When a business needs equipment, vehicles, or property, leasing is often a smarter move than buying outright. But not all leases work the same way. The two main types, operating leases and finance leases, differ in terms of ownership, duration, and how they affect your financials.
An operating lease works like a rental agreement. You use the asset for a set period, make regular payments, and return it at the end of the term. A finance lease (formerly called a capital lease) is closer to a financed purchase. You take on most of the risks and benefits of ownership, and often have the option to buy the asset when the lease ends.
Choosing the right lease structure can impact your cash flow, balance sheet, and tax obligations. This guide breaks down the key differences to help you make the best decision for your business.
What Is an Operating Lease?
An operating lease is a contract that allows a business to use an asset without taking ownership of it. The lessor (the company that owns the asset) rents it to the lessee (the business using it) for a fixed period, typically shorter than the asset's useful life.
At the end of the lease term, the asset is returned to the lessor. There's no transfer of ownership, no bargain purchase option, and the lessee doesn't assume the risks that come with owning the asset.
Common characteristics of an operating lease:
- Ownership stays with the lessor throughout the lease and after it ends
- Lease term is usually less than 75% of the asset's economic life
- No option to purchase the asset at below-market value
- The lessor is often responsible for maintenance and insurance
- Payments are typically recorded as operating expenses
Examples of assets commonly leased through operating leases:
- Office space and commercial real estate
- Vehicles and fleet cars
- IT equipment (laptops, servers, printers)
- Machinery that needs frequent upgrading
Operating leases are popular with businesses that want flexibility, prefer to avoid long-term commitments, or need equipment that becomes outdated quickly.
What Is a Finance Lease?
A finance lease is a contract where the lessee assumes most of the risks and rewards of owning an asset, even though the lessor technically holds the title. This type of lease is structured more like a loan than a rental agreement.
Finance leases were previously called capital leases under older accounting standards. The terminology changed, but the concept remains the same: the lessee uses the asset for most or all of its useful life and often has the option to purchase it at the end of the term.
Common characteristics of a finance lease:
- Ownership transfers to the lessee at the end of the lease, or there's a bargain purchase option
- Lease term covers 75% or more of the asset's economic life
- The present value of lease payments equals or exceeds 90% of the asset's fair market value
- The lessee is responsible for maintenance, insurance, and repairs
- The asset and corresponding liability appear on the lessee's balance sheet
Examples of assets commonly leased through finance leases:
- Heavy machinery and manufacturing equipment
- Commercial vehicles and trucks
- Specialized industry equipment
Finance leases make sense for businesses that plan to use an asset long-term and want the benefits of ownership without paying the full cost upfront.
Operating Lease vs Finance Lease: Key Differences
How Each Lease Type Affects Your Business Finances
What this means for your business:
An operating lease keeps your balance sheet lighter, which can help maintain borrowing capacity and healthier financial ratios.
A finance lease adds both assets and liabilities to your books. This increases your debt-to-equity ratio but better reflects long-term asset value.
Cash flow also differs: operating lease payments stay consistent, while finance lease payments are higher early on due to interest front-loading.
Tax Implications in Canada
1. Operating Lease
Lease payments are fully deductible as a business expense in the year they're made. This is straightforward: you pay, you deduct.
2. Finance Lease
Since the asset is treated as if you own it, you can deduct the interest portion of your payments and claim Capital Cost Allowance (CCA) on the asset's depreciated value over time.
3. Which is better for taxes?
It depends on your situation. Operating leases offer immediate, predictable deductions. Finance leases may provide larger deductions in the early years through CCA, but the benefit is spread out and depends on the asset class.
Advantages and Disadvantages
1. Operating Lease
2. Finance Lease
When to Choose an Operating Lease vs a Finance Lease
Ask yourself these questions:
- How long will I need this equipment?
Less than 5 years → operating.
Long-term → finance.
- Do I want to own it at the end?
Yes → finance.
No → operating.
- Does this equipment become outdated quickly?
Yes → operating.
No → finance.
- Is keeping debt off my balance sheet important? Yes → operating.
- Is this asset essential to my daily operations? Yes → finance.
FAQ
1. Which lease type is better for small businesses?
It depends on your cash flow and goals. Operating leases are often a good fit for small businesses because they require lower upfront costs and keep debt off the balance sheet. But if you need equipment long-term and want to build equity, a finance lease may be more cost-effective over time.
2. Can you switch from an operating lease to a finance lease?
Not usually mid-contract. Lease terms are set at the start and changing the structure requires renegotiating with the lessor. However, when your lease ends, you can choose a different type for your next agreement.
