From time-to-time, transactions or scenarios occur that require consideration of whether an operating lease or a finance lease is the best way forward for parties involved. Whilst the structures are similar, from a legal perspective, there continue to be key differences in how operating and finance leases are structured and function.
Historically, the two received different accounting treatment, with operating leases being effectively off-balance sheet. This, however, changed with the introduction of IFRS 16 in 2019, with that distinction in accounting treatment ceasing to apply.
An operating lease is traditionally described as an aircraft hire contract between the lessor (as owner) and a lessee (i.e. an airline) for the agreed term, which is normally no longer than 12 years. The lessor leases the aircraft to the lessee; the lessee pays (amongst other things) rent and at the end of the term, the aircraft is returned to the lessor.
Under this structure, the ownership (and residual value) risk will remain with the lessor with operating leases, also including more stringent maintenance and insurance requirements than finance leases in order to protect the aircraft’s value. Protecting the value is crucial to the lessor, as once the initial lease ends, the lessor will look to lease the aircraft out again in order to further monetise the asset. A lessor will usually enter into several operating leases over the life of an aircraft in order to recoup its initial expenditure and more. Operating leases will therefore, include much more detailed maintenance, insurance and return conditions and, in addition to rent, the lessee will be required to cover exposure in respect of maintenance costs (whether through regular maintenance reserve payments or an end of lease compensation payment).
Rental amounts will, of course, be a commercial negotiation and take into account many different factors. The lessor will look at items such as current market conditions, credit of the airline, availability of similar aircraft, lease rate factors and (if used in a tax leasing structure) the potential tax benefits available to a lessor via the use of an operating lease. Whilst it will be specific to the jurisdiction of the owner/lessor, the tax treatment of an operating lease is a fundamental difference between it and a finance lease, operating leases are “true leases” because no ownership rights in the aircraft pass meaning that the lessor can utilise certain tax deductions in respect of the aircraft/rent received. As such, operating leases are an integral element of certain tax lease structures such as JOLCOs.
Lessees like operating leases as they allow them to expand a fleet without the requirement for large capital expenditures. It also means that they can modernise their fleet through bringing in newer aircraft and disposing of older models all whilst protecting their liquidity position. For Lessors, operating leases are good long-term investments with potentially lucrative revenue streams. There is also a sizeable secondary market for lessors to trade aircraft amongst themselves, nearly always with the lease “transferred” via a novation or assignment and assumption depending on jurisdiction.
A finance lease ultimately confers the economic benefit of the asset on the lessee and is a common financing tool. Whilst there could be multiple users of an aircraft during its economic lifetime where operating leases are used, the lessee is intended to be the sole economic beneficiary of the asset in a finance lease. Such structures are commonly used in financings, for example export credit agency structures where an orphan SPV will lease the aircraft by way of a finance lease to the relevant lessee. The financing nature of the structure does mean there are added regulatory consideration here though and local law “financial leasing” regulations should always be considered.
The structure is ostensibly similar insofar as the lessor will lease the aircraft to the lessee for an agreed term and the lessee will pay rent over that period. However, that rent will effectively amortise the capital cost of acquiring that aircraft. In addition, the lessee will be entitled to take title to the aircraft, either through an early termination option (and paying the outstanding capital cost then due) or at the end of the term through a nominal purchase option (once the capital cost has fully amortised). On payment of the early termination amount or purchase option, legal title will pass to the lessee.
As an economic owner, the lessee is the one who takes the ownership risks/reward. Given the expectation that the aircraft will not be returned to the lessor, the lessee is not generally required to pay anything towards maintenance events (as would be the case with an operating lease where the aircraft will ultimately be returned to the lessor).
Most leasing transactions will be formulated with a clear idea of whether an operating lease or financing lease is required, however for those bespoke transactions, it is always good to remind ourselves of the characteristics and structures of both.