Lease Financing
INTRODUCTION
Financial Services basically mean all those kinds of services provided in financial
terms whe...
Lease Financing
LEASING
Leasing as financial service is a contractual agreement where the owner (lessor)
of equipment tran...
Lease Financing
The credit squeeze announced by the R.B.I coupled with the strict implantation of
the Tandon & Chore commi...
Lease Financing
There was thus virtual explosion in the number of leasing companies rising to
about 400 companies in 1990....
Lease Financing
the asset. Thus, a lessee can be a lessor for a sub-lessee, unless the parent lessor
has restricted the ri...
Lease Financing
must be capable of re-delivery: it must be durable (at least during the lease
period), identifiable and se...
Lease Financing
If it is a financial lease transaction, the rentals will simply be the recovery of the
lessor's principal,...
Lease Financing
an operating lease because the lessor is taking a risk on asset values, is a full
payout lease, but the le...
Lease Financing
However, in many jurisdictions, it is the existence of
such buyout option that demarcates between lease an...
Lease Financing
asset cost as such. Hence, the down payment or first lease rent serves the purpose
of a margin.
Between ad...
Lease Financing
TYPES OF LEASING
FINANCE LEASE
A lease is defined as finance lease if it transfers a substantial part of t...
Lease Financing
iv. The present value of the minimum lease payments (See Glossary) is greater
than or substantially equal ...
Lease Financing
The lessor too has no significant risk/reward other than that
of a virtual money-lender: he would continue...
Lease Financing
The risk the lessor takes is not asset-based risk but lessee-based risk. The
value of the asset is importa...
Lease Financing
gets shifted to the hire-vendor. If the asset were to become obsolete during the
pendency of the hire term...
Lease Financing
Nature Of
Expenditure
Lease rentals paid by the lesee are
entirely revenue expenditure of
lessee.
Only int...
Lease Financing
markets regulation - most countries' central banks maintain some control on
financial intermediaries.
o Th...
Lease Financing
Based on the 4 major areas listed above (general regulation, asset rights, taxation
and accounting), there...
Lease Financing
OPERATING LEASE
The International Accounting Standards Committee defines an Operating Lease as
"any lease ...
Lease Financing
thereon. Therefore, specializing in operating leases calls for an in-depth
knowledge of the equipments per...
Lease Financing
Differences between Finance and Operating Leases
Financial Lease
• Risks and rewards of
ownership are tran...
Lease Financing
off.
• The lessor retains legal
ownership for the duration of
the lease term, though the
lessee may or may...
Lease Financing
SALE AND LEASEBACK
In a sale and leaseback transaction, the owner of equipment sells it to a leasing
compa...
Lease Financing
short-term debt by medium-term finance (assuming that the leaseback
arrangement is a finance lease).
From ...
Lease Financing
lease is the sales-aid lease where the equipment supplier catalyzes the lease
transaction. In other words,...
Lease Financing
Leveraged Lease
Sells Asset Leases Assets
Domestic Lease & International Lease
A lease transaction is clas...
Lease Financing
Second, as the payments to the supplier and the lease are denominated in
different currencies, the economi...
Lease Financing
LEASING TO LESEE AND LESSOR
Advantages of ‘LEASING’ to ‘LESSEE’
There are several extolled advantages of a...
Lease Financing
(6) Maintenance And Specialized Services:
In case of special kind of lease arrangement, Lessee can avail s...
Lease Financing
(2) Tax Benefits:
The lessor being owner of asset can claim various tax benefits such as
depreciation.
(3)...
Lease Financing
LEGAL ASPECTS OF LEASING
As there is no separate statue for equipment leasing in India, the
provisions rel...
Lease Financing
1. Description of the lessor, the lessee, and the equipment.
2. Amount, time and place of lease rentals pa...
Lease Financing
iii. Other public sector leasing organizations.
I. Pure Leasing Companies:
These companies operate indepen...
Lease Financing
PUBLIC SECTOR LEASING
(i). Financial Institutions: The financial institution such as IFCI, ICICI, IRBI
and...
Lease Financing
ACCOUNTING TREATMENT OF LEASE
Presently the accounting treatment of lease transactions in India is as foll...
Lease Financing
together, and cry out loud: "We will not write a single penny of lease transactions
in India, unless the G...
Lease Financing
meantime, some Rs 20000 crores worth lease transactions would have
been signed in the country, and obvious...
Lease Financing
depreciation and tax depreciation are miles apart. There are plenty of countries all
over the world where ...
Lease Financing
Can the accounting distinction be used for tax laws?
It would be disastrous to adopt the accounting distin...
Lease Financing
asset, but one of mere funding. There are tests in many countries to distinguish
between true leases and f...
Lease Financing
To partly implement the McGregor approach, lease accounting standards in most
countries, including IAS 17,...
Lease Financing
lessee will record, as a liability, the present value of lease rentals payable,
in other words, the princi...
Lease Financing
In other words, to the profit as reported in profit and loss account, the
principal portion of lease renta...
Lease Financing
ACCOUNTING FOR NON PERFORMING LEASES
There is no information in the guidance note on lease accounting, 199...
Lease Financing
Income already recognized, and lying unrealized, will be reversed-this, in
accounting sense means the inco...
Lease Financing
TAXATION IN TERMS OF LEASING:
1. Basic tax treatment of lease and hire-purchase transactions:
The tax trea...
Lease Financing
As it is the beneficial ownership rights of the lessor that is crucial, the distinction
between lease and ...
Lease Financing
Supreme Court ruling in First Leasing Company of India where the Supreme
Court distinguished a lease from ...
Lease Financing
plastic or rubber factories
Bottles and crates 50%
Computers (proposed) 60%
Pollution control devices, ene...
Lease Financing
character of acquisition of the asset by the lessee, the lessee's claim for lease
rentals was disallowed.
...
Lease Financing
transfer of property in goods from one person to another for a consideration. But
Sales Tax is leviable on...
Lease Financing
In HP, also, there are 2 sales. Supplier S sells to the NBFC and the NBFC
simultaneously sells to the Cust...
Lease Financing
 Sales Tax Rates :
Since under the sharing arrangement all the CST collections are retained
by the state ...
Lease Financing
it is there in the fine print - a 5% service tax on the gross receivables of leasing
and hire purchase com...
Lease Financing
recognized in law as interest or principal. In case of lease transactions, the lease
rental is surely the ...
Lease Financing
LEASING IN RELATION TO BANK FINANCE
With both leasing and bank financing involving credit decisions and fi...
Lease Financing
From the lessee’s perspective, there is only one substantive difference between a
loan and a lease: with a...
Lease Financing
PROBLEMS OF LEASING
Leasing has great potential in India. However, leasing in India faces
serious handicap...
Lease Financing
Most people believe that lessees prefer leasing because of the tax
benefits it offers. In reality, it only...
Lease Financing
were 1-year deposits while the deployment of funds was mostly for longer
tenures. It is only the contagion...
Lease Financing
quite holy and sound - certain energy saving devices, pollution control devices etc
qualify for such allow...
Lease Financing
PLAYERYS IN THE INDIAN LEASING INDUSTRY
There is a shake out in the market at the moment-90% of which is c...
Lease Financing
ICICI 1500 Capital Equipment
Ships
Aircrafts
Railway Wagons
5-10 Years Financial
FIRST
LEASING
150 Vehicle...
Lease Financing
LEASING: TOUCHING THE PEAK
Twenty five years ago, Farouk Irani quit his high profile job in
Citibank to la...
Lease Financing
Leasing Yearbook would place India at some 36th
place, but admittedly that data
is only the estimate of th...
Lease Financing
outstanding business of last year was paid, and there was a 20% growth in net
business (as can be seen fro...
Lease Financing
The post -liberalization era saw a spate of new ventures and fresh investments
by existing ventures. Thoug...
Lease financing
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  • A RELIABLE AND A GENUINE PROVIDER THAT CAN DELIVER BANK GUARANTEE AND OTHER FORM OF BANKING INSTRUMENTS FOR LEASE WHICH ARE MAINLY FRESH CUT.

    Bank instruments which are cash backed can be used as thus; clients looking for loans to finance their businesses also serve as a collateral to get loans from banks in other to engage into any project at hand further details will be emailed upon request.

    Email: mklease.broker@gmail.com
    Skype ID: mklease.broker
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Lease financing

  1. 1. Lease Financing 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 categorized into (a) Non –Banking Finance Companies (b) Commercial Banks, and (c) Merchant Banks. Financial Services in India is too vast and varied too have evolved at one place and at one time. One of the main entities that offer financial services in India is Non-Banking Finance Companies. These NBFCs registered with Reserve Bank of India mainly perform fund based services to the customer. Fund based services of NBFCs include: leasing, hire-purchase and other asset based services whereas fee based services of NBFCs include bill discounting, portfolio management and other advisory services. 1
  2. 2. Lease Financing LEASING Leasing as financial service is a contractual agreement where the owner (lessor) of equipment transfers the right to use the equipment to the user (lessee) for an agreed period of time in return for a rental. At 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. If 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 (lessor) of an asset (leased asset) provides the asset for use by the lessee at a consideration (rentals), either fixed or dependent on any variables, for a certain period (lease period), either fixed or flexible, with an understanding that at the end of such period, the asset, subject to the embedded options of the lease, will be either returned to the lessor or disposed off as per the lessor's instructions”. Leasing was prevalent during the ancient Sumerian and Greek civilizations 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 19th century where the rail road manufacturers in the U.S.A resorted to leasing of rail cars and locomotives. The equipment leasing industry came into being in 1973 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 – IDBI, IFCI, ICICI and the State Financial Corporations (SCFs) provided bulk of the term loans and the commercial banks provided working capital finance required by the manufacturing sector on relatively soft terms. Given the easy availability of funds at reasonable cost, there was obvious no need to look for alternative means of financing. 2
  3. 3. Lease Financing The credit squeeze announced by the R.B.I coupled with the strict implantation of the Tandon & Chore committees’ norms on Maximum Permissible Bank Finance (MPBF) for working capital forced the manufacturing companies to divert a portion of their long – term funds for their working capital. HISTORY AND DEVELOPMENT OF LEASING The history of leasing dates back to 200BC when Sumerians leased goods. Romans had developed a full body law relating to lease for movable and immovable property. However the modern concept of leasing appeared for the first time in 1877 when the Bell Telephone Company began renting telephones in USA. In 1832, Cottrell and Leonard leased academic caps, grown and hoods. Subsequently, during 1930s the Railway Industry used leasing service for its rolling stock needs. In the post war period, the American Air Lines leased their jet engines for most of the new air crafts. This development ignited immediate popularity for the lease and generated growth of leasing industry. The concept of financial leasing was pioneered in India during 1973. The First Company was set up by the Chidambaram group in 1973 in Madras. The company undertook leasing of industrial equipment as its main activity. The Twentieth century Leasing Company Limited was established in 1979. By 1981, four finance companies joined the fray. The performance of First Leasing Company Limited and the Twentieth Century Leasing Company Limited motivated others to enter the leasing industry. In 1980s financial institutions made entry into leasing business. Industrial Credit and Investment Corporation was the first all India financial institution to offer leasing in 1983. Entry of commercial banks into leasing was facilitated by an amendment of Banking Regulation Act, 1949. State Bank of India was the first commercial bank to set up a leasing subsidiary, SBI capital market, in October 1986. Can Bank Financial Services Ltd., BOB Financial Service Ltd., and PNB Financial Services Limited followed suit. Industrial Finance Corporation’s Merchant Banking division started financing leasing companies as well as equipment leasing and financial services. 3
  4. 4. Lease Financing There was thus virtual explosion in the number of leasing companies rising to about 400 companies in 1990. In the subsequent years, the adverse trends in capital market and other factors led to a situation where apart from the institutional lessors, there were hardly 20 to 25 private leasing companies who were active in the field. The total volume of leasing business companies was Rs.5000 crores in 1993 and it is expected to cross Rs.10, 000 crores by March 1995. ELEMENTS IN LEASE STRUCTURE This is an explanation of the elements in a lease - the parties, asset, rentals, residual value, etc. This section would also elaborate the unique features of a lease as different from a regular financing transaction. 1. The transaction: The transaction of lease of lease is generically an asset-renting transaction. What distinguishes a lease from a loan is that in the latter, what is lent out is money; in a lease, what is lent out is the asset. 2. Parties to a lease: 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. Any one can be a lessor, and any one can be a lessee, subject 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 4 Ownership is no pre-condition for leasing:
  5. 5. Lease Financing the asset. Thus, a lessee can be a lessor for a sub-lessee, unless the parent lessor has restricted the right to sub-lease. 3. The leased asset: The subject 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. Only 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. Hence, intangible assets are assigned, whereas tangible assets may be leased. The concept of leasing will have the following limitations: 1. What cannot be owned cannot be leased. Thus, human resources cannot be "leased". 2. While lease of movable properties can be affected by mere delivery, immovable property is incapable of deliveries in physical sense. Most 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 example, in Anglo-Saxon legal systems (UK, Australia, India, Pakistan, 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. A 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 5 Leasing of immovable properties may have complications:
  6. 6. Lease Financing must be capable of re-delivery: it must be durable (at least during the lease period), identifiable and severable. The existence of the leased asset is an essential element of a lease transaction - the asset must exist at the beginning of the lease, during the lease and at the end of the lease term. Non-existence of the asset, for whatever reason, will be fatal to the lease. 4. Lease period: The term of lease, or lease period, is the period for which the agreement of lease shall be in operation. As 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. During 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. In 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 investment; the latter intended to allow the lessee to exhaust a substantial part of the remaining asset value. The primary period is normally non-cancelable, and the secondary period is normally cancelable. 5. Lease rentals: The lease rentals represent the consideration for the lease transaction. This is what the Lessee pays to the Lessor. 6 Leased asset is a necessary pre- condition:
  7. 7. Lease Financing If it is a financial lease transaction, the rentals will simply be the recovery of the lessor's principal, and a certain rate of return on outstanding principal. In other words, the rentals can be seen as bundled principal repayment and interest. If it is an operating lease transaction, the rentals might include several elements depending upon the costs and risks borne by the Lessor, such as: • Interest on the lessor's investment. • If the lessor is bearing any repairs, insurance, maintenance or operation costs, them charges for such cost. • Depreciation in the asset. • Servicing charges or packaging charges for providing a package of the above service. 6. Residual value: Put simply, "residual value" means the value of the leased equipment at the end of the lease term. If 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 equipment. If 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 equipment 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 lessee; 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 equipment. Such a lease, obviously 7
  8. 8. Lease Financing 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 equipment at the end of the lease term. 7. End-of-term options: The options allowed to the lessee at the end of the primary lease period are called end-of-term options. Essentially, one, or more, of the following options will be given to the lessee at the end of the lease term: • Option to buy (buyout option) at a bargain price or nominal value (typical in a hire-purchase transaction), called bargain buyout option • Option to buy at a fair market value or fixed, but substantial value • Option to renew the lease at nominal rentals, called bargain renewal option • Option to renew the lease at fair market rentals or substantial rentals • Option to return the equipment In any lease, which option will be suitable depends on the nature of the lease transaction, as also the applicable regulations. For example, 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 quite natural that the lessee should be allowed to exhaust the whole of the remaining value of the equipment. Regulation permitting, the lessor provide the lessee a bargain purchase option to allow the lessee to complete the purchase of the equipment. 8
  9. 9. Lease Financing However, in many jurisdictions, it is the existence of such buyout option that demarcates between lease and hire-purchase transaction. If 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. In essence, a renewal option achieves the same purpose as a purchase, but the lessor retains his ownership as also his reversionary interest in the equipment. Fair market value options, either for purchase of equipment, or for renewal, are typical of operating leases, but are really speaking no more than assuring to the lessee a continued use of the equipment. If equipment 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. 8. Upfront payments: Lessors may require one or more of the following upfront, that is, instant payments from a lessee: • Initial lease rental or initial hire or down payment • Advance lease rental • Security deposit • Initial fees The initial lease rent or initial hire (the word hire is more common in case of hire-purchase transactions) is a surrogate for a margin or borrower contribution in case of loan transactions. Note that given the nature of a lease or hire-purchase as asset-renting transaction, it is not possible to expect a lessee's contribution to 9 Buyout option may characterize the lease as hire-purchase: Margins in leases are taken as initial rental:
  10. 10. Lease Financing asset cost as such. Hence, the down payment or first lease rent serves the purpose of a margin. Between advance lease rent and initial lease rent - the difference is only technical. The whole of the initial lease rental is supposed to be appropriated to income on the date of its receipt, whereas advance rental is still an advance - normally an advance against the last few rentals. Therefore, the advance rental will remain as a deposit with the lessor to be adjusted against the last few rentals. The security deposit is a proper deposit to secure against the lessee's commitments under the contract - it is generally intended to be refunded at the end of the lease contract. 10
  11. 11. Lease Financing TYPES OF LEASING FINANCE LEASE A 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. According to the International Accounting Standards Committee (IASC), 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 term; (or) ii. The lessee has the option to purchase the asset at a price which is expected to be sufficiently lower than the fair market value at the date the option becomes exercisable and, at the inception of the lease, it is reasonably certain that the option will be exercised; (or) iii. The lease term is for a major part of the useful life of the asset. The title may or may not eventually be transferred; (or) 11
  12. 12. Lease Financing iv. The present value of the minimum lease payments (See Glossary) is greater than or substantially equal 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 Accounting Standards Board (FASS) of USA. The FASS has in fact defined certain cut-off points for criteria (iii) and (iv). According to the FASS definition of a finance lease, if the lease term exceeds 75 percent of the useful life of the asset or if the present value of the minimum lease payments exceeds 90 percent of the fair market value of the asset at the inception of the lease, the lease will be classified as a 'finance lease' Financial leases are "loan look-alike": However, 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 As you might notice, in the above example, the lessee has been put virtually in the position of an asset owner - he has the right to use the asset for 5 years, with a power to extend the lease period for another 5 years. The first 5 years are called the primary lease period and the extended period is called the secondary lease period. The lease is non-cancelable during the primary lease period - that is, the lessee cannot return the asset and not pay balance of the lessor's 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 enjoyed by the lessee virtually for the whole of its economic life. 12 The primary and secondary lease period :
  13. 13. Lease Financing The lessor too has no significant risk/reward other than that of a virtual money-lender: he would continue getting the lease rentals for the primary period which will fully-payout the lessor's investment in the lease as also give him his desired return on investment, irrespective of the state, value or utility of the asset. If the lessee performs as per agreement, the lessor would get no more, and no less, than such pre-fixed return on investment. Incidentally, in the present example, the lessor gets a return of 12.98% - this is equivalent to the rate of interest in case of loans. As this rate is not explicit, but implicit in the rate of rentals, the rate is implicit rate of return or IRR. Features of financial leases: The above discussion leads to the following features of financial leases: Financial leases allow the asset to be virtually exhausted by the same lessee. Financial leases put the lessee in the position of a virtual owner. The lessor takes no asset-based risks or asset-based rewards. He only takes financial risks and financial rewards, and that is why the name financial leases. The lease is non-cancelable, meaning the lessee cannot return the asset and not pay the whole of the lessor's investment. In this sense, they are full-payout, meaning the full repayment of the lessor's investment is assured. As the lessor generally would not take any position other than that of a financier, he would not provide any services relating to the asset. As such, the lease is net lease. 13 The IRR: Full payout lease:
  14. 14. Lease Financing The risk the lessor takes is not asset-based risk but lessee-based risk. The value of the asset is important only from the viewpoint of security of the lessor's investment. In financial leases, the lessor's payback period, viz., primary lease period is followed by an extended period to allow exhaustion of asset value by the lessee, called secondary lease period. As the renewal is at a token rental, this option is called bargain renewal option. Alternatively, if the regulations permit, the lessee may be given a purchase option at a nominal price, called bargain buyout or purchase option. In financial leases, the lessor's rate of return is fixed: it is not dependant upon the asset-value, performance, or any other extraneous costs. The fixed lease rentals give rise to an ascertainable rate of return on investment, called implicit rate of return. Financial leases are technically different but substantively similar to secured loans. Financial leases and Hire-purchase: In some countries, distinction is made between lease and hire-purchase transactions. A hire-purchase transaction is usually defined as one where the hirer (user) has, at the end of the fixed term of hire, an option to buy the asset at a token value. In other words, financial leases with a bargain buyout option at the end of the term can be called a hire-purchase transaction. Hire-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. If such an option is embedded, hire-purchase becomes significantly different from a financial lease: the risk of obsolescence 14 Hire-purchase and financial leases compared
  15. 15. Lease Financing gets shifted to the hire-vendor. If 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. Hire-purchase is of British origin - the device originated much before leases became popular, and spread to countries which were then British dominions. The device is still popular in Britain, Australia, New Zealand, India, Pakistan, etc. Most of these countries have enacted, in line with United Kingdom, specific laws dealing with hire-purchase transactions. DIFFERENCE BETWEEN LEASE FINANCING AND HIRE PURCHASE BASIS LEASE FINANCING HIRE PURCHASE Meaning A Lease transaction is a commercial arrangement, whereby an equipment owner or manufacturer conveys to the equipment user the right to use the equipment in return for a rental. Hire purchase is type of installment credit under which the hire purchaser agrees to take the goods on hire at a stated rental, which is inclusive of the repayment of principal as well as interest, with an option to purchase. Option To User No option is provided to the lessee (user) to purchase the goods. Option is provided to the hirer(user). 15
  16. 16. Lease Financing Nature Of Expenditure Lease rentals paid by the lesee are entirely revenue expenditure of lessee. Only interest element included in the hire purchase, installments is revenue expenditure by nature. Components Lease rentals comprise of two elements (1) finance charge and (2) capital recovery. Hire purchase installments comprise of three elements (1) normal trading profit (2) finance charge (3) recovery of cost of goods/assets. Substance of financial lease: If financial leases are substantively so close to secured financing transactions, the categorical issue is: why should they be treated as a lease at all? Why should they not be regulated, taxed and accounted for as plain loan transactions? This question may be significant from viewpoint of : • Regulation of financial leasing activity. • Asset rights of the lessor. • Taxation of the lessor/lessee. • Accounting for the lease transaction. In each case, treating the lease as a lease or, based on substance, a financing transaction, 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 16
  17. 17. Lease Financing 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 If the lease is treated as a financing transaction, the lessor should not be allowed to claim any asset-related benefit, such as depreciation. His 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 Balance Sheet of the lessee rather than the lessor, along with a corresponding liability to pay fixed rentals to the lessor. Ideally, 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. However, such ideal is never achieved. There are two reasons to this - one, to an extent, laws, regulators and taxmen are conditioned by the legal fabric of a transaction. And two, lessors would emphasize 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 World 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. Besides, the lease/loan treatment also depends upon the maturity of a country's regulatory system to appreciate the substance of a deal by exploding its form - understandably, doing so is not easy because it would mean going beyond the apparent form of a contract. 17
  18. 18. Lease Financing Based on the 4 major areas listed above (general regulation, asset rights, taxation and accounting), there might be numerous combinations treating financial leases as loans on security for some purpose and true lease for some other purposes. Accountings standards are the first (perhaps because they are least dependent on a statute) to realize the indifference between leases and loans. Taxation, particularly, income-tax, moves close to accounting standards. General 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 be used 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 (IV) is satisfied. In a finance lease, the lessee is responsible for repair, maintenance and insurance of the asset. The lessee also undertakes a "hell or high water" obligation to pay rental regardless of the condition or the suitability of the asset. A finance lease which operates over the entire economic life of the equipment is called a "full pay out lease". 18
  19. 19. Lease Financing OPERATING LEASE The International Accounting Standards Committee defines an Operating Lease as "any lease other than a finance lease". An Operating Lease has the following characteristics: a.. The lease term is significantly less than the economic life of the equipment. b. The lessee enjoys 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 equipment in which case an operating lease is called a 'wet lease'. An operating lease where the lessee bears the costs of insuring and maintaining the leased equipment 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 equipment-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 realization of a substantial resale value (on expiry of the first lease) to recover the investment cost plus a reasonable rate of return 19
  20. 20. Lease Financing thereon. Therefore, specializing in operating leases calls for an in-depth knowledge of the equipments per se and the secondary (resale) market for such equipments. Of course the prerequisite is the existence of a resale market. Given the fact that the resale market for most of the used capital equipments in our count~ lacks breadth, operating leases are not in popular use. But then this form of lease ideally suits the requirements of firms operating in sun rise industries which are characterized by a high degree of technological risk. Following are illustrative situations where a lease will be regarded as an operating lease: • If the lease has a cancellable period, during which rentals forming more than 10% in present value terms of the fair value of the asset are received; • If part of the rentals are contingent or conditional, and such rentals form more than 10% in present value terms of the fair value of the asset; • If the lessor relies upon unguaranteed residual value, and such value forms more than 10% in present value terms of the fair value of the asset; • If 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 10% 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 lessee; • If the lessor's IRR and the lessee's incremental borrowing rate differ: the lease may be a financial lease for the lessor and an operating lease for the lessee 20
  21. 21. Lease Financing Differences between Finance and Operating Leases Financial Lease • Risks 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 exempt the lessee from financial liabilities before the lessor. • The goal of the lessee is either to acquire the asset or at least use the asset for most of its economic life. As 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 the title 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 Lease • Economic 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. • It is not the lessee’s intention to acquire the asset, and lease payments are determined accordingly. In addition, an asset under an operating lease may subsequently be rented out. • The present value of all lease 21
  22. 22. Lease Financing 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 quality, technical characteristics, and completeness, even though it retains 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. 22
  23. 23. Lease Financing SALE AND LEASEBACK In a sale and leaseback transaction, the owner of equipment 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'. A classic example of this type of transaction is the sale and leaseback of safe deposit vaults resorted to by commercial banks is Under 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. SALE TRANSACTION SALE VALUE LEASE TRANSACTION LEASE RENTALS Sales and Leaseback The leasing company offers these lockers on a long-term lease to the bank. The advantages to the bank are: a. It is able to unlock its investment in a low income yielding asset. b. It is able to enjoy the uninterrupted use of the lockers (which can be leased to its customers). c. It can invest the sale proceeds (which are not subject to the reserve ratio requirements) in high income yielding commercial loans. In general, the 'sale and leaseback' arrangement is a readily available source of funds for financing the expansion and diversification programs of a firm. In 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 SELLER BUYER LESSEE LESSOR
  24. 24. Lease Financing short-term debt by medium-term finance (assuming that the leaseback arrangement is a finance lease). From the leasing company's angle a sale and leaseback transaction poses certain problems. First, it is difficult to establish a fair market value of the asset being acquired because the secondary market for the asset may not exist; even if it exists, it may lack breadth. Second, the Income Tax Authorities can disallow the claim for depreciation on the fair market value if they perceive the fair market value as not being 'fair'. DIRECT LEASE A direct lease can be defined as any lease transaction which is not a "sale and leaseback" transaction. In other words, in a direct lease, the lessee and the owner are two different entities. A direct lease can be of two types: Bipartite Lease and Tripartite Lease. Bipartite Lease In a bipartite lease, there are two parties to the transaction - the equipment 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 equipment (upgrade lease) or additions to the original equipment configuration. The lessor undertakes to maintain the equipment and even replaces the equipment that is in need of major repair with similar equipment in working condition (swap lease). Of 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 equipments covered by the lease. Tripartite Lease A tripartite lease on the other hand is a transaction involving three different parties -the equipment supplier, the lessor, and the lessee. Most of the equipment lease transactions fall under this category. An innovative variant of the tripartite 24
  25. 25. Lease Financing lease is the sales-aid lease where the equipment supplier catalyzes the lease transaction. In other words, he arranges for lease finance for a prospective customer who is short on liquidity. Sales-aid leasing can take one of the following forms: a.. The equipment supplier can provide a reference about the customer to the leasing company. b. The equipment 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 equipment and obtains an assignment of the lease rental. By 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 equipment from the lessor in the event of default by the lessee or in the form of providing a guarantee on behalf of the lessee. LEVERAGED LEASE In a leveraged lease transaction, the leasing company (called equity investor) invests in the equipments 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) Obtains 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. On 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. A schematic representation of transaction is represented in the figure: 25
  26. 26. Lease Financing Leveraged Lease Sells Asset Leases Assets Domestic Lease & International Lease A lease transaction is classified as a domestic lease if all parties to the transaction to the equipment supplier, the lessor and the lessee are domiciled in the same country. On the other hand, if the parties are domiciled in different countries, the transaction is classified as an International Lease Transaction. The distinction between a domestic lease transaction and an international lease transaction is important for two reasons. First, packaging an international lease transaction calls for, a. An understanding of the political and economic climate; and b. Knowledge of the tax and the regularity framework governing these transactions in the countries concerned. 26 Manufacturer Lessor Lessee Lender
  27. 27. 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 exchange rates. In short, international lease transactions unlike domestic lease transactions are affected by two additional sources of risk – country risk and currency risk. 27
  28. 28. Lease Financing LEASING TO LESEE AND LESSOR Advantages of ‘LEASING’ to ‘LESSEE’ There are several extolled advantages of acquiring capital assets on lease: (1) Saving of capital: Leasing covers the full cost of the equipment used in the business by providing 100% finance. The lessee is not to provide or pay any margin money as there is no down payment. In this way the saving in capital or financial resources can be used for other productive purposes e.g. purchase of inventories. (2) Flexibility And Convenience: The lease agreement can be tailor- made in respect of lease period and lease rentals according to the convenience and requirements of all lessees. (3) Planning Cash Flows: 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. (4) Improvement In Liquidity: Leasing enables the lessee to improve their liquidity position by adopting the sale and lease back technique. (5) Shifting of Risk of Obsolescence: The lessee can shift the risk upon lessor by acquiring the use of asset rather than buying the asset. 28
  29. 29. Lease Financing (6) Maintenance And Specialized Services: In case of special kind of lease arrangement, Lessee can avail specialized services of lessor for maintenance of asset leased. Although lessor charges higher rentals for providing such services, lessee’s overall administrative and service costs are reduced because of specialized services of the lessor. (7) Off-The-Balance-Sheet-Financing: Leasing provides "off balance sheet" financing for the lessee, in that the lease is recorded neither as an asset nor as a liability. Disadvantages of ‘LEASING’ to ‘LESSEE’ (1) Higher Cost: 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. (2) Risk of being deprived the use of asset in case the leasing company winds up. (3) No Alteration In Asset: Lessee cannot make changes in asset as per his requirement. (4) Penalties On Termination Of Lease: The lessee has to pay penalties in case he has to terminate the lease before expiry o lease period. Advantages of ‘LEASING’ to ‘LESSOR’ (1) Higher profits: The lessor can get higher profits by leasing the asset. 29
  30. 30. Lease Financing (2) Tax Benefits: The lessor being owner of asset can claim various tax benefits such as depreciation. (3) Quick Returns: By leasing the asset, the Lessor can get quick returns than investing in other projects of long gestation period. Disadvantages of ‘LEASING’ to ‘LESSOR’ (1) High Risk of Obsolescence: The lessor has to bear the risk of obsolescence as there are rapid technology changes. (2) Price Level Changes: In case of inflation, the prices of asset rises but the lease rentals remain fixed. (3) Long term Investment: Leasing requires the long term investment in purchase of an asset, and takes long time to cover the cost of that asset 30
  31. 31. Lease Financing LEGAL ASPECTS OF LEASING As there is no separate statue for equipment leasing in India, the provisions relating to bailment in the Indian Contract Act govern equipment leasing agreements as well section 148 of the Indian Contract Act defines bailment as: “The 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 ‘bailor’ and the person to whom they are delivered is called the ‘bailee’. Since an equipment 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 expressly specified in the least contract) as defined by the provisions of sections 150 and 168 of the Indian Contract Act. Essentially these provisions have the following implications for the lessor and the lessee. 1. 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. 2. The lessor has the obligation to pay the lease rentals as specified in the lease agreement, to protect the lessor’s title, to take reasonable care of the asset, and to return the leased asset on the expiry of the lease period. CONTENTS OF A LEASE AGREEMENT The lease agreement specifies the legal rights and obligations of the lessor and the lessee. It typically contains terms relating to the following: 31
  32. 32. Lease Financing 1. Description of the lessor, the lessee, and the equipment. 2. Amount, time and place of lease rentals payments. 3. Time and place of equipment delivery. 4. Lessee’s responsibility for taking delivery and possession of the leased equipment. 5. Lessee’s responsibility for maintenance, repairs, registration, etc. and the lessor’s right in case of default by the lessee. 6. Lessee’s right to enjoy the benefits of the warranties provided by the equipment manufacturer/supplier. 7. Insurance to be taken by the lessee on behalf of the lessor. 8. Variation in lease rentals if there is a change in certain external factors like bank interest rates, depreciation rates, and fiscal incentives. 9. Options of lease renewal for the lessee. 10. Return of equipment on expiry of the lease period. 11. Arbitration procedure in the event of dispute. STRUCTURE OF LEASING INDUSTRY The present structure of leasing industry in India consists of (1) Private Sector Leasing and (2) Public Sector Leasing. The private sector leasing consists of: i. Pure Leasing Companies. ii. Hire Purchase and Finance Companies and iii. Subsidiaries of Manufacturing Group Companies. The public sector leasing organisation are divided into: i. Leasing divisions of financial institutions. ii. Subsidiaries of public sector banks. 32
  33. 33. Lease Financing iii. Other public sector leasing organizations. I. Pure Leasing Companies: These companies operate independently without any link or association with any other organisation or group of organization. The First Leasing Company of India Limited. The Twentieth Century Finance Corporation Limited, and the Grover Leasing Limited, fall under this category. II. Hire Purchase and Finance Companies: The companies started prior to 1980 to do hire purchase and finance business especially for vehicles added leasing to their activities during 1980. Some of them do leasing as major activity and some others do leasing on a small scale as a tax planning device. Sundaram Finance Limited and Motor and General Finance Limited belong to this group. III. Subsidiaries of Manufacturing Group Companies: These companies consist of two categories, (a). Vendor leasing (b). In house leasing (a). Vendor leasing: This type of companies are formed to boost and promote the sale of its parent companies’ products through offering leasing facilities. (b). In House Leasing: In house leasing or capture leasing companies are set up to meet the fund requirements or to avoid he income tax liabilities of the group companies. 33
  34. 34. Lease Financing PUBLIC SECTOR LEASING (i). Financial Institutions: The financial institution such as IFCI, ICICI, IRBI and NSIC have set up their leasing divisions or subsidiaries to do leasing business. The shipping credit and Investment Company of India offers leasing facilities in foreign currencies for ships, deep seas fishing vehicles and related equipment to its clients. (ii). Subsidiaries of Banks: The commercial banks in India can, under section 19(1) of the Banking Regulation Act, 1949, setup subsidiaries for undertaking leasing activities. The SBI was the first bank to start a subsidiary for leasing business in 1986. Leasing in SBI is transacted through, Strategic Business Unit (SBU) of the bank. Each SBU is manned by specially trained staff and is equipped with the latest technological aids to meet the needs of top corporate clients. For the bank as a whole, leasing is considered as a high growth area. Now the bank is concentrating only on ‘Big Ticket Leasing’ which is generally of Rs.5 crore and above. So far SBI disbursed more than Rs.300 crores by way of leasing with the average size of deal being Rs.25 crores. (iii). Other Public Sector Organizations: A few public sector manufacturing companies such as Bharat Electronics Limited, Hindustan Packaging Company Limited, Electronic Corporation of India Limited have started to sell their equipment through leasing. 34
  35. 35. Lease Financing ACCOUNTING TREATMENT OF LEASE Presently the accounting treatment of lease transactions in India is as follows: 1. The leased asset is shown on the balance sheet of the lessor. 2. Depreciation and other tax 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 expense in the books of the lessee. In 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. It may be noted that in countries like the United States and the United Kingdom, 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. Depreciation 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. Background and international accounting changes on lease accounting: There were some 500 odd leasing companies in India about 5 years ago. Now, not more than 50 serious operators are left, who are searching for ways to survive in the coming 5 years. In my view, it is high time for those 50 players to join hands 35
  36. 36. Lease Financing together, and cry out loud: "We will not write a single penny of lease transactions in India, unless the Government speaks out its mind. Enough is enough. A business can survive taxes, and duties, and sanctions, but no business can survive uncertainty. So, unless the Government clarifies what does it have in mind regarding income-tax, sales-tax, accounting and other issues that have been drifting like the nebula for last 20 years, we cannot, and shall not write a single lease." Leasing in India would go down in history as a clear victim of legislative inaction. It is true that governments have their own way: they do not act; they react. But it is perplexing 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: • Controversy erupted regarding leasing companies' claim for depreciation in 1995 as some companies were found to have made exaggerated claims or claims that were not genuine. The Association of Leasing and Financial Services Cos. (ALFSC) has been pleading for last 5 years that the CBDT frame rules that would help the assessing officers distinguish between genuine leases and garbed financial transactions. ALFSC has also suggested model rules drawing from several other countries. Obviously enough, there was nothing that the CBDT would have lost by enacting these rules, and nothing stood to gain by not enacting them. However, nothing has been done for last 5 years. Result: as there is no rule from the CBDT, every assessing officer, and every appellate commissioner, has framed his or her own rule. Most 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-tax was imposed on lease transactions some 16 years ago. No one was clear as to how would the jurisdiction and incidence of tax be determined. We allowed the controversy to linger for all these years waiting for the Supreme Court to give a ruling only in year 2000. In the 36
  37. 37. Lease Financing meantime, some Rs 20000 crores worth lease transactions would have been signed in the country, and obviously enough, the Supreme Court ruling that operates 16 years back in history cannot be favourable to them all. At the same time, it cannot be favourable to the States as well. Any one who understands the ruling would agree that the States would not be happy with the ruling and would force the Central Govt to alter the law, possibly with retrospective effect. Again - we let things loose and unsettled for years, and wait for a crisis-like situation, and then correct our mistakes in history. • Accounting standards for lease transactions have been in the limelight for quite a while. The ICAI has expressed its resolve to adopt in India something akin to the pre-1999 version of IAS-17. This is exactly what the Institute proposed sometime in year 1983-4. For last 16 years, the framing of accounting standards has been lurching, hit by a Court-stay for some time, uncertainty for a larger time. In the meantime, IAS 17 has already been amended. There is a new thinking internationally about lease accounting, and the pre-1999 version of IAS-17 that the Institute is seeking to adopt is in the process of being discarded world-over. In other words, we would be adopting a standard, just when the rest of the world is about to reject it. Every industry needs a safe harbour: more so for lease transactions which envisage long term investments. It is the duty of the State to define what is it policy towards a business. In the current controversy relating to accounting standards for lease transactions, some interesting issues have cropped up. Will change of accounting standard deny tax depreciation to leases? This is absolute rubbish. Accounting standards are meant for preparation of books for account, not for guidance of tax officers. As things exist, accounting 37
  38. 38. Lease Financing depreciation and tax 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 tax purposes by lessors. UK itself is a prominent example. South Africa is yet another. Even in the largest leasing market in the World, USA, tax 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 India adopts IAS-17-type capitalization by lessees, it would lead to loss of tax depreciation. Unless the tax department also thinks alike (which would be a disaster, as I explain below), there is no linkage between tax treatment and accounting treatment when it comes to depreciation. Merely because a lease is capitalized by the lessee for accounting purposes does not entitled the lessee, or disentitled the lessor to claim depreciation. Has the accounting distinction between financial and operating leases served any purpose? It is today almost universally agreed that the accounting distinction between financial and operating leases has not served any purpose. As the accounting difference is based on fine mathematics, lessors and lessees world-over have devised leases which in essence are financial leases but qualify for operating lease definition. This is what prompted an Australian gentleman -McGregor - to make a cothetic argument against the financial-operating lease distinction. McGregor study became the basis for what is called "the new approach" to lease accounting. It is based on this approach that IAS 17 was revised with effect from 1999. Under the revised standard, disclosure is required for non-cancellable leases in the books of the lessee, irrespective of whether the lease is a financial lease or operating lease. In other words, as far as the lessee is concerned, accounting standards no more distinguish between a financial and an operating lease. 38
  39. 39. Lease Financing Can the accounting distinction be used for tax laws? It would be disastrous to adopt the accounting distinction between financial and operating leases for tax purposes. As mentioned above, the accounting distinction is based on fine mathematics which is extremely complicated and subjective. The primary test used for accounting purposes is the "present value" test. Apart from being complicated, the present value test is: • Different for the lessor and the lessee (in case of the lessor, his IRR is used; in case of the lessee, his incremental borrowing rate is used) • Subjective, as the incremental borrowing rate for the lessee is an arguable issue • Prone to manipulation by using structuring elements like security deposit which are not used in computing the present value test. Should India adopt IAS-17? Almost the whole of civilized world has adopted. Much smaller and lesser developed economies have adopted IAS 17, many years ago, and leasing has continued to grow there. Leave aside unfamiliar names, all our neighbors - Bangla Desh, Sri Lanka and Pakistan, adopted IAS 17 several years back. That has not deterred the growth of leasing in any way in any of these countries. So there should be no apprehension as to leasing meeting an untimely death due to accounting standards being revised to meet internationally accepted norms. If anything will cause the untimely death of the industry, it is lack of regulation, leading to lack of certainty. What kind of tax treatment should be applicable to leases? As discussed before, the financial lease/ operating lease distinction would be a disaster for tax laws. For tax purposes, what is more relevant is the test of a "true lease", meaning a lease that does not reflect intent of owning and letting out an 39
  40. 40. 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. Besides this, it might make sense to use a simple but very powerful limitation: leasing tax shelter not being used against non-leasing incomes. Several countries, such as Malaysia, Sri Lanka, South Africa, have enacted this rule. This rule allows the leasing tax 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 Institute of Chartered Accountants of India (ICAI) recently issued a new accounting standard no AS 19 on leases, replacing the existing Guidance Note on lease accounting. The new standard is applicable for all leases entered on or after 1st April 2001: from this, it is understood that the statement will not affect past leases. However, 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. It has been made out that the new accounting standard is drawn in accordance with international accounting standard no. 17. However, this is not true as the IAS 17 itself underwent revision in 1997. ICAI's AS 19 is based on the pre-1997 version of IAS 17. Internationally, lease accounting continues to be in a state of flux ever since McGregor published a new approach to lease accounting under which the traditional distinction between financial and operating leases is to become irrelevant and companies are required 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. In other words, if during the lease period, the benefits arising from an asset exceed 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. 40
  41. 41. Lease Financing To partly implement the McGregor approach, lease accounting standards in most countries, including IAS 17, have already been revised which now requires disclosure operating leases on the balance sheet of the lessee. Further changes may be on the way, as IASB as well as the UK's Accounting Standards Board have issued approach papers to implement the McGregor approach in full. Application of Lease In Transfer of Right And Service The new statement applies to all lease contracts - financial or operating. As an important point, the statement also applies to all hire purchase contracts, which are essentially financial leases. The standard is applicable to all lease contracts, even if such lease involves substantial services by the lessor. On the other hand, the standard does not apply to service contracts, even if the same involve provision of right to use. The distinction between a transfer of right to use, and a service contract, is relevant for several purposes and there are some very nice interpretations of this difference. There is a lease, if I transfer the right to my asset to you. There is a service, if I use my asset for your benefit. In other words, the distinction between lease and service is based on whether the use of the asset is made by the lessee, or for the lessee's benefit by the lessor. What are the main ingredients ? The main ingredients of the accounting standard are: • As for lease transactions which are currently capitalised on the books of the lessor, the accounting will be based on financial/ operating leases. • For a financial lease, the lessor will not capitalise or depreciate the asset on his books: the lessor will merely record a receivable, at the outstanding principal value. The lessee will record the asset, as his fixed asset, and depreciate the same as per usual depreciation policies of the lessee. The 41
  42. 42. 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 expense by the lessee. • In 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 expense by the lessee, subject to evening out in case of structured rentals. The asset/liability will be off-the-books of the lessee. • If 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. • If a sale and leaseback transaction results into an operating lease, a lessee will book profit/loss on sale irrespective of the sale price of the asset, depending on the fair value of the asset. 1. Will it have tax implications ? The fears expressed before that the new method of accounting will result into loss of tax benefits by the lessor have now been allayed. In Feb., 2001, the CBDT issued a circular clarifying that the change of accounting rules will have no bearing on the tax treatment. That is to say, subject to other conditions for depreciation allowance, a lessor in a lease will claim tax benefits, even though he will not be reflecting the asset as his fixed asset on balance sheet. This also means that the lessor will be subjecting his gross rentals as income, even though he takes to profit and loss a/c only the finance charges inherent in rentals. 42
  43. 43. Lease Financing In 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 tax purposes and depreciation will be allowed. As for the lessee, though he capitalises the asset on his financial statements, he will not be able to depreciate the asset for tax purposes. Though he takes to earnings statement only the finance charges inherent in lease rentals, he will claim the whole of the rentals as expense. Thus, the new accounting standard leads to a new era of dichotomy between tax and accounting principles, and it will be quite a tough time for the tax officers to negotiate through this dichotomous rule. In essence, when things are tough for the tax officers, they are tougher for the tax payers! 43
  44. 44. Lease Financing ACCOUNTING FOR NON PERFORMING LEASES There is no information in the guidance note on lease accounting, 1995, for non- performing assets. The general accounting principles for non-performing assets is contained in accounting standard 9 on Revenue Recognition which is more or less on the lines of the International Accounting Standards on the issue. The Standard provides that whereas, in general, incomes are to be recognized on the basis of accrual, in case of an uncertainty in the ultimate realization of an income, the treatment is as follows: • If the uncertainty is prevalent at the time of raising the claim for the income, the recognition of the income shall be postponed • If the uncertainty arises subsequent to the claim being made, there shall be a provision made to the extent 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 Prudential Norms of the RBI A lease will be regarded as a non-performing asset based on overdues for more than 12 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. If the lease transaction is a non-performing asset, there is a four-fold impact on the revenue/provisioning requirements: No income shall be recognized on an accrual basis-income recognition will shift to cash or accrual basis. 44
  45. 45. Lease Financing Income already recognized, and lying unrealized, will be reversed-this, in accounting sense means the income recognized will be provided for. Notably, in case of lease transactions, the income that requires reversal is only the financial charge element inherent in the rentals, not the entire rental. A 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 Companies Act. The NBFCs should make provisions against NPAs with correlation to the net book value of the assets in four stages at 10, 40, 70 and 100 per cent as follows : ⇒ Rentals are overdue up to 12 months Nil ⇒ Sub-standard assets : where any amounts of hire charges or 10 percent of the lease rentals are overdue for more than 12 months net book value but up to 24 months ⇒ Doubtful assets : Where any amounts of hire charges or lease 40 percent of the rentals are overdue for more than 24 months net book value but up to 36 months ⇒ Where any amounts of hire charges or 70 percent of the rentals lease are overdue for more than 36 months net book value but up to 48 months ⇒ Loss assets: Where any amounts of hire charges or lease 100 percent of the rentals are overdue for more than 48 months net book value 45
  46. 46. Lease Financing TAXATION IN TERMS OF LEASING: 1. Basic tax treatment of lease and hire-purchase transactions: The tax treatment of lease transactions in India is based on whether the lease qualifies as a lease or will be treated as a hire-purchase transaction. If the transaction is treated as a lease, the lessor shall be eligible for depreciation on the asset. The entire lease rentals will be taxed as income of the lessor. The lessee, correspondingly, will not claim any depreciation and will be entitled to expense off the rentals. If the transaction is a hire purchase or conditional sale transaction, the hirer will be allowed to claim depreciation. This is based on an old Circular of the Dept. issued in year 1943. The financing charges inherent in hire instalments will be taxed as the hire-vendor's income and allowed as the hirer's expense. 2. Depreciation in case of Leasing and hire-purchase transactions: Being the sole determinant of the tax treatment of leases, the distinction between lease and hire-purchase transactions becomes extremely important. Essentially, the distinction is based on the beneficial ownership of the asset. In order to qualify for depreciation, the lessor has to establish himself to be both the legal and beneficial owner of the asset. As 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). Having thus permanently divested himself of his beneficial rights, the lessor becomes ineligible to claim depreciation. 46
  47. 47. Lease Financing As it is the beneficial ownership rights of the lessor that is crucial, the distinction between lease and hire-purchase goes beyond the mere existence of option to buy in the lease. If, explicitly or implicitly, it is apparent that the lessor has agreed to a permanent beneficial enjoyment of the asset by the lessee, the lease may be treated as a hire purchase or a plain financing transaction. 3. Depreciation allowance on lease transactions: A lease qualifying 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 tax-payer claiming depreciation should own the asset. No doubt, the lessor owns the asset, but as discussed earlier, it is not legal ownership alone that is sufficient; the lessor must establish himself to be the beneficial owner as well. It is on the failure of the condition of beneficial ownership that the legal owner in case of hire-purchase is not allowed depreciation. The lessor's 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 joint owner or a single owner. In case of joint ownerships, depreciation was not allowable until 1996 when a specific amendment was inserted to make syndicated leases possible; confusion, however, persists on whether two or more lessors jointly leasing an asset will be treated for tax purposes as a separate assessable entity. When a movable property becomes a permanent fixtures to land not belonging to the lessor, the lessor ceases to be the legal owner of such fixture. This basic legal might create problems for Indian lessors leasing out assets that are in the nature of permanent fixtures to ground. Such intent is even reflected from the recent 47
  48. 48. Lease Financing Supreme Court ruling in First Leasing Company of India where the Supreme Court 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 taxpayer should be using the asset. It is understood clearly that the taxpayer uses the asset in the business of leasing; hence, it is on the strength of the lessor's use that depreciation is claimed and not on the strength of the lessee's use. Use or its absence by the lessee should not, therefore, cast any implication on the lessor's depreciation claim. Depreciation is allowed in India 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. Acquisition 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. 4. Rates of depreciation: Rates of depreciation are listed in the Schedule to the Income-tax Rules. Like under the English system, India makes distinction between "plant or machinery" and other assets based on the functional test. The age-old functional test in Yarmouth v. France holds in India. Based 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. Under this caption, the applicable depreciation rates on some of the generally eased assets are given in the Table below : Motor cars 20% General plant or machinery (residuary rate) 25% Lorries, buses or taxies plying on hire, aeroplanes, moulds used in 40% 48
  49. 49. Lease Financing plastic or rubber factories Bottles and crates 50% Computers (proposed) 60% Pollution control devices, energy saving devices, renewable energy devices, rollers in flour mills, gas cylinders, etc. 100% 5. Sale and leaseback transactions: Sale and leaseback transactions came under a lot of flak during 1995-96, when transactions in junk funding were being labeled as sale and leasebacks at phenomenal values. The Income-tax 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 seller's depreciated value. This provision is applicable only where the seller is the lessee; in other words, not applicable for every lease of second-hand assets. However, in such cases, the fair valuation rule that existed earlier, in Explanation (3) to sec. 43 (1) shall continue to apply. 6. Deduction of rentals by the Lessee: In general, in a lease, the lessee will be allowed to claim the rentals as an expense. This is subject to general rules of reasonableness and the power of the tax officer to invoke substance of a transaction ignoring its legal form. One important case where the claim by the lessee for rental was disallowed is Centre for Monitoring of Indian Economy case, where based on the fact that the lease had partaken the 49
  50. 50. Lease Financing character of acquisition of the asset by the lessee, the lessee's 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. If this case is a precedent, then lease rentals are not tax-deductible in any single financial lease. However, even the Supreme Court has differentiated between lease and hire- purchase in the latest First Leasing Company of India case. Therefore, most likely the Centre for Monitoring of Indian Economy case will not be able to withstand at higher judicial forums SALES TAX PROVISION PERTAINING TO LEASING: The major sales tax provisions relevant for leasing are as follows: 1. The lessor is not entitled for the concessional rate of central sales tax because the asset purchased for leasing is meant neither for resale nor for use in manufacture. (It 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 tax). 2. The 46th Amendment Act has brought lease transitions under the purview of ‘sale’ and has empowered the central and state government to levy sales tax on lease transactions. While the Central Sales Tax Act has yet to be amended in this respect, several state governments have amended their sales tax laws to impose sales tax on lease transactions. a. Levy of Sales Tax: Sales Tax is leviable when goods are sold. Thus there must be " Goods and there must be a sale. "Goods” include all types of movable property. “Sale " means a 50
  51. 51. Lease Financing transfer of property in goods from one person to another for a consideration. But Sales Tax is leviable only on a person who is a dealer. A casual transaction by a non-dealer is not subject to Sales Tax. Thus, if an individual salary earner sells off his personal car, there is no Sales Tax attracted. To summarize, Sales Tax is leviable on sale of goods by a dealer. b. Sales Tax on financial leases: In a Finance Lease, NBFCs are the owner of the Goods and the lessee only has the right to use the goods on payment of lease rentals. It is a contract of hiring or bailment. Hence there is no “sale “as defined. However, there is a transfer of the right to use the goods from us to the lessee. And this has become taxable as a deemed sale. The Sales Tax, also called "Lease Tax ", is leviable on the Transfer of Right to Use the goods from us to the lessee. And the tax is charged as each rental for use of the lease asset becomes due and payable. It may be noted that Lease Tax is a case of taxing a non-sale -the consumption of utility of goods - though there is no transfer of title. . Whether it is good law or will the Courts strike down this Tax ? We are not sure, but NBFCs are agitating the matter in a Court. c. Sales Tax on Lease V/s. Hire Purchase Transactions: Lease is a sale followed by a transfer of right to use. Supplier S sells to the NBFC and the NBFC gives the goods on lease to Customer C (Transfer of the right to use the goods). Hence, there are two sale transactions - the sale proper, and the lease. 51
  52. 52. Lease Financing In HP, also, there are 2 sales. Supplier S sells to the NBFC and the NBFC simultaneously sells to the Customer C by entering into a hire purchase agreement. Commercially 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 Tax on the Sale and a Lease Tax (if any) on the transfer of the right to use. In a Hire Purchase there will be 2 Sales Taxes applicable on 2 separate sales. However, sales-tax laws (for historical reasons only) treat lease and hire purchase substantially differently. Since the choice of the instrument, viz., lease or hire purchase, may lead to material sales- tax difference, it is important that the sales-tax implications are analyzed before choosing the instrument or concluding the transaction. Government Jurisdiction in levying Sales Tax :  In a sale outside India or in the course of import into or export out of India. If the sale is outside India or in the course of import into India or export out of India , India cannot tax such a sale.  Sale within a State : If the sale is within a state then that state has the power to tax it.  Sale in the course of inter state trade: If the sale takes place in the course of Inter state trade, the Central Government can tax such a sale. However, there is no administering machinery of the Central Government to administer inter state sale tax. The same is delegated to the state governments. That state where the inter state movement commences has the jurisdiction and the rate chargeable is also that applicable in that state for CST transactions. 52
  53. 53. Lease Financing  Sales Tax Rates : Since under the sharing arrangement all the CST collections are retained by the state concerned, states have been allowed to reduce the CST rates and also give exemptions. So while as a general rule CST is 10% or such higher rate if the State charges a higher rate of tax on the local sale of the subject goods; or 4% with C Form, this could vary from state to state. But the State Government cannot increase the Central Sales Tax from 10/4 % in any case. Therefore, NBFC’s will have multiple CST assessments, one in each state from where goods move.  NBFC’s shifting jurisdiction: As explained, the jurisdiction in Inter state transaction is in the state where movement of goods commences. But NBFCs can shift the jurisdiction from all states to say Maharashtra. This can be done by endorsement of the LR during transit. If endorsement is done the jurisdiction shifts to the place where endorsement was made. Thus NBFCs could instruct the Supplier to send goods physically to Customer and hand over the LR in our name at our Bombay address. NBFCs will then endorse the Consignee copy of the LR in favour of the Customer and forward it to the Customer. The Customer will claim the goods from the transporter by producing this endorsed LR. Service Tax on Lease Transactions Service Tax on Lease Transactions with effect from 1st July, 2001: Everyone knew, though without any clue to the reasons that the Finance Ministry officials are not particularly very sympathetic to leasing and hire purchase, but no one ever thought that the Finance Minister had this provision up his sleeve. No one could have even apprehended this hearing him deliver his Budget Speech. But 53
  54. 54. Lease Financing it is there in the fine print - a 5% service tax on the gross receivables of leasing and hire purchase companies. The Budget deals a body blow to the already moribund leasing and hire purchase sector - imposing a service tax on not just the income but the entire receivables out of lease and hire purchase transactions. Not only are leasing and hire purchase companies proposed to be brought under tax, they are also grossly discriminated against: as loans from banks, an alternative to lease and hire purchase, have not been brought under the tax. Constitutional validity to be questioned: Surprisingly enough, leasing as well as hire purchase are not a part of services under the Constitution - as they are defined as "sales" in the Constitution and are liable to sales-tax. Service tax cannot be imposed on leasing and hire purchase activities as they are defined as sales under the Constitution and the Constitution places restrictions on tax on sale or purchase of goods - leasing and hire purchase being defined as sale and purchase of goods. The Central Govt's right to tax such sales is only limited to inter-state transactions with the States having the right to tax intra-state transactions. The receivables from lease and hire purchase transactions are therefore, sale revenues under the Constitution, and they cannot be taxed as value for services. Gross value of services Does this mean, in case of a bank, even the repayment of the loan is to be charged to service tax? Not really. First of all, because bank loans are not even included in the definition of financial services. And two, because the splitting of interest and principal is defined in the bank's loan agreement. In case of hire purchase, the splitting of interest and principal is an accounting adjustment, and is not 54
  55. 55. Lease Financing recognized in law as interest or principal. In case of lease transactions, the lease rental is surely the gross value for the leasing service. So as it seems, leasing and hire purchase companies better pack up - since they have to shell out a 5% of their own principal, and 5% of their income, to the Government before they can take up anything to their revenue account. INCOME TAX PROVISIONS RELATING TO LEASING: The principal income-tax provisions relating to leasing are as follows: 1. The lessee can claim lease rentals as tax-deductible expenses. 2. The lease rentals received by the lessor are taxable under the head of ‘Profits and Gains . of Business or Profession’ 3. The lessor can claim investment allowance (this may be doubtful) and depreciation on the investment made in leased assets. 55
  56. 56. Lease Financing LEASING IN RELATION TO BANK FINANCE With 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 sale/liquidation). Banks and other lenders tend to look at the balance sheet value of collateral. The second is that leasing companies are more sales and service oriented—they are using their specialized knowledge to “bridge the gap” between suppliers and purchasers, and the specialized 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 equipment acquisition; leasing companies specialize in finance, credit and equipment acquisition and disposal (equipment dealing). In effect, both the supplier and the lessee are “outsourcing” certain portions of their business to a service provider that also happens to have a certain capacity to borrow and lend money. The Difference between Financial Leasing and Loans 56
  57. 57. Lease Financing From the lessee’s 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. The many similarities between a loan and a financial lease include: ■ The lessee and borrower have the choice over the acquisition 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. ■ Over the period of both a loan and a lease, interest and capital (equipment cost) are repaid. ■ 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 reclaim/repossess assets. ■ The risks and costs of ownership, including maintenance and obsolescence, remain with the borrower and lessee. Also, under both a loan or a financial lease, if the asset appreciates, neither the lender nor the lessor benefits. ■ The agreements are non-cancelable until either the lessor or the lender has recovered its outlay. ■ The borrower or lessee can either settle the agreement (in the case of the lease) or repay the loan early. 57
  58. 58. Lease Financing PROBLEMS OF LEASING Leasing has great potential in India. However, leasing in India faces serious handicaps which may mar its growth in future. The following are some of the problems. 1. Unhealthy Competition: The market for leasing has not grown with the same pace as the number of lessors. As a result, there is over supply of lessors leading to competitor. With the leasing business becoming more competitive, the margin of profit for lessors has dropped from four to five percent to the present 2.5 to 3 percent. Bank subsidiaries and financial institutions have the competitive edge over the private sector concerns because of cheap source of finance. 2. Lack of Qualified Personnel: Leasing requires qualified and experienced people at the helm of its affairs. Leasing is a specialized business and persons constituting its top management should have expertise in accounting, finance, legal and decision areas. In India, the concept of leasing business is of recent one and hence it is difficult to get right man to deal with leasing business. On account of this, operations of leasing business are bound to suffer. 3. Tax Considerations: 58
  59. 59. Lease Financing Most people believe that lessees prefer leasing because of the tax benefits it offers. In reality, it only transfers; the benefit i.e. the lessee’s tax shelter is lessor’s burden. The lease becomes economically viable only when the transfer’s effective tax rate is low. In addition, taxes like sales tax, wealth tax, additional tax, surcharge etc. add to the cost of leasing. Thus leasing becomes more expensive form of financing than conventional mode of finance such as hire purchase. 4. Stamp Duty: The states treat a leasing transaction as a sale for the purpose of making them eligible to sales tax. On the contrary, for stamp duty, the transaction is treated as a pure lease transaction. Accordingly a heavy stamp duty is levied on lease documents. This adds to the burden of leasing industry. 5. Delayed Payment and Bad Debts: 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 fixing the rentals at the time of lease agreement. These problems would disturb prospects of leasing business. The current problems of Indian leasing could be listed as follows, again without any order of listing: Asset-liability mismatch: Most non-banking finance companies in India had relied extensively on public deposits -this was not a new development, as the RBI itself was constantly encouraging and supporting the deposit-raising activities of NBFCs. If the resulting asset-liability mismatch, to everybody's agreement, is the surest culprit of all NBFC woes today, it must have been a sudden realization, because over all these years, each Governor of the RBI has passed laudatory remarks on the deposit-mobilization by NBFCs knowing fully well that most of these deposits 59
  60. 60. Lease Financing were 1-year deposits while the deployment of funds was mostly for longer tenures. It is only the contagion created by the CRB-effect that most NBFCs have realized that they were sitting on gun-powder all these years. The sudden brakes put by the RBI have only worsened the mismatch. Generally-bad economic environment: Over past couple of years, the economy itself has done pretty badly. The demand for capital equipment has been at one of the lowest ebbs. Automobile sales have come down; corporate have found themselves in a general cash crunch resulting into sticky loans. Poor and premature credit decisions in the past: Most NBFCs have learnt a very hard way to distinguish between a good credit prospect and a bad credit prospect. When a credit decision goes wrong, it is trite that in retrospect, it invariably seems to be the silliest mistake that ever could have been made, but what Indian leasing companies have suffered are certainly problems of infancy. Credit decisions were based on a pure financial view, with asset quality taking a back-seat. Tax-based credits: In most of the cases of frauds or hopelessly-wrong credit decisions, there has been a tax motive responsible for the transaction. India has something which many other countries do not- a 100% first year depreciation on several assets. Apparently, the list of such assets is limited and the underlying fiscal rationale 60
  61. 61. Lease Financing quite holy and sound - certain energy saving devices, pollution control devices etc qualify for such allowance. But that being the law, it is left to the ingenuity of our extremely competent tax consultants to widen the range with innovative ideas of exploiting these entries in the depreciation schedule. Thus, there have been cases where domestic electric meters have been claimed as energy saving devices, and the captive water softenizer in a hotel has been claimed as water pollution control device! As leasing companies were trying to exploit these entries, a series of fraudsters was successful in exploiting, to the hilt, the propensity of leasing companies to surpass all caution and all lending prudence to do one such transaction to manage its taxes, and thus, false papers for non-existing wind mills and never-existing bio-gas plants were fabricated to lure leasing companies into losing the whole of their money, to save the part that would have gone as government taxes! Extraneous problems - frauds, closures and regulation: As they say, it does not rain, it pours. Several problems joined together for leasing companies - the public antipathy created by the CRB episode and subsequent failures of some good and several bad NBFCs, regulation by the RBI requiring massive amount of provisions to be created for assets that were non-performing, etc. It certainly was not a good year to face all these problems together . 61
  62. 62. Lease Financing PLAYERYS IN THE INDIAN LEASING INDUSTRY There is a shake out in the market at the moment-90% of which is complete. Today there are close to 800 leasing companies in the market of these, about 50- 60 companies operate on a national level. This figure once stood at 4000. This is an indicator of the enormity of the shakeout in the market. The top ten players in the market account for about 65% of the market. Company Name Volume Of Business (Rs. In Crores approx) Asset Categories Leased Average Lease Tenor Nature Of Leases TATA FINANCE 500 Aircrafts 100% Depreciable Assets Infrastructural Equipment 8-10 Years Financial Operating L & T FINANCE 30 Equipment Computers 5 Years Financial Operating KOTAK MAHINDRA 20 Commercial Vehicles 3-4 Years Financial 62
  63. 63. Lease Financing ICICI 1500 Capital Equipment Ships Aircrafts Railway Wagons 5-10 Years Financial FIRST LEASING 150 Vehicles Equipment Computers 3-5 Years Financial IL & FS 500 Plant & Machinery Ships Aircrafts Power Equipment 5-7 Years Financial Operating ASHOK LEYLAND FINANCE 50 Vehicles Plant & Machinery 5-7 Years Financial CHOLA- MUNDULUM FINANCE 50 Vehicles Computers Equipment 5 Years Financial Operating SREI INTERNATI ONAL 30 Construction Equipment 100% Depreciable Assets 5 Years Financial 63
  64. 64. Lease Financing LEASING: TOUCHING THE PEAK Twenty five years ago, Farouk Irani quit his high profile job in Citibank to launch his dream project: a leasing company in India. On 10th Sept., 1973, Irani was able to convince Dr A C Muthia, Industrialist, to have the First Leasing Company of India incorporated. For several years, First Leasing Company remained the Only Leasing Company. Ever since IFC, Washington decided to support Indian leasing with investment in companies in 4 metros, Indian leasing has never looked back. This was about 1980. Early eighties' capital market boom found many young entrepreneurs riding the leasing wave. As it celebrates its 25th Birthday, Indian leasing is today a central part of the financial system. On its way, it has passed through several twists and turns. Financial industry World-over has a very high beta factor: it is hyper-sensitive to changes in economic scenario. Periods of general prosperity are extremely good for the leasing industry; downturns in economic cycle cost is extremely high. That apart, financial system is invariably affected by the contagion effect: failures of a few players affect even the healthy ones. Though it is currently passing through a testing time, leasing has had an undeniable role in Indian economy. From consumer finance to small industry, heavy industry to automobiles, from railways to electricity boards, almost every sector of the economy has utilized leasing as its source capital. Having attained an average over-30% growth rate over past 7 years, Indian leasing has reached the 14th largest place in the World, a fact which is least realized by most. India at the 14th largest place in World leasing sounds incredible! But it is true, and true contrary to the internationally available statistics published by the London Financial Group. The Group's data, published every year in the World 64
  65. 65. Lease Financing Leasing Yearbook would place India at some 36th place, but admittedly that data is only the estimate of the author thereof, and the author of the data might have ranked Indian leasing volume based on India's per capita income ! When it comes to size, India has the obvious advantage of being such a vast nation. Center for Monitoring of Indian Economy compiles data about Indian leasing volumes, which is carried as a part of India Leasing Yearbook published by the Association of Leasing and Financial Services Cos. The data compiled by the Center shows aggregate balance sheet value of leased and hired assets (though for balance sheet purposes, lease and hire-purchase transactions are distinguished, there is no material difference between the two - hence the volumes have been clubbed here) at about Rs. 261 billion (End March 1997). This is based on reporting by 226 companies, whereas the business, particularly hire-purchase, is spread amongst some 3000 large and small companies. Estimated outstanding business done by these firms is about Rs. 15 billion (at Rs. 5 million per such firm). That apart, the data also excludes the massive annual volume of business by the Indian Railway Finance Corporation (IRFC). IRFC is a hundred percent subsidiary of Indian Railways, and its leases are dedicated to the parent Railways only. Of late, almost entire floating stock acquisition by Railways is being acquired on lease from IRFC. The outstanding value of leases done by IRFC adds to about Rs. 120 billion. Thus, the aggregate volume comes to about Rs. 396 billion, which is about USD 11 billion as per then-prevailing exchange rates. USD 11 billion of outstanding volume cannot by itself give India a ranking in the London Financial Group data, since these rankings are based on incremental volume. However, a rough estimate of new business can be made from the above data (unfortunately, the Centre for Monitoring of Indian Economy data do not give any idea of new leasing and hire-purchase volume). Supposing 30% of the 65
  66. 66. Lease Financing outstanding business of last year was paid, and there was a 20% growth in net business (as can be seen from the Chart above), there was a 50% new business, over the volume outstanding at the beginning of the year. Relative to the business at the end of the year, the incremental volume should have been about 33% (50/150). Therefore the annual leasing volume in India is estimated at about USD 3.67 billion, on a rough and conservative estimate. In London Financial Group data, this should put India at 12-13th place, close to Hong Kong. This would also be the third largest market in Asia, next only to Japan and Korea. The only infirmity in the above ranking is that the London Financial Group data are not as of March 1997 - that, however, should not seriously disrupt the ranking of India, because other Asian markets in 1996-7 period have generally registered a negative growth. Factors that contributed to growth of Indian leasing: With the exception of 1996-97 and 1997-98, the 1990s have generally been a good decade for Indian leasing. The average rate of growth on compounding basis works out to 24% from 1991-92 to 1996-97. Broadly, the following factors have been responsible for the growth of Indian leasing, in no particular order: • No entry barriers : Any one could float a leasing entity, and even an existing company not in leasing business can write a lease purely for tax shelters. • Buoyant growth in capital expenditure by companies : 66
  67. 67. Lease Financing The post -liberalization era saw a spate of new ventures and fresh investments by existing ventures. Though primarily funded by the capital markets, these ventures relied upon leasing as a source of additional or stand-by funding. Most leasing companies, who were also merchant bankers, would have funded their clients who hired them for issue management services. • Fast growth in car market: Needless to state with facts, the growth in car leasing volume has been the highest over these years - the spurt in car sales with the entry of several new models was funded largely by leasing plans. • Tax motivations: India continues to have unclear distinction between a lease that will qualify for tax purposes, and one which would not. In retrospect, this is being realized as an unfortunate legislative mistake, but the absence of any clear rules to distinguish between true leases and financing transactions, and no bars placed on deduction of lease tax breaks against non-leasing income, propelled tax-motivated lease transactions. There was a growing market in sale and leaseback transactions, which, if tested on principles of technical perfection or financial prudence, would appear to be a shame on everyone's face. • Optimistic capital markets: Data would establish a clear connection between bullish stock markets and the growth in both number of leasing entities and lease volumes. Year 1994-1995 saw the peak of primary market activity where a company, even if a new entrant in business, could price itself on unexplainable premium and walk out with pride. 67

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