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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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 19 th 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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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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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:

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

must be capable of re-delivery: it must be durable (at least during the lease

period), identifiable and severable.

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Leasing of immovable properties may have complications:

Lease Financing

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.

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.

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Leased asset is a necessary pre-condition:

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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

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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Lease Financing

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 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

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Buyout option may characterize the lease

as hire-purchase:

Lease Financing

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 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

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Margins in leases are taken as initial

rental:

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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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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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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 :

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:

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:

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Hire-purchase and financial leases compared

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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 of these countries have enacted, in line with United Kingdom, specific laws

dealing with hire-purchase transactions.

DIFFERENCE BETWEEN LEASE FINANCINGAND 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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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.

ComponentsLease 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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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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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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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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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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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

payments is significantly less

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off.

The lessor retains legal

ownership for the duration of

the lease term, though the

lessee may or may not buy out

the leased asset at the end of

the lease, with the lessor

charging only a nominal fee for

the transfer of asset to the

lessee.

The lessee chooses the supplier

of the asset and applies to the

lessor for funding. This is

significant because the leasing

company that funds the

transaction should not be liable

for the asset 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.

than the full asset price.

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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

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SELLER BUYER

LESSEE LESSOR

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

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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:

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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

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.

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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.

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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.

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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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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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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.

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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.

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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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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

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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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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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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.

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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

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Lease Financing

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

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

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.

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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

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Lease Financing

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

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

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

inherent in lease rentals, which will also be debited as 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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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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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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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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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.

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

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Lease Financing

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

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

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Lease Financing

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

plastic or rubber factories

40%

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Lease Financing

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

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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

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

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Lease Financing

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.

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

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Lease Financing

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.

Sales Tax Rates :

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Lease Financing

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

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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Lease Financing

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

recognized in law as interest or principal. In case of lease transactions, the lease

rental is surely the gross value for the leasing service.

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Lease Financing

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

have to shell out a 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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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 LoansFrom 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.

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Lease Financing

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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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: 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

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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

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.

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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

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

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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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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

ICICI 1500 Capital Equipment 5-10 Years Financial

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Ships

Aircrafts

Railway Wagons

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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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 10 th 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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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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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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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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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.

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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LEASING COMPANIES- CASE STUDY

IL&FS- Infrastructure Leasing & Financial Services Ltd.

Overview

A financial giant, IL&FS’s mandate is to ensure an atmosphere with financial

backing including funding to create a world-class infrastructure. The management

concluded that an important aspect of infrastructure is education and created a

company IL&FS ETS to look after this important aspect.

Business Need

Il&FS ETS created K-Yan Design Center, an independent research group to

create a new approach to learning. Prof. Kirti Trivedi was appointed to head the

project. The KDC team envisaged a comprehensive learning environment and

wanted a software created that would function as the primary resource of this

learning environment.

Challenges and Requirements

The biggest challenge was that the requirements were not clear. It was a dream in

which the achievables were known, but not the deliverables. It was not known

how or what exactly needed to be done, it was not even known for sure whether

it’s possible. To add to that the funds available were limited.

Web Access Role

Web Access decided to test its baseline, “If you can dream it, we can do it”. It

accepted the challenge with a broad outline target. It also agreed to something

unthinkable in the IT industry. An evolving requirement with a locked in time and

cost estimation. We managed to successfully create 3 different software with

multiple modules by working closely with the KDC team in developing the

evolving framework and creating requirement specifications in a iterative and

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evolving manner.

Benefits and Outcome

K-Creator, K-Class and K-Content together constitute a learning environment that

is unique. It uses the latest technologies, but is customised to be used even by

teachers in rural India with zero knowledge of computers. It supports the many

languages that India has, whilst allowing the students to seamlessly use and enjoy

the system, without formal computer training. It is a good example of unity in

diversity that makes India unique.

CSI LEASING COMPANY

Leasing IT Doesn't Have to be Difficult

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 asset

management chaos. By choosing to lease its PC’s 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.

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The Solution

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

acquire several hundred additional PC’s, 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

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 company’s IT leasing needs.

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

months to realize it had lost the company’s 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.

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PROLOGIS-Leasing & Property Management

Honda

Honda’s Easy Transition to New ProLogis Distribution Facility:

In September 2005, Honda Logistics UK was based in an old converted factory in

Swindon and planning to move to new premises in the town.  ProLogis learned of

Honda’s requirement while in the process of buying 42 acres of land at South

Marston, an established commercial location to the North West of Swindon.  Only

five miles from Junction 15 of the M4 – and next door to Honda’s own giant

manufacturing plant producing the new Honda Civic –South Marston would be

Honda’s ideal location.

Armed with a detailed understanding of Honda’s needs, ProLogis explained its

way of working and ability to deliver before the crucial lease break of April 2006.

The ProLogis team demonstrated how it could incorporate fit-out into the package

and still provide substantial savings to Honda.

Crucial lease break:

Working together on the specification for the pre-let, ProLogis and Honda

developed a design which would enhance the functions of office and warehouse,

helping to make Honda’s logistics operations far more efficient.  ProLogis then

worked with award-winning architect Michael Sparks Associates to gain planning

permissions and design and deliver a bespoke 350,000 sq ft (32,516 sq m)

distribution warehouse, before Honda’s crucial lease break of April 2006. 

The resulting building responds to the aims of Honda Logistics UK.  The

company sought a design which would project the division’s status within the

group and display the Honda brand in a dynamic application of the corporate

livery.

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The external design reflects its use as Honda’s state-of-the-art distribution center. 

Elevations use crisp detailing, creating a natural rhythm with the alternate use of

different profiles and colors of external cladding. 

The warehouse incorporates 21,000 sq ft (1951 sq m) of offices on three stories. 

Amenity areas include a canteen, a fully-equipped kitchen, showers, lockers and

administrative accommodation.  In addition, Honda required a mezzanine space of

23,400 sq ft (2,175 sq m) inside the warehouse, along with dispatch offices and

extensive plant areas. ProLogis arranged all the fit-out, including gas-fired

ambient heaters and racking along with an area of strengthened slab to

accommodate future racking.  The building is fully sprinklered. 

Smooth transition:

The layout of the site and the orientation of the building are ideally arranged for

the smooth and efficient operation of a major logistics facility. Offices are

positioned to allow adequate supervision of the service area, while a service road

provides 360-degree circulation.  Particular attention was paid both to the

intensive demands of heavy vehicles and to security.

In January 2006, Honda began a smooth transition into its new home.  ProLogis

was able to meet Honda’s precise requirements in a timeframe of just ten months. 

Honda Logistics UK now uses ProLogis’ state-of-the-art facility to supply car

parts, motorbikes and power equipment nationwide.

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Cherokee Carpet Industries

Company Background:

Cherokee Carpet Industries of Dalton, Georgia is a manufacturer of

residential and commercial carpeting. With 315 employees, Cherokee

Carpet Industries boasts $50 million a year in revenues. In its five years in

business, Cherokee Carpet has grown rapidly. 1999 was the first year that

Cherokee Carpet will have audited financial statements.

As a closely held and highly leveraged S-corporation, to grow its company,

Cherokee was looking for strategic financing methods that would position

the company for the next level. Since its inception, Cherokee has leveraged

the benefits of leasing as a strategy to grow the company. At present, the

company leases $150,000 annually in equipment.

What was the Need?

Rapid growth in its five years in business continues to present a need for

Cherokee Carpet to minimize its capital requirements. Cherokee Carpet

Industries had a need for a Plantex 36 End Extruder for polypropylene and

nylon carpet yarns, an industrial piece of equipment. Cherokee Carpet

considered a straight purchase of $3.5 million for the piece of equipment,

but discovered that leasing afforded them the opportunity to leverage their

financial resources. When the company weighed the opportunity costs of a

straight out purchase against the lease payments, leasing offered a better

solution.

Cherokee recognized equipment leasing would provide tax benefits as well

as preserve operating capital. The primary reason Cherokee Carpet chose to

lease versus purchase the industrial piece of equipment was because as the

company was rapidly expanding, leasing offered Cherokee Carpet the ability

to maximize cash flow. Therefore Cherokee Carpet had more capital

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available for the operation of the company and for business growth

investments.

What were the Terms of the Lease:

CIT Group, the equipment leasing company, structured the lease to help Cherokee Carpet Industries minimize its capital requirements. The lease was negotiated to the terms of a seven year capital lease with an early buy out (EBO) option at three and five years and limits on fair market value.

Results:

Leasing equipment as a financing option afforded Cherokee Carpets the

ability to leverage their capital, increase cash flow and maintain more funds

for business expenditures. CIT, was able to customize a program to meet

Cherokee Carpet's financial and equipment needs.

East Texas Copy Systems (ETCS) and Canon Financial Services,

Inc. (CFS)

Company Background:

East Texas Copy Systems (ETCS) of Tyler, Texas is an authorized Canon

Dealer of digital networked office equipment. With 15 employees, ETCS

services large quantity accounts, such as hospitals, school districts, city and

county governments and major industries.

One of ETCS' largest customers, a non-profit health system, was looking to

take advantage of leasing equipment as a means to minimize cash outlay and

acquire 400 copiers and facsimile machines, as well as to structure a deal

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that would satisfy the health systems' billing needs. At present, ETCS leases

$500,000 annually in equipment to this customer.

What was the Need?

ETCS recognized that having the hospital lease copiers from Canon

Financial Services would offer more flexible leasing terms, reduce its costs

in procuring the equipment and enable the company to pay for the

equipment as it is being used. Thus, lending to the efficiency and

productivity of the business.

ETCS needed a flexible, all-cost included leasing program in order to meet

its customer's requirements. When considering financing options, the health

system also looked at acquiring the copiers using a bank line of credit;

however, leasing the equipment from Canon Financial proved to be a more

flexible and process efficient solution.

What were the Terms of the Lease:

The challenge of meeting the customers billing needs was to integrate an

aggregate cost-per-copy billing cycle with individual cost center reporting.

Canon Financial structured the lease to meet the billing needs defined by the

health system. Each copier was billed with individual reporting to its own

cost center. Aggregate pricing was based on lease volume within a 60-day

period; thus, lowering the lease price as the hospital continued to order

copiers.

Canon Financial Services' flexible invoicing accommodated the hospital's

payment terms, thus avoiding administrative delinquency, which had been a

problem with the hospitals previous financing source.

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Results:

The flexible lease that ETCS developed with Canon Financial Services,

afforded the hospital the ability to lease six to 10 copiers per month; thus,

reducing monthly capital outlay while affording the hospital the equipment

needed to supply their growing demand for copiers. This arrangement

allowed ETCS to win the hospital's business and steadily increase its volume

leased through Canon Financial Services based on equipment demand.

easing their copiers afforded the health system the ability to both leverage

their capital, in addition to, protecting themselves from technical

obsolescence.

Customer Quote:

"CFS structured the billing cycle to the individual cost centers, making it

more convenient for the hospital's different invoicing needs," said Greg

Walker, ETCS President. "Not all financing sources would be as flexible or

accommodating as CFS. In this industry there are several, national faceless

equipment dealers and leasing companies who have the "me too" attitude.

CFS really proved to be extremely customer service- oriented, just as we

like to be at ETCS."

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.

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Hamid Lahcen, Chairman and CEO of Spacemakers, was considering 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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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; corporates 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 certainly

problems 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!

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,

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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

growth. Leasing firms of yesteryears were everything: money market players,

merchant bankers and discount houses. Gradually, both regulators and industry

participants have realized that clearer roles are necessary for stability.

There are so many merits in vendor-based leasing that it is surprising that it has

not made its debut in India still. For the asset vendor, a leasing plan is a sales-aid,

and for the lessor, it is easy access to a vast market, with equipment support from

the vendor. In 1997-98 and after, many lessors will be forced to leave general

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equipment leasing market and line up with suppliers of equipment. Vendor

leasing in time to come will be a very significant part of the leasing market.

True asset-based funding is an extension of the vendor lease market. The two

generally go together to develop into operating leasing. Full scale operating

leasing, that is, leases will in-built cancellation options, will take quite some time

to develop in India, but features of operating leases will be introduced once

vendor tie-ups take place.

The intensity of price-based competition will be split between the corporate

finance market and the consumer finance market. The latter has always placed

emphasis on service, accessibility, and nonquantifiables of that sort, but the

corporate finance market consists of a professional treasury manager who will

have to justify the cost of money to his boss. So far, leasing has continued to sell

itself on several intangibles as speed, smile, and simplicity, but corporate finance

quickly moves to a dilemma where every one is fast, everyone smiles and every

one is simple enough for the sophisticated audience. It is there the price becomes

decisive. Leasing, with all its cost additives as sales tax and stamp duties, will

have to sustain as a cost-competitive financing option.

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, FI’s,

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

leasing industry, the future of this sector seems to be very bleak.

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METHODOLOGY

This project is the mixture of theoretical as well as practical knowledge. Also

it contains ideas and information imparted by the guide. The secondary data

required for the project was collected from various web sites and the book of

reputed author. The project started with sorting all the raw data and arranging

them in perfect order. To add value to the project and to understand the

practicality of LEASE FINANCING

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ANNEXURES

LEASE

A contract in which one party conveys the use of an asset to another party

for a specific period of time at a predetermined rate.

LEASE RATE (Rental Payment)

The periodic rental payment to a lessor for the use of assets. Others may

define lease rate as the implicit interest rate in minimum lease payments.

LESSEE

The user of the equipment being leased.

LESSOR

The party to a lease agreement who has legal or tax title to the equipment,

grants the lessee the right to use the equipment for the lease term, and is

entitled to the rentals.

LEVERAGED LEASE

In this type of lease, the lessor provides an equity portion (usually 20 to 40

percent) of the equipment cost and lenders provide the balance on a

nonrecourse debt basis. The lessor receives the tax benefits of ownership.

OPEN-END LEASE

A conditional sale lease in which the lessee guarantees that the lessor will

realize a minimum value from the sale of the asset at the end of the lease.

OPERATING LEASE

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Any lease that is not a capital lease. These are generally used for short

term leases of equipment. The lessee can acquire the use of equipment for

just a fraction of the useful life of the asset. Additional services such as

maintenance and insurance may be provided by the lessor.

RESIDUAL VALUE

The value of an asset at the conclusion of a lease.

SALE-LEASEBACK

An arrangement whereby equipment is purchased by a lessor from the

company owning and using it. The lessor then becomes the owner and

leases it back to the original owner, who continues to use the equipment.

SALES-TYPE LEASE

A lease by a lessor who is the manufacturer or dealer, in which the lease

meets the definitional criteria of a capital lease or direct financing lease.

TAX LEASE

A lease wherein the lessor recognizes the tax incentives provided by the

tax laws for investment and ownership of equipment. Generally, the lease

rate factor on tax leases is reduced to reflect the lessor's recognition of this

tax incentive.

VENDOR LEASING

A working relationship between a financing source and a vendor to

provide financing to stimulate the vendor's sales. The financing source

offers leases or conditional sales contracts to the vendor's customers. The

vendor leasing firm substitutes as the captive finance company of a

manufacturer or distributor through the extension of leasing to customers,

provisions of credit checking, and performance of collections and

operational administration. Also known as lease asset servicing or vendor

program.

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. CAPITAL LEASE

Type of lease classified and accounted for by a lessee as a purchase and by

the lessor as a sale or financing, if it meets any one of the following

criteria: (a) the lessor transfers ownership to the lessee at the end of the

lease term; (b) the lease contains an option to purchase the asset at a

bargain price; (c) the lease term is equal to 75 percent or more of the

estimated economic life of the property (exceptions for used property

leased toward the end of its useful life); or (d) the present value of

minimum lease rental payments is equal to 90 percent or more of the fair

market value of the leased asset less related investment tax credits retained

by the lessor. (Also see finance lease.)

CERTIFICATE OF ACCEPTANCE (Delivery and Acceptance)

A document whereby the lessee acknowledges that the equipment to be

leased has been delivered, is acceptable, and has been manufactured or

constructed according to specifications

DIRECT FINANCING LEASE (Direct Lease)

A non-leveraged lease by a lessor (not a manufacturer or dealer) in which

the lease meets any of the definitional criteria of a capital lease, plus

certain additional criteria.

ECONOMIC LIFE (Useful Life)

The period of time during which an asset will have economic value

and be usable.

EFFECTIVE LEASE RATE

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The effective rate (to the lessee) of cash flows resulting from a lease

transaction. To compare this rate with a loan interest rate, a company must

include in the cash flows any effect the transactions have on federal tax

liabilities.

FIRST AMENDMENT LEASE

The first amendment lease gives the lessee a purchase option at one or

more defined points with a requirement that the lessee renew or continue

the lease if the purchase option is not exercised. The option price is

usually either a fixed price intended to approximate fair market value or is

defined as fair market value determined by lessee appraisal and subject to

a floor to insure that the lessor's residual position will be covered if the

purchase option is exercised.

If the purchase option is not exercised, then the lease is automatically

renewed for a fixed term (typically 12 or 24 months) at a fixed rental

intended to approximate fair rental value, which will further reduce the

lessor's end-of-term residual position. The lessee is not permitted to return

the equipment on the option exercise date. If the lease is automatically

renewed, then at the expiration of that initial renewal term, the lessee

typically has the right either to return the equipment without penalty or to

renew or purchase at fair market value.

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FINANCE LEASE

Typically, a finance lease is a full-payout, noncancellable agreement, in

which the lessee is responsible for maintenance, taxes, and insurance.

FULL PAYOUT LEASE

A lease in which the lessor recovers, through the lease payments, all costs

incurred in the lease plus an acceptable rate of return, without any reliance

upon the leased equipment's future residual value.

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