To qualify as a finance lease, the lessee needs to consider the substance of the transaction rather than the legal form of the contract. Examples of situations that individually or in combination would result in the lease being treated as a finance lease are:
• ownership is transferred to the lessee at the end of lease term;
• there is a 'bargain purchase option';
• the lease term is for the majority of the leased asset's economic life;
• the present value of minimum lease payments equals substantially all the fair value of the leased asset; and
• the leased asset is of a specialised nature such that only the lessee could use it without major modifications.
Examples of situations that individually or in combination could result in the lease being treated as a finance lease are:
• if the lease is cancelled, the lessor's losses are borne by the lessee;
• gains and losses from the fluctuation in the fair value of the residual are borne by the lessee; and
• the lessee has the ability to continue the lease for a secondary period at below market rental.
IAS 17 uses the concept of risks and rewards associated with ownership. In many PFI contracts, the infrastructure is either constructed by (or for) the operator or passed to the operator by the grantor. Ownership of the property might therefore be considered to vest with the operator. However, in practice:
• ownership of the infrastructure asset might revert free of charge to the grantor at the end of the concession arrangement - usually the case with transport, prisons, hospitals, schools and head office accommodation;
• if ownership of the infrastructure asset does not revert to the grantor for nil consideration, reversion might be achieved at a 'bargain' price;
• the present value of the service payments is likely to equal substantially all the fair value of the asset, since the payments are set to recover not only the cost of the infrastructure but also a profit margin (although the effect of the service element would need to be considered);
• it is likely that the asset is of a specialised nature such that only the grantor could use it without modifications - that is, use it in its existing use. This is not necessarily true for all types of PFI contract, particularly where there are emerging markets in relation to hospitals, for example; and
• there may be some PFI contracts where the indicative factors of the grantor bearing the operator's losses on cancellation, bearing any fluctuations in fair value, and the ability to continue the arrangement at a below market price also exist.