33548465 Lease Financing

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INTRODUCTION

Financial Services basically mean all those kinds of services provided in financial

terms where the essential commodity is money. These services include: leasing,

hire purchase, consumer credit, investment banking, commercial banking, venture

capital, insurance, credit rating, bill discounting, and mutual funds , stock

broking, housing finance, vehicle finance, mortgages and car loans, factoring

among other things.

Various entities that provide these services are basically categoried into

!a" #on $%anking Finance &ompanies

!b" &ommercial %anks, and

!c" 'erchant %anks.

Financial Services in (ndia is too vast and varied too have evolved at one place

and at one time. )ne of the main entities that offer financial services in (ndia is

#on*%anking Finance &ompanies. These #%F&s registered with +eserve %ank of

(ndia mainly perform fund based services to the customer. Fund based services of #%F&s include: leasing, hire*purchase and other asset based services whereas fee

based services of #%F&s include bill discounting, portfolio management and

other advisory services.

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LEASING

Leasing as financial service is a contractual agreement where the owner !lessor"

of euipment transfers the right to use the euipment to the user !lessee" for an

agreed period of time in return for a rental. -t the end of the lease period the asset

reverts back to the lessor unless there is a provision for the renewal of the contract

or there is a provision for the transfers of ownership to the lessee. (f there is any

such provision for transfer of ownership, the deal is treated as hire purchase.

Therefore, a lease could be generally defined as -

“A contract where a party being the owner (e!!or" o# an a!!et (ea!e$ a!!et"

pro%i$e! the a!!et #or &!e by the e!!ee at a con!i$eration (renta!"' either

#ie$ or $epen$ent on any %ariabe!' #or a certain perio$ (ea!e perio$"'

either #ie$ or #eibe' with an &n$er!tan$ing that at the en$ o# !&ch perio$'

the a!!et' !&b)ect to the e*be$$e$ option! o# the ea!e' wi be either ret&rne$

to the e!!or or $i!po!e$ o## a! per the e!!or+! in!tr&ction!,

Leasing was prevalent during the ancient Sumerian and reek civiliations where

leasing of land, agricultural implements, animals mines and ships took place. The practice of leasing came into being sometime in the later half of the /0th century

where the rail road manufacturers in the 1.S.- resorted to leasing of rail cars and

locomotives.

The euipment leasing industry came into being in /023 when the first leasing

company, appropriately named as First Leasing This industry however remained

relegated to the background until the early eighties, because the need for these

industry was not strongly felt in industry. The public sector financial institutions $

(4%(, (F&(, (&(&( and the State Financial &orporations !S&Fs" provided bulk of

the term loans and the commercial banks provided working capital finance

reuired by the manufacturing sector on relatively soft terms. iven the easy

availability of funds at reasonable cost, there was obvious no need to look for

alternative means of financing.

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The credit sueee announced by the +.%.( coupled with the strict implantation of

the Tandon 5 &hore committees6 norms on 'a7imum 8ermissible %ank Finance

!'8%F" for working capital forced the manufacturing companies to divert a

portion of their long $ term funds for their working capital.

.ISTOR/ AND DE0ELO12ENT O3 LEASING

The history of leasing dates back to 9%& when Sumerians leased goods.

+omans had developed a full body law relating to lease for movable and

immovable property. ;owever the modern concept of leasing appeared for the

first time in /


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There was thus virtual e7plosion in the number of leasing companies rising to

about ? companies in /00.

(n the subseuent years, the adverse trends in capital market and other

factors led to a situation where apart from the institutional lessors, there were

hardly 9 to 9A private leasing companies who were active in the field. The total

volume of leasing business companies was +s.A crores in /003 and it is

e7pected to cross +s./, crores by 'arch /00A.

ELE2ENTS IN LEASE STRUCTURE

This is an e7planation of the elements in a lease * the parties, asset, rentals,

residual value, etc. This section would also elaborate the uniue features of a lease

as different from a regular financing transaction.

4 The tran!action5

The transaction of lease of lease is generically an asset*renting transaction. Bhat

distinguishes a lease from a loan is that in the latter, what is lent out is moneyC in a

lease, what is lent out is the asset.

6 1artie! to a ea!e5

There are two parties to a lease: the owner and the user, called the lessor and the

lessee. The lessor is the person who owns the asset and gives it on lease. The

lessee takes the asset on lease and uses it for the period of the lease.

-ny one can be a lessor, and any one can be a lessee, sub=ect to usual conditions

as to competence to contract, or holding of properties.

Technically, in order to be a lessor, one does not have

to own the asset: one has to have the right to use the

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)wnership is no pre*condition forleasing:


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asset. Thus, a lessee can be a lessor for a sub*lessee, unless the parent lessor has

restricted the right to sub*lease.

7 The ea!e$ a!!et5

The sub=ect of a lease is the asset, article or property to be leased. The asset may

be anything * an automobile, or aircraft, or machine, or consumer durable, or land,

or building, or a factory. )nly tangible assets can be leased * one cannot

contemplate the leasing of the intangible assets, since one of the essential

elements of a lease is handing over of possession, along with the right to use.

;ence, intangible assets are assigned, whereas tangible assets may be leased.

The concept of leasing will have the following limitations:

/. Bhat cannot be owned cannot be leased. Thus, human resources cannot be

DleasedD.

9. Bhile lease of movable properties can be

affected by mere delivery, immovable property

is incapable of deliveries in physical sense. 'ost

countries have specific laws relating to transactions in immovable properties:

if such law provides a particular procedure for a lease of immovable or real

estate, such procedure should be complied with. For e7ample, in -nglo*Sa7on

legal systems !1E, -ustralia, (ndia, 8akistan, etc.", transactions in real estate

are not valid unless they are effected by registered conveyance. This would

apply to lease of land and buildings, and permanent attachments to land.

3. - lease is structurally a rental for the lease period: with the understanding that

the asset will be returned to the lessor after the period. Thus, the asset must be

capable of re*delivery: it must be durable !at least during the lease period",

identifiable and severable.

5

asing of immovableoperties may havemplications:


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The e7istence of the leased asset is an essential

element of a lease transaction * the asset must e7ist at

the beginning of the lease, during the lease and at the

end of the lease term. #on*e7istence of the asset, for

whatever reason, will be fatal to the lease.

8 Lea!e perio$5

The term of lease, or lease period, is the period for which the agreement of lease

shall be in operation. -s an essential element in a lease is redelivery of the asset

by the lessee at the end of the lease period, it is necessary to have a certain period

of lease. 4uring this certain period, the lessee may be given a right of

cancellation, and beyond this period, the lessee may be given a right of renewal,

but essentially, a lease should not amount to a sale: that is, the asset being given

permanently to the lessee.

(n financial leases, is common to differentiate between the primary lease period

and the secondary lease period. The former would be the period over which the

lessor intends recovering his investmentC the latter intended to allow the lessee to

e7haust a substantial part of the remaining asset value.

The primary period is normally non*cancelable, and the secondary period is

normally cancelable.

9 Lea!e renta!5

The lease rentals represent the consideration for the lease transaction. This is what

the Lessee pays to the Lessor.

(f it is a financial lease transaction, the rentals will simply be the recovery of the

lessors principal, and a certain rate of return on outstanding principal. (n other

words, the rentals can be seen as bundled principal repayment and interest.

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Leased asset is anecessary pre*condition:


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(f it is an operating lease transaction, the rentals might include several elements

depending upon the costs and risks borne by the Lessor, such as:

• (nterest on the lessors investment.

• (f the lessor is bearing any repairs, insurance, maintenance or operation

costs, them charges for such cost.

• 4epreciation in the asset.

• Servicing charges or packaging charges for providing a package of the

above service.

: Re!i$&a %a&e5

8ut simply, Dresidual valueD means the value of the leased euipment at the end of

the lease term.

(f the lease contains a buy out option with the lessee, residual value would mostly

mean the value at which a lessee will be allowed to buy the euipment.

(f there is no embedded purchase option, residual value might mean the value that

the lessee or some one else assures will be the minimum value of the euipment at

the end of the lease term. This is typical in case of financial leases where the

lessor cannot grant a buyout option to the lesseeC for the lessor to protect himself

against asset*based risks, he would take an assured residual value commitment

either from the lessee himself or from a third party, typically an insurance

company.

The residual value might also the value that the lessor assures to pay*back to the

lessee in case the lessee returns the asset to the lessor: that is, it might be the value

the lessor assures as the minimum value of the euipment. Such a lease, obviously

an operating lease because the lessor is taking a risk on asset values, is a full

payout lease, but the lessor agrees to refund the guaranteed value on the lessee

returning the euipment at the end of the lease term.

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; En$-o#-ter* option!5

The options allowed to the lessee at the end of the primary lease period are called

end*of*term options. >ssentially, one, or more, of the following options will be

given to the lessee at the end of the lease term:

• )ption to buy !buyout option" at a bargain price or nominal value !typical

in a hire*purchase transaction", called bargain b&yo&t option

• )ption to buy at a fair market value or fi7ed, but substantial value

• )ption to renew the lease at nominal rentals, called bargain renewa

option

• )ption to renew the lease at fair market rentals or substantial rentals

• )ption to return the euipment

(n any lease, which option will be suitable depends on the nature of the lease

transaction, as also the applicable regulations. For e7ample, in a full payout

financial lease, the lessor would have recovered the whole or substantially the

whole of his investment during the primary lease period. Therefore, it is uite

natural that the lessee should be allowed to e7haust the whole of the remaining

value of the euipment. +egulation permitting, the lessor provide the lessee a

bargain purchase option to allow the lessee to complete the purchase of the

euipment.

;owever, in many =urisdictions, it is the e7istence of

such buyout option that demarcates between lease and

hire*purchase transaction. (f the lessor is interested to

structure the lease as a lease and not hire*purchase, he

would be advised not to provide any buyout option, but instead, to allow the

lessee to renew the lease to continue the use of the asset. (n essence, a renewal

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%uyout option maycharacterie the lease

as hire*purchase:


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option achieves the same purpose as a purchase, but the lessor retains his

ownership as also his reversionary interest in the euipment.

Fair market value options, either for purchase of euipment, or for renewal, are

typical of operating leases, but are really speaking no more than assuring to the

lessee a continued use of the euipment. (f euipment has to be bought at its

prevailing market value, it can be bought from the market rather than from the

lessor * therefore, the fair market value option carries no value for the lessee.


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advance against the last few rentals. Therefore, the advance rental will remain as a

deposit with the lessor to be ad=usted against the last few rentals.

The security deposit is a proper deposit to secure against the lessees

commitments under the contract * it is generally intended to be refunded at the

end of the lease contract.

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T/1ES O3 LEASING

3INANCE LEASE

- lease is defined as finance lease if it transfers a substantial part of the risks and

rewards associated with ownership from the lessor to the lessee. -ccording to the

(nternational -ccounting Standards &ommittee !(-S&", there is a transfer of a

substantial part of the ownership*related risks and rewards if:

i. The lease transfers ownership of the asset to the lessee by the end of the lease

termC !or"

ii . The lessee has the option to purchase the asset at a price which is e7pected to

be sufficiently lower than the fair market value at the date the option

becomes e7ercisable and, at the inception of the lease, it is reasonably certain that

the option will be e7ercisedC !or"

iii. The lease term is for a ma=or part of the useful life of the asset. The title

may or may not eventually be transferredC !or"

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iv. The present value of the minimum lease payments !See lossary" is greater

than or substantially eual to the fair market value of the asset at the

inception of the lease. The title may or may not eventually be transferred.

The aforesaid criteria are largely based on the criteria evolved by the Financial

-ccounting Standards %oard !F-SS" of 1S-. The F-SS has in fact defined

certain cut*off points for criteria !iii" and !iv". -ccording to the F-SS definition

of a finance lease, if the lease term e7ceeds 2A percent of the useful life of the

asset or if the present value of the minimum lease payments e7ceeds 0 percent

of the fair market value of the asset at the inception of the lease, the lease will

be classified as a finance lease

3inancia ea!e! are =oan oo>-ai>e=5

;owever, financial leases, though being leases by structure, are financings by

contrivance. To achieve the financing purpose, the leasing structure here tries to

eliminate the substantive differences between leasing and plain financings

-s you might notice, in the above e7ample, the lessee has been put virtually in the

position of an asset owner * he has the right to use the asset for A years, with a

power to e7tend the lease period for another A years.

The first A years are called the pri*ary ea!e perio$ and

the e7tended period is called the !econ$ary ea!e perio$.

The lease is non-canceabe during the primary lease

period * that is, the lessee cannot return the asset and not

pay balance of the lessors rentals. For the secondary period, the lessee will have

no incentive of returning the asset, as what the lessee has to pay is nominal,

whereas the asset might still carry substantial value. Thus, the asset will be

en=oyed by the lessee virtually for the whole of its economic life.

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The primaryand secondarylease eriod :


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The lessor too has no significant riskGreward other than that

of a virtual money*lender: he would continue getting the

lease rentals for the primary period which will #&y-payo&t the lessors

investment in the lease as also give him his desired return on investment,

irrespective of the state, value or utility of the asset. (f the lessee performs as per

agreement, the lessor would get no more, and no less, than such pre*fi7ed return

on investment.

(ncidentally, in the present e7ample, the lessor gets a return

of /9.0! or a!!et-ba!e$ rewar$!. ;e only takes

#inancia ri!>! and #inancia rewar$!, and that is why the name financial leases.

The lease is non-canceabe, meaning the lessee cannot return the asset and not

pay the whole of the lessors investment.

(n this sense, they are #&-payo&t, meaning the full repayment of the lessors

investment is assured.

-s the lessor generally would not take any position other than that of a

financier, he would not provide any services relating to the asset. -s such, the

lease is net ea!e.

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The (++:

Full payoutlease:


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The risk the lessor takes is not a!!et-ba!e$ ri!> but e!!ee-ba!e$ ri!> . The

value of the asset is important only from the viewpoint of security of the lessors

investment.

(n financial leases, the lessors payback period, vi., pri*ary ea!e perio$ is

followed by an e7tended period to allow e7haustion of asset value by the lessee,

called !econ$ary ea!e perio$. -s the renewal is at a token rental, this option is

called bargain renewa option. -lternatively, if the regulations permit, the lessee

may be given a purchase option at a nominal price, called bargain b&yo&t or

p&rcha!e option.

(n financial leases, the lessors rate of return is fi7ed: it is not dependant upon

the asset*value, performance, or any other e7traneous costs. The fi7ed lease

rentals give rise to an ascertainable rate of return on investment, called i*picit

rate o# ret&rn.

Financial leases are technically different but substantively similar to secured

loans.

3inancia ea!e! an$ .ire-p&rcha!e5

(n some countries, distinction is made between lease and hire*purchase

transactions. - hire*purchase transaction is usually defined as one where the hirer

!user" has, at the end of the fi7ed term of hire, an option to buy the asset at a token

value. (n other words, financial leases with a bargain buyout option at the end of

the term can be called a hire*purchase transaction.

;ire*purchase is decisively a financial lease transaction, but

in some cases, it is necessary to provide the cancellation

option in hire*purchase transactions by statute: that is, the

hirer has to be provided with the option of returning the

asset and walking out from the deal. (f such an option is embedded, hire*purchase

becomes significantly different from a financial lease: the risk of obsolescence

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;ire*purchaseand financialleasescompared


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gets shifted to the hire*vendor. (f the asset were to become obsolete during the

pendency of the hire term, the hirer may off*hire the asset and closes the contract,

leaving the owner with less than a full*payout.

;ire*purchase is of %ritish origin * the device originated much before leases

became popular, and spread to countries which were then %ritish dominions. The

device is still popular in %ritain, -ustralia, #ew Iealand, (ndia, 8akistan, etc.

'ost of these countries have enacted, in line with 1nited Eingdom, specific laws

dealing with hire*purchase transactions.

DI33ERENCE ?ET@EEN LEASE 3INANCING

AND .IRE 1URC.ASE

?ASIS LEASE 3INANCING .IRE 1URC.ASE

2eaning

- Lease transaction is a

commercial arrangement, whereby

an euipment owner or manufacturer

conveys to the euipment user the

right to use the euipment in return

for a rental.

;ire purchase is type o

installment credit unde

which the hire purchase

agrees to take the good

on hire at a stated renta

which is inclusive of th

repayment of principal a

well as interest, with a

option to purchase.

Option To U!er

#o option is provided to the lessee!user" to purchase the goods.

)ption is provided to thhirer!user".

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Nat&re O#

Epen$it&re

Lease rentals paid by the lesee are

entirely revenue e7penditure of

lessee.

)nly interest elemen

included in the hir

purchase, installments i

revenue e7penditure b

nature.

Co*ponent!

Lease rentals comprise of two

elements !/" finance charge and !9"

capital recovery.

;ire purchase installment

comprise of thre

elements !/" norma

trading profit !9" financ

charge !3" recovery of cos

of goodsGassets.

S&b!tance o# #inancia ea!e5

(f financial leases are substantively so close to secured financing transactions, the

categorical issue is: why should they be treated as a lease at allJ Bhy should they

not be regulated, ta7ed and accounted for as plain loan transactionsJ

This uestion may be significant from viewpoint of :

• +egulation of financial leasing activity.

• -sset rights of the lessor.

• Ta7ation of the lessorGlessee.

• -ccounting for the lease transaction.

(n each case, treating the lease as a lease or, based on substance, a financingtransaction, may lead to completely different implications.

o From viewpoint of general regulation of financial leasing activity, if it is

taken as financing by another name, it should form a part of overall financial

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markets regulation * most countries central banks maintain some control on

financial intermediaries.

o The asset*rights of the lessor would also be similar to those of a secured

lender, while in a plain lease contract, the lessor is the sole owner of the asset

and the lessee is merely its bailee.

o (f the lease is treated as a financing transaction, the lessor should not be

allowed to claim any asset*related benefit, such as depreciation. ;is income

should be the implicit part of rentals going towards return on investment.

Likewise, the lessee, apparently a mere user of the asset, should be treated as a

virtual owner and should be allowed all asset*based benefits.

o From accounting viewpoint, if the lease is a mere financing arrangement,

the asset should feature on the %alance Sheet of the lessee rather than the

lessor, along with a corresponding liability to pay fi7ed rentals to the lessor.

(deally, any system should be able to differentiate or integrate transactions based

on their substance, and not nomenclature. So, if financial leasing is so close to

lending, it should have been treated as such for every purpose, and the lessor

should have been treated as a lender.

;owever, such ideal is never achieved. There are two reasons to this * one, to an

e7tent, laws, regulators and ta7men are conditioned by the legal fabric of a

transaction. -nd two, lessors would emphasie upon on one or more structural

differences between a lease and a loan, and be able to create a situation by which

the substance rule fails.

Therefore, financial leasing all over the Borld continues to live with, or rather

thrive on, differing approaches to its character * it being treated at par with loans

for some purposes, and distinguished from loans in for some others. %esides, the

leaseGloan treatment also depends upon the maturity of a countrys regulatory

system to appreciate the substance of a deal by e7ploding its form *

understandably, doing so is not easy because it would mean going beyond the

apparent form of a contract.

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%ased on the ? ma=or areas listed above !general regulation, asset rights, ta7ation

and accounting", there might be numerous combinations treating financial leases

as loans on security for some purpose and true lease for some other purposes.

-ccountings standards are the first !perhaps because they are least dependent on a

statute" to realie the indifference between leases and loans. Ta7ation, particularly,

income*ta7, moves close to accounting standards. eneral property laws are the

last to do so, because often, for enforcement of a contract, the way the parties

create their mutual rights apparently is more important than what could have been

their intent behind such creation.

For the purpose of determining the present value, the discount rate to be used by

the lessor will be the rate of interest implicit in the lease and the discount rate to beused by the lessee will be its incremental borrowing rate.

Therefore, a lease is to be classified as a finance lease if one of the conditions !iii" or

!(V" is satisfied.

(n a finance lease, the lessee is responsible for repair, maintenance and

insurance of the asset. The lessee also undertakes a Dhell or high waterD

obligation to pay rental regardless of the condition or the suitability of the asset.- finance lease which operates over the entire economic life of the euipment is

called a Dfull pay out leaseD.

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O1ERATING LEASE

The (nternational -ccounting Standards &ommittee defines an )perating Lease as

Dany lease other than a finance leaseD.

-n )perating Lease has the following characteristics:

a.. The lease term is significantly less than the economic life of the euipment.

b. The lessee en=oys the right to terminate the lease at short notice without any

significant penalty.

c. The lessor usually provides the operating know*how, suppliers, the related

services and undertakes the responsibility of insuring and maintaining the

euipment in which case an operating lease is called a wet lease. -n

operating lease where the lessee bears the costs of insuring and maintaining

the leased euipment is called a dry lease.

From the features of an operating lease, it is evident that this form of a lease does

not shift the euipment*related business and technological risks from the lessor

to the lessee. The lessor structuring an operating lease transaction has to depend

upon multiple leases or on the realiation of a substantial resale value !on e7piry

of the first lease" to recover the investment cost plus a reasonable rate of return

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thereon. Therefore, specialiing in operating leases calls for an in*depth

knowledge of the euipments per se and the secondary !resale" market for such

euipments. )f course the prereuisite is the e7istence of a resale market.

iven the fact that the resale market for most of the used capital euipments in

our countK lacks breadth, operating leases are not in popular use. %ut then this

form of lease ideally suits the reuirements of firms operating in sun rise

industries which are characteried by a high degree of technological risk.

3oowing are i&!trati%e !it&ation! where a ea!e wi be regar$e$ a! an

operating ea!e5

• (f the lease has a cancellable period, during which rentals forming more

than /H in present value terms of the fair value of the asset are receivedC

• (f part of the rentals are contingent or conditional, and such rentals form

more than /H in present value terms of the fair value of the assetC

• (f the lessor relies upon unguaranteed residual value, and such value forms

more than /H in present value terms of the fair value of the assetC

• (f the lessor relies upon guaranteed residual value, but such value is

guaranteed by a third party, and such third*party*guaranteed residual value

forms more than /H in present value terms of the fair value of the asset *

in this case, the lease will be regarded as a financial lease for the lessor but

an operating lease for the lesseeC

• (f the lessors (++ and the lessees incremental borrowing rate differ: the

lease may be a financial lease for the lessor and an operating lease for the

lessee

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Di##erence! between 3inance an$ Operating Lea!e!

3inancia Lea!e

• +isks and rewards of

ownership are transferred to,

and borne by, the lessee. This

includes the risks of accidental

ruin or damage of the asset

!although these risks may be

insured or otherwise assigned".

Thus damage that renders an

asset unusable does not e7empt

the lessee from financial

liabilities before the lessor.

• The goal of the lessee is either

to acuire the asset or at least

use the asset for most of its

economic life. -s such, the

lessee will aim to cover all or

most of the full cost of the asset

during the lease term and

therefore is likely to assume thetitle for the asset at the end of

the lease term. The lessee may

gain the title for the asset

earlier, but not before the full

cost of the asset has been paid

Operating Lea!e

• >conomic ownership with all

corresponding rights and

responsibilities are borne by the

lessor.The lessor buys insurance

and undertake responsibility for

maintenance.

• The goal of the lessee is usage of

the leased asset for a specific

temporary need, and hence the

operating lease contract covers

only the short*term use of the

asset. Further, the duration of an

operating lease is usually much

shorter than the useful life of the

asset.

• (t is not the lessee6s intention to

acuire the asset, and lease

payments

are determined accordingly. (n

addition, an asset under an

operating lease may

subseuently be rented out.

• The present value of all lease

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off.

• The lessor retains legal

ownership for the duration of

the lease term, though the

lessee may or may not buy out

the leased asset at the end of

the lease, with the lessor

charging only a nominal fee for

the transfer of asset to the

lessee.

• The lessee chooses the supplier

of the asset and applies to the

lessor for funding. This is

significant because the leasing

company that funds the

transaction should not be liable

for the asset uality, technical

characteristics, and

completeness, even though itretains the legal ownership of

the asset. The lessee will also

generally retain some rights

with respect to the supplier, as

if it had purchase asset directly.

payments is significantly less

than the full asset price.

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SALE AND LEASE?AC

(n a sale and leaseback transaction, the owner of euipment sells it to a leasing

company which in turn leases it back to the erstwhile owner !the lessee". The

leaseback arrangement in this transaction can be in the form of a finance

lease or an operating lease.

- classic e7ample of this type of transaction is the sale and leaseback of safe

deposit vaults resorted to by commercial banks is 1nder this arrangement the bank

sells the safe sells the safe deposit vaults in its custody to a leasing company at a

market price which is substantially higher than the book value.

S-L> T+-#S-&T()#

S-L> V-L1>

L>-S> T+-#S-&T()#

L>-S> +>#T-LS

Sae! an$ Lea!ebac>

The leasing company offers these lockers on a long*term lease to the bank. The

advantages to the bank are:

a. (t is able to unlock its investment in a low income yielding asset.

b. (t is able to en=oy the uninterrupted use of the lockers !which can be leased to

its customers".

c. (t can invest the sale proceeds !which are not sub=ect to the reserve ratio

reuirements" in high income yielding commercial loans.

(n general, the sale and leaseback arrangement is a readily available source of

funds for financing the e7pansion and diversification programs of a firm. (n case

where capital investments in the past have been funded by high cost short*term

debt, the sale and lease back transaction provides an opportunity to substitute the

23

S>LL>+ %1>+

L>SS>> L>SS)+


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Lease Financing

short*term debt by medium*term finance !assuming that the leaseback

arrangement is a finance lease".

From the leasing companys angle a sale and leaseback transaction poses certain

problems. First, it is difficult to establish a fair market value of the asset being

acuired because the secondary market for the asset may not e7istC even if it

e7ists, it may lack breadth. Second, the (ncome Ta7 -uthorities can

disallow the claim for depreciation on the fair market value if they perceive

the fair market value as not being FfairF.

DIRECT LEASE

- direct lease can be defined as any lease transaction which is not a Dsale and

leasebackD transaction. (n other words, in a direct lease, the lessee and the owner

are two different entities. - direct lease can be of two types: %ipartite Lease and

Tripartite Lease.

?ipartite Lea!e

(n a bipartite lease, there are two parties to the transaction * the euipment

supplier cum*lessor and the lessee. The bipartite lease is typically structured as an

operating lease with in*built facilities like up gradation of the euipment

!upgrade lease" or additions to the original euipment configuration. The

lessor undertakes to maintain the euipment and even replaces the euipment

that is in need of ma=or repair with similar euipment in working condition

!swap lease". )f course, all these add*ons to the basic lease arrangement are

possible only if the lessor happens to be a manufacturer or a dealer in the class of

euipments covered by the lease.

Tripartite Lea!e

- tripartite lease on the other hand is a transaction involving three different

parties *the euipment supplier, the lessor, and the lessee. 'ost of the euipment

lease transactions fall under this category. -n innovative variant of the tripartite

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Lease Financing

lease is the sales*aid lease where the euipment supplier catalyes the lease

transaction. (n other words, he arranges for lease finance for a prospective

customer who is short on liuidity. Sales*aid leasing can take one of the

following forms:

a.. The euipment supplier can provide a reference about the customer to the

leasing company.

b. The euipment supplier can negotiate the terms of the lease with the

customer and complete the necessary paper work on behalf of the leasing

company.

c. The supplier can write the lease on his own account and discount the lease

receivables with the designated leasing company.The effect of the transaction is that the leasing company owns the euipment and

obtains an assignment of the lease rental. %y and large, sales*aid lease is supported

by recourse to the supplier in the event of default by the lessee. The recourse can

be in the form of the supplier offering to buyback the euipment from the lessor

in the event of default by the lessee or in the form of providing a guarantee on

behalf of the lessee.

LE0ERAGED LEASE

(n a leveraged lease transaction, the leasing company !called euity investor"

invests in the euipments by borrowing a large chunk of the investment with full

recourse to the lessee and without any recourse to it. The lender !also called the

loan participant"

)btains the assignment of the lease and the rentals to be paid by the lessee, and a

first mortgage on thee leased asset. The transaction is routed through a trustee who

looks after the interests of the lender and the lessor. )n receiving the rentals from the

lessee, the trustee remits the debt* service component of the rental to the loan

participant and the balance to the lessor. - schematic representation of transaction is

represented in the figure:

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Lease Financing

Le%erage$ Lea!e

Sells -sset Leases -ssets

Do*e!tic Lea!e B Internationa Lea!e

- lease transaction is classified as a domestic lease if all parties to the transaction to

the euipment supplier, the lessor and the lessee are domiciled in the same country.

)n the other hand, if the parties are domiciled in different countries, the transaction

is classified as an (nternational Lease Transaction.

The distinction between a domestic lease transaction and an international lease

transaction is important for two reasons. First, packaging an international leasetransaction calls for,

a. -n understanding of the political and economic climateC and

b. Enowledge of the ta7 and the regularity framework governing these

transactions in the countries concerned.

26

'anufacturer Lessor Lessee

Lender


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Lease Financing

Second, as the payments to the supplier and the lease are denominated in

different currencies, the economies of the transactions from the points of view of

both the lessor and the lessee tend to be affected by the variations in the relevant

e7change rates. (n short, international lease transactions unlike domestic lease

transactions are affected by two additional sources of risk $ country risk and

currency risk.

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Lease Financing

LEASING TO LESEE AND LESSOR

A$%antage! o# LEASING to LESSEE

There are several e7tolled advantages of acuiring capital assets on lease:

!/" Sa%ing o# capita:

Leasing covers the full cost of the euipment used in the business by providing

/H finance. The lessee is not to provide or pay any margin money as there is no

down payment. (n this way the saving in capital or financial resources can be used

for other productive purposes e.g. purchase of inventories.

!9" 3eibiity An$ Con%enience:

The lease agreement can be tailor* made in respect of lease period and lease

rentals according to the convenience and reuirements of all lessees.

!3" 1anning Ca!h 3ow!:

Leasing enables the lessee to plan its cash flows properly. The rentals can be paid

out of the cash coming into the business from the use of the same assets.

!?" I*pro%e*ent In Li&i$ity:

Leasing enables the lessee to improve their liuidity position by adopting the sale

and lease back techniue.

!A" Shi#ting o# Ri!> o# Ob!oe!cence5

The lessee can shift the risk upon lessor by acuiring the use of asset rather than buying the asset.

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Lease Financing

!@" 2aintenance An$ SpeciaiFe$ Ser%ice!:

(n case of special kind of lease arrangement, Lessee can avail specialied services

of lessor for maintenance of asset leased. -lthough lessor charges higher rentals

for providing such services, lessee6s overall administrative and service costs are

reduced because of specialied services of the lessor.

!2" O##-The-?aance-Sheet-3inancing :

Leasing provides Doff balance sheetD financing for the lessee, in that the lease is

recorded neither as an asset nor as a liability.

Di!a$%antage! o# LEASING to LESSEE

!/" .igher Co!t5

The lease rental include a margin for the lessor as also the cost of risk of

obsolescene, it is, thus regarded as a form of financing at higher cost.

!9" Ri!> of being deprived the use of asset in case the leasing company winds

up.

!3" No Ateration In A!!et:

Lessee cannot make changes in asset as per his reuirement.

!?" 1enatie! On Ter*ination O# Lea!e:

The lessee has to pay penalties in case he has to terminate the lease before e7piry

o lease period.

A$%antage! o# LEASING to LESSOR

!/" .igher pro#it!:

The lessor can get higher profits by leasing the asset.

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Lease Financing

!9" Ta ?ene#it!:

The lessor being owner of asset can claim various ta7 benefits such as

depreciation.

!3" &ic> Ret&rn!5

%y leasing the asset, the Lessor can get uick returns than investing in other

pro=ects of long gestation period.

Di!a$%antage! o# LEASING to LESSOR

!/" .igh Ri!> o# Ob!oe!cence:

The lessor has to bear the risk of obsolescence as there are rapid technology

changes.

!9" 1rice Le%e Change!:

(n case of inflation, the prices of asset rises but the lease rentals remain fi7ed.

!3" Long ter* In%e!t*ent:

Leasing reuires the long term investment in purchase of an asset, and takes long

time to cover the cost of that asset

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Lease Financing

LEGAL AS1ECTS O3 LEASING

-s there is no separate statue for euipment leasing in (ndia, the

provisions relating to bailment in the (ndian &ontract -ct govern euipment

leasing agreements as well section /?< of the (ndian &ontract -ct defines

bailment as:

MThe delivery of goods by one person to another, for some purpose, upon a

contract that they shall, when the purpose is accomplished, be returned or

otherwise disposed off according to the directions of the person delivering them.

The person delivering the goods is called the Nbailor6 and the person to whom they

are delivered is called the Nbailee6.

Since an euipment lease transaction is regarded as a contract of bailment,

the obligations of the lessor and the lessee are similar to those of the bailor and

the bailee !other than those e7pressly specified in the least contract" as defined by

the provisions of sections /A and /@< of the (ndian &ontract -ct. >ssentially

these provisions have the following implications for the lessor and the lessee.

/. The lessor has the duty to deliver the asset to the lessee, to legally authorise

the lessee to use the asset, and to leave the asset in peaceful possession of the

lessee during the currency of the agreement.

9. The lessor has the obligation to pay the lease rentals as specified in the lease

agreement, to protect the lessor6s title, to take reasonable care of the asset, and to

return the leased asset on the e7piry of the lease period.

CONTENTS O3 A LEASE AGREE2ENT

The lease agreement specifies the legal rights and obligations of the lessor

and the lessee. (t typically contains terms relating to the following:

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Lease Financing

/. 4escription of the lessor, the lessee, and the euipment.

9. -mount, time and place of lease rentals payments.

3. Time and place of euipment delivery.

?. Lessee6s responsibility for taking delivery and possession of the leased

euipment.

A. Lessee6s responsibility for maintenance, repairs, registration, etc. and the

lessor6s right in case of default by the lessee.

@. Lessee6s right to en=oy the benefits of the warranties provided by the

euipment

manufacturerGsupplier.

2. (nsurance to be taken by the lessee on behalf of the lessor.


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Lease Financing

iii. )ther public sector leasing organiations.

(. 1&re Lea!ing Co*panie!5

These companies operate independently without any link or association with any

other organisation or group of organiation. The First Leasing &ompany of (ndia

Limited. The Twentieth &entury Finance &orporation Limited, and the rover

Leasing Limited, fall under this category.

((. .ire 1&rcha!e an$ 3inance Co*panie!5

The companies started prior to /0


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Lease Financing

1U?LIC SECTOR LEASING

!i" 3inancia In!tit&tion!: The financial institution such as (F&(, (&(&(, (+%(

and #S(& have set up their leasing divisions or subsidiaries to do leasing business. The shipping credit and (nvestment &ompany of (ndia offers leasing

facilities in foreign currencies for ships, deep seas fishing vehicles and related

euipment to its clients.

!ii". S&b!i$iarie! o# ?an>!5 The commercial banks in (ndia can, under section

/0!/" of the %anking +egulation -ct, /0?0, setup subsidiaries for undertaking

leasing activities. The S%( was the first bank to start a subsidiary for leasing

business in /0lectronics Limited, ;industan 8ackaging &ompany

Limited, >lectronic &orporation of (ndia Limited have started to sell their

euipment through leasing.

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Lease Financing

ACCOUNTING TREAT2ENT O3 LEASE

8resently the accounting treatment of lease transactions in (ndia is as follows:

/. The leased asset is shown on the balance sheet of the lessor.

9. 4epreciation and other ta7 shields associated with the leased asset are

claimed by the lessor.

3. The entire lease rental is treated as income in the books of the lessor and

as e7pense in the books of the lessee.

(n nutshell, from the point of view of the lessee, a lease transaction represents an

off*the balance*sheet transaction and this appears to be an important advantage

associated with leasing. (t may be noted that in countries like the 1nited States

and the 1nited Eingdom, where leasing is very popular, leases which meet certain

criteria are capitalised in the books of the lessee. This essentially implies that:

a. The leased asset and the corresponding liability !reckoned at the present

value of the stream of rental payments" are shown on the balance sheet of the

lessee.

b. 4epreciation charges are claimed by the lessee, and

c. The lease rental is split into two parts, the interest component !which is

charged to the profit and loss statement" and the principal repayment

component.

?ac>gro&n$ an$ internationa acco&nting change! on ea!e

acco&nting5

There were some A odd leasing companies in (ndia about A years ago. #ow, not

more than A serious operators are left, who are searching for ways to survive in

the coming A years. (n my view, it is high time for those A players to =oin hands

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Lease Financing

together, and cry out loud: DBe will not write a single penny of lease transactions

in (ndia, unless the overnment speaks out its mind. >nough is enough. -

business can survive ta7es, and duties, and sanctions, but no business can survive

uncertainty. So, unless the overnment clarifies what does it have in mind

regarding income*ta7, sales*ta7, accounting and other issues that have been

drifting like the nebula for last 9 years, we cannot, and shall not write a single

lease.D

Leasing in (ndia would go down in history as a clear victim of legislative inaction.

(t is true that governments have their own way: they do not actC they react. %ut it

is perple7ing as to how could the government sleep over the fate of multi*billion

dollar industry for so many years. Look at the following hard facts:

• &ontroversy erupted regarding leasing companies claim for depreciation

in /00A as some companies were found to have made e7aggerated claims

or claims that were not genuine. The -ssociation of Leasing and Financial

Services &os. !-LFS&" has been pleading for last A years that the &%4T

frame rules that would help the assessing officers distinguish between

genuine leases and garbed financial transactions. -LFS& has also

suggested model rules drawing from several other countries. )bviously

enough, there was nothing that the &%4T would have lost by enacting

these rules, and nothing stood to gain by not enacting them. ;owever,

nothing has been done for last A years. +esult: as there is no rule from the

&%4T, every assessing officer, and every appellate commissioner, has

framed his or her own rule. 'ost of these officers have looked at lease

transactions with a kind of inherent vengeance: therefore, the end result is

common but the reasoning is different. That is, depreciation is disallowed,

for reasons that differ from case to case.

• Sales*ta7 was imposed on lease transactions some /@ years ago. #o one

was clear as to how would the =urisdiction and incidence of ta7 be

determined. Be allowed the controversy to linger for all these years

waiting for the Supreme &ourt to give a ruling only in year 9. (n the

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Lease Financing

depreciation and ta7 depreciation are miles apart. There are plenty of countries all

over the world where leases may be capitalised for accounting purposes by

lessees, and yet depreciated for ta7 purposes by lessors.

1E itself is a prominent e7ample. South -frica is yet another. >ven in the largest

leasing market in the Borld, 1S-, ta7 and accounting principles for leasing

depreciation are markedly different and the difference is honoured and settled

over time.

So, there is no scope for the popular fear that if (ndia adopts (-S*/2*type

capitaliation by lessees, it would lead to loss of ta7 depreciation. 1nless the ta7

department also thinks alike !which would be a disaster, as ( e7plain below", there

is no linkage between ta7 treatment and accounting treatment when it comes to

depreciation. 'erely because a lease is capitalied by the lessee for accounting

purposes does not entitled the lessee, or disentitled the lessor to claim

depreciation.

.a! the acco&nting $i!tinction between #inancia an$ operating ea!e! !er%e$

any p&rpo!eH

(t is today almost universally agreed that the accounting distinction between

financial and operating leases has not served any purpose. -s the accounting

difference is based on fine mathematics, lessors and lessees world*over have

devised leases which in essence are financial leases but ualify for operating lease

definition. This is what prompted an -ustralian gentleman *'cregor * to make a

cothetic argument against the financial*operating lease distinction. 'cregor

study became the basis for what is called Dthe new approachD to lease accounting.

(t is based on this approach that (-S /2 was revised with effect from /000.

1nder the revised standard, disclosure is reuired for non*cancellable leases in the

books of the lessee, irrespective of whether the lease is a financial lease or

operating lease. (n other words, as far as the lessee is concerned, accounting

standards no more distinguish between a financial and an operating lease.

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Lease Financing

asset, but one of mere funding. There are tests in many countries to distinguish

between true leases and financial transactions, which can be used in our country.

%esides this, it might make sense to use a simple but very powerful limitation:

leasing ta7 shelter not being used against non*leasing incomes. Several countries,

such as 'alaysia, Sri Lanka, South -frica, have enacted this rule. This rule allows

the leasing ta7 shelter to be absorbed within the leasing business, but not to be

used against other incomes. This by itself would curb the misuse of leasing

depreciation.

The (nstitute of &hartered -ccountants of (ndia !(&-(" recently issued a new

accounting standard no -S /0 on leases, replacing the e7isting uidance #ote on

lease accounting. The new standard is applicable for all leases entered on or after

/st -pril 9/: from this, it is understood that the statement will not affect past

leases. ;owever, for practical considerations, it will be advisable for

companies to switch over to the new method in respect of all lease transactions,

including those which are running.

(t has been made out that the new accounting standard is drawn in accordance

with international accounting standard no. /2. ;owever, this is not true as the (-S/2 itself underwent revision in /002. (&-(s -S /0 is based on the pre*/002

version of (-S /2.

(nternationally, lease accounting continues to be in a state of flu7 ever since

'cregor published a new approach to lease accounting under which the

traditional distinction between financial and operating leases is to become

irrelevant and companies are reuired to record as asset or liability the fair value

of benefits to be derived from a leased asset and the fair value of payments to be

made under the lease agreement. (n other words, if during the lease period, the

benefits arising from an asset e7ceed the lease payments, the lease is an asset even

if it is an operating lease. This would, inevitably, be true in case of a financial

lease anyway.

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Lease Financing

lessee will record, as a liability, the present value of lease rentals payable,

in other words, the principal inherent in future lease rentals.

• The lessor will take to revenue only the interest or finance charges

inherent in lease rentals, which will also be debited as e7pense by the

lessee.

• (n case of operating leases, the lessor will account for the asset as his own

asset, and depreciate the same as per regular depreciation policy of the

lessor. The rentals will be recognised as income by the lessor and e7pense

by the lessee, sub=ect to evening out in case of structured rentals. The

assetGliability will be off*the*books of the lessee.

• (f a sale and leaseback transactions results into a financial lease, no profit

on sale will be booked by the seller*lessee who will treat the sale proceeds

as a liability.

• (f a sale and leaseback transaction results into an operating lease, a lessee

will book profitGloss on sale irrespective of the sale price of the asset,

depending on the fair value of the asset.

/. @i it ha%e ta i*pication! H

The fears e7pressed before that the new method of accounting will result

into loss of ta7 benefits by the lessor have now been allayed. (n Feb.,

9/, the &%4T issued a circular clarifying that the change of accounting

rules will have no bearing on the ta7 treatment.

That is to say, sub=ect to other conditions for depreciation allowance, a

lessor in a lease will claim ta7 benefits, even though he will not be

reflecting the asset as his fi7ed asset on balance sheet. This also means

that the lessor will be sub=ecting his gross rentals as income, even though

he takes to profit and loss aGc only the finance charges inherent in rentals.

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Lease Financing

(n other words, to the profit as reported in profit and loss account, the

principal portion of lease rentals not recognised as income will be added

for ta7 purposes and depreciation will be allowed.

-s for the lessee, though he capitalises the asset on his financial

statements, he will not be able to depreciate the asset for ta7 purposes.

Though he takes to earnings statement only the finance charges inherent in

lease rentals, he will claim the whole of the rentals as e7pense.

Thus, the new accounting standard leads to a new era of dichotomy

between ta7 and accounting principles, and it will

be uite a tough time for the ta7 officers to negotiate through this

dichotomous rule. (n essence, when things are tough for the ta7 officers,

they are tougher for the ta7 payersO

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Lease Financing

ACCOUNTING 3OR NON 1ER3OR2ING LEASES

There is no information in the guidance note on lease accounting, /00A, for non*

performing assets. The general accounting principles for non*performing assets is

contained in accounting standard 0 on +evenue +ecognition which is more or less

on the lines of the (nternational -ccounting Standards on the issue.

The Standard provides that whereas, in general, incomes are to be recognied on

the basis of accrual, in case of an uncertainty in the ultimate realiation of an

income, the treatment is as follows:

• (f the uncertainty is prevalent at the time of raising the claim for the income,

the recognition of the income shall be postponed

• (f the uncertainty arises subseuent to the claim being made, there shall be a

provision made to the e7tent of the uncertainty.

This statement lays down the basic difference between a provision against an

income, and non*recognition of income, which is very significant. The

accounting for non*performing assets is guided by the 8rudential #orms of the

+%(

- lease will be regarded as a non*performing asset based on overdues for more

than /9 months. That is, if dues under a lease or hire purchase transaction remain

unpaid, fully or partly, for more than twelve months, the transaction will be

treated as a non*performing asset. The twelve month time frame is markedly

longer than the general international standard of 3 months only.

(f the lease transaction is a non*performing asset, there is a four*fold impact on

the revenueGprovisioning reuirements:

#o income shall be recognied on an accrual basis*income recognition will shift

to cash or accrual basis.

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Lease Financing

(ncome already recognied, and lying unrealied, will be reversed*this, in

accounting sense means the income recognied will be provided for. #otably, in

case of lease transactions, the income that reuires reversal is only the financial

charge element inherent in the rentals, not the entire rental.

- provision shall be made to mark the deterioration in the under lying security

value on the basis of the depreciation of the asset as per the &ompanies -ct.

The #%F&s should make provisions against #8-s with correlation to the net

book value of the assets in four stages at /, ?, 2 and / per cent as follows :

⇒ +entals are overdue up to /9 months #il

⇒ Sub*standard assets :

where any amounts of hire charges or / percent of the lease

rentals are overdue for more than /9 months net book value

but up to 9? months

⇒ 4oubtful assets :

Bhere any amounts of hire charges or lease ? percent of the

rentals are overdue for more than 9? months net book value

but up to 3@ months

⇒ Bhere any amounts of hire charges or 2 percent of the rentals

lease are overdue for more than 3@ months net book value but up to ?< months

⇒ Loss assets:

Bhere any amounts of hire charges or lease / percent of the

rentals are overdue for more than ?< months net book value

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Lease Financing

TAATION IN TER2S O3 LEASING5

4 ?a!ic ta treat*ent o# ea!e an$ hire-p&rcha!e tran!action!5

The ta7 treatment of lease transactions in (ndia is based on whether the lease

ualifies as a lease or will be treated as a hire*purchase transaction.

(f the transaction is treated as a lease, the lessor shall be eligible for depreciation

on the asset. The entire lease rentals will be ta7ed as income of the lessor. The

lessee, correspondingly, will not claim any depreciation and will be entitled to

e7pense off the rentals.

(f the transaction is a hire purchase or conditional sale transaction, the hirer will

be allowed to claim depreciation. This is based on an old &ircular of the 4ept.

issued in year /0?3. The financing charges inherent in hire instalments will be

ta7ed as the hire*vendors income and allowed as the hirers e7pense.

6. Depreciation in ca!e o# Lea!ing an$ hire-p&rcha!e tran!action!5

%eing the sole determinant of the ta7 treatment of leases, the distinction between

lease and hire*purchase transactions becomes e7tremely important.

>ssentially, the distinction is based on the beneficial ownership of the asset. (n

order to ualify for depreciation, the lessor has to establish himself to be both the

legal and beneficial owner of the asset. -s in a hire*purchase transaction, the

lessor allows to the lessee the right to buy the asset at a nominal price, it can be

seen that the lessor has parted with the whole of his beneficial interest in the asset.

The lessor will not be able to benefit from the asset during the lease period !as

there is a committed right to use to the hirer", and beyond the lease period !as

there is a right to buy the asset with the hirer". ;aving thus permanently divested

himself of his beneficial rights, the lessor becomes ineligible to claim

depreciation.

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Lease Financing

-s it is the beneficial ownership rights of the lessor that is crucial, the distinction

between lease and hire*purchase goes beyond the mere e7istence of option to buy

in the lease. (f, e7plicitly or implicitly, it is apparent that the lessor has agreed to a

permanent beneficial en=oyment of the asset by the lessee, the lease may be

treated as a hire purchase or a plain financing transaction.

7 Depreciation aowance on ea!e tran!action!5

- lease ualifying as true lease will entitle the lessor to claim depreciation. The

true lease conditions and the conditions generally applicable for depreciation as

such are not independent * the former are drawn essentially from the latter.

The ta7*payer claiming depreciation should own the asset. #o doubt, the lessor

owns the asset, but as discussed earlier, it is not legal ownership alone that is

sufficientC the lessor must establish himself to be the beneficial owner as well. (t is

on the failure of the condition of beneficial ownership that the legal owner in case

of hire*purchase is not allowed depreciation. The lessors beneficial ownership of

the leased asset is proved essentially by the right of reversion of the asset at the

end of the lease period * this highlights the significance of proving that the lessor

has a substantive and not merely notional or technical right of reversion of the

asset.

The lessor may be a =oint owner or a single owner. (n case of =oint ownerships,

depreciation was not allowable until /00@ when a specific amendment was

inserted to make syndicated leases possibleC confusion, however, persists on

whether two or more lessors =ointly leasing an asset will be treated for ta7 purposes as a separate assessable entity.

Bhen a movable property becomes a permanent fi7tures to land not belonging to

the lessor, the lessor ceases to be the legal owner of such fi7ture. This basic legal

might create problems for (ndian lessors leasing out assets that are in the nature of

permanent fi7tures to ground. Such intent is even reflected from the recent

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Supreme &ourt ruling in First Leasing &ompany of (ndia where the Supreme

&ourt distinguished a lease from hire*purchase on the ground whether the transfer

of right to use in a lease resulted into a permanent effective right of use being

transferred, preparatory to a sale.

The other condition for depreciation is that the ta7payer should be using the asset.

(t is understood clearly that the ta7payer uses the asset in the business of leasingC

hence, it is on the strength of the lessors use that depreciation is claimed and not

on the strength of the lessees use. 1se or its absence by the lessee should not,

therefore, cast any implication on the lessors depreciation claim.

4epreciation is allowed in (ndia on a pooling basis: all assets eligible for the same

rate of depreciation under a particular class of assets will be treated as one pool,

or block of assets. -cuisition of fresh assets is treated as addition to the block,

and the sales or transfers, at whatever be their transfer consideration, are netted

off from the block. Therefore, no regard is had to the profit or loss on sale of an

individual asset.

8 Rate! o# $epreciation5

+ates of depreciation are listed in the Schedule to the (ncome*ta7 +ules. Like

under the >nglish system, (ndia makes distinction between Dplant or machineryD

and other assets based on the functional test. The age*old functional test in

armouth v. France holds in (ndia. %ased on this test, any assets that the lessor

leases out are obviously income*earning tools in his business, and would

therefore, be regarded as plant or machinery for his business.

1nder this caption, the applicable depreciation rates on some of the generally

eased assets are given in the Table below :

'otor cars 9H

eneral plant or machinery !residuary rate" 9AH

Lorries, buses or ta7ies plying on hire, aeroplanes, moulds used in ?H

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plastic or rubber factories

%ottles and crates AH

&omputers !proposed" @H

8ollution control devices, energy saving devices, renewable energy

devices, rollers in flour mills, gas cylinders, etc.

/H

9 Sae an$ ea!ebac> tran!action!5

Sale and leaseback transactions came under a lot of flak during /00A*0@, when

transactions in =unk funding were being labeled as sale and leasebacks at

phenomenal values.

The (ncome*ta7 law was amended to insert a specific provision about sale and

leasebacks, which now restricts the amount with reference to which depreciation

can be claimed in a sale and leaseback transaction, to the written down value in

the hands of the seller*lessee. That is, the actual cost of the asset to the lessor will

be ignored, and instead, depreciation will be allowed on the sellers depreciated

value.

This provision is applicable only where the seller is the lesseeC in other words, not

applicable for every lease of second*hand assets. ;owever, in such cases, the fair

valuation rule that e7isted earlier, in >7planation !3" to sec. ?3 !/" shall continue

to apply.

: De$&ction o# renta! by the Le!!ee5

(n general, in a lease, the lessee will be allowed to claim the rentals as an e7pense.

This is sub=ect to general rules of reasonableness and the power of the ta7 officer

to invoke substance of a transaction ignoring its legal form. )ne important case

where the claim by the lessee for rental was disallowed is &entre for 'onitoring

of (ndian >conomy case, where based on the fact that the lease had partaken the

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character of acuisition of the asset by the lessee, the lessees claim for lease

rentals was disallowed.

This case cannot be taken to be a trend*setter because the facts in this case were

not materially different from most other financial leases. (f this case is a

precedent, then lease rentals are not ta7*deductible in any single financial lease.

;owever, even the Supreme &ourt has differentiated between lease and hire*

purchase in the latest First Leasing &ompany of (ndia case. Therefore, most likely

the &entre for 'onitoring of (ndian >conomy case will not be able to withstand at

higher =udicial forums

SALES TA 1RO0ISION 1ERTAINING TO LEASING 5

The ma=or sales ta7 provisions relevant for leasing are as follows:

/. The lessor is not entitled for the concessional rate of central sales ta7

because the asset purchased for leasing is meant neither for resale nor for use in

manufacture. !(t may be noted that if a firm buys an asset for resale or for use in

manufacture it is entitled for the confessional rate of sales ta7".

9. The ?@th -mendment -ct has brought lease transitions under the purview

of Nsale6 and has empowered the central and state government to levy sales ta7 on

lease transactions. Bhile the &entral Sales Ta7 -ct has yet to be amended in this

respect, several state governments have amended their sales ta7 laws to impose

sales ta7 on lease transactions.

a Le%y o# Sae! Ta5

Sales Ta7 is leviable when goods are sold. Thus there must be D oods and there

must be a sale. DoodsP include all types of movable property. MSale D means a

transfer of property in goods from one person to another for a consideration. %ut

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Sales Ta7 is leviable only on a person who is a dealer. - casual transaction by a

non*dealer is not sub=ect to Sales Ta7. Thus, if an individual salary earner sells off

his personal car, there is no Sales Ta7 attracted. To summarie, Sales Ta7 is

leviable on sale of goods by a dealer.

b Sae! Ta on #inancia ea!e!5

(n a Finance Lease, #%F&s are the owner of the oods and the lessee only has

the right to use the goods on payment of lease rentals. (t is a contract of hiring or

bailment. ;ence there is no Msale Mas defined.

;owever, there is a transfer of the right to use the goods from us to the lessee.

-nd this has become ta7able as a deemed sale. The Sales Ta7, also called DLease

Ta7 D, is leviable on the Transfer of +ight to 1se the goods from us to the lessee.

-nd the ta7 is charged as each rental for use of the lease asset becomes due and

payable.

(t may be noted that Lease Ta7 is a case of ta7ing a non*sale *the consumption of

utility of goods * though there is no transfer of title. . Bhether it is good law or

will the &ourts strike down this Ta7 J Be are not sure, but #%F&s are agitatingthe matter in a &ourt.

c. Sae! Ta on Lea!e 0J! .ire 1&rcha!e Tran!action!5

Lease is a sale followed by a transfer of right to use. Supplier S sells to the #%F&

and the #%F& gives the goods on lease to &ustomer & !Transfer of the right to

use the goods". ;ence, there are two sale transactions * the sale proper, and the

lease.

(n ;8, also, there are 9 sales. Supplier S sells to the #%F& and the #%F&

simultaneously sells to the &ustomer & by entering into a hire purchase

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agreement. &ommercially speaking, the two transactions are not different. There

are two contracts in either case, usually bundled in a single delivery from the

supplier to the end*user.

Therefore, in a Lease, there will be a Sales Ta7 on the Sale and a Lease Ta7 !if

any" on the transfer of the right to use. (n a ;ire 8urchase there will be 9 Sales

Ta7es applicable on 9 separate sales. ;owever, sales*ta7 laws !for historical

reasons only" treat lease and hire purchase substantially differently. Since the

choice of the instrument, vi., lease or hire purchase, may lead to material sales*

ta7 difference, it is important that the sales*ta7 implications are analyed before

choosing the instrument or concluding the transaction.

Go%ern*ent K&ri!$iction in e%ying Sae! Ta 5

(n a sale outside (ndia or in the course of import into or e7port out of

(ndia.

(f the sale is outside (ndia or in the course of import into (ndia or e7port

out of (ndia , (ndia cannot ta7 such a sale.

Sale within a State :

(f the sale is within a state then that state has the power to ta7 it.

Sale in the course of inter state trade:

(f the sale takes place in the course of (nter state trade, the &entral

overnment can ta7 such a sale. ;owever, there is no administering

machinery of the &entral overnment to administer inter state sale ta7.

The same is delegated to the state governments.

That state where the inter state movement commences has the =urisdiction and therate chargeable is also that applicable in that state for &ST transactions.

Sae! Ta Rate! 5

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Since under the sharing arrangement all the &ST collections are retained

by the state concerned, states have been allowed to reduce the &ST rates

and also give e7emptions. So while as a general rule &ST is /H or such

higher rate if the State charges a higher rate of ta7 on the local sale of the

sub=ect goodsC or ?H with & Form, this could vary from state to state. %ut

the State overnment cannot increase the &entral Sales Ta7 from /G? H

in any case. Therefore, #%F&6s will have multiple &ST assessments, one

in each state from where goods move.

N?3C! !hi#ting )&ri!$iction5

-s e7plained, the =urisdiction in (nter state transaction is in the state where

movement of goods commences. %ut #%F&s can shift the =urisdiction

from all states to say 'aharashtra.

This can be done by endorsement of the L+ during transit. (f endorsement is done

the =urisdiction shifts to the place where endorsement was made. Thus #%F&s

could instruct the Supplier to send goods physically to &ustomer and hand over

the L+ in our name at our %ombay address. #%F&s will then endorse the

&onsignee copy of the L+ in favour of the &ustomer and forward it to the

&ustomer. The &ustomer will claim the goods from the transporter by producing

this endorsed L+.

Ser%ice Ta on Lea!e Tran!action!

Service Ta7 on Lease Transactions with effect from 4!t K&y' 64:

>veryone knew, though without any clue to the reasons that the Finance 'inistryofficials are not particularly very sympathetic to leasing and hire purchase, but no

one ever thought that the Finance 'inister had this provision up his sleeve. #o

one could have even apprehended this hearing him deliver his %udget Speech. %ut

it is there in the fine print * a AH service ta7 on the gross receivables of leasing

and hire purchase companies.

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The %udget deals a body blow to the already moribund leasing and hire purchase

sector * imposing a service ta7 on not =ust the income but the entire receivables

out of lease and hire purchase transactions.

#ot only are leasing and hire purchase companies proposed to be brought under

ta7, they are also grossly discriminated against: as loans from banks, an

alternative to lease and hire purchase, have not been brought under the ta7.

Con!tit&tiona %ai$ity to be &e!tione$5

Surprisingly enough, leasing as well as hire purchase are not a part of services

under the &onstitution * as they are defined as DsalesD in the &onstitution and are

liable to sales*ta7. Service ta7 cannot be imposed on leasing and hire purchase

activities as they are defined as sales under the &onstitution and the &onstitution

places restrictions on ta7 on sale or purchase of goods * leasing and hire purchase

being defined as sale and purchase of goods. The &entral ovts right to ta7 such

sales is only limited to inter*state transactions with the States having the right to

ta7 intra*state transactions. The receivables from lease and hire purchase

transactions are therefore, sale revenues under the &onstitution, and they cannot

be ta7ed as value for services.

Gro!! %a&e o# !er%ice!

4oes this mean, in case of a bank, even the repayment of the loan is to be charged

to service ta7J #ot really. First of all, because bank loans are not even included in

the definition of financial services. -nd two, because the splitting of interest and principal is defined in the banks loan agreement. (n case of hire purchase, the

splitting of interest and principal is an accounting ad=ustment, and is not

recognied in law as interest or principal. (n case of lease transactions, the lease

rental is surely the gross value for the leasing service.

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Lease Financing

So as it seems, leasing and hire purchase companies better pack up * since they

have to shell out a AH of their own principal, and AH of their income, to the

overnment before they can take up anything to their revenue account.

INCO2E TA 1RO0ISIONS RELATING TO LEASING5

The principal income*ta7 provisions relating to leasing are as follows:

/. The lessee can claim lease rentals as ta7*deductible e7penses.

9. The lease rentals received by the lessor are ta7able under the head of

N8rofits and ains

. of %usiness or 8rofession6

3. The lessor can claim investment allowance !this may be doubtful" and

depreciation on the

investment made in leased assets.

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LEASING IN RELATION TO ?AN 3INANCE

Bith both leasing and bank financing involving credit decisions and financial

risks, the key differences are that two additional factors apply to leasing

companies:

First, they have knowledge of the asset !and often the industry", and hence are

lending to some degree on an asset basis. This is different from collateral*based

lending, however, in that they are lending based on the ability of the asset to

contribute to cash flow !either to the lessee or in case of forced saleGliuidation".

%anks and other lenders tend to look at the balance sheet value of collateral.The second is that leasing companies are more sales and service orientedQthey

are using their specialied knowledge to Mbridge the gapP between suppliers and

purchasers, and the specialied knowledge of leasing companies may also give

them an advantage in disposing of the repossessed leased assets. Suppliers are

generally not specialists in finance or credit decisions, while lessees are not

specialists in finance or euipment acuisitionC leasing companies specialie in

finance, credit and euipment acuisition and disposal !euipment dealing". (n

effect, both the supplier and the lessee are MoutsourcingP certain portions of their

business to a service provider that also happens to have a certain capacity to

borrow and lend money.

The Di##erence between 3inancia Lea!ing an$ Loan!

From the lessee6s perspective, there is only one substantive difference between a

loan and a lease: with a loan, the asset belongs to the borrower, whereas with a

lease, the asset belongs to the lessor.

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The many similarities between a loan and a financial lease include:

R The lessee and borrower have the choice over the acuisition of the asset.

The borrower and lessee !providing the terms of the lease are met" would be

able to retain the asset once payments are complete.

R )ver the period of both a loan and a lease, interest and capital !euipment

cost" are repaid.

R Should there be default on either a loan or a lease, as long as the loan is secured,

both the lender and lessor have legal rights to reclaimGrepossess assets.

R The risks and costs of ownership, including maintenance and obsolescence,

remain with the borrower and lessee. -lso, under both a loan or a financial

lease, if the asset appreciates, neither the lender nor the lessor benefits.

R The agreements are non*cancelable until either the lessor or the lender has

recovered its outlay.

R The borrower or lessee can either settle the agreement !in the case of the

lease" or repay the loan early.

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1RO?LE2S O3 LEASING

Leasing has great potential in (ndia. ;owever, leasing in (ndia faces

serious handicaps which may mar its growth in future. The following are some of

the problems.

/. Unheathy Co*petition:

The market for leasing has not grown with the same pace as the number

of lessors. -s a result, there is over supply of lessors leading to competitor. Bith

the leasing business becoming more competitive, the margin of profit for lessors

has dropped from four to five percent to the present 9.A to 3 percent. %ank

subsidiaries and financial institutions have the competitive edge over the private

sector concerns because of cheap source of finance.

9. Lac> o# &ai#ie$ 1er!onne5

Leasing reuires ualified and e7perienced people at the helm of its

affairs. Leasing is a specialied business and persons constituting its top

management should have e7pertise in accounting, finance, legal and decision

areas. (n (ndia, the concept of leasing business is of recent one and hence it is

difficult to get right man to deal with leasing business. )n account of this,

operations of leasing business are bound to suffer.

3. Ta Con!i$eration!5

'ost people believe that lessees prefer leasing because of the ta7

benefits it offers. (n reality, it only transfersC the benefit i.e. the lessee6s ta7 shelter

is lessor6s burden. The lease becomes economically viable only when the

transfer6s effective ta7 rate is low. (n addition, ta7es like sales ta7, wealth ta7,

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additional ta7, surcharge etc. add to the cost of leasing. Thus leasing becomes

more e7pensive form of financing than conventional mode of finance such as hire

purchase.

?. Sta*p D&ty5

The states treat a leasing transaction as a sale for the purpose of making

them eligible to sales ta7. )n the contrary, for stamp duty, the transaction is

treated as a pure lease transaction. -ccordingly a heavy stamp duty is levied on

lease documents. This adds to the burden of leasing industry.

A. Deaye$ 1ay*ent an$ ?a$ Debt!5

The problem of delayed payment of rents and bad debts add to the

costs of lease. The lessor does not take into consideration this aspect while fi7ing

the rentals at the time of lease agreement. These problems would disturb prospects

of leasing business.

The c&rrent probe*! o# In$ian ea!ing co&$ be i!te$ a! #oow!'

again witho&t any or$er o# i!ting5

A!!et-iabiity *i!*atch5

'ost non*banking finance companies in (ndia had relied e7tensively on public

deposits *this was not a new development, as the +%( itself was constantly

encouraging and supporting the deposit*raising activities of #%F&s. (f the

resulting asset*liability mismatch, to everybodys agreement, is the surest culprit

of all #%F& woes today, it must have been a sudden realiation, because over all

these years, each

Documents

33548465 Lease Financing