Leasing

Meaning:
A lease can be defined as an arrangement between the lessor (owner of the
asset) and the lessee (user of the asset). Whereby the lessor purchases an
asset for the lessee and allows him to use it in exchange for periodical
payments. These payments are called lease rentals or minimum lease
payments (MLP). Leasing is beneficial to both parties for availing tax
benefits or doing tax planning. It is becoming the most preferred source of
asset financing.

Advantages of leasing are:-

1.Balanced Cash Outflow-

The biggest advantage of leasing is that cash outflow or payments related to

leasing are spread out over several years, hence saving the burden of one-
time significant cash payments. This helps a business to maintain a steady
cash-flow profile.

2.Quality Assets-

While leasing an asset, the ownership of the asset still lies with the lessor,
whereas the lessee just pays the rental expense. Given this agreement, it
becomes plausible for a business to invest in good quality assets which
might look unaffordable or expensive otherwise.

3.Capital Investment-

Given that a company chooses to lease over investing in an asset by

purchasing, it releases capital for the business to fund its other capital
needs or to save money for a better capital investment decision.
4.Tax Benefit-

Leasing expenses or lease payments are considered as operating expenses

and hence, of interest, are tax-deductible.

5.Off-Balance Sheet Debt-

Although lease expenses get the same treatment as interest expenses, the
treatment of lease is different from debt. Leasing is classified as an off-
balance sheet debt and doesn’t appear on the company’s balance sheet.

6.Planning-

Lease expenses usually remain constant over the asset’s life or lease tenor
or grow in line with inflation. This helps in planning expenses or cash
outflow when undertaking a budgeting exercise.

Disadvantages of Leasing
1.Lease Expenses-

The treatment of lease payments is as expenses rather than as equity

payments towards an asset.

2.Limited Financial Benefits-

If paying lease payments toward land, the business cannot benefit from any
appreciation in the value of the land. The long-term lease agreement also
remains a burden on the business as the agreement is locked and the
expenses for several years are fixed. In a case when the use of an asset does
not serve the requirement after some years, lease payments become a
burden.

3.Reduced Return for Equity Holders-

Given that lease expenses reduce the net income without any appreciation
in value, it means limited returns or reduced returns for an equity
shareholder. In such a case, there is no achievement of the objective of
wealth maximization for shareholders.

4.Debt-

Although a lease doesn’t appear on a company’s balance sheet, investors

still consider long-term leases as debt and adjust their valuation of a
business to include leases.

5.Limited Access to Other Loans-

Given that investors treat long-term leases as debt, it might become

difficult for a business to tap capital markets and raise further loans or
other forms of debt from the market.

6.Processing and Documentation-

Overall, entering into a lease agreement is a complex process and requires

thorough documentation and proper examination of an asset being leased.

7.No Ownership-

At the end of the leasing period, the lessee doesn’t become the asset owner
though quite a good sum of payment is being done over the years towards
the asset.

8.Maintenance of the Asset-

The lessee remains responsible for the maintenance and proper operation
of the asset being leased.

9.Limited Tax Benefit-

For a new start-up, the tax expense is likely to be minimal. In these

circumstances, no added tax advantage derives from leasing expenses.
Hire purchase
Meaning:

Hire purchase is a method of financing of the fixed asset to be purchased on

future date. Under this method of financing, the purchase price is paid in
installments. Ownership of the asset is transferred after the payment of the
last installment.

Features of Hire Purchase:

The main features of hire purchase finance are:

1.The hire purchaser becomes the owner of the asset after paying the last
installment.

2.Every installment is treated as hire charge for using the asset.

3.Hire purchaser can use the asset right after making the agreement with
the hire vendor.

4.The hire vendor has the right to repossess the asset in case of difficulties
in obtaining the payment of installment.

5.Rental payments are paid in installments over the period of the

agreement.

6.Each rental payment is considered as a charge for hiring the asset. This
means that, if the hirer defaults on any payment, the seller has all the rights
to take back the assets.

7.All the required terms and conditions between both the parties involved
are documented in a contract called Hire-Purchase agreement.

8.The frequency of the installments may be annual, half-yearly, quarterly,

monthly, etc. according to the terms of the agreement.Assets are instantly
delivered to the hirer as soon as the agreement is signed.
9.If the hirer uses the option to purchase, the assets are passed to him after
the last installment is paid.

10.If the hirer does not want to own the asset, he can return the assets any
time and is not required to pay any installment that falls due after the
return.

Advantages of Hire Purchase:

1.Financing of an asset through hire purchase is very easy.

2.Hire purchaser becomes the owner of the asset in future.

3.Hire purchaser gets the benefit of depreciation on asset hired by him/her.

4.Hire purchasers also enjoy the tax benefit on the interest payable by
them.

5.Immediate use of assets without paying the entire amount.

6.Expensive assets can be utilized as the payment is spread over a period of

time.

7.Fixed rental payments make budgeting easier as all the expenditures are
known in advance.

8.Easy accessibility as it is a secured financing.

9.No need to worry about the asset depreciating quickly in value as there is
no obligation to buy the asset.

Disadvantages of Hire Purchase:

1.Ownership of asset is transferred only after the payment of the last
installment.
2.The magnitude of funds involved in hire purchase are very small and only
small types of assets like office equipment’s, automobiles, etc., are
purchased through it.

3.The cost of financing through hire purchase is very high.

4.The addition of any covenants increases the cost.

5.If the hired asset is no longer needed because of any change in the
business strategy, there may be a resulting penalty.

6.Total amount paid towards the asset could be much higher than the cost
of the asset due to substantially high-interest rates.

Tax related issues in leasing

1.Basic tax treatment of lease and hire-purchase transactions:

The tax treatment of lease transactions in India is based on whether the

lease qualifies 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 off the rentals.

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

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

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.

5. Sale and leaseback transactions:

Sale and leaseback transactions came under a lot of flak during 1995-96,
when transactions in junk funding were being labeled as sale and
leasebacks at phenomenal values.The Income-tax law was amended to
insert a specific 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.

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 inflow.

There are no well-defined 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.

7. Deduction of rentals by the Lessee:

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 officer 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.

8. Deduction of tax at source:

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.