Leasing Final 1

8/2/2019 Leasing Final 1

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MFS Management of financial services

LEASING (LEASE-FINANCING)DEFINITION

According to the Institute of Chartered Accountants of India, "a lease is an agreement

whereby the lessor conveys to the lessee, in return for rent, the right to use an asset for an

agreed period of time. Lessor is a person who conveys to another person (lessee) the right to

use an asset in consideration of a payment of periodical rental, under a lease agreement.

Lessee is a person who obtains from the lessor, the right to use the asset for a periodical

rental payment for an agreed period of time".

A financing arrangement that provides a firm with the advantage of using an asset

without owning it, may be termed as leasing .

CHARACTERISTICS OF LEASE

The following are the characteristics of a lease:

The Parties

There are two parties to a lease agreement. They are: the lessor and the lessee. Lessor

is a person who conveys to another person (lessee) the right to use an asset in consideration

of a periodical rental payment, under a lease agreement. Lessee is a person who obtains, the

right to use the asset from the lessor for a periodical rental payment for an agreed period of

time.

The Asset

Leasing is used for financing the use of fixed assets of high value. The asset is the

property to be leased out. It may include an automobile, an aircraft, plant & machinery, a

building, etc. However, the ownership of the asset is separated from the use of the asset.

During the period of the lease, the ownership of the asset rests with the lessor, while the useis transferred to the lessee.

The Term

The term of the lease is called. the lease period. It is the period for which the lease

agreement is in operation. It is illegal to have a lease without a specified term. However, in

India, perpetual lease is in operation, where the lease period is for an indefinite period of

time. On expiry of the lease period, the asset reverts to the lessor mentioned in the 'operating

lease'. In the case of a financial lease, the lease period is in consonance with the economic life

of the asset, so 14at the lessee is given the advantage of exclusive Use throughout its useful

period.Sometimes, the lease period may be broken into primary lease period and secondary

lease period. A primary lease period is a period during which the lessor wants to get back the

investment together with interest. A secondary period comprises the latter part of the lease

period, where only nominal rentals are charged in order to keep the lease agreement

operational.

The Lease Rentals

Lease rentals constitute the consideration payable by the lessee as specified in the

lease transaction. Rentals are determined to cover such costs as interest on the lessor'sinvestment, cost. of any repairs and maintenance that are part of the lease package,

depreciation ~n the leased asset and any other service charges in connection with the lease ..


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TYPES OF LEASE

Lease is of different types. They are discussed below:

Financial LeaseA financial lease, also called 'capital lease', is a contract involving payment over an

obligatory period of specified sums sufficient in total to amortize the capital outlay, besides

giving some profit to the lessor .

According to the International Accounting Standard (IAS) No.17, "a financial lease is

a lease that transfers substantially all the risks and rewards incident to ownership of an asset.

Title mayor may not eventually be transferred.

According to the Institute of Chartered Accountants of India, "financial lease is a

lease under which the present value of the minimum lease payments at the inception of the

lease exceeds or is equal to substantially the whole of the fair value of the leased asset."

A financial lease is non-cancelable in nature. The lessee is responsible for the

maintenance of the asset leased. The lease generally provides for the renewal of the lease on

expiry of the lease contract.

Variants of financial lease include full payout lease and true lease.

Full payout lease In this type of lease, the lessor recovers the full value of the leased

asset, within the period of the lease, by way of lease rentals and the residual value.

According to the US Controller of Currency, " a full pay-out lease is one from which

the lessor can reasonably expect to realize a return of its full investment in the leased

property plus the estimated cost of financing the property over the term of the lease

from the sources such as rentals, estimated tax benefits and the estimated residual

value of the property at the expiration of the initial term of the lease. It could be

considered a typical financial lease; as within the first lease period, the asset leased

out fully pay-off its' value, in addition to yielding the lessor, a desired return on

investments."

True lease In this type of lease, the typical tax-related benefits, such as investment tax

credit, depreciation tax shields, etc are offered to the lessor.

Operating Lease

An operating lease is any other type of lease whereby the asset is not fully amortized

during the non cancelable period of the lease, and where the lessor does not rely on the leaserentals for profits. It is basically an economic service. It is a short-term lease on a period-to-

period basis, the period of lease being less than the useful life of the asset.

The lease is cancelable at short-notice by the lessee. The lessee has the option of

renewing the lease after the expiry of the lease period. It is the responsibility of the lessor to

ensure maintenance, 'insurannce, etc of the asset, which is chargeable by the lessor. It is a

high-risk lease to the lessor, since it could be cancelled at any time.

Net lease: A variant of operating lease is net lease. A type of lease where the lessor is

not concerned with the repairs and maintenance of the leased asset is known as 'net

lease'. The only function of the lessor is to provide a financial service. According tothe V.S. Controller of Currency, "a net lease is one in which the lessor will not


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provide, directly or indirectly or be obligated to provide any of the following:

The servicing, repair or maintenance of the lease property during the lease

term The purchasing of parts and accessories for the lease property

The loan of a replacement or substitute while the lease property is being

serviced The purchasing of insurance for the lessee, except where the lessee has failed

in its contractual obligation to purchase or maintain the required insurance

The renewal of any license or registration for the property unless such action

is clearly necessary to protect the interest of the lessor"

Conveyance type Lease

It is a very long tenure lease applicable to immovable properties. The intention of the

lease is to convey title in property. Such .leases are entered into for periods which may be as

long as 99 years or 999 years.

Leveraged Lease

When a part or whole of the financial requirement involved in a lease are arranged

with the help of a financier, it takes the form of leveraged lease. This type of 1ease is resorted

to in cases where the value of the leased asset is very high. In this type of lease, the lessor,

who is also a financier, involves one more financier, who may hold a charge over the leased

asset, over and above a part of the lease rentals.

Sale and Leaseback

Under this type of lease, the owner of an asset sells it to the lessor, and gets the asset

back under the lease agreement. The ownership of the asset changes hands from the original

owner to the lessor, who i n turn leases out the asset, back to the original owner. This paper

exchange of title has the effect of providing immediate free finance to the selling company,

the lessee. This transaction also helps the release of funds tied up in that particular asset.

Partial Pay-out Lease

It is a type of lease whereby the lessor obtains full payment of the lease in several

leases. This broadly falls under the category of operating lease.

Consumer Leasing

Leasing of consumer durables such as televisions, refrigerators, etc, is called

consumer leasing. It has assumed popularity with the rapid increase in the quantum of

consumer credit. According to the VS Controller of Currency, "Consumer lease is a contract

in the form of a lease or bailment for the use of personal property by a natural person for a

period of time exceeding four months, and for a total contractual obligation not exceeding $

25,000, primarily for personal, family, or household purposes, whether or not the lessee has

the option to purchase or otherwise become the owner of the property at the expiration of the

lease, except that such term shall not include any credit sales."

Balloon Lease

A type of lease, which has zero residual value at the end of the lease period, is called

'balloon lease'. It also means a kind of a lease where the lease rentals are low at the inception,


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high during the mid years, and low again during the end of the lease.

Close-end Leasing

A leasing arrangement whereby the asset leased out is reverted to the lessor is known

as 'close-end leasing'. It is also called 'walk-away' lease.

Open-end Leasing

A term commonly used in automobile leasing in the USA, it means a lease agreement

where the lessee guarantees that the lessor will realize a minimum value from the sale of the

asset at the end of the lease period.

Under this arrangement, if the asset's residual value fetches less price than agreed, the

lessee pays the difference to the lessor. In the same manner, where the asset's residual value

fetches more than the value agreed, the lessor pays the excess to the lessee. It is so called

because the lessee does not know the actual cost of the asset until it is sold at the end of the

lease.

Swap Leasing

In swap leasing, the lessee is allowed to exchange equipment leased out whenever the

original asset has to be sent to the lessor for some repair Or maintenance.

Wrap Leasing

When the lessee further sub-leases the asset to the end-user, retaining a fee and a

share of the residual value, it is called wrap leasing. Normally, the term of the first lease is

longer than the second, in order to maximize the first lessor's tax deductions. It is so called

because the first lease wraps the second lease.

Import Leasing

The leasing of imported capital goods is known as 'import leasing'. It is beneficial to

the lessee because arranging any other source of funding may take a long time, during which

the prices of the importable item, as also the rates of exchange, may change. Moreover,

lenders don't usually finance the import ,duty, which forms a sizable part of the acquisition of

such items.

Special proceduresFollowing are the special procedures for import leasing under the

Export-Import Policy of 1990-93, and the handbook of procedures:

a.Permission Import leasing is allowed only where specific permission of theauthorities is obtained

b.HPforms The leasing company may also relinquish its rights in favor of the actualuser, the lessee, with the approval of the concerned licensing authority. This

means that financing of imports on the basis of hire purchase agreements is

also possible. These hire purchase agreements may be worded as lease

agreements coupled with an option to buy. Permission of the licensing

authority for relinquishing the lessor's right may be obtained while applying

for the joint license.

c.ConditionsThe conditions to be satisfied by the leasing company are as follows:

Provision in the Memorandum of Association, with leasing as one of the objectivesMinimum issued and paid up capital of the company should be Rs.1 crore.


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The company's shares must be listed in a recognized stock exchange

d.Endorsement. Endorsement of the import license is required, thus making the

leasing companies joint holders of the import licence

e.ComplianceBoth the lessor and the lessee are jointly liable for compliance of the

terms and conditions of the licence.f.FTZsIf leasing of assets i6 to be done to units located in free trade zones, necessary

permission from the Board of approvals in the concerned zone shall be

obtained

g.Consent letterFiling a consent letter duly signed both by the lessor and the lessee,

accompanied by a copy of the lease agreement must be provided to the

regional licensing authorities

Cross-border Leasing

A type of lease where the lessor in one country leases out assets to a lessee to another

country, is known as cross-border leasing. The jurisdictions of lessors and lessees are in twodifferent countries. Cross-border leasing originated in the 1970s in the US. Financial

institutions in the US, leased out, big assets, such as airplanes, etc to the lessees outside USA.

The intention was to skim the benefits of income tax and depreciation with a view to reduce

financial cost to the lessees.

Double-dip

According to the concept of double-dip, it is possible to have the advantage of

depreciation tax benefits twice, depending on the prevalence of differing tax laws in two

different countries. For instance, the lessor in India leases out an asset to a lessee in USA.

Assuming that the tax laws of India do not differentiate between true leases and tax-oriented

leases, it is considered a financial lease, where risk and rewards are transferred, to the lessee.

In this case, capital allowances (depreciation tax benefits) are granted to the Indian lessor.

Similarly, the lessee in USA under the said lease, may be considered for granting

depreciation tax allowances upon the. satisfaction of certain conditions which may be

provided for capital lease.

Triple-dip

Where the benefit of depreciation tax allowances is available in three different

jurisdictions for a single asset leased out, it is a case of triple-dip. Accordingly, benefits are

available for hire purchase, true lease, and capital lease.

Japanese Cross-border Leasing

The Japanese leasing falls broadly under three categories, namely samurai leasing,

shogun leasing and mushashi leasing. A 'Samurai Lease' was encouraged by the

government of Japan with the intention of reducing the huge surplus in the balance of

payments enjoyed by Japan. Samurai lease was intended for the acquisition of large value

items such as aircrafts, etc through cheap foreign currency loans provided by the Export-

lmport bank of Japan. Exemptions were given from the Foreign Exchange and Trade Laws of

Japan for such leases.

In the year 1980 a Yen-dominated 'Shogun Lease'was brought into use with theamendment of the Foreign Exchange and Trade Laws of Japan. Accordingly, Japanese


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leasing companies were allowed to lease or sell equipment located outside Japan to non-

residents. The 'Mushashi Lease', which was basically leasing in foreign currency, was also

popular in Japan.

International Leasing

When a leasing company operates in different countries through its branches, it is acase of international leasing. International leasing is active in countries such as US, Japan and

Hong Kong. 'US Leasing lnternational' started the first international leasing company in the

year 1959, in Canada. The single most important problem faced by international leasing

companies is that they have to face draconian provisions in foreign exchange laws prevailing

in the respective countries.

FINANCIAL LEASE Vs OPERATING LEASEFinancial lease is different from operating lease in the following manner:

SI.

No

Characteristic

s Financial lease Operating Lease

I SpecificityThe asset leased out is use-

specific for the

The asset leased out may

be used

lesseecommonly by a number of

users in

sequence

2Ownership

Risks

The lessee bears the risks and

rewards

The risks and rewards

associated with

associated with the use of the

asset leased;

the use of the asset leased

is borne by

the lessor is simply the legalowner of the

the lessor, and the lessee issimply

asset provided with the use of

the asset for

a certain period time

3 ObsolescenceThe lessee bears the risks of

obsolescenceThe

less

or

bear

s

th

e

ris

ksof

Riskobsolesce

nce

4 CancelabilityThe lease cannot be cancelled by

either of

The lease can be cancelled at

the

the parties. The lessor is ratherinterested in

option of the lessee and thelessor

rentals and not in the assetdoes not have the difficulty

of leasing

the same asset to other

willing lessees

5 Lease PeriodThe lease period usually

coincides with the

Lease period is generally

small, as the

life of the asset, and may be

broken into

lessor intends to lease the

same asset

primary and secondary period several times to varioususers


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6

.

Mainten

ance

The cost of repairs and

maintenance are

The cost of repairs and

maintenance

borne by the lessee; the lessor is

merely a

'are borne by the

lessor'

financier in the deal

7Lessor's

Service

As the lessor is just a financial

institution,

The lessor is specialized in

handling

it does not render any

specialized service in

and operating the particular

asset and.

connection with the leaseusually provides specialized

services

8 Pay-outIt is a full pay-out lease,. where a

single

. It is usually a non-payout

lease, as

lease repays the cost of the asset,

together

. the lessor is in the business

of leasing

with the interestthe asset to various usersseveral times.

TEST FOR FINANCIAL LEASE

In order to determine whether or not a lease is a financial lease, the following tests

can be employed:

Substance Test

According to the substance test, to constitute a financial lease, all the benefits and the

risks of the lease must be available, to the lessee. The various benefits include the right of useof the asset, right to exclusively enjoy any appreciation in the value of the asset, right to

prohibit anybody else from using the asset or sharing the benefits of appreciation, right to

claim damages or any other chargers from the supplier, etc. Similarly, the lessee must be

exposed to various risks, such as loss due to idle capacity, technological obsolescence, loss

due to damage in transit, liability to pay any taxes attached to ownership of the asset, etc.

Full Payment Test

If the lessor recovers the whole of the asset cost together with interest, the lease is

regarded as a financial lease. Similarly, if the minimums lease payments, together with

covenanted residual value payback is 90 percent or more of the asset cost,it

constitutes afinancial lease to the lessee.

Transfer of Title Test

When the lessee has an option to buy or sell the asset leased, it constitutes a financial

lease. The lessee is absolved of the duty of returning the asset to the lessor.

Lease Term Test

If the lessee is allowed to exhaust the asset to junk, the lessee shall be considered the

beneficial owner of the asset, and this test is sufficient to constitute a financial lease for the

lessee. In other words, if the lease term extends to the whole, or substantively the whole of

the asset's economic life, i.e quantitatively 75 percent or more, the lease is taken as a financial

lease.


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MYTHS ABOUT LEASING

Although leasing is believed to be the most beneficial form of financing, there are

several myths surrounding it. They are as follows:

100% Financing

A commonly held opinion is that leasing provides 100 percent financing, without

having to borrow. Although it is true that leasing enables avoidance of acquisition of the

asset, there is an incursion of liability by way of a periodical payment of lease rentals.

Off-balance Sheet Financing

As against borrowing which gets shown as a liability with its resultant effect on thedebt-equity ratio, the leasing liability need not be shown in the balance sheet. This is

supposed to keep the debt-raising capacity of the firm intact, though this is not quite true. The

debt-raising ability of a firm is dependent upon its ability to service its debt, and not on the

balance sheet ratios and their interpretations.

In fact, the contractual obligations under both borrowing and leasing remain in tact

through interest all lease rentals. Hence, both the options add to financial risks. Therefore, to

say that leasing is a better option, in that it does not require to be shown in-the balance sheet

is not tenable.

Better Performance

Another commonly held view is that leasing helps improve the financial performance

of a firm. This is because; it is possible to enhance the ROI with less asset base. Such ratios,

which are the result of accounting adjustments, are illusory in reality. A lease transaction is

capable of creating wealth for the firm, only if it yields a positive NPY.

No Evaluation

It is believed that leasing does not require to be included in any capital expenditure

evaluation, since there are no capital investments involved. This argument defies logic,

because leasing, like a buying decision, needs to be examined carefully of cash flow

consequences in order to determine the possible advantages of it. In the absence of any

screening, the decision to accept leasing might expose the firm to business fluctuations, and

endanger its very survival.

PARTICIPANTS

There are a number of players present in the leasing industry. A brief discussion of

these players is presented below:

Lessors

There are different kinds of lessors. They are specialized leasing companies, one-offlessors, manufacturer lessor, banks-sponsored leasing companies, financial institutions, in-


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house lessors, etc.

o Specialized leasing companies specialize in the business of leasing assets.

They target their clients through advertisement, etc. The volume of business

transacted by them is huge. They command a massive build-up of capital

strength and expand their business operations through grand alliances and tie-ups. One-off lessors are those companies which come to the leasing business

for the purpose of availing the advantage of huge depreciation and tax

benefits.

o Manufacturer-lessors are those who are in the field of manufacturing capital

assets, that are available for leasing. IBM, and United Shoe Machinery

Corporation, US are some of the pioneering manufacturing companies which

have ventured into the business of leasing.

o Banks-sponsored leasing companies are those which operate as subsidiaries

of the banks, and have been established for the purpose of undertaking the

leasing business. For instance, under the provisions of the Banking

Regulations (Amendment) Act, 1984 banks in India have been permitted to set

up their own associates for carrying out the leasing business.

o Financial institutions constitute another important segment of the leasing

business. In India, institutions such as ICICI, etc provide leasing services.

Lessees

The lessees constitute a wide range of companies, from blue chip companies to small

units, which avail the financial services from the lessor companies. The considerations for,

and the conditions under which, such companies operate vary. A characteristic of the Indian

lessees is that most of them belong to the private sector,

Lease Brokers

Lease brokers are the intermediaries between the lessors and lessees who help find a

suitable lessor for a prospective lessee and vice versa. Armed with information and rapport,

lease brokers help both lessors and lessees with financial advantage through tough

negotiations and by providing a wider choice.

Lease F inanciers

Lease financiers are, banking institutions which provide financial assistance to lessors

for the purpose of acquiring the assets that are to be leased. Such assistance is usually securedby the hypothecation of the leased asset, and also by the assignment of lease rentals.

THE LEASING PROCESS

The process of leasing takes the following steps:

Lease Selection

The first step in a leasing transaction is the selection of the asset to be taken out on

lease basis. The lessee does this by giving due consideration to various requirements such as,

lease payments and other factors. The lessee then approaches the leasing company or the

lease broking company for the purpose of finalizing the lease deal. A lease agreement is

broadly negotiated.


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Order & D elivery

Based on the selection made by the lessee, the lessor goes about placing an order for

the manufacture of the asset to be leased. The manufacturer delivers the asset at the site of the

lessee who; in turn, gives a notice of acceptance to the lessor.

Lease ContractBoth the parties sign a lease agreement setting out the details of the terms of the lease

contract. Leases will normally be full payout, with varying terms and conditions. The usual

lease period ranges from 3 to 5 years.

Lease Period

During the currency of the lease period, the lessee will make lease payment at regular

intervals, as agreed upon between the parties. The lessee will ensure the proper upkeep and

maintenance of the asset leased.

In addition, the lessee will also be entitled to warranties and after-sales services from

the lessor. At the end of the lease period, the lessee may either renew the lease OT terminate

the lease, and retreat the asset to the lessor, or may even acquire the asset from the lessor.

However, it is to be noted that there is no possibility of the lessee being given the purchase

option in the lease agreement itself.

SERVICES OF LESSOR

The lessor renders the following services to the benefit of the lessee:

Provision of Credit Facility

One of the most important functions of a lessor is granting credit facility to enable the

lessee to acquire the use of the asset, by permitting the lessees to avoid paying the full

purchase price of the asset. Lessees, instead, amortize this debt by instalments of rental

payments. The rentals charged by the lessor include the cost of the asset and interest charges.

Absorbing Obsolescence Risks

In the case of a non-cancelable financial lease, t)1e risk of obsolescence arising out of

the usage of the asset has to be borne by the lessee. However, in the case of a non-cancel able

operating lease, the lessor provides the advantage of 30 days time for cancellation of the lease

by the lessee, which should enable the lessee to acquire a new asset to cope with the change

in technology. In this case, the lessor will collect certain" amount of compensation from the

lessee by way of premium, which is added to the periodical lease rentals.

Comprehensive Package \The lessor usually undertakes to provide a package of services, or pay for services

such as general maintenance, wealth tax and accounting etc to the lessee. This way, the lessor

saves the lessee from having to deal with each piecemeal payment.

ADVANTAGES OF LEASING

Leasing as a financial service offers the following potential advantages both to the

lessor and lessee:

Advantages to Lessor

1. Stable business Leasing mechanism provides for a continuous and stablemanufacturing business for the lessor. The business is supported by the lessee's continued


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patronage, since there is no necessity for capital investment outlay. It is possible for the

lessee to acquire the asset even in times of depression, thus contributing to the growth of the

manufacturer's sales, even in times of depression.

2. Wider distributionLeasing allows for capturing a wider distribution network by the

lessor. This assumes significance given the fact that the lessees do not have to allocate fundsfor heavy capital investments.

3.Sale of suppliesDepending on the nature of the leasing arrangement, the lessor has

to ensure the supply of spare parts and components required for the maintenance of the asset

leased. This would augment the sale by the lessor-manufacturer.

4.Second-hand marketIn the case of operating lease, where the asset leased by thelessee is reverted to the lessor, it is possible for the lessor to either lease out the asset again,

or to sell it in the open market. This creates a second-hand market for the used asset.

5. Tax benefits There is relative tax benefit for the receipt of lease rentals. For

instance, sales tax payable on lease rentals is lower than the direct tax payable on revenue

receipts on the sale of the asset. This enables the manufacturer-lessor to supply products at

highly competitive rates. In addition, the lessor-owner of the asset can also claim depreciation

tax benefits on assets let out on lease. This provides a better tax planning opportunity to the

lessor ..

6. Absorbing obsolescence risks In the case of a non-cancelable financial lease, the

risk of obsolescence arising from the usage of the asset has to be borne by the lessee. In the

same way, the cancelable nature of operating lease enables the lessor to cancel the lease and

acquire a new asset for further lease. In addition, the lessor charges a premium on the lease

rentals.

7. Fillip to capital marketLeasing companies, as intermediaries of finance, give animpetus to 'investment activity, and facilitate the flow of savings into real investments. By

reducing the terms on which finance. is provided, lessors encourage an accelerated rate of

real investment. This way, leasing companies contr4bute to the growth and development of

the capital market.

8. Easy finance The availability of easy and convenient finance has proved to be a

great stimulant for the increase in demand for capital equipment. This in turn boosts the

manufacture and sales of the leasing companies.

9. Other benefits In addition to the benefits discussed above, the lessor commands

some of the following benefits too: Advantage of collateral security on the lease payments by the lessee

Offers a high growth potential, even in times of general depression

High return on equity because of better leveraging

Ability to accept public deposits, and contribute to better financial resources

Advantages to Lessee

1. Efficient use of funds Leasing arrangements allow the lessee to acquire the use of

the asset without having to own it. This dispenses with the need for capital investment. This

also enables the lessee to make efficient use of the available financial resources. This way,

more funds are released for working capital purposes. In addition, the conservation of cashoutflow also contributes to the profitability of the firm.


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2. Cheaper source Leasing, as a mode of financing the use of capital assets, is found

to be less expensive, as compared to other modes such as the buying option, etc.

3. Flexible source . Leasing of equipment is a highly flexible source of financing, as

compared to other methods. The flexible nature of the lease contract allows for promotion of

the mutual interest of the parties, especially of the lessee. This is because it is alwayspossible for a leasing plan to be tailor-made to suit the requirements of the lessee. However,

the extent of flexibility of the lease depends on its financing structure.

4. Enhanced borrowing capacity Leasing is considered advantageous to the lessee

since ithelps enhance the ability to borrow in a diversified way. This is possible because thelessor's credit rating of the lessee is less stringent. Besides, owing to the advantage of lower

debt-equity ratio, lease financing allows for a mix of financing methods rather than re1ying

on one source.'

5. Off-balance sheet financingThe biggest advantage claimed by lease financing is

that the asset acquired, and the corresponding liability, need not be shown in the balancesheet. This helps keep the debt-equity ratio of the lessee either intact or low, thus contributing

to an improved ROJ. This is possible because there is an increase in operating income,

without any increase in net block.

6. Tax benefits The extent of benefit that would be derived by owning an asset, by

way of depreciation tax shield is less than the benefit to the lessee by way of lease rentals.

This is because depreciation tax shield is less than lease rentals. Moreover, lease rentals are

fully tax-deductible. Further, this will help amortize the cost of the asset in the books of the

lessee in a much shorter period. This also enables the lessee to write off more amounts in the

initial years, which eventually makes it possible to postpone taxes to the latter years.

Similarly, the lease on land permits the lessee to write-off land values against taxable income,

which is not otherwise permissible under income tax rules.

7. Favorable terms The terms of financial arrangements with institutions are usually

restrictive and disadvantageous to loanees. Lease arrangements allow the use of the asset on

favorable terms.

8. Guards against obsolescence In the case of operating lease, the lessee can be

protected from the risk of obsolescence of the asset leased, since it is always possible for the

lessee to terminate the existing lease arrangement anytime, and to take up another asset under

a fresh lease. This becomes all the more significant in the context of rapid technological

changes.

9. A voidance of initial cash outlay Leasing provides 100 percent financing and the

benefit of using the finances without having to borrow. The initial investment required is thus

avoided in a leasing arrangement.

10. Better liquidity 'Sale and Lease-back' arrangements provide the advantage of

better liquidity, since it enables the lessee to make a sale of the asset owned to the prospective

lessor, and then take the asset back on lease. This helps a lessee-firm to overcome a liquidity

crunch by being in a position to sell and realize cash. This helps overcome working capital

crises.

11. Other benefits


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Avoidance of applicability of the provisions of FEMA

Lease rentals are permissible for reimbursement, even under government

contracts

Provision of long-term finance without diluting ownership control

Leasing avoids complex decisions relating to capital budgeting exercises,especiaIly in the context of government companies, where capital budgeting is

quite cumbersome

No trouble in the disposal of the used asset by the user-lessee, since the asset

reverts to the lessor on expiry of the lease contract

Efficient mode of financing which allows piecemeal acquisition of small

equipments

No disturbance to the normal lines of credit

Easy and convenient payment of lease rentals, which is unaffected even during

the inflation periods. An ideal mode of asset acquisition, especially for non-profit organizations

such as hospitals, which are continuously confronted with the budget

constraints

LIMITATIONS OF LEASE FINANCING

Although leasing is claimed to be possessing certain overriding advantages over the

traditional buy-and-use m04e of financing, it is fraught with various limitations as discussed

below:

Disguised Debt FinancingEvidence has been gained through studies that lease financing is another form of debt

financing. In fact, it is considered to be a disguised form of debt financing. It essentially

involves borrowing of an asset, instead of funds. Moreover, the obligations of leasing are

similar to those incurred under debt financing. In a survey conducted in the US in 1959, it has

been found that leasing was an intermediate between secured and unsecured debt.

Costly Option

When the leasing company acts only as a financial intermediary, and borrows from

the market at prevailing or even higher interest rates, leasing may prove to be a costlier

exercise as compared with a straight borrowing. Loss of Tax Shield

If depreciation rates are higher, and leasing is preferred over buying, it may result in

loss of depreciation tax shield for the lessee.

Double Sales-tax

Depending on the prevailing sales tax laws in various states, there are possibilities of

the lease rental revenues attracting sales tax twice, once at the time of the sale and again

when the asset is leased out.

Loss of Residual Value

There is a loss of residual value for the lessee, since the leased asset has to be returnedto the lessor at the end of the lease period. If the residual value of the leased asset fetches a


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substantial amount of scrap, it would bring the advantages of cash flow. Moreover, sale of

residue sometimes acts as a protective shield against inflationary erosion of money.

Unfavorable Gearing

Like any other borrowing, leasing also creates fixed obligations. This results in an

increase in the capital gearing of the company. This might be disadvantageous to theborrowing capacity of the company.

No Ownership

Unfortunately leasing does not provide the advantage of ownership to the users. This

is not suitable especially for those who would not be satisfied merely with the right of usage,

as against the right of ownership, of the asset.

Risk of Default

If the lessor has borrowed funds in hypothecation in order to acquire the asset for

being leased out and if there is a default in the repayment of instalments, the asset may be

taken over by the financial institution. This might hamper the interest of the lessee and

ultimately affect business.

No Working Capital

Leasing provides a mechanism only for long-term capital requirements. It fails to

provide access to much needed working capital finance.

Indiscriminate Finance

Lease companies provide lease financial assistance to the lessee, sometimes too

enthusiastically, without considering their requirements, project feasibility, repayment

capability, etc. This attitude of indiscriminate financing defeats the genuine object of leasing.

Long-term Venture

The lessor is in a relatively disadvantageous position, since funds are required to be

invested for a longer term. It naturally takes years to recover the original cost of the assets

that are leased out, which in turn exposes the lessor to various types of risks.

TAX ASPECTS OF LEASING

Lease transactions have implications under both the Income Tax Act as well as Sales

Tax Act. The various tax aspects of leasing are detailed below:

Income Tax Implications

Leasing, as a finance function, has implications for income tax purposes. It is a deviceoffering potential tax benefits to both the lessor and the lessee. Leasing arrangements provide

for a significant scope for tax exemption or, reduction/deferring of tax liability, and the

possibility of sharing tax savings in the event of heavy tax incidence. In fact, leasing serves as

an instrument by which it is possible to conveniently transfer the benefits of tax incentives

from the purchaser-owner (lessor) to the user (lessee) of the asset/equipment.~

IMPLICATIONS FOR LESSOR-DEPRECIATION TAXSHIELD

The lessor can use depreciation allowances as tax shield. Accordingly, the lessor can

deduct the amount of depreciation on leased assets from the taxable income. This results in

reduction of the tax liability, thus making available more profits for distribution to equityshareholders.


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The various provisions relating to depreciation allowance are detailed below:

1. The purpose The provision for depreciation is to be made under the rules and

provisions prescribed under the Companies Act for accounting purposes, and by the Income

Tax Act for taxation purposes. Under the Companies Act, depreciation is provided for the

purpose of computation of managerial remuneration, dividend payment and disclosure infinancial statements.

2. The ratesLeasing companies in India are expected to provide depreciation in the

book of accounts in accordance with Section XIV of the Companies Act For" this purpose,

separate rates of depreciation are prescribed for various types of depreciable assets, both on

Written Down Value (WDV) basis as well as on Straight-line basis. The Act also permits

leasing companies to adopt any other method of depreciating the asset as maybe approved by

the Central Government from time to time, which has the effect of writing-off 95 percent of

the original cost of the asset on expiry of the specified period. For the purpose of availing the

benefits of tax deductibility and tax: incentives, leasing companies in India invariably follow

the rates and methods as prescribed under the Income Tax Act.

Block-wise rates are used for computing depreciation using only the Written down

Value (WDV) method. Accordingly, the relevant rates are asfollows: 25%, 40% and 100% for plant and machinery, depending on the value and

usage

10% on office buildings, furniture and fittings

If the actual cost of plant and machinery does not exceed Rs.5,OOO; the entire

cost is allowed to be written-off in the first year of its use

If an acquired asset has been used for a period of less than 180 days during the

year, depreciation on such assets is allowed only at 50 percent of the computed

depreciation according to the relevant rate

3. ConditionsFor leasing companies to avail the depreciation allowances under theIncome Tax Act, the following conditions are to be satisfied in accordance with Section 32:

The asset is owned by the lessor-leasing company-assessee

The asset is used by the assessee for the purpose of business

The asset is in the form of buildings, furniture, machinery and plants including

ships, vehicles, books. scientific apparatus and surgical equipments, etc

4. Lessor's ownershipThe lessor is eligible to claim the benefit of depreciation tax-

shield as the legitimate owner of the asset leased, although the section does not explicitly

provide for claims of depreciation allowance on leased assets by a lessor. In fact, the lessor's

ownership has been decided very clearly through rulings by courts and appellate tribunals.

5. Other allowancesThe lessor is not eligible for any other allowances apart from the

depreciation allowance. Hence, the lessor will not be eligible for any tax shield relating to

investment allowance. Moreover, it is not possible for the lessor to take advantage of higher

transfer value of the asset, acquired under the sale-and lease-back arrangement, with a view

to minimize tax liability. Such a claim may be disputed by the income tax authorities.

6. Sale and leaseback With regard to asset acquired under the sale and leaseback

arrangement, depreciation allowance can be claimed only on the book value, and not on theinflated/revalued amount of the asset. This took effect from 1996-97.


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7. Fractional depreciationWhen a syndicate of leasing companies owns the leased

asset jointly, there is no possibility of fractional depreciation (each syndicate member

availing the depreciation allowance in proportion to their share of investment). The option

open to such leasing companies is to form an association of persons for the purpose of

income tax assessment. The association, as a separate entity of persons, is eligible to claimdepreciation shield. However, with effect from 1996-1997, leasing companies are permitted

to avail of fractional depreciation to the extent of their participation in the syndicated

arrangement/consortium.

8. Amount of depreciationThe annual depreciation amount will be determined on the

basis of the actual cost of the asset, and its Classification in the relevant block of assets. The

actual cost of the asset refers to the purchase price of the asset plus the incidental charges that

are necessary to put the asset in a usable state.

Examples of such asset includes freight and carriage inwards, installation charges,

expenses that are incurred to facilitate the use of the asset such as expenses on the training of

operators or on essential construction work. Relevant block of assets is the group of assets

falling within.. a certain class of assets, such as building, machinery, plant or furniture, for

which the same rate of depreciation is prescribed.

9. Capital gain/lossWhen the sale of a categorized block of assets takes place, the

terminal depreciation, or balancing charge, cannot be treated as capital gain. Instead, capital

gains will occur only under the following situations:

a.Where the sale proceeds exceed the WDV of the whole block

b.Where the entire block is sold out

c. Where the assets are 100 percent depreciable

10. Inadequate profitsIn the event of profits being inadequate or absent, depreciationwill go unabsorbed. In such a case, the unabsorbed depreciation can be set-off against any

business income; as a case of unabsorbed loss. It is possible to carry forward such

depreciation without time limit. For the purpose of such carry forward, a maximum period of

eight years is allowed, with effect from 1996-97. The un absorbed depreciation, however,

cannot be assigned/transferred/claimed by the transfer of business. ,

11. MATUnder the provisions of Minimum Value Added Tax (MAT) introduced in.

the 1996-97 budget, corporates had to pay a tax @ 12.5 percent on book profits. This was,

however, replaced by the Minimum Advance Alternative Tax (MAAT) in the 1997-98

budget.

12. Lessors incomeThe relevant provisions, as applicable to the computation of the

lessor's income under the Income Tax Act are summarized below:

Lease incomeLease rental income is taxable under the head 'Profits and Gains of

Business and Profession', where leasing constitutes the lessor's (leasing company)

main activity. In all other cases, lease rental income will be taxable under the

head' Income from Other Sources'

Allowable expensesThe following expenses are allowed for deduction for the

purpose of determining the taxable income of the leasing company:

Depreciation, rent, rates, taxes, repairs and insurance of the leased asset where

such expenditure is borne by the lessor .


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Amortization of certain preliminary expenses such as expenditure for

preparation of project report, feasibility report, market survey, etc .

Legal charges for drafting/printing of memorandum of association and articles

of association, registration expenses, public issue expenses, other than on

debentures and loans, subject to maximum of 2.5 percent of the cost of theproject/capital employed, allowable in 10 equal instalments

Interest on borrowed capital .

Bad debts

All expenses incurred in improving trade/business Entertainment expenses

subject to prescribed limits

Travel expenses on the basis of approved norms

IMPLICATIONS FOR LESSEE

The relevant tax implications of leasing for the lessee ~re detailed below: Allowability of lease Rentals

Under the Income Tax Act, lease rentals are allowed as a normal business expenditure

of the lessee for assessment purposes. For this purpose, the payment of lease rental should be:

In the nature of revenue

Not a personal expense .

Wholly and exclusively related to business purposes of the assessee (lessee)

Deduction of Incidental Expenses

The various incidental expenses, such as repairs and maintenance, insurance, finance

charge and so on, that are incurred by the lessee as part of maintenance of the leased asset areallowed for deduction from taxable income of the lessee by the Income Tax Act. Similarly, it

is possible for the lessee to claim expenses on the installation of equipment for calculating

taxable income. Such expenses need not be capitalized, since the ownership of the asset is not

vested in the lessee-assessee.

TAX PLANNING ASPECTS

Leasing comes handy for both for the lessor and the lessee and helps them plan and

save taxes. The various tax planning implications of lessor and the lessee are detailed below:

For the LessorThe deductibility of depreciation in the computation of the taxable income is the main

source of tax saving.

For the Lessee

It is the lease rentals that offer the advantage of tax shield. The lessee can use lease

rental deduction as a tax planning instrument either by way of flexible structuring of

lease rentals or by way of transfer of unabsorbed capital to the lessor.

Flexiblestructuring o flease rentalsIt is possible for the lessee to reduce his current or

future tax liability through flexible structuring of lease rentals. This is possible by

structuring a lease package such that a large part of the lease rentals would becomepayable in the first year, when the expected cash flow will be higher, thus reducing


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tax liability and a very small fraction becomes payable during the remaining lease

term. This would be matched with a low volume of cash flows, thus reducing the tax

liability again. Such an arrangement is always subject to approval by the income tax

authorities.

Transferof unabsorbed capitalIt is possible for the lessee to transfer investment-related unabsorbed tax shield to the lessor for absorption. This facility is available to a

lessee who enjoys 100 percent deduction of income for tax, by way of income from

exports, tax shield on fresh capital investment, etc. For such lessees, investment

related tax shields would be of no use, as that would not have any impact on its cash

flows. Instead, if the investment related tax shields could be transferred to a lessor, it

is quite possible to expect that the lessor will pass on the counter benefit to the lessee

in the form of reduced lease rentals, which will in turn enhance the operating cash

flows of the lessee.

FINANCIAL IMPLICATIONS

Lease transactions would have accounting and financial implications for both the

lessors and the lessees as detailed below:

a. For Lessee

Tax shield on lease rentals is available as business expenditure

Depreciation tax shield is not available

Tax shield on lease rentals represents a cash inflow

Tax shield on depreciation represents cash outflow (cash inflow foregone)b. For Lessor

Depreciation tax shield is available

Tax shield on lease rentals is not available as business expenditure Tax shield

on depreciation represents cash inflow

Tax shield on lease rentals represent a cash outflow (cash inflow foregone)

Net salvage value of an equipment is treated as a post-tax cash flow

IMPLICATIONS UNDER SALES TAX

The sales tax aspects of leasing transactions are governed by the legislative

framework of the Central Sales Tax Act, 1957 (CST), enacted by the Government of India,and Sales Tax Acts (STA) of various states. Whereas the CST governs the levy and collection

of sales tax on the inter-state sale of goods only, the respective STAs govern the tax on sale

of goods within a state (intra-state sale). The implications of lease transactions are detailed

under the relevant provisions of the concerned Acts as follows:

On Purchase of Equipment

A normal rate of sales tax or the appropriate rate as applicable to intra-state

purchase/sale of goods in the respective state, whichever is higher, is imposed

where the purchase of an equipment by a lessor involves inter-state sale, the

transaction attracting the provisions of the CST Where the lessor uses the goods sold by a registered dealer, the dealer is


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entitled to a concessional sales tax rate of 4 percent. For this purpose, the

goods sold must be used for the purpose of resale, for manufacturing of tax

able goods, for use in mining, or for use in the generation/distribution of

electricity/ any other form of power

The equipment supplier to a lessor is not entitled to a concessional rate of salestax but has to pay central sales tax at the normal rate of 10 percent

The intra-state purchase of equipment attracts sales tax stipulated in the

appropriate STA

On lease Rentals

The concept of sales taxing lease rentals was introduced with the enactment of the

Constitution (Forty-Sixth Amendment) Act, 1982. Prior to 1982, there was no sales tax on

lease rentals. The Act enabled the respective state governments to levy tax on transaction,

which did not fall in the category of conventional sale/purchase covered by the CST and

STAs. The concept of tax on the sale and purchase of goods was enlarged to enable the state

governments to impose sales tax on lease rentals.

Accordingly, the said Act provided for the levy of tax on the transfer of the right to

use any goods for any purpose (whether or not for a specified period)for cash, deferred

payment or other valuable consideration. This way leasing was also brought within the ambit

of the sales tax. net. Accordingly, lease rentals can now be taxed under the STAs in all the

states, except Maharashtra which has enacted a separate legislation under the name

Maharashtra Lease Act, 1985 to tax lease rentals.

Following are the salient features of the sales tax on lease rentals in general:

Annual taxable turnover/aggregatelease rentals of the lessor is the basis of

Ievy of sale's tax, the rates of tax varying from state to state

Additional taxessuch as surcharge, additional surcharge, additional sales tax on

turnover, exceeding 'a specified limit (turnover tax) are also levied on the lease

rentals

Registration for lessors as dealers is compulsory, if they have an annual

taxable turnover exceeding a particular limit under the STA. With leasing

companies/dealers having to register in all those states where leasing is done,

it would result in a situation of multiple registrations for leasing companies

Sales tax is leviable only on the use of leased asset by the lessee which

requires legal possession of the goods

Sale of Asset

Exemptions that are available in respect of normal second sale within the state are

usually not available for lease transactions. For example, a leasing company buys .equipment

from a supplier and leases it to a lessee, both within the same state. Local taxes will be levied

on goods sold by the equipment supplier to the leasing company, and such a levy is called the

sales tax on first sale. Second sale, or deemed sale, connotes the transaction between the

lessor and the lessee. In respect of such a sale there is no sales tax levied. However, such an

exemption is not available to lease transactions. This way, the transactions relating to

equipment leasing suffer a multiple-point levy, irrespective of the goods covered by thetransaction.


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Financial Implications

The financial implications of a sales tax levy will be in the realm of lease-related cash

flow and lease rentals. This is to the extent of tax impact on the lessee.

FUNDING ASPECTS OF LEASINGThe quantum of funds required determines, to a large extent, the growth and

development of leasing business. There are several sources of funding that are available to

leasing companies. The principal financial sources are owned funds and borrowed funds.

Owned funds comprise of share capital and retained earnings. Borrowed funds comprise of

bank borrowings, institutional borrowings, debentures, deposits, commercial papers,

debentures/bonds, funds from insurance companies, pension funds, mutual funds and so on.

Most of these sources are also open to corporates in general. The most important of these

funding sources are public deposits, bank borrowings and institutional borrowings from

development/public financial institutions.

Deposits

A major source of finance for a leasing company is deposits. The provisions relating

to the acceptance and repayment of deposits, their minimum and the maximum maturity

periods, the rate of interest, and soon, are governed by the provision of the NBFCs'

Directions of RHI, 1977.

Bank Borrowings

Bank borrowings that may be availed by leasing companies take the form of cash

credit facility. 'The terms and conditions of the facility, such as the amount of cash credits

that can be availed of and the related terms and conditions, are regulated by RBI stipulations.

The relevant RHI directions are furnished below:

Maximum limitThe maximum borrowings by a leasing company from all sources

including deposits, debentures/bonds and borrowings from banks and financial

institutions should not exceed 10 times the 'net owned funds'. In respect of leasing

companies which are predominantly engaged in equipment leasing where a minimum

of75% of the company's assets are in equipment leasing, and where 75% of its gross

income is derived from these activities as per the last audited balance sheet of the

company, the maximum borrowings from banks should not exceed three times their

net owned funds. In respect of other equipment leasing companies, the limit is two

times their net owned funds. For this purpose, net owned funds (NOF) is computed 'asfollows:

Paid up capital + Free reserves - Accumulated balance of loss (balance of deferredrevenue expenditure and also other intangible assets)

With effect from April 1997, RHI removed the overall limits of bank credit to leasing

companies to fully comply with the requirements of registration, credit rating and prudential

norms. The banks would therefore determine the level of credit to such companies on their

own. The measure was aimed at providing greater operational freedom to banks.

Nature of facilityLeasing companies are provided with financial assistance by banks

based on the expected flow of lease rental receivables. Receivables out of a lease

transaction therefore constitute the essential asset for a leasing company. The credit


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limit for each and every individual leasing company is determined within the

calculated maximum permissible bank finance. The facility is extended on a

revolving basis whereby leasing companies are permitted to avail the limit for

other lease transactions on the liquidation or the reduction of lease finance

liability.

MAXIMUM PERMISSIBLE BANK FINANCE

Maximum Permissible Bank Finance (MPBF), also known as Drawing Power

(DP) is calculated on the basis of lease rental receivables in the next five years of

leasing concerns. The method involves calculation of outstanding credit for a period of

five years, and the relevant drawing power against that particular transaction. While

calculating the MPBF, the following Items are excluded when arriving at the ceiling for

bank lending:

Funds raised from financial/investment institutions

Deferred payment guarantees provided by the banks on behalf of leasing

companies Assets created against deferred payment guarantees issued by banks

All these imply that bank finance will be to the extent of 3 times (or 2 times, as the

case may be) of NOF, irrespective of the quantum of finance raised by leasing

companies from financial/investment institutions.

Requirements

Leasing companies are expected to adhere to the following norms while availing

financial facility from banks:

Current ratio The minimum current ratio of 1.33 as prescribed by the second

method of lending must be adopted by all leasing concerns. The ratio is required

to be maintained by the leasing companies, both for the estimated projections as

well as for the actuals, as pet the latest audited balance sheet.

ReportsEvery leasing company is required to submit the following statements as

part of the 'quarterly information system' :

Monthly statement of leased assets and rentals receivable with details

such as lessee, description of equipment, date of lease agreement, value

of equipment (original), depreciated value, lease rentals due to be

bifurcated as overdue, due within next 60 months, due beyond next 60

months and total.

Quarterly statement of the summarized position of current assets and

liabilities, indicating the estimates at the beginning of each quarter and

actuals of the quarter that ended, along the pattern of CMA DatabaseForm

Half yearly operating and funds flow statements containing data relevant


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to leasing business, along the lines of CMA Database Form

A certificate from statutory auditors/chartered accountants to be

submitted for figures of outstanding credit under lease agreement for

calculation of MPBF

The banks cannot finance secondary and tertiary lease agreements for the

same equipment, the bank finance being made available only to 'full pay-

out' leases of new equipments

The receipts of lease rentals are required to be routed through the bank

accounts, with no diversion of funds to other lines of activities such as

manufacturing, investment, etc

Multiple banking/consortium arrangements are permitted if the

borrowing/leasing-concerns deal with more than one bank in accordance

with general guidelines in this regard

RBI introduced the following changes in terms of financing to leasing

companies: .

a.Formation of a consortium by a bank is not necessary, even if the credit limit

per borrower exceeds Rs.50crore

b.Banks are permitted to extend credit using the 'need-based approach'

c.Banks are permitted to adopt the syndication route instead of the consortium

route irrespective of the quantum of credit involved, if the arrangement

suits the borrower and the financing banks

d.The loan component of the working capital limit (MPBF) is enhanced to 80% and

75% in case of borrowers enjoying working capital credit limit ofRs.20crores

and more and between Rs.l0-20crores respectively, the balance being in the

form of cash credit.

e.The level ofloan and cash credit component in case of borrowers with a limit of less

than Rs.l0crores would be settled between the banks and the borrowers

The MPBF framework has been dismantled/withdrawn, and banks are now free to

evolve their own methods of assessing the working capital requirements of the borrowers

within the prudential guidelines and exposure norms. For this purpose, banks may follow a

cash budget system for assessing the working capital finance in respect of large borrowers.

However, individual banks may also retain the present MPBF system with necessary

modifications, 'or any other system. This calls for the formulation of a loan policy by every

bank regarding its lending.

Borrowingsfrom Institutions

Leasing companies obtain financial assistance from Development Finance Institutions

(DFIs) such as IFCI, IDBI, ICICI, etc. The salient features of the lending schemes operated

by these institutions are as follows:

Eligibility Criteria


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The criteria of eligibility to be -satisfied by the leasing companies, which seek

financial assistance from the financial institutions are:

Type of organizationThe leasing company must be a registered cooperative

society or an incorporated public or private limited company

ProfitabilityThe leasing company should be in leasing and/or hire purchasebusiness for a minimum period of three complete accounting years, with a

satisfactory track record of its performance and sound financial position. The

company must be a profit-earning and dividend-paying concern, with no

statutory due outstanding or no defaults committed in repayment of the loans

obtained from banks and financial institutions or fixed deposits

Default position An important criterion to be used for, assessing the credit

worthiness of the leasing company is that its average recovery of lease rentals

has never gone down beyond the limit of 10 percent defaults

Debt-equity ratioThe leasing company should have a reasonably satisfactory

debt-equity ratio and debt service coverage ratio not exceeding 4: I, and debt

service coverage ratio of around 1.60 Eligible businesses In order to be

eligible, the concerns must be engaged in leasing of industrial plants,

equipments, machinery, or other fixed tangible assets, including vehicles, ship,

and aircraft

Terms and Conditions

The main terms and conditions relating to lending by financial institutions to leasingcompanies are:

InterestThe loans advanced by financial institutions bear fixed rate of interest,

calculated on an annual basis, on the outstanding principal amount. Interest

rates are flexible, but are fixed by institutions in consultation with each other

Commitment chargeCommitment charges are payable by leasing companies

@ 1 % per annum from the date of the loan agreement. The purpose of levying

commitment charges is to ensure that leasing companies duly make use of the

loan sanctioned by financial institutions

Liquidated damages Liquidated damages are payable by leasing companieswhere there is a default committed in the payment of principal, interest,

commitment charge or other amount payable under the loan agreement. It is

imposed @ 2% per annum. Moreover, the arrears of liquidated damage also

carry interest at the applicable rate of interest

Period of repaymentRepayment period is usually decided between the leasing

company and the financial institution, depending on the nature of cash flows

from the leasing business. Loans are to be generally repaid in a period of3 or 5

years, in monthly instalments. The instalment payment starts from the month

following the procurement of the loan amount. Wherever moratorium is

allowed, the repayment will commence only after the expiry of the said period


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Security/MarginExclusive charge has to be created on all its immovable and

movable properties, subject to the existing charge created by the company

thereon by the borrower-leasing company, in favour of the institution lending

money on the acquisition of equipment, plant and machinery and other assets

by the company. A security margin to the extent of33.3% is required to bemaintained. The margin may be maintained in the form of additional assets

with the lender, or by way of cash deposits

Personal guarantee In order to ensure timely payment of the loan instalments,

personal guarantees of one or more promoters/directors will be required by the

lending institutions. Such guarantees will be irrevocable and unconditional,

and may be joint or several for the payment of the loan, alf interests and other

amount thereon

Assignment of lease rentals Financial institutions may require the leasing

company to assign the right on the lease rentals. This may done as an

additional precaution to ensure zero default

Other conditions In addition to the above terms and conditions, the lending

agency may also put forth terms such as proper utilization of loan amount,

safety to the equipment purchased with the loan amount, insurance of the

leased assets purchased with the loan amount, restricting utilization ofloan

amount to purchase the approved asset to be leased out, etc

TYPES OF FINANCE

The finance assistance available from financial institutions may take any or all of the

following forms:

a) Line of credit

b) Loan

c) Discounting of notes drawn against lease rentals

d) Funding requirement: The funding requirements ofleasing companies is determined

on the basis of the annual budget prepared by the equipment leasing concerns. The

annual plan is drafted based on their estimated business. In fact, the limits of credit

are determined based on estimates of business cash flows only. Besides, the budget

serves as a barometer for determining the amount of the monthly loan instalments;

Funds are also made available to a lease transaction by drawing notes payable or

through promissory notese) Documentation: Two documents are required to be executed by the parties

concerned; the lenders, the financial institutions and borrowers, or the leasing

companies. The main documents are Loan agreement and the Agreement of

Hypothecation. It is quite possible that the lender institution may require to execute

more documents, if it warranted by the facts of the case


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CONCLUSION

An arrangement whereby a person called 'the lessee' commands the use of an

asset without owning the same, in consideration of a periodic rental payment called

'the lease charges' to 'the lessor', is known as 'leasing'. A lease is of various types,

such as financial lease, operating lease, import lease, cross-border lease, etc. In afinancial lease, all the risks and rewards associated with the ownership of an asset

are transferred to the lessee, who becomes the owner of the asset, for all practical

purposes. An operating lease resembles a hire whereby the lease has a shorter

tenure, besides being cancelable at the option of the lessee. Leasing of imported

capital goods is called 'import leasing'. In a typical cross-border leasing, the lessor

in one country leases out assets to a lessee in another country, with the jurisdiction

of lessors and lessees being in two different countries.

There are several myths about leasing, an example being that leasing is a

disguised form of borrowing with all attendant consequences. Similarly, leasingdoes not, indeed, provide the so-called advantage of off-balance sheet financing.

The participants in lease financing service include, the lessor, the lesee, lease

brokers and lease financiers. The lessor extends several benefits to the parties

involved in a lease agreement, such as provision of credit facility, absorbing risk of

obsolescence, etc. Leasing is of immense use to both the lessor and lessee. Leasing

facilitates accelerated production and sale of goods, provide tax benefits to lessee,

gives a fillip to the capital market, enables the lessee to make efficient use of funds,

provide a cheaper source of capital funds, and helps avoid capital outlay. However,

leasing is fraught with many drawbacks. For instance, leasing usually proves to be acostly proposition, besides causing loss of depreciation tax shield and residual of

value.


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REFERENCES

Financial Services and System by Dr. S GURUSAMY

Financial Services and System by M Y KHAN

www.google.com

www.wikipedia.org
http://www.google.com/http://www.wikipedia.org/http://www.wikipedia.org/http://www.google.com/

Documents

Leasing Final 1