2/11/2020 Income-tax Issues in Leasing and hire-purchase – Vinod Kothari Consultants

Income-tax Issues in Leasing and hire-purchase

INCOME-TAX ISSUES IN
LEASING AND HIRE-
PURCHASE
This section will summarize the income-tax treatment
of lease and hire-purchase transactions.

Details of income-tax issues relating to lease and

hire-purchase can be found in Vinod Kothari‘s Lease
Financing and Hire-purchase, Chapters 16 and 17.

The applicable law is dealt with under the following

captions:

1. Basic tax treatment of lease and hire-

purchase transactions

2. What distinguishes between lease and

hire-purchase

3. Allowability of depreciation on lease

transactions

4. Depreciation rates

5. Sale and leaseback transactions

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6. Taxation of income in case of hire-

purchase transactions

7. Lessee’s claim for lease rentals

8. Hirer’s claim for depreciation

9. Deduction of tax at source

10. Leases by cross-border lessors.

1. Basic tax treatment of lease and hire-purchase

transactions:

The tax treatment of lease transactions in India is

based on whether the lease quali es as a lease or will
be treated as a hire-purchase transactions.

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 o 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
Deptt issued in year 1943. The nancing charges
inherent in hire instalments will be taxed as the hire-
vendor’s income and allowed as the hirer’s expense.

2. What distinguishes between lease and hire-

purchase:

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 bene cial

ownership of the asset. In order to qualify for
depreciation, the lessor has to establish himself to be
both the legal and bene cial owner of the asset. As in
a hire-purchase transaction, the lessor allows to the

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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 bene cial interest in the asset. The lessor will
not be able to bene t 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 bene cial rights,
the lessor becomes ineligible to claim depreciation.

As it is the bene cial ownership rights of the lessor

that is crucial, the distinction between lease and hire-
purchase goes beyond the mere existence of option
to buy in the lease. If, explicitly or implicitly, it is
apparent that the lessor has agreed to a permanent
bene cial enjoyment of the asset by the lessee, the
lease may be treated as a hire-purchase or a plain
nancing transaction.

Based on the above, the conditions for a true lease

transaction have been summarized by the author.
Click here for the true lease conditions.

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 su cient; the lessor must establish himself to be
the bene cial owner as well. It is on the failure of the
condition of bene cial ownership that the legal
owner in case of hire-purchase is not allowed
depreciation.

The lessor’s bene cial 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
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the signi cance 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 speci c 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

xtures to land not belonging to the lessor, the lessor
ceases to be the legal owner of such xture. This
basic legal tenet is common in England and India, and
therefore, the recent English decision of the House of
Lords in BMI Investments might create problems for
Indian lessors leasing out assets that are in the
nature of permanent xtures to ground. Such an
intent is even re ected from the recent Supreme
Court ruling in First Leasing Company of India where
the Supreme Court distinguished a lease from hire-
purchase on the ground whether the transfer of right
to use in a lease resulted into a permanent e ective
right of use being transferred, preparatory to a sale.

The other condition for depreciation is that the tax

payer should be using the asset. It is understood
clearly that the tax payer 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
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consideration, are netted o from the block.

Therefore, no regard is had to the pro t 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 leased 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, 40%

moulds used in plastic or rubber factories

Bottles and crates 50%

Computers (proposed) 60%

Pollution control devices, energy saving devices, 100%

renewable energy devices, rollers in our mills, gas
cylinders, etc.

5. Sale and leaseback transactions:

Sale and leaseback transactions came under a lot of

ak during 1995-96, when transactions in junk
funding were being labeled as sale and leasebacks at
phenomenal values.

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The Income-tax law was amended to insert a speci c

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. Tax treatment in case of hire-purchase

transactions:

In case of hire-purchase transactions, the hire-vendor

pays tax on the income inherent in hire instalments,
not on the whole of the hire rentals. Thus, the tax is
charged only on the income, and not the in ow.

There are no well-de ned rules on determination of

income in case of hire-purchase transactions –
therefore, accounting method adopted by the tax
payer will generally be followed. Thus, either of the
straight-line, sum-of-digits, or actuarial or IRR basis
can be adopted for income allocation.

In the case of Nagarjuna Investment Trust, recently,

the Hyderabad Tax Tribunal has made a detailed
analysis of the straight-line method. Though this was
a case where the tax payer sought to follow di erent
methods of income allocation for tax purpose and for
accounting purposes, the case has brought to fore
the possible interpretation of the word “evenly” (not
necessarily meaning “equally”) as used in the 1943
Circular relating to hire-purchase tax treatment.

7. Deduction of rentals by the Lessee:

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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 o cer to invoke substance of a
transaction ignoring its legal form.

One important case where the claim by the lessee for

rental was disallowed is Centre for Monitoring of
Indian Economy case, where based on the fact that
the lease had partaken the character of acquisition of
the asset by the lessee, the lessee’s claim for lease
rentals was disallowed.

This case cannot be taken to be a trend-setter

because the facts in this case were not materially
di erent from most other nancial leases. If this case
is a precedent, then lease rentals are not tax-
deductible in any single nancial lease. However,
even the Supreme Court has di erentiated 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.

8. Depreciation claim by the Hirer:

The 1943 Circular of the Department allows

depreciation in case of hire-purchase to the hirer of
the asset.

Inspite of the old Circular, there have been problems

once in a while in claiming depreciation. There have
been problems on the part of the hirers in getting
depreciation allowed; and there has been a unique
case where the nancier has claimed depreciation in
a hire-purchase transaction [A P Paper Mills].

However, in general, Departmental circulars are

understood as binding on lower tax authorities, and
therefore, the Circular can be safely treated as
decisive.

9. Deduction of tax at source:

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Deduction of tax at source by the payer is applicable

for several payments, including interest on loans.

There is no question of there being any loan or

interest in case of lease transactions. In case of hire-
purchase transactions, a controversy was created
recently in the context of Interest-tax Act. The
resolution of the controversy seems to go into the
vexatious question of substance of hire-purchase
transactions.

Hire-purchase agreements should provide the hirer

with an option to buy the asset and an option to
retire the asset during the tenure of hire. Such
agreements obviously spell an asset-based risk for
the nancier, and hence, cannot be viewed as
nancial transactions.

However, if hire-purchase has no asset-based risks or

rewards for the hire-vendor, it may be treated as a
nancial transaction with all the attendant
consequences – deduction of tax at source, interest-
tax, and more signi cantly, the transaction not being
viewed as a true hire-purchase transaction even from
legal viewpoint. See here for details of requirements
of true hire-purchase and case law on the point.

10. Leases by cross-border lessors:

To know more about India as a host-market for cross-

border leases, click here.

There is no major di erence between leases by

Indian lessors and cross-border lessors.

India goes by the universal basis in computing and

taxing income – therefore, income deemed to accrue
and arise in India, even for entities not resident in
India, will be taxable here. Income arising out of an
asset in India will be deemed to accrue and arise in
India. Hence, in a lease, or in a hire-purchase
transaction, the hire rentals, will be deemed to accrue

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or arise in India if the either the asset or the tax-

payer is domiciled in India.

The principles for computation of income to be taxed

remain the same as in case of resident tax payers.

The only signi cant issue is withholding tax. Any

payment to a non-resident requires deduction of tax
at source.

The problem of withholding tax and double taxation

(tax on territorial basis in India and universal basis in
country of residence) is partly resolved by double tax
avoidance treaties.

India has double tax avoidance treaties with many

countries, but one of the most e ective jurisdictions
is Mauritius with which India has a comprehensive
treaty. For entities domiciled in Mauritius, there will
be no deduction of tax at source in India.

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