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.
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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.
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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.
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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
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Ownership is no
pre-condition for
leasing:

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
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Leasing of immovable
properties may have
complications:

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.
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Leased asset is a
necessary pre-
condition:

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
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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.
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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
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Buyout option may
characterize the lease
as hire-purchase:
Margins in leases
are taken as initial
rental:

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.
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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)
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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.
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The primary
and secondary
lease period :

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.
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The IRR:
Full payout
lease:

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
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Hire-purchase
and financial
leases
compared

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).
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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
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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.
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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".
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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
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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
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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
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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.
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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. 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. 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. 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. 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. 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. 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. 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
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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:
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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. 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. 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.
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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. 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
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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
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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. 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. 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. 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. 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.
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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!
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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.
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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
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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.
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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
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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%
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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. 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
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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.
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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.
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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
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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
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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.
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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
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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.
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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:
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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
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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
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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
.
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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
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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
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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
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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
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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 :
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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.
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