h h e l d and r e m i t t e d t o t h e C a n a d i a n g o v e r n m e n t . T h i s e f f e c t i v e l y s t o p s a l l f u r t h e r l e v -e r a g e d l e a s e s on C a n a d i a n r a i l w a y r o l l i n g s t o c k f i n a n c e d i n t h e U n i t e d S t a t e s . W i t h h o l d i n g t a x i s a p p l i e d o n l y t o t h e i n t e r e s t payments on f o r e i g n Bond f i n a n c i n g b u t on l e a s e f i n a n c i n g i t a p p l i e s 1 t o b o t h ^ i n t e r e s t and r e p a y m e n t o f p r i n c i p a l . T h i s s t u d y f o u n d t h a t t h e c o n c e r n o f t h e C a n a d i a n g o v e r n m e n t o v e r p o s s i b l e l o s s o f t a x revenues as a r e s u l t o f l e a s i n g i s o v e r s t a t e d . A c o m p a r i s o n o f l e a s i n g o r b u y i n g the same a s s e t by a t a x a b l e C a n a d i a n c o r p o r a t i o n p r o v e d t h a t t h e r e i s a b s o l u t e l y no d i f f e r e n c e tn t a x revenues to t h e g o v e r n -ment even on a p r e s e n t v a l u e c a l c u l a t i o n . On l e a s e s s i g n e d by n o n - t a x a b l e c o r p o r a t i o n s l o w e r t a x revenues c o u l d r e s u l t f r o m the l o w e r f i n a n c e c h a r g e s f o r l e a s i n g as opposed t o b o r r o w i n g i n o r d e r t o b u y . i f the f i n a n c e c h a r g e s a r e e q u a l i z e d f o r the two a l t e r n a t i v e s , t h e n t h e governmenitri; r e c e i v e s more t a x revenue i n p r e s e n t v a l u e terms f r o m the use o f l e a s i n g than i f c o r p o r a t i o n s b o r r o w e d i n o r d e r t o p u r c h a s e a s s e t s . A d d i t i o n a l f i n d i n g s o f t h i s s t u d y i i , n c l u d e : (1) C a n a d i a n and U ; S . l e a s e f i n a n c i n g i s d i f f e r e n t i a t e d p r i m a r i l y by a c c e l e r a t e d d e p r e c i a t i o n and use o f the i n v e s t m e n t t a x c r e d i t (7% o f the c o s t o f the a s s e t can be d e d u c t e d f r o m t a x p a y a b l e ) i n t h e s U n i t e d S t a t e s . As a r e s u l t , U . S . l e a s e r a t e s are g e n e r a l 1 y 1 ower t h a n C a n a d i a n l e a s e r a t e s , g i v e n c o m p a r a b l e debt r a t e s . ( 2 ) The t h e o r y t h a t t h e d?fference,t : . f between debt and l e v e r a g e d l e a s e r a t e s i n c r e a s e s as debt r a t e s i l n c r e a s e was not s u p p o r t e d by t h e e m p i r i c a l e v i d e n c e f r o m CN l e a s e s . (3) The o n l y b i b l i o g r a p h y e o n equipment l e a s i n g was p u b -l i s h e d i n 1960. T h i s s t u d y i n c l u d e s d e t a i l e d b i b l i o g r a p h y w h i c h s h o u l d be he 1 p f u 1 i t o r e s e a r c h e r s . vi The s t u d y c o n c l u d e s w i t h two r e c o m m e n d a t i o n s : (1) The C a n a d i a n g o v e r n m e n t s h o u l d t a k e s t e p s t o e n c o u r a g e r a t h e r t h a n d i s c o u r a g e l e v e r a g e d l e a s i n g - i n Canada by r e v i s i n g I T - I S ^ . ( 2 ) The new w i t h h o l d i n g t a x r e g u l a t i o n s s h o u l d be amended t o a p p l y o n l y t o t h e i n t e r e s t p o r t i o n o f l e a s e payments l e a v i n g t h e c o u n t r y . v i i TABLE OF CONTENTS CHAPTER PAGE 1 INTRODUCTION Objectives of the Study Importance of the Study Methodology Summary of Succeeding Chapters HISTORICAL METHODS OF FINANCING RAILROAD 8. EQUIPMENT Equipment Obligations Legal Status Experience in Default Types of Obligations Conditional Sale Agreements (The New York Plan) Equipment Trust Agreements (The Phi ladelphia Plan) True Leases Comparative Advantages and Disadvantages of the Plans THE DEVELOPMENT OF LEASING AS A FINANCIAL 23. ALTERNATIVE History Current S t a t i s t i c s Types of Leases Operating Financial Leveraged Leases Leveraging as an Inherent Part of Financing Advantages and Disadvantages of Leasing Advantages Discredited Advantages Disadvantages UNDERLYING FINANCIAL THEORY ON LEASE EVALUATION 41. Basic Issues Lease-or-Buy vs. Lease-or-Borrow Select ion of Appropriate Cash Flows Select ion of Appropriate Discount Rates Development of Financial Theory Discounted Cash Flow Method V a n c i l ' s Basic Interest Rate Method Bower, Herringer and Williamson v i i i CHAPTER PAGE Beechy's Ef fec t ive Interest Method Johnson and Lewellen Roenfeldt and Osteryoung Gordon's NPV Model Evaluation of the Models and Their Usefulness i n a Prac t i ca l Sett ing Equivalence of the NPV and IRR Approaches Current State of the Art 5 APPLICATION OF LEASING THEORY TO CN AND CP RAIL 68. History of Leasing by CN and CP Comparison of CN and CP Financing Analysis of Interest Rate Spreads from CN Leases Effect of Leasing on Annual Capital Budgets Long-run Financial Implications Summary 6 CANADIAN GOVERNMENT POLICY ON LEASING 86. General Background The Capital Cost Allowance System Interpretat ion B u l l e t i n IT-17 Interpretat ion B u l l e t i n IT-164 The Public Interest Minimization of Capital Idleness Economies of Spec ia l iza t ion Adequate Credit Evaluation Fluctuations in the Business Cycle Effects on Tax Revenue Summary 7 CONCLUSIONS AND RECOMMENDATIONS 102. Conclusions Recommendations Areas for Further Research SELECTED BIBLIOGRAPHY GLOSSARY OF TERMS 110. 118. CHAPTER PAGE APPENDICES: A. Letter from the Minis ter of Finance of Canada 122. B. Leveraged Lease Transactions - U.S. and Canadian 124. C. ELAC Survey Results 129 D. Computer Simulation of Hypothetical Leveraged Leases 137 E. CN Equipment Leases Signed Between 1969 and 1974 142 F. CP Equipment Leases Signed Between 1969 and 1974 152 G. Interpretation Bul le t ins IT-17 and IT-164 153 H. ELAC Br ie f on IT-17 157 LIST OF TABLES PAGE 1. Cash Flow Stages in a Leveraged Lease 34 2. A. Net Present Value Models 46 B. Internal Rate of Return Models 47 3. Notation to Accompany NPV and IRR Models 48 4. Cash Flow From CP Rai l Lease Dated Oct. 15, 1973 62 5. Cash Flows Using Gordon's NPV Model 63 6. Cash Flows Using Roenfeldt and Osteryoung's IRR Model 64 7. Interest Spread Categories on CN Lease Financing 1969 - 1974 74 8. Interest Rate Spreads on CN Leases 1969-1974 75 9. New R o l l i n g Stock Ordered Annually by CN and CP 79 10. Railway Equipment Under Lease by CN and CP 80 11. New R o l l i n g Stock Leased by CN as a Percent of Total New R o l l i n g Stock Acquired Annually 81 12. I n i t i a l Cost of Equipment Leased by CN 82 13. Estimated Savings to CN i n Finance Charges Over the Lives of Leases Signed During 1969-1974 82 14. S e n s i t i v i t y Analysis on Salvage Value of Leased Equipment - Residual Values Needed to Overcome Lease Advantage 83 15. Present Value of Tax Revenues to the Canadian Govern-ment From Corporations Involved i n the Financing of Equipment for Users (Lessees or Purchasers) which are Taxable or Non-taxable Corporations. (A) Including Depreciation Deductions (B) Excluding Depreciation Deductions 98 16. Cash Flow Analysis by Years - Canadian Lease Financing 126 17. Cash Flow Analysis by Years - U.S. Lease Financing 127 x i PAGE 18. Computer Simulation of a Hypothetical Railway Car Lease Transaction with U.S. Financing (A) (B) Including Investment Tax Credit Excluding Investment Tax Credit 139. 140. 19. CN 1969 Equipment Leases 145. 20. CN 1970 Equipment Leases 146. 21. CN 1971 Equipment Leases 147. 22. CN 1972 Equipment Leases 148. 23. CN 1973 Equipment Leases 149. 23.A CN 1973 Equipment Leases Continued 150. 24. CN 1974 Equipment Leases 151. 25. CP Equipment Leases 1969-1974 152. LIST OF FIGURES 1 . Equipment Obligations as Part of Total Long Term Debt 2. Railway R o l l i n g Stock Leveraged Lease Transaction Financed in Canada 3. Canadian Leveraged Lease Transaction - Lessor's Cash Flow Analysis by Years 4. Theoretical Relationship Between Lease Rates and Long Term Debt Rates (U.S. Financing Including ITC) 5. Car Orders Related to Railway Earnings 6. Comparison of Canadian and U.S. Leveraged Lease Transactions - Lessor's Cash Flow Analysis by Years 7. Theoretical Relationship Between Basis Point Spreads and Long Term Debt Rates in the United States With and Without the Investment Tax Credit Incorporated in Leveraged Leases z i i i ACKNOWLEDGEMENTS A thesis could be compared to a long and d i f f i c u l t journey. As I reach the end of mine, I would l i k e to pause to recognize some of the many who provided sustenance, encouragement and d i r e c t i o n along the way. I am espec ia l ly indebted to Professor Wil l iam G. Waters I I , my thesis committee chairman. His c l a r i t y of view, substantive e d i t o r i a l commentary and good humour engendered much of what i s worthy in th is paper. I also thank Professor Bernhard Schwab for his keen interes t in synthesizing the theory on leasing and devotion of time far beyond the c a l l of duty. Professor Trevor D. Heaver contributed s i g n i f i c a n t advice p a r t i c u l a r l y with respect to the objectives of the study. Although i t i s impossible to acknowledge a l l of the deserving contributors to a project of th is scope, I would l i k e to mention some of the members of the f i n a n c i a l community who supplied much time and t a l e n t . I am indebted to E . J . Denyar, Vice President Finance, Canadian National Railways and H. S l a t e r , Director Corporate Financing, CP Rail for t h e i r guidance on the corporate views, Mark H a r r i s , Vice President and Direc tor , McLeod, Young, Weir & Company L t d . provided valuable commentary and suggestions on the i n s t i t u t i o n a l arrangements and tax impl i ca t ions . Larry Grant, Lease Analys t , NAC Leasing Corporation, ran the computer simulation which was used to derive the theoret ical re la t ionship between debt and lease rates . I am also indebted to the Transportation Development Agency for i t s f i n a n c i a l xiv support of my studies through a T.D.A. Fel lowship. F i n a l l y , my wife Una deserves a great deal of c red i t for the s a c r i f i c e s and adjustments she has made during the l a s t year and a h a l f . As well as typing the many drafts and preparing the f i n a l manuscript, she has also provided much warmth and happiness. 1. CHAPTER 1  INTRODUCTION Objective of the Study Leveraged leasing of equipment has become the lowest cost and most readi ly avai lable source of external funds for transportation companies i n North America. This study examines the experience of the p r i n c i p a l Canadian ra i l roads with leveraged leasing of r o l l i n g stock. It also examines some recent changes i n Canadian government regulations which w i l l s i g n i f i c a n t l y a f fec t the future of leveraged leasing in Canada. Importance of the Study This i s the f i r s t comprehensive study of leveraged leasing in Canada. It i s also the f i r s t study on f i n a n c i a l analysis of leasing in North America that includes empirical information on lease rates.' ' ' There have been approximately 1,000 a r t i c l e s published on various aspects of leasing during the past decade and a h a l f . The only bibliography on equip-2 ment leasing was published in 1960. To save future researchers the 1 To date there has been only one other comprehensive study on the f i n a n c i a l analysis of l eas ing . See Thomas A. Nelson, "The Impact of Leases on F i n -ancial A n a l y s i s " , Occasional Paper No. 10, Bureau of Business and Economic Research, Michigan State U n i v e r s i t y , East Lansing, Michigan, 1963. The dearth of published studies i n th i s f i e l d stems d i r e c t l y from the unava i l -a b i l i t y of detai led data on leas ing . 2 Credit Research Foundation, "A Bib l iographica l L i s t i n g On Equipment ii Leasing" , National Associat ion of Credit Management, New York, 1960. 2. considerable investment in time and e f f o r t required to search out relevant a r t i c l e s , a comprehensive bibliography on equipment leasing has been provided i n the Selected Bibl iography. In addit ion the author has arranged with the Equipment Lessors Associat ion of Canada to publish a complete bibliography of a l l a r t i c l e s on equipment leasing which-have 3 been published since 1960. The underlying f i n a n c i a l theory on the lease-or-buy decision for a poten-i a l lessee has developed only recent ly . . As a consequence there i s inadequate treatment of th is theory in every textbook on f inance. Chapter 4 provides a synthesis of the various theoret ica l approaches which should be of interes t both to academics and businessmen. This study should also be of s igni f i cance to the f i n a n c i a l community because i t includes appl ica t ion of recently developed f i n a n c i a l theories to contemporary corporate s i t u a t i o n s . I t need hardly be mentioned that the study should be of in teres t to CN and CP. The d o l l a r values of the equipment budgets, for the two railways are in the area of $300-400 m i l l i o n annually. During the l a s t f i v e years , CN alone acquired 18,891 pieces of new r a i l equipment at a cost of $547.8 4 m i l l i o n . This study determines that the to ta l cost of equipment acquired 3 Terrance J . Norman, "Equipment Leasing Bibliography 1960-1964", Equipment Lessors Associat ion of Canada, Willowdale, Ontario , (forthcoming). 4 Ken Romain, "Equipment Order Worth $95 M i l l i o n i s Part of CN's $1 B i l l i o n Program", The Globe and M a i l , (Toronto), June 19, 1974,p.B4. 3. on f i n a n c i a l leases by CN since 1969 amounts to $400.3 m i l l i o n or 73% of the new assets were on lease. The study also estimates that CN w i l l save up to $90 m i l l i o n i n f inancing charges over the l i v e s of those leases compared to conventional debt f inanc ing . The present value of those savings i s about $60 m i l l i o n . Looking to the fu ture , CN President Dr. Robert A. Bandeen has predicted that his company w i l l acquire $1 b i l l i o n worth of new r o l l i n g stock in the next f i v e years , i . e . almost double the amount of the l a s t f i v e years . By leveraged leasing CN could save up to $225 m i l l i o n in f inancing charges on that equipment. However, the p o s s i b i l i t y of such f inancing on new r o l l i n g stock has been threatened by two recent changes in Canadian government pol icy a f fec t ing l eas ing : (1) r e s t r i c t i v e income tax regulations on leveraged leasing in Canada and (2) the appl ica t ion of withholding tax on a l l lease payments leaving the country. In a d d i t i o n , the Canadian government recently i n s t i t u t e d a complete review of the capi ta l cost allowance (depreciation) system. This study should be of in teres t i n that review. Methodology The study has mult iple f o c i i . The p r i n c i p a l ones are (1) a review and synthesis of the f i n a n c i a l theory on leasing (2) appl icat ion of theo-r e t i c a l models to the lease-or-buy decisions of CN and CP and (3) analysis of Canadian government po l i cy on leas ing . A to ta l of seven d i f f e r e n t f i n a n c i a l models on the analysis of the lease-or-buy/borrow decision are surveyed. Comparisons are drawn between the 4. basic approaches and the assumptions inherent in each of the models. The models are c r i t i c a l l y evaluated and two representative ones are tested for equivalence by using the data from a recent lease t ransact ion. The data for the analysis of e f fec t ive interes t rates i s taken from the o r i g i n a l copies of the leases signed by CN and CP. According to the R a i l -way Act , one o r i g i n a l copy of every lease signed by a Canadian railway must be f i l e d with the Registrar General of Canada within 21 days of execution. . These leases are avai lable to publ ic sc rut iny . They contain a great deal of information including the schedule of lease payments, cost of debt for the l e s s o r , renewal and purchase options, and a complete descr ipt ion of the equipment. To cross-check the to ta l d o l l a r values of a l l r o l l i n g stock acquired by the two railway companies during the per iod, a survey was conducted of the announcements of new equipment orders by the railways in trade publ i ca t ions . This information was cross-checked with changes i n equipment reg is t ra t ions by the two railways in the O f f i c i a l Railway Equipment Register and with information f i l e d with S t a t i s t i c s Canada. The accuracy of the information was then confirmed by further discussion with the ra i lways . Summary of Succeeding Chapters Chapter 2 traces the development of equipment obl igat ions as a major source of external capi ta l for the r a i l r o a d s . I t examines the viewpoints of both the ra i l roads and the investors . The legal status and experience in default 5. with equipment obl igat ions are discussed. The i n s t i t u t i o n a l arrangements are set out for each of the three types of o b l i g a t i o n s : (1) condit ional sale agreements, (2) equipment t rus t agreements and (3) true leases. F i n a l l y , the advantages and disadvantages of the three d i f f e r e n t obl igat ions are compared. Chapter 3 reviews the development of leasing as a f i n a n c i a l a l t e r n a t i v e . A b r i e f h is tory of the development of leasing i s followed by s t a t i s t i c s on the current s ize of the leasing market i n North America. The next part summarizes the basic difference between the two major types of l eas ing : operating and f i n a n c i a l . A special type of f i n a n c i a l lease , the leveraged lease, i s discussed in d e t a i l . I t i s dist inguished by cer ta in character-i s t i c s : (1) three p r i n c i p a l part ies are involved rather than the usual two (lessee and l e s s o r ) , (2) the cash flows occur in four separate phases and (3) the to ta l cash received by the lessor exceeds his equity p a r t i c -ipat ion and his investment i s recovered q u i c k l y . A recent example of a leveraged lease transaction i s presented to c l a r i f y these points . Next the use of leveraging in other forms of f inancing is compared with leveraged leas ing . The chapter ends with a discussion of the advantages and disad-vantages of lease f inancing. Chapter 4 examines the underlying f i n a n c i a l theory on lease evaluat ion. There are three basic issues in the f i n a n c i a l analysis of l e a s i n g : (1) i s i t only a f inancing decision or i s i t a j o i n t investment-financing dec i s ion ; (2) what are the appropriate cash flows to use; and (3) what are the appropriate 6. discount rates . Af ter discussing these i ssues , the development of f i n -ancial leasing models is traced up to the most recent one proposed in March, 1974. The pr inc ipa l controversy i n the l i t e r a t u r e has been over whether the analysis i s handled best by a net present value (NPV) or an internal rate of return (IRR) approach. The various f i n a n c i a l leasing models are evaluated and t h e i r usefulness in a prac t i ca l se t t ing i s discussed. The equivalence of the NPV and IRR approaches i s demonstrated by using the f igures from a recent f i n a n c i a l lease signed by CP R a i l . The chapter concludes with an analysis of the current state of the ar t i n leasing theory. Chapter 5 applies the la tes t theory to leases signed by CN and CP between 1969 and 1974. F i r s t the his tory of long-term f i n a n c i a l leasing of r a i l -way r o l l i n g stock in Canada i s traced from i t s inception in 1969 to the present time. Then the CP lease described in Chapter 4 i s applied to CN to determine i f there are any differences i n lease analysis for the two com-panies since CN i s owned by the government and CP is a widely held publ ic company. Next the in teres t rate spreads (difference between debt and lease rates) from the CN leases are compared with theoret ical values that have been derived by computer s imulat ion . The next part analyzes the e f fect of leasing on the annual capi ta l budgets for the two railway companies. The chapter ends with an assessment of the long-run f i n a n c i a l implicat ions for the railway companies with respect to l eas ing . Chapter 6 analyzes government pol icy on leasing in Canada. It leads o f f 7. with a discussion of the general background and history of Canadian tax pol icy concerning leas ing . The next part describes the capi ta l cost allowance (depreciation) system in Canada followed by a review of two i n t e r -pretat ion b u l l e t i n s that have been issued by the Department of National Revenue i n recent years. The Department i s in the process of rev i s ing the f i r s t one fol lowing representations from the Equipment Lessors Associat ion of Canada (ELAC). Because of the importance of tax i m p l i c -ations for leasing transactions and vice versa, there has been considerable controversy over whether or not equipment leasing i s in the publ ic i n t e r e s t . Five considerations are examined to evaluate th is question: (1) minimization of cap i ta l id leness ; (2) economies of s p e c i a l i z a t i o n ; (3) adequate c red i t evaluat ion; (4) smoothing f luctuat ions i n the business c y c l e ; and (5) ef fects on tax revenues. The conclusion i s that the implicat ions of leveraged leasing for tax revenues to the Canadian government are n e g l i g i b l e even when calculated i n present value terms. Chapter 7 presents the conclusions and recommendations a r i s i n g out of th i s study. Areas for further research in the f i e l d of lease analysis are suggested. 8. CHAPTER 2 " •-  • - si HISTORICAL METHODS OF FINANCING RAILROAD EQUIPMENT Railway companies in Canada i n i t i a l l y received most of t h e i r external funds from bond f inancing in London. By the late 19th century many of the North American ra i l roads had reached the l i m i t in what they could finance through open mortgages on t h e i r property. At about the same time the f i n a n c i a l markets in New York had developed in s ize and expertise aided by the innovative a t t i tude of the American businessman. Various forms of equipment obl igat ions were devised by the Americans to provide new markets for external f inancing by the r a i l r o a d s . 1. Equipment Obligations Equipment obl igat ions may be defined as corporate obl igat ions issued for the acquis i t ion of r o l l i n g stock (railway cars or locomotives) and secured by exclusive reservation of t i t l e to the equipment. They are exclusive in the sense of not sharing th is securi ty with other creditors of the r a i l r o a d This reservation could be accomplished through: (1) an undisguised con-d i t i o n a l sale (as in the time purchase of a t e l e v i s i o n s e t ) ; or (2) an agreement ca l l ed an equipment t rus t under which the r a i l r o a d i s s t ipula ted to be using the equipment only as lessee u n t i l payments are completed (the instal lment payments being disguised as r e n t ) ; or (3) an outr ight lease. P r i o r to 1950 most r a i l r o a d equipment f inancing in North America was under e i ther of the f i r s t two forms because leasing d i d n ' t come into vogue u n t i l a f ter the Second World War. 9. Equipment obl igat ions have become the chief source of external funds for the ra i l roads because the. strength of these obl igat ions makes them the most economical and i n some cases the only source of external funds. ' ' Street compared the gross capi ta l expenditures of Class 1 railways in the United States with charges to earnings for depreciat ion, retirements and 2 equipment obl igat ions for the period 1890-1955. Updating his data to 1971 from Moody's Transporation Manual showed that equipment obl igat ions increased from approximately 1% of to ta l r a i l r o a d debt in 1890 to about 40% in 1971 (see Figure #1). The steady increase af ter the Second World War was s i g n i f i c a n t . Even more revealing i s the fact that almost a l l of the new bonds issued were for ref inancing of previous issues. I t i s important to note that leases are excluded from the figures on equipment obl igat ions because the U.S. ra i l roads are not required to f i l e such i n f o r -mation with the Interstate Commerce Commission, the source of much of the information complied by Moody's. There are several reasons why the railways have placed such heavy dependence on equipment ob l iga t ions . Probably the most important one is that t h e i r tota l capi ta l expenditures have exceeded t h e i r depreciation reserves. Since i t i s very d i f f i c u l t to arrange external f inancing for f ixed railway plant such as bridges, roadbed, hump yards and centra l ized t r a f f i c c o n t r o l , 1 D.M. S treet , Railroad Equipment Financing, Columbia Univers i ty Press, New York, 1959, p .2 . 2 i b i d . , pp.10-11. FIGURE #1 EQUIPMENT OBLIGATIONS AS PART OF TOTAL LONG TERM DEBT A L L RAILWAYS IN UNITED STATES EXCEPT SWITCHING & TERMINAL COMPANIES 8 J t o z: ° 7 i — i / TOTAL LONG TERM DEBT OQ 6 5 4 3 EQUIPMENT OBLIGATIONS 1925 1930 — i 1935 — i — 1940 1945 1950 1955 1960 YEARS 11. i t became good business to finance equipment acquis i t ions with low cost external f inancing while applying i n t e r n a l l y generated funds to finance projects which would otherwise have been d i f f i c u l t or impossible to f inance. From the investors ' viewpoint the advantages are: 1. The equipment i s indispensable to operation of the railway company. 2. Railroad r o l l i n g stock is durable and has a very low physical obsol -escence rate . The wheels and brakes are changed when they wear out but the basic car las ts as long as 40 to 50 years. 3. In the event of de fau l t , the owner has the a b i l i t y to repossess the equipment and s e l l i t in the best market. There i s l i t t l e d i f f i c u l t y in repossessing because the equipment i s e f f e c t i v e l y l i m i t e d to the North American continent where there i s considerable uniformity of law. 4. The equipment i s c o l l a t e r a l with a ready market value. I t i s standard guage so i t can be readi ly sold to another r a i l r o a d or private car company. As part of t h e i r normal operations, rai1 roads interchange t h e i r equipment so there i s no problem in moving cars to a new l o c a t i o n . 5. The form of the obl igat ion i s such that in bankruptcy or reorgan-i z a t i o n , the equipment c e r t i f i c a t e i s a d i rec t claim on on the 12. property and is not commingled with other c laims. The disadvantages are: 1. The demand for r a i l r o a d equipment might f a l l o f f sharply i . e . economic obsolescence. 2. In the event of de faul t , payment would be delayed even though f u l l recovery might be achieved in the long run. Legal Status The legal claim to ownership of r o l l i n g stock in the United States and Canada is protected by f i l i n g one o r i g i n a l copy of the equipment obl igat ion with the Interstate Commerce Commission in Washington and the Registrar General of Canada i n Ottawa respect ive ly . Recording i s necessary in only one of the countries unless one of the part ies to the agreement has oper-ations in the other country. The most important development in the past century regarding equipment obl igat ions was the controversy surrounding the p e t i t i o n for reorganization f i l e d on June 7, 1933 by the Chicago, Rock Island and P a c i f i c Railway Company. The mortgage bondholders contended that , under Section 77 of the Bankruptcy A c t , the equipment t rus t holders should be restrained:from 3 J . F . Weston and E.F . Brigham, Managerial Finance, 2nd E d i t i o n , H o l t , Rinehart and Winston, 1966, p.384. 13. repossessing t h e i r equipment j u s t as the mortgage bondholders are restrained from foreclos ing upon t h e i r property. Further they contended that the equip-ment obl igat ion was merely a securi ty t i t l e , i n other words a mortgage. Congress resolved the matter by adding Subsection ( j ) to Section 77 of the Bankruptcy Act as fo l lows : " The t i t l e of any owner, whether as trustee or otherwise, to r o l l i n g stock equipment leased or condi t iona l ly sold to the debtor, and any r ight of such owner to take possession of such property in compliance with the provisions of any such lease or condit ional sale contract , sha l l not be affected by the pro-vis ions of th is s e c t i o n . " 4 This exemption was l a t e r tested and upheld by the 1954 Court of Appeals decision i n the h i s t o r i c New York, Ontario and Western case. In dismissing the appeal the t r i a l judge pointed out that the objective of the exemption was to maintain a strong equipment f inancing market because i f that market should dry up " r a i l r o a d reorganization trustees might often be unable to procure needed equipment, with the consequence that suspension of oper-5 ations would often be accelerated . . . " . The recent f inancing of equipment obl igat ions for over 2,400 new f r e i g h t cars for the bankrupt Penn Central substantiates the e f fec t of th is exemption.^ Experience in Default I t i s sometimes assumed that equipment obl igat ions are r i s k l e s s investments. This i s not e n t i r e l y true but there are many cases where payments have been 4 Bankruptcy Act of the United States, amendment dated 1935. 5 215 F 2nd 63 (1954) 6 Railway Age, 1973, Annual Car Orders 14, maintained r ight through receivership or reorganization proceedings, others involv ing minor delays in payment and almost none involving substantial 7 8 loss . According to Dewing, the Denver and Rio Grande reorganization of 1886 i s "the only instance in the his tory of American railway finance where the holders of equipment obl igat ions issued under the Phi ladelphia Plan were forced to suf fer for a considerable per iod" . Street provides a g detai led account of a l l equipment obl igat ions that involved defaul t . According to him there have been only 4 cases since 1900 i n which holders of equipment obl igat ions have had to repossess and s e l l the pledged equipment. Of these there were only 2 serious losses where the rea l iza t ions worked out to 62% and 70% of the face value. They are j u s t 2 exceptions in thousands of cases of f u l l payment on time. Equipment obl igat ions o f fer the p r o b a b i l i t y rather than the certa inty of punctual payment, thus they cannot be considered r i s k i ess investments. The best c r i t e r i a are s t i l l (1) the earning power of the issuing r a i l r o a d to ensure puntual i ty and (2) l o n g - l a s t i n g , marketable equipment to ensure ultimate f i n a n c i a l safety. 7 8 9 Street , o p . c i t . , p.69 A.S . Dewing, A Study of Corporation S e c u r i t i e s , New York, 1934, p.371 Street , o p . c i t . , Chapter 5 In summary, the equipment obl igat ion i s an extremely powerful f inancing tool with i t s strength based upon the legal r ight to repossess and the economic opportunity to s e l l elsewhere r o l l i n g stock without which the r a i l r o a d cannot operate. 2. Types of Obligations (a) Conditional Sale Agreements (The New York Plan) The f i r s t d i s t i n c t i v e r a i l r o a d equipment f inancing i n North Amer ica 1 0 was undertaken in 1839 by the proprietors of the Locks and Canals Company at Lowel l , Massachusetts which had b u i l t several locomotives for the Baltimore and Susquehanna Rail Road Company. The locomotives were del ivered to the presdient of the r a i l r o a d who acted as an agent for the s e l l e r s under an agreement by which t i t l e was to remain with the s e l l e r s u n t i l the notes accepted in payment had been f u l l y pa id . This i s a c l a s s i c and undisguised condit ional sale agreement sometimes ca l l ed "The New York P lan" . The i n s t i t u t i o n a l arrangements under the condit ional sale plan are as fo l lows : 1. The trustee makes payment to the manufacturer with funds supplied by the r a i l r o a d (the down payment) and by the underwriters; 2. The underwriters s e l l notes of the r a i l r o a d which are secured by 10 Paul Smith J r . , The Development of the Legal Status of American R a i l - road Equipment S e c u r i t i e s , Unpublished J . S . D . D i s s e r t a t i o n , New York Univers i ty School of Law, March, 1950, p.14. reservation of t i t l e to the equipment in the trustee for the benefit of the noteholders u n t i l the notes are paid i n f u l l ; 3. The r a i l r o a d agrees as fo l lows : (a) to pay p r i n c i p a l and interes t on the notes, (b) to maintain, operate, repair and (when necessary) insure the equipment, (c) to pay a l l taxes and (d) to do everything necessary to protect the trustee 's t i t l e ; 4. Upon payment i n f u l l on the notes, the trustee turns over t i t l e to the equipment to the r a i l r o a d ; 5. The r a i l r o a d has the r ight to the use of the equipment only as long as i t maintains payments on the notes. In the event of default on the payments, the trustee has the r ight to seize the equipment. (b) Equipment Trust Agreements (The Phi ladelphia Plan) In 1845 the S c h u y l k i l l Navigation Company negotiated a loan for the f inancing of barges and subsequently of railway cars . This was the f i r s t 11 agreement that included s p e c i f i c mention of a lease. This agreement then developed i n 1848 into the "Railroad Car Trust of Phi ladelphia" which was the e a r l i e s t car t rus t of th i s k ind . 11 Francis Rawle, "Car Trust S e c u r i t i e s " , American Bar Associat ion  Reports, VIII (1885), pp.277-322 17. The Phi ladelphia Plan was conceived because of cer ta in legal decisions in the State of Pennsylvania which held the retention of t i t l e i n the vendor under a condit ional sale of a chattel to be i n v a l i d as against t h i r d p a r t i e s . Thus the contract could not be safely drawn in the form of a condit ional sale and i t was necessary to base the contract upon the idea of a bailment (see Glossary) with an option in the vendee to purchase the cars at the termination of the contract . These contracts have always been upheld even though the so-ca l led rent was i n r e a l i t y the 12 payment of the purchase price by insta l lments . Thus the Phi ladelphia Plan i s r e a l l y not a lease but a disguised condit ional sale agreement. Some of i t s unique i n s t i t u t i o n a l arrangements are as fo l lows : 1. The r a i l r o a d contracts with the manufacturer for the purchase of the equipment but takes care not to acquire i t (or make payment for i t ) d i r e c t l y ; 2. The manufacturer de l ivers certa in documents to the t rustee , the most important ones being the b i l l of sale and the r a i l r o a d ' s acceptance of the equipment; 3. The trustee makes payment with funds received from the r a i l r o a d ("advance r e n t a l " , normally about 20% of the purchase p r i c e , repre-senting the down payment) and the balance from the underwriters 12 i b i d . , p.277. 18. (representing the pr inc ipa l amount of the equipment t rus t cer t -i f i cates) ; 4. The equipment t rus t c e r t i f i c a t e s are sold to the publ ic by the underwriters. They mature s e r i a l l y i n from one to f i f t e e n years and 13 they carry dividends at a rate s t ipula ted in the t rus t agreement. They are guaranteed as to p r i n c i p a l and dividends by the r a i l r o a d company; 5. The r a i l r o a d agrees to pay as r e n t a l , sums s u f f i c i e n t to cover p r i n c i p a l and dividends on the equipment t rus t c e r t i f i c a t e s . A l l other covenants of the r a i l r o a d and the r ights and remedies of the trustee are s i m i l a r to those under the New York Plan. (c) True: Leases In 1949 the Equitable L i f e Assurance Society of the United States pioneered a program of lease plans as an a l ternat ive to the f i r s t two forms of equip-ment f inanc ing . This was the beginning of " true" leases which are d i f f e r -entiated from Phi ladelphia Plan leases in that they do not include auto-matic transfer of t i t l e to the equipment to the lessee at the end of the lease. If a purchase option i s included in the lease, i t i s at f a i r market value. 13 It i s customary to use the term "dividends" when re fer r ing to in teres t on equipment t rus t c e r t i f i c a t e s issued under the Phi ladelphia Plan -Leonard D. Adkins and DeForest B i l l y o u , "Current Developments i n R a i l -Road Equipment Financing" , The Business Lawyer, X I I , A p r i l , 1957, p.207. 19. The i n s t i t u t i o n a l arrangements for finance leases are as fo l lows : 1. As under the Phi ladelphia P lan , the r a i l r o a d contracts with the manufacturer for the purchase of the equipment but takes care not to acquire i t (or make payment for i t ) d i r e c t l y . 2. The manufacturer del ivers certa in documents to the t rustee , the most important ones being the b i l l of sale and the r a i l r o a d ' s acceptance of the equipment. 3. The trustee makes payment with funds received from the " investor-.. 14 owners . 4. The r a i l r o a d uncondit ionally agrees to pay rental without any offsets and in installments as spec i f ied in the lease. A l l other covenants of the r a i l r o a d and r ights and remedies of the trustee are s i m i l a r to those under both the New York and the Phi ladelphia Plans except for the transfer of t i t l e at termination. Provision may be made in the lease for renewal options at f a i r rental value. (d) Comparative Advantages and Disadvantages of the Plans From the point of view of the r a i l r o a d , the advantage of the lease arrange-ment i s that (a) no down payment i s required and (b) the r a i l r o a d i s e n t i t l e d to deduct the ent ire rent from i t s income for tax purposes. This 14 Assuming an unleveraged lease. In the case of a leveraged lease the investor-owners would be made up of two separate p a r t i e s ; the equity and the debt investors . This w i l l be covered in more depth i n Chapter 3. 20. rent reduction i s a larger amount than interes t plus depreciation under the other plans over a comparable period. In Canada railways can deprec-iate the i r equipment at only 6% annually on decl in ing balance (Class 4) for example, r o l l i n g stock under equipment t rus t f inanc ing , whereas 15 leasing companies can depreciate s i m i l a r assets at 20% annually (Class 8) . This slow w r i t e - o f f for the Canadian ra i l roads has the e f fect of t ipping the scales in favour of leasing in a t y p i c a l lease arrangement (see Chapters 4 & 5) . The depreciation rate for Canadian railway equipment was assessed over 20 years ago when railway r o l l i n g stock normally had a useful l i f e of 40 to 50 years. Today the useful l i f e of a r a i l r o a d car i s about 30 years and diesel locomotives generally l a s t only 20 years even with a major rebui ld during that time. The lease arrangement i s also advantageous to certa in ra i l roads with r e s t r i c t i v e covenants in t h e i r mortgages or other f inancing agreements i f f ixed charges exceed a spec i f i ed amount. In r a i l r o a d accounting, in teres t on equipment t rus t or condit ional sale o b i i g a t i o n s , i s a f ixed charge but i fi rent under an equipment lease i s not. Obviously the disadvantage to the r a i l r o a d of a true lease i s that the r a i l r o a d does not acquire t i t l e to the equipment without payment upon termination of the lease and the benefit of the residual value i s l o s t . 15 CCH Canadian L t d . , Canadian Depreciation Guide, 13th E d i t i o n , p.24. 16 Adkins & B i l l y o u , o p . c i t . , p.210. 21. A condit ional sale agreement also has an advantage over an equipment t rus t i n that usually no down payment i s required i f a substantial part of the equipment may not be del ivered u n t i l some time a f ter the execution of the documents. Under equipment t rus t agreements i t i s normal to s e l l the ent i re amount of the equipment t rus t c e r t i f i c a t e s at one t ime 1 ^ and to deposit the proceeds with the trustee to be held pending del ivery of the equipment. The r a i l r o a d , however, must pay interes t on the c e r t i f i c a t e s from the date of i ssue. Although the trustee may invest any temporary sur-plus funds in short term government s e c u r i t i e s , the in teres t received is less than that paid by the r a i l r o a d . Under leases and condit ional sale agreements the money i s advanced as required in accordance with the schedule for del ivery of the equipment. Even i n these cases the investors protect themselves against delay by contracting for a commitment fee on the deferred advances i n the case of condit ional sales or by contracting for the railway to pay for inter im financing arranged with a bank or t rus t company in the case of leases. The combined ef fect of the burden of the 20% down payment required for equipment t r u s t agreements and the advent of leveraged leasing coupled with the U.S. Investment Tax Credit which subs tant ia l ly reduced e f fec t ive in teres t rates on leases has swung the recent trend in r a i l r o a d equipment f inancing strongly in favour of leas ing . The next chapter w i l l trace the background 17 However, some equipment t rus t agreements provide for sale of the c e r t i f i c a t e s in installments corresponding to del ivery of the equip-ment but the arrangements must be made well i n advance and they are less f l e x i b l e to changes i n del ivery dates. of leasing i n North America and i t s appl ica t ion to the f inancing of r a i l r o a d equipment. 23. CHAPTER 3 THE DEVELOPMENT OF LEASING AS A FINANCIAL ALTERNATIVE History Leasing is not a new concept. I t could be traced back in h is tory to the " rent ing" of property by feudal lords i n Europe. This was the only device by which a serf could acquire the r i g h t to the use of a g r i c u l t u r a l land. The "rent" to be paid to the landlord was in the form of a certa in per-centage of the crop y i e l d . Thus, in many s i t u a t i o n s , owners (public author i t ies as well as private i n d i v i d u a l s ) looked to the lease as a means of obtaining economic rewards for the use of land that they were unwi l l ing to s e l 1 . I t was only a matter of time before leasing was adapted from real estate to moveable property. Probably the f i r s t instance of equipment leasing was the chartering of ships . However, i t was not u n t i l a f ter the Second World War that equipment leasing became a general pract ice in North America. At that time there were combined pressures of t i g h t money conditions and tremendous demands for expansion of the economy. Leasing was one of the few ways the burgeoning industry i n the United States could finance the equipment i t desperately needed for expansion. However, at that time leasing was considered as merely a temporary mechanism which would be discarded as soon as prac t i cab le . Leasing was b r i e f l y in vogue again during the m i d - f i f t i e s but i t could not shake the aura of i l l e g i t i m a c y about i t . I t was often asserted that leasing was only for 24. those who couldn' t secure t r a d i t i o n a l f inanc ing . In 1963 the leasing industry in the United States was given a stimulus when the Comptroller of the Currency ruled that U.S. banks could engage in leasing d i r e c t l y to customers. The entry of the banks into the leasing f i e l d gave the industry and the product a new r e s p e c t a b i l i t y and coupled with the introduction of the investment tax c r e d i t , i t tr iggered an explosive increase in volume of business in the United States. Tight money conditions such as in 1969-70 encouraged many treasurers of large corporations to consider leasing as an a l ternat ive source of f inanc ing . A l s o , many companies such as the a i r l i n e s were faced with large capi ta l expenditures to replace outmoded equipment and yet they could not u t i l i z e the tax shelter from depreciation benefits on the new equipment because they did not have enough p r o f i t s . Consequently the sale of the tax shelter to a bank, leasing company or investor t rus t became the most economical means of f inancing the equipment because the e f f e c t i v e lease rate was much lower than the long term debt rate and the tax shel ter could not be u t i l i z e d in any event. The investment tax c redi t i n the United States accentuated th is advantage i n favour of leasing for such companies because i t too could be passed through to the lessor i n return for a lower lease rate (often the difference i n ra tes , known as the "spread", was as much as 500 basis points or 5% in favour of l eas ing) . With the above s t i m u l i , leasing in the United States became an e f fec t ive too l for implementing that government's expansionary economic pol icy by ensuring that depreciation and investment tax credi ts are f u l l y u t i l i z e d by companies 25. that would not benefit otherwise. To date the Canadian chartered banks have not been allowed to lease d i r e c t l y but there are indicat ions that th is w i l l be changed i n the forthcoming rev is ion of the Canadian Bank Act which i s scheduled for 1977. 1 In the meantime U.S. leasing companies have been attracted to Canada by the vacuum created by the absence of the Canadian chartered banks and the increasingly competitive climate in the United States. I t has been estimated that as 2 much as 85% of the assets leased i n Canada are foreign owned. Current S t a t i s t i c s Edward H a r s h f i e l d , Senior Vice President of C i t i c o r p Leasing International Inc. (one of the world's largest leasing companies), has estimated that as 3 of 1974 more than $105 b i l l i o n worth of equipment has been leased worldwide. Other estimates show that the volume of lease transactions in Canada has r isen from about $50 m i l l i o n i n 1960 to approximately $1 b i l l i o n in 1973.^ 1. Wayne Cheveldayoff, "Chartered Banks Being Drawn to Equipment Leasing Business", Toronto Globe and M a i l , May 4, 1973, p . B l . Also Beatrice Riddel 1 and Stephen Duncan, "Next - A Brawl Over Bank A c t " , Financial  Post, December 15, 1973, p . l . 2 Statement by Glen Langdon, President of the Equipment Lessors Associat ion of Canada, at the 1st Annual Meeting and Conference of that associat ion i n Ottawa on September 24, 1974. 3 Edward H a r s h f i e l d , "Worldwide Growth Seen in Equipment Leasing" , Industr ia l Leasing, Maclean Hunter L t d . , Toronto, March, 1974, p.26. 4 Wayne Cheveldayoff, "Volume of Lease Arrangements Increases to $1 B i l l i o n This Year", Toronto Globe and M a i l , May 4, 1973, p.B5. 26. However, aside from general f igures such as the above, there i s very 5 l i t t l e author i ta t ive data on leasing i n North America. In an e f f o r t to compile some basic information on the character and composition of the leasing market in Canada, the newly formed Equipment Lessors Associat ion of Canada (ELAC) commissioned Touche, Ross and Company to conduct a survey of the industry . The preliminary results of the survey (See Appendix C) released in May, 1974 revealed an astonishing 56% annual compound growth rate i n assets leased i n Canada over the period from 1962 to 1972. S t a t i s t i c s Canada has now taken on the task of providing good s t a t i s t i c a l data on the industry i n co-operation with ELAC. To put the above very b r i e f f igures in perspective, the investment by leasing companies in Canada currently represents about 3% of the to ta l annual investment i n new capi ta l equipment by a l l Canadian businesses. Corresponding U.S. f igures indicate that over 6% of a l l American capi ta l assets are purchased annually by lessors . The U.S. leasing market i s generally considered to have a 5 to 10 year head s t a r t on the Canadian market. In the United States there are about 1,800 f i n a n c i a l i n s t i t u t i o n s and subsidiar ies of i n d u s t r i a l companies who are engaged in general equipment l eas ing .^ In Canada there are 54 leasing 5 Tom Messer, "Huge Growth Predicted for Leasing Industry" , Industr ia l  Leasing, Maclean Hunter L t d . , Toronto, March, 1974, p .5 . 6 Peter Vanderwicken, "The Powerful Logic of the Leasing Boom", Fortune, November, 1973, p.136 27. companies but, depending on the d e f i n i t i o n , th is f igure could range as high as 94 companies involved i n l eas ing . ' ' Types of Leases 1. Operating Operating leases are usually short-term (5 years or less) and the i n i t i a l cost of the asset i s not f u l l y repaid during that term. The lessor often assumes a l l the r e s p o n s i b i l i t i e s of ownership including maintenance, insur -ance and taxes. The lease payments on operating leases include provis ion for the r i sks of obsolescence and maintenance that are assumed by the l essor . Operating leases today generally are l imi ted to automobile rental and short-term contracts for heavy equipment needed for s p e c i f i c jobs. 2. Financial Financial leases are usually of longer terms such as 8 to 15 years. The f u l l cost of the asset plus a p r o f i t i s recovered by the lessor in the form of rental rece ipts , tax benef i t s , and residual value. Financial leases are net of any offsets such as maintenance, insurance and taxes other than income tax. They are usually non-cancellable. Thus the r i s k of obsolescence i s borne by the lessee. Financial leases usually include a purchase option at f a i r market value and/or renewal options at f a i r rental value on completion of the i n i t i a l term. 7 Messer, op. c i t . 28. 2. (a) Leveraged Leases In recent years a special form of f i n a n c i a l lease has become very popular for f inancing large t i c k e t items such as a i r c r a f t and r o l l i n g stock. Some-times i t i s ca l l ed a "leveraged lease" or a "tax shel ter lease" . Leveraged leases vary in s t ructure ; they have not been a u t h o r i t a t i v e l y defined. From the viewpoint of the lessee they are very s i m i l a r to standard f i n a n c i a l leases, but from the l essor ' s viewpoint they character-i s t i c a l l y have certa in common features: ( i ) Three P r i n c i p a l Parties are Involved: 1. a lessee who i s contractual ly bound to f u l f i l l his obl igat ions under the lease regardless of what happens to the property. Generally the lease covers most of the useful l i f e of the asset. 2. a long-term credi tor (lender) who provides the major portion of the purchase pr ice of the asset as a loan (between 50% and 80% of the funds). Typica l ly the loan is non-recourse to the lessor and i s usually secured by a mortgage on the leases asset , an assign-ment of the lease and lease payments and sometimes a guarantee of the debt by the lessee. 3. a lessor (commonly c a l l e d the "equity par t i c ipant " ) who generally acquires the asset in connection with a s p e c i f i c lease arrangement and who provides the remainder of the purchase p r i c e . Usually the equity par t i c ipant operates through a contro l led t rus t which i s l e g a l l y the l essor . The equity par t i c ipant usually obtains an income tax r u l i n g (pr ior to closing) c e r t i f y i n g that the lease meets the c r i t e r i a for the equity par t i c ipant to be considered as the owner of the leased asset. His securi ty pos i t ion i n the asset , the lease, and the lease payments are subordinate to that of the long-term c r e d i t o r . An example of a recent r o l l i n g stock leveraged lease transaction i s included in Figure #2. Cash Flows The second prominent feature of a leverage lease i s the pattern of cash flows to the lessor which can be described in s i m p l i f i e d fashion i n 4 states (ignoring earnings on reinvested funds): 1. Investment: The lessor pays out cash for his share of the purchase price of the leased asset. 2. Net cash in f low: In the ear ly years of the lease the lessor receives a net cash inflow stemming from (a) rental receipts less (b) debt service payments plus (c) investment tax c redi t ( i f applicable) and other tax FIGURE »2 30 PAYMENT FLOWS IN A RAILWAY  ROLLING STOCK LEVERAGED LEASE TRANSACTION  FINANCED IN CANADA DECEMBER 1, 1971 LEASING BROKER AND INVESTMENT BANKER: MCLEOD, YOUNG, C O . L T D . WEIR arranged fo r e q u i t y , placed debt and negot iated lease terms. Fee: 1-2% of equip ment cost ($37,780 -$75,560) TOTAL COST : , $3,778,000 INCLUDING FEDERAL SALES TAX EQUIPMENT: 200 - 52' GONDOLA CARS REPORTING MARKS: CN 136400 - 136599 BUILDER: CN SHOPS, POINT ST. CHARLES (MONTREAL) benefits from depreciation of the asset and interes t expense on the non-recourse debt which i n this phase exceed the rental rece ipts . Of course these benefits are only rea l ized i f the lessor has other taxable income; the tax benefits do not l i t e r a l l y give r i s e to a cash inflow but rather reduce cash outflow. 3. Net cash outflow: In each succeeding year of the lease the sum of tax deductions for depreciation and interes t declines and eventually f a l l s below rental income, there by creating taxable income for the lessor . As a r e s u l t , the net cash inflow to the lessor s teadi ly declines and eventually reverses so that i n the l a t t e r years of the lease the lessor experiences a net cash outf low, (See dotted l i n e in Figure 3). 4. Residual r e a l i z a t i o n : At the termination of the lease, the asset i s e i ther sold by the lessor or re-leased thus producing a f i n a l cash flow (considered as a s ingle payment in th i s case to s i m p l i f y the a n a l y s i s ) . The four cash flow stages are i l l u s t r a t e d by the example in Table which i s derived from Table #16 and the accompanying assumptions Appendix B. 32. ( i i i ) Recovery of Funds in Excess of Equity P a r t i c i p a t i o n The t h i r d prominent feature of leveraged leases i s apparent from Figure #3: the to ta l cash received by the lessor during the net cash inf low stage exceeds his equity p a r t i c i p a t i o n . That "excess" cash flow arises quickly and reverses s lowly. Thus the lessor "recovers" his investment early in the l i f e of the lease (after 3 years have elapsed i n the above example) and for several years thereafter has funds in excess of his o r i g i n a l investment avai lable for reinvestment elsewhere. The earnings on the reinvestment of those "excess" funds are one of the major considerations to the lessor . Leveraging as an Inherent Part of Financing It i s a commonly-held view that leveraged leases are unlike any other form of investment. This view has been challenged on the grounds that each of the elements of a leveraged lease has i t s counterpart in other business transact ions. Many ordinary lessors as well as other corporate e n t i t i e s are "leveraged" in the sense that they finance the acquis i t ion of assets at least par t ly with long-term debt. Any owner of depreciable assets financed i n part by long-term debt has many of the elements of cash flow that characterize a leveraged lease. F i n a l l y , many corporations and indiv idua ls earn income by reinvest ing the funds made avai lable by per-manent tax reductions and temporary tax d e f e r r a l s . Those who contend that leveraged leases are unique usually acknowledge that such leases are made up of elements found elsewhere. They point out that THOUSANDS OF DOLLARS FUNDS RECOVERED IN EXCESS OF EQUITY INVESTMENT $357,000 SOURCE: APPENDIX B, T A B L E 1 5, COLUMNS 8 & c o TABLE #1 CASH FLOW STAGES IN A LEVERAGED L E A S E LESSOR'S CASH INFLOW (OUTFLOW) PHASES TOTALS INVESTMENT PHASE NET CASH INFLOW PHASE NET CASH OUTFLOW PHASE • RESIDUAL REALIZATION PHASE INVESTMENT IN LEASED A S S E T $ ( 3 , 1 3 5 . O O O ) 1 , ; - - $ ( 3 , 1 3 5 , 0 0 0 ) RENTAL R E C E I P T S $9,819,000 $6,546,000 - $ 1 6 , 3 6 5 , 0 0 0 INCOME TAX CREDITS (CHARGES) $ 1 , 9 7 7 , 0 0 0 $ ( 2 , 3 2 8 , 5 0 0 ) - $ ( 3 5 1 , 5 0 0 ) DEBT SERVICE PAYMENTS - • $ ( 7 , 8 1 8 , 0 0 0 ) $ ( 5 , 2 0 8 , 0 0 0 ) f ( 1 3 , 0 2 6 , 0 0 0 ) S A L E OF LEASED A S S E T • - - $ 500 , 0 0 0 I 500,000 LESSOR'S NET CASH INFLOW (OUTFLOW) $ ( 3 , 1 3 5 , 0 0 0 ) $ 3,978,000 $( 9 9 0 , 5 0 0 ) $ 500,000 r 352,500 NOTES: 1. I n c l u d e s U n d e r w r i t i n g f e e s o f $135,000 2. T o t a l s may n o t a d d up due t o r o u n d i n g SOURCE: APPENDIX B, TA B L E 16 35. leveraged leases generally provide an early return of the l essor ' s invest -ment a f ter which a further cash flow y i e l d s funds which can be reinvested to provide earnings. This cash flow l a t e r reverses and i t i s the tempor-ary use of these funds which consti tutes one of the major economic incentives to the investor . The proponents of th is view claim that no r e a l i s t i c sense of that e f fec t can be gained from looking at a leveraged lease merely as a combination of a lease, non-recourse debt and various tax benef i t s . But the underlying reason for the substantial differences in e f fec t ive rates between standard f i n a n c i a l leases and leveraged leases i s the a b i l i t y of the lessor to u t i l i z e the depreciation and' other tax related benef i ts . A large leasing company that finances i t s leases with in-house funds, which are themselves levered according to the company's debt/equity r a t i o , often has more depreciation on i t s books than i t can use to o f f se t income for tax purposes. Thus i t cannot a f ford to of fer the lessee a lower e f fec t ive rate i n return for passing substantial depreciation benefits through to the lessor . However, i n the case of the leveraged lease, the equity p a r t i c -ipants have entered the transaction pr imar i ly because they can use the tax s h i e l d to o f f se t income from other sources during the cash inflow of the lease. Advantages and Disadvantages of Leasing  Advantages Various advantages have been a t t r ibuted to leasing by lessors and f i n a n c i a l analysts . Although there i s some overlap, Bower, Herringer and Williamson c l a s s i f y these advantages into three groups: (1) Operating Advantages i . e . pertaining to basic cash flows such as a f te r - tax inflows from operations before deduction of f inancing charges. Examples are: (a) tax advantages from leasing through accelerat ion of deductions ( this may or may not be the case). (b) leasing permits firms that are unable to use the U.S. investment tax c red i t to benefit through lower rental payments by passing th is c red i t over to the lessor (even Canadian firms could do t h i s ) . (2) Risk Advantages i . e . pertaining to uncertainties of basic cash f lows. An example i s : (a) leasing reduces the r i s k of obsolesence and passes the : r i s k i n residual value to the lessor . (3) Financial Advantages i . e . pertaining to p r i o r claims on the basic cash f lows. Examples are: (a) leasing permits 100% f inanc ing . (b) leasing leads to junior c la ims , does not add debt on a balance sheet, and i s ignored by f i n a n c i a l analysts , hence i t adds to borrowing capacity. (c) leasing often enables firms to avoid some of the 8 Bower, Herringer and Will iamson, "Lease Evaluat ion" , The Accounting  Review, ( A p r i l , 1966), p.257. 37. t r a d i t i o n a l covenants which frequently impede or even preclude the sourcing of funds from i n s t i t u t i o n a l 9 investors or otherwise r e s t r i c t managerial f l e x i b i l i t y . Discredited Advantages^ Some of the advantages a t t r ibuted to leasing i n e a r l i e r days have since been d i sc red i ted . As the f inanc ia l community becomes more sophis t i ca ted , the real advantages to leasing are more apparent so that i t i s unnecessary for anyone to maintain fa lse advantages. (1) Frees Working Capital While i t may be true that leasing frees working capi ta l which would otherwise have been t i e d up in f ixed assets, th is applies equally as well to other a l ternat ive means of f inancing . (2) Improves Apparent Financial Posi t ion Since leases are not c a p i t a l i z e d on the balance sheet, firms can improve t h e i r apparent f i n a n c i a l pos i t ion in the eyes of stockholders by reducing debt and increasing lease f inanc ing . The equivalence of leasing and borrowing has been widely debated by the f i n a n c i a l community. In the United States , the Financial Accounting Standards Board (FASB - the successor to the Accounting Pr inc ip les Board) and 9 Although, i f debt i s outstanding at the same time, these covenants may be present anyway. 10 This section draws on Steve Engelberg, "Equipment Leasing in Canada", MBA Research Paper, McGil l U n i v e r s i t y , March 1974, pp.19-23 38. the Securi t ies Exchange Commission (SEC) have come out strongly i n favour of some method of reporting lease transactions on balance s h e e t s . 1 1 (3) Increases the Debt Capacity of a Firm I t i s often asserted that leasing increases the debt capacity of a f i r m . However, quite often what i s thought to be an expansion of the pool of c r e d i t i s r e a l l y the phenomenon of "compartmentalization" of f inanc ing , that i s , the use of several d i f f e r e n t sources can sometimes provide more funds in tota l because indiv idual lenders are w i l l i n g to r i s k only a l i m i t e d amount of t h e i r funds with one borrower. These sources of funds were already avai lable to the f i r m , i t jus t had not taken the i n i t a t i v e to use them. Professor! Richard Vancil of Harvard Univers i ty discussed this point in his ground-breaking 12 book on leas ing . " As a prac t i ca l matter, the e f fec t of f i n a n c i a l leases on corporate c redi t p o l i c i e s cannot be stated c a t e g o r i c a l l y ; i t i s a matter of the judgments of indiv iduals both inside and outside the corporat ion. When management sets i t s own l i m i t a t i o n on the use of corporate c red i t ( i . e . uses less c red i t than the f i n a n c i a l community would readi ly make a v a i l a b l e ) , the l i m i t a t i o n must be a r e f l e c t i o n of the degree of r i s k (through leverage) which management feels i t i s prudent to assume. In such a case, f i n a n c i a l leases, which are simply another way of gaining leverage, probably should be considered as quite s i m i l a r , i f not equivalent , to debt. For companies operating under an i n t e r n a l l y imposed "debt" r e s t r i c t i o n , i t seems safe to conclude that f i n a n c i a l leases do not o f f e r the advantage of permitting the 11 APB Opinion No. 31, American Ins t i tute of C e r t i f i e d Publ ic Accountants, New York, June, 1973. 12 Richard F. V a n c i l , Leasing of Industr ia l Equipment, McGraw-Hil l , New York, 1963, pp.33-34 39. corporation to use more of i t s c red i t than i t could use d i r e c t l y in the form of debt. In other s i t u a t i o n s , the judgment of f i n a n c i a l i n s t i t u t i o n s about the appropriate amount of leverage may be more r e s t r i c t i v e than management's judgment. Here, f i n a n c i a l leases may o f f e r an advant-age over debt by e i ther (1) providing new sources of debt-type funds or (2) opening up a new " layer" of c red i t that had not pre-viously been u t i l i z e d . New sources might be w i l l i n g to provide funds at a cost s i m i l a r to the cost of e x i s t i n g debt even though old sources might be reluctant to increase the amount of funds they had provided; the "compartmentalized" r i s k ; is spread over a larger number of investors . New layers of c r e d i t might be avai lable be-cause the investor i s compensated for his r i s k by charging a higher interes t rate than the e a r l i e r , senior layers had charged." Disadvantages (1) High Cost One of the most common reasons c i ted by companies who are not using lease f inancing i s the higher cost of leasing over borrowing. This i s true for operating leases involv ing small capi ta l outlays ($10,000 - $500,000) but once you reach the market segment for "big t i c k e t " assets, f i n a n c i a l leasing i s usually cheaper than borrowing. Of prime s igni f icance in the l a t t e r case is the taxable income posi t ion of the lessee. I f the company acquiring an asset does not expect to be able to use the tax shields from deprec iat ion, i n t e r e s t , and the U.S. investment tax c red i t ( i f a p p l i c a b l e ) , then the to ta l costs from leasing could be lower than from borrowing i n order to buy, even when the loss of residual value i s considered. (2) Lack of Control over Assets Another frequently c i t e d disadvantage of leasing is the lack of control 40. over f a c i l i t i e s which might have s t ra teg ic importance in the bus-iness , espec ia l ly i f renewal or purchase options are not negotiated at the outset. Once again th is pertains more to operating than to f i n a n c i a l leases. In the l a t t e r case, the lessee enjoys a l l the benefits of ownership as long as he does not default on the lease payments. Financial leases are generally long-term (15-20 years) with renewal and purchase options. The lessee loses no control over the assets under such leases. (3) Ownership is a Status Symbol There i s a psychological factor in favour of ownership which s t i l l looms large i n modern soc ie ty , even though i t may not be j u s t i f i a b l e in a cost-benefi t ana lys i s . Ownership is a status symbol, espec ia l ly where f a c i l i t i e s of production are concerned. However, the leasing market has mounted a formidable attack on th is psychological bar r ie r and i t appears to be crumbling. Over the years many of the advantages and disadvantages of leasing have been modified by changed tax laws and investor a t t i tudes . A mere l i s t i n g of the advantages and disadvantages i s no longer s u f f i c i e n t . More sophist icated methods of analysis have become necessary and they w i l l be examined in the next chapter. 41. CHAPTER 4 UNDERLYING FINANCIAL THEORY ON LEASE EVALUATION 1. Basic Issues Although leasing has grown considerably in p r a c t i c e , there has not been agree-ment on the correct method for analyzing the f i n a n c i a l impact on the f i r m . In determining the correct method of a n a l y s i s , three essential factors must be considered. F i r s t , i s i t only a f inancing dec i s ion , i . e . lease-or-borrow ( in order to purchase), or i s i t a j o i n t investment-financing d e c i s i o n , i . e . lease-or-buy? Second, what the the appropriate cash flows to be incorporated in the analysis? T h i r d , what i s (are) the appropriate rate(s) at which these flows should be discounted?^ (A) Lease-or-Buy vs . Lease-or-Borrow There has been a heated debate in the l i t e r a t u r e as to whether the a l te rnat ive to leasing i s buying, borrowing, or both. The lease-or-borrow approach recog-nizes that a lease i s quasi-debt. To separate the f i n a n c i a l and investment dec i s ion , the lease-or-borrow approach extracts the debt aspects i m p l i c i t in the lease arrangements. Once these f inancing aspects have been removed, the 2 costs of leasing are compared to the costs of ownership. A major problem with the lease-or-borrow approach is the requirement; that acceptab i l i ty of the investment be assessed f i r s t . Only i f the purchase 1 Wil l iam L. Sartor is and Ronda S. Pau l , "Lease Evaluation - Another Capital Budgeting Dec is ion" , Financial Management, Summer, 1973, p.46. 2 i b i d . 42. generates a return greater than the cost of capi ta l can the lease decision be 3 considered. This does not allow for the p o s s i b i l i t y that the purchase may have a negative net present value, whereas a lease arrangement for the same asset may have a pos i t ive net present value because of the difference in discount rates for the two methods of f inancing . The lease-or-buy approach does not require the acceptance of a project p r i o r to the evaluation of the cost of l eas ing . I t allows for the independent determination of the acceptab i l i ty of the purchase and of the lease, and, i f both are acceptable, the determination of the better of the two. The major c r i t i c i s m of the lease-or-buy approach is that i t does not take into account the r i s k d i f f e r e n t i a l s resu l t ing from -. capi ta l structure changes when a f i rm leases or buys an asset. The lease-or-borrow approach comes c losest to holding f i n a n c i a l r i s k constant when comparisons are made with the cash flows involved in leasing and borrowing in order to purchase (assuming 100% debt 4 f inanc ing) . Although the current debate i n accounting c i r c l e s over f u l l disclosure of long term leases on balance sheets suggests that f i n a n c i a l leases are not completely comparable to debt, many analysts and investors c a p i t a l i z e such leases when making corporate evaluations and the trend i s c e r t a i n l y in that d i r e c t i o n . Van Home suggests in his text that the cost of leasing rate should be included in the ca lcu la t ion of a f i r m ' s overal l 'weighted average cost 3 i b i d . , p.47 4 When comparing long term leases with corporate bonds of equal term having f ixed ra tes , one of the few d i f f e r e n t i a l s in f i n a n c i a l r i s k i s the salvage value of the assets upon termination of the lease. This subject i s covered in Chapter 5 with respect to the CN leases. 43. of c a p i t a l . The legal status of a f i n a n c i a l lease in a s i t u a t i o n involving bankruptcy or reorganization of a lessee is ce r ta in ly d i f f e r e n t from that of a bond indenture. The lessor ' s r ights are normally r e s t r i c t e d to one year ' s lease payments. However, in bankruptcy the lessor has the r ight to seize the assets under lease and in almost a l l f i n a n c i a l leases those assets are worth more than the tota l outstanding lease payments. In reorganization the lessee would l i k e l y continue to make the lease payments ahead of in teres t and p r i n c i p a l on bonds because otherwise the use of the leased assets (which are usually essential to company operations) would be l o s t . Many lessors also require a deposit which w i l l apply to the f i n a l lease payment(s) in leases involv ing greater r i s k . Consequently a f i n a n c i a l lease may be a stronger document than an indenture for a debenture. One further area of r i s k d i f f e r e n t i a l i n long term leasing versus borrowing involves the penalties that are sometimes assessed for premature abondonment of the equipment on lease. Most f i n a n c i a l leases today include ear ly ter -mination pr iv i l eges and the costs are stated e x p l i c i t l y in the leases. These costs should be weighted according to t h e i r expected p r o b a b i l i t y and the resu l t added to the cost of leasing in the comparison. 5 J . C . Van Home, Financial Management and P o l i c y , 2nd E d i t i o n , Prentice-H a l l , Englewood C l i f f s , N . J . , 1971, pp.582-583. 44. (B) Selection of Appropriate Cash Flows The second controversial issue in the f i n a n c i a l analysis of leasing has been the se lect ion of correct cash f lows. The analysis i s complicated by the existence of : (a) pre-tax and a f ter - tax cash f lows, (b) tax shields provided by i n t e r e s t , lease payments and deprec iat ion, (c) future salvage value of the assets and (d) possible recapture of depreciation on disposal of the assets . Borrowing i s usually analyzed on a pre-tax basis but in order to compare bor-rowing and leasing the analysis must be a f ter - tax because tax implicat ions are an integral part of lease f inancing . There are two d i f f e r e n t tax shields involved i n the a f ter - tax analysis of debt f inancing : (1) in teres t payments are tax deductible and (2) depreciation on the asset may be deducted for tax purposes. The a f ter - tax analysis of lease f inancing involves only one tax sh ie ld i . e . the lease payments are f u l l y deductible as expenses for tax purposes. The future salvage value w i l l be l o s t i f the assets are leased, thus an e s t i -mation of such value must be included in the ana lys i s . I f the assets are sold there w i l l be recapture of depreciation i f the s e l l i n g price exceeds the book value. The tax on such recapture of depreciation must be included. (C) Select ion of Appropriate Discount Rate(s) The t h i r d issue has been the se lect ion of the appropriate discount ra te ( s ) . 45. Ideal ly the discount rate(s) should capture the degree of r i s k in the pro-posal . There are two a l t e r n a t i v e s . One may use the overa l l cost of capi ta l to discount a l l cash flows or one may segregate the indiv idual cash flow components according to the i r r i s k charac ter i s t i cs and apply appropriate discount rates . I t does not seem unreasonable to use two or more discount rates for s i g n i f i c a n t l y d i f f e r e n t cash flow commitments with d i f f e r e n t degrees of r i s k . 2. Development of Financial Theory The preceding issues can be most c l e a r l y highlighted by comparing the various f i n a n c i a l models that have been proposed over the past 15 years . These models may be broadly c l a s s i f i e d as e i ther net present value (NPV) or internal rate of return (IRR) approaches. The most important ones have been summarized in equation form in Tables #2A and #2B with the corresponding notation i n Table #3. In some cases the models were not proposed in equation form i n i t i a l l y . The notation has been standardized as far as poss ib le . References to operating costs such as maintenance and insurance have been excluded because they do not apply to net finance leases on r o l l i n g stock. (A) Discounted Cash Flow (-DCF) Method The conventional method of analyzing leases has been to compare the discounted present value of the cash flows from leasing and borrowing. 6. James C T . Mao, Quantitative Analysis of Financial Decisions, The MacMillan Company, New York, 1969, p.323. T A B L E 2A 46 NET PRESENT V A L U E MODELS (A) L E A S E (B) PURCHASE OR BORROW DISCOUNTED CASH FLOW (DCF) METHOD > J — N P V C D ° / , : f w (i + M 4 • w ( 1 + k ) V A N C I L ' S B A S I C INTEREST RATE (B IR) METHOD L, (L, - i f ) T v—7 (P f + 1t) - ( 1 t - + D t ) T (1 + > ) 1 . (1 + k ) 1 B ^ — ' r 1 , (1 + k ) 1 B (1 + k ) t W t=l SV n - (SV n - BV) T (1 + k) n BOWER, HERRINGER AND WILLIAMSON n (L t ) T ^ — , (P t + 1t) ( i t + D t) T v — t h < L t > T v — - ( p t + 1y , 1 • F NPVC j> , - — , ^ 1 (1 + r)* (1 + k)* 8 * (1 + TY (1 + lO 1 t = l t = l SV n - (SVn - BV) T (1 + k ) n JOHNSON AND LEWELLEN ^ — ' TD t ^ - r L t (1 - T) T D * * r  (  - ) SV - T (SV - BV) 9 n L) ( 1 + r ) 1 l + k ) n t=l t=l GORDON S NPV MODEL Y 7 E 1 -T) ( i t J + pt . ^-'(T) D t L) ( i + i)1 ^ — ' ( l + D* t = l t = l ' _ ( i - T) L t _ S V j + ^ (T) D; ^ — ( 1 + I ) 1 (1 + k ) J 1 (1 + k ) 1 t - 1 t - - j + l FABLE 2B INTERNAL RATE OF RETURN MODELS (A) L E A S E (B) BUY OR BORROW BEECHY S E F F E C T I V E INTEREST RATE METHOD. n W W 1 (pt + it) ^ — ' (1 + r_)* (1 + rL)n ROENFELDT AND OSTERYOUNG n D' t=l (1 + rL)1 47. t=l SV„ - (SV n - BV) T (L t ) (1 - T) • D t(T) , P t + 1 t - ( l t ) T 48. T A B L E #3 NOTATION TO ACCOMPANY NPV AND IRR MODELS a n n u a l c o n t r a c t u a l l e a s e p a y m e n t a n n u a l i n t e r e s t p o r t i o n o f d e b t ( r i s k f r e e ) a n n u a l p r i n c i p a l p o r t i o n o f d e b t a n n u a l d e p r e c i a t i o n on a s s e t m a r g i n a l o r d i n a r y c o r p o r a t e i n c o m e t a x r a t e f i r m ' s w e i g h t e d a v e r a g e c o s t o f c a p i t a l number o f y e a r s o f u s e f u l l i f e o f t h e a s s e t n umber o f y e a r s l i f e o f t h e l e a s e e x p e c t e d c a s h s a l v a g e v a l u e a t y e a r n b o o k v a l u e a t y e a r n f i r m ' s b o r r o w i n g r a t e b e f o r e t a x ( B I R ) t a x r a t e a p p l i c a b l e t o g a i n s a n d l o s s e s on t h e d i s p o s a l o f f i x e d a s s e t s t o t a l p r e - t a x c a s h c o s t s e x p e c t e d t o be r e q u i r e d t o o p e r a t e t h e a s s e t i n y e a r t i f i t i s p u r c h a s e d by t h e f i r m i n i t i a l p u r c h a s e p r i c e o f t h e a s s e t e q u i v a l e n t l o a n r e p a y m e n t o f t h e t a x d e d u c t i o n c e r t a i n t y - e q u i v a l e n t c o e f f i c i e n t o r r i s k a d j u s t m e n t f a c t o r d i s c o u n t r a t e f o r b o r r o w i n g d i s c o u n t r a t e f o r l e a s i n g c a s h f l o w b e f o r e t a x e s a n d d e p r e c i a t i o n a s a r e s u l t o f i n v e s t m e n t e x p e c t e d v a l u e o f t h e e q u i p m e n t a t e x p i r a t i o n o f t h e l e a s e d e p r e c i a t i o n o f S V j d u r i n g t i n t e r e s t r a t e o n r i s k f r e e c a s h f l o w 49. Under lease f inanc ing , the company pays l _ t do l lars of rent in year t (t = 1, 2 . . . n ) . Since rental payments are f u l l y deductible for tax purposes, the net cash outflow associated with each rental payment i s equal to L,£ (1 - T) . Discounting these net cash outflows at the f i r m ' s marginal investment return of k, the discounted present value cost of leasing i s determined: " L t (1 - T) NPVC. = ) (1A) (1 + k ) t t=l Assuming 100% debt f inanc ing , the debt would be repayable i n yearly payments of P^ dol lars of pr inc ipa l and i ^ do l lars of in teres t . However, the in teres t expenses are deductible for income tax purposes so that i ^ (T) should be sub-tracted from the cash outflow. In a d d i t i o n , since the company has legal t i t l e to the asset under debt f inanc ing , i t can deduct depreciation in computing i t s income tax l i a b i l i t i e s i . e . (T). Discounting these cash flows at k, the discounted present value cost associated with debt f inancing i s equal t o : NPVCB ~ ( P t + V - ( i t + D t ) T " S V n > (IB) t - i ( 1 + k » If the asset was not 100% financed by debt, then a term should be added to equation (IB) to account for the amount of the down payment. James Mao7 conducted a s e n s i t i v i t y analysis of such costs by d i f f e r e n t i a t i n g 7 i b i d . , p.328 50. the difference between equations (1A) and (IB) with respect to T, the tax ra te . In his example i t was shown that leasing was cheaper than borrowing as long as the marginal tax rate was less than 76.2 percent. Other var-iables in the equations could be tested in the same way (a s e n s i t i v i t y analysis on salvage value i s described in Chapter 5).. The use of DCF analysis has been c r i t i c i z e d on the grounds that the costs so computed r e f l e c t the intermingled effects of tax savings and the amount of funds provided. A further objection to the DCF approach i s that since leasing provides 100% f inancing and debt usually does not , there w i l l be more f ixed charges under leasing than under debt plans. These higher f ixed charges may prompt investors to discount the corporation's earnings (or dividends) at a higher rate . The DCF method does not allow for the resu l t ing difference i n the e f fec t of the two f inancing a l ternat ives on the cost of equity funds. (B) V a n c i l ' s Basic Interest Rate (BIR) Method In 1961 Vancil developed the "Basic Interest Rate" (BIR) method which has become the c l a s s i c approach to lease a n a l y s i s . ^ His method was d i f f e r e n t from the usual discounted cash flow analysis because he eliminated the ef fects of f i n a n c i a l leverage i n leasing and thus compared lease and debt f inancing plans s t r i c t l y on the basis of tax savings. He introduced a second discount rate ca l l ed the Basic Interest Rate ( i . e . the f i rm's pre-tax cost of debt) into the analysis (given as r in equation 8 Richard F. V a n c i l , "Lease or Borrow - New Method of A n a l y s i s " , Harvard  Business Review, (Sept. - Oct. 1961), pp.138-159. 2A). Equation 2A shows the net present value cost of leasing to be composed of two f lows: (a) the present value of lease payments discounted at the BIR minus (b) the tax sh ie ld created by the lease payments discounted at the f i r m ' s cost of c a p i t a l . L t (L. - i j T NPVC, - x U M ; t = 1 (1 + r.)* (1 + k ) * Equation 2B shows the cost of debt f inancing to be composed of the net pre-sent value of : (a) p r i n c i p a l and interes t minus the tax s h i e l d from interes t and depreciation minus (b) the salvage value at the end of the useful l i f e of the asset , a l l discounted at the cost of c a p i t a l . The ordinary tax rate has been used because the capi ta l gains tax rate i s applicable only i f the gain on the sale of the asset exceeds the o r i g i n a l cost . NPVCB ( P t + 1 t ) - ( i t + D t)T t=l ( l + k ) * SVn - (SVn - BV)T (2B) (1 + k ) n V a n c i l ' s approach i s s i m i l a r to the DCF method assuming 100% debt f inancing but the major difference i s his use of two discount rates . The use of the lower rate r rather than k to discount the lease payments i s j u s t i f i e d on the grounds that these are c e r t a i n . On the other hand, the f i rm may not be 52. able to use the tax shields in some years , thus the use of k i s j u s t i f i e d . However, to be consistent r should have been used to discount the p r i n c i p a l and interes t payments i n equation 2B. (C) Bower, Herringer and Williamson (BHW) A very s i m i l a r model was proposed by Bower, Herringer and Williamson (BHW) in 1966.^ They computed the outstanding p r i n c i p a l (P^) on the equivalent loan somewhat d i f f e r e n t l y and allowed for the p o s s i b i l i t y of some operating costs such as insurance and maintenance but they have been excluded here for s i m p l i c i t y . As shown i n equations 3A and 3B, the main difference in t h e i r model over previous ones i s the use of r ( as recommended above) to discount both the lease payments and the equivalent loan payments. (4>T + S V n " ( S V n " B V > T (3A) (1 + k)1 (1 + k ) n NPVCL = NPVCr t=l ( p t + V ( D t + V T (3B) (1 + r) (1 + k) 1 9 R.S. Bower, F .C. Herringer, and J . P . Wil l iamson, "Lease Eva luat ion" , The Accounting Review,(April 1966), pp. 257-265 53. (D) Beechy's Ef fec t ive Interest Rate Method Thomas Beechy proposed a new model in 1969 which was then revised in 1970. 1 0 He was the f i r s t one to use the internal rate of return approach for lease. ana lys i s . Using this method the e f fec t ive in teres t rates for each of leasing and"borrowing are calculated as"shown in equations 4A and 4B. In equation 4A the i n i t i a l cost of the asset i s given as I Q . The cash flows from the lease payments are added to the tax sh ie ld from interes t and deprec-i a t i o n minus the tax sh ie ld of the loan repayment which i s equivalent to the tax deductions under l eas ing . The equation i s then solved for r ^ , the discount rate for leas ing . L f + ( i t + D - L ' ) T SVn - (SVn - BV)T I = \ + n " (4A) o t=l (1 + r L ) t (1 + r L ) n S i m i l a r l y in equation 4B the i n i t i a l cost of the asset and the cash flows from interes t and pr inc ipa l on the equivalent loan are a l l given. The equation i s then solved for r^ , the discount rate for borrowing. The lowest e f fec t ive rate i s the c r i t e r i a for the lease or borrow dec is ion . 10 Thomas H. Beechy, "Quasi-Debt Analysis of Financial Leases", The  Accounting Review, ( A p r i l , 1969), pp. 375-381 , "The Cost of Leasing: Comment and Correc t ion" , The Accounting Review, (Oct. 1970) pp. 769-773 54. ^ — * " T T T T T t t=i (4B) U + r D ) ' (E) Johnson and Lewellen (J & L) Johnson and Lewellen published an a r t i c l e in 1972 that attracted a great 11 deal of attent ion. They advocated the "lease-or-buy" approach using NPV as the c r i t e r i on for analyzing the lease as an ordinary cap i ta l budgeting problem. Equation 5A shows the cost of leasing to be equal to (a) the a f ter - tax net cash flow of the revenues minus the costs a r i s ing from using the asset and discounted at the cost of cap i ta l minus (b) the a f ter - tax cash flows from the lease payments discounted at the f i rm ' s borrowing rate. L t (1 - T) (5A) (1 + r ) * The cost of debt financing i s given in equation 5B as (a) the net cash flows from operation of the asset minus the tax payable on the p r o f i t net of deprec-i a t i on a l l discounted at the cost of cap i ta l plus (b) the a f ter - tax proceeds from the salvage value. For s impl ic i ty, .equat ion 5.has;been stated as NPVC, R t - ( C t - 0 t)J (1 - T) t = l (1 + k) 11 R.W. Johnson and W. Lewellen, "Analysis of the Lease-or-Buy Decis ion", Journal of Finance, (Sept. 1972), pp. 815 - 823. See also "Comments" and "Reply" in Sept. 1973 issue 55. ANPV = NPVB - NPVL in Table #2A. n 7 ( R t " " T ( R t " C t " D t ) NPVC B (1 + k ) * t=l (5B) S V n " T g ( S V n " BV) + (1 + k) n Their main point was that the investment and f inancing decisions should be combined i n lease ana lys i s . They argued that a good leasing proposal could make the acquis i t ion of cer ta in assets viable whereas previously those assets would not have been acquired according to standard investment ana lys i s . Thus they advocated examining the value of a new project subject to f i n a n c i a l 12 considerations and th i s i s in d i rec t c o n f l i c t with accepted prac t i ce . (F) Roenfeldt and Osteryoung ( R & 0) Roenfeldt and Osteryoung reverted to an IRR approach in t h e i r lease-or-borrow 13 model which was developed i n 1973. They focused on the f inancing dec is ion . A l l costs relevant to f inancing were evaluated on an a f ter - tax basis . They also adjusted for r i s k in the estimate of salvage value, something that had not been considered e x p l i c i t l y in previous models. Using equation 6A, the a f ter - tax percentage cost of leasing is the discount 12 R.L. Roenfeldt and J .S . Osteryoung, " Analysis of Financial Leases", Financial Management, Spring, 1973, p.75 13 i b i d . , pp.74-87 56. r a t e , r ^ , which equates (a) the a f t e r - t a x cash flows o f the lease payments plus the tax s h i e l d from d e p r e c i a t i o n plus (b) the r i s k adjusted a f t e r - t a x cash inflow from the salvage value, with the i n i t i a l cost o f the a s s e t , I . The a f t e r - t a x percentage cost o f borrowing i s simply the discount r a t e , r ^ in equation 6B, which equates the a f t e r - t a x d o l l a r c o s t of i n t e r e s t payments plus the p r i n c i p a l repayments, with the amount of p r i n c i p a l borrowed. ( L t ) (1 - T) + D t(T) t-1 ( 1 + ^ » n [ ( S V n ) - (SV n - BV)l] (1 + r L ) n (6A) t=l P t + \ (1 t ) T (6B) (1 + r D ) The r i s k o f p a r t i c u l a r cash flows i n f i n a n c i a l lease e v a l u a t i o n was covered 14 i n more depth i n a recent a r t i c l e by Harold Wyman. Using the modern cap-i t a l budgeting theory that a p r o j e c t should be judged on i t s expected rate 15 of return and on the p r o b a b i l i t y d i s t r i b u t i o n o f that r e t u r n , Wyman 14 Harold E. Wyman, " F i n a n c i a l Lease Evaluation Under Conditions of U n c e r t a i n i t y " , The Accounting Review, ( J u l y , 1973), pp.489-93. 15 David B. Hertz, "Investment P o l i c i e s That Pay Off " , Harvard  Business Review, (Jan. - Feb. 1968), pp. 96-108. 57. advocated that a f i n a n c i a l lease with uncertain elements should be evaluated on the basis of both the expected interes t cost and i t s d i s t r i b u t i o n . He considered residual values and operating costs as the variables that are most uncertain. toyman suggested using stochastic computer simulation and assuming p r o b a b i l i t y d i s t r i b u t i o n s for the uncertain variables in order to calculate a series of expected a f ter - tax interes t cost equivalents with various p r o b a b i l i t i e s . These figures could then be compared with the current a f ter - tax cost of debt f inancing. He suggested several decision r u l e s , the best one being: accept no lease where the average expected interes t cost equivalent i s greater than the cost of long term debt. By graphing the p r o b a b i l i t i e s versus expected a f ter - tax in teres t cost equiv-alents for d i f f e r e n t leasing proposals, i t i s then possible to compare the d i f f e r e n t r i sks involved. (G) Gordon's NPV Model In the most recent major a r t i c l e published in this controversial s e r i e s , Professor Myron Gordon of the Univers i ty of Toronto reverted to the lease-or-buy approach by rev is ing the Johnson-Lewellen m o d e l . ^ His model d i f f e r e d from the J & L model i n 4 respects: 1. the ; choice of d i s -count rates 2: a difference i n term between the lease payments and the l i f e of 16 Myron J . Gordon, "A General Solution to the Buy-or-Lease Decis ion: A Pedagogical Note", Journal of Finance, March, 1974, pp.245-250 58. the capi ta l asset , 3. differences i n r i s k among the components of the buy and lease cash f lows; and 4. n e u t r a l i z i n g the i m p l i c i t debt f inancing t i e d into the lease a l t e r n a t i v e . Equation 7A shows the NPV of leasing to be equal to (a) the outflow of the a f ter - tax lease payment at t=0 minus (b) the a f ter - tax cash flows of the subsequent lease payments discounted at the r i s k free interest rate: plus (c) thea f te r - tax cashflows which are a resu l t of the investment and are discounted at the cost of capi ta l minus (d) the expected value of the asset upon expir -at ion of the lease plus (e) the tax benefits from depreciation of the asset from the end of the lease u n t i l the end of i t s useful l i f e discounted at the cost of c a p i t a l . (1 - T) L t=l n (7A) + t=l n + The NPV of buying is given in equation 7B as (a) the same outflow in the f i r s t term as in 7A minus (b) the a f ter - tax difference between the payment on the equivalent loan and amortization of that loan for tax purposes plus 59. the before tax amortization of the loan a l l discounted at the r i s k free rate plus (c) the a f ter - tax cash flow resu l t ing from the investment over the l i f e of the asset discounted at the cost of capi ta l plus (d) the tax benefits from depreciation of the asset over i t s l i f e discounted at the r i s k free rate . NPVB - - - (1 - T)L Q [ l - T ) ( i t ) J + P j " (1 - T) R " (T) D H 1 + TZ (7B) t=l ( 1 + k ) * t = 1 ( 1 + i )t 3. Evaluation of the Models and Their Usefulness i n a Prac t i ca l Sett ing The various models could generally be categorized as net present value (NPV) or internal rate of return (IRR). Accordingly, the problems which may be encountered with e i ther approach are: (a) the net present value method is sens i t ive to the discount rate used and i t does not account for the r i s k of changes over long time periods, (b) the internal rate of return may have mult iple solutions and those solutions may be incorrect because i m p l i c i t in the ca lcu la t ion is the assumption that cash surpluses are reinvested at the internal rate of return and i f th is assumption i s not v a l i d then the true rate of return would not be the r e s u l t . 60. In practice the internal .rate of return approaches are more popular in evaluating f inanc ia l leases because they are easier to explain to business-men who are accustomed to dealing in e f fec t ive in teres t costs when consider-ing f inancing decis ions . P r i o r to Gordon's model, a l l of the NPV models eliminated by assumption the p o s s i b i l i t y of leasing having an in teres t cost or capi ta l structure e f fec t d i f f e r e n t from debt. Thus they are generally not very useful in explaining the equi l ibr ium conditions under which both leasing and borrowing would e x i s t 17 simultaneously i n the capi ta l s t ructure . 18 Findlay summarizes the argument as fo l lows : To the extent that leasing i s the exact equivalent of borrowing, and investment r i s k i s constant, then the a f ter - tax discount rate for l e a s i n g , r ^ , may be compared d i r e c t l y with the a f ter - tax cost of debt f inanc ing , r n . I f investors view leasing as having no e f fec t upon the r i s k of the f i r m , then r^ may be compared d i r e c t l y with the a f te r - tax cost of c a p i t a l , k. F i n a l l y , i f investors view leasing as adding some r i s k but not as much as debt, then the capi ta l structure could contain more to ta l debt with both leasing and debt than otherwise and the equi l ibr ium marginal r^ would l i e between r^ and k. In the introduction of his model, Gordon provides a der ivat ion of the proof that a corporation should use the r i s k free interes t rate i , without deducting corporate income 17 M. Chapman Findlay I I I , "Financial Lease Evaluat ion: Survey and Synthesis" , Working Paper, McGil l U n i v e r s i t y , 1973, p.10. 18 i b i d . , p.12 61. tax , in ca l cu la t ing the present value of an a f ter - tax r i s k free cash f low. He advocates the appropriate use of i and k as discount rates according to the r i sk iness of the indiv idual cash flows i n the lease ana lys i s . Equivalence of the NPV and IRR Approaches In order to test i f the use of an NPV or an IRR approach would make any difference to the lease-or-buy analysis by the Canadian ra i lways , the f igures from a recent lease signed by CP Rai l (see Table 4) were used to test the equivalence of the most recent NPV and IRR approaches. The CP example was used in order to demonstrate the e f fec t of the tax s h i e l d i n the analysis because CN cannot make use of the tax benefits created by interes t and depreciation or lease payments. Table 5 i l l u s t r a t e s the cash flows using Gordon's NPV model (changed to NPV (C g - C L ) for s i m p l i c i t y ) and Table 6 i l l u s t r a t e s the cash flows using the IRR model of Roenfeldt and Osteryoung. The resul ts are summarized below. They indicate that under both approaches the buy decision would have been rejected in favour of l eas ing . While the IRR method was easier to use, i t did not incorporate a l l of the features contained in Gordon's model, which appears to be the best one proposed to date. I 62. TABLE 4 CASH FLOW FROM  CP RAIL LEASE DATED OCT. 15, 1973 (Using $10,000 Capital Investment) ( P t ) (Dt) Annual Annual Lease Loan Interest Principal Depreciation Payments Payments 0 1973 $ $ - $ 600.00 $ 1 74 895.80 191.06 564.00 870.00 1,086.86 2 75 878.21 208.65 530.16 870.00 1,086.86 3 76 859.01 227.85 498.35 870.00 .1,086.86 "4 ' 77 838.04 248.04 468.45 870.00 1,086.86 5 78 815.14 271.72 440.34 870.00 1,086.86 6 79 790.15 296.71 413.92 870.00 1,086.86 7 80 762.83 324.03 389.09 870.00 1,086.86 8 81 733.02 353.84 365.74 870.00 1,086.86 9 82 700.46 386.40 343.80 870.00 1,086.86 10 83 664.90 421.96 323.17 870.00 1,086.86 11 84 626.06 460.80 303.78 870.00 1,086.86 12 85 583.66 503.20 285.55 870.00 1,086.86 13 86 537.35 549.51 268.42 870.00 1,086.86 14 87 486.79 600.07 252.31 870.00 1,086.86 15 88 431.56 655.30 237.18 870.00 1,086.86 16 89 371.26 715.60 222.94 500,00 1,086.86 17 90 305.41 781.45 209.57 500.00 1,086:86 18 91 233.50 853.36 196.99 500.00 1,086.86 19 92 154.97 931.89 185.17 500.00 1,086.86 20 93 69.08 1,017.78 174.06 500.00 1,086.86 21 94 - 163.62 - _ 22 95 - 153.80 _ 23 96 - 144.57 _ 24 97 - 135.90 _ 25 98 - 127.75 _ 26 99 - 120.08 27 2000 - 112.88 28 01 - 106.10 _ 29 02 - 99.74 -30 03 - 93.75 _ $11,737.20 $10,000.00 $8,531.18 $15,550.00 $ 21,737.20 TABLE 5 CASH FLOWS USING GORDON'S NPV MODEL (A) (B) (C) (D) (E) 1973 0 $ - $ 300.00 $ $ -74 1 586.20 258.72 399.08 - -75 2 545.20 222.76 366.13 - -76 3 507.60 192.41 335.90 - -77 4 473.11 165.93 308.16 - -78 5 441.49 143.10 282.72 - -79 6 412.49 " 123.40 259.38 - -80 7 385.90 106.42 237.96 - -81 8 361.52 91.76 218.31 - -82 9 339.16 79.15 200.29 - -83 10 318.67 68.26 183.75 - -84 11 299.88 58.86 168.58 - -85 12 282.66 50.76 154.66 - -86 13 266.87 43.78 141.89 - -87 14 252.40 37.75 130.17 - -88 15 239.14 32.56 119.42 - -89 16 226.99 28.08 62.97 - -90 17 215.86 24.21 57.77 - -91 18 205.66 20.88 53.00 - -92 19 196.31 18.01 48.62 - -93 20 187.78 15.53 44.61 129.58 -94 21 - - - - 7.57 95 22 - - - 6.36 96 23 - - - 5.33 97 24 - - - - 4.48 98 25 - - - - 3.76 99 26 - - - - 3.15 2000 27 - - - - 2.65 01 28 - - - - 2.22 02 29 - - - - 1.86 03 30 - - - - 1.56 $6,744.89 $2,082.35 $3,773.37 $ 129.58 . $ 38.94 TABLE 6 CASH FLOWS USING ROENFELDT AND OSTERYOUNG'S IRR MODEL PURCHASE 1973 0 $ ' -74 1 638.96 75 2 647.76 76 3 657.36 77 4 667.84 78 5 679..29 79 6 691.79 80 7 705.45 81 8 720.35 82 . 9 736.63 83 10 754.41 84 11 773.83 85 12 795.03 86 13 818.19 87 14 843.47 88 15 871.08 89 16 901.23 90 17 934.16 91 18 970.11 92 19 1,009.38 93 20 1,052.26 L E A S E ' (A) (B) (C) $ 300.00 $ 435.00 282.00 -435.00 265.08 -435.00 249.18 -435.00 234.23 435.00 220.17 -435.00 206.96 -435.00 194.55 435.00 . 182.87 • -435.00 171.90 -435.00 161.59 -435.00 151.89 -435.00 142.78 435.00 134.21 -435.00 126.16 -435.00 118.59 -250.00 111.47 -250.00 104.79 -250.00 98.50 250.00 92.59 -250.00 87.03 511.20 65. Gordon's NPV Model j NPV (C B - C , . (1 - T) ( i ) + P " (T) D. t - i + t=i <1 + 1» J (1 - T) L t SVj + (T) D t=i d + 1 ) t d = K ) j t-j+i ( 1 + K ) t NPV (C B - C L ) = (A) - (B) - (C) - (D) + (E) = $798.53 re ject buying NOTE: The CP Rail lease payments were semi-annually i n arrears . This corresponds to the payment schedule on the equivalent loan; con-sequently Gordon's a f ter - tax i n i t i a l lease payment does not appear in th is example. Roenfeldt and Osteryoung's IRR Model j y » P t + \ " <V T t - l ( 1 + ^ I = j Purchase J (L. ) (1 - T) + D. (T) A. f(SV.) - (SV. - BV.) T| J = \ x J J J Lease t=l d + r0" (1 + r L ) J 66. 20 PURCHASE $10,000 = } ' r Q = 10.52% /1 , \ t t=l 20 . , (A) + (B) 1 (511.20) r. = 8.48% $10,000 = y 7 + L (1 + r ^ ) t (1 + .*, choose leasing where: j = 20 years T = 50% P t = annual p r i n c i p a l portion of loan payments i = 9% K = 12% = annual depreciation (6% on dec l in ing balance) l_£ = annual lease payments: $870 for t = 1 - 15 $500 for t = 16 - 20 SVj= 12.5% of o r i g i n a l cost n = 30 years (see CP Annual Report 1973, p.11) I = $10,000 BV.= $2,727 J P t + i ' t = $1,086.86 = annual loan payments Current State of the Art The model proposed by Gordon i s the best both conceptually and in prac t i ce . I t appears that he has captured a l l of the advantages of an NPV model in dealing with investment r i s k while at the same time o f f s e t t i n g the differences in f i n a n c i a l r i s k between leasing and debt by the correct choice of discount 67. rates for the d i f f e r e n t cash f lows. This i s only possible with an NPV model. Thus he has covered a l l three of the basic issues introduced at the beginning of th is chapter: 1) he has maintained a lease-or-buy approach while synthesizing the essential features of the lease-or-borrow approach; 2) the CP Rail example i l l u s t r a t e d the importance of separating the d i f f e r e n t cash f lows; and 3) he has provided a proof for the proper discount rates to be used in lease ana lys i s . Assuming that Gordon i s correc t , then a l l the previous models are wrong. 68. CHAPTER 5 APPLICATION OF LEASING THEORY TO CN AND CP RAIL  History of Leasing by CN and CP Canadian National Railways started long-term leasing of new r o l l i n g stock on a small scale i n 1969, pr imar i ly for i t s U.S. s u b s i d i a r i e s , the Grand Trunk Western and the Duluth, Winnipeg and P a c i f i c Railroad companies (see Appendix E) . Leasing of Canadian manufactured r o l l i n g stock began i n 1969 with a series of non-leveraged lease contracts with Industr ia l Acceptance Corporation L t d . , a Canadian finance company. Soon the large s ize of the transactions at tracted U.S. Leasing International Inc . , ,one of the biggest lease brokers in the world. They structured leveraged leases using U.S. f inancing and offered CN much lower e f fec t ive in teres t costs on leas ing . In 1971 the Canadian f i n a n c i a l market became interested in f inancing leveraged leases. Mark Harris of McLeod, Young, Weir & Company Ltd . arranged a number of leveraged leases for CN with Canadian f i n a n c i a l sources but in the summer of 1972 the Department of National Revenue refused to give an advance tax r u l i n g for a leveraged lease on some new covered hopper cars for C N . 1 The Canadian investors would not go into the deal without an advance r u l i n g . As a r e s u l t , the cars came of f the assembly l i n e at National Steel Car i n Hamilton but they could not be moved by CN because that would cause 1 Beatrice R i d d e l l , "Leveraged Leasing: Ottawa Derai l ing a R o l l i n g Tax Shel ter?" , The Financial Post, September 23, 1972, p . l 69. legal problems regarding ownership for a subsequent lessor (see Chapter 2 on i n s t i t u t i o n a l arrangements for equipment o b l i g a t i o n s ) . Af ter some scrambling, the CN f i n a n c i a l o f f i c e r s quickly arranged a leverage lease deal in the United States through Salomon Brothers, one of the largest investment dealers i n New York. Since that time there have been no further leveraged leases arranged with Canadian equity investors ; CN equipment leases have been l e f t s t r i c t l y to U.S. f i n a n c i a l sources. CP Rai l signed i t s f i r s t and only leveraged lease in the f a l l of 1973 using U.S. f inanc ing , (see Appendix F ) . As part of the Budget brought down on May 6, 1974, the Canadian Minis ter of Finance announced a proposed change in the Income Tax Act (see Appendix A) which would have a s i g n i f i c a n t impact on the leveraged leasing of Canadian r o l l i n g stock using U.S. f i n -2 ancing. Although the Budget and the government were simultaneously defeated i n a vote of non-confidence, the Libera l Party was returned to power in the ensuing e l e c t i o n , th is time with a majority of members in the House of Commons. The proposal was reintroduced i n the Budget of November 18, 1974 as fo l lows : " That where a f te r November 18, 1974 a person resident in Canada pays or credi ts an amount to a non-resident person for the use of railway r o l l i n g stock referred to in subparagraph 2 1 2 ( l ) ( d ) ( v i i ) of the said A c t , such payment sha l l be subject to tax under Part XIII of the said Act unless the payment i s made by a railway company 2 The proposal was set out in paragraph 116 of the Ways and Means Motion of May 6, 1974 coincident with the Budget Speech of the Minis ter of Finance, the Honourable John N. Turner. (a) pursuant to a agreement i n w r i t i n g entered into on or before November 18, 1974, or (b) for the temporary use of the railway r o l l i n g stock for a period or periods not expected to exceed in the aggregate 90 days i n any 12 month per iod, and the country i n which the non-resident person i s resident grants subs tant ia l ly s i m i l a r r e l i e f for the year to the company in respect of payments received by i t from a person resident in that country for the temporary use by that person of railway r o l l i n g s tock." 3 This means that the Canadian railways must deduct 15% i n withholding tax from a l l lease payments leaving the country and remit th is money to the federal government. On debt f inancing from foreign sources, withholding tax i s applicable only on the in teres t portion of payments but on lease payments i t includes deductions on both interes t and repayment of p r i n c i p a l . One small concession i s given to" the railways on payments for the temporary use in Canada of foreign r o l l i n g stock for up to 90 days per year as long as the withholding tax arrangements are reciprocated by the foreign country. In pract ice "foreign country" refers to the United States. The exemption from withholding tax on payments for the use of railway r o l l i n g stock had existed for over 20 yeqrs according to subparagraph 2 1 2 ( l ) ( d ) ( v i i ) of the Canadian Income Tax Act . Appl icat ion of the withholding tax w i l l e f f e c t i v e l y stop a l l further leveraged leases for Canadian r o l l i n g stock financed by U.S. investors since they cannot af ford to lose 15% of t h e i r investment. Even i f the U.S. investor applied the Canadian tax wi thheld , 3 Budget, Notices of Ways and Means Motions, Department of Finance, Government of Canada, November 18, 1974, p.194. as a c red i t toward his U.S. tax payable, there i s a l i m i t to the amount that can be credited i n this way. The U.S. government w i l l allow an investor to claim foreign taxes paid as a c red i t toward his U.S. taxes only up to the f rac t ion of (a) income received from e i ther that foreign country or a l l foreign countries together divided by (b) tota l income from a l l sources (domestic and fore ign) . This i s often referred to as 4 the foreign source income problem for U.S. investors . I t would be uneconomic for the Canadian railways to absorb the 15% w i t h -holding tax because th is tax i s equivalent to an increase in f inancing charges in the order of 15%. The current d i f f e r e n t i a l between lease and debt rates i s about 3% so i t would be cheaper for the railways to borrow at a 9% interes t rate than to lease at a 21% e f fec t ive rate (6% + 15%) when the withholding tax i s absorbed. If the withholding tax was applied to only the in teres t portion of the lease payments, the e f fec t ive lease f inancing rates would increase from 6% i n the above example to about 7% which would s t i l l be cheaper than borrowing at 9%. Comparison of CN and CP Financing I f CN had signed the same lease as in the CP example i n Chapter 4 , the lease-or-buy decision would have been even more in favour of leas ing . Because CN i s a crown corporation i t pays no federal income taxes. This s i m p l i f i e s the comparison considerably; i t i s necessary only to compare 4 For an excel lent treatment of th is subject see: Harvey Shapiro and David Klock, "Some Aspects of U.S. Tax Treatment of Foreign-Source Income", Journal of Economics and Business, Temple U n i v e r s i t y , . . Winter 1974, pp.134-139. the NPV or IRR of the lease payments with the corresponding equivalent loan without reference to tax s h i e l d s . Accordingly the internal rates of return (costs of f inancing) in the above mentioned example are 9.00% for debt and 5.25% for leasing as viewed by CN. The corresponding rates for CP were 10.52% for debt and 8.48% for leasing assuming that the tax shields could be used by CP in e i ther case. These are not the true costs of debt and leasing for CP. They were derived from Roenfeldt and Osteryoung's IRR Model which i s useful only for com-parisons between leasing and borrowing for a s ingle f i rm because the tax s h i e l d from depreciation i s added to the cost of leasing rather than sub-tracted from the cost of borrowing. Also the R & 0 Model does not incor-porate a l l of the features i n Gordon's NPV Model. I f the depreciation benefits were subtracted from the cost of debt in the R & 0 Model, the a f ter - tax cost of debt for CP in the example would be 0.5% and the a f ter - tax cost of leasing would be -1.6% i . e . the sum of CP's lease payments less tax benefits would be less than the o r i g i n a l cost of the asset. The a f ter - tax spread between debt and leasing rates remains at about 2% which is equivalent to a 4% or 400 basis point spread before tax. This i s comparable to the before tax spread calculated for CN. The primary reason for the large spread between leasing and borrowing rates for CP is the depreciation rate that i s allowed on railway equip-ment owned by a Canadian r a i l r o a d and used as part of a railway system i . e . 6% on decl in ing balance. Any other corporation owning railway r o l l i n g stock can depreciate i t at 20% on dec l in ing balance. CP Rail cannot even lease railway cars at favourable rates from CanPac Leasing, a subsidiary of CP Investments, because CanPac would then be required to depreciate the cars at the lower 6% rate . The true a f ter - tax cost of debt for CP should be 4.5% assuming a tax rate of 50% and a before-tax borrowing rate of 9%. Since CN i s not tax-able , both i t s before-tax and a f ter - tax borrowing rates would be 9% assuming equal r i s k classes (credi t rat ings) for the two companies. This means that CP's f inancing costs a f ter - tax are cheaper than CN's. However, with lease f inanc ing , CN can " s e l l " the tax shields normally derived from ownership of capi ta l assets in return for lower f inancing costs . This puts i t on an even footing with CP in long term f inanc ing . Analysis of Interest Rate Spreads from CN Leases The data on e f fec t ive lease rates and corresponding long-term debt or equipment t rus t rates from Appendix E are summarized in Table 8. The f igures are separated into 4 categories according to whether the f inancing was done i n Canada or the United States and whether the equipment i s for domestic Canadian serv ice , internat ional service or domestic U.S. service (GTW, DWP or CV). The four categories and the means and standard deviations of the in teres t spreads are as fo l lows : 74. TABLE 7 INTEREST SPREAD CATEGORIES ON CN LEASE FINANCING 1969 - 1974 CATEGORY FINANCING 1. 2. 3. 4. Canadian U.S. U.S. U.S. SERVICE Canadian Domestic Canadian Domestic International U.S. Domestic MEAN 2.208 1.453 3.246 3.818 STANDARD DEVIATION 0.066 0.535 0.508 0.435 The leases i n the f i r s t category were a l l signed within a four month per iod , hence the low standard deviat ion in spreads. It i s in teres t ing to note that the mean spread is smallest for the second category. This may be due to pro-blems which U.S. investors have with foreign source income as mentioned pre-v ious ly . Accordingly the spread should be higher for equipment used in internat ional service since in that case only 50% of the lease income would be foreign source for U.S. inves tors , and the spread should be highest for equipment used in U.S. domestic service because there would be no foreign source income problem. Since the spread for Canadian domestic service equipment i s lower for U.S. than for Canadian f inanc ing , th is suggests that the slower depreciation wri te o f f and lack of investment tax c red i t in Canada are more than o f f se t by the 100% foreign source income problem for U.S. investors . According to the theoret ical discussion of the re la t ionship between e f fec t ive lease rates and corresponding debt rates in Appendix D, the spread should TABLE 8 Interest Rate Spreads on CN Leases 1969 - 1974 LEASE CATEGORY DEBT LEASE DATE RATES RATES SPREAD: Nov. /71 8.800 6.650 2.150 Dec. /71 8.500 6.331 . 2.169 Dec. 771 8.500 6.244 : 2.256 Dec. 771 8.500 6.336 2.164 Feb. Ill 8.100 . 5.800 ' 2.300 ; MEANS: . 8.480 6.272 2.208 Nov. /70 9.750 8.766 0.984 Feb. /71 8.000 6.993 1.007 Apr. /71 8.250 6.862 . 1.388 June /72 8.000 6.023 1.977 Oct./72 8.000 5.976 2.033 Nov. /72 8.000 6.093 1.097 Jan. /73 8.000 7.176 0.824 Apr. /73 8.000 6.572 1.428 Apr. /73 7.8/5 6.295 1.580 Apr. /73 7.875 6.159 1.716 May /73 7.750 5.643 2.107 Sept./73 8.250 6.523 1.727 Jan. /74 8.500 6.069 1.431 Jan. /74 8.125 7.896 0.229 MEANS: 8.170 6.717 1.453. Apr. /71 8.500 6.061 2.439 May 771 8.625 6.252 2.373 Aug. /71 8.750 5.730 3.020 Apr. 772 7.875 4.170 3.705 Nov. /72 8.000 4.368. 3.632 Feb. /73 7.875 4.858 3.017 Apr. /73 7.875 4.333 3.542 Apr. /73 8.000 4.279 3.721 Oct. /73 8.750 5.246 3.504 Jan. /74 8.750 5.246 3.504 MEANS: 8.300 5.054 3.246 Sept.771 8.250 4.809 3.441 Nov. /71 8.000 4.770 3.230 Aug. /72 8.000 4.102 3.898 Dec". /72 7.500 3.745 3.755 Sept./73 8.250 3.948 4.302 Oct. /73 8.750 4.468 4.282 MEANS: 8.125 4.307 3.818 76. increase as debt rates increase (see Figure 4) . The empirical data did not support the theory, in f a c t , the re la t ionship was s l i g h t l y negative in a l l categories except U.S. f inancing for equipment in domestic service in the United States. Ef fect of Leasing on Annual Capital Budgets As mentioned i n Chapter 3, i t has often been asserted that leasing can expand the debt capacity of a f i r m . Examination of recent CN equipment orders shows a steady increase in new r o l l i n g stock ordered over the years with a sharp jump in 1973 (see Table 9) . In general , North American r a i l -roads have tended to accelerate new equipment orders during periods when demand was high and to cut back d r a s t i c a l l y when business was s lack . There i s a d i rec t re la t ionship between peak demands and high earnings for r a i l -roads. Figure 5 i l l u s t r a t e s that there i s also a high corre la t ion between railway earnings and car orders although i n the l a s t few years the car order cycle has been smoothing out, possible due to increased leasing of equipment. The increase i n earnings and the high level of demand in 1973 probably explains the jump i n equipment ordered by CN in that year . FIGURE #4 THEORETICAL RELATIONSHIP BETWEEN L E A S E RATES AND LONG TERM DEBT RATES DEBT RATES SOURCE: APPENDIX D FIGURE #5 CAR ORDERS RELATED TO RAILWAY EARNINGS YEARS SOURCES: MOODY'S RAILROAD STOCKS RAILWAY AGE TABLE 9 NEW ROLLING STOCK ORDERED ANNUALLY BY CN AND CP CANADIAN NATIONAL RAILWAYS* CANADIAN PACIFIC RAILWAY CARS LOCOMOTIVES TOTAL CARS LOCOMOTIVES TOTAL 1969 3,220 70 3,290 2,624 101 2,725 1970 3,300 91 3,391 1,244 15 1,259 1971 2,917 63 2,980 690 64 754 1971 1,306 141 1,447 165 40 205 1972 6,731 121 6,852 1,216 33 1,249 17,474 486 17,960 5,939 253 6,192 * NOTE: Includes subsidiary companies (GTW, DWP, CV) SOURCE: Railway Age, Annual Reviews of Car & Locomotive Orders Leasing cer ta in ly made i t easier for CN management to finance equipment a c q u i s i t i o n s . Although i t was s t i l l necessary to have the overal l capi ta l budget approved by Parliament, indiv idual leases could be approved so le ly by the President and Board of Direc tors , thus reta ining control over the method of f inanc ing . Parliamentary approval for CN's 1972 budget was held up for two years but the company continued to function normally. I t i s d i f f i c u l t to determine whether CN's equipment orders would have been the same regardless of l eas ing . However, the use of leasing did provide CN management with more r e s p o n s i b i l i t y for new equipment investment and financing decisions away from the glare of constant public s c rut iny . 80. Table 10 i l l u s t r a t e s the steady increase in equipment under lease by CN every year , ranging from 2,200 to 3,600 new units of equipment leased annually. CP R a i l ' s experience was quite d i f f e r e n t . They acquired less than 500 units on lease in every year except 1970. Table 11 i l l u s t r a t e s that 86% of the new r o l l i n g stock acquired by CN between 1969 and 1973 was leased. The figures for 1971 and 1973 are extreme i n that more than 100% of the equipment acquired in those years was on lease. I t i s possible that the CN Annual Reports only include 5 Canadian equipment whereas Appendix E contains data on equipment leased by the U.S. subsidiar ies of CN in addit ion to the equipment leased d i r e c t l y by CN. TABLE 10 UNITS OF RAILWAY EQUIPMENT UNDER LEASE BY CN AND CP CANADIAN NATIONAL RAILWAYS CANADIAN PACIFIC RAILWAY CARS LOCOS. TOTAL INCR. OVER* PREV. YEAR CARS LOCOS. TOTAL INCR. OVEI PREV. YEAI 1969 2,384 16 2,400 2,397 864 0 864 482 1970 5,692 12 5,704 3,304 1,981 0 1,981 1,117 1971 7,915 5 7,920 2,216 2,021 0 2,021 40 1972 10,403 91 10,494 2,574 2,358 0 2,358 337 1973 14,082 60 14,142 3,648 2,839 0 2,839 481 5 The statement by Dr. Bandeen that CN has acquired 18,891 pieces of new r a i l equipment during the l a s t 5 years supports th i s hypothesis. See footnote 4 in Chapter 1. 81. * NOTE: Since these figures include r o l l i n g stock on short term operating leases whereby the number of cars on lease can f luctuate up and down, these f igures cannot be d i r e c t l y related to new cars and loco-motives leased during the year. SOURCE: S t a t i s t i c Canada, #52-209 TABLE 11 NEW ROLLING STOCK LEASED BY CN AS A PERCENT  OF TOTAL NEW ROLLING STOCK ACQUIRED ANNUALLY 1969 1970 1971 1972 1973 NEW ROLLING STOCK ACQUIRED ON LEASES 585 3,836 3,430 1,960 3,689 TOTAL NEW ROLLING STOCK ACQUIRED 2,980 4,617 2,332 2,486 3,285 % OF NEW EQUIPMENT THAT WAS LEASED 20% 83% 147% 79% 112% TOTALS 1969-73 13,500 15,700 86% SOURCE: Appendix E and CN Annual Reports Long-run Financial Implications The major reason CN went heavily into leasing i s undoubtedly that i t was the lowest cost f inancing a v a i l a b l e . The e f fec t ive leasing rates were far below what the company would have to pay in in teres t rates on e i ther CN or Government issued bonds. The estimated to ta l savings i n f inancing charges over the l i v e s of the leases amount to almost $90 m i l l i o n as shown i n Table 13 which is derived from Table 12. TABLE 12 INITIAL COST OF EQUIPMENT LEASED BY CN ( in $Mi11ions) Category 1969 1970 1971 1972 1973 1974 1 $ 9.869 $17,905 $38,131 $17,393 $ 0.851 $ -2 - 31.483 11.970 15.969 85.003 59.204 3 - 14.863 15.312 5.445 25.956 24.480 4 9.627 5.515 4.971 2.329 3.337 0.707 TOTALS $19,496 $69,766 $70,384 $41,136 $115,147 $84,391 GRAND TOTAL: $400,320,000 SOURCE: Appendix E TABLE 13 ESTIMATED SAVINGS TO CN IN FINANCE CHARGES OVER THE LIVES OF LEASES SIGNED DURING 1969-1974 (In $Mi11ions) Category 1969 1970 1971 1972 1973 1974 1 $2,295 $ 4.163 $ 8.867 $ 4.045 $ 0.198 $ -2 - 4.900 1.863 2.486 13.229 9.214 3 - 4.875 5.022 1.786 8.514 8.029 4 3.726 2.135 1.924 0.901 1.292 0.273 TOTALS $6,021 $16,073 $17,676 $ 9.218 $23,233 $17,516 GRAND TOTAL: $89,737,000 SOURCE: Tables 8 and 12 These f igures were derived by applying the mean debt and lease rates for each category to determine the difference in to ta l costs for leasing and borrowing. In present value terms as of 1974 the savings to CN amount to 83. about $60 m i l l i o n . This was calculated by using a discount rate of 8.3% which is the mean debt rate for CN over the period 1969-1974. This i s a conservative measure because i f the mean lease rate had been used to discount the benef i t s , the present value would have been higher. Incorporated within the e f fec t ive lease rates i s a loss of residual value at the end of the lease amounting to 10% of the o r i g i n a l value of the equipment. I f the residual value in fact does become higher at the end of the lease, the savings in finance charges would be reduced accordingly. One way to analyze th is e f fec t in quant i tat ive terms is to take the semi-annual savings from leasing versus borrowing (expressed as a percent-age of the equipment cost) and set up an annuity over the l i f e of the lease at the corresponding debt rate . This was done for each category of CN equipment lease as fo l lows : TABLE 14 SENSITIVITY ANALYSIS ON SALVAGE VALUES OF LEASED EQUIPMENT Residual Values Needed to Overcome Lease Advantage (Expressed as a percent of o r i g i n a l cost of asset) Category Residual Needed 1 55% 2 40% 3 73% 4 83% 84. I t becomes q u i t e p o s s i b l e that these f i g u r e s could be a t t a i n e d i f high i n f l a t i o n rates i n North America continue. However, at the same time the comparison between current and f u t u r e d o l l a r outlays becomes even more important. The lower lease payments in current d o l l a r s tend to o f f s e t the i n f l a t i o n a r y e f f e c t s on salvage values. A f u r t h e r long-run f i n a n c i a l i m p l i c a t i o n f o r CN with respect to l e a s i n g i s that the long term debt p o s i t i o n of the r a i l r o a d w i l l be slowly reduced i f no more debt i s added, and payment o f i n t e r e s t and p r i n c i p a l continues at the present l e v e l . In f a c t because of the lower o v e r a l l f i n a n c i n g charges from f i n a n c i a l l e a s e s , CN should have more net earnings a v a i l a b l e to pay o f f t h i s debt f a s t e r . However, si n c e the current l e v e l of long term debt stands at about $1.9 b i l l i o n , i t w i l l take a long time to e l i m i n a t e i t . Summary Leveraged l e a s i n g of r o l l i n g stock has proved to be the lowest cost external source of funds f o r the Canadian r a i l r a o d s . Furthermore, U.S. f i n a n c i n g , coupled with the American investment tax c r e d i t and f a s t e r U.S. deprec-i a t i o n w r i t e - o f f s , has been the cheapest source o f leveraged leases f o r equipment used i n i n t e r n a t i o n a l s e r v i c e or i n U.S. domestic s e r v i c e . This a l t e r n a t i v e source of f i n a n c i n g has provided a mechanism whereby CN's f i n a n c i n g costs can be reduced to approach the a f t e r - t a x f i n a n c i n g costs o f CP. According to n a t i o n a l t r a n s p o r t a t i o n p o l i c y , i t i s d e s i r a b l e to have CN and CP compete on equal terms. In order to complete t h i s e q u a l i t y 85. argument, i t would be necessary to el iminate the long-term debt that has been on the CN books dating back to i t s inception and at the same time make CN a taxable e n t i t y . Both of these changes are desirable from the viewpoint of morale of the employees of CN since the company could then be run as a normal corporation with i t s p r o f i t s r e f l e c t i n g the a b i l i t y of those o f f i c e r s and employees to operate the company success fu l ly . The tax implicat ions would be of no consequence to the federal government because i t owns CN. 86. CHAPTER 6 CANADIAN GOVERNMENT POLICY ON LEASING General Background Unt i l recently the Canadian Government has not had a pol icy on leas ing . In 1963, regulations concerning "Lease-Option Hire-Purchase" agreements were removed from Section 18 of the Income Tax Act because they were i n e f f e c t i v e . ^ In 1967 the (Carter) Royal Commission on Taxation recommended that deta i led l e g i s l a t i v e rules on leasing would be imprac-t i c a l but that s p e c i f i c provisions should be introduced to allow only reasonable deduction of rent by a lessee as an expense for tax purposes. The prime concern of the government was to d i f f e r e n t i a t e between true leases and disguised condit ional sale contracts which were designed with the intention of avoiding taxes. The l i n e of d i s t i n c t i o n between a sale and a lease contract can be very narrow at times. The important factors to look for in a lease which is r e a l l y a disguised condit ional sale agreement are: (1) the length of the lease in r e l a t i o n to the useful l i f e of the asset and (2) a nominal purchase option at the end of the lease. There are p a r t i c u l a r factors which complicate the formulation of govern-ment po l i cy on leas ing . In a typ ica l lease arrangement in Canada the Russell Duthoit , Canadian Income Tax Postponement and Avoidance Oppor- t u n i t i e s Afforded by the Long Term Lease, unpublished MBA t h e s i s , Univers i ty of B r i t i s h Columbia, August, 1971,"p.7. Report of the Royal Commission on Taxation, Volume IV, Ottawa, Queen's P r i n t e r , 1967, pp. 242-243. 87. lessee claims the lease payments as an expense for income tax purposes and the lessor deducts capi ta l cost allowance (depreciation) from his income. I f the lessee has taxable income against which the capi ta l cost allowance could be charged and the lessee and lessor both have the same tax ra tes , then there i s no loss of tax revenue to the government, that i s , the net tax payable i s the same as i f the asset had been purchased d i r e c t l y by the user. However, i f the lessee i s unable to make use of the capi ta l cost allowance while the lessor i s able to make use of i t , then there may be an i n i t i a l tax loss to the government. But the lessor must f i r s t use the capi ta l cost allowance to of fset taxable income in the form of rent from the lessee. The lessee in th is case i s not in a pos i t ion to deduct the rent payments as an expense for tax purposes because i t does not have taxable income. Thus there i s a t rade-off between these two effects and in fact the net tax revenue to the government w i l l probably be higher as a r e s u l t of l eas ing . The Capital Cost Allowance System Capital cost allowance (CCA) is a tax incentive designed to encourage investment in new capi ta l assets. I t i s pr imar i ly an instrument of economic po l i cy but i t i s administered by the Department of National Revenue in order to ensure that no more than the maximum allowable deduc-tions are taken by a corporat ion. The capi ta l cost allowance system was introduced in 1949 to give corporate taxpayers the statutory r ight to claim allowances for the cost of deprec-88. iable assets , thus permitting the tax-free recovery of c a p i t a l . P r i o r to that t ime, corporations claimed depreciation for tax purposes but there were no rules and indiv idual claims were dealt with under the highly unsatisfactory method of m i n i s t e r i a l d i s c r e t i o n . In a d d i t i o n , no losses were allowed on the disposal of depreciable assets. I n i t i a l l y corporations were required to record the same amount of depreciation i n t h e i r books for f i n a n c i a l reporting purposes as they claimed for tax purposes, but th is requirement was removed in 1954. Various CCA classes were created in 1949 with s p e c i f i c depreciation rates for each of them and the dec l in ing 3 balance method of ca l cu la t ion was established at that time. The CCA system has provided an incentive for companies to add to plant and equipment. A saving arises i n i t i a l l y because the allowance for tax pur-poses usually exceeds s t ra ight l i n e depreciation on the company books in the ear ly years of owning the asset. This provides for tax deferment which i s r e a l l y an in teres t - f ree loan from the government. Since the cost of each new asset in the same class i s added to the undepreciated capi ta l cost balance, some tax i s deferred i n d e f i n i t e l y as long as new investments i n that class are made at regular i n t e r v a l s . For complete d e t a i l s on the capi ta l cost allowance system see: Canadian Depreciation Guide 1974, 13th E d i t i o n , CCH Canadian L imi ted , Don M i l l s , Ontario. Over the years , special incentives have been superimposed on the system for economic or social po l i cy reasons (e .g. accelerated w r i t e - o f f s for po l lu t ion control equipment and a special two-year w r i t e - o f f for manu-factur ing and processing equipment). Occasionally the system has been used as a d i s i n c e n t i v e , that i s , the denial or reduction of cap i ta l cost allowance for s p e c i f i c periods in order to slow business a c t i v i t y in a certa in sector of the economy. Recently there has been a rapid accumulation of deferred taxes by corpor-ations in Canada. At the end of June, 1974 accumulated deferred taxes exceeded $5.9 b i l l i o n , an increase of 31% over a year e a r l i e r . ^ This f igure includes two main sources of tax d e f e r r a l : (1) the capi ta l cost allowance system and (2) immediate expensing of exploration and develop-ment costs by resource companies. As far as capi ta l cost allowances are concerned the f igure i s r e a l l y overstated by one-half because i n pract ice corporations maximize t h e i r depreciation deductions for tax purposes and minimize them for f i n a n c i a l reporting to shareholders. Consequently the most accurate indicator i s the arithmetic mean of the two extremes. In a d d i t i o n , no account has been taken for those corporations that have not been able to use a l l of the capi ta l cost allowance avai lable to them because they do not have enough income to of fset for tax purposes or Beatrice R i d d e l ! , " C a p i t a l Cost Allowances: Searchlight on Old Tax Incentive" , The Financial Post, October 19, 1974, p .5 . because they are tax exempt. According to J . E. Morgan, a Deputy General Manager of the Royal Bank of Canada, "The government i s concerned more about current revenues than anything e l se . They look on a lease, which i s , in e f f e c t , a postponement of taxes, as taking revenue away from them I see nothing wrong with a company who can' t use the deprecia?. t ion on an asset , s e l l i n g that depreciation to someone else in return for a lower rate . In the end, some company w i l l make an addit ional p r o f i t because of being able to do that and therefore w i l l be paying more taxes. Over a f i v e to ten year per iod , the government should be better of f because the i n -dustry w i l l grow, p r o f i t s w i l l be greater and taxes w i l l be higher . " 5 (As part of his February, 1973 Budget, Finance Minis ter John Turner promised "a thorough examination of the ent ire [CCA] system so that Parliament w i l l be in a pos i t ion to modernize our whole approach to capi ta l cost allowances I am v i t a l l y con-cerned that our system for business depreciation be f a i r and reasonable and not a hidden method for avoiding t a x a t i o n . " 6 The problem i s to obtain an objective measure of the extent to which the tax saving has contributed to addit ional capi ta l investment and the ex-tent of "windfa l l p r o f i t " on investment that would have been made anyway. Nevertheless, with capi ta l markets in t h e i r present depressed condition and with i n f l a t i o n eating into corporate cash for the replacement of inventories and worn out equipment, the tax system i s becoming an increas-ingly important tool for f inancing capi ta l investment. Leasing provides Mary Ricard, "Canada's Leasing Industry Has Its Problems", Canadian  Business, March, 1974, p.52. R i d d e l ! , op. c i t . 91. the leverage f o r that t o o l , e spec ia l ly for companies that can not u t i l i z e the current tax benef i ts . Interpretation B u l l e t i n IT-17 On July 5, 1971 the Department of National Revenue (DNR) issued Inter-pretation B u l l e t i n IT-17 on the subject of "Lease Option and S imi lar Agreements; Sale and Leaseback Agreements" (see Appendix G). This b u l l e t i n out l ined s i x rules of thumb such that i f any one of them i s contravened the lease transaction would be regarded as a loan. The leasing industry in Canada became very concerned because v i r t u a l l y any lease could be interpreted as contravening at least one of the r u l e s . The Equipment Lessors Associat ion of Canada presented i t s views in a b r i e f to the government in the Spring of 1974 (see Appendix H). At the 1st Annual Meeting and Conference of ELAC in Ottawa on September 23, 1974 the members were pleasantly surprised at the announcement by John Stacey of Revenue Canada - Taxation that IT-17 would soon be revised along the l ines suggested by ELAC. The revised b u l l e t i n w i l l indicate that transactions purporting to be leases w i l l be considered to be sales, only where: (1) the lessee automatically acquires t i t l e to the property af ter payment of a spec i f ied amount in the form of r e n t a l ; (2) the lessee has the r ight during or at the expirat ion of the lease to acquire the property at a price which, at the inception of the lease, i s subs tant ia l ly less than the probable f a i r market value of the property at the time or times of permitted acquis i t ion by the l e s s e e . 7 Thus both the lessee and the lessor w i l l be required to ensure that a reasonable attempt i s made to write agreements with option prices that approximate estimated f a i r market values. DNR also agreed with a suggestion from ELAC that when a lessee disposes of an asset acquired as a resul t of exercis ing an option under a lease, proceeds on the subsequent sale of that property in excess of the option price should be taxed at f u l l income rates rather than at cap i ta l gains rates . Accordingly DNR recommended to the Department of Finance that i t Q consider amendments to the Income Tax Act to provide for the change. The new guidelines recognize that leasing has proved to be a viable a l ternat ive to other forms of f inancing the acquis i t ion of assets. In i t s new approach DNR agrees that tax considerat ions, while of some s i g -nif icance in consummating lease agreements, do not i n themselves es tabl i sh the substance of an agreement. What concerns DNR most i s that " s i g n i f i c a n t sums paid for the purchase of property are not being charged against income as rent for which no recapture can be made from a lessee who exercises his options and then s e l l s the property at a price which reimburses him for a l l or part of the r e n t . " 9 John Stacey, Interpretation O f f i c e r , Revenue Canada - Taxation, Speech before the 1st Annual Meeting and Conference of the Equipment Lessors Associat ion of Canada, Skyline H o t e l , Ottawa, September 23, 1974. Equipment Lessors Association of Canada, Newsletter, Volume 3, Number 4 , October, 1974, p .2 . ^ i b i d . 93. Interpretation B u l l e t i n IT-164 On June 5, 1974 DNR issued Interpretation B u l l e t i n IT-164 on the subject of "Capital Cost Allowance on Certain Leveraged Investments" (see Appen-dix G). This b u l l e t i n confirmed the view of the Department tha t , i n a leveraged lease t ransact ion , capi ta l cost allowance could be taken by the lessor only on that part of the investment for which he i s at r i s k . As covered i n d e t a i l in Chapter 3, the investor in a leveraged lease transaction usual ly provides only about 20-30% of the cost of the assets to be leased. The remaining funds are secured from long term lenders who have no recourse to the lessor - investor in the event of default by the lessee. In t h i s case the lessor would be able to claim only 20-30% of the cost of the asset as a capi ta l cost for tax purposes. No mention i s made of what happens to the remaining capi ta l cost for tax purposes. Presumably DNR keeps i t as a "windfa l l gain" to the government. Glen Langdon, President of the Equipment Lessors Association of Canada, has stated that the d i s t i n c t i o n in treatment by DNR between leveraged and standard f i n a n c i a l leases i s unwarranted because i t should be of no con-sequence to DNR as to how a lessor finances a lease since the lessor s t i l l must pay f u l l tax on the income earned from i t . ^ Wayne Cheveldayoff, "Clear Tax Pol icy Advocated for Leasing Business", The Globe and M a i l , Toronto, May 5, 1973, p . B l . The Public Interest Is equipment leasing i n the publ ic interest? To answer th is question one must examine the possible impacts of equipment leasing on: (1) cap i ta l id leness , (2) economies of s p e c i a l i z a t i o n , (3) c red i t evaluat ion , (4) f luctuat ions in the business c y c l e , and (5) taxxrevenues for the government. The fo l lowing discussion draws heavily from an a r t i c l e on th is subject by Joel Dean.^ (1) Minimization of Capital Idleness One kind of capi ta l idleness which leasing can reduce stems from the lumpiness of conventional capi ta l sources such as bond and equity issues. While a f i rm 's demand for capi ta l i s l i k e l y to be lumpy as w e l l , i t i s d i f f i c u l t to match supply and demand. Raising debt or equity funds tends to produce capi ta l in amounts which exceed immediate requirements. The reasons are due to cost and i n s t i t u t i o n a l fac tors . However, lease f inan-cing can mesh the demand and supply for capi ta l p e r f e c t l y , item by item. (2) Economies of Spec ia l iza t ion Leasing can also minimize costs by improving the resale markets for equip-ment. Often equipment i s highly spec ia l ized and confined to a p a r t i c u l a r ^ Joel Dean, "The Economics of Equipment Leasing" , The Univers i ty of  I l l i n o i s Law Forum, Spring, 1962, p.52. locat ion where the resale market i s so thin that the user may not have the knowledge to permit disposal at a reasonable p r i c e . It may be that l a rge , d i v e r s i f i e d leasing companies can provide such services at lower economic costs . (3) Adequate Credit Evaluation Leasing i s a way of making capi ta l markets more perfect or at least more accessible to users of equipment than would otherwise be the case. Lessors are l i k e l y to have a better knowledge of the c red i t worthiness of t h e i r c l i e n t s than would other c red i t sources such as banks and finance companies. Also lessors may have an incentive to assume greater c red i t r i s k s and may be l e g a l l y better able to bear those r i s k s than would a c lose ly supervised f i n a n c i a l i n s t i t u t i o n . This resul ts in greater a v a i l a b i l i t y of capi ta l to small firms who are usually at a disadvantage in the search for conventional loans. As a r e s u l t , leasing can make entry and expansion easier for businessmen, thereby increasing the effectiveness of competition. Leasing can also be a force diminish-ing the optimum size of the f i r m insofar as access to capi ta l i s re lated to optimum s i z e . (4) Fluctuations i n the Business Cycle Control of the business cycle goes undisputed as a national economic goal . Attainment of that goal depends to a large extent on the a b i l i t y to smooth out capi ta l investment. Leasing contributes d i r e c t l y to such smoothing because the propensity to lease rather than buy i s stronger during a downswing i n the economy. Thus, while there i s no p a r t i c u l a r reason to expect that leasing tends to level c y c l i c a l peaks in economic a c t i v i t y , the a v a i l a b i l i t y of th is form of f inancing probably bolsters the demand for equipment when the business outlook is gloomy and funds are short . (5) Effects on Tax Revenues Joel Dean's treatment of th i s subject considers only the e f fec t on taxes payable by the lessee. He examined the tax ef fects for a f i r m using three f inancing assumptions: (A) a l l equi ty , (B) 50% debt, and (C) 100% debt, that i s , lease f inanc ing . He concluded that tax revenues to the government are diminished by equipment leasing as contrasted with owner-ship . However, th i s conclusion is incorrect because he has merely demon-strated the;;tax benefits to a f i rm from f i n a n c i a l leverage through ei ther debt or lease f inancing . To analyze the ef fects on tax revenues for the government, i t i s necess-ary to consider the tax ef fects on a l l of the part ic ipants i n a lease transaction while holding f i n a n c i a l leverage constant for the lessee. In a , lease transaction the lessee i s e n t i t l e d to deduct his rent payments as an expense for tax purposes. However, the lessor must pay tax on that rental income. Then the l essor , as owner of the assets , i s e n t i t l e d to deduct depreciation as an expense for income tax purposes. I f the lessor borrows a portion of the amount of funds used to purchase the assets, he can deduct the interes t paid on the borrowed funds as an expense for tax purposes. However, the lender must then pay tax on his interest income. In most lease transactions a l l of the par t ic ipants are corporations, thus they pay tax at the same rate . This means that there is no change in tax revenues for the government as a r e s u l t of l e a s i n g ; the pr inc ipa l difference i s the d i s t r i b u t i o n a l e f fec t of the lessee gaining tax benefits from expensing rental payments and the lessor pay-ing tax on that rental income. In p r a c t i c e , the biggest advantage of leasing accrues to the corporation which i s i n a non-taxable p o s i t i o n . It could not u t i l i z e the tax sh ie ld from depreciation and interes t i f i t purchased the assets by borrowing a portion of the funds needed. It could obtain a lower e f fec t ive i n t e r -est cost by leasing and, in e f f e c t , " s e l l i n g " the tax sh ie ld from deprec-i a t i o n and interes t i n the early years of the lease to the lessor . In t h i s case the lessee w i l l not u t i l i z e the advantage of the tax sh ie ld from rent payments. However, the lessor w i l l s t i l l have to pay tax on that rental income. Thus the to ta l tax revenue for the government w i l l a c tua l ly increase i n a lease involv ing a non-taxable lessee. The impact on tax revenues for the government has been formulated i n present value terms in Table 15. I t i l l u s t r a t e s that there i s absolutely T A B L E I S '. P R E S E N T V A L U E OF T A X R E V E N U E S TO T H E C A N A D I A N G O V E R N M E N T F R O M C O R P O R A T I O N S I N V O L V E D  I N T H E F I N A N C I N G O F E Q U I P M E N T F C R U S E R S ( P U R C H A S E R S OR L E S S E E S ) W H I C H A R E T A X A B L E OR N O N - T A X A B L E C O R P O R A T I O N S ( E x p r e s s e d 1 n m i l l i o n s o f d o l l a r s a n d u s i n g a d i s c o u n t r a t e o f 1 0 * ) ( A ) I N C L U D I N G D E P R E C I A T I O N D E D U C T I O N S T A X A B L E : L e s s e e : R E N T P u r c h a s e r : D E P R E C . I N T E R E S T L e n d e r : ; ' I N T E R E S T L e s s o r : R E N T D E P R E C . ( 1 ) L E S S E E ( 4 . 1 4 9 ) N / A N / A s 1 . 7 7 7 4 . 1 4 9 ( 2 . 6 4 4 ) I N T E R E S T ( 1 . 7 7 7 ) ( 2 ) P U R C H A S E R N / A ( 2 . 6 4 4 ) ( 1 . 7 7 7 ) 1 . 7 7 7 N / A N / A N / A N O N - T A X A B L E : ( 3 ) L E S S E E N / A . N / A 1 . 7 7 7 4 . 1 4 9 ( 2 . 6 4 4 ) ( 1 . 7 7 7 ) ( 4 ) P U R C H A S E R N / A 0 0 1 . 7 7 7 N / A N / A N / A N E T P R E S E N T V A L U E O F T A X T O G O V ' T : $ ( 2 . 6 4 4 ) $ ( 2 . 6 4 4 ) t l .ns $ 1 . 7 7 7 ( B ) E X C L U D I N G D E P R E C I A T I O N D E D U C T I O N S L e s s e e : R E N T P u r c h a s e r : I N T E R E S T L e n d e r : I N T E R E S T L e s s o r : R E N T I N T E R E S T ( 4 . 1 4 9 ) N / A 1 . 7 7 7 4 . 1 4 9 ( 1 . 7 7 7 ) N / A ( 1 . 7 7 7 ) 1 . 7 7 7 N / A N / A N / A N E T P R E S E N T V A L U E O F T A X T O G O V ' T : 0 N / A 1 . 7 7 7 4 . 1 4 9 ( 1 . 7 7 7 ) $ 4 . 1 4 9 1 . 7 7 7 N / A N / A $ 1 . 7 7 7 S o u r c e : A p p e n d i x B , T a b l e 1 6 . no difference in tax revenues to the government even i n present value terms when a taxable corporation leases or purchases an asset. I f a non-taxable corporation leases equipment the government w i l l receive tax revenue equal to the difference in present value of the tax rate times lease payments minus the . depreciation benef i t s . In the example in Table 15 the government w i l l receive taxes worth $1,505,000 in present value terms whereas i t would have received $1,777,000 i f the company had borrowed 70% of the cost of the asset and repaid that money over 15 years at 9% i n t e r e s t . The difference in tax revenues i s due to lower f inancing costs i n leas ing . If the e f fec t ive lease rate had been 9% rather than 6.9%, the present value of the tax revenues to the government, would have been $2,072,000. I t has generally been recognized that increased costs ( including f inancing charges) w i l l r e s u l t in increased tax revenues w i t h -out increasing tax rates . This i n f l a t i o n a r y e f fec t was recently acknow-ledged by DNR when i t introduced tax indexing on personal income taxes. It has been argued that the capi ta l cost allowance system i n Canada i s an instrument of economic po l i cy designed to encourage capi ta l investment. Taking that argument a step f u r t h e r , why should these incentives not be avai lable to non-taxable corporations and to rap id ly growing enterprises which do not yet have the p r o f i t s to enable them to benefit from these incent ives . I f such companies could reduce t h e i r f inancing costs by " s e l l i n g " t h e i r r ight to capi ta l cost allowance to corporations who could 100. use i t , then the CCA system would perform i t s function better . In such cases, the present value of the benefits to the government in the form of addit ional tax revenues from leasing transactions could be determined by removing the depreciation deductions from the c a l c u l a -t i o n s . Table 15 (B) i l l u s t r a t e s that again there would be no e f fec t on the net present value of the tax revenues to the government when a taxable corporation leases or purchases assets. However, the table i l l u s t r a t e s that now there w i l l be a far greater difference i n tax revenues to the government i n favour of leas ing . This i s because the depreciation and interes t deductions are useless to a non-taxable pur-chaser of assets. Under these conditions the increase in present value of the tax revenues from leasing would be $4,149,000 compared to pur-chasing which remains at an increase of $1,777,000. Considering that there is a neg l ig ib le impact on tax revenues in present value terms with a non-taxable lessee when depreciation deductions are included in the ca lcu la t ion and that there are s i g n i f i c a n t increases in tax revenues when depreciation deductions are excluded and that there are absolutely no effects on tax revenues in present value terms with taxable corporations under e i ther c o n d i t i o n , i t i s suggested that more attention be given by the government to encourage leasing in general because i t w i l l stimulate capi ta l investment and leveraged leasing in p a r t i c u l a r because i t w i l l lower f inancing costs for corporations. 101. Summary The conclusions to be drawn for Canadian government p o l i c y on leasing centre around misconceptions about the tax impl ica t ions . Too much emphasis has been placed on lease agreements that have been designed s p e c i f i c a l l y to avoid taxes. Such agreements are not d i f f i c u l t to spot once the reader i s accustomed to the terminology used in leas ing . Furthermore, i t i s not d i f f i c u l t to pol ice the market i f a set of guide-l ines i s i n s t i t u t e d . In the United States a few c l e a r l y defined rules keep that t h r i v i n g leasing market in l i n e . The fact that leasing increases the v e l o c i t y of f i s c a l measures to s t im-ulate capi ta l investment in the country v i a the "sale" of depreciation deductions to lessors should be of importance to government p o l i c y , espec ia l ly during periods of decreased economic a c t i v i t y . 102. CHAPTER 7  CONCLUSIONS This study has reviewed the development of equipment leasing as an important and growing f i n a n c i a l a l t e r n a t i v e . I t i s the lowest cost and most widely accepted form of a t t rac t ing external funds for the North American r a i l r o a d s . In recent years appl ica t ion of the investment tax c r e d i t i n the United States, coupled with accelerated depreciation and the entry of the banks into the market, has caused a boom i n f i n a n c i a l leasing i n that country which has spread into Canada. The review and synthesis of the f i n a n c i a l theory on leasing has provided an analysis of the two basic approaches: net present value versus internal rate of re turn. The review has also highlighted the three issues which are of c r i t i c a l importance to the underlying f i n a n c i a l theory on lease evaluat ion: (1) i s leasing only a f inancing decision or i s i t a j o i n t investment-financing d e c i s i o n , (2) which cash flows should be selected i n the a n a l y s i s , and (3) what discount rate(s) should be used on the cash f lows. Gordon has developed a new NPV model j u s t recent ly . His model was tested against Roenfeldt and Osteryoung's IRR model using the figures from a recent lease signed by CP Rail and the resul ts were com-pared. Gordon's model was found to belthe best for analyzing the lease-or-buy decision because of the se lect ion of cash flows and the use of the proper discount rates . 103. The lease-or-buy decisions of CN and CP were examined using two of the theoret ical models that have been proposed. The models confirmed that the railways were correct in t h e i r decision to lease. It has often been asserted that leasing expands the pool of c red i t a v a i l -able to a f i r m . This study determined that capi ta l budgets for the two railways were not expanded d i r e c t l y by l eas ing , however, i t i s possible that leasing has helped to smooth but the year to year f luctuat ions in new equipment orders. The long-run f i n a n c i a l implicat ions of leasing by the railways centre around the resul t ing saving;; . i n f inancing charges and the loss of residual value in the equipment. This study has estimated that CN has saved almost $90 m i l l i o n i n finance charges over the l i v e s of the leases signed during the l as t f i v e years. The present value of these benefits i s about $60 m i l l i o n . A s e n s i t i v i t y analysis on the salvage values found that residual values at the end of the leases would have to range between 55% and 83% of the o r i g i n a l cost of the assets in current d o l l a r terms in order to wipe out these savings in f inancing charges. I t i s l i k e l y that such residual values could only be attained by continued high i n f l a t i o n rates and then the e f fec t of rent being paid with cheaper do l la rs in the future would o f f se t the i n f l a t i o n a r y ef fects on salvage values. The prac t i ca l experience with leasing by CN and CP has been vast ly d i f f e r e n t . CN signed 63 long-term leases during the period 1969 to 1974 whereas CP 104. signed only one. The explanation for t h i s could be that the advantages of leasing were much more v i s i b l e to CN because i t i s a non-taxable Crown corporation and the analysis of differences in f inancing costs between leasing and borrowing i s s traight- forward in a before-tax c a l c u l a t i o n . This study found that the in teres t rate spread for CN using the Roenfeldt and Osteryoung model was twice as big as the spread for CP. But the former i s r e a l l y both a before-tax and an a f ter - tax ca l cu la t ion since CN i s non-taxable and the l a t t e r i s s t r i c t l y an a f ter - tax c a l c u l a t i o n . There-fore the advantages to both CN and CP are comparable. However, the rea-sons favouring leasing are d i f f e r e n t for each of the companies. CN cannot use the tax shel ter from depreciation and interes t so i t achieves lower f inancing costs by s e l l i n g the tax shel ter to a corporation which can depreciate the assets and deduct the in teres t expense from taxable income. On the other hand, CP can use the tax shel ter derived from owning an asset but i t can only depreciate railway r o l l i n g stock at 6% on dec l in ing balance. Thus CP can achieve lower f inancing costs by s e l l i n g the tax shel ter to a corporation which can depreciate the same assets at 20% on dec l in ing balance in Canada or at comparable accelerated depreciation rates i n the United States. The study concluded with an examination of Canadian government pol icy on leas ing . It was found that government o f f i c i a l s have tended to focus t h e i r attention on cases where corporations or ind iv idua ls have evaded taxes,by the i l l e g a l treatment of leases as condit ional sale agreements and vice 105. versa for tax purposes. The implicat ions of leasing in the sens i t ive area of tax pol icy are often misunderstood. This may have been caused by a combination of fac tors : (1) there i s a shortage of scholar ly studies on the issues involved in l eas ing , (espec ia l ly in,.Canada)^ and (2) the Canadian equipment leasing industry has only recently organized i t s e l f to present i t s views to Ottawa. This study has found that leasing does not s i g n i f i c a n t l y a f fec t tax revenues for. the Government, even when calculated in present value terms. It i s hoped that the study w i l l provide eustimuTus for the Government to take a new look at i t s po l i cy on leveraged leasing in Canada. The quant i tat ive analysis of the lease-or-buy decision for CN and CP has shown that leveraged leasing of new r o l l i n g stock is the cheapest source of external funds for these companies. The use of f i n a n c i a l sources in the United States provided the biggest spread i n in teres t rates for equip-ment used in internat ional service and in U.S. domestic service because of the U.S. investment tax c redi t and accelerated depreciat ion. In fact the U.S. taxpayer has subsidized the f inancing of Canadian r o l l i n g stock. The recent appl ica t ion of Canadian withholding tax (15% of the ent i re rent) on these transactions has stopped them completely. As a r e s u l t , the Canadian economy (and the Canadian taxpayer in the case of CN) w i l l lose . With leveraged leasing in the United States now e f f e c t i v e l y blocked, the next cheapest f i n a n c i a l a l te rnat ive for the Canadian ra i l roads i s leveraged ..leasing 106. within Canada. In order to do t h i s , i t i s f i r s t necessary for the Canadian government to reconsider i t s posi t ion with respect to depreciation on l e v -eraged leases. This study has argued that leveraged leasing is in the publ ic in teres t and that i t w i l l not cause a reduction i n the tax base in Canada. In f a c t , leasing can be an e f fec t ive lever for f i s c a l measures to stimulate capi ta l investment. The study also provided some subsidiary findings... A comparative analysis of leases in the United States and Canada showed that Canadian lease rates are generally higher than those i n the United States. This i s because of faster depreciation w r i t e - o f f s and the a v a i l a b i l i t y of the investment tax c red i t in the United States. A comparative analysis was made between the proposed theoret ica l before-tax in teres t rate spreads (the difference between borrowing and leasing rates) and the actual spreads found in the leases signed by CN between 1969 and 1974. The theory hypothesizes that spreads w i l l increase with increases i in debt rates , which means that leasing should become more advantageous at high debt rates . The theory was not supported by empirical evidence. However, a l a r g e r , homogeneous data sample would be needed to provide conclusive evidence. The Selected Bibliography contains the most extensive reference source on equipment leasing published to date. Due to space l i m i t a t i o n s only 170 of the approximately 1,000 references are included but a complete b i b l i o -graphy on equipment leasing between 1960 and 1974 w i l l be published under 107. separate cover. The capi ta l requirements for the two Class 1 railways in Canada during the next f i v e years are staggering. CN has estimated that i t w i l l need $5 b i l l i o n for capi ta l expenditures on improvements to f ixed plant and equip-ment. One b i l l i o n dol lars of th i s i s for new r o l l i n g stock. Internal ly generated funds w i l l not even approach this f i g u r e . As the railways are now reaching capacity on t h e i r present system, f re ight rates w i l l have to be increased i n l i n e with marginal costs . I f these increases are to be minimized, the best method of r a i s i n g new capi ta l must be encouraged. This involves f inding the optimal combination of equi ty , debt and lease f inancing consistent with market condit ions . Leveraged leasing should be an integral part of that f inancing package. Recommendations 1. Revise IT-164 to permit leveraged leasing in Canada Since the decision to apply withholding tax on Canadian r o l l i n g stock leases financed in the United States i s v i r t u a l l y i r r e v o c a b l e , 1 Canadian transportation companies should be permitted to seek the lowest possible f inancing costs for new equipment by arranging l e v -eraged leases in Canada. This w i l l require rev is ion of IT-164 by the Department of National Revenue to eliminate the current r e s t r i c t i o n s on depreciation deductions for leveraged leases. The effects on tax revenues for the Canadian government w i l l be neg l ig ib le 1 Even i f the decision was reversed, the United States government would l i k e l y put a step to any further use of ITC to finance Canadian-built equipment now that attention has been drawn to th i s point . 108. even when the various charges and credits are discounted to present value. This pol icy w i l l enable Canadian transportation companies to obtain the large amounts of external capita l which they need for expansion during the next decade. 2. Amend the withholding tax regulations Canadian withholding tax should only be charged on the interest portion of lease payments on f inanc ia l leases arranged with foreign investors. This would correspond to the current treatment of interest payments on foreign debt financing whereby repayment of pr inc ipa l i s not subject to withholding tax. Areas for.Further Research A number of interest ing sub-topics have appeared during the course of th i s study. The pr inc ipa l one i s a more detai led empirical analysis of the spreads between debt and lease rates. There i s a great deal of information contained in the U.S. ra i l road equipment leases which are f i l e d with the ICC in Washington. The sample used in th i s study was too narrow to provide con- -elusive results a f ter i t was divided into operating and financing categories pecul iar to Canadian railway r o l l i n g stock financed in the United States. The most promising category for analysis was category number 4, namely U.S. f inancing with the equipment being used in domestic service in the United States. The estimate of residual value i s one factor that i s extremely important in lease evaluation. However, there i s very l i t t l e published information 109. on the resale market for r o l l i n g stock in North America. A survey of the market in th is f i e l d , possibly in conjunction with the Associat ion of American Rai l roads , would be h e l p f u l . As noted in Chapter 4, Wyman has suggested that simulation procedures should be used to analyse the high r i s k variables i n a lease. To date only determinist ic simulation models have been used in the leasing i n -dustry. I t would be useful to develop a stochast ic simulation model for leveraged leas ing . SELECTED BIBLIOGRAPHY 110. FINANCIAL ANALYSIS A X E L S O N , K E N N E T H S . " N E E D E D : A G E N E R A L L Y A C C E P T E D K F . T H C C F O R M E A S U R I N G L E A S E C O M M I T M E N T S " . F I N A N C I A L € - X E C - U T - I V E , J U L Y , 1 9 7 1 , E E . 4 0 - 2 B O O T H E , D . P . , J R . " T H E P R A d I C A L „ , P R Q S » A ! I » r . - C O N S O F L E A S I N G " . U N I V E R S I T Y O F . I L L I N O I S L A W F O R U M , S P R I N G : , - V 9 6 ' 2 . - ' . " P K 1 - 1 5 . R E P R I N T E E 111 " C B r & T I V E B U S I N E S S F I N A N C I N G I I " , P R - A C T I S I N G " L AW I N S T I T U T E , H E W Y O R K , 1 9 6 5 P P . 1 4 9 - 1 6 5 B U R K E A R T H U R J . " T H I R D P A R T Y - L E ' A S I N G F R O M A U S E R ' S V I E W P O I N T " , D A T A M A T I O N , N O V E M B E R , 1 9 6 9 , P P . 1 4 3 - 1 7 D E A N , J O E L . " T H E E C O N O M I C S O F E Q U I P M E N T L E A S I N G " , U N I V E R S I T Y O F I L L I N O I S  L A W ' F O R U M , S P R I N ' G , 1 9 6 2 , P P 3 . 3 - 5 5 . G A N T , D O N A L D R . . - " I L L U S I O N I N L E A S E F I N A N C I N G " , H A R V A R D E U S I N E S S R E V I E W ' M A R C H - A P R I L , 1 9 5 9 , P P ; 1 2 ' 1 - 1 4 2 . + L E T T E R S O F C O M M E N T I N M A Y - J U N S A N D J U L Y -A U G U S T , T 9 5 9 I N H A R V A R D B U S I N E S S R E V I E W . . " A C R I T I C A L L O O K A T L E A S E F I N A N C I N G " . C O N T R O L L E R , J U N E , • 1 9 6 1 , ' ' P P ~ 2 7 4 - 2 7 7 . + D I S C U S S I O N I N ' S E P T E M B E R , 1 9 6 1 I S S U E , P . 4 1 4 A N E N O V E M E E R , 196 1 I S S U E , P . 5 2 2 . G R I E S I N 3 E R , F R A N K K . " P R O S A N D C O N S O F L E A S I N G E Q U I P M E N T " , H A R V A R D B U S I N E S S  R E V I E W , M A R C H - A P R I L , 1 9 5 5 , P P . 7 5 - 8 9 . . . H E R T Z , D A V I D B . " I N V E S T M E N T P O L I C I E S T H A T P A Y O F F " . H A R V A R D B U S I N E S S R E V I E W , J A N U A R Y - F E B R U A R Y , 1 9 6 8 , P P 9 6 - 1 0 8 . H O L M E S , A . " L E A S I N G - A M A R K E T I N G C O N C E P T " . C A N A D I A N C H A R T E R E C A C C O U N T A N T , O C T O B E R , 1 9 6 9 , P P . 2 6 9 - 7 2 . M A N N , C L I F T O N D . " E V A L U A T I N G • • J H E - C . O S T I N A L E A S E P R O P O S A L " , M A N A G E M E N T  A C C O U N T I N G , J U L Y , 1 9 7 1 , P P . ' 5 6 - 8 . H C E A C H R O N , W . D . " L E A S I N G - A D I S C O U N T E D C A S H F L O W A F F F C A C H " , T H E C O N T R O L L E R , H A Y , 1 9 6 1 , P P 2 1 3 - 2 1 9 . P A R K E R , G E O R G E G . C . , ' M I L L E R , H E N R Y S . " T H E L E A S E : U S E - W I T H O U T O W N E R S H I P " C O L U M B I A J O U R N A - L O F W O R L D B U S I N E S S , S E P T E M B E R - O C T O B E R , 1 9 7 0 , P P . 7 7 - 8 2 . R A N K I N , J . K . " L E A S E S : L E T T H E M S E R V E B O T H P A R T I E S " , I H C U S T R I A L C i V E I C P M E N T , R A Y , 1 9 7 3 , P P . 5 - 8 . S C H W A B , B E R N H A R D A N D N I C O L , R O B E R T E . G . " F R O M D C U B L E - E E C U N I N G - B A L A N C E . T 0 S U M - O F - T H E - Y E A R S ' - D I G I T S D E P R E C I A T I O N : A N O P T I M U M S W I T C H I N G R U L E " . T H E  A C C O U N T I N G R E V I E W , A P R I L , 1 , 9 6 9 , P P 2 9 2 - 2 9 6 . S P R A S U E , J A M E S C . " T R U E • C O S T O F L E A S I N G " , C O S T A N D M A N A G E M E N T , M A R C H - A P R I L , 1973, P P . 24 -7. V A N C I L , R I C H A R D F . , - A N T H O ' H Y , R O B E R T ' N . " T H E F I N A N C I A L C O M M U N I T Y L O O K S A T L E A S I N G " , H A R V A R D B U S I N E S S - R E V I E W , N O V E M B E R - D E C E M B E R , 1 9 5 9 , P P . 1 1 3 . - 1 3 0 . H E S T O N , J . F R E D . , C R . A - I G , R U P E R T . " U N D E R S T A N D I N G L E A S E F I N A N C I N G " , C A L I F O R N I A  M A N A G E M E N T R E V I E W , I I , - W I N T E R , 1 9 6 0 , p p j 6 7 - 7 5 . H I M A N , H . E . " F I N A N C I A L L E A S E E V A L U A T I O N U N D E R C O N D I T I O N S C F U N C E R T A I N T Y " , T H E A C C O U N T I N G R E V I E W , J U L Y , 1 9 7 3 , P P . 4 8 9 - 9 3 . Z I S E S , A L V I N . 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FINANCIAL MANAGEMENT AND POLICY. 2ND EDITION, ENG LE WOOD CLIFFS, N.J.: PRENTICE-HALL, INC., 1971, CHAPTER 22. BELSCH, GLENN A., ZLATKOVICH, CHARLES T. AND WHITE, JOHN A. "PENSIONS AND LEASES" IN INTERMEDIATE ACCOUNTING. 3RD ECITION, HOMEWCCC, ILL., 1972, PP 714-764. VESTON, J. FRED AND BRIGHAM, EUGENE F. MANAGERIAL FINANCE. 4TH EDITION, HOLT, RINEHART AND WINSTON, INC., 1972, PP 459-469. BRIGHT, M. G. DISCOUNTED CASH FLOW. MCGRAW-HILL PUBLISHING COMPANY LTD., LONEOH, ENGLAND, 1967. 117. R E P O R T S , MONOGRAPHS, BIBLIOGRAPHIES, E T C . BANKRUPTCY ACT OF THE UNITED STATES, AMENDMENT DATED 1935. CELIA, ALEXANDER P. "FINANCING INDUSTRIAL EQUIPMENT LEASES", CREDIT RESEARCH FOUNDATION, INC., NEW YORK, 1961. CREDIT RESEARCH FOUNDATION. "A BIBLIOGRAPHICAL LISTING CN EQUIEMENT LEASING". NATIONAL ASSOCIATION OF CREDIT MANAGEMENT, NEW YORK, 1960. BITEMAN, W . J . AND DAVISSON, C.N. "THE LEASE AS A FINANCING AND SELLING DEVICE" ANN ARBOR, MICHIGAN: BUREAU OF BUSINESS RESEARCH, UNIVERSITY CF MICHIGAN, 195 1 , 108 P. . ENBERG, HENRY W. I I ( E D . ) . "EQUIPMENT LEASING TRANSCRIPT". PRACTISING LAW  INSTITUTE, NEW YORK CITY, 1973, 317 P. FOUNDATION FOR MANAGEMENT RESEARCH, THE. "THE FROS AND CCNS OF LEASING". CHICAGO, 1959 GREENFIELD, HARVEY AND GRIESINGER, FRANK K. "SALE-LEASEBACKS AND LEASING IN REAL ESTATE AND EQUIPMENT TRANSACTIONS". MCGRAW-HILL ECCK COMPANY, 1958 HAMEL, HENRY G. "LEASING IN IN LUST RY". NATIONAL INDUSTRIAL CONFERENCE BOARD, BUSINESS POLICY STUDY NO. 127, NEW YORK, 1968, 111 P. L A W SOCIETY OF UPPER CANADA. THE LEASE IN MpDERN BUSINESS. RICHARD DE BOO LIMITED, TORONTO, 1965 L A W, WARREN A. "EQUIPMENT LEASING AND COMMERCIAL BANKS" ASSOCIATION OF  RESERVE CITY BANKERS,.CHICAGO, I L L . , JUNE, 1963. -MACHINERY -AND -ALLIED- PR ODUCTS -INSTITUTE. "LEAS I NG - OF I--NEUST-BI-AL EQUIPMENT". WASHINGTON, D.C., 1965, 160 P. MCGUGAN, VINCENT J . , CAVES; RICHARD E. "INTEGRATION ANE COMPETITION IN TEE EQUIPMENT LEASING INDUSTRY", HARVARD INSTITUTE OF ECONOMIC RESEARCH, 1972, 25 PAGES. MCGUGAN, VINCENT J . "COMPETITION AND ADJUST ME NT . IN THE EQUIPMENT LEASING INDUSTRY". FEDERAL RESERVE BANK OF BOSTON, RESEARCH REPORT #51, NOVEMBER, 1972, 155 P. E E T Z , DONALD H. LEASING STANDARDS AND PROCEDURES. THOMAS PUBLICATIONS LTD., KAUKAUNA, WISCONSIN, 1968. NELSON , A. THOMAS. "THE IMPACT OF LEASES ON FINANCIAL ANALYSIS". OCCASIONAL PAPER NO. 10, BUREAU OF BUSINESS AND ECONOMIC RESEARCH, CRACUATE SCECCL OF BUSINESS ADMINISTRATION, MICHIGAN STATE UNIVERSITY: EAST LANSING, 1963. S P E E C H E S L A N G D O N , GLEN. 1ST ANNUAL MEETING AND CONFERENCE, EQUIEMENT LESSORS ASSOCIA-T I O N O F CANADA, SKYLINE HOTEL, OTTAWA, SEPTEMBER 24, 1973. . S T A C E Y , JOHN. 1ST ANNUAL MEETING AND CONFERENCE, EQUIPMENT LESSORS ASSOCIA-T I O N O F CANADA, SKYLINE HOTEL, OTTAWA, SEPTEMBER 23, 1974. 118. GLOSSARY OF TERMS * Advance Rul ing : A wri t ten delcaration by the Department of National Revenue issued in response to a wri t ten request from parties to a s p e c i f i c transaction for c l a r i f i c a t i o n and treatment of cer ta in tax consequences a r i s i n g from that spec-i f i c t ransact ion. Apparent or Ef fec t ive Lease Rate: Bailment: Basis Point Spread: Broker: Because lease rentals are not broken down into components of p r i n c i p a l and i n t e r e s t , a useful guide had to be found to measure such rentals for comparison purposes. "Apparent rate" may be defined as the in teres t rate for an i d e n t i c a l transaction had i t been a loan and not a lease o r , more s c i e n t i f i c a l l y , the interes t rate at which the stream of r e n t a l s , together with the option price i f i t i s contrac tual , can be d i s -counted to the exact purchase pr ice of the leased asset. A del ivery of goods or money by one person to another in- t r u s t , for some special purpose, upon a contract , expressed or impl ied , that the t rus t sha l l be f a i t h f u l l y executed. The difference between long term debt rates and e f fec t ive lease rates expressed in basis points where one percentage point difference equals one hundred basis points . A company or person who arranges lease transactions between lessees and lessors for a fee. C e r t i f i c a t e of Acceptance: Default : A document required by lessors to confirm del ivery and acceptance of equipment by lessee and approval of a vendor's invoice for payment. The f a i l u r e by lessee to carry out his obl igat ions under the lease, e . g . , make rental payments, main-ta in the equipment i n good condi t ion , insure same, etc . Equipment Lease: A contract whereby one party (the " lessor") grants to another (the "lessee") the use of one or more pieces of equipment for a certa in period of time for a consideration c a l l e d " r e n t a l " . NOTE: The major part of th is glossary of terms i s taken from the Glossary of Leasing Terms published by The Equipment Lessors Associat ion of Canada. 119. Fair Market Value: The value which would obtain in an arm's length transaction between an informed and w i l l i n g buyer-user (other than ( i ) a lessee currently in possession or ( i i ) a used equipment dealer) and an informed and w i l l i n g s e l l e r under no compulsion to s e l l and, i n such determination, costs of removal from the locat ion of current use s h a l l not be a deduction from such value. Fa i r Rental Value: S i m i l a r l y , i t i s the value which would obtain i n an arm's length transaction between an informed and w i l l i n g lessee-user (other than a lessor-user currently in possession) and an informed and w i l l i n g lessor under no compulsion to lease and, in such determination, costs of removal from the locat ion of current use sha l l not be a deduction from such value. Financial or F u l l A lease i n which the contractual rentals return the Payment Lease: l essor ' s ent ire investment during the basic term of the lease, together with the desired y i e l d on that investment. Float ing Rentals: I n s t i t u t i o n a l Investors: Lessee: Lessor: Leveraged Lease: Rentals which are subject to upward or downward adjustment during the lease term based upon an agreed upon index. If the index changes during the term of the lease, the subsequent rentals w i l l be adjusted accordingly. Investors such as banks, insurance companies, t r u s t s , pension funds, foundations, and educat ional , char-i t a b l e and r e l i g i o u s i n s t i t u t i o n s . The party who uses the equipment, makes the rental payments and deducts same as an expense in com-puting his net income. The party who i s the owner of the equipment and receives the rentals paid by the lessee and is e n t i t l e d , among other things , to claim capi ta l cost, allowances with respect to the equipment. A lease in which the Lessor borrows a portion (usually 60-80%) of the purchase price of the leased equipment from i n s t i t u t i o n a l investors on a non-recourse bas is . Their loan- is secured by a f i r s t charge on the equipment, an assignment of the lease and of the rentals thereunder. In a typ ica l transaction the balance of the purchase price i s provided by one or more investors who become owners and lessors of the equipment. 120. Net Lease: A l l costs i n connection with the use of the equipment are to be paid by the lessee i n a d d i t i o n to the re n t a l payable under the le a s e . For example, taxes, insurance, and maintenance are paid d i r e c t l y by the l e s s e e . Operating Lease: A l e a s e , the term of which i s u s u a l l y much s h o r t e r than the useful l i f e o f the as s e t , and under which the l e s s o r provides s e r v i c e s such as maintenance, insurance, e t c . A lease of railway tank cars i s an example, as are c e r t a i n automobile or truck l e a s e s . Purchase Option: Put: Renewal Option: Rental: Residual Value: Sale and Leaseback: Term o f Lease: The r i g h t given by l e s s o r to lessee to purchase the leased equipment. Option arrangements can vary. For example, the option p r i c e may be a f i x e d sum or be equal to the f a i r market value o f the equipment at the time the option i s to be e x e r c i s e d . Options may be a v a i l a b l e during or at the end of the lease term. A r i g h t the l e s s o r has to s e l l an a s s e t to another party a t a f i x e d p r i c e a t some e s t a b l i s h e d future p o i n t i n time. This i s u s u a l l y done to p r o t e c t the l e s s o r ' s exposure on the r e s i d u a l value o f the leased equipment a t the end of the lease term. A r i g h t given by l e s s o r to le s s e e under a lease to continue using the equipment f o r a f u r t h e r period of time a f t e r the expiry o f the peri o d o r i g i n a l l y agreed upon, f o r an agreed upon r e n t a l . The c o n s i d e r a t i o n paid by lessee to l e s s o r f o r the use o f the equipment. The net value, i f any, o f the equipment at the end of the lease term. Residual value may be estimated by the l e s s o r before the lease commences and taken i n t o account i n e s t a b l i s h i n g the r e n t a l . The actual r e s i d u a l value, may, of course, turn out to be higher or lower than the l e s s o r ' s o r i g i n a l estimate. A t r a n s a c t i o n i n which a l e s s o r purchases assets and then leases such assets back to the person from whom they were purchased. The period of time during which the lessee i s e n t i t l e d to the use of the equipment. 121. Transaction Fee: A negotiated "front-end" fee payable by lessee to lessor as consideration for services performed by lessor . Also referred to as "commitment fee" or "negotiation fee" . True Lease: A transaction that i s recognized both in law and by tax author i t ies as providing the lessor with the tax benefits of ownership. The lessor has f u l l proprietary r ights i n the asset and computes his income for tax purposes by deducting from the gross rental payments the sum of (a) capi ta l cost a l low-ance, and (b) in teres t and operating expenses. The lessee expenses the ent i re lease payment and cannot c a p i t a l i z e the asset for tax purposes. Trustee: In certa in large lease transact ions , a corporation or ind iv idua l may act as trustee to hold t i t l e to leased property for the benefit of the . lessor and creditors of the lessor . The trustee may perform functions such as serv ic ing debt payments. Useful L i f e : The period of time during which an asset w i l l have economic value and be usable. Y i e l d : The rate of return to the lessor on a lease invest -ment, as calculated by the lessor . " Y i e l d " w i l l d i f f e r from "Apparent Rate" when the e f fec t of income taxes on the cash flow from the rentals i s taken into considerat ion. 124. APPENDIX B Comparison of U.S. and Canadian Leveraged Leases Tables 16 and 17 i l l u s t r a t e a t y p i c a l leveraged lease transaction using Canadian and U.S. f inancing respec t ive ly . The major differences i n the analyses are due to the d i f f e r e n t depreciation schedules (the U.S. system allows a faster wr i teo f f in the ear ly years but requires that the estimated salvage value remain undepreciated) and the U.S. investment tax c red i t (7% of the i n i t i a l cost of the equipment can be deducted from income tax payable). The conclusion i s that e i ther U.S. leasing companies w i l l obtain higher p r o f i t s than Canadian leasing companies o r , what i s more l i k e l y , U.S. lease rates w i l l be lower than Canadian lease ra tes , given equal debt ra tes , because the benefits w i l l be passed along to the lessee in a competitive leasing market. Assumptions to Accompany Tables 16 and 17 Common Assumptions: Cost of Assets: $10,000,000 Lease term: 15 years Lease payments: $1,091,000 per year (payable on l a s t day of each year) Residual value: O r i g i n a l l y estimated at $500,000 and sold for that amount at lease termin-a t i o n , therefore the sale does not produce a taxable gain or l o s s . 125. Equity investment by lessor : $3,000,000 Long term debt: (non-recourse) Lessor's income tax rate : $7,000,000 bearing interest at 9.0% and repayable in annual instal lments (on l a s t day of each year) of $868,000. 50% (assumed to continue in existence throughout the term of the lease. Canadian Financing Assumptions: Depreciation rate allowable to lessor for income tax 20% on dec l in ing balance annually, purposes: Recapture of Depreciation: (the assets would form a separate asset class in a leveraged lease transaction) Capital cost of the equipment at the end of the lease i s $281,000. The assets are sold for $500,000 and $219,000 ($500,000 - $281,000) i s added to income. U.S. Financing Assumptions: Depreciation allowable to lessor for income tax purposes: 7-year ADR l i f e using double dec l in ing balance method for the f i r s t two years , sum-of-the-years d i g i t s method for the remaining l i f e , depreciated to $500,000 salvage value. Investment tax c r e d i t : 7% of the cost of the asset or $700,000 (real ized by the lessor upon i n i t i a t i o n of the lease) . TABLE #16 CASH FLOW ANALYSIS BY YEARS - CANADIAN LEASE FINANCING INCOME • (Rent & Residual Value) DEPRECIATION • ( F o r Income Tax Purposes) D E B T (EAR INTEREST PRINCIPAL (1) (2) (3) . w Q $ $ 2,000,000 1 . 1,091,000 1,600,000 $ 630,000 $ 238,000 2 1,091,000 1,280,000 609,000 260,000 3 1,091,000 1,024,000 585,000 283,000 4 1,091,000 819,000 560,000 309,000 5 1,091,000 655,000 532,000 337,000 6 1,091,000 524,000 502,000 367,000 7 1,091,000 419,000 469,000 - 400,000 8 1,091,000 335,000 433,000 436,000 9 ''• 1,091,000 268,000 393,000 475,000 10 1,091,000 215,000 351,000 518,000 11 1,091,000 172,000 304,000 564,000 12 1,091,000 137,000 253,000 615,000 13 1,091,000 110,000 198,000 ' 671,000 14 1,091,000 88,000 137,000 731,000 15 1,091,000 70,000 72,000 796,000 TOTALS $16,365,000 $ 9,719,000 $6,026,000 $7,000,000 NOTES: 1 UNDERWRITING FEES : Leasing Broker: $100,000 Investment Banker: $35,000 2 TAX RATE: 50% 3 INCLUDES INITIAL INVESTMENT OF $3 MILLION BY LESSOR • TAXABLE INCOME TAX OTHER INCOME CREDITS NET CASH CUMULATIVE EXPENSES (Loss) (Charges) FLOW CASH FLOW (5) (6) (7) (8) (9) $ 135.0001 $(2,135,000) $ 1,067,500 $(2,067,500)3 $(2,067,500) (1,139,000) . 569,500 793,500 (1,274,000) - ( 798,000) 399,000 621,000 ( 653,000) - ( 518,000) 259,000 482,000 ( 171,000) - ' ( 288,000) 144,000 366,000 195,000 - . ( • 96,000) 48,000 270,000 465,000 - 65,000 ( 32,500) 190,500 655,500 - 203,000 ( 101,500) 121,500 777,000 323,000 ( 161,500) 61,500 838,500 429,000 ( 214,500) 8,500 847,000 526,000 , ( 263,000) ( 40,000) 807,000 - • 615,000 ( 307,500) ( 84,500) 722,500 700,000 ( 350,000) ( 127,000) 595,500 • - 783,000 (' 391,500) ( 168,500). ^427,000 - • , '• 866,000 ( 433,000) ( 210,000) 217,000 - 1,168,000 ( 584,000) 140,000 357,000 $ 135,000 $ 639,000 $( 352,000) $ 357,000 DEBT RATE IS 9% EFFECTIVE LEASE RATE IS 6.9% (IF SALVAGE VALUE OF 5% OF ORIGINAL COST IS INCORPORATED, RATE BECOMES 7.26%) »—• CT) TABLE #17 CASH FLOW ANALYSIS SY YEARS - U.S. LEASE FINANCING YEAR • INCOME (Rent & Residual Value DEPRECIATION (For Income Tax Purposes) D E B T INTEREST PRINCIPAL OTHER EXPENSES TAXABLE INCOME (LOSS) INCOME TAX CREDITS (Charges) NET CASH FLOW CUMULATIVE NET CASH FLOW (1) (2) (3) (4) (5) (6) (7) (8) (9) 0 - - - $(3,000,OOO)3 $(3,000,000) 1 $ 1,091,000 $ 2,857,140 $ 630,000 $ 233,000 $ 135,OOO1 $ (2,531,140) $1,265,570 2.121.0704 ( 878,930) 2 1,091,000 2,040,820 609,000 260,000 - (1,558,820) 779,410 1,001,410 122,480 3 1,091,000 1,700,680 585,000 283,000 - (1,194,680) 597,340 .820,340 942,820 4 1,091,000 1,360,540 560,000 309,000 ( 829,540) 414,770 636,770 1,579,590 5 1,091,000 1,020,410 532,000 337,000 • - ( 461,410) 230,700 452,700 2,032,290 6 1,091,000 520,410 502,000 367,000 - 68,590 ( 34,290) 187,710 2,220,000 7 1,091,000 - 469,000 400,000 622,000 ( 311,000) ( 89,000) 2,131,000 8 1,091,000 - 433,000 436,000 - 658,000 ( 329,000) ( 107,000) 2,024,000 9 1,091,000 . - 393,000 475,000 - 698,000 ( 349,000) ( 126,000) 1,898,000 10 1,091,000 - 351,000 . (518,000 - 740,000 ( 370,000) ( 148,000) 1,750,000 11 1,091,000 - 304,000 564,000 - . . 787,000 ( 393,500) ( 170,500) - 1,579,500 12 1,091,000 . . 253,000 615,000 - • 838,000 (.419,000) ( 196,000) 1,383,500 13 1,091,000 193,000 671,000 893,000 ( 446,500) ( 224,500) 1,159,000 14 1,091,000 • - 137,000 ' 731,000 " * - 954,000 ( 477,000) ( 254,000) 905,000 15 1,091,000 . 500,000 72,000 796,000 • . - 1,019,000 ( 509,500) 213,500 1,118,500 TOTALS $ 16,865,000 $ 10,000,000 .$6,026,000 $7,000,000 $ 135,000 $ 702,000 $ 305,000 $ 1,118,500 -1 UNDERWRITING FEES: Leasing Broker : $100,000 Investment Banker: $35,000 2 TAX RATE: 50% 3 INCLUDES INITIAL INVESTMENT OF $3 MILLION BY LESSOR 4 INCLUDES $700,000 FOR INVESTMENT TAX CREDIT (7% OF ASSET COST) DEBT RATE IS 9% EFFECTIVE LEASE RATE IS 6.9% (IF SALVAGE VALUE OF 5% OF ORIGINAL COST IS INCORPORATED, RATE BECOMES 7.26%) . ,_ CO 129. APPENDIX C EQUIPMENT LESSORS ASSOCIATION OP CANADA PRELIMINARY INDUSTRY SURVEY RESULTS Distribution of the Leasing Questionnaire was made by Touche, Ross & Co. to 68 potentially interested companies i n the business categories l i s t e d below, and received back a total of 34 forms i n various stages of completion from the indicated respondent groups. # Mailed Respondent Groupings # Returned %age Response 12 Investment Dealers 7 58 39 Leasing Companies 13 Finance Companies 4 Others 18 . 46 8 62 68 1 25 34 50% The quality and v a l i d i t y of the responses to each of the survey questions varied according to the size of the group answering a particular question - therefore, i n reporting the survey results at this time, we have regrouped the question/answer blocks to show the number of respondents i n each case. It should be noted that no attempt has been made to interpret these results for the reader. Section I - General (a) Main leasing business of respondents: full-payout equipment leasing 25 non-payout operating leasing 2 f u l l r i s k as les3or~29 automobile leasing 1 leverage leasing 4 lease brokerage 1 no risk as lessor= 5 . not i n the leasing business 1 Total a l l respondents 34 (b) Number of years i n leasing business: started after Dec. 31, 1972 4 less than one year 7 between 1 and 2 years ' 6 between 3 and 5 years 6 between 6 and 10 y6ars 2 over 10 years . 8 to t a l of a l l respondents 33 130. 2 (c) Kumber of companies reporting branches arid number of branches: 8 finance companies reported having 234 branches 21 other lessors reported having 92 branches .29 companies reported having 326 branches • 5 companies reported having no branches 34 respondents reported a total of 326 branches (d) Proportion of ELAC members responding versus non-members: ELAC membership responding = 19 out of 26 to t a l or 73.1% non-ELAC members responding 15 out of 42 mailed or 35.7% total a l l respondents = 34 out. of.68 mailed or 50% (e) Foreign operations: direct operation subsidiary, a f f i l i a t e or in parent operation foreign market U.S. Europe Other yes ' B 18 15 10 no 18 16 13 15 t o t a l respondents 26 34 28 25 (£) Foreign ownership, and public versus private ownership: degree of foreign # of companies ownership reporting o% 9 1 to 24.9% 5 25 to 49.9% 1 50 to 74.9% 1 75 to 99.9% 4 100% 13 tot a l respondents 33 public companies 4 private companies 21 other 1 total respondents 26 (g) Number of employees i n leasing operations: . 1972 1971 1970 1967 1962 employees 733 580 500 291 33 respondents 2 8 1 6 1 3 9 . 4 (h) Equipment leasing accounted for the indicated % of net earnings: 1972 1971 1970 1967 1962 0 - 10% 9 6 5 2 3 11 - 25% - - - 1 • - • 26 - 50% - - • 1 — 51 - 75% 3 1 2 - -76 - 100% 12 10 _7 _6 . _5 tot a l 24 17 14 10 8 respondents Section 2 - Equipment Leasing (Finance-Full Payout) It should be noted here that many respondents either did not have the data required to complete this section or for various reasons would not release i t to Touehe, Ross - in any event, we are now reporting only the most complete blocks of data. Also note that $ figures are i n thousands of dollars (000's). Basic Data 1972 1971 1970 1967 1962 gross lease receivables $629,321 $443,123 $313,774 $65,793 $7,111 * of respondents 16 12 9 4 3 number of lessees 38,027 30,188 24,434 13,140 919 # of respondents 13 10 7 4 3 number of leases 74,404 56,356 # of respondents 12 10 52,862 32,289 8 5 1,881 4 132. Provincial Data from 14 Respondents for 1972 only # of branches Original equipment cost Quebec Ontario B r i t i s h Columbia Alberta Manitoba ' Newfoundland Nova Scotia Saskatchewan New Brunswick Prince Edward Island Northwest Territories 81 $215,205 111 162,309 42 87,664 36 4 3,296 11 15,480 5 4,012 13 3,885 15 3,678 10 2,622-1 353 1 168 326 $538,672 Cost vs. of total 39.9 30.1 16.3 ' 8.0 2.9 .7 .7 .7 .5 .1 .1 100.0 Equipment Category - Data from 15 Respondents for 1972 Only Original eg ui-pmcnt cost Cost vs. % of total a i r c r a f t agriculture automotive communications computers construction hotel, restaurant & apartment materials handling medical & health services mining o f f i c e equipment & furnishing public u t i l i t i e s railway r o l l i n g stock r e t a i l i n g water vessels other $ 26.401 4.7 602 .1 53,031 9.5 2,658 .5 41,414 7.4 54,302 9.7 4,613 .8 €1,187 10.9 23,799 4.2 28,126 5.0 102,945 18.4 3,832' .7 75,516 13.6 26,123 4.7 19,596 3.5 35,316 6.3 $559,461 100.0 133. 5 Section 3 - Equipment Leasing (Operational-Non Full Payout) As only one lessor completed this section according to Touche, Ross & Co., the information was withheld from ELAC . Section 4 - Leveraged Leasing, Investment•Dealers As only one company completed'this section according to Touche, Ross & Co., 'the ^ -information was withheld from ELAC. Section 5 - Additional Leasing Information Credit (22 companies reported) 1. The percentage of the number of accounts with payments 60 days or more past due to the to t a l number of a l l active lease accounts ranged from 0% to 3%. The percentage of t o t a l balance in accounts with payments 60 days or more past due to the total of a l l gross lease receivables ranged from 0% to 5%. The net bad debt loss during the most recent f i s c a l year as a percentage of average gross lease receivables outstanding during the same period ranged from 0% to 3.5%. The allowance for doubtful accounts as a nercentage of gross lease receivables ranges from 0% to 3.6%. The allowance for doubtful accounts as a percentage of net lease receivables ranges from 0% to 3.2%. The allowance for doubtful accounts as a percentage of earned income ranges from 0% to 10%. 2. 3. 4. 5. 6. Business r e p o r t e d ^ v ^ n 8 ° f b u s i n e s s generated from various sources as reported by 20 companies were as follows: % of gross lease receivables brokers . 4 own sales force 67 vendors 11 re-orders from existing customers 12 referrals from a f f i l i a t e s 6 100% 134 The percentages of business written during the most current f i s c a l period f a l l i n g into the indicated ranges of i n i t i a l length of term are as follows: (24 companies reported) 15% 46% 23% 7% 9% The accounting method employed by 20 out of 21 reporting companies was the Finance Method - only one company reported using the Operating Method. Of these 20 companies, 13 used the Sum of the Digits version of the Finance Method and 7 used the Acturarial version. Of 25 companies responding to the question as to whether or not an acquisition charge was recorded at the time a lease contract was recorded, 7 responded affirmatively, 18 responded negatively. Of the seven recording acquisition charges, 3 used a figure based on the cost of the equipment, while the remaining four recorded an amount based on a percent of the finance charge. Twenty-four companies responded to the question "Please state whether anticipated residuals (as opposed to contractual) are included i n unearned income" yes 12 no 11 sometimes 1 total respondents 24 Of the twelve companies responding affirmatively to the residual question, 8 employed an appraisal approach to valuing the residual, while 3 more employed a s t a t i s t i c a l projection approach - the last company of the twelve employed another unspecified method. With respoect to the lease brokerage business, six companies replied to the question of how brokerage income was recorded as follows: at the time of leasing 4 as funds are received 2 by formula -other -1 - 3 years 3 - 5 years 5 - 7 years 7 - 10 years over 10 years total respondents 6 135. PRESS RELEASE '•, . PRELIMINARY INDUSTRY SURVEY RESULTS An astonishing 56% compound growth rate highlights the 10 year period between 1962 and 1972. Over $629 Million worth of lease receivables were held by those 16 companies as of year-end 1972 - this would indicate that investment by lessors i n new capital assets i n 1972 represented at least 1.8% of the total investment of a l l Canadian business i n new capital equipment during that year. '. \ Furthermore, since the corresponding U.S. figures indicate that over 6% of a l l American capital assets are purchased by lessors each year, and since the U.S. leasing market i s generally considered to have, had a 6 to. 10 year head start and i s correspondingly more mature, indications are excellent that the Canadian leasing market w i l l continue' to experience strong growth in the future. Current estimates of the market size i n Canada range close to $1 B i l l i o n wprht of lease receivables for 1974. The survey questions were specifically designed to eliminate information relating to equipment "rentals", real estate lease and car leases since these a c t i v i t i e s are not relevant to "equipment leasing" perse. Thus the reported results exclude information from such companies as IBM, Xerox, Hertz, Avis, Bell Telephone, etc. An equipment lease typically runs for between 3 and 15 years during which time period the lessee pays rentals to the lessor which i n the aggregate are at least equal to the original cost of the equipment under lease. Equipment owned by leasing companies and used by others as of December 31st, 1972 was divided into several categories by percent of total dollars invested i n a l l types of assets: o f f i c e equipment & furnishings 18.4 computers & communications 7.9 heavy on and off highway vehicles 9.5 a i r c r a f t , railway r o l l i n g stock & ships 21.8 construction and materials handling 20.6 medical and health services 4.2 hotel, restaurant and r e t a i l store 5.5 manufacturing, mining, agricultural 11.4 public u t i l i t i e s 0.7 " Significantly, the national scope of the industry was ..underlined by the survey results to the extend that leas accommodation i s offered to business i n every province and territory i n Canada from over 3 2 6 branch locations. The actual geographical distribution of lease dollar investments held few surprises, although i t was interesting to note that Ontario's dominant position i s shrinking due to recent rapid growth in other provincial markets particularly Quebec. Ontario 3 0 . 1 3 9 . 9 . 1 6 . 3 8 . 0 9 Q Quebec Br i t i s h Columbia Alberta Manitoba Newfoundland Z • y 7 Nova Scotia . 7 7 Saskatchewan • New Brunswick • ' c Prince Edward Island. . D 1 Northwest Territories . X . 1 137. APPENDIX D Computer Simulation of Hypothetical Leveraged Leases Assumptions: Capital cost : Term of lease: Residual value: Lease payments: Transaction fee: Income tax rate : Depreciat ion: Sinking fund factor : $1,000,000 15 years $125,000 Payable semi-annually in arrears 2% of the capi ta l cost 50% Double dec l in ing balance switching to sum-of-the-years 1 d i g i t s * 3.5% (af ter- tax) Using determinist ic computer s imulat ion, a s e n s i t i v i t y analysis was conducted on U.S. lease rates as debt rates were increased (see Tables 18 (A) and (B)) . The return on investment for the lessor was increased from 6 to 10% in increments of 1%. This corresponds to the increase in debt rates from 6 to 14% in increments of 2% because the l e s s o r ' s return i s an af ter - tax f igure whereas the debt rate i s before-tax and the tax rate i s 50%. The assumed returns for the lessor fo l low current standards in the industry. The spread between the lease and debt rates increased For an excel lent discussion of the optimum depreciation schedule see: Bernhard Schwab and Robert E. G. N i c o l , "From Double-Declining-Balance to Sum-of-the-Years' D ig i t s Depreciation: An Optimum Switching Rule" , The Accounting Review, A p r i l , 1969, pp. 292-296. 138. as the debt rates were increased. The re la t ionship i s expressed graph-i c a l l y i n Figure 4 i n Chapter 5 and i n Figure 7 below. The increasing spread i s due to the increasing deductions f o r income tax purposes from the debt incorporated within the leveraged lease. The conclusion from t h i s analysis i s that leveraged leasing becomes more advantageous as interest rates increase. 139. TABLE 18 (A) Hypothetical Railway Car Lease Transaction with U.S. Financing (A) Investment Tax Credi t Included SIMULATION* (1) (2) (3) (4) (5) Receipts $121,392 $136,500 $ 152,730 $169,950 $188,025 Residual 12,500 12,500 . 12,500 12,500 12,500 Sub Total 133,892 149,000 165,230 182,450 200,525 Less: Capital Cost Interest Fee 100,000 36,873 2,000 100,000 51,987 2,000 100,000 68,230 2,000 -100,000 85,433 2,000 100,000 103,380 2,000 Sub Total 138,873 153,987 170,230 187,433 205,380 \ Taxable Income ( 4,981) ( 4,987) ( 5,000) (4,983) (4,855) Tax I? 50% 2,490 2,493 2,500 2,491 2,427 Sub Total ( 2,491) ( 2,494) ( 2,500) ( 2,492) ( 2,428) Investment Tax Credi t 7,000 7,000 7,000 7,000 7,000 Reportable Income 4,509 ' 4,506 4,500 4,508 4,572 Less Tax Deferred 2,490 2,493 2,500 2,491 2,427 Cash $ 2,019 $ 2,013 $ 2,000 $ 2,017 $ 2,145 Return on Investment (%) 6.006 7.000 8.010 9.006 10.002 Long Term Debt Rate (%) Ef fect ive Lease Rate (%) 6.000 2.598 8.000 4.274 10,000 5.966 12.000 7.662 14.000 9.352 Basis Point Spread 340.2 372.6 403.4 433.8 464.8 140. T A B L E 18 ( B ) H y p o t h e t i c a l R a i l w a y C a r L e a s e T r a n s a c t i o n w i t h U.S. F i n a n c i n g ( B ) I n v e s t m e n t T a x C r e d i t E x c l u d e d SIMULATION # R e c e i p t s R e s i d u a l ( 6 ) $ 1 3 7 , 8 5 0 12,500 ( 7 ) $ 1 5 4 , 8 9 0 12,500 ( 8 ) $ 1 7 2 , 8 4 2 12,500 ( 9 ) $ 1 9 1 , 6 2 5 12,500 ( 1 0 ) $ 2 1 1 , 2 1 5 12,500 Sub T o t a l 150,350 167,390 185,342 204,125 2 2 3 , 7 1 5 L e s s : C a p i t a l C o s t 100,000 100,000 •, 100,000 I n t e r e s t 4 2 , 4 4 6 58,792 76,123 F e e 2,000 2,000 2,000 100,000 9 4 , 3 5 7 2,000 100,000 113,407 2,000 Sub T o t a l 144,446 160,792 178,123 196,357 2 1 5 , 4 0 7 T a x a b l e Income ( 5,904) ( 6,598) ( 7,219) ( 7,768) ( 8,308) T a x @ 5 0 % Sub T o t a l 2,952 ( 2*952) 3,299 ( 3,299) 3,609 3,884 4,154 ( 3,610) ( 3,8841 ( 4 . 1 5 4 1 I n v e s t m e n t T a x C r e d i t R e p o r t a b l e Income 2,952 3,299 3,610 3,884 4,154 L e s s T a x D e f e r r e d C a s h $ 2,952 $ 3,299 $ 3,610 $ 3,884 $ 4,154 R e t u r n on I n v e s t m e n t (%.) 6.002 7.002 8.006 9.002 . 10.006 L o n g T e r m D e b t R a t e {%) 6.000 8.000 10.000 12.000 14.000 E f f e c t i v e L e a s e R a t e (%) 4.420 6.184 7.938 9.680 11.418 B a s i s P o i n t S p r e a d 158.0 181.6 206.2 232.0 258.2 FIGURE 7 500 f 400 1 BASIS POINT SPREAD (Difference between debt and lease rates) 300 200 4-100 THEORETICAL RELATIONSHIP BETWEEN BASIS POINT SPREADS AND LONG TERM DEBT RATES IN THE UNITED STATES WITH AND WITHOUT THE INVESTMENT TAX CREDIT INCORPORATED IN LEVERAGED LEASES 142. APPENDICES E & F  Leases Signed by CN and CP Between 1969 and 1974  Explanation of; Data Tables 19 through 25 are set out in the fo l lowing manner: The f i r s t column e n t i t l e d "Number of Uni ts " refers to the number of locomotives or railway cars under lease. Next fol lows a descr ipt ion of the equip-ment including the load l i m i t in tons and the cubic capacity of the cars i n most cases. The horsepower i s usual ly given for the diesel locomotives. Next i s a l i s t i n g of the s e r i a l numbers on the equipment. They are o f f i c i a l l y known as the reporting marks which are assigned by the Associat ion of American Railroads so that no two cars or locomotives can have the same i d e n t i f i c a t i o n marks. A code for the manufacturing company that b u i l t the equipment i s in the next column. The codes are i d e n t i f i e d in the key to abbreviations which f o l l o w s . Then the o r i g i n a l cost of the equipment i s quoted in m i l l i o n s of d o l l a r s . The as ter iks refer to costs quoted in U.S. d o l l a r s . The next column denotes the country where the lease was f inanced. Following that i s the country where the equipment w i l l be used. The abbreviation "INT" refers to equipment that w i l l be used in internat ional service between Canada and the United States. The s u f f i x "IS" or "A" a f ter the i n i t i a l s in the reporting marks (eg. CNIS) means that the equipment i s r e s t r i c t e d to internat ional service . This i s because Canadian federal sales tax need not benpaid on such equipment as long as the equipment 143. does not make a domestic t r i p in Canada, that i s , from one point in Canada to another. * The next column e n t i t l e d "TERM YEARS" refers to the length of the lease agreement in years. Next i s the date of the lease. Then the name of the lessor . "DELIVERY" refers to dates for del ivery of the equipment. Often the lessor w i l l set a cutoff date beyond which there w i l l be a higher e f f e c t i v e lease ra te . This i s usual ly determined by the dates when the lessor must f i l e income tax returns . The e f fec t ive lease rate "EFFECT. RATE (%)" i s next. I t i s r e a l l y an internal rate of return on the lease payments plus an a l l o c a t i o n for loss of salvage value, a l l d i s -counted back to the o r i g i n a l cost of the equipment to solve for the ra te . The debt rate refers to the interes t rate on equipment t rus t c e r t i f i c a t e s or notes secured by the equipment. They are sold on the strength of the leaseeand the c red i t of the lessee. This i s the debt portion which usual ly makes up 70-80% of the funds used to purchase the equipment to be leased. The purchase and renewal options are usual ly f a i r market value (FMV) and f a i r rental value !(RRV). These terms are defined in the Glossary. The l a s t column i s e n t i t l e d "NOTES" and they are se l f -explanatory . The federal Budget of November 18, 1974 removed the 12% federal sales tax from transportat ion equipment such as railway r o l l i n g stock. Thus th i s r e s t r i c t i o n i s no longer necessary. 144. KEY TO ABBREVIATIONS USED IN•APPENDICES E AND F SOURCES OF DATA CANADIAN NATIONAL RAILWAYS, MONTREAL C ? R A I L , MONTREAL INTERSTATE COMMERCE COMMISSIOM,•WASHINGTON MOODY'S TRANSPORTATION MANUAL RAILWAY AGE - ANNUAL REVIEW OF CAR AND LOCOMOTIVE URDFRS REGISTRAR GENERAL OF CANADA, OTTAWA BUILDER CODES {MFG. CO.) ACF - ACF INDUSTRIES IMC. BETH - BETHLEHEM STEEL CORP., JOHNSTOWN, PA. BF - BERWICK FORGE CN-M - CN PDINTE ST. CHARLES SHOPS, MONTREAL, QUE. CN-W - CN TRANSCONA SHOPS, WINNIPEG, MAN. • EMD - GENERAL MUTORS, ELECTRO-MOTIVE D I V I S I O N (U.S.) GMC - GENERAL MOTORS CANADA LTD., DIESEL DIV., LONDON, ONT. GSC - GREENVILLE STEEL CAR COMPANY H-S - HAWKER SI DDE LEY, TRENTON, N.S. IEC - IEC HOLDEN LTD. (NAPANEE I N D U S T R I E S ) , NAPANEE* ONTARIO MIL - MARINE 1NDUSTR1ES LTD., SOREL, QUE. MLW - MLW-WORTHINGTO.M LTD., MONTREAL, QUEBEC NSC - NATIONAL STEEL CAR CORP., HAMILTON, ONT. ORT - DRTMER FREIGHT CAR COMPANY PRO - PROCOR LTD., O A K V I L L E , ONT. P-S - PULLMAN-STANDARD WSK - WHITEHEAD AND KALES MISCELLANEOUS CODES EXPRhSSED IN U. S. DOLLARS (COST SM I L L . ) FAIR MARKET VALUE (PURCHASE OPTION) SEE GLOSSARY FAIR RENTAL VALUE (RENEWAL OPTION) CANADIAN NAIIONAL KAIL WAYS 1969 EQUIPMENT LEASES WO. 3F U N I T S UESCK11'rION or EOU f PMENT S E k I A L MFG. NUMBERS CD. tMlLL. WHERE FINANCED WHERE TERM USED YEARS LEASE DATE LESSOR DEL IVERY EFFECT. -Oi-P-T KA1EI*) KATE PP T [ C-JS : NOTES PIIKCH. rfilNEK 3 0 0 CH. R E I K I G . C'K; (C'JU C3M-P A H * E N T I 7 0 - T U N l'J'6" OUUK ' j CN 2 1'jOOO' -23'J299 9 . 8 6 9 CAN. CAN. 15 JULY 10 IAC LTD. > SEPT. 30 7 . 3 7 5 f-HV. 1- 1 5 Y; I F > 5 •< .-t S AI 7« cr nniG R E M 12 SJ-<.0 (MEiEL LXCI-'Ot IVLS 3,000 HP 50 H I G H C'JCE C3X caas 100-TON 17* H K J H C'J3€ 33X CARS 70-TON <i1 CjVt^rD ilfJCPERS 100-TON **2 7 CD. I t . GTW 5 9 0 0 EMU - 5 9 1 1 GTW 3 0 5 9 5 0 - 3 C 5 9 9 9 GTW 3 0 5 7 0 0 - 3 0 5 8 7 3 USLI> 9 5 0 - 9 9 5 • 99 7 - 9 9 9 GSC iSC 2.96R* U.S. 1.387* U.S. 5 . 2 7 2 * U.S. N/A U.S. U. S. U . S . U.S. 10 AUG 1 DEC. 1 CIT LEASING CORPORATION U.S. RAILWAY LEASING CO. OPER. L FASf C A N A D I A N N A T I O N A L R A I L W A Y S 1970 E Q U I P M E N T L E A S E S N O . OF U M T S I N S C R I P T I O N UF E U ' J I P M E N T S E k l A L NUMBERS M F G . cn. C O S T WHERE WHERE ( M I L L . F I N A N C E D U S E D -TERM L E A S E Y E A R S D A T E L E S S O R D E L I V E R Y E F F E C T . DcftT O P T I O N S : R A T E ( I ) R A T E P U R C H . RENEW N O T E S 3 5 0 2 50 UULKHL-AO F I A T 70-TH.N C U V . H O P P E R S 5 9 ' 100-TIJII 4 350 C U . F T . M I L CM 3 7 7 0 0 0 H - S - 3 7 7 2 4 9 E X . 1 4 7 , 2 3 6 4 . 8 8 3 U . S . 4 . 7 2 0 U . S . I N T . C A N . 2 0 A P R . U . S . L E A S I N G I N T L . I N C . 7 . 4 5 3 2 0 MAY U . S . L E A S I N G 15 I N T L . I N C . 1 0 . 1 2 5 FOR I N T L . L U M B E R T R A F F I C 7 5 0 c n v . H O P P E R S •y>> 1 3 5 0 cr. I O O - K J N CM 3 7 7 2 5 0 H - S 1 4 . 2 6 0 U . S . - 3 7 7 9 9 9 E X 2 5 3 , 2 5 7 6 4 4 • 0 4 9 , 1 9 7 238 C A N . 2 0 J U N E U . S . L E A S I N G 1 I N T L . I N C . 1 0 . 1 2 5 3 5 4 0 0 150 F L J S H DECK I LAI CARS t 9 • 4 " S U - 4 0 - L o c o s . 3 , 0 0 0 H P 7 0 - r r r i B O X •CAR I DAMAGE F R E E ) B U L K H E A D F L A T C A R S 7 0 - T O M P I G G Y B A C K r I. A I C A H S 6 3 , 5 0 - T O N OTW 3 0 3 3 2 6 HE TH $ 1 , 1 1 9 U . S . - 3 0 3 393 OTW 5 ( 2 1 EMD - 5 9 2 9 GTW 3 0 9 4 0 0 b F . - 3 0 " 4 3 4 UKC 6 0 8 6 0 0 M I L - 6 0 8 9 9 9 CN 6 8 7 2 0 0 I E C - 6 8 7? 74 C N - 6 8 b 2 0 0 - 6 i | l ) 2 / 4 2 . 2 9 8 * U . S . 0 . 7 3 6 * U . S . 5 . 5 8 0 U . S . 2 . 352 C A N . U . S . U . S . U . S . I N T . 15 J U N E C . I . T . C O R P . 15 15 15 i A U G C . I . T . C O R P . 1 2 0 A U G . U . S . L E A S I N G 17 I N T L . I N C . 15 AUG I A C L T D . 7 . 7 0 2 9 . 5 0 0 1 0 . 2 5 0 FMV 1 0 . 2 5 0 FMV F M V 1 - 5 Yif F RV 3 - 5 YR l : 2 . P . M 8 1 2 : 1 . J 8 1 2 * 3: 1 . 4 1 0 9 ? CF OHIO. C U S T S - A N I L FOR I N T L L U M B E R T R A F F I C t ( ; V . HOPPCR'J I O O - T O N CN 3 7 i ) 0 0 0 N S C - 3 7 6 3 4 9 6 . 7 3 3 C A N . C A N . 15 S E P T . I AC L T D . N / A 2 - * YR 1 : b% 4 : UF U R 1 G . K L N T 2 5 0 l iULK.MEAU F L A T (. A P. S 7 0-1 ON U J / . H O P P E R S . I 0 0 - I U N 3 . 9 2 0 C A N . CH 3 7 H 3 5 0 N S C 1 2 . 5 0 3 U . S . - 3 7 H 9 9 9 C A N . 15 S E P T . I AC L T D . 9 . 9 2 5 15 NOV 1ST WESTERN > J A N 1 / 7 1 8 . 7 6 6 1 RANK £ T R U S T COMPANY N / A 9 . 7 5 0 f MV 2 - 5 YR 1 : 61 2 : 4 * IT CIRIG, R E N T N I L T P I - C - V L L F L A T C A R S H 9 • 4 •• 1 0 0 - I UN C l - V i " I Ii H O P P E R S C C V . H O P P E R S loo-nr i ,TW 1 0 4 H 5 3 P - S $ 1 , 3 6 2 * U . S . - 3 0 4 9 2 6 C N I S 3 T 9 2 5 0 N S C $ 4 , 4 0 0 U . S . - J 7 9 4 9 9 CN 3 7 9 0 0 0 NSC - 3 7 9 2 4 9 4 . 9 0 0 C A N . U . S . I N T . C A N . 15 D E C . 15 15 D E C . 31 1ST WESTERN BANK £ T R U S T COMPANY IAC L T D . 9 . 1 2 5 IMV 2 - 5 YR 1: 6 * 2 : 4T ( F C IR IG . RENT CANADIAN . NATIONAL RAILWAYS 1971 EOUI PMENT LEASES •JO. 3F J N I T S DESCRIPTION OF EQUIPMENT SERIAL MFG. COST WHERE WHERE TERM LEASE NUMBERS CO. tMILL. FINANCED USED YEARS DATE LESSOR DELIVERY EFFECT. RATE!?) P E P r R A T E OPTIONS: PURCH. RENEW NOTES 235 400 2'.3 50 250 106 65 25 12 350 CONTAINER FLATS 82' 70-TON NEWSPRINT BOX CARS 50'6" 70-TON CUSH. UND COVERED HOPPERS . COVERED HOPPERS COVERED HOPPERS ' 100-TON FRAME FLAT CAl-S 89"." BULKHEAD FLAT CARS E I-LEV EL FLAT CARS SAC< ECrMT. TPI-LEVEL FLAT CARS *1C*S COVERED HOPPERS VACUUM SP-38-AC LOC OHO TIvr s BJLKhEAU FLAT CARS 70-TO.N SC'NDOLA' CA1S 52 ' CN 635050 -635284 CN 404000 -404399 CTrf 315130 -3 15179 CN 3 7 9000 -379249 GTW.303394 - 303459 OWC 606350 -606849 GTrf 3042 39 -304293 GTW 307 500 -307550 GTA 307700 -307784 GTW 5800 -5811 CN 606000 -606349 CN 136400 -136599 H - S N S C P-S bETH MIL bETH P-S EMD MIL CN-M 4. 745 7.225 4.277 0. 770 * 4. 900 1.127 * 6. 743 1.776 • 0.532 * 1.681 * 0.714 * 0.523 U . S . U . S . U . S . CAN. U . S . U . S . U . S . u.s. U . S . U . s. CAN. 2.663 * U . S . 5. 283 3.778 CAN. CAN. CAN. INT . INT. CAN. INT . INT. u.s. U . S . INT. INT. CAN. u.s. CAN. 15 15 15 15 15 15 20 15*" 8 15 8 15 15 15 FEB 1ST WESTERN BANK FEB - MAY 6.993 FMV N I L C TRUST C O . APR U.S. LEASING 15 INT'L. INC. AP* U.S. LEASING 26 INf'L. INC. APR IAC LTD. 27 MAY U.S. LEASING 12 INT'L. INC. AUG 1ST WESTERN BANK 15 C TRUST C O . SEPT TRUST CO. FOR 8 USL, INC. NOV SECJRITY PACIFIC 15 NATIONAL BANK 1971 > JULY 31/71 6.862 NOV 19 DEC 1 GUARANTY TRUST > JAN 1/72 C O . {TRADERS I BAN<ERS TRUST CO. (OJEBEC) (PROCOR S ROYAL TRUSTI > JAN 1/72 JAN 1/72 > 8.355 6.061 9.785 5. 730 .250 FMV R.500 FMV 4.8085"! 4.935 0 j 8.250 FMV 2-5 YR l:6T, 2:4T i:F URIC. RtNT FMV NIL 8.750 FMV FMV 4.770 8.000 6.650 8.000 FUV 6. 3359"J > 8.500 FMV 6.6056 J 1-5 YR F RV 2-5 YR F RV 2-5 \'< AT 5.P196T OF If'.V S-A ADVANCE 2-5 YR 1: 1.5*491 2: 1.1035* or our.. COST S-A ARREARS 238 1 50 CONTAINER. FLAT CARS TPI-LEVEL F L AT CARS S9'4" 70-TON IN SOL. "-0X CARS 10-1 in MOV. SUI.KHUS. CN ',35285 -63S46e <LX 463T.464I CN 6 3 9501 -1. yi^p.t H - S CN 700500 700649 CN 286000 -28 6549 4. 345 4.679 CAN. CAN. CAN . HJ1LS-.Q AMENDED C RESTATED MARCH 23, 1972 15 DEC 31 CANADA TRUST COMPANY GUARANTY TRUST CO. I TRADERS) JAN - APR 1972 6. 331 8.500 8.500 2-5 YR AI F R V 2-5 YR FOR AT 5.01"ht GROCERY UF I MV PRODUCTS S-A AilRhARS V C A N A D I A N N A T I O N A L R A I L W A Y S 1 9 7 2 E Q U I P M E N T L E A S E S N O . If D E S C R I P T I O N O F S E R I A L M F G . J N I T S E Q U I P M E N T N U M B E R S C O . 1 5 0 1 2 5 J O O 1 0 0 4 3 E I - L E V E L F L A T C A R S 7 0 - T O N H I G H C J i S E W G U i l C H I I ' C A R S G O I O O L A C A R S 5 5 ' 1 0 0 - T O N * G D N I A I N F k F L A I C A R S 9 4 - 1 0 0 - T O N F L U S H D E C K F L A T - C A R S 9 9 " . " 7 & - T 0 N C N 7 1 U 5 U O H - S - 7 1 0 6 4 9 C N M H 0 6 0 0 N S C - 6 6 0 7 2 4 C N 1 5 7 0 0 0 H - S - 1 5 7 2 9 9 C M 6 3 9 5 2 6 l l - S - 6 ! 9 6 2 5 C f I A 7 5 3 0 0 0 B E T H - 7 5 3 0 4 2 C O S T W H F R R W H E R E T E R M L E A S E L E S S O R S M I L L . F I N A N C E D U S E D Y E A R S D A T E D E L I V E R Y 2 . 0 2 1 6 . I ' I O C A N . C A N . I . U A H C A N . C A N . C A N . C A N . C A N . 1 5 15 1 5 1 5 0 . 7 5 9 * U . S . I N T . 1 5 F E B C D N A C C E P T A N C E 2 8 C O R P . L T D . A P R B A N K OF NEW 1 Y O R < E F F E C T . P C !1 T ( I P I I C N S : N O T E S K A I E ( X ) R A T E P U N C H . R E N E W 5 . 6 0 0 B . 1 0 I ) I MV - S Y R 2 . 0 ! l t V i 6 T . C I M ' - 1 > 2 5 OF G R I T . . C O S T S - A A R R E A R S 4 . 1 6 9 7 7 . 8 7 5 F M V 1 - 5 Y R AT F R V . 1 0 0 1 2 5 C O V F P r D H O P P E R S P R E S S U R E U N L O A D LOW D E C K F L A T C A R S 8 9 ' 4 " 7 0 - T O N C N 7 0 0 6 5 0 N S C - 7 0 0 7 7 4 3 . 1 0 0 C A N . C A N . 2 0 3 . 9 4 9 U . S . C A N . 2 0 J U N E 1ST S E C U R I T Y 1 B A N K O F I D A H O 6 . 0 2 2 9 8 . 0 0 0 F M V 2 - 5 YR A T F R V 5 0 2 5 0 1 2 C O V E R E D H O P P E R S 1 0 0 - T O ' l 4 7 5 0 C F 4 C O N T A I N E R F L A T C A R S 9 4 ' 1 0 0 - T U N 3 0 / C A R S 5 2 7 0 - T O N lb' G i i L O D O R S 3 0 X C A R S 5 2 ' < i " 1 0 0 - T O N 1 0 " S L . D O O R S B O X C A R S 5 2 ' f t " 1 0 0 - I O N 1 0 ' S L . D O O R S S O N i J O L A C A R S 1 0 0 - T T I 5 0 ' 6 ' ' P E G E S T A E F L A T C A R S H 9 ' 4 " 7 0 - T O N G T W 3 1 5 1 8 0 P - S - 3 1 5 2 2 9 C N 6 3 9 7 0 0 M I L r 6 3 9 f i 1 4 C N 5 5 7 0 0 0 N S C - 5 5 7 4 3 9 C N 4 1 5 0 0 0 N S C - 4 1 5 0 4 9 0 . 8 5 9 * U . S . U . S . 1 5 C N I S 4 1 7 0 0 0 N S C . - 4 1 7 2 4 9 G T W 1 4 7 6 0 0 OR T - 1 4 7 6 9 9 GTW 3 0 3 4 6 0 B E T H - 3 0 3 4 7 1 2 . 3 4 9 U . S . C A N . 8 . 6 7 0 U . S . C A N . 2 0 1 . 0 0 1 U . S . C A N . 2 0 4 . 4 6 B U . S . I N T . 2 0 1 . 4 7 0 • U . S . U . S . 1 5 0 . 2 1 H • U . S . I N T . 1 5 . A U G B A N K O F 1 NEW Y O R K 2 0 O C T U . S . L E A S I N G 1 I N T ' L . I N C . N O V 1 S T S E C U R I T Y 1 S T A T E D A N K N O V 1 S T S E C U R I T Y 1 S T A T E B A N K D E C T R U S T C O . F O R 1 5 U S L , I N C . > J A N 1 / 7 3 J A N 1 / 7 3 > J A N 1 / 7 3 > 4 . 1 0 2 0 8 . 0 0 0 F M V 1 - 5 Y R F R V 5 . 9 6 7 3 fi.000 F M V 2 - 5 Y R © AT F R V 6 . 0 9 3 2 6 . 4 4 0 0 8 . 0 0 0 F MV . ' - 5 Y K A T F R V 4 . 3 6 6 2 8 . 0 0 0 F M V 2 - 5 YR A t F R V 3 . 7 4 5 2 7 . 5 0 0 F M V 2 - 5 Y R F R V N O T E S : Q fcAS LI) TJN 1 4 Y R . & U I U E L I N E H A S I S t W I L L H E A B O U T . 2 5 1 1 H I G H E R I F 1 5 Y R . G U I D E L I N E R E Q U I R E D B Y I R S W I T H I N T H E I N I T I A L 5 Y R . I M ' R K I D I . CO CANADIAN NATIONAL RAILWAYS 1973 EQUIPMENT LEASES NO. 3F DESCRIPTION OF SERIAL MFG. COST WHFRF J.-.ITS ECUIPMENT NUMBERS CO. • tMILL. FINANCED 122 3 0 100 ".00 2* WHERE USED PIGGYBACK FLAT CARS ( P.EBUI LT ) PEI.EStAL FLATS 70-IClf 89"." 1-420 DIESEL LOCOMOTIVES 2,000 HP GONDOLA CARS 100-1 ON 52'6" STEEL BOX CARS CUSH. UJDERFR. 5 0 • 6 " TRAILER FLAT CARS" DEL HI ICH 3 9 • 4 " STEEL BOX CARS CUSH. 'JNDERFR. JO'S" PRESSURE FLOW COV. HOPPERS 3 300 Cf CN 683000 CN-M ' 1.521 -683121 CNA 750200 HETH 0.906 -750238 CN 2500 -2529 ML W 10.100 CN 137000 H-S - 1 37349 6.889 CN 407000 NSC 2.088 -407099 CN 682050 NSC 1.246 -6S2096 CNIS 408000 NSC .- 7.457 -408149 OK: 403500 -403749 • CNIS 374500 PRO ' 0.718 -374523 U.S. U.S. U.S. U.S. U.S. U.S. U.S. u.s. CAN. INT. CAN. CAN. CAN. CAN. INT. INT. TERM LEASE YEARS DATE LESSOR DELIVERY 15 15 15 15 15 JAN U.S. LEASING 31 I NT 1L• INC. FEB CENTRAL BANK, 1 N.A. APR U.S. LEASING > JULY 1 INT'L. INC. JULY 1 AUG EFFECT. DEBT RATE!*) RATE 7.1765 8.000 4.8580 7.H75 LY 1 6. 2945 "\ - AUG 31 6.445? > 31 > 7.6400 J 7. 875 APR U.S. LEASING > JULY 1 INT'L. INC. JULY 1 - AUG AUG 31 APR U.S. LEASING 1 INT'L. INC. 1 6. 1588 T 31 6.3103 V 7.1 > 7.6400 ) > JAN 1/74 JAN 1/74 > OPT I CIS: PURCH. RENEW FMV 2-5. YR Al FRV FMV 2-5 YR AT FRV FMV 2-5 YR At FRV F«V 2-5 YR AT FRV NOTE S 4.3329 "I 4.9940 J 7.S75 FMV 2-5 YR AT FRV 400 51 200 BUL<HEAD FLAT CAI'S fO-T'JN 3ULKMI. All FLAT CARS 70-TON OWC 605000 CN-W 2.924 -605199 •WC 605200 H-S -605599 PRESSURE FLOW CNIS 374524 PRO COV. HIIPPLRS 3 300 CF FLAT CARS 100-TON 62'6" -374574 CYLIN. HOP'ERS CN 346500 NSC IOC-ION 2300 CF -346553 5.9 17 1.541 CN 667100 CN-M 3.715 -66 /274 CN 66 7900 -667924 U.S. U.S. U.S. INT. INT. INT. CAN. CAN • i 15 V 15 15 15 APR 1ST SECURITY 15 BANK OF UTAH APR 1ST SECURITY 15 BANK OF UTAH > JAN 1/74 4.2786 "Y JAN 1/74 > 4.7476 J l)Ot) FMV JUNE-AUG/73 6.5722 8.000 FMV :'-•> YR AT FRV 2-5 YR AT FRV DP 38-2 DIESEL CN 5519 L OCIIMOf I VLS -5560^  GMC 14.239 CAN. MAY U.S. LCASING 15 INT'L. INC. > AUG/73 5.6426 7.750 FMV 2-5 Y R Al I RV 0 ASSIGNED TO MERCANTILE-SAFE DEPOSIT f. TRUST COMPANY CANADIAN NATIONAL RAILWAYS 1973 EQUIPMENT LEASES CCNTINUEO NT Oc CFICRIPT TON OF SERIAL MFC• COST WHERE VHERE TERM LEASE T S . ejL,t pvEST A'jyeEPS- — CC. —SM ILL-i—FINAVCEC- USEO YEAS S-OATE— LESSOR CEL IVERY EFFECT. 0E8T CPTlCNSf RAT- f t t i ftAT-E PVRC-*TT-R«fE*- NCTES -C"- 3 J-?-0 lE-Sfrt (rf*—5-56-1 5 CC 17i-720 -UrsS-; - C A N ^ -t5-irccMOT I V E S 300 ??x CARs •• • • 5Z*S" 70-TCN is- en. O C C R S -4 CO — - 9-i'x CARS ••• 5 3 ' ' J " 7 0 - T C N 1 ? ' PL ' . r.-DOOPS Ico •• e r x CARS 5 0 ' 6 " 7 0 - T C N E V \ « ! L O A O O I V . -5610 CN 557440 - NSC - 557 739 -CN-UICOC —NSC~ -411399 - CN 410000 —NSC — 2 . 4 7 1 U. S. CAN. 1 5 -410099 . 6 . 3 6 7 V.Si"— CAN* 1 5 - 7 . 9 7 6 U*rSs C A N J 1 5 — GCnCLA CARS 100-TON CCN1A! NER Tl AT CARS —10i-TCN CN 137350 H-S 4.104 U.S. CAN. 15 - 13754<3 CN 639200 MIL 5.327 U.S. CAN. 15 -631444 SEPT 1ST WESTERN , > JAN 1/74 6.5Z28 1- &ANK-- 6-THt/5T ; 1—TO— COMPANY . t.5257 •" •- JAN 1- MARCH—1 t.9 691-V 8.250 FMV 2-3 tH FRV ; 15 Ft US I- D5C>C •FLAT CASS - 0.295* U.S. INT. 1 5 4.46BC :"-c~-^* 1*1113 ; • O A N K 3.9402 8.250 FMV 1-5 YR FRV i;o cr-/ER?o -.jppfj^  C'RS" ICC-TIN GT n 13S1CC ACF 1.771* U.S. 133199--— 0. S. 15 OCT 1ST SFCURt T-Y -15 MNK' OF UTAH - - — 4.4660 8.750 FMV 2-5 YR ... ; fRV- — -Kj-Jn-CvM ?s'6" lJO-Tr)N FLUSH CEC< FIAT CABS -e <- • 4 -—9 -»-OEC-i« -CTvr-30655t CSC Ovfl30< -3C6573 -IN-T-S 1 5 -GTW 3C352S WCK 0.077* U.S. -303532 INT. 15 S. OCT TRUST COMPANY > HAY 14/74 5.2462 8.750 FMV 2— 5 YR J 15 F OR USL. INC. FRV JI-IEVEL -Fv » t - CAR S-89 '4" GTW 304300 WCK 1 .793* U.S. 304 3 67 : " INT . 1 5 CCV". t-CPof'S 33CC CL. FT. -O-iS 51 tAN". C- A ttt -20— 5.6895 28 Ft'.:SH CECK -ft A T:-CA' S — CNA 753200 WCK -75-3 227- 0.554* U.S. INT. 1! 2.50 RuLKHfA!) FLAT • DwC 605400 CN-W — 2.924 U.S. ' INT . 15 C.'^ S 70-TCN -605799 52' S" I CCT 1ST SECURITY ' 15 BANK CF UTAH 8.750 FCV 2-5 VR FRV O CANADIAN NATIONAL RAILWAYS 1974 EUUIPMENT LEASES NO. OF UNITS DESCRIPTION DF EQUIPMENT SERIAL NUMPERS MFG. CO. COST $MILL. WHERE WHERE FINANCEO USED TERM YEARS LEASE DATE LESSOR DELIVERY EFFECT. R A T E m DEBT KATE OPTIONS: PURCH. RENEW NOTES 10 136 11 140 22 30 TRAILER FLAT CARS 70-T3N PEDESTAL FLAT CARS 70-T3N STANDARD FLAT CARS 100-TON 1-420 D I E S E L L O C O K T J I I V E S ~,V 40-2 DIESEL .Locawot ivts WOOOCHIP CARS STL. SHFCTHEAD M - 4 2 0 DIESEL LOCOMOTIVES GP 40-2 DIESEL LOCOMOTIVES :N 682097 -682163 CN 7 5 O 0 9 0 - 7 5 0 0 9 9 C N 6 6 /2 75 - 6 6 7410 CN 2530 -2537 CN 9400 -9 4 10 CN 880725 -e80864 CN 2538 -2559 CN 94 11 -9490 NSC NSC 1 . 7 8 2 U.S. CAN. GMC 2.639 7. 769 U.S. CAN. GMC 32.072 U.S. CAN. U.S. CAN. U.S. CAN. U.S. CAN. U.S. CAN. U.S. CAN. 15 15 15 15 15 JAN 1ST SECURITY > JULY 1/74 7.0686 1 BANK OF UTAH 8.500 FMV 2-5 Y^5 f RV > AUG 1 7.0686^  8.500 FMV 2-5 YR BAN< OF UTAH, AUG 1 - DEC 31 7.1993J F R V N.A. JAN 1ST SECURITY 1 31 120 HIGH CJBE BOX CARS JUKHEAO FLAT CARS CN4 795000 -795030 DWC 605680 -605799 1.131 * U.S. INT. 1.754 U.S. INT. 15 15 JAN TRJST COMPANY 15 FOR USL, INC. 5.2462 8.750 FMV 2-5 YR FRV 185 CAFE-BAR-DOME .UUNGE CARS 3 U L K H F A D FLAT CARS COVERED HOPPER CARS COVERED HOPPER CARS DEPRESSED CENTER FLATS JONDOIA COAL A^kS 100-TON CN 2 700 -2705 CNIS 368000 NSC -368999 CNIS 368000 NSC - 368999 CN 6741 00 NSC -674102 CN 199200 H-S -199293 2.666 1. 169 3. 7 7 9 2.000 U.S. U.S. U.S. U.S. U.S. U.S. CAN. INT. INT. INT. CAN. 10 15 J A M 15 1ST SECURITY STATE BANK 7.8962 8.125 FMV ::] APR TRUST COMPANY 4 FOR USL, INC. APR TRUST COMPANY 8 FOR USL, INC. APR TRUST COMPANY 10 FOR USL, INC. > MAY 31/74 4.4680 9.30P FMV 9.500 FMV 9 . 5 0 0 FMV 2 - 5 Y R F R V 2 - 5 Y R FRV 2 - 5 Y R F R V 2-5 YR FOR UNIT T RV TRAIN SERV. LLISCAR TO VAN COVERED HOPPER CARS 100-TON 3 8 00 CO FT CNIS 368000 NSC -368999 INT. 15 MAY EXCHANGE NAT'L. > AUG 31/74 1 BAN< OF CHICAGO 9.625 FMV 2 - 5 YR FRV 29 180 FLUSH DECK FLAT CARS C TIE 00WN EJMT. XM 80* CARS 50'6" 100-TON 0.707 * U.S. CNA 404400 -404579 U.S. MAY 7 DOMESTIC ONE LEASING CORP. 6.6601 JUNE CANAT LTD. 28 1 0 . 7 0 0 F M V 2 - 5 V R F R V V C P K A I L EQUIPMENT LEASES 1969 - 1974 NO. 'J! UNI TS L'CSCI'. II' 11 UN OF EQU 1PMENT SERIAL MEG. NUMBERS CO. COST tMILL . WHERE WHERE TERM LEASE FINANCED USED YEARS DATE LESSOR DELIVERY EFFECT. RATEUI UEEU OPTIONS: RATE PURCH. RENEW NOTES 12 8JKHCAO FLAT CARS PEDESTAL FLAT C/.i-S WIIH SADDLF. S;ACK. EQUI PMfcNf. CP I 117000 -i 17199 CPAA 590025 BETH . -590036 4. 269 U.S. 20 0.299 * U.S. } OCT HORG WARNER 15 EQUITIES 1973 CORPORATION 2-5 YR 1: 1.H 7 25S CF UR1G. COST 2: FRV APPENDIX G 153. DEPARTMENT OF NATIONAL REVENUE, TAXATION S U B J E C T : INCOME T A X ACT Lease-Option and Similar Agreements Sale and Leaseback Agreements S E R I A L N O : IT— 17 D A T E : July5, 1971 R E F E R E N C E : Section 12(l)(b) (Also Sections 4, 7(1), ll(l)(d), 12(l)(a), 12(2) and 137(1)) It is necessary to determine, with regard to leasing agreements, whether payments made in respect of those agreements are in substance payments of rent or payments on account of the purchase price of property or, in the case of sale-leaseback agreements, repayments of a loan. As there is no special provision in the Income Tax Act dealing with such agreements, this determina-tion must be made on the basis of general law and the provisions of the agreement itself. Individual cases will be treated in accordance with the general statements of Departmental policy that follow: Lease-Option Agreements Lease-option agreements vary considerably in their terms. At one extreme is the agreement that provides for rental payments at a reasonable rate during the currency of the agreement and gives the lessee an option to purchase the property at the end of the rental period, and sometimes also at some earlier time or times, at a price that reasonably approximates what is likely to be its depreciated value at the time or times when the option is exercisable. (In this connection "depreciated value" refers to the cost of the property less a reasonable allowance for wear and tear, and not to its undepreci-ated capital cost as computed under the Act.) Where an agreement is of this nature, the annual payments will be dealt with as rent, and a subsequent exercise of the option to purchase will not change their character to that of payments on account of the sale price of the property, even if the agreement provides that some part of them will be so applied should the option be exercised. At the other extreme is the case where property is rented on terms that call for the title to pass to the lessee at no additional cost when all the rentals required under the agreement have been paid. In circumstances such as this, the agreement is in substance an agreement for sale, and the same would apply where the payment to be made at a time when an option to purchase can be exercised is so low in relation to what will be the estimated depreciated vaiue of the property at that time that any reasonable person obviously would exercise the option. When an agreement is, in substance, an agree-ment for sale, the payments ordinarily will be dealt with as payments on account of capital which are not deductible, as rent or otherwise, in computing income; and the purchaser's capital cost ordinarily will be equal to the sum of the amounts he is required to pay to the vendor. When a payment is considered to be on account of the purchase price, the purchaser may take the view that such a payment is a blended payment, being partly a capital payment and partly a payment of either rent or interest. While it cannot be admitted, in these circum-stances, that part of the payment is rent, the view that part is interest, and deductible in computing the purchaser's income by reason of Section 1 l(l)(d), may have merit, provided that a similar amount can be included in income of the vendor pursuant to Section 7(1). In these circumstances it is possible to impute interest only where it can be shown conclusively that the aggregate of all payments to be made under the contract is greater than the fair market value of the property. The amount of total interest so imputed will be the lesser of (1), the excess of such payments over fair market value or (2), the amount of interest over the term of the agreement calculated by applying to the fair market value of the property a suitable interest rate prevailing at the time of the execution of the agreement. If the purchaser's contention is accepted, there will be ex-cluded, of course, from the capital cost of the property to him any amounts allowed or to be allowed as deductions for interest in computing his income. 154. Between the extremes there will be many examples of varying kinds. The Department's principal interest is to see that significant sums paid for the purchase of property are not being charged against income as rent, of which no recapture can be made from a lessee who exercises his option and then sells the property at a price which reimburses him for all or part of the "rent". Some of the factors that will be considered when determining whether the substance of a transaction is a lease or sale are listed below. If the answer to one or more of the factors in items 1 to 6 is in the affirmative, a sale may be indicated: (1) Is the option to purchase exercisable with'ti a period which is materially less than the useful i.fe of the property with the rental payments in that period amounting to a substantial portion of the fair market value of the property at date of inception of the lease, or, in the same circum-stances, has the lessee a right to renew the lease for the remaining approximate useful life of the property at a rental substantially less than fair market rental which makes the renewal of the lease almost a certainty? (2) Does the lessee have the right during or at the expiration of the lease to acquire the property at a price which at the inception of the lease was substantially less than the probable fair market value of the property at the time or times of permitted acquisition by the lessee? (3) Was the property acquired by the lessor to meet the special needs of the lessee and will it probably be usable for that purpose by the lessee only? (4) Does the term of the lease correspond sub-stantially to the estimated useful life of the property with the lessee obligated to pay costs such as taxes, insurance, and maintenance which are usually considered incidental to ownership? (5) Has the lessee guaranteed the obligations of the lessor with respect to the property leased? (6) Is some portion of the periodic rental payment specifically designated as interest or readily rec-ognizable as the equivalent of interest? In relation to the above factors, the registration of. the transaction as a Conditional Sales Contract is not necessarily a decisive factor. Nor is it necessarily decisive when the agreement makes no provision for the transfer of title, or specifically precludes the transfer of title. Sale-Leaseback Agreements These agreements also vary considerably in their terms and will be treated as far as is possible in similar fashion to that outlined for lease-option agreements. One extreme is where an agreement provides for a realistic original selling price and for rental payments at a reasonable rate during the currency of the agreement, and there is either no repurchase option or an option price that reasonably approximates the depreciated value of the property (as defined above). The other extreme in this type of agreement may involve the sale of property that is largely depreciated for income tax purposes for a price considerably in excess of fair market value, with the vendor undertaking to lease the property b3ck from the purchaser. The terms will closely approximate the repayment of a loan with interest and the agreement may call for the title to revert to the vendor at little or no cost when all rentals required under the agreement have been paid. Some agreements may have no option provision but give the lessee permission, either in the lease document or by separate written agreement, to dispose of the leased property virtually at will. In these circumstances the agreement is, in substance, a loan arrangement. Con-sequently the vendor and the purchaser will be con-sidered to be a borrower and a lender respectively, with the payments being dealt with as payments on account of principal and interest. The total amount of interest is readily ascertainable by computing the difference be-tween the amount advanced and the total to be repaid. The interest content of individual payments can be determined by recourse to appropriate interest tables. The question of whether the borrower may deduct the interest portion will depend on the use made of the borrowed funds. Again there will be many cases falling between the two extremes. The Department's principal interest in these cases is to see that repayments of borrowed money of a significant amount are not being charged against income as rent. Effect on Lessor lt is the Department's policy to apply the same interpretation of an individual contract or agreement to both the lessor and the lessee who are parties to it. 155. DEPARTMENT OF NATIONAL REVENUE. TAXATION P m T' S P 0 H £ T A "5" 1 ^  NI j fcu d & DS4 a ut g> Brad i til ay L _ J J L r J y y y y S U B J E C T : S E R I A L N O : R E F E R E N C E : INCOME TAX ACT Capital Cost Allowance on Certain Leveraged Investments IT-164 D A T E : June 5,1974 Paragraph 20(1 )(a) 1. This bulletin presents the Department's views in the determination of the capital cost of certain "leveraged investments" for the purpose of calculating capital cost allowance under paragraph 20(1 )(a) of the Act. 2. In this bulletin "leveraged investment" means an arrangement whereby a person (or persons) (hereinafter called "the investor") acquires an equity interest in capital property ("the investment") at a stated purchase price substantially in excess of the amount actually invested or put at risk by him. One of the main objects of the arrangement is for the investor to secure the right to capital cost allowance on the total stated purchase price. Generally the investor intends to use the addi-tional capital cost allowance to reduce other income. 3. The leveraged investment is generally property which qualifies for a high rate of capital cost allowance as provided by the Income Tax Regulations, for ex-ample, an aircraft (40 per cent), a motion picture film other than a television commercial-(60 per cent), videotape or a motion picture film that is a television commercial message (100 per cent), and certain manu-facturing and processing equipment (50 per cent). A leveraged investment may also form part of a leasing arrangement,where the user of equipment is tax-exempt (for example, a municipality) or non-taxable, or where the capital cost allowance claim by the investor can be greater than that by the user on the same equipment; for example, railway rolling stock that is part of a railway system is Class 4 (6 per cent) but to the investor is Class 8 (20 per cent). 4. The general nature and form of such investments are described below under the headings "Motion Picture Films" and "Leveraged Equipment Leases". Motion Picture Films 5. A leveraged investment in a motion picture film may generally be categorized according to whether the investment is made: (a) prior to the completion of production, or P U B L I S H E D U N D E R T H E A U T H O R I T Y O F T H E D E P U T Y M I N I S T E R O F N A T I O N A L R E V E N U E F O R T A X A T I O N (b) after the completion of production and perhaps after varying degrees of distribution. 6. The following example illustrates the general fea-tures of a leveraged investment made prior to the completion of the film: (a) The film has a budgeted cost of $500,000. (b) Financing of the film is as follows: (i) $180,000 obtained through loans and ad-vances by other parties involved in producing, exhibiting and distributing the film; (ii) an investment of $200,000 by the Canadian Film Development Corporation (CFDC) pursuant to paragraph 10(l)(a) of the CFDC Act (the CFDC is a Crown corporation established to invest in Canadian feature films to assist the Canadian film industry); (iii) a cash investment of $120,000 by the investor. (c) All monies advanced will only be recouped from earnings from the distribution of the film. In addition, all parties share, in a specified manner, in the earnings in excess of those used to repay the advances. (d) For his investment the investor purports to obtain title to the film upon its completion. None of the other parties have any effective recourse against the investor for monies advanced since their rights to repayment are limited to their participa-tion in the earnings of the film. (e) The film is property of the investor described in Class 18 of Schedule B of the Income Tax Regula-tions and as such is subject to a capital cost allowance rate of 60 per cent. 7. The investor described above is often a limited partnership with a group of individual investors as limited partners and a newly incorporated company as a general partner with the limited partners as shareholders of the corporation. Each of the limited partners con-tributes a share of the investment (in the above example, $ 120,000) and the limited partnership obtains title to the film. 8. Where a film is acquired after production is com-pleted, the purchase agreement generally provides for an immediate cash outlay (say $120,000) substantially less than the total stated purchase price (say $500,000) with the balance to be repaid only out of earnings from the distribution of the film. Generally the only recourse by the vendor of the film for non-payment is repossession of the film after a specified number of years. Where a limited partnership is the investment vehicle, recourse other than repossession may be indicated by the agreement but generally the only effective action against non-payment is still the repossession of the film. 156. 9. Under the types of financial arrangements outlined above the Department takes the position that the capital cost of the film to the investor for the purpose of paragraph 20(1 )(a) is only that cost which has been laid out or in fact put at risk by the investor, either through investment of cash or borrowed funds unconditionally repayable whatever the fortunes of the film in question may be. Subject to the remarks in paragraph 11, in either case noted above that capital cost is $ 120,000. 10. Where, as a result of earnings from the distribution of the film, additional amounts are paid by the investor toward its stated purchase price, such amounts consti- ' tute additional capital cost of that film, except in cases 1 described in paragraph 11. 11. In certain cases the capital cost of a film for the > purpose of its inclusion in Class 18 of Schedule B of the Regulations is NIL, since: ' (a) the him is not considered to have been acquired by the taxpayer for the purpose of gaining or ! producing income therefrom, or (b) the film is not in fact a Class 18 property; for example, where the investor does not acquire a motion picture film but only the rights to its distribution in a specified territory. Leveraged Equipment Leases 12. It is necessary to determine whether payments made ' in respect of leasing agreements where there is an option i to acquire the leased property are in substance payment of rent or payment on account of the purchase price of 1 property or, in the case of sale-leaseback agreements, repayment of a loan. This determination must be made on the basis of general law and the provisions of the agreement itself. Departmental policy in this area is expressed in the Interpretation Bulletin entitled "Lease-Option and Similar Agreements, Sale and Leaseback Agreements". The following comments assume that the lease referred to is in substance a lease. i 13. A typical leveraged equipment-leasing arrangement is as follows: (a) A taxpayer (called "the user") arranges with a manufacturer for certain equipment. (b) The user (or in some cases the manufacturer) invites various financial institutions to submit tenders for the financing of the equipment. (c) A financial institution may submit a tender which calls for one of its clients ("the investor") to put up approximately 20 per cent of the asset cost with the remaining 80 per cent to be supplied by other parties (e.g., insurance companies, banks and pension funds) whose participation is also arranged for by the financial institution. The financial institu-tion may itself take the position of the investor. (d) The tender showing the lowest financing cost to the user generally is awarded the financing contract. (e) The investor arranges with a trustee (usually a trust company) for the issuance of notes or certifi-cates by the trustee to the other parties supplying 80 per cent of the equipment cost. The other parties purchasing these notes or certificates agree to look only to the equipment and the user for the security of the funds they invest. Accordingly, the investor has no liability for the 80 per cent of the equipment cost financed by the issue of the notes or certifi-cates. The investor pays his 20 per cent to the trustee and the trustee then pays the manufacturer in full for the equipment and receives title. (f) The trustee then sells the equipment to the inves-tor under a conditional sale agreement which permits title to remain with the trustee as security for the notes or certificates issued to the other parties. However, the terms of the conditional sale agree-ment specify that the investor is required to make payments to the trustee only to the extent of rentals to be received from the user under a lease arrangement between the user and the investor. (g) The lease between the investor and the user calls for a lease term approximately the same as the equipment's useful life. The lease rentals, which are calculated to yield sufficient rental revenue to pay only principal and interest on the notes or certifi-cates plus a fair market yield on the 20 per cent invested by the investor, are assigned to the trustee as payments due under the conditional sale agree-ment. The proceeds are used by the trustee to pay the principal and interest on the notes or certificates issued by the trustee with the balance payable to the investor. 14. All the written agreements evidencing the above-listed sequence of events generally are dated the same day and the purchase, sale and lease are integral parts of the whole financing arrangement. Accordingly, any review of the arrangement cannot be based on the terms of any single document. 15. It may be claimed by the investor that under a typical arrangement as described above he is entitled to capital cost allowances on the full cost of the property by virtue of being the sole owner of the equipment once the amounts owing to the other parties have been discharged and the initial term of the lease has ended. However the Department's view is that, for the purpose of paragraph 20(1 )(a), the capital cost of the leased equipment to the investor cannot include any part of the cost in respect of which there is no recourse against him in the event of a default. In the above example the capital cost would not include the 80 per cent of that-cost financed through the other parties. APPENDIX H 1ST DRAFT ELAC SUBMISSION TO THE DEPARTMENT OF NATIONAL REVENUE, TAXATION AND DEPARTMENT OF FINANCE CONCERNING REVENUE CANADA'S INTERPRETATION BULLETIN IT 17 Dear S i r : The Association welcomes this opportunity of responding to the invitation to comment on the content and application of the Department's Interpretation Bulletin IT 17 following our preliminary discussions in May. Our views are set out ' i n ten sections as follows: Section I - A Brief Summary of the Associations's Position Section II - Background Considerations Section I I I - Lease Transactions and Tax' Section IV - The Right Environment for the Canadian Equipment Leasing Industry Section V - Toward a New and Acceptable Bulletin IT 17 Section VI - The Impact of Current Guidelines Section VII - Sale - Leaseback Agreements Section VIII- Effect on Lessor Section IX - Equipment Leasing and Provincial Jurisdiction Section X - Conclusion Section I - A BRIEF SUMMARY OF THE ASSOCIATION'S POSITION In the absence of specific provisions in the Income Tax Act dealing with leasing agreements in modern form, the Association accepts the need for guidelines on tax treatment to be applied to equipment l e a s i n g c o n t r a c t s . But the current guidelines o u t l i n e d i n I n t e r p r e t a t i o n B u l l e t i n IT 17 are .. not the answer. In t h e i r present form these guidelines, o r i g i n a l l y intended to prevent the i n t e r m i t t e n t use by n o n - f i n a n c i a l intermediaries of l e a s i n g agreements or s a l e leaseback agreements •as tax havens, e f f e c t i v e l y bar modern l e s s o r s from t r a n s a c t i n g business i n a manner that has been commercially and f i n a n c i a l l y acceptable w i t h i n recent years. • * In our view, B u l l e t i n IT 17 should be amended to provide c l e a r g u i d e l i n e s on the tax a p p l i c a t i o n and s p e c i f i c a l l y i n three basic s i t u a t i o n s ; • when the Lessee exercises a purchase option and immediately s e l l s the asset f o r an amount higher than i t s purchase p r i c e , where the net proceed should be treated as revenue taxable at a p p l i c a b l e r a t e s , when the lessee exercises the purchase option and r e t a i n s "the asset f o r use i n h i s own operation which should r e s u l t i n an increase i n p r o f i t taxable at a p p l i c a b l e r a t e s , and when the lessee exercises the purchase option and subsequently trades i n the equipment against a new equipment a c q u i s i t i o n r e s u l t i n g i n a lower c a p i t a l cost allowance and a higher taxable .income. - BACKGROUND CONSIDERATIONS (a) The Equipment Lessors A s s o c i a t i o n of Canada The A s s o c i a t i o n represents t h i r t y (30) companies involved i n equipment l e a s i n g i n Canada. I t s members include independant l e a s i n g companies, investment houses, bank oriented firms, sales finance companies involved i n equipment leasing i n Canada / 3 2. 3. Section I I 159. and abroad. Information derived from a recent survey, copy of which i s attached as Appendix A, indicates the remarkable growth i n equipment leasing i n the past decade. These results suggest that total lease receivables i n 1973 could approach one a b i l l i o n dollars. . A description of the aims and objectives of the Association, i t s . b r i e f history and i t s future role i n equipment leasing industry i n Canada are outlined i n a brief fact sheet attached as Appendix B. (b) The Industry The Association considers equipment leasing to be the fastest growing method of financing asset acquisition in the western world. It i s an essential alternative to the financing of. assets to assist Canadian industry to ...develop on a competitive basis both at home and abroad. Because it- provides opportunities to budget more effectively for equipment acquisition and expands the lessee's available credit, leasing w i l l continue to grow at a l i v e l y rate. With the provision of "improved legal security to the lessor, the lessee can usually obtain' expanded lines of credit that w i l l permit him to increase his business operation. In particular, leasing i s a tremendously important factor i n the supply of equipment to small business and new enterprises thus enhancing the creation of new jobs. If the industry i s to provide leasing services on a continuing basis i t must do so in a well defined and favourable environment . Its methods of financing and the application of tax have been subject to innumerable interpretations and rulings .on the basis of general law and the provisions of lease agreements. Imposing changed guidelines, such as are contained i n Bulletin IT 17, retroactively, we consider inequitable. Not only do-they impose undue restrictions, they ignore Lhe working relationships established between the Department of Finance and the industry on the basis of dealings i n good faith that have enabled the industry to fl o u r i s h i n Canada as in other Western nations. 160. . - 4 -(c) I m p l i c a t i o n s i n C i r c u l a r IT 17 The government 1s g e n e r a l p o l i c y and a t t i t u d e toward equipment l e a s i n g as a form o f f i n a n c i a l s e r v i c e should be c l e a r l y d e l i n e a t e d . At p r e s e n t , d e s p i t e the s i g n i f i c a n c e of equipment l e a s i n g as an i n t e g r a l p a r t df the c a p i t a l market i n Canada, the main t h r u s t of B u l l e t i n IT 17 appears t o be based on the assumption t h a t equipment l e a s i n g by Canadian c o r p o r a t e e n t i t i e s should be discouraged. Indeed the te n o r of the B u l l e t i n i m p l i e s t h a t equipment or b u i l d i n g l e a s i n g i s undertaken t o a v o i d tax payments r a t h e r than as a v i a b l e a l t e r n a t i v e t o t r a d i t i o n a l forms of f i n a n c i n g asset a c q u i s i t i o n . S e c t i o n III - LEASE TRANSACTIONS AND TAX Any thorough examination o f the t o t a l e f f e c t of a lea s e t r a n s a c t i o n , i t s impact on the manufacturer or s u p p l i e r of equipment and on the l e s s o r , l e s s e e , and u s e r , c l e a r l y r e v e a l s t h a t the t o t a l income t a x pa i d i s d i r e c t l y comparable t o t h a t i n any other form of f i n a n c i a l t r a n s a c t i o n . Moreover, i n some cases more'than the o r d i n a r y tax w i l l be p a i d . Let us look then a t the t o t a l t a x p i c t u r e i n terms of l e a s e versus purchase. From the v i e w p o i n t of the v a r i o u s p r i n c i p a l s i n the t r a n s a c t i o n : (a) The Lessee . C l e a r l y d u r i n g the prime term of a l e a s e , a les s e e ' s Income Tax may be d e f e r r e d by v i r t u e o f the i n c r e a s e i n expenses as compared to those i n a purchase agreement. That i s , i f a le a s e term i s c o n s i d e r a b l y s h o r t e r than the p e r i o d over which c a p i t a l c o s t allowance may be c l a i m e d , then l e s s tax w i l l be pa i d during t h i s p e r i o d . On the other hand, i f a l e a s e i s renewed a t the c o n c l u s i o n of the primary term, r e n t a l payments t o the les s e e w i l l be l e s s than normal c a p i t a l c o s t allowance thereby i n c r e a s i n g the l e s s e e ' s t a x a b l e income. •••••/5 With respect to the lessor's taxable income, tax rates w i l l be affected by the volume of equipment purchased, the effective CCA rate and other general operating costs. In fact during certain periods lessors have been known to pay tax in excess of the amounts reported on operating statements. (c) The Individual There are instances i n which leased equipment w i l l actually•increase tax paid i n certain areas. For example, on company operated cars income benefits may be charged to employees at 1% of cost or one third of the lease rental. In most cases the latter provision amounts to substantially more than 1% of the cost and thus taxable benefits to employees are increased resulting in increased personal tax paid. (d) The Equipment Manufacturer -Moreover leasing, as opposed to purchasing, w i l l frequently eliminate cash discounts on purchases, reduce trade-in values and increase the frequency of re-ordering. These factors w i l l result in increased taxable income to the manufacturer or supplier and hence the volume of corporate tax paid. (e) The Government With respect to provincial sales tax, the tax due i s calculated on a to t a l rental rather than on capital cost,. Furthermore an increase i n the level of sales tax applies on the balance of payments due under lease contracts i n force whereas i t does not apply on purchases made prior to the date of the increase. Hence, both the application of tax on t o t a l rental and the increase in tax on contracts i n force tend to increase provincial sales tax paid, ultimately reducing the flow of federal cash required to assist provinces through the allocation of income tax dollars. 162. - 6 -Section IV - THE RIGHT ENVIRONMENT FOR THE CANADIAN EQUIPMENT LEASING INDUSTRY  In our view r i g i d enforcement of. the provisions of B u l l e t i n IT 1 7 would tend to create an environment i n which i t would be impossible f o r many equipment l e a s i n g companies to continue i n business i n Canada. Not only would t h i s r e s u l t i n e v i t a b l y i n t r a n s f e r r i n g equipment l e a s i n g to offshore industry i t would a l s o wreak havoc on domestic industry that c u r r e n t l y employs more than 1500 people and supplies equipment to Canadian industry with an estimated value at •the end of 197 3 i n excess of $1 b i l l i o n . C l e a r l y t h i s approach would not be i n the best i n t e r e s t s of the country. (a) Economic Growth Most budgets presented by the M i n i s t r y of Finance of the current government, have been designed to promote an increase i n the supply of equipment and b u i l d i n g s f o r industry with the object of c r e a t i n g a d d i t i o n a l employment and i n t r i n s i c wealth. Quite c l e a r l y , l e a s i n g as a v i a b l e a l t e r n a t i v e to t r a d i t i o n a l f i n a n c i n g as a means of acquiring" such a s s e t s , has contributed s i g n i f i c a n t l y to the achievement of such o b j e c t i v e s . Conversely r e s t r i c t i n g l e a s i n g i n any way would c o n t r a d i c t those o b j e c t i v e s . For example, i n new or small business e n t e r p r i s e s the use of accelerated d e p r e c i a t i o n may be of l i m i t e d value or concern. On the other hand a l e a s i n g company i n a p o s i t i o n to make use of the c a p i t a l cost allowance w i l l pass on a p o r t i o n of those b e n e f i t s to the equipment user i n the form of reduced r e n t a l . (b) Technological Growth Furthermore, l e a s i n g a l s o enables small business enterprises and new ones t o acquire advanced technology and equipment when lack of c a p i t a l or cash would deter them. Thus they produce goods and se r v i c e s that permit them to improve t h e i r competitive edge against f o r e i g n imports. / 7 16 . « 7 -(c) Equipment Modernization On balance equipment l e a s i n g by reducing the term of w r i t e - o f f or d e p r e c i a t i o n i n e f f e c t a c c e l e r a t e s the frequency with which a company w i l l re-equip with updated equipment. . This f a c t o r i s of tremendous s i g n i f i c a n c e i n data processing, health s e r v i c e s , o f f i c e a d m i n i s t r a t i o n and i n the c o n s t r u c t i o n and t r a n s p o r t a t i o n i n d u s t r i e s , e t c . S t a t i s t i c a l evidence of t h i s r o l l - o v e r f a c t o r can ..be provided by member companies. Section V ~ TOWARD A NEW AND ACCEPTABLE BULLETIN IT 17 There are a number of ways i n which B u l l e t i n IT 17 should be amended to permit the development of new and mutually acceptable g u i d e l i n e s „ I t i s extremely important that the method of taxing lease contracts be c l e a r and unequivocal. Furthermore the importance of equipment l e a s i n g r e q u i r e s that these methods be e n t i r e l y equitable to both l e s s o r and l e s s e e . Outlined below are a number of modifications i n • B u l l e t i n IT 17 that we consider d e s i r a b l e : (a) . Nomenclature and D e f i n i t i o n s ' • Terminology and d e f i n i t i o n s i n B u l l e t i n IT 17 should be c o n s i s t e n t and i n keeping with trade p r a c t i c e . For example, there appears to be some confusion between the use of the terms "market value" and "depreciated value". In some cases " f a i r market value appears to r e f e r to the o r i g i n a l cost of equipment, whereas "depreciated value" appears to r e f e r to " f a i r market value" sometime a f t e r the date o f commencement of the lease. With p a r t i c u l a r reference to "depreciated value", there may be s u b s t a n t i a l l y d i f f e r e n t values involved dependent upon whether (a) equipment i s sold on s i g h t , or (b) equipment has to be removed from i t s l o c a t i o n , r e f u r b i s h e d and r e s o l d , or (c) where equipment has to be removed, refurbished and stored, accruing i n t e r e s t costs plus s e l l i n g costs and commissions as w e l l . The r a p i d growth of l e a s i n g i n Canada, as elsewhere, has r e s u l t e d i n . / 8 a p r o l i f e r a t i o n of terms and a v a r i e t y of d e f i n i t i o n s leading to some confusion both within the industry and with respect to i t s r e l a t i o n s with othehr sectors, p a r t i c u l a r l y government. In many cases, these d e f i n i t i o n s must also be consistent with and take cognizance of accepted accounting p r i n c i p l e s used f o r the r e p o r t i n g of f i n a n c i a l transactions and operating statements. As a r e s u l t we f e e l there i s a d i s t i n c t need f o r the A s s o c i a t i o n to work c l o s e l y with Canada Revenue - Taxation, to move^toward a mutually acceptable glossary of terms and d e f i n i t i o n s within the framework of an acceptable business environment that w i l l lend i t s e l f to the continued growth of equipment l e a s i n g i n Canada. As a s t a r t i n g point we have attached a compendium of d e f i n i t i o n s and terminology as Appendix C. (b) C o n f l i c t s with C a p i t a l Cost Allowances The term "depreciated value" i n B u l l e t i n IT 17 appears to be i n d i r e c t c o n f l i c t with the p r i n c i p l e of c a p i t a l cost allowance. When equipment i s sold at any time the s a l e should not create any income tax problems i f sold at the lower of "depreciated value" or "undepreciated c a p i t a l cost". I f the user purchases the equipment and holds i t f o r a number of years, i t may be disposed of without tax i m p l i c a t i o n i f done so at the balance of the undepreciated c a p i t a l cost. However, i f the user were to lease the same equipment and then purchase i f from the l e s s o r at the same undepreciated c a p i t a l cost, B u l l e t i n IT 17 i n d i c a t e s that i f such value were l e s s than "depreciated value" the user could" incur a tax l i a b i l i t y . Thus i n t e r p r e t a t i o n i s p r e j u d i c i a l to equipment l e a s i n g compared with outright ownership. (c) Interest Should be Imputed on O r i g i n a l Cost of Equipment Where i n t e r e s t must be imputed because of an assessment r e s u l t i n g i n a purchase rather than lease, i t should be imputed on the basis of an o r i g i n a l cost of equipment not " f a i r market value" which must be unknown. Furthermore, we submit i n t e r e s t should be c a l c u l a t e d on an ......./9 165. - 9 -a c t u r a r i a l basis not on a s t r a i g h t l i n e b a s i s . (d) The Purchase Option In paragraph 3 of the I n t e r p r e t a t i o n B u l l e t i n IT 17,•' under the heading Lease Option Agreements, two extremes of lease option agreement v a r i a t i o n s are o u t l i n e d , t h e ' i m p l i c a t i o n being that there are a number of a l t e r n a t i v e tax egpape s i t u a t i o n s which might d i s q u a l i f y the t r a n s a c t i o n as a lease. In our view there are only three basic s i t u a t i o n s i n which a c l e a r g u i d e l i n e on the a p p l i c a t i o n of tax should be e s t a b l i s h e d . These are: 1) . when the lessee exercises a purchase option and immediately s e l l s the asset f o r an amount, higher than h i s purchase p r i c e , 2) when the lessee exercises, the purchase option and , does not r e s e l l the asset, r e t a i n i n g i t f o r use i n h i s own operations, and 3) when the lessee exercises the purchase option and subsequently trades i n the equipment against new equipment a c q u i s i t i o n . ( i ) In the f i r s t instance there may be an escape of some p o r t i o n of the tax dependent upon which i s the higher amount, the tax r a t e on c a p i t a l gains, or the lessee's i n d i v i d u a l tax rate on p r o f i t s . The net proceeds on the sale of the asset i n such a case we consider should be t r e a t e d as simple revenue to the lessee, taxable at the a p p l i c a b l e r a t e . ( i i ) . In the second instance, where the lessee r e t a i n s the equipment f o r use, there should be no escape of tax f o r the lower cost of production brought about by the exercise of the option should r e s u l t i n an increase of p r o f i t s which would then be taxable at a p p l i c a b l e r a t e s . ....../10 166. - 10. -( i i i ) In the t h i r d instance the cost of the new equipment i s reduced, thereby lowering the c a p i t a l cost allowance and i n c r e a s i n g taxable income. Section VI - • THE -IMPACT OF CURRENT GUIDELINES  Guideline #1 With respect to paragraph 3, Subsection (1) page 2 of B u l l e t i n IT 17 ~a low renewal r e n t a l w i l l increase the taxable income of a l e s s e e , •the s i t u a t i o n ' i n which a piece of equipment i s written o f f during i t s prime productive period and subjected to a low renewal r e n t a l a f t e r that period i s no d i f f e r e n t , i n theory than c a p i t a l cost allowance. The l a t t e r provides a s u b s t a n t i a l l y greater tax deductible cost during the e a r l y l i f e of the equipment, reducing i n . l e v e l as higher maintenance costs and lower competitive p r o d u c t i v i t y of equipment occur. Furthermore, leases with low renewal rates do not perforce i n d i c a t e renewal i s almost a c e r t a i n t y . On the contrary, i n leases of t h i s kind the quick w r i t e - o f f provides an a d d i t i o n a l i n c e n t i v e to the lessee to acquire new equipment of a more e f f i c i e n t and productive nature. Once again the d i f f i c u l t y i n determining what a " u s e f u l l i f e " , "competitive p r o d u c t i v i t y " or "obsolescent l i f e " i s underscored. S i m i l a r l y d i f f e r e n t i a t i n g between " o r i g i n a l cost" and " f a i r market value" i n t h i s context gives r i s e to more problems of d e f i n i t i o n . Guideline #2 The g u i d e l i n e as stated i n subsection (2) Page 2 of B u l l e t i n IT 17 i n t h i s respect are i n our view i n v a l i d other than i n extreme cases f o r there i s no tax l o s s . I t i s c e r t a i n l y the p r a c t i c e of most l e a s i n g companies to e s t a b l i s h a r e a l i s t i c value at the end of the lease. And of course, . i t i s to t h e i r b e n e f i t to have a r e s i d u a l s a l e with a value as high as p o s s i b l e as i t increases the l e s s o r ' s • • • • • • / l l y i e l d . On the other hand, i t i s extremely d i f f i c u l t to estimate, at the i n c e p t i o n of a lease, a probable f a i r market value at the termination of a lease. Furthermore f o r l e a s i n g to be competitive with ownership the lower of undepreciated c a p i t a l cost or f a i r market value should be a v a i l a b l e without a t t r a c t i n g any income tax .assessment. B a s i c a l l y even a low option to purchase does not a f f e c t the t o t a l tax paid. Indeed i t may w e l l increase o v e r a l l taxable income by i n c r e a s i n g p r o d u c t i v i t y . At the same time a r i d i c u l o u s l y "low option p r i c e such as $1.00 does tend to i n d i c a t e the o r i g i n a l i n t e n t i n the t r a n s a c t i o n was to s e l l not lease. Guideline #3 We submit th a t there i s no l o g i c a l reason why a s p e c i a l i z e d piece of equipment should not be leased as w e l l as purchased and to i n d i c a t e otherwise i s to be t o t a l l y i r r e l e v a n t and discrimatory. The p r i v i l e g e of l e a s i n g should be equally a v a i l a b l e f o r the a c q u i s i t i o n of s p e c i a l equipment. Indeed every asset that i s acquired by a lessee f o r a s p e c i f i c purpose q u a l i f i e s as s p e c i a l i z e d equipment. In a d d i t i o n the r i g h t to lease should be extended to such items as "leasehold" improvements or quasi leasehold improvements. Attached as Appendix D are a number of examples. Guideline #4 • • We submit that the assumption of the costs such as taxes, insurance and maintenance are t o t a l l y i r r e l e v a n t as to the a p p l i c a t i o n of tax or the i n t e n t of the lease versus buy agreement. The assumption of costs such as taxes, insurance and maintenance under competitive market conditions devolves upon which ever party can do what f o r the lowest cost and have l i t t l e or nothing to do with ownership. Guideline #5 Once again the guaranteeing of o b l i g a t i o n s has no relevance as /12 168. - 12 -between the functions of l e a s i n g or purchase but i s wholly a business or commercial consideration. At the same time i t i s d i f f i c u l t to construe what might c o n s t i t u t e a guarantee by a l e s s e e . For example, does an assignment of lease payment to a lender c o n s t i t u t e a guarantee by the lessee of the l e s s o r ' s o b l i g a t i o n . Surely t h i s normal commercial t r a n s a c t i o n should not be c l a s s i f i e d as a guarantee. Guideline #6 . -We submit that p e r i o d i c r e n t a l payments may be d i v i d e d i n t o any number of components by accepted f i n a n c i a l methods. Thus, r e n t a l payments could be paid to include return of c a p i t a l , cost of doing business and p r o f i t . True, t i would be p o s s i b l e to construe the combination of the "cost of doing business " plus " p r o f i t " as " i n t e r e s t " whether or not the balance of the payment i s "return of loan c a p i t a l " or "amortization of the o r i g i n a l cost of equipment". Consequently a l i t e r a l i n t e r p r e t a t i o n would r e s u l t i n the c l a s s i f i c a t i o n of any r e n t a l payment as a payment on a s a l e . Cost of borrowing by l e s s o r s f l u c t u a t e s s u b s t a n t i a l l y , more p a r t i c u l a r l y during the l a s t few months. The f a c t that these costs are passed on to the lessee should not preclude the a v a i l a b i l i t y of the l e a s i n g f u n c t i o n . For example t h i s would include a lease contract indexed i n some manner to the cost of borrowed funds. This requirement would c o n f l i c t with some provinces where sales tax r e g u l a t i o n s r e q u i r e an estimate of s e r v i c e charge versus " c a p i t a l repayment" i n c a l c u l a t i n g p r o v i n c i a l sales tax due. C l e a r l y then the designation of part of a p e r i o d i c r e n t a l payment as i n t e r e s t i s i n no way fundamental to the determination of a lease. Section VII - SALE - LEASEBACK AGREEMENTS We submit that a "sale on Leaseback" i s I n d i s t i n q u i s h a b l e from the /13 169. - 1 3 -purchase of new equipment d e l i v e r e d d i r e c t l y to a l e s s e e . On the other hand, we do agree that a purchase of used equipment, whether i t be leased back to the s e l l e r o f the equipment or leased to another party, should be subject to an independent e v a l u a t i o n i f not purchased at book value. Even i n those cases i n which a loan has been confirmed we cannot agree that the imputed i n t e r e s t should only be deductable when based on the d i s p o s i t i o n of the funds derived from the s a l e , s u r e l y a s a l e on leaseback i s simply a r e v e r s a l of a p r i o r t r a n s a c t i o n and the i n t e r e s t so imputed, i f the t r a n s a c t i o n had been a c o n d i t i o n a l sale from the s t a r t , would have been used f o r the purchase of equipment and thus would be deductable. Section VIII - EFFECT ON LESSOR While we might agree that the same i n t e r p r e t a t i o n of a contract f o r both lessee and l e s s o r i s an i d e a l s i t u a t i o n , we do consider t h i s somewhat U t o p i a n concept to be very d i f f i c u l t to enforce. With more than 200,000 l e a s ^ contracts involved i n Canada, i n many cases with lessee and l e s s o r i n widely separated l o c a t i o n s and with equipment in s t i l l another l o c a t i o n , enforcement of the i d e a l i s obviously impossible. Section IX - EQUIPMENT LEASING AND PROVINCIAL JURISDICTION The A s s o c i a t i o n considers i t important that the p r o v i s i o n s of B u l l e t i n IT 17 should be consistent with r e l a t i v e p r o v i s i o n s within p r o v i n c i a l government j u r i s d i c t i o n s and we would be pleased to review those p r o v i s i o n s should i t be d e s i r a b l e . Section X - CONCLUSION -Since many of these views expressed i n t h i s submission may be of i n t e r e s t to your colleagues i n the Department of Finance, we have taken the l i b e r t y of d i r e c t i n g a copy t o Mr. and others i n t h a t / I 1 * 170. - 14 Department. Should you f e e l that f u r t h e r c l a r i f i c a t i o n of these views may be developed through personal meetings, the A s s o c i a t i o n would'be pleased to have a small but representative delegation meet with you and your p r i n c i p a l s at your convenience. R e s p e c t f u l l y submitted 

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