M.F.S.CHAPTER – 2M. Y. KHAN

THEORETICAL AND REGULATORY FRAMEWORK OF LEASING

Chapters Objectives:

• Evolution of leasing in INDIA• Concept of lease finance• Contents of lease agreement• Process of leasing• Classification of lease• Advantage and limitations of lease• Tax provisions of leasing

Pre 1970 1970 - 1995 Post 1995

- Only HP companies - Automobile financing

mainly for commercial vehicles

- Fixed Deposit: main

source of funds

- Entry into equipment finance through:

* Leasing * Hire Purchase - Commencement of car finance

- Access to Capital Markets - Funds from FDs and Banks

- Exit of large no. of companies:

* Small & Large * Indian & Foreign

- Regulation by RBI

- Few companies diversified into related financial services

Leasing In India: Evolution Phases

SREI International Finance

Sundaram Finance

Cholamandalam Finance

Mahindra & Mahindra

GE Capital

Leasing Industry: Major Players

Shriram Finance

Tata Finance

Countrywide Finance

Citicorp

Lease Finance: The Concept

• “Conceptually, a lease may be defined as a contractual agreement between two parties namely Lessor (owner of the asset) and Lessee (User of the asset) in which the lessor provides an asset/equipment to the lessee for use over a period of time and in return the lessee provides periodical lease rentals to the lessor and at the end of lease period, the asset reverts to the lessor”

• A lease is a contractual arrangement where the lessor grants the lessee the right to use an asset in return for periodical payments.

• Leasing essentially involves the divorce of ownership from the economic use of an asset/equipment.

Essential Elements of Lease:

• Parties to the contract• Asset• Ownership separated from user• Term of lease• Lease Rentals• Modes of terminating lease:

A. The lease is renewed on a perpetual basis or for a definite period.B. The asset reverts to the lessor.C. The assets reverts to the lessor and the lessor sells it to a third

party.D. The lessor sells the asset to the lessee.

Clauses in Lease Agreement:

Nature of the lease

Description

Delivery and redelivery

Period

Lease rentals

Use (Purpose)

Repairs and maintenance (Lessor or Lessee)

Alteration

Legal aspects of Leasing

• The lessor has the duty to… Deliver the asset to the lessee Authorize the lessee to use the asset Leave the asset in peaceful possession

The lessee has the obligation to… Pay the lease rentals periodically Take reasonable care of the asset Return the leased asset

STEPS IN LEASING:

Classification of Lease:

1. Finance Lease and Operating Lease2. Sales and Lease Back and Direct lease

– Bipartite Lease– Tripartite Lease

3. Single Investor Lease and Leveraged Lease4. Domestic Lease and International Lease

– Import Lease– Cross Border Lease

1. Finance Lease and Operating Lease:

• Finance Lease:• “According to the International Accounting Standard (IAS - 17), the

finance lease is the one in which the lessor transfers to the lessee, substantially all the risks and rewards incidental to the ownership of the asset whether or not the title is eventually transferred”.

Key Features:– FL is suitable for ships, aircrafts, railway wagons, lands, buildings

and heavy machines. – FL is long term, non cancellable lease agreements.– In FL the cost of an assets is fully amortized during primary lease

period.– In FL, the lessee has an option to purchase the asset at the end

of lease period.– FL is also called as “Full Pay Out Lease”. – Maintenance of asset is done by lessee.

Operating Lease:

• “According to the IAS - 17, an operating lease is one which is not a finance lease. In an operating lease, the lessor does not transfer all the risks and rewards incidental to the ownership of the asset and the cost of the assets is not fully amortized during the primary lease period”.

Key Features:– OL is useful in case of computers, office equipments,

trucks, automobiles etc.– OL refers to short term lease agreement or the term of

lease is always lesser than the economic life of an asset.– The primary lease period does not cover the cost of an

asset.– Maintenance of asset is done by lessor.

2. Sale and lease back and Direct lease

• Sale and lease back:• “In this, the owner of an asset sales it to the a leasing

company (lessor) which leases it back to the owner (lessee)”.• For exp. Safe Deposite Vaults by Banks.

• Direct Lease:A. Bipartite Lease:“In such lease, there are two parties in the lease transaction namely equipment supplier cum lessor and lessee”.B. Tripartite Lease:“In such lease, there are three parties in the lease agreement namely equipment supplier, lessor and lessee.

3. Single Investor Lease and Leveraged Lease:

Single investor lease:• In such lease, two parties namely lessor and lessee are

included in lease transaction.• The leasing co’ (lessor) funds/finance the entire investment

by an appropriate mix of debt and equity funds.

Leveraged Lease:• Three parties are involved in lease transaction namely Lessor

(equity investor), Lender and Lessee.

4. Domestic Lease and International Lease:

Domestic Lease:• “A lease transaction is classified as domestic if all the parties

to the agreement, namely equipment supplier, lessor and lessee are domiciled in the same country”.

International Lease:• “If the parties to the lease transaction are domiciled in

different countries, its known as Int. Lease”.A. Import Lease: “In an import lease, the lessor and lessee are domiciled in the same country but the equipment supplier is located in a different country.B. Cross Border Lease: “it means the lessor and lessee are domiciled in different countries. The domicile of the supplier is immaterial in this case.

Advantages of Leasing – To the Lessee

• Financing of capital goods 100% financing of capital goods w/o capital investments. Lessee is able to commence business w/o making any investment.

• Additional source of financing Capital can be deployed in other strategic aspects of business like

WC.• Less costly (compared to Bank Finance)• Ownership preserved

No threat of dilution of ownership which is applicable in EQ. and DEBT FIN.

• Avoids conditionalities viz. conditionalities associated with EQ/DEBT Issue and Bank Loan

• Flexibility in structuring of lease rentals• Obsolescence Risk is averted• Simplicity

Advantages to Lessor:

• Full security Only becoz of “Ownership Preserved”

• Tax benefit Mainly Depriciation

• High profitability Since return from business is more than CoC

• Trading on equity

• High growth potential

Limitations of Leasing:

• Restrictions on use of Equipment Addition/alteration of asset is not permissible

• Loss of residual value Since Ownership remains with Lessor

• Limitations of financial lease Higher payout obligation in case of premature termination

of lease.

• Consequences of defaultViolation of clauses of Lease Contract may result in to

termination of Lease.

• Understatement of Lessee assets• Sales tax : Double Taxation

Leasing - Tax provisions

• Lessor:• The depreciation can be claimed by the lessor and

not the lessee.

• Depreciation can be charged as a tax deductible expense item by lessor.

• The lease rentals received by lessor are taxable as profit & gain from business.

Leasing – Income Tax Provisions

• Lessee: • The lease rentals and Insurance, repairs,

maintenance charges paid by lessee are tax deductible items of expenses for the lessee.

Sales Tax Aspects

• A lease normally has 3 important elements from the view point of Sales Tax:

1. The purchase of the asset by lessor.

2. Transfer of right to use an asset to a lessee for a specified period of time.

3. Sale of asset on expiry of the term.