lease final)

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1) INTRODUCTION

Financial Services basically mean all those kinds of services provided infinancial 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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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.

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.

3) 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

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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

Corporations Merchant Banking division started financing leasing companies as

well as equipment leasing and financial services. 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.

4) 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:

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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 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".

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,

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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.

2. 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

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 thelease 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 primarylease period and the secondary lease period. The former would be the period

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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.

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.

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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 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.

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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.

However, in many jurisdictions, it is the existence of such buyout option thatdemarcates 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

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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 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 -

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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.

5) TYPES OF LEASING

FINANCE LEASE

A lease is defined as finance lease if it transfers a substantial part of the risksand 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:

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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)

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 toeliminate the substantive differences between leasing and plain financings

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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 substantialvalue. Thus, the asset will be enjoyed by the lessee virtually for the whole of its

economic life.

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 orIRR.

Features of financial leases:

The above discussion leads to the following features of financial leases:

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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.

The risk the lessor takes is not asset-based riskbut 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

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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 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

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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.

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Option To User

No option is provided to the lessee

(user) to purchase the goods.

Option is provided to

the hirer(user).

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 :

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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

markets regulation - most countries' central banks maintain some control onfinancial 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.

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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.

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.

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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".

O

PERATING 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.

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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 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;

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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

Differences between Finance and Operating Leases

Financial Lease

Risks and rewards of ownershipare 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

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

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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 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. Further, the duration of an

operating lease is usually much

shorter than the useful life of the

asset.

It is not the lessees intention to

acquire the asset, and lease

payments

are determined accordingly. In

addition, an asset under an

operating lease may subsequentlybe rented out.

The present value of all lease

payments is significantly less

than the full asset price.

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asset. The lessee will also

generally retain some rights with

respect to the supplier, as if it had

purchase asset directly.

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 banksis 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.

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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 short-term debt by medium-term finance (assuming that theleaseback 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,

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LESSEE LESSOR


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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 lessorundertakes 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

lease is the sales-aid lease where the equipment supplier catalyzes the lease

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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

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

represented in the figure:

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

transaction calls for,

a. An understanding of the political and economic climate; and

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Manufacturer Lessor Lessee

Lender


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b. Knowledge of the tax and the regularity framework governing these

transactions in the countries concerned.

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.

6) 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:

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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.

(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, lessees 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:

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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) Riskof 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.

(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

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(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

7) 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

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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 lessors title, to take reasonable care of the asset, and

to return the leased asset on the expiry of the lease period.

8) 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:

1. Description of the lessor, the lessee, and the equipment.

2. Amount, time and place of lease rentals payments.

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3. Time and place of equipment delivery.

4. Lessees responsibility for taking delivery and possession of the leased

equipment.

5. Lessees responsibility for maintenance, repairs, registration, etc. and the

lessors right in case of default by the lessee.

6. Lessees 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.

9) 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.

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The public sector leasing organisation are divided into:

i. Leasing divisions of financial institutions.

ii. Subsidiaries of public sector banks.

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.

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(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.

10) 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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11) ACCOUNTING FOR NON PERFORMING LEASES

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 lessorallows 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

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to buy the asset with the hirer). Having thus permanently divested himself of his

beneficial rights, the lessor becomes ineligible to claim depreciation.

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

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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

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

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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 plastic or rubber factories

40%

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.

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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 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

12) SALES TAX PROVISION PERTAINING TO LEASING:

The major sales tax provisions relevant for leasing are as follows:

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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 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.

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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.

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, NBFCs will have multiple CST assessments, one

in each state from where goods move.

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 it is

there in the fine print - a 5% service tax on the gross receivables of leasing and hire

purchase companies.

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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.

13) 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.

14) LEASING IN RELATION TO BANK FINANCE

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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 orientedthey 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.

15) 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:

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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:

Most people believe that lessees prefer leasing because of the tax benefits

it offers. In reality, it only transfers; the benefit i.e. the lessees tax shelter is

lessors burden. The lease becomes economically viable only when the transfers

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

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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.

16) 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 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:

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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 certainlyproblems 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

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

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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 RBIrequiring 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

17) PLAYERYS IN THE INDIAN LEASING INDUSTRY

There is a shakeout 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 50-60companies 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.

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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

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

50 Vehicles

Plant & Machinery

5-7 Years Financial

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FINANCE

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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18) 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:

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:

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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.

Access to public deposits:

Most leasing companies in India have relied, some heavily, on retail

public funds in the form of deposits. Most of these deposits were raised for 1

year tenure, and on promise of high rates of interest, at times even more than

the regulated rate (which was lifted in 1996 to be reintroduced in 1998).

A generally go-go business environment:

At the backdrop of all this was a general euphoria created by liberalization

and the economic policies of Dr. Manmohan Singh.

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19) LEASING IN EMERGING ECONOMIES:

Emerging economies face several challenges, including the need for

investment. This is compounded by an under-capitalized banking system that is

only able to offer its potential clients a limited range of products. In turn, small and

medium-size companies possess insufficient collateral or credit history to access

more traditional bank finance. This results in a shortage of credit available to

domestic entrepreneurs. Developing the leasing sector as a means of delivering

finance increases the range of financial products in the marketplace and provides a

route for accessing finance to businesses that would otherwise not have it, thus

promoting domestic production, economic growth, and job creation. In addition,

many developed countries suffer from underdeveloped or imperfect legal

institutions. Although in principle secured lending and leasing should be roughly

equivalent in terms of risk, in many jurisdictions experience has shown that legal

ownership is recognized by all participants, especially courts, more readily and

consistently than secured lending. This can reduce the risk to lenders (lessors)

considerably. The value of this advantage of leasing should not be underestimated,

particularly in more challenging environments.

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Figure 1-1 shows the role leasing plays in emerging economies and in developed

economies and the room for growth in the use of leasing in emerging economies.

The chart shows that leasing can provide a valuable additional source of finance

within these markets. The effect of leasing can be further accelerated and

strengthened where the in country conditions allow for investment by IFC and

other international financial institutions, with these institutions recognizing the

positive effects of leasing and introducing medium-term finance into markets

where no alternative currently exists.

In many markets, discussion of leasing often focuses on large-ticket leasing,

cross border structures, or tax implications. While these are also important, any

discussion of leasing should be kept as broad as possible and consider the effects

for all businesses, including small and medium-size enterprises.

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20) LEASING COMPANIES- CASE STUDY

a) CSI LEASING COMPANY

CSI Leasing Customer:

Leading supplier to the automotive industry

2,500 employees in 50 locations worldwide

The Problems

By using several technology lessors, this IT department found itself in assetmanagement chaos. By choosing to lease its PCs and laptops directly from the

captive finance arm of the manufacturer, this $600 million company believed it had

found the most convenient solution for its IT leasing needs. It quickly learned,

however, that its organization was not quite big enough to garner much attention

from the captive leasing company. Equipment orders were delayed. Shipment

locations were consistently incorrect. Invoices were confusing and often late. Since

no single dedicated account manager was assigned to the business, it took multiple

calls to multiple departments at the captive finance company to correct ongoing

errors.

The Solution

The captive failed to improve its service. As a result, when faced with the

need to acquire several hundred additional PCs, the company chose the same

brand equipment, but a different lessor. Following the recommendations of

executives from companies similar to its own, it gave CSI Leasing a test run. These

references attested to the dependability and accuracy of the services they received

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from CSI. With CSI, they gained a single point of contact for all ordering, as well

as a local account executive immediately responsive to their various needs.

Four years later, CSI Leasing is handling all of this companys IT leasing needs.

A remarkable side note to this story - it took the captive leasing company

five months to realize it had lost the companys business.

How CSI did it:

Unlike manufacturers captive leasing arms, CSI does not exist to drive

product sales for a parent company. Since we do not make the products we finance,

we realize the only way to create a loyal customer is to master the principles of

account management. We started by getting the basics right quick turnaround on

orders, accurate invoices and documentation, and responsive service. Online

invoice information, quick vendor payment and simple end of lease procedures

further increased satisfaction. At CSI, we truly believe there is no excuse for less

than exceptional service.

b) HARDWARE LEASING COMPANY

The Leveraged Lease

Spacemakers of Kuwait is the largest independent owner-operator of large-

scale automated self-storage complexes in the greater Kuwait City area. The

company opened its first self-storage complex in Kuwait in 1994 and now has

facilities throughout downtown Kuwait City and nearby residential areas. The

business is based on a franchise management company based in Cincinnati, USA.

Hamid Lahcen, Chairman and CEO of Spacemakers, was considering

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options for financing $1 million of new forklifts needed for the commercial storage

facilities. Because there was no corporate tax in Kuwait, Spacemakers could not

take advantage of the equipment's depreciation tax shield. Hence Lahcen was

considering a fifteen year lease of the equipment.

The Canadian lessor, Hardware Leasing Co., had offered to structure a

capital lease for Spacemakers, as long as Hardware Leasing could arrange non-

recourse financing for the equipment. Hardware wished to purchase the forklifts

with $200,000 of its own cash and $800,000 borrowed from ABN AMRO Bank in

Dubai at 7.5%. The leasing company's effective tax rate was 30%, and Canadian

tax laws permit use of the double-declining balance method for leasing companies.

The forklifts had a tax life of seven years.

Hardware Leasing estimated that it could sell the equipment for $200,000

(the residual value after 15 years). Spacemakers, the lessee, had requested an early

buyout option (an "EBO") after ten years. Immediately upon purchase, the lessor

would lease the equipment to the lessee for fifteen years. Rents would be paid

monthly, on the same day the debt services were due, and the rents always would

be sufficient to pay debt service.

When Lahcen received a fax summarizing the terms of the lease, he could

hardly believe his eyes. The lessor offered Spacemakers a 15-year lease with 180

equal monthly payments of $8,052. This included an effective interest rate of only

6.5% per annum. Not only was the rate very attractive, but Spacemakers would

also receive 100% financing with no downpayment. He decided to push his luck

and try for the early buyout option. He scribbled "Accepted, as long as we get the

EBO!" on the term sheet, signed it, and faxed it back to Toronto.

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21) CONCLUSION: FUTURE OF LEASING

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.

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 certainlyproblems of infancy. Credit decisions were based on a pure financial view, with

asset quality taking a back seat.

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 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. 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!

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A number of factors will precipitate the consolidation in Indian leasing, and

the process is already on. First, bifurcation of leasing and non-leasing activities,

such as merchant banking, will go a long way in breaking the financial

conglomerates, who may find themselves better focusing on investment banking

rather than dabbling into leasing at the same time. Second, in whichever forms of

business, mass distribution is possible, that is, where the customer is more or less

homogenous, larger firms will eat up the shares of the smaller ones. This is

something everyone can see happening in the car finance market. Three, reduced

rates by the industry leaders will set benchmark rates in the market which will

force many marginal players out. Fourth, regional players will survive but will find

their relevance in a new avatar as "lease brokers", or to use a better word, "lease

originators". These firms will originate small ticket leases, sell their portfolios to

larger players, thereby encashing their wafer-thin spreads and walking out to

originate another transaction. Such activity has flourished in USA, and we will see

much of the same story in India too.

Cross-border competition will come in two forms: direct cross-border

transactions, and cross-border investments in lease transactions. A number of

global leasing giants have already occupied their positions in India. Capital account

convertibility measures will precipitate the process. The impact of foreign

investments will be greater consolidation activity at home.

During the initial phases of growth of any industry, there is a trend towards

diversification: firms try to attain growth in numbers by unfocused diversification,

but soon realize that diversified presence creates organizational pressures, which

are difficult to cope with. This leads to a trend towards consolidation and focused

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However, the near future for the NBFC Sector seems to be far from

satisfactory. Given the present state of the economy and industry, lack of

confidence by investors, apathy from banks, chaotic and multiple tax regime, non

existence of effective recovery mechanism and unfair competition provided by

MNCs, FIs, the surviving NBFCs have a tough time before them. However, the

country is at a turning point and the requirement of capital equipments for

industrial expansion and huge infrastructural projects will once again lead to the

spurring demand for lease and hire purchase finance and the efficient and cost

effective NBFCs therefore, could have a bright future. Moreover with various

issues like change in accounting norms, sales and service tax on lease rentals and

tax issues facing the leas

lease final)

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