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Background and International Accounting Changes On Lease Accounting
Background and International Accounting Changes On Lease Accounting
Background and International Accounting Changes On Lease Accounting
accounting:
There were some 500 odd leasing companies in India about 5 years ago. Now, not
more than 50 serious operators are left, who are searching for ways to survive in the
coming 5 years. In my view, it is high time for those 50 players to join hands together,
and cry out loud: "We will not write a single penny of lease transactions in India, unless
the Government speaks out its mind. Enough is enough. A business can survive taxes,
and duties, and sanctions, but no business can survive uncertainty. So, unless the
Government clarifies what does it have in mind regarding income-tax, sales-tax,
accounting and other issues that have been drifting like the nebula for last 20 years, we
cannot, and shall not write a single lease."
Every industry needs a safe harbour: more so for lease transactions which envisage
long term investments. It is the duty of the State to define what is it policy towards a
business.
In the current controversy relating to accounting standards for lease transactions, some
interesting issues have cropped up.
UK itself is a prominent example. South Africa is yet another. Even in the largest leasing
market in the World, USA, tax and accounting principles for leasing depreciation are
markedly different and the difference is honoured and settled over time.
So, there is no scope for the popular fear that if India adopts IAS-17-type capitalization
by lessees, it would lead to loss of tax depreciation. Unless the tax department also
thinks alike (which would be a disaster, as I explain below), there is no linkage between
tax treatment and accounting treatment when it comes to depreciation. Merely because
a lease is capitalized by the lessee for accounting purposes does not entitled the
lessee, or disentitled the lessor to claim depreciation.
Has the accounting distinction between financial and operating leases served any
purpose?
It is today almost universally agreed that the accounting distinction between financial
and operating leases has not served any purpose. As the accounting difference is
based on fine mathematics, lessors and lessees world-over have devised leases which
in essence are financial leases but qualify for operating lease definition. This is what
prompted an Australian gentleman -McGregor - to make a cothetic argument against
the financial-operating lease distinction. McGregor study became the basis for what is
called "the new approach" to lease accounting. It is based on this approach that IAS 17
was revised with effect from 1999.
Under the revised standard, disclosure is required for non-cancellable leases in the
books of the lessee, irrespective of whether the lease is a financial lease or operating
lease. In other words, as far as the lessee is concerned, accounting standards no more
distinguish between a financial and an operating lease.
Can the accounting distinction be used for tax laws?
Different for the lessor and the lessee (in case of the lessor, his IRR is used; in
case of the lessee, his incremental borrowing rate is used)
Subjective, as the incremental borrowing rate for the lessee is an arguable issue
Prone to manipulation by using structuring elements like security deposit which
are not used in computing the present value test.
Almost the whole of civilized world has adopted. Much smaller and lesser developed
economies have adopted IAS 17, many years ago, and leasing has continued to grow
there. Leave aside unfamiliar names, all our neighbors - Bangla Desh, Sri Lanka and
Pakistan, adopted IAS 17 several years back. That has not deterred the growth of
leasing in any way in any of these countries.
As discussed before, the financial lease/ operating lease distinction would be a disaster
for tax laws. For tax purposes, what is more relevant is the test of a "true lease",
meaning a lease that does not reflect intent of owning and letting out an asset, but one
of mere funding. There are tests in many countries to distinguish between true leases
and financial transactions, which can be used in our country.
Besides this, it might make sense to use a simple but very powerful limitation: leasing
tax shelter not being used against non-leasing incomes. Several countries, such as
Malaysia, Sri Lanka, South Africa, have enacted this rule. This rule allows the leasing
tax shelter to be absorbed within the leasing business, but not to be used against other
incomes. This by itself would curb the misuse of leasing depreciation.
The Institute of Chartered Accountants of India (ICAI) recently issued a new accounting
standard no AS 19 on leases, replacing the existing Guidance Note on lease
accounting. The new standard is applicable for all leases entered on or after 1st April
2001: from this, it is understood that the statement will not affect past leases. However,
for practical considerations, it will be advisable for companies to switch over to the
new method in respect of all lease transactions, including those which are running.
It has been made out that the new accounting standard is drawn in accordance with
international accounting standard no. 17. However, this is not true as the IAS 17 itself
underwent revision in 1997. ICAI's AS 19 is based on the pre-1997 version of IAS 17.
There is no information in the guidance note on lease accounting, 1995, for non-
performing assets. The general accounting principles for non-performing assets is
contained in accounting standard 9 on Revenue Recognition which is more or less on
the lines of the International Accounting Standards on the issue.
The Standard provides that whereas, in general, incomes are to be recognized on the
basis of accrual, in case of an uncertainty in the ultimate realization of an income, the
treatment is as follows:
If the uncertainty is prevalent at the time of raising the claim for the income, the
recognition of the income shall be postponed
If the uncertainty arises subsequent to the claim being made, there shall be a
provision made to the extent of the uncertainty.
This statement lays down the basic difference between a provision against an income,
and non-recognition of income, which is very significant. The accounting for non-
performing assets is guided by the Prudential Norms of the RBI
A lease will be regarded as a non-performing asset based on overdues for more than
12 months. That is, if dues under a lease or hire purchase transaction remain unpaid,
fully or partly, for more than twelve months, the transaction will be treated as a non-
performing asset. The twelve month time frame is markedly longer than the general
international standard of 3 months only.
A provision shall be made to mark the deterioration in the under lying security value on
the basis of the depreciation of the asset as per the Companies Act.
The NBFCs should make provisions against NPAs with correlation to the net book value
of the assets in four stages at 10, 40, 70 and 100 per cent as follows :
Sub-standard assets :
where any amounts of hire charges or 10 percent
of the lease rentals are overdue for more than 12 months
net book value but up to 24 months
Doubtful assets :
Where any amounts of hire charges or lease 40 percent of
the rentals are overdue for more than 24 months net
book value
but up to 36 months
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. The lessor's beneficial 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 the significance 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 specific 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 fixtures to land not belonging to the
lessor, the lessor ceases to be the legal owner of such fixture. This basic legal might
create problems for Indian lessors leasing out assets that are in the nature of
permanent fixtures to ground. Such intent is even reflected 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 effective right of use being transferred, preparatory to a sale.
The other condition for depreciation is that the taxpayer should be using the asset. It is
understood clearly that the taxpayer 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 consideration, are netted off from the block.
Therefore, no regard is had to the profit 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 eased
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, moulds 40%
used in plastic or rubber factories
Bottles and crates 50%
Computers (proposed) 60%
Pollution control devices, energy saving devices, renewable 100%
energy devices, rollers in flour mills, gas cylinders, etc.
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.
This case cannot be taken to be a trend-setter because the facts in this case were not
materially different from most other financial leases. If this case is a precedent, then
lease rentals are not tax-deductible in any single financial lease. However, even the
Supreme Court has differentiated 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
SALES TAX PROVISION PERTAINING TO LEASING:
The major sales tax provisions relevant for leasing are as follows:
1. The lessor is not entitled for the concessional rate of central sales tax because
the asset purchased for leasing is meant neither for resale nor for use in manufacture.
(It may be noted that if a firm buys an asset for resale or for use in manufacture it is
entitled for the confessional rate of sales tax).
2. The 46th Amendment Act has brought lease transitions under the purview of ‘sale’
and has empowered the central and state government to levy sales tax on lease
transactions. While the Central Sales Tax Act has yet to be amended in this respect,
several state governments have amended their sales tax laws to impose sales tax on
lease transactions.
In a Finance Lease, NBFCs are the owner of the Goods and the lessee only has the
right to use the goods on payment of lease rentals. It is a contract of hiring or bailment.
Hence there is no “sale “as defined.
However, there is a transfer of the right to use the goods from us to the lessee. And this
has become taxable as a deemed sale. The Sales Tax, also called "Lease Tax ", is
leviable on the Transfer of Right to Use the goods from us to the lessee. And the tax is
charged as each rental for use of the lease asset becomes due and payable.
It may be noted that Lease Tax is a case of taxing a non-sale -the consumption of utility
of goods - though there is no transfer of title. . Whether it is good law or will the Courts
strike down this Tax ? We are not sure, but NBFCs are agitating the matter in a Court.
Lease is a sale followed by a transfer of right to use. Supplier S sells to the NBFC and
the NBFC gives the goods on lease to Customer C (Transfer of the right to use the
goods). Hence, there are two sale transactions - the sale proper, and the lease.
In HP, also, there are 2 sales. Supplier S sells to the NBFC and the NBFC
simultaneously sells to the Customer C by entering into a hire purchase agreement.
Commercially speaking, the two transactions are not different. There are two contracts
in either case, usually bundled in a single delivery from the supplier to the end-user.
Therefore, in a Lease, there will be a Sales Tax on the Sale and a Lease Tax (if any) on
the transfer of the right to use. In a Hire Purchase there will be 2 Sales Taxes applicable
on 2 separate sales. However, sales-tax laws (for historical reasons only) treat lease
and hire purchase substantially differently. Since the choice of the instrument, viz.,
lease or hire purchase, may lead to material sales-tax difference, it is important that the
sales-tax implications are analyzed before choosing the instrument or concluding the
transaction.
That state where the inter state movement commences has the jurisdiction and the rate
chargeable is also that applicable in that state for CST transactions.
This can be done by endorsement of the LR during transit. If endorsement is done the
jurisdiction shifts to the place where endorsement was made. Thus NBFCs could
instruct the Supplier to send goods physically to Customer and hand over the LR in our
name at our Bombay address. NBFCs will then endorse the Consignee copy of the LR
in favour of the Customer and forward it to the Customer. The Customer will claim the
goods from the transporter by producing this endorsed LR.
The Budget deals a body blow to the already moribund leasing and hire purchase sector
- imposing a service tax on not just the income but the entire receivables out of lease
and hire purchase transactions.
Not only are leasing and hire purchase companies proposed to be brought under tax,
they are also grossly discriminated against: as loans from banks, an alternative to lease
and hire purchase, have not been brought under the tax.
Leasing has great potential in India. However, leasing in India faces serious handicaps
which may mar its growth in future. The following are some of the problems.
1. Unhealthy Competition:
The market for leasing has not grown with the same pace as the number of lessors. As
a result, there is over supply of lessors leading to competitor. With the leasing business
becoming more competitive, the margin of profit for lessors has dropped from four to
five percent to the present 2.5 to 3 percent. Bank subsidiaries and financial institutions
have the competitive edge over the private sector concerns because of cheap source of
finance.
3. Tax Considerations:
Most people believe that lessees prefer leasing because of the tax benefits it
offers. In reality, it only transfers; the benefit i.e. the lessee’s tax shelter is lessor’s
burden. The lease becomes economically viable only when the transfer’s effective tax
rate is low. In addition, taxes like sales tax, wealth tax, additional tax, surcharge etc. add
to the cost of leasing. Thus leasing becomes more expensive form of financing than
conventional mode of finance such as hire purchase.
4. Stamp Duty:
The states treat a leasing transaction as a sale for the purpose of making
them eligible to sales tax. On the contrary, for stamp duty, the transaction is treated as a
pure lease transaction. Accordingly a heavy stamp duty is levied on lease documents.
This adds to the burden of leasing industry.
Asset-liability mismatch:
Most non-banking finance companies in India had relied extensively on public deposits
-this was not a new development, as the RBI itself was constantly encouraging and
supporting the deposit-raising activities of NBFCs. If the resulting asset-liability
mismatch, to everybody's agreement, is the surest culprit of all NBFC woes today, it
must have been a sudden realization, because over all these years, each Governor of
the RBI has passed laudatory remarks on the deposit-mobilization by NBFCs knowing
fully well that most of these deposits were 1-year deposits while the deployment of
funds was mostly for longer tenures. It is only the contagion created by the CRB-effect
that most NBFCs have realized that they were sitting on gun-powder all these years.
The sudden brakes put by the RBI have only worsened the mismatch.
Most NBFCs have learnt a very hard way to distinguish between a good credit prospect
and a bad credit prospect. When a credit decision goes wrong, it is trite that in
retrospect, it invariably seems to be the silliest mistake that ever could have been made,
but what Indian leasing companies have suffered are certainly problems of infancy.
Credit decisions were based on a pure financial view, with asset quality taking a back-
seat.
Tax-based credits:
In most of the cases of frauds or hopelessly-wrong credit decisions, there has been a
tax motive responsible for the transaction. India has something which many other
countries do not- a 100% first year depreciation on several assets. Apparently, the list of
such assets is limited and the underlying fiscal rationale quite holy and sound - certain
energy saving devices, pollution control devices etc qualify for such allowance. But that
being the law, it is left to the ingenuity of our extremely competent tax consultants to
widen the range with innovative ideas of exploiting these entries in the depreciation
schedule. Thus, there have been cases where domestic electric meters have been
claimed as energy saving devices, and the captive water softenizer in a hotel has been
claimed as water pollution control device! As leasing companies were trying to exploit
these entries, a series of fraudsters was successful in exploiting, to the hilt, the
propensity of leasing companies to surpass all caution and all lending prudence to do
one such transaction to manage its taxes, and thus, false papers for non-existing wind
mills and never-existing bio-gas plants were fabricated to lure leasing companies into
losing the whole of their money, to save the part that would have gone as government
taxes!
As they say, it does not rain, it pours. Several problems joined together for leasing
companies - the public antipathy created by the CRB episode and subsequent failures
of some good and several bad NBFCs, regulation by the RBI requiring massive amount
of provisions to be created for assets that were non-performing, etc. It certainly was not
a good year to face all these problems together
Twenty five years ago, Farouk Irani quit his high profile job in Citibank to
launch his dream project: a leasing company in India. On 10 th Sept., 1973, Irani was
able to convince Dr A C Muthia, Industrialist, to have the First Leasing Company of
India incorporated.
For several years, First Leasing Company remained the Only Leasing Company. Ever
since IFC, Washington decided to support Indian leasing with investment in companies
in 4 metros, Indian leasing has never looked back. This was about 1980. Early eighties'
capital market boom found many young entrepreneurs riding the leasing wave.
As it celebrates its 25th Birthday, Indian leasing is today a central part of the financial
system. On its way, it has passed through several twists and turns. Financial industry
World-over has a very high beta factor: it is hyper-sensitive to changes in economic
scenario. Periods of general prosperity are extremely good for the leasing industry;
downturns in economic cycle cost is extremely high. That apart, financial system is
invariably affected by the contagion effect: failures of a few players affect even the
healthy ones.
Though it is currently passing through a testing time, leasing has had an undeniable role
in Indian economy. From consumer finance to small industry, heavy industry to
automobiles, from railways to electricity boards, almost every sector of the economy has
utilized leasing as its source capital. Having attained an average over-30% growth rate
over past 7 years, Indian leasing has reached the 14 th largest place in the World, a fact
which is least realized by most.
India at the 14th largest place in World leasing sounds incredible! But it is true, and
true contrary to the internationally available statistics published by the London Financial
Group. The Group's data, published every year in the World Leasing Yearbook would
place India at some 36th place, but admittedly that data is only the estimate of the author
thereof, and the author of the data might have ranked Indian leasing volume based on
India's per capita income ! When it comes to size, India has the obvious advantage of
being such a vast nation.
Center for Monitoring of Indian Economy compiles data about Indian leasing volumes,
which is carried as a part of India Leasing Yearbook published by the Association of
Leasing and Financial Services Cos. The data compiled by the Center shows aggregate
balance sheet value of leased and hired assets (though for balance sheet purposes,
lease and hire-purchase transactions are distinguished, there is no material difference
between the two - hence the volumes have been clubbed here) at about Rs. 261 billion
(End March 1997). This is based on reporting by 226 companies, whereas the business,
particularly hire-purchase, is spread amongst some 3000 large and small companies.
Estimated outstanding business done by these firms is about Rs. 15 billion (at Rs. 5
million per such firm).
That apart, the data also excludes the massive annual volume of business by the Indian
Railway Finance Corporation (IRFC). IRFC is a hundred percent subsidiary of Indian
Railways, and its leases are dedicated to the parent Railways only. Of late, almost
entire floating stock acquisition by Railways is being acquired on lease from IRFC. The
outstanding value of leases done by IRFC adds to about Rs. 120 billion.
Thus, the aggregate volume comes to about Rs. 396 billion, which is about USD 11
billion as per then-prevailing exchange rates.
USD 11 billion of outstanding volume cannot by itself give India a ranking in the London
Financial Group data, since these rankings are based on incremental volume. However,
a rough estimate of new business can be made from the above data (unfortunately, the
Centre for Monitoring of Indian Economy data do not give any idea of new leasing and
hire-purchase volume). Supposing 30% of the outstanding business of last year was
paid, and there was a 20% growth in net business (as can be seen from the Chart
above), there was a 50% new business, over the volume outstanding at the beginning
of the year. Relative to the business at the end of the year, the incremental volume
should have been about 33% (50/150).
Therefore the annual leasing volume in India is estimated at about USD 3.67 billion, on
a rough and conservative estimate.
In London Financial Group data, this should put India at 12-13 th place, close to Hong
Kong. This would also be the third largest market in Asia, next only to Japan and Korea.
The only infirmity in the above ranking is that the London Financial Group data are not
as of March 1997 - that, however, should not seriously disrupt the ranking of India,
because other Asian markets in 1996-7 period have generally registered a negative
growth.
With the exception of 1996-97 and 1997-98, the 1990s have generally been a good
decade for Indian leasing. The average rate of growth on compounding basis works out
to 24% from 1991-92 to 1996-97. Broadly, the following factors have been responsible
for the growth of Indian leasing, in no particular order:
No entry barriers :
Any one could float a leasing entity, and even an existing company not in
leasing business can write a lease purely for tax shelters.
The post -liberalization era saw a spate of new ventures and fresh investments by
existing ventures. Though primarily funded by the capital markets, these ventures
relied upon leasing as a source of additional or stand-by funding. Most leasing
companies, who were also merchant bankers, would have funded their clients who
hired them for issue management services.
Fast growth in car market:
Needless to state with facts, the growth in car leasing volume has been the
highest over these years - the spurt in car sales with the entry of several new
models was funded largely by leasing plans.
Tax motivations:
India continues to have unclear distinction between a lease that will qualify for tax
purposes, and one which would not. In retrospect, this is being realized as an
unfortunate legislative mistake, but the absence of any clear rules to distinguish
between true leases and financing transactions, and no bars placed on deduction
of lease tax breaks against non-leasing income, propelled tax-motivated lease
transactions. There was a growing market in sale and leaseback transactions,
which, if tested on principles of technical perfection or financial prudence, would
appear to be a shame on everyone's face.
Data would establish a clear connection between bullish stock markets and the
growth in both number of leasing entities and lease volumes. Year 1994-1995
saw the peak of primary market activity where a company, even if a new entrant
in business, could price itself on unexplainable premium and walk out with pride.
Most leasing companies in India have relied, some heavily, on retail public funds in the
form of deposits. Most of these deposits were raised for 1 year tenure, and on promise
of high rates of interest, at times even more than the regulated rate (which was lifted in
1996 to be reintroduced in 1998).
A generally go-go business environment:
At the backdrop of all this was a general euphoria created by liberalization and
the economic policies of Dr. Manmohan Singh.
Business Need
Il&FS ETS created K-Yan Design Center, an independent research group to create a
new approach to learning. Prof. Kirti Trivedi was appointed to head the project. The
KDC team envisaged a comprehensive learning environment and wanted a software
created that would function as the primary resource of this learning environment.
The biggest challenge was that the requirements were not clear. It was a dream in
which the achievables were known, but not the deliverables. It was not known how or
what exactly needed to be done, it was not even known for sure whether it’s possible.
To add to that the funds available were limited.
The Problems
The Solution
The captive failed to improve its service. As a result, when faced with the need to
acquire several hundred additional PC’s, the company chose the same brand
equipment, but a different lessor. Following the recommendations of executives from
companies similar to its own, it gave CSI Leasing a test run. These references attested
to the dependability and accuracy of the services they received from CSI. With CSI,
they gained a single point of contact for all ordering, as well as a local account
executive immediately responsive to their various needs.
Four years later, CSI Leasing is handling all of this company’s IT leasing needs.
A remarkable side note to this story - it took the captive leasing company five months to
realize it had lost the company’s business.
Unlike manufacturers’ captive leasing arms, CSI does not exist to drive product sales for
a parent company. Since we do not make the products we finance, we realize the only
way to create a loyal customer is to master the principles of account management. We
started by getting the basics right – quick turnaround on orders, accurate invoices and
documentation, and responsive service. Online invoice information, quick vendor
payment and simple end of lease procedures further increased satisfaction. At CSI, we
truly believe there is no excuse for less than exceptional service.
Armed with a detailed understanding of Honda’s needs, ProLogis explained its way of
working and ability to deliver before the crucial lease break of April 2006. The ProLogis
team demonstrated how it could incorporate fit-out into the package and still provide
substantial savings to Honda.
Working together on the specification for the pre-let, ProLogis and Honda developed a
design which would enhance the functions of office and warehouse, helping to make
Honda’s logistics operations far more efficient. ProLogis then worked with award-
winning architect Michael Sparks Associates to gain planning permissions and design
and deliver a bespoke 350,000 sq ft (32,516 sq m) distribution warehouse, before
Honda’s crucial lease break of April 2006.
The resulting building responds to the aims of Honda Logistics UK. The company
sought a design which would project the division’s status within the group and display
the Honda brand in a dynamic application of the corporate livery.
The external design reflects its use as Honda’s state-of-the-art distribution center.
Elevations use crisp detailing, creating a natural rhythm with the alternate use of
different profiles and colors of external cladding.
The warehouse incorporates 21,000 sq ft (1951 sq m) of offices on three stories.
Amenity areas include a canteen, a fully-equipped kitchen, showers, lockers and
administrative accommodation. In addition, Honda required a mezzanine space of
23,400 sq ft (2,175 sq m) inside the warehouse, along with dispatch offices and
extensive plant areas. ProLogis arranged all the fit-out, including gas-fired ambient
heaters and racking along with an area of strengthened slab to accommodate future
racking. The building is fully sprinklered.
Smooth transition:
The layout of the site and the orientation of the building are ideally arranged for the
smooth and efficient operation of a major logistics facility. Offices are positioned to allow
adequate supervision of the service area, while a service road provides 360-degree
circulation. Particular attention was paid both to the intensive demands of heavy
vehicles and to security.
In January 2006, Honda began a smooth transition into its new home. ProLogis was
able to meet Honda’s precise requirements in a timeframe of just ten months. Honda
Logistics UK now uses ProLogis’ state-of-the-art facility to supply car parts, motorbikes
and power equipment nationwide.
Company Background:
Cherokee Carpet Industries of Dalton, Georgia is a manufacturer of residential and
commercial carpeting. With 315 employees, Cherokee Carpet Industries boasts
$50 million a year in revenues. In its five years in business, Cherokee Carpet has
grown rapidly. 1999 was the first year that Cherokee Carpet will have audited
financial statements.
Rapid growth in its five years in business continues to present a need for Cherokee
Carpet to minimize its capital requirements. Cherokee Carpet Industries had a
need for a Plantex 36 End Extruder for polypropylene and nylon carpet yarns, an
industrial piece of equipment. Cherokee Carpet considered a straight purchase of
$3.5 million for the piece of equipment, but discovered that leasing afforded them
the opportunity to leverage their financial resources. When the company weighed
the opportunity costs of a straight out purchase against the lease payments,
leasing offered a better solution.
Results:
East Texas Copy Systems (ETCS) and Canon Financial Services, Inc.
(CFS)
Company Background:
East Texas Copy Systems (ETCS) of Tyler, Texas is an authorized Canon Dealer
of digital networked office equipment. With 15 employees, ETCS services large
quantity accounts, such as hospitals, school districts, city and county governments
and major industries.
One of ETCS' largest customers, a non-profit health system, was looking to take
advantage of leasing equipment as a means to minimize cash outlay and acquire
400 copiers and facsimile machines, as well as to structure a deal that would
satisfy the health systems' billing needs. At present, ETCS leases $500,000
annually in equipment to this customer.
ETCS recognized that having the hospital lease copiers from Canon Financial
Services would offer more flexible leasing terms, reduce its costs in procuring the
equipment and enable the company to pay for the equipment as it is being used.
Thus, lending to the efficiency and productivity of the business.
ETCS needed a flexible, all-cost included leasing program in order to meet its
customer's requirements. When considering financing options, the health system
also looked at acquiring the copiers using a bank line of credit; however, leasing
the equipment from Canon Financial proved to be a more flexible and process
efficient solution.
Results:
The flexible lease that ETCS developed with Canon Financial Services, afforded
the hospital the ability to lease six to 10 copiers per month; thus, reducing monthly
capital outlay while affording the hospital the equipment needed to supply their
growing demand for copiers. This arrangement allowed ETCS to win the hospital's
business and steadily increase its volume leased through Canon Financial
Services based on equipment demand.
easing their copiers afforded the health system the ability to both leverage their
capital, in addition to, protecting themselves from technical obsolescence.
Customer Quote:
"CFS structured the billing cycle to the individual cost centers, making it more
convenient for the hospital's different invoicing needs," said Greg Walker, ETCS
President. "Not all financing sources would be as flexible or accommodating as
CFS. In this industry there are several, national faceless equipment dealers and
leasing companies who have the "me too" attitude. CFS really proved to be
extremely customer service- oriented, just as we like to be at ETCS."
Hamid Lahcen, Chairman and CEO of Spacemakers, was considering options for
financing $1 million of new forklifts needed for the commercial storage facilities.
Because there was no corporate tax in Kuwait, Spacemakers could not take advantage
of the equipment's depreciation tax shield. Hence Lahcen was considering a fifteen year
lease of the equipment.
The Canadian lessor, Hardware Leasing Co., had offered to structure a capital lease for
Spacemakers, as long as Hardware Leasing could arrange non-recourse financing for
the equipment. Hardware wished to purchase the forklifts with $200,000 of its own cash
and $800,000 borrowed from ABN AMRO Bank in Dubai at 7.5%. The leasing
company's effective tax rate was 30%, and Canadian tax laws permit use of the double-
declining balance method for leasing companies. The forklifts had a tax life of seven
years.
Hardware Leasing estimated that it could sell the equipment for $200,000 (the residual
value after 15 years). Spacemakers, the lessee, had requested an early buyout option
(an "EBO") after ten years. Immediately upon purchase, the lessor would lease the
equipment to the lessee for fifteen years. Rents would be paid monthly, on the same
day the debt services were due, and the rents always would be sufficient to pay debt
service.
When Lahcen received a fax summarizing the terms of the lease, he could hardly
believe his eyes. The lessor offered Spacemakers a 15-year lease with 180 equal
monthly payments of $8,052. This included an effective interest rate of only 6.5% per
annum. Not only was the rate very attractive, but Spacemakers would also receive
100% financing with no downpayment. He decided to push his luck and try for the early
buyout option. He scribbled "Accepted, as long as we get the EBO!" on the term sheet,
signed it, and faxed it back to Toronto.
Over past couple of years, the economy itself has done pretty badly. The demand for
capital equipment has been at one of the lowest ebbs. Automobile sales have come
down; corporates have found themselves in a general cash crunch resulting into sticky
loans.
Most NBFCs have learnt a very hard way to distinguish between a good credit prospect
and a bad credit prospect. When a credit decision goes wrong, it is trite that in
retrospect, it invariably seems to be the silliest mistake that ever could have been made,
but what Indian leasing companies have suffered are certainly problems of infancy.
Credit decisions were based on a pure financial view, with asset quality taking a back
seat.
In most of the cases of frauds or hopelessly wrong credit decisions, there has been a
tax motive responsible for the transaction. India has something which many other
countries do not- a 100% first year depreciation on several assets. Apparently, the list of
such assets is limited and the underlying fiscal rationale quite holy and sound - certain
energy saving devices, pollution control devices etc qualify for such allowance. But that
being the law, it is left to the ingenuity of our extremely competent tax consultants to
widen the range with innovative ideas of exploiting these entries in the depreciation
schedule. As leasing companies were trying to exploit these entries, a series of
fraudsters was successful in exploiting, to the hilt, the propensity of leasing companies
to surpass all caution and all lending prudence to do one such transaction to manage its
taxes, and thus, false papers for non-existing wind mills and never-existing bio-gas
plants were fabricated to lure leasing companies into losing the whole of their money, to
save the part that would have gone as government taxes!
A number of factors will precipitate the consolidation in Indian leasing, and the process
is already on. First, bifurcation of leasing and non-leasing activities, such as merchant
banking, will go a long way in breaking the financial conglomerates, who may find
themselves better focusing on investment banking rather than dabbling into leasing at
the same time. Second, in whichever forms of business, mass distribution is possible,
that is, where the customer is more or less homogenous, larger firms will eat up the
shares of the smaller ones. This is something everyone can see happening in the car
finance market. Three, reduced rates by the industry leaders will set benchmark rates in
the market which will force many marginal players out. Fourth, regional players will
survive but will find their relevance in a new avatar as "lease brokers", or to use a better
word, "lease originators". These firms will originate small ticket leases, sell their
portfolios to larger players, thereby encashing their wafer-thin spreads and walking out
to originate another transaction. Such activity has flourished in USA, and we will see
much of the same story in India too.
Cross-border competition will come in two forms: direct cross-border transactions, and
cross-border investments in lease transactions. A number of global leasing giants have
already occupied their positions in India. Capital account convertibility measures will
precipitate the process. The impact of foreign investments will be greater consolidation
activity at home.
During the initial phases of growth of any industry, there is a trend towards
diversification: firms try to attain growth in numbers by unfocused diversification, but
soon realize that diversified presence creates organizational pressures, which are
difficult to cope with. This leads to a trend towards consolidation and focused growth.
Leasing firms of yesteryears were everything: money market players, merchant bankers
and discount houses. Gradually, both regulators and industry participants have realized
that clearer roles are necessary for stability.
There are so many merits in vendor-based leasing that it is surprising that it has not
made its debut in India still. For the asset vendor, a leasing plan is a sales-aid, and for
the lessor, it is easy access to a vast market, with equipment support from the vendor.
In 1997-98 and after, many lessors will be forced to leave general equipment leasing
market and line up with suppliers of equipment. Vendor leasing in time to come will be a
very significant part of the leasing market.
True asset-based funding is an extension of the vendor lease market. The two generally
go together to develop into operating leasing. Full scale operating leasing, that is,
leases will in-built cancellation options, will take quite some time to develop in India, but
features of operating leases will be introduced once vendor tie-ups take place.
The intensity of price-based competition will be split between the corporate finance
market and the consumer finance market. The latter has always placed emphasis on
service, accessibility, and nonquantifiables of that sort, but the corporate finance market
consists of a professional treasury manager who will have to justify the cost of money to
his boss. So far, leasing has continued to sell itself on several intangibles as speed,
smile, and simplicity, but corporate finance quickly moves to a dilemma where every
one is fast, everyone smiles and every one is simple enough for the sophisticated
audience. It is there the price becomes decisive. Leasing, with all its cost additives as
sales tax and stamp duties, will have to sustain as a cost-competitive financing option.
However, the near future for the NBFC Sector seems to be far from satisfactory. Given
the present state of the economy and industry, lack of confidence by investors, apathy
from banks, chaotic and multiple tax regime, non existence of effective recovery
mechanism and unfair competition provided by MNCs, FI’s, the surviving NBFCs have a
tough time before them. However, the country is at a turning point and the requirement
of capital equipments for industrial expansion and huge infrastructural projects will once
again lead to the spurring demand for lease and hire purchase finance and the efficient
and cost effective NBFCs therefore, could have a bright future. Moreover with various
issues like change in accounting norms, sales and service tax on lease rentals and tax
issues facing the leasing industry, the future of this sector seems to be very bleak.
METHODOLOGY
LEASE
A contract in which one party conveys the use of an asset to another party for a
specific period of time at a predetermined rate.
The periodic rental payment to a lessor for the use of assets. Others may define
lease rate as the implicit interest rate in minimum lease payments.
LESSEE
The user of the equipment being leased.
LESSOR
The party to a lease agreement who has legal or tax title to the equipment, grants
the lessee the right to use the equipment for the lease term, and is entitled to the
rentals.
LEVERAGED LEASE
OPEN-END LEASE
A conditional sale lease in which the lessee guarantees that the lessor will realize
a minimum value from the sale of the asset at the end of the lease.
OPERATING LEASE
Any lease that is not a capital lease. These are generally used for short term
leases of equipment. The lessee can acquire the use of equipment for just a
fraction of the useful life of the asset. Additional services such as maintenance
and insurance may be provided by the lessor.
RESIDUAL VALUE
SALE-LEASEBACK
SALES-TYPE LEASE
A lease by a lessor who is the manufacturer or dealer, in which the lease meets
the definitional criteria of a capital lease or direct financing lease.
TAX LEASE
A lease wherein the lessor recognizes the tax incentives provided by the tax laws
for investment and ownership of equipment. Generally, the lease rate factor on
tax leases is reduced to reflect the lessor's recognition of this tax incentive.
VENDOR LEASING
. CAPITAL LEASE
Type of lease classified and accounted for by a lessee as a purchase and by the
lessor as a sale or financing, if it meets any one of the following criteria: (a) the
lessor transfers ownership to the lessee at the end of the lease term; (b) the
lease contains an option to purchase the asset at a bargain price; (c) the lease
term is equal to 75 percent or more of the estimated economic life of the property
(exceptions for used property leased toward the end of its useful life); or (d) the
present value of minimum lease rental payments is equal to 90 percent or more
of the fair market value of the leased asset less related investment tax credits
retained by the lessor. (Also see finance lease.)
The period of time during which an asset will have economic value and be
usable.
The effective rate (to the lessee) of cash flows resulting from a lease transaction.
To compare this rate with a loan interest rate, a company must include in the
cash flows any effect the transactions have on federal tax liabilities.
The first amendment lease gives the lessee a purchase option at one or more
defined points with a requirement that the lessee renew or continue the lease if
the purchase option is not exercised. The option price is usually either a fixed
price intended to approximate fair market value or is defined as fair market value
determined by lessee appraisal and subject to a floor to insure that the lessor's
residual position will be covered if the purchase option is exercised.
If the purchase option is not exercised, then the lease is automatically renewed
for a fixed term (typically 12 or 24 months) at a fixed rental intended to
approximate fair rental value, which will further reduce the lessor's end-of-term
residual position. The lessee is not permitted to return the equipment on the
option exercise date. If the lease is automatically renewed, then at the expiration
of that initial renewal term, the lessee typically has the right either to return the
equipment without penalty or to renew or purchase at fair market value.
FINANCE LEASE
A lease in which the lessor recovers, through the lease payments, all costs
incurred in the lease plus an acceptable rate of return, without any reliance upon
the leased equipment's future residual value.