Financing Leasing vs Operating Leasing

Zhu and Company Y signed a financing leasing contract, in which both parties agreed that Zhu would purchase a set of equipment and lease to Company Y, after the lease expired, if Company Y could pay off the financing principal and the lease fee, then the set of equipment should belong to Company Y, otherwise, the lease period shall be extended. Later then, Company Y defaulted on the lease, Zhu brought a lawsuit against Company Y. Company Y defended with the excuse that Zhu had not obtained the financial business license, so the contract should be deemed as invalid. The court of first instance decided the contract was valid. The court of second instance decided the contract was invalid, and the case should be decided as a lending dispute. The retrial court pointed out that the contract was invalid, and it was not proper to take is as a lending dispute, instead, it should be judged in accordance with the relevant judicial interpretation of the Supreme People’s Court, which prescribed as “if the invalidity of the contract is caused due to the faults of both parties, the leased property may be returned to its owner, and each party shall bear the responsibilities for compensating for the damages corresponding to its own faults.””

In view of this, the precondition for a financing leasing contract is that the lessor shall be a leasing company which has obtained the approval of the finance administration authority, and be engaged in financing leasing business, otherwise, the contract might be deemed as invalid. However, there is no such precondition for an operating leasing contract.

In practice, a more common phenomenon is that different parties might have different interpretations on the nature of a leasing contract,which leads to the disputes on the implementation of this contract and the relevant financial issues.

Generally speaking, the typical differences between a financing leasing and an operating leasing are as follows:

Firstly, the parties are different. A financing leasing contract shall involve 3 parties, which are the lessee, the seller and the lessor, and the lessor shall have a financial business license. An operating leasing contract only involves 2 parties, the lessee and the lessor.

Secondly, the owner of the leased property is different. Under a financing leasing contract, the lessee could choose a property of a third party (ie, the seller), the lessor will perform the financing function, and the third party shall deliver the property to the lessee directly. Under an operating leasing contract, normally the leased property belongs to the lessor.

Thirdly, the defect liability is different. Under a financing leasing contract, the seller shall undertake the defect liability instead of the lessor. Under an operating leasing contract, the lessor shall undertake the defect liability.

Fourthly, the maintenance obligation is different. Under a financing leasing contract, the lessee shall undertake the maintenance obligation.Under an operating leasing contract, normally the lessor shall undertake the maintenance obligation,unless otherwise agreed by the parties.

Fifthly, the ownership of the leased property after the expiration of the leasing period is different. Under a financing leasing contract, normally, the leased property shall be owned by the lessee. Under an operating leasing contract, the leased property shall be owned by the lessor.

However, due to the different needs of the involved parties, in practice, many leasing contracts failed to prescribe their nature, and the relevant articles might have the characteristics of a financing leasing contract and an operating leasing contract. The courts might judge the situation in a comprehensive manner. In order to avoid such uncertainty on the nature of a leasing contract, we recommend companies shall stipulate the nature of a leasing contract clearly in the relevant contracts.

In addition, from the perspective of the finance management, the rent could be treated as depreciation as a fixed asset under a financing leasing contract, but it shall be treated as an expense under an operating leasing contract. If there is any disputes on the nature a leasing contract, then the finance management on the rent might not be recognized by the tax authorities.