Why Firms Lease Short-Lived Assets: A Tax-Based Explanation 2019-02-13آ why firms lease...
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canadian tax journal / revue fiscale canadienne (2008) vol. 56, no 3, 639 - 60
Why Firms Lease Short-Lived Assets: A Tax-Based Explanation
Ling Chu, Robert Mathieu, and Ping Zhang*
P r é c i s
Les auteurs étudient l’impact de la vie utile des biens utilisés par les entreprises au Canada sur leurs décisions de les louer ou non. Leur analyse théorique fait voir que les entreprises sont d’autant plus enclines à louer des biens qui ont une vie utile brève. En particulier, ils montrent que dans un marché de capitaux concurrentiel, il existe une relation directe entre la baisse des paiements de location et la hausse des taux d’impôt du locateur. En conséquence, la vie utile d’un bien est un facteur pertinent dans la décision de le louer ou non, puisque les taux d’impôt du locateur sont moins susceptibles d’être élevés à long terme, ce qui donne lieu à des frais de location plus élevés et à une réduction des activités de location. À l’aide d’un échantillon de sociétés canadiennes cotées en bourse, les auteurs présentent également une preuve empirique que la vie d’un bien est négativement liée à la quantité de biens qui sont loués par une entreprise.
A b s t r A c t
The authors examine the impact of assets’ useful lives on firms’ leasing decisions in Canada. Their theoretical analysis demonstrates that firms are more likely to lease assets with shorter useful lives. More specifically, they show that in a competitive financing market, lease payments are a decreasing function of lessors’ tax rates. Therefore, the useful life of an asset is relevant in leasing decisions because lessors’ tax rates are less likely to remain at the highest level over a longer horizon, leading to higher leasing costs and less leasing activity. Using a sample of publicly traded Canadian companies, the authors also provide empirical evidence that the useful life of an asset is negatively associated with the proportion of assets leased by a firm.
Keywords: Leases n capitaL cost aLLowance n cca n capitaL investments
* Ling Chu and Robert Mathieu are of the School of Business & Economics at Wilfrid Laurier University, Waterloo, Ontario; Ping Zhang is of the Rotman School of Management at the University of Toronto. The authors would like to thank Theresa Libby, Alan Macnaughton, three anonymous referees, and participants at the European Accounting Association 2008 annual conference for their helpful comments. Financial support for this project was provided by the CA/Laurier Centre for the Advancement of Accounting Research and Education and by the Social Sciences and Humanities Research Council of Canada.
640 n canadian tax journal / revue fiscale canadienne (2008) vol. 56, no 3
intro duc tio n
For most firms, lease liabilities account for a significant portion of total liabilities. The Equipment Leasing Association states in a recent survey that 8 out of 10 companies lease some or all of their equipment. In fact, the lease liability has been determined to represent more than 40 percent of all fixed claims for the average firm where fixed claims are defined as the sum of the book value of all long-term debt, the book value of all capital leases, and the present value of all future operating lease obliga- tions.1 Therefore, it is important to understand in what situations leasing is a cheaper form of financing than direct borrowing. In this article, we investigate the relation- ship between tax-related leasing costs and assets’ useful lives both theoretically and empirically.
Previous theoretical and empirical studies considering the effect of taxes on leasing decisions include Miller and Upton;2 Myers, Dill, and Bautista;3 Ang and Peterson;4
c o n t e n t s
Introduction 640 Tax Treatment of Leases in Canada 642
Specified Leasing Property Rules 644 The Theoretical Analysis 645
The Setting 645 The Empirical Analysis 648
The Methodology 648 The Results 652
Conclusion 656 Appendix 657
Basic Assumptions 657 Interest on a Loan 657 The Tax Shield (CCA) from an Owned Asset 659 Present Value of the Lease After Tax for the Lessor 659 The Costs of Financing a Purchase Versus Leasing the Asset for the User 660
1 See Weili Ge, “Off-Balance-Sheet Activities, Earnings Persistence and Stock Prices: Evidence from Operating Leases,” American Accounting Association, 2006 Financial Accounting and Reporting Section Meeting Paper (online: http://www.ssrn.com/abstract=816044).
2 Merton H. Miller and Charles W. Upton, “Leasing, Buying, and the Cost of Capital Services” (1976) vol. 31, no. 3 The Journal of Finance 761-86.
3 Stewart C. Myers, David A. Dill, and Alberto J. Bautista, “Valuation of Financial Lease Contracts” (1976) vol. 31, no. 3 The Journal of Finance 799-819.
4 James Ang and Pamela P. Peterson, “The Leasing Puzzle” (1984) vol. 39, no. 4 The Journal of Finance 1055-65.
why firms lease short-lived assets: a tax-based explanation n 641
Krishnan and Moyer;5 Shanker;6 and Graham, Lemmon, and Schallheim.7 However, these studies do not consider the impact of assets’ useful lives on firms’ leasing deci- sions. The main objective of this article is to examine the impact of assets’ useful lives on the leasing decisions under the current Canadian income tax law. In our analysis, we relate tax rate uncertainty in future periods to the costs and benefits of leasing. We then empirically test our predictions using a sample of firms traded on the Toronto Stock Exchange (TSx) in the 2005 fiscal year. This analysis is particularly useful for tax practitioners who assist their clients with the decisions on whether to lease or buy assets.
Empirical studies have tested earlier models that predicted a greater use of leases by firms with low tax rates. Evidence on this topic is mixed. While some studies fail to support the existence of a negative relationship between the tax rate and the use of leases,8 more recent work documents evidence consistent with earlier models. For example, Sharpe and Nguyen9 use the presence of operating loss carryforwards to proxy for firms’ marginal tax rates. Their results indicate that firms with loss carry- forwards (that is, low tax rate) have more leases. Graham, Lemmon, and Schallheim10 avoid endogeneity problems in measuring tax by using tax rates before considering the financing effects. Using this measure, they provide evidence of a negative asso- ciation between the use of leases and tax rates. Using Canadian data, Shanker11 also examines the association between tax rates and the use of leases. She finds that firms with higher marginal tax rates are less likely to use leases.
Our study contributes to the literature in several ways. First, we develop a multi- period model that allows for uncertainty in the lessors’ future tax rates. Thus, we are able to predict that leasing decisions are negatively affected by assets’ useful lives. We then empirically test our prediction. To our knowledge, this is the first article to study the relationship between assets’ useful lives and the lease decisions. The empirical analysis provides evidence that the useful lives of assets are negatively associated with the proportion of leases held by firms in our sample. These results suggest that assets with longer useful lives are less likely to be leased. The coefficient on the discount rate is insignificantly consistent with our expectation that the impact
5 V. Sivarama Krishnan and R. Charles Moyer, “Bankruptcy Costs and the Financial Leasing Decision” (1994) vol. 23, no. 2 Financial Management 31-42.
6 L. Shanker, “Tax Effects and the Leasing Decisions of Canadian Corporations” (1997) vol. 14, no. 2 Canadian Journal of Administrative Sciences 195-205.
7 John R. Graham, Michael L. Lemmon, and Jim S. Schallheim, “Debt, Leases, Taxes and the Endogeneity of Corporate Tax Status” (1998) vol. 53, no. 1 The Journal of Finance 131-62.
8 See, for example, Ang and Peterson, supra note 4, and Krishnan and Moyer, supra note 5.
9 Steven A. Sharpe and Hien H. Nguyen, “Capital Market Imperfections and the Incentive To Lease” (1995) vol. 39, no. 2-3 Journal of Financial Economics 271-94.
10 Supra note 7.
11 Supra note 6.
642 n canadian tax journal / revue fiscale canadienne (2008) vol. 56, no 3
of this variable in the decision is marginal. Also consistent with our expectation, the tax variables are insignificant. Finally, other variables such as leverage ratio, working capital, proportion of capital assets, and size of the firm affect the decision to lease assets.
The article proceeds as follows. We discuss the tax treatments of leases in the next section and then we introduce our model. We present the empirical tests of our theoretical prediction and finally we make concluding remarks.
tA x tre Atment o f Le A se s in c A n A dA
A lease is a contract allowing a firm (the lessee) to use an asset that is the property of another party (the lessor) in exchange for lease payments. At the end of the lease term, the asset can be returned to the lessor, and the lessee may or may not guaran- tee the residual value. Alternatively, the ownership of the asset can be transferred to the lessee at the end of the lease term through a bargain purchase option or without conditions. Although the lessor retains the legal ownership of the asset throughout the lease term, the lease conditions could be such that the lessee enjoys most of the benefits associated with the owner