Lease Financing

Contents:

What is lease Finance

Characteristics of leasing
Financial lease and Operating lease Tax Implications of Leasing Evolution of lease as financing technique Effects of Owning the asset

Lease Vs Borrow Decisions

ABOUT LEASE FINANCE

Leasing, as a financing concept, is an agreement between two parties, the "lessor" and the "lessee". The lessor owns a capital asset, but allows the lessee to use it. The lessee makes payments under the terms of the lease to the lessor, for a specified period of time. Leasing is, therefore, a form of rental. Leased assets have usually been plant and machinery, cars and commercial vehicles, but might also be computers and office equipment.

CHARCTERISTICS

In lease transaction the lessee doesn't get the ownership of asset but gets as right only to use the asset. It is used for financing the use of fixed assets of high value.

The amount regularly paid for the use of such asset is called lease rental. As it is treated as rent it is revenue expenses.
Such transaction can we made for both immovable and movable properties. Sometimes the agreement provides that the lessee will have a right to buy the asset when lease contract will be over , at the time of making the contract or at the end of contract. If there is not right to buy in the lease contract, the lease will have to return the to the lesser when period of lease contract is over. When prices of asset are constantly rising due to inflation the lease arrangement keeps the lessee free from effect of price rise. His rent remain the same when price rise or fall.

Types of Leasing

Financial Lease:
A long term lease contract which extends over the whole useful life of an asset and which cannot be cancelled is known as Financial Lease. Lease term is spread over the major part of the asset life i.e. more than 75% of asset life is covered under lease contract. The ownership is transferred to the lessee at the end of the economic life of the asset. The lessor transfers substantially all the risks and rewards related to the asset to the lessee. A finance lease is a full-payout, in which the lessee is responsible for maintenance, taxes , insurance and depreciation. The lessee record the leased item as an asset on his/her balance sheet and the lessor record the lease as a sale on his/her own balance sheet.

 Operating

lease

This is a type of lease in which asset is leased for a short period and the contract is cancellable after giving notice of a fixed period, e.g.

giving an office space on a 2 year lease cancellable on 60-days notice.

Thus the period of such type of lease is shorter than the assets economic life, the original cost of the asset cannot be recovered in a

single lease .

The risk of obsolescence remains with the lessor. The lessor is also responsible for the insurance and other expenses.

It typically qualifies for off-balance sheet treatment.

Financial Lease Vs Operating Lease

Financial Lease
Asset

Operating Lease
Asset

is used for specific purpose.

is used commonly by number of users in sequence.

Lessor
Lessor Lease

Lessee
Lessee Lease

bears all the risks and rewards.

bears the risk of obsolesce.

bears all the risks and rewards.

bears the risk of obsolesce.

cant be cancelled by either of

parties.
Lease

can be cancelled out at the option of lessee and the lessor does not have any difficulty of leasing the same asset.
Lease

periods coincides with the life of the

period is small as against the life of

asset.
Cost

asset.
Cost

of repairs and maintenance are borne by lessee.

It

of repairs and maintenance are borne by lessor.

It

is full- payout lease, single lease repays the cost of asset, together with the interest.

is non- payout lease , as lessor is in business of leasing the assets to various users several times.

Tax Implications

Income Tax Implications For Lessor

Lessor can use depreciation allowances as a tax shield.

Separate rates of depreciation are prescribed for various types of depreciable assets, both on WDV method and straight line method.
Block wise rate used for computing depreciation under WDV method are:

25%,40%, 100% for plant, machinery depending upon on value & usage. 10% on office building, furniture & fittings If actual cost of P&M does not exceed Rs.5000 ,the entire cost is allowed to be written- off in the first year of its use. The asset is owned by lessor- lessee company Asset is used by the lessor for purpose of business. Lessor is not eligible for any other allowances.

For getting depreciation allowances, following conditions are to satisfied:

 Income

Tax Implications For Lessee

Lease rentals are allowed as a normal business expenditure of the lessee for assessment purposes. The payment of lease rental should be:

In the nature of revenue

Not a personal expense

Wholly and exclusively related to business purposes of the lessee.

Evaluation of Leasing as Financing technique

Advantages to Lessee

Permit alternative / efficient use of funds.

Faster & Cheaper Credit. Flexibility.

Off- balance Sheet financing.

Tax benefits. Boon to Small Firm. Protection against Obsolescence. Hundred Percent Financing & Avoidance of initial cash outlay

 Advantages

to Lessor

Stable business Second hand market Tax benefits Absorbing Obsolescence risks High growth, even in times of depression.

Disadvantages of Leasing
Asset taken on lease does not provide ownership right. Asset taken on lease cant be provided as a security to bankers & financial Institutions Certain tax benefits/incentives such as subsidy may not be available on leased equipment. A manufacturer who wants to discontinue a particular line of business will not in a position to terminate the contract except by paying heavy penalties. If the lessee is not able to pay rentals regularly, the lessor would suffer a loss particularly when the asset is a sophisticated one & less liquid.

Lease provides mechanism for long term capital requirements. It fails to provide to much needed working capital finance.

Effects of Owning the asset

Buyer becomes legal owner of the asset Buyer has to pay purchase price either in lump sum or in installments together with interest Purchased asset can be used as security to others

Risk of obsolesce lies with buyer

Asset can be sold or disposed off by buyer as and when desired.

Owning can be purchased with

Owned capital Borrowed capital

Tax effects for buyer in case of buying an asset Buyer can claim depreciation. Buyer can also charge expenses incurred on repairs, maintenance of the asset. If asset is purchased by taking a loan then interest on loan can also be claimed as expense while calculating business income.

Lease Vs Borrow Decisions

Illustration: Silver Star Ltd. Wants to acquire an industrial equipment costing
Rs.20 lakhs. There are two alternatives:

To buy equipment by taking a loan of rs.20lakhs repayable in 5 equal year end installments with interest 14% p.a. To take it on lease for period of 5 years at annual lease rent of Rs.5 lakhs payable at each year end. Other information:

Tax rate is applicable to company is 30%.

Normal rate of depreciation is 15%, additional depreciation of actual cost of equipment is also available in first year of acquisition. Present value factor at 13% 2 0.783 3 0.693 4 5 0.885 0.613 0.543

Year 1

Life of asset is 5 years and at the end of life there will be no scrap realization.

Thank you