III AFA UNIT 2 -LEASE FINANCING ADV FM NOTES-2020

Concept of Leasing
From the standpoint of finance, assets are acquired to generate cashflow. Finance executives or
managers understand that the cash flows are generated by use of assets and not by owning them
(the assets). Almost any asset that can be bought (sold) can also be taken (given) on lease. For
example, a firm having a factory 20 km away from Nagpur city requires a couple of buses for
transportation of staff from city to the factory site.
The firm can either purchase the buses by using its own fund (equity financing) or by taking loan
from bank (debt financing) or partly by own fund and partly by loan (equity and loan financing).
Alternatively, the firm can take the buses on lease. Therefore, lease is nothing but an alternative
financing arrangement. More specifically, lease is a financing decision. First, a firm has to make
an investment
decision in an asset that will generate cash flow. After that the finance manager has to decide
whether the asset is to be bought by using internal fund or borrowing or by both or by taking the
asset on lease.
Before we can compare lease with other modes of financing (equity or debt) it is necessary to
understand how lease arrangements work and the differences between types of lease. Later in this
chapter we shall make an analysis comparing lease vis-à-vis owning through equity or debt based
on valuation after considering the tax implication for decision.
HOW DOES LEASING WORK
In the most basic sense a lease is an agreement between the two persons whereby the owner of the
asset (called lessor) allows the other person (called lessee) to use the asset for a regular periodic
payment. Lease arises out of contract between the lessor and lessee. The terms of lease agreement
are the most vital in understanding the type of lease and their financial implication on lessor and
lessee.
Example 1– X Car rental Ltd., agrees to use Y Builders Ltd. – a luxury sedan car for Rs. 25000/ -
per month for 2 years to be used for showing the customers the flats developed by the latter located
at different places in Delhi ,NCR region. X Car Rental is lessor and Y Builders Ltd is the lessee
under the arrangement.

What is lease
Lease can be defined as a right to use equipment or capital goods on payment of periodical amount.
This may broadly be equated to an instalment credit being extended to the person using the asset
by the owner of capital goods with small variation.

Parties to a Lease Agreement

There are two principal parties to any lease transaction as under:
III AFA UNIT 2 -LEASE FINANCING ADV FM NOTES-2020

• Lessor : Who is actual owner of equipment permitting use to the other party on payment of
periodical amount.
• Lessee : Who acquires the right to use the equipment on payment of periodical amount.
TYPES OF LEASING
Based on these variations, the following classifications have evolved:
• Finance lease vs operating lease
• Sale and lease back vs direct lease
• Single investor lease vs leveraged lease
• Domestic vs international lease
Financial Lease Vs Operating Lease
A finance lease, or capital lease, is essentially a form of borrowing. According to the Accounting
Standard 19 of ICAI, a finance lease is a lease which meets any one of the following requirements.
• The lease agreement transfers ownership to the lessee before the lease expires.
• The lessee can purchase the asset for a bargain price when the lease expires.
• The lease lasts for at least 75 percent of the asset’s estimated economic life.
• The present value of lease payments is at least 90 percent of the asset’s value.
From an economic point of view, finance lease results in a substantial transfer of the risks and
rewards of ownership from the lessor to the lessee.
An operating lease can be defined as any lease other than a finance lease. The salient features of
an operating lease are:
• The lease term is significantly less than the economic life of the equipment.
• The lessee enjoys the right to terminate the lease at short notice without any significant
penalty.
• The lessor usually provides the operating know-how and the related services and
undertakes the responsibility of insuring and maintaining the equipment. Such 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’.

Single Investor Lease versus Leveraged Lease

In a single investor lease transaction, the leasing company (lessor) funds the entire investment by
raising an appropriate mix of debt and equity. The important point to be noted is that the debt funds
raised by the leasing company are without recourse to the lessee. Put differently, the lender cannot
demand payment from the lessee in the event of the leasing company defaulting on its debt
servicing obligations.
III AFA UNIT 2 -LEASE FINANCING ADV FM NOTES-2020

In a leveraged lease transaction, the leasing company or lessor (called the equity participant) and
a lender (called the loan participant) jointly fund the investment in the asset to be leased to the
lessee. The funding provided by the loan participant is usually structured in the form of a fixed
rate loan without recourse to the leasing company. Each lease rental received from the lessee is
bifurcated into two parts: a part which represents the debt service charge on the loan is passed on
to the loan participant and the balance which is passed on to the leasing company. The loan
provided by the loan participant is secured by a first charge on the future rentals payable by the
lessee and a fixed charge on the leased asset.
Domestic Lease versus International Lease
A lease transaction is classified as a domestic lease if all parties to the lease transaction—the
equipment supplier, the lessor, and the lessee —are domiciled in the same country. A lease
transaction is classified as an international lease if one or more of the parties to the transaction
is/are domiciled in a different country.
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) a knowledge of the tax and the
regulatory framework governing these transactions in the countries concerned. Second, as the
payments to the supplier and/or the lease payments tend to be denominated in different currencies,
the economics of the transaction from the point of view of both the lessor and the lessee tend to be
affected by the variations in the relevant exchange rates. Put differently, international lease
transactions (unlike domestic lease transactions) are exposed to two additional sources of risk—
country risk and currency risk.
RATIONALE FOR LEASING
A variety of reasons are cited in support of leasing. Some of them are plausible while others are
dubious.
Plausible Reasons
Convenience
Suppose you want a car for one month. You can buy one and sell it after a month. Doing so,
however, will involve a lot of effort, time, and cost. You have to select one, arrange for its
financing, and negotiate its resale after your use. Clearly it is not worth doing all this, when you
have the simple alternative of renting the car for a month. Likewise, when a company needs an
equipment for a short period, it makes sense to lease it, rather than buy it. Of course, such a lease
will invariably be an operating lease.
Benefits of Standardisation
Suppose you run a finance company that specialises in leasing trucks. You are effectively lending
money to a number of firms that may vary in size and risk. Since the asset in each case is the same
(a truck), you can use a standardised contract and you don’t have to incur large administrative and
investigative costs. Put differently, standardisation and economies of scale will reduce
III AFA UNIT 2 -LEASE FINANCING ADV FM NOTES-2020

administration and transaction costs. Due to these benefits, leasing can be a cheaper source of
finance, particularly for smaller companies.

Better Utilisation of Tax Shields

The tax benefit of asset ownership may vary across various units in the economy. The sources of
this variation are (i) differences in the tax rates across economic units and (ii) differences in the
level of past and current income across economic units. Due to such differences in tax shelters
enjoyed by various firms, leasing may be a tax beneficial arrangement. A firm that cannot, on its
own, avail of tax benefits of owning an asset may share a part of that benefit in the form of lower
lease rentals by taking the asset on lease from a firm that enjoys tax benefits in full.
Fewer Restrictive Covenants
Term loans have several restrictive covenants associated with them. These relate to matters like
new investments, additional financing, working capital position, managerial appointments,
dividend payment, and provision of guarantees. By comparison lease contracts contain fewer and
less restrictive covenants. Further, many firms are averse to the ‘nominee director’ clause often
found in term loan agreements. Lease financing, however, does not carry such ‘inconvenient
clauses’.
Lower Cost of Obsolescence Risk
In an operating lease, the lessee can terminate the lease at will. This means that the risk of
obsolescence is borne by the lessor. The lessor, however, enhances the lease rental suitably for
bearing the risk of obsolescence. In effect, the lessee bears the cost of obsolescence risk. Is it
possible for a user of asset to reduce the economic cost of obsolescence by way of leasing? Yes,
this may happen. The lessor, with better access to potential users of assets, may be able to find an
economic use for somewhat obsolescent assets and thereby reduce the economic cost of
obsolescence. A part of this economic advantage is likely to be passed on to the user (lessee) of
the asset under competitive pressures in the leasing market.
Expeditious Implementation
If debt financing is sought from lending institutions, the process of project preparation, appraisal,
and sanction can be somewhat time consuming. It may take one to three months and sometimes
even longer. As against this, lease financing can be tied up quickly. It can be finalised within a few
days. Hence, leasing facilitates expeditious implementation of a project. This may reduce cost and
provide some competitive edge.
Matching of Lease Rentals to Cash Flow Capabilities
The pattern of debt servicing burden, given a certain amount of term loan, is more or less uniform
for all types of borrowers. This is because a term loan is typically repayable in 8 to 16 equal semi-
annual instalments and the interest is payable on the outstanding loan amount. As against this,
leasing companies claim that they can tailor make lease rentals to match the cash flow capability
III AFA UNIT 2 -LEASE FINANCING ADV FM NOTES-2020

of the lessee. They may offer the following patterns of lease rentals: seasonal, stepped-up, deferred.
Seasonal lease rentals have appeal to firms which have pronounced seasonality in their operations.
Stepped-up lease rentals are suitable for firms which are likely to experience a gradual increase in
their revenues over a period of time. Deferred lease rentals make sense when there is a long
gestation period before revenues are generated. Further, lease rentals may be adjusted to enable
the lessee to derive the maximal tax advantage from lease payments.

DUBIOUS REASONS FOR LEASING

Hundred Percent Financing

Leasing companies often claim that they provide “100 percent financing” because they pay the
entire cost of the leased asset. Hence they argue that leasing preserves the capital of the lessee
firm.
How valid is this argument? If a firm leases the asset, it does conserve its cash. However, it
conserves its cash even when it borrows and buys the asset. Whether the firm goes for the leasing
option or the borrowing-cum-buying option it incurs a similar liability, while preserving its cash.
So there is nothing special about leasing.
Circumvention of Certain Controls
In some organisations, leasing decisions are considered as operating decisions and not capital
budgeting decisions. This may induce managers to resort to leasing so that they can circumvent
the rigorous or time-consuming approval procedure required for capital budgeting.
In a similar vein, financial institutions may sometimes suggest the leasing option to their clients,
if they cannot grant term loans in order to conform with certain lending norms.
Favourable Financial Ratios
Traditionally, leases (both operating and financial) have been regarded as off-balance sheet sources
of finance in India. This means that the leased asset and the liability associated with it are not
shown on the balance sheet of the lessee firm. Thanks to such a treatment, leasing improves the
debt equity ratio of the firm.
The present accounting standard of the Institute of Chartered Accountants of India, however,
requires that a finance lease must be shown in the books of the lessee.

TYPICAL CONTENTS OF 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:
III AFA UNIT 2 -LEASE FINANCING ADV FM NOTES-2020

1. Description of the lessor, the lessee, and the equipment.

2. Amount, time, and place of lease rental 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. Option of lease renewal for the lessee.
10. Return of equipment on expiry of the lease period.
11. Arbitration procedure in the event of dispute.
LEASE EVALUATION

Lessee Perspective
A lease can be evaluated either as an investment decision or as a financing means. If an
investment decision has already been made, a firm (lessee) has to evaluate whether it will
purchase the asset equipment or acquire it on lease basis. The lease rentals can
be taken as interest on debt. Thus leasing in essence is alternating source of financing
to borrowing. The lease evaluation thus is debt financing versus lease financing.
The decision criterion used is Net Present Value of leasing NPV (L) / Net Advantage
of Leasing (NAL). The discount rate used is the marginal cost of capital (Ke) for all
cash flows other than lease payments and the Pretax cost of long term debt for lease
payment (Kd). The value of the interest tax shield is included as forgone cash flow in
the computation of NPV (L) / NAL.

Calculation of NPV (L) / NAL:

Cost of Asset
III AFA UNIT 2 -LEASE FINANCING ADV FM NOTES-2020

Less PV of Lease rentals (LR) (Discounted at Kd)

Add PV of tax shield on LR (Discounted at Ke)
Less PV of interest on debt tax shield. (Discounted at Ke)
Less PV of tax shield on depreciation (Discounted at Ke)
Less PV of salvage value (Discounted at Ke)
If NAL / NPV(L) is positive, the leasing alternative to be used, otherwise borrowing
alternative would be preferable.

Evaluation of Lease Methods

There are three methods of evaluating a leasing proposal viz. Present Value analysis,
Internal Rate of Return analysis, and the Bower Herringer Williamson method.
(a) Present Value Analysis:
In this method, the present value of the annual lease payments (tax adjusted) is compared
with that of the annual loan repayments adjusted for tax shield on depreciation and interest,
and the alternative which has the lesser cash outflow will be chosen.
(b) Internal rate of return analysis:
Under this method there is no need to assume any rate of discount. To this extent, this is
different from the former method where the after-tax cost of borrowed capital was used as
the rate of discount. The result of this analysis is the after tax cost of capital explicit in the
lease which can be compared with that of the other available sources of finance such as a
fresh issue of equity capital, retained earnings or debt. Simply stated, this method seeks to
establish the rate at which the lease rentals, net of tax shield on depreciation are equal to
the cost of leasing
(c) Bower-Herringer-Williamson Method:
This method segregates the financial and tax shield aspects of lease financing. The model
compare the financing benefit of leasing with tax advantage/operating benefit of leasing.
The procedure of evaluation is briefly as follows :
1. Compare the present value of debt with the discounted value of lease payments (gross),
the rate of discount being the gross cost of debt capital. The net present value is the financial
advantage (or disadvantage).
2. Work out the comparative tax benefit during the period and discount it at an appropriate
cost of capital. The present value is the operating advantage (or disadvantage) of leasing.
3. If the net result is an advantage, select leasing
III AFA UNIT 2 -LEASE FINANCING ADV FM NOTES-2020

The Indian Leasing Scenario

Evolution of Leasing in India

Leasing in India originated in 1973. It grew in popularity as a financial product quickly, and by
1986, as per RBI’s records, there were 339 equipment leasing companies with leased assets
aggregated to USD 36.85 million.
From 1986 till 1996 was a period of a significant boom in the industry. The factors that
worked to fuel the boom included tax incentives due to first year depreciation and investment
allowance, positive response to leasing IPOs by the capital markets, strong performance by early
starting companies, etc. There were two more factors, discussed below, that fueled an
unsustainable growth the lure of public deposits, and lack of accounting standards.
To make matters worse, most states in India introduced sales-tax on lease transactions
around the same time. The applicability of sales-tax on lease transactions served as an extra cost
to be borne by the lessee, severely affecting the economics
of the transaction. This tax was an incremental tax; that is, with no offset available for the lessee
to absorb the additional tax burden.
New accounting standard AS 18, largely emulating IAS 17, was issued by ICAI in 2001,
treating a financial lease at par with a secured lending transaction. While there was a confirmation
by the Central Board of direct Taxes (CBDT) that despite lessee capitalisation in case of financial
leases for accounting purposes, the eligibility of depreciation to leasing entities will continue to be
driven by tax rules, the past history with dubious leasing transactions engineered solely for tax
motive, led tax authorities to continue to deny tax
benefits particularly for financial leases.
In the absence of any tax benefits and the added burden of VAT, there remained little
incentive for lessors to push leasing as a product and
gradually, by late 1990S, leasing entities shifted to the traditional loan format.
Volumes of lease transactions continued to come down from 1996 to 2004. In 2004, most
states in the country adopted value-added taxation (VAT), which allowed the lessors to offset their
output VAT liability on the sales tax charged on
III AFA UNIT 2 -LEASE FINANCING ADV FM NOTES-2020

Deposits and Depreciation – the twin factors that led to bursting of the leasing
boom

Financial companies in India had traditionally been allowed to accept deposits

from the public. While the limit up to which non-financial companies have
been allowed to accept deposits has been only 25%, for financial companies,
the limit was 1000% of net owned funds. Most of the leasing entities took
advantage of largely unregulated deposit market, and started accepting
deposits mostly for tenures of 1 year. While the leasing companies continued
to accept deposits, these short term deposits were
deployed for long term slowly leading the companies to a growing build-up of
severe asset-liability mismatches.

In early years of leasing, India had no accounting standard dealing with lease
transactions. Hence, a lessor could treat all lease rentals as income, and thereby,
report substantially higher leasing incomes than the actual interest embedded in
lease rentals. A lessee could keep all leases off-the-balance sheet. This led to
higher-than-real profits in initial years booked by leasing entities, which would
reverse in later years, thereby creating unsustainable financial statements.
Around the same time, tax assessments of several leasing companies revealed
the use of leasing as a mechanism for tax shelter. Several sham transactions came
to the fore, where assets for which a lease was ndertaken were either non-existent
or could not be identified. In an effort to capture the high depreciation available on
some of the asset classes, several sale and lease back transactions were
undertaken with artificial inflation in asset values, leading to tax officers
disallowing depreciation to the lessors in such transactions and remaining
conspicuously cautious of sale and lease back transactions.

lease rentals against the VAT paid by them at the time of purchase of the asset. This
brought down the tax burden in the lease transactions removing some of the disincentives in
leasing. However, the VAT system also meant significant compliance costs, as every leasing
transaction would have to be reported for VAT purposes. There was also a question of loss of
present value, as the VAT suffered on the purchase of the asset could be offset only over a period
of time by way of set off against lease rentals.
In July 2017, the entire indirect tax regime in India underwent as Goods and Services
Tax was introduced. This addressed most of the concerns with respect to off-setting of taxes paid
on inputs with the tax liability.
III AFA UNIT 2 -LEASE FINANCING ADV FM NOTES-2020

Legal aspects of leasing in India

There is no specific enactment dealing with leases of equipment; the governing law for leases is
the law of contracts, or common law, i.e., the Indian Contract Act, 1872, which provides decisive
force to the lease agreement. Additionally, the Transfer of Property Act, 1881 also deal with lease
of properties, however, the law deals mainly deals with immovable property. As per common law
principles,
a lease of movable property involves 4 essential features:
a.The subject matter of lease, that is, the goods
b.Transfer of possession of goods to the lessee
c.Transfer of right to use the goods to the lessee
d.Re-delivery of the goods by the lessee to the lessor on expiry of the lease.

Regulatory aspects of leasing business

As per RBI regulations, it is mandatory for a company that is in the business of financing to have
a certificate of registration classifying it as a financial services company.
As per the National Industrial Classification Code4, financial leases are regarded as financial
transactions, considered under “financial services activities” while operating leases, are regarded
as rental contracts, and dealt with in a separate section on “renting and leasing activities”.
Since a financial lease is regarded as a financial contract, any entity principally engaged in the
business of financial leases is considered to be a Non-Bank Finance Company (NBFC). An entity
is considered to be principally engaged in financial activities if it satisfies the twin “principal
business criteria” laid down by the RBI vide its press release dated 8th April, 1999:5
• At least 50% of the total assets of Company should be financial assets; and
• At least 50% of the gross income should be derived from the financial assets.

GST and lease transactions

The introduction of GST led to subsuming of differentiated taxes on production (excise), sales
(VAT),services (service tax) and other several taxes such as entry tax, octroi etc.
into one comprehensive tax.
III AFA UNIT 2 -LEASE FINANCING ADV FM NOTES-2020

The process of this change involved an amendment of the Constitution, presenting and passing of
the GST Bill, and framing and implementing several procedural rules, besides, of course,
administrative changes

Particulars Erstwhile regime New regime

Operating Lease Financial Lease Operating Financial Lease

Lease

Service vs. Deemed Sale as per Article Both Sale and Service Supply of Supply of Services, except for
Sale 366(29A)(d) Services cases where the transaction
involves automatic transfer of
title of goods at the end of the
tenure, which would qualify as
Supply of Goods

On Intra- • Lease rentals are subject
state to VAT
transaction
• Input Tax credit on VAT
paid is available subject
to the transaction and
the asset being eligible
for credit
• Lease rentals are subject • Lease rentals would be subject to CGST & SGST
to VAT
• Input credit of CGST would be used to set-off
• Service Tax is charged @ output liability of CGST
10% of prevailing Service
• Input credit of SGST would be used to set-off
Tax rate on the Interest
output liability of SGST
component

On Inter- • CST to be charged on • CST to be charged on • Lease rentals would be subject to IGST
state lease rentals lease rentals
• Input Tax credit of IGST would be first used to
transaction
• Input credit of CST paid • Service Tax is charged @ set-off of IGST first, thereafter CGST and lastly
is not available for set-off 10% of prevailing Service SGST
and hence becomes a Tax rate on the Interest
sunk cost component

• Input credit of CST paid

is not available for set-off
and hence becomes a
sunk cost

High seas • Basic customs duty chargeable • Basic Customs duty would be levied (as it will
Lease not be subsumed into GST)
• Additional duty u/s 3(5) is payable
• IGST would be charged in place of Additional
duty
III AFA UNIT 2 -LEASE FINANCING ADV FM NOTES-2020

Major leasing players in the market

Leasing players in India can be categorised under the following heads:
a. Non-Banking Financial Companies
b. Non-Banking Non-Financial Companies
c. Specialised entities
• Car finance companies
• Captive financing arms of Vendors and OEM
• Cab aggregators
• Indian Railway Finance Corporation

Non-banking financial companies

Complementing the banking system, NBFCs occupy a significant position in financial
intermediation. Though banks have lower cost of funds, NBFCs have advantages of speedier
documentation, informal and closer access with customers, geographical outreach, strong
relationships with Original Equipment Manufacturers (OEMs) and equipment dealers, less
stringent regulatory requirements as compared to banks, etc. NBFCs are not bound by priority
sector lending requirements, nor required to maintain Statutory liquidity ratio (SLR) and Cash
reserve ratio (CRR). In terms of organisational structures, NBFCs have stronger decentralisation
of decision-making, giving them ability to have faster turnaround times. These differences have
resulted into NBFCs demonstrating higher rate of growth assets.

Non-banking non-financial companies

There are several companies, which are not financial companies as they focus primarily on
operating leases, and hence, are regarded as NBNFCs. These companies provide operating leases
of several assets such as IT equipment, furniture, office equipment, equipment such as lifts and
security equipment in commercial property complexes, etc.
Most of these companies assign their rental receivables to other financiers such as banks and
NBFCs, soon after origination of the transaction, and thus, extract out a large part of their
investment in the transaction, leaving an investment in the residual value. Thus, the skin-in-the-
game of such companies is the residual value.

Car finance companies

Several companies focus on leasing or financing of passenger cars. Car leasing has been viewed
as a separate segment, as the lessee’s motivations for car lease includes provision of an amenity
for its executive, including an opportunity for the executive to acquire the car at the end of the
lease term. From the lessor perspective as well, car leasing entities are either vendor affiliates, or
III AFA UNIT 2 -LEASE FINANCING ADV FM NOTES-2020

they are specialised companies who have their expertise on car leasing and fleet management
services.

Captive financing arms of Vendors and OEMs

As is globally the trend, major vendors and OEMs of capital equipment, including cars, healthcare
products, IT equipment etc. provide, either by themselves or through dedicated captive companies,
finance against equipment sold by the parents. Some of these captive financiers provide leasing
option too. The captive lessors obviously have their own set of advantages – they may get a residual
value or remarketing support from the parent. For the parent, the ability to provide the leasing
option becomes a sales-aid tool, thereby becoming a win-win proposal for both. Of course, for the
customer, quite often, the estimation of residual value by the captive is higher than what the
customer would possibly fetch if he were to remarket the asset himself – making the leasing option
attractive.

Self-drive car rental companies and Cab aggregators

The growth in the business of aggregation of cabs has led to a surge in short car renting business.
Online cab aggregators are now making forays into the leasing space. Additionally, there has been
a new opportunity of self-drive car rental business, with several such companies coming up in the
recent past. A report by an industry insider puts the growth rate of self-drive car rental in India at
around 12%.

Indian Railways Finance Corporation (IRFC)

IRFC stands out as the largest among the lessors in terms of leasing volumes, and yet, so distinct
from the rest of the leasing fraternity. IRFC was formed for, and continues to be solely focused
on, financing its parent, viz., Indian Railways. So, all the financing done by IRFC is for Indian
Railways, and all the financing done by IRFC is leasing only. IRFC leases a variety of assets –
floating stock (wagons, coaches), as well as project assets (railway lines, bridges, etc.).
Considering IRFC’s business dedicated to the Indian Railways to be distinct from other players in
the leasing, we have excluded IRFC’s leasing volumes from the total leasing volumes.