LEASING

•Concept
•Development of Leasing business
•Types of leasing business.
•Advantages to Lessor and lessee.
•Tax aspect
•Difference between Leasing & Hire Purchase
 Concept
Lease is defined under :
–Transfer of Property Act
–Indian Accounting Standard (AS) 19
–International Accounting Standard – 17 (IAS)
–Sale of Goods Act, 1930; Indian Contract Act, 1872; Transfer of Property Act, 1882
Transfer of Property Act defines a lease as “a transaction in which a party owing an
asset provides the asset for use over a period of time to another for consideration either
in the form of periodic rent or in the form of down payment.”
At the end of the lease period the asset/ equipment reverts back to the lessor unless
there was provision for the renewal of the contract.

Accounting Standard (AS) 19 : Lease is an agreement whereby the lessor conveys to

the lessee the right to use an asset for an agreed period of time in return for a payment
or series of payments.
•Lease involves divorce of ownership from economic use of an asset.
•Lease financing is a device of financing / money lending. It is an alternative to debt
financing.
•It is an alternative to buying. Service rendered by an asset is important & not the title
to it.
•Lessee position is akin to that of a person who own the asset with borrowed money.
 Concept

•Real function of lessor is not to rent the asset but lending funds and
lease financing is a contract of lending money.
•Lessee is free to choose the asset according to his requirements.
•Lessor does not take recourse to the asset as long as the rentals are
regularly paid to him.
 Essential Elements
•Manufacturer/ Supplier
•Lessor: leasing company
•Lessee
Both lessor and lessee may be individuals, partnership, joint stock companies,
corporations or financial institutions.
•Lease brokers may act as intermediaries in arranging lease deals.
•Lease financiers : who refinance the lessor either by providing long
term loan or by subscribing to equity of lessor.
•Asset: are the subject matter of lease contract.
–Automobile, plant and machinery, equipment, land and building, factory,
running business, aircraft etc.
–Asset must be of lessee’s choice & suitable for his business.
•Term of lease
Lease should of definite period otherwise it will be legally inoperative. In
perpetual lease also there is an option to renew it further at the end of its
period.
 Essential Elements
• Equipment Leasing Companies and Hire Purchase Companies are called Asset
Finance Companies (AFCs).

• RBI has defined AFCs as:

– “a company which is a financial institution which is carrying on as its principal business
the financing of physical assets supporting economic activity, such as automobiles,
tractors, lathe machines, …. “

• Lease Rentals:
– Finance Lease- Interest + Principal
– Operating Lease- Interest+ Principal+ Repair & Maintenance, Depreciation, Insurance
etc.
– Equated OR Structured
• Stepped up/ Upfront lease, Stepped down/ Back-end lease
 Development of Leasing Business
• Leasing is an age old concept.
• First leasing transaction in 1066: Conqueror
William rented ships for intrusion in Britain.
• World War II led to the evolution of equipment
leasing.
• Traditionally land, animals, agricultural tools
were involved in leasing.
• Now leasing involves high value items like ships,
aircrafts, cars, railroad equipments, computers,
office equipments etc.
 Development of Leasing Business
• First Leasing Co. of India Ltd. (1973) was first leasing co. in India in organized form.
Software, windmill, telecom towers leasing etc. Assigned AA+ by FITCH.

• 20th Century Finance Corporation Ltd., Jayabharat Credit & Investment Ltd., Sundaram
Finance entered the industry in 1980s. Leasing business picked up in 1980’s. In 2011-
12 Indian leasing business volume touched an astonishing figure of USD 41 million.
• Railway Wagon Leasing Scheme 2008. IRFC funds were insufficient.
• ICICI bank pioneer.
• SBI and Canara Bank active players.
• The annual leasing business in India is estimated at USD 3.67 billion with an annual
average growth rate of more than 30%.
• Indian leasing Industry holds 12th to 13th position in the world and is the 3rd largest
player in Asia after Japan & Korea.
• Post liberalization foreign financial firms entered the leasing business starting with GE
Capital. Other leading international brands Siemens, Volkswagen, IBM, Hewlett-
Packard.
• Presently there are more than 400 leasing players in India.
 Development of Leasing Business
• Number of lessors in India exceeds those in U.S. which
is the world’s leading market.
• Dahotre Committee’s recommendations mark a
significant phase in development of leasing business.
– RBI formed guidelines for allowing commercial banks to fund
leasing companies.
– Leasing companies have to get registered with RBI as NBFC
• Tax concessions and depreciation benefits are the
motivations behind leasing arrangement.
• Items like pollution control devices, renewable energy
devices, gas cylinders are eligible for 100 %
depreciation
 CLASSIFICATION
Classification of lease as Finance or Operating
Lease is done on the basis of the:
Extent to which risk and reward incidental to
ownership of the asset is transferred.
Risk refers to the possibility of loss arising on
account of idle capacity or technological
obsolescence
Reward refers to the cash flows that are
generated from the usage of equipment & the
realization of appreciation of anticipated residual
value on the expiry of economic life.
 Classification

1. Finance lease and Operating lease.

2. Sale and lease back and Direct lease
3. Leveraged lease.
4. Domestic & International lease.
 FINANCE LEASE
 As per IAS 17 in a finance lease the lessor transfers to the lessee
substantially all risk and reward incidental to the ownership of
the asset.
– Title may or may not eventually get transferred.
 Legal ownership with lessor & defacto ownership with lessee.
 Obligation of payment of lease rentals over a non cancellable
lease period.
 Full payout leases: Lease rentals payable are sufficient to
amortize the capital outlay of the lessor and leave some profit.
 Type of assets: buildings, heavy machinery, ships, aircrafts,
railway wagons etc.
 FINANCE LEASE
IAS 17 stipulates following criteria for classifying a lease as finance lease:
 Ownership of the equipment is transferred to lessee at the end of
lease period OR
 Lessee has the option to purchase the equipment at a price which is
sufficiently lower than the fair market value at the date the option is
exercisable & at the inception of the lease it is certain that the option
will be exercised.
 Lease term is for major part of the useful life of the asset i.e. (i)
physical life (ii) technological life (iii) product market life. Major part
means lease term exceeds 75% of the useful life of the equipment.
 The present value of the minimum lease payments is greater than or
substantially equal to the fair market value of the asset at the
inception.
 Leased asset is of specialized nature such that only lessee can use it
without major modification.
 FINANCE LEASE
Finance lease is structured to include the following features:
 Lessee selects the equipment as per his requirement from the
manufacturer.
 Lessee negotiates the price, delivery schedule, warranty and other
terms of payment.
 Lessor purchases the equipment from the manufacturer.
 Lessor leases the equipment to lessee. Lessor retains the ownership
while lessee is allowed to use the asset.
 Option to purchase the asset at future date may exist, however this
practice is rare in India.
 Primary lease period- cancellation during this comes at a heavy cost.
 Secondary lease period: lease rentals are substantially low.
 Lessee enjoys peaceful use of asset provided he pays lease rentals.
 Risk of obsolescence & liability for repair, maintenance and insurance
are borne by the lessee.
 Suitable for low depreciation assets like cars, plant & machinery,
furniture & fixtures etc that have long economic life.
 OPERATING LEASE
 In operating lease, lessor does not transfer all the risk & reward
incidental to the ownership of the asset.
 Is generally for a period shorter than the economic life of the asset. It
is cancellable by either party.
 Lease period is shorter than the expected asset life, lease rentals are
not sufficient to totally amortise the cost of asset.
 Lessor does not rely on single lessee for recovery of his investment.
 He has ultimate interest in the residual value of the asset.
 Lessor bears the risk of obsolescence.
 Lessor provides for maintenance, insurance and other support services
related to the asset.
 Suitable for high depreciation assets like computers & windmills.
 Suitable for assets where technology changes are very fast.
 Suitable for companies that have high taxable income.
 Eg. Providing mobile cranes with operators.
 Chartering of aircrafts & ships including provision of crew
 Hiring computers, taxi’s etc.
 Aspects of
Operating Lease Financial Lease
Difference
Definition A lease in which all risks and rewards related to asset ownership In financial lease (Also known as capital lease), the
remain with the lessor for the leased asset is called operating lease. risks and rewards related to ownership of asset
In this lease, the asset is returned by the lessee after using it for leased are transferred to the lessee.
lease term agreed upon.

Ownership Ownership of the asset remains with the lessor for the entire lease Ownership transfer option at the end of the lease
period. period is there with the lessee. Title might or might
not be transferred eventually.
Accounting Operating lease is treated generally like renting. That means, the Financial lease is treated like loan generally. Here,
Effect lease payments are treated as operating expenses and the asset the asset ownership is considered of the lessee and
does not show on the balance sheet. so asset appears on the balance sheet.

Purchase In operating lease, the lessee does not have any option to buy the Financial lease allows the lessee to have a purchase
Option asset during the lease period. option at less than the fair market value of the
asset.
Lease Term Lease term extends to less than 75% of the projected useful life of Lease term is generally more than or equal to
the leased asset. estimated economic life of the asset leased.

Expenses Lessee pays only the monthly lease payment in operating lease. In financial lease, lessee bears insurance,
Borne maintenance and taxes.
Tax Benefit Since operating lease is as good as renting, lease payment is Lessee can claim interest and depreciation both, as
considered as expense. No depreciation can be claimed. financial lease is treated like a loan.

Running Cost In operating lease, no running or administration costs are to be In a financial lease, running cost and administration
borne for example: registration, repairs etc. since it gives only right expenses are higher.
to use the asset.

Example Normally, A Projector, Computers, Laptops, Coffee Dispensers etc Normally, Plant and Machinery, Land, Office
Building etc
 SALE & LEASE BACK
 Indirect form of leasing.
 Owner of the equipment sells it to leasing company (lessor).
 Lessor further leases it back to the owner (lessee).
 Therefore, the lessor buys the asset from lessee instead of
buying from vendor.
 Lessee gets the funds (sale proceeds) of the asset immediately
and can utilize those funds for working capital or other
purposes.
 Reduces the debt equity ratio and so enhances the borrowing
capacity of lessee.
– Eg. Sale & lease back of lockers by banks.
– Sale & lease back arrangement can be in the form of finance or
operating lease.
 SALE & LEASE BACK DEAL

• Bhushan Steel has been under pressure from its

lenders to pare debt.
• About 51 banks have a combined exposure of
Rs.40,000 crore to the company.
• In February, the company had also entered into a
sale and lease-back arrangement for its oxygen
plants in Odisha in a move to ease stressed cash
flow.
Read more at: http://www.livemint.com/Money/rAmyADRMPHl1pFgcuvtOdP/Bhushan-Steel-
stock-surges-on-debt-restructuring-reports.html?utm_source=copy
 SALE & LEASE BACK DEAL

ICBC will provide IndiGo financial solutions for the introduction of A320 and
other aircraft to the fleet in the form of sale and lease back or financial lease or
commercial lending. The majority of IndiGo's fleet is financed through sale
and leaseback agreements - under which a third party owns the planes and
then rents them to the airline - and is one factor analysts say has helped keep
the airline profitable while India's other big carriers lose money in a highly
competitive market.
 Bipartite and Tripartite lease/ Direct Lease

 Bipartite lease:
– lessor (equipment supplier) (ii) lessee.
– Lessee acquires the asset directly from lessor (equipment supplier) It
may be structured in the form of operating lease and provide facilities
to upgrade or swap the asset.
 DIRECT LEASE
Tripartite lease
(i) Equipment supplier (ii) lessor (lease finance Co.) (iii) lessee
Equipment supplier arranges for lease finance for the lessee.
Writes lease on his own account.
Gets lease rentals discounted from lease finance company
Lease company now owns the asset
Lease rentals are assigned to the lessor
Supplier may have to buy back the equipment from lessor if
lessee defaults.
–Also called sales aid lease as they are usually with recourse to the
supplier if lessee defaults.
 Leveraged Lease
 There are three parties to this transaction
(i) lessor (equity investor)
(ii) Lessee
(iii) lender.

 Lessor or the leasing company buys the asset with his own
equity and substantial borrowing from lender.
 Lender gets secured by first mortgage on leased assets,
assignment of lease rentals.
 Trustee looks after the interest of lender and lessor.
 Trustees receive the lease rentals from lessee and remits the
debt service component to the lender and balance to the lessor.
 Suitable for high investment intensive assets like ships, aircrafts
etc.
 Domestic & International Lease
 Domestic lease: If lessee, lessor and equipment supplier are all
domiciled in same country.
 International lease
• Import lease- Lessor & lessee are domiciled in same country
whereas the equipment supplier located in different country.

•Cross border lease: Lessor & lessee are located in different

countries. Such lease is subject to currency risk and country risk.
 Advantages to Lessee
1. Less Initial capital required.
2. Business ownership preserved.
3. Easy source of finance
4. Less costly.
5. Shifting the risk of new technology.
6. Avoids conditionalities
7. Conserve borrowing capacity
8. Off Balance Sheet mode of financing
9. Flexibility in structuring of rentals.
Methods of lease rental calculation:
(i) Equated (ii) Stepped (iii) Deferred (iv) Ballooned method

9. Tax advantages.
10. Low maintenance cost.
 Advantages to Lessor
 Tax benefit
 High profitability
 Prompt returns
 Increased sales
 Full security
 Less cumbersome and time consuming
 Limitations
1. Restriction on the use of assets (additions, alterations,
insurance)
2. Limitation of finance lease
1. No warranty for lessee.
2. Premature termination option not available or costly.
3. Loss of residual value.
4. Consequences of default.
Operating lease- asset repossessed.
Finance lease- lessee to pay damages or accelerated lease rentals.
5. Understatement of lessee’s asset. (op. lease)
6. Double sales tax.
TAX ASPECT OF LEASING
TAX CONSIDERATION

Income Tax Sales Tax

 Income Tax Consideration
Lessor Lessee
•If leasing is main business activity-lease • If lease rentals paid by lessee are
rental taxable under the head “profits & purely for business purposes then they
gains from income & profession” are allowed as deduction as a normal
otherwise they come under Income from business expenditure.
other sources. • In finance lease expenses of rent,
•Section 32 of IT Act provides for taxes, insurance & repair of leased asset
depreciation on assets used by assesse are borne by lessee for which he can
for business. claim deduction under Income Tax Act.
•Leased assets are deemed to be used in
lessor’s business of leasing. •Tax planning through flexible structuring
•Depreciation, expenses of rent, taxes, of lease rentals.
insurance & repair of leased asset are
allowed as deductible expenses.
•Lessor is eligible for depreciation tax
shield.
•Depreciation computed on block wise
rate on WDV method.
• Accounting convention Under Indian Income Tax
treats assets under Act, lessor being the owner
financial lease as if of the asset, is entitled to
assets were owned by claim depreciation and
the lessee. Lessee being the user is
entitled to expense out the
lease rentals irrespective of
what is stated in
accounting standards.
 Sales Tax Aspect
Levy of sales tax on leasing transactions is subject to
(i) Central Sales Tax Act 1957 for inter state sale of goods, and
(ii) Sales Tax Act (STA) of respective state for intra state sale.

Levy of Sales Tax has 3 elements.

1. Purchase of equipment.
2. Lease rentals
3. Sale of asset at the expiry of the lease.

 PURCHASE OF EQUIPMENT

 If purchase of equipment by lessor involves inter state sale---CST is levied @ 10% .

 If it is Intra state sale—rate applicable to the respective state is levied.
 Acc. To recent Supreme Court ruling, the place of signing the lease agreement will
decide the tax jurisdiction & not the state where the goods are put to use.
 Sales Tax Aspect
 LEASE RENTALS

 Before 1982, no sales tax was levied on lease rentals.

 Constitution (46th Amendment) Act, 1982- transfer on right to use goods for any
purpose for cash or other consideration was included in the tax on purchase/ sale of
goods.
 Lease rentals attract sales tax under STA in all states except Maharashtra.
 Sales tax is payable on aggregate annual lease rentals of lessor.
 In addition, in many states additional surcharge is levied if turnover (lease rentals)
exceeds specified limit.
 Lessor has to seek registration as a dealer under local sales tax law.

 Transaction between equipment supplier & leasing company is called first sale & is
subject to CST or STA.
 Transaction between lessor & lessee is also a deemed sale & called second sale.
Normally second sale is exempted from levy of sales tax. However, this exemption is
not available in leasing transactions.
 Hence, EQUIPMENT LEASE TRANSACTIONS SUFFER MULTIPLE POINT LEVY OF
SALES TAX
• Sales Tax is leviable on sale of goods by a dealer.
• From the viewpoint of sales-tax, the meaning of the word “sale” has been
expanded by including several transactions which are not sales in normal
parlance. A “transfer of right to use goods” is included in this expanded definition.
A delivery of goods on hire purchase is also included.
• 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 the lessor to the
lessee . And this has become taxable as a deemed sale.
• Since in an operating lease also, there is transfer of right to use goods, there is a
sale.

• VAT is a tax on value added, that is, on the difference between the cost of
“inputs” and the value “outputs”.
• In terms of actual imposition, sales-tax is computed on the value of the output
first. Then, the sales-tax actually paid, in the State, on the inputs will be deducted
(set-off) from the tax calculated on outputs. The net tax is paid to the
government.
Lease
• Ownership with lessor
• Lessee has no right to own
the leased asset
• Dep. Claimed by lessor.
• Entire lease rental
deductable expense.
• Entire capital cost borne by
lessor.
• Salvage value-lessor
Hire Purchase
• Ownership in the name of
hirer.
• Legal & complete owner upon
payment of last installment.
• Dep. Claimed by hirer
• Installment split into interest &
principal. Deduction available
for interest only.
• Some capital contributed by
hirer also.
• Salvage value claimed by hirer
 Evaluation of leasing decision

Q. XYZ is planning to procure a server for IT applications costing

Rs.45 lakh. Due to fast changing developments in the field of
technology & to avoid risk of obsolescence, the firm is
considering leasing the server for a period of 3 years at a rental
of Rs.18 lakh per annum in arrears. Alternatively, the firm can
buy the server by borrowing at 12%. The firm pays tax @ 40%.
Depreciation rate that can be claimed by the firm is 33.33%.
(a) Find whether it is beneficial for XYZ Co. to lease the server or
buy it.
(b) If the salvage value is reckoned to be 3 lakh at the end of 3
years, does the decision change?
• Cost of equipment = 45 lakh
• Lease Rentals = 18.00
• Salvage Value (i)0, (ii) 3 lakh
• Life = 3 years
• Cost of debt (pre tax) = 12 %
• Cost of debt (post tax) = 7.20%
• Depreciation rate = 33.33%
• Tax rate = 40%
 Present 0 1 2 3
Value
A. Lease Option
•Lease Rentals -18.00 -18.00 -18.00
•Tax saved on lease rentals 7.20 7.20 7.20
•Cash Flow-Lease -10.80 -10.80 -10.80
A. Present Value (lease rentals) -28.24 0.00 -10.07 -9.40 -8.77

B. Buy Option
• Initial Cost -45.00
• Depreciation 15.00 15.00 15.00
•Tax saved on Depreciation 6.00 6.00 6.00
•Cash Flow -45.00 6.00 6.00 6.00
B. Present value (Buy) -29.31 -45.00 5.60 5.22 4.87
NAL (A-B) 1.07 45.00 -16.80 -16.80 -16.80
>0; leasing
is profitable
 Present 0 1 2 3
Value
B. Buy Option
• Initial Cost -45.00
• Depreciation 15.00 15.00 15.00
•Tax saved on Depreciation 5.60 5.60 5.60
• Salvage Value Realized 3.00
•Cash Flow -45.00 5.60 5.60 8.60
B. Present value (Buy) -27.92 -45.00 5.22 4.87 6.98
NAL (A-B) -0.32 45.00 -16.40 -16.40 -19.40
<0
Buying is
profitable
 Leasing Vs. Buying-Evaluation
A firm has to install a generator set costing Rs.1500 lakh. A leasing firm has offered it
on lease for a period of its useful life of 5 years on a lease rent of Rs. 450 lakh per
annum. Alternatively, the firm can buy the generator by borrowing at 20%, claim
depreciation of 25% on written down value basis and realize a salvage value of
Rs.100 lakh. Evaluate whether the firm should buy or lease the generator set. Tax
rate is 35%.
Steps
1. Post tax cost of borrowing
2. Lease evaluation (A)
3. Dep. Schedule
4. Tax saved on capital loss
5. Buying evaluation (B)
1. Tax saved on dep
2. Tax saved on capital loss
3. Salvage value
6. Present value of cash flows
7. Net advantage of lease (A-B)
 Year Present 0 1 2 3 4 5
Value

Lease
options(A)
Lease rentals -450 -450 -450 -450 -450

Post tax cost of 292.50 292.50 292.50 292.50 292.50

lease rentals
Present -1028.79 -258.85 -229.07 -202.72 -179.40 -158.76
Value@13%
TOTAL (A) -1028.79
 Year Present 0 1 2 3 4 5
Value

Buying Option
(B)
Cash flow- buy -1500

•Depreciation 375 281.25 210.94 158.20 118.65

Tax saved on 131.25 98.44 73.83 55.37 41.53

dep
Salvage value 100

Tax saved 89.60

capital loss
Total Cash -1500 131.25 98.44 73.83 55.37 231.13
Flows
PVF 13%, 1-5 0.885 0.783 0.693 0.613 0.543

Present value of -1096.16 -1500 116.16 77.08 51.16 33.94 125.50

cash flows
NAL (A-B) -1028.79- Leasing
(- 1096.16) advised
 Depreciation Schedule

Outstanding Depreciation Outstanding at

in beg. of @ 25% end of year
year

1 1500 375 1125

2 1125 281.25 843.75

3 843.75 210.94 632.81

4 632.81 158.20 474.61

5 474.61 118.65 355.96

Less: Salvage 100

value
Capital loss 255.96
Tax saved on 255.96×0.35 =
capital loss 89.60
 Leasing Co’s in India
• Shriram Trans
• M&M Financial
• Bajaj Finance
• Shriram City
• Sundaram Fin Cholamandalam
Manappuram Fin
• Magma Fincorp
• SREI Infra
• Optiemus Infra
• Intec Capital
• Sakthi Finance
• GE Capital
• Magnum Fincap
• Cubical Fin Ser
• SP Capital Fin
• Guj Lease Fin
• Transpek Financ
• India Lease Dev
• Margo Finance
• Visagar Fin
• Autoriders Fin
• Aadi Industries
• Mahan Ind
• Mefcom Agro Ind
• Nu Tech Corpn
• Roselabs Fin
• Pioneer Invest
• DFL Infra
• CFL Capital