1) INTRODUCTION

Financial Services basically mean all those kinds of services provided in

financial terms where the essential commodity is money. These services include:
leasing, hire purchase, consumer credit, investment banking, commercial banking,
venture capital, insurance, credit rating, bill discounting, and mutual funds , stock
broking, housing finance, vehicle finance, mortgages and car loans, factoring
among other things.

Various entities that provide these services are basically categorized into
(a) Non –Banking Finance Companies
(b) Commercial Banks, and
(c) Merchant Banks.

Financial Services in India is too vast and varied too have evolved at one place
and at one time. One of the main entities that offer financial services in India is
Non-Banking Finance Companies. These NBFCs registered with Reserve Bank of
India mainly perform fund based services to the customer. Fund based services of
NBFCs include: leasing, hire-purchase and other asset based services whereas fee
based services of NBFCs include bill discounting, portfolio management and other
advisory services.

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 2) LEASING

Leasing as financial service is a contractual agreement where the owner

(lessor) of equipment transfers the right to use the equipment to the user (lessee)
for an agreed period of time in return for a rental. At the end of the lease period the
asset reverts back to the lessor unless there is a provision for the renewal of the
contract or there is a provision for the transfers of ownership to the lessee. If there
is any such provision for transfer of ownership, the deal is treated as hire purchase.
Therefore, a lease could be generally defined as -

“A contract where a party being the owner (lessor) of an asset (leased

asset) provides the asset for use by the lessee at a consideration (rentals),
either fixed or dependent on any variables, for a certain period (lease period),
either fixed or flexible, with an understanding that at the end of such period,
the asset, subject to the embedded options of the lease, will be either returned
to the lessor or disposed off as per the lessor's instructions”.

Leasing was prevalent during the ancient Sumerian and Greek civilizations
where leasing of land, agricultural implements, animals mines and ships took place.
The practice of leasing came into being sometime in the later half of the 19th
century where the rail road manufacturers in the U.S.A resorted to leasing of rail
cars and locomotives.
The equipment leasing industry came into being in 1973 when the first
leasing company, appropriately named as First Leasing This industry however
remained relegated to the background until the early eighties, because the need for
these industry was not strongly felt in industry. The public sector financial
institutions – IDBI, IFCI, ICICI and the State Financial Corporations (SCFs)
provided bulk of the term loans and the commercial banks provided working

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capital finance required by the manufacturing sector on relatively soft terms. Given
the easy availability of funds at reasonable cost, there was obvious no need to look
for alternative means of financing.
The credit squeeze announced by the R.B.I coupled with the strict implantation of
the Tandon & Chore committees’ norms on Maximum Permissible Bank Finance
(MPBF) for working capital forced the manufacturing companies to divert a
portion of their long – term funds for their working capital.

3) HISTORY AND DEVELOPMENT OF LEASING

The history of leasing dates back to 200BC when Sumerians leased goods.
Romans had developed a full body law relating to lease for movable and
immovable property. However the modern concept of leasing appeared for the
first time in 1877 when the Bell Telephone Company began renting telephones in
USA. In 1832, Cottrell and Leonard leased academic caps, grown and hoods.
Subsequently, during 1930s the Railway Industry used leasing service for its
rolling stock needs. In the post war period, the American Air Lines leased their jet
engines for most of the new air crafts. This development ignited immediate
popularity for the lease and generated growth of leasing industry.

The concept of financial leasing was pioneered in India during 1973. The
First Company was set up by the Chidambaram group in 1973 in Madras. The
company undertook leasing of industrial equipment as its main activity. The
Twentieth century Leasing Company Limited was established in 1979. By 1981,
four finance companies joined the fray. The performance of First Leasing
Company Limited and the Twentieth Century Leasing Company Limited motivated
others to enter the leasing industry. In 1980s financial institutions made entry into
leasing business. Industrial Credit and Investment Corporation was the first all

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India financial institution to offer leasing in 1983. Entry of commercial banks into
leasing was facilitated by an amendment of Banking Regulation Act, 1949. State
Bank of India was the first commercial bank to set up a leasing subsidiary, SBI
capital market, in October 1986. Can Bank Financial Services Ltd., BOB Financial
Service Ltd., and PNB Financial Services Limited followed suit. Industrial Finance
Corporation’s Merchant Banking division started financing leasing companies as
well as equipment leasing and financial services. There was thus virtual explosion
in the number of leasing companies rising to about 400 companies in 1990.

In the subsequent years, the adverse trends in capital market and other
factors led to a situation where apart from the institutional lessors, there were
hardly 20 to 25 private leasing companies who were active in the field. The total
volume of leasing business companies was Rs.5000 crores in 1993 and it is
expected to cross Rs.10, 000 crores by March 1995.

4) ELEMENTS IN LEASE STRUCTURE

This is an explanation of the elements in a lease - the parties, asset, rentals,

residual value, etc. This section would also elaborate the unique features of a lease
as different from a regular financing transaction.

1. The transaction:

The transaction of lease of lease is generically an asset-renting transaction.

What distinguishes a lease from a loan is that in the latter, what is lent out is
money; in a lease, what is lent out is the asset.

2. Parties to a lease:

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 There are two parties to a lease: the owner and the user, called the lessor and
the lessee. The lessor is the person who owns the asset and gives it on lease. The
lessee takes the asset on lease and uses it for the period of the lease.

Any one can be a lessor, and any one can be a lessee, subject to usual
conditions as to competence to contract, or holding of properties.

Technically, in order to be a lessor, one does not have to own the asset: one
has to have the right to use the asset. Thus, a lessee can be a lessor for a sub-
lessee, unless the parent lessor has restricted the right to sub-lease.

3. The leased asset:

The subject of a lease is the asset, article or property to be leased. The asset
may be anything - an automobile, or aircraft, or machine, or consumer durable, or
land, or building, or a factory. Only tangible assets can be leased - one cannot
contemplate the leasing of the intangible assets, since one of the essential elements
of a lease is handing over of possession, along with the right to use. Hence,
intangible assets are assigned, whereas tangible assets may be leased.

The concept of leasing will have the following limitations:

1. What cannot be owned cannot be leased. Thus, human resources cannot be

"leased".

While lease of movable properties can be affected by mere delivery, immovable

property is incapable of deliveries in physical sense. Most countries have specific
laws relating to transactions in immovable properties: if such law provides a
particular procedure for a lease of immovable or real estate, such procedure should
be complied with. For example, in Anglo-Saxon legal systems (UK, Australia,

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India, Pakistan, etc.), transactions in real estate are not valid unless they are
effected by registered conveyance. This would apply to lease of land and buildings,
and permanent attachments to land.

2. A lease is structurally a rental for the lease period: with the understanding
that the asset will be returned to the lessor after the period. Thus, the asset
must be capable of re-delivery: it must be durable (at least during the lease
period), identifiable and severable.

The existence of the leased asset is an essential element of a lease

transaction - the asset must exist at the beginning of the lease, during the
lease and at the end of the lease term. Non-existence of the asset, for
whatever reason, will be fatal to the lease.

4. Lease period:

The term of lease, or lease period, is the period for which the
agreement of lease shall be in operation. As an essential element in a lease is
redelivery of the asset by the lessee at the end of the lease period, it is
necessary to have a certain period of lease. During this certain period, the
lessee may be given a right of cancellation, and beyond this period, the
lessee may be given a right of renewal, but essentially, a lease should not
amount to a sale: that is, the asset being given permanently to the lessee.

In financial leases, is common to differentiate between the primary

lease period and the secondary lease period. The former would be the period

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 over which the lessor intends recovering his investment; the latter
intended to allow the lessee to exhaust a substantial part of the remaining
asset value.

The primary period is normally non-cancelable, and the secondary

period is normally cancelable.

5. Lease rentals:

The lease rentals represent the consideration for the lease transaction.
This is what the Lessee pays to the Lessor.

If it is a financial lease transaction, the rentals will simply be the

recovery of the lessor's principal, and a certain rate of return on outstanding
principal. In other words, the rentals can be seen as bundled principal
repayment and interest.

If it is an operating lease transaction, the rentals might include several

elements depending upon the costs and risks borne by the Lessor, such as:

• Interest on the lessor's investment.

• If the lessor is bearing any repairs, insurance, maintenance or operation
costs, them charges for such cost.
• Depreciation in the asset.
• Servicing charges or packaging charges for providing a package of the above
service.

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6. Residual value:

Put simply, "residual value" means the value of the leased equipment
at the end of the lease term.

If the lease contains a buy out option with the lessee, residual value
would mostly mean the value at which a lessee will be allowed to buy the
equipment.

If there is no embedded purchase option, residual value might mean

the value that the lessee or some one else assures will be the minimum value
of the equipment at the end of the lease term. This is typical in case of
financial leases where the lessor cannot grant a buyout option to the lessee;
for the lessor to protect himself against asset-based risks, he would take an
assured residual value commitment either from the lessee himself or from a
third party, typically an insurance company.

The residual value might also the value that the lessor assures to pay-
back to the lessee in case the lessee returns the asset to the lessor: that is, it
might be the value the lessor assures as the minimum value of the
equipment. Such a lease, obviously an operating lease because the lessor is
taking a risk on asset values, is a full payout lease, but the lessor agrees to
refund the guaranteed value on the lessee returning the equipment at the end
of the lease term.

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7. End-of-term options:

The options allowed to the lessee at the end of the primary lease period are
called end-of-term options. Essentially, one, or more, of the following options
will be given to the lessee at the end of the lease term:

• Option to buy (buyout option) at a bargain price or nominal value (typical in

a hire-purchase transaction), called bargain buyout option
• Option to buy at a fair market value or fixed, but substantial value
• Option to renew the lease at nominal rentals, called bargain renewal option
• Option to renew the lease at fair market rentals or substantial rentals
• Option to return the equipment

In any lease, which option will be suitable depends on the nature of the lease
transaction, as also the applicable regulations. For example, in a full payout
financial lease, the lessor would have recovered the whole or substantially the
whole of his investment during the primary lease period. Therefore, it is quite
natural that the lessee should be allowed to exhaust the whole of the remaining
value of the equipment. Regulation permitting, the lessor provide the lessee a
bargain purchase option to allow the lessee to complete the purchase of the
equipment.

However, in many jurisdictions, it is the existence of such buyout option that

demarcates between lease and hire-purchase transaction. If the lessor is
interested to structure the lease as a lease and not hire-purchase, he would be
advised not to provide any buyout option, but instead, to allow the lessee to renew
the lease to continue the use of the asset. In essence, a renewal option achieves the

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same purpose as a purchase, but the lessor retains his ownership as also his
reversionary interest in the equipment.

Fair market value options, either for purchase of equipment, or for renewal,
are typical of operating leases, but are really speaking no more than assuring to the
lessee a continued use of the equipment. If equipment has to be bought at its
prevailing market value, it can be bought from the market rather than from the
lessor - therefore, the fair market value option carries no value for the lessee.

8. Upfront payments:

Lessors may require one or more of the following upfront, that is, instant
payments from a lessee:

• Initial lease rental or initial hire or down payment

• Advance lease rental
• Security deposit
• Initial fees

The initial lease rent or initial hire (the word hire is more common in case of
hire-purchase transactions) is a surrogate for a margin or borrower contribution in
case of loan transactions. Note that given the nature of a lease or hire-purchase as
asset-renting transaction, it is not possible to expect a lessee's contribution to asset
cost as such. Hence, the down payment or first lease rent serves the purpose of a
margin.

Between advance lease rent and initial lease rent - the difference is only
technical. The whole of the initial lease rental is supposed to be appropriated to
income on the date of its receipt, whereas advance rental is still an advance -

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normally an advance against the last few rentals. Therefore, the advance rental will
remain as a deposit with the lessor to be adjusted against the last few rentals.

The security deposit is a proper deposit to secure against the lessee's commitments
under the contract - it is generally intended to be refunded at the end of the lease
contract.

5) TYPES OF LEASING

FINANCE LEASE
A lease is defined as finance lease if it transfers a substantial part of the risks
and rewards associated with ownership from the lessor to the lessee. According to
the International Accounting Standards Committee (IASC), there is a transfer of a
substantial part of the ownership-related risks and rewards if:

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i. The lease transfers ownership of the asset to the lessee by the end of the lease
term; (or)
ii. The lessee has the option to purchase the asset at a price which is expected to
be sufficiently lower than the fair market value at the date the option becomes
exercisable and, at the inception of the lease, it is reasonably certain that the option
will be exercised; (or)
iii. The lease term is for a major part of the useful life of the asset. The title may
or may not eventually be transferred; (or)
iv. The present value of the minimum lease payments (See Glossary) is greater
than or substantially equal to the fair market value of the asset at the inception
of the lease. The title may or may not eventually be transferred.

The aforesaid criteria are largely based on the criteria evolved by the Financial
Accounting Standards Board (FASS) of USA. The FASS has in fact defined
certain cut-off points for criteria (iii) and (iv). According to the FASS definition of
a finance lease, if the lease term exceeds 75 percent of the useful life of the asset
or if the present value of the minimum lease payments exceeds 90 percent of the
fair market value of the asset at the inception of the lease, the lease will be
classified as a 'finance lease'

Financial leases are "loan look-alike":

However, financial leases, though being leases by structure, are financings

by contrivance. To achieve the financing purpose, the leasing structure here tries to
eliminate the substantive differences between leasing and plain financings

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 As you might notice, in the above example, the lessee has been put virtually
in the position of an asset owner - he has the right to use the asset for 5 years, with
a power to extend the lease period for another 5 years.

The first 5 years are called the primary lease period and the extended period is
called the secondary lease period.

The lease is non-cancelable during the primary lease period - that is, the
lessee cannot return the asset and not pay balance of the lessor's rentals. For the
secondary period, the lessee will have no incentive of returning the asset, as what
the lessee has to pay is nominal, whereas the asset might still carry substantial
value. Thus, the asset will be enjoyed by the lessee virtually for the whole of its
economic life.

The lessor too has no significant risk/reward other than that of a virtual
money-lender: he would continue getting the lease rentals for the primary period
which will fully-payout the lessor's investment in the lease as also give him his
desired return on investment, irrespective of the state, value or utility of the asset.
If the lessee performs as per agreement, the lessor would get no more, and no less,
than such pre-fixed return on investment.

Incidentally, in the present example, the lessor gets a return of 12.98% - this is
equivalent to the rate of interest in case of loans. As this rate is not explicit, but
implicit in the rate of rentals, the rate is implicit rate of return or IRR.

Features of financial leases:

The above discussion leads to the following features of financial leases:

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 Financial leases allow the asset to be virtually exhausted by the same lessee.
Financial leases put the lessee in the position of a virtual owner.

The lessor takes no asset-based risks or asset-based rewards. He only takes

financial risks and financial rewards, and that is why the name financial leases.

The lease is non-cancelable, meaning the lessee cannot return the asset and
not pay the whole of the lessor's investment.

In this sense, they are full-payout, meaning the full repayment of the lessor's
investment is assured.

As the lessor generally would not take any position other than that of a
financier, he would not provide any services relating to the asset. As such, the
lease is net lease.

The risk the lessor takes is not asset-based risk but lessee-based risk. The
value of the asset is important only from the viewpoint of security of the lessor's
investment.

In financial leases, the lessor's payback period, viz., primary lease period is
followed by an extended period to allow exhaustion of asset value by the lessee,
called secondary lease period. As the renewal is at a token rental, this option is
called bargain renewal option. Alternatively, if the regulations permit, the lessee
may be given a purchase option at a nominal price, called bargain buyout or
purchase option.

In financial leases, the lessor's rate of return is fixed: it is not dependant upon
the asset-value, performance, or any other extraneous costs. The fixed lease rentals

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give rise to an ascertainable rate of return on investment, called implicit rate of
return.

Financial leases are technically different but substantively similar to secured

loans.

Financial leases and Hire-purchase:

In some countries, distinction is made between lease and hire-purchase

transactions. A hire-purchase transaction is usually defined as one where the hirer
(user) has, at the end of the fixed term of hire, an option to buy the asset at a token
value. In other words, financial leases with a bargain buyout option at the end of
the term can be called a hire-purchase transaction.

Hire-purchase is decisively a financial lease transaction, but in some cases, it

is necessary to provide the cancellation option in hire-purchase transactions by
statute: that is, the hirer has to be provided with the option of returning the asset
and walking out from the deal. If such an option is embedded, hire-purchase
becomes significantly different from a financial lease: the risk of obsolescence gets
shifted to the hire-vendor. If the asset were to become obsolete during the
pendency of the hire term, the hirer may off-hire the asset and closes the contract,
leaving the owner with less than a full-payout.

Hire-purchase is of British origin - the device originated much before leases

became popular, and spread to countries which were then British dominions. The
device is still popular in Britain, Australia, New Zealand, India, Pakistan, etc. Most

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of these countries have enacted, in line with United Kingdom, specific laws dealing
with hire-purchase transactions.

DIFFERENCE BETWEEN LEASE FINANCING

AND HIRE PURCHASE

BASIS LEASE FINANCING HIRE PURCHASE

A Lease transaction is a Hire purchase is type

Meaning commercial arrangement, whereby of installment credit
an equipment owner or under which the hire
manufacturer conveys to the purchaser agrees to
equipment user the right to use the take the goods on hire
equipment in return for a rental. at a stated rental,
which is inclusive of
the repayment of
principal as well as
interest, with an option
to purchase.

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 No option is provided to the lessee Option is provided to
Option To User (user) to purchase the goods. the hirer(user).

Lease rentals paid by the lesee are Only interest element

Nature Of
entirely revenue expenditure of included in the hire
Expenditure
lessee. purchase, installments
is revenue expenditure
by nature.

Lease rentals comprise of two Hire purchase

Components
elements installments comprise
(1) finance charge and of three elements
(2) capital recovery. (1) normal trading
profit
(2) finance charge
(3) recovery of cost of
goods/assets.

Substance of financial lease:

If financial leases are substantively so close to secured financing

transactions, the categorical issue is: why should they be treated as a lease at all?
Why should they not be regulated, taxed and accounted for as plain loan
transactions?

This question may be significant from viewpoint of :

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 • Regulation of financial leasing activity.
• Asset rights of the lessor.
• Taxation of the lessor/lessee.
• Accounting for the lease transaction.

In each case, treating the lease as a lease or, based on substance, a financing
transaction, may lead to completely different implications.

o From viewpoint of general regulation of financial leasing activity, if it is

taken as financing by another name, it should form a part of overall financial
markets regulation - most countries' central banks maintain some control on
financial intermediaries.
o The asset-rights of the lessor would also be similar to those of a secured
lender, while in a plain lease contract, the lessor is the sole owner of the asset
and the lessee is merely its bailee.
o If the lease is treated as a financing transaction, the lessor should not be
allowed to claim any asset-related benefit, such as depreciation. His income
should be the implicit part of rentals going towards return on investment.
Likewise, the lessee, apparently a mere user of the asset, should be treated as a
virtual owner and should be allowed all asset-based benefits.
o From accounting viewpoint, if the lease is a mere financing arrangement, the
asset should feature on the Balance Sheet of the lessee rather than the lessor,
along with a corresponding liability to pay fixed rentals to the lessor.

Ideally, any system should be able to differentiate or integrate transactions

based on their substance, and not nomenclature. So, if financial leasing is so close
to lending, it should have been treated as such for every purpose, and the lessor
should have been treated as a lender.

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 However, such ideal is never achieved. There are two reasons to this - one, to an
extent, laws, regulators and taxmen are conditioned by the legal fabric of a
transaction. And two, lessors would emphasize upon on one or more structural
differences between a lease and a loan, and be able to create a situation by which
the substance rule fails.

Therefore, financial leasing all over the World continues to live with, or rather
thrive on, differing approaches to its character - it being treated at par with loans
for some purposes, and distinguished from loans in for some others. Besides, the
lease/loan treatment also depends upon the maturity of a country's regulatory
system to appreciate the substance of a deal by exploding its form -
understandably, doing so is not easy because it would mean going beyond the
apparent form of a contract.

Based on the 4 major areas listed above (general regulation, asset rights,
taxation and accounting), there might be numerous combinations treating financial
leases as loans on security for some purpose and true lease for some other
purposes. Accountings standards are the first (perhaps because they are least
dependent on a statute) to realize the indifference between leases and loans.
Taxation, particularly, income-tax, moves close to accounting standards. General
property laws are the last to do so, because often, for enforcement of a contract, the
way the parties create their mutual rights apparently is more important than what
could have been their intent behind such creation.

For the purpose of determining the present value, the discount rate to be used
by the lessor will be the rate of interest implicit in the lease and the discount rate to
be used by the lessee will be its incremental borrowing rate.

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Therefore, a lease is to be classified as a finance lease if one of the conditions (iii) or
(IV) is satisfied.

In a finance lease, the lessee is responsible for repair, maintenance and

insurance of the asset. The lessee also undertakes a "hell or high water"
obligation to pay rental regardless of the condition or the suitability of the asset.
A finance lease which operates over the entire economic life of the equipment is
called a "full pay out lease".

O
PERATING LEASE

The International Accounting Standards Committee defines an Operating Lease as

"any lease other than a finance lease".

An Operating Lease has the following characteristics:

a.. The lease term is significantly less than the economic life of the equipment.

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b. The lessee enjoys the right to terminate the lease at short notice without any
significant penalty.

c. The lessor usually provides the operating know-how, suppliers, the related
services and undertakes the responsibility of insuring and maintaining the
equipment in which case 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'.
From the features of an operating lease, it is evident that this form of a lease
does not shift the equipment-related business and technological risks from the
lessor to the lessee. The lessor structuring an operating lease transaction has to
depend upon multiple leases or on the realization of a substantial resale value (on
expiry of the first lease) to recover the investment cost plus a reasonable rate of
return thereon. Therefore, specializing in operating leases calls for an in-depth
knowledge of the equipments per se and the secondary (resale) market for such
equipments. Of course the prerequisite is the existence of a resale market.
Given the fact that the resale market for most of the used capital equipments in
our count~ lacks breadth, operating leases are not in popular use. But then this form
of lease ideally suits the requirements of firms operating in sun rise industries
which are characterized by a high degree of technological risk.

Following are illustrative situations where a lease will be regarded as an

operating lease:

• If the lease has a cancellable period, during which rentals forming more than
10% in present value terms of the fair value of the asset are received;
• If part of the rentals are contingent or conditional, and such rentals form
more than 10% in present value terms of the fair value of the asset;

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 • If the lessor relies upon unguaranteed residual value, and such value forms
more than 10% in present value terms of the fair value of the asset;
• If the lessor relies upon guaranteed residual value, but such value is
guaranteed by a third party, and such third-party-guaranteed residual value
forms more than 10% in present value terms of the fair value of the asset - in
this case, the lease will be regarded as a financial lease for the lessor but an
operating lease for the lessee;
• If the lessor's IRR and the lessee's incremental borrowing rate differ: the
lease may be a financial lease for the lessor and an operating lease for the
lessee

Differences between Finance and Operating Leases

Financial Lease Operating Lease

• Risks and rewards of ownership • Economic ownership with all

are transferred to, and borne by,
the lessee. This includes the risks
of accidental ruin or damage of
the asset (although these risks
may be insured or otherwise
assigned). Thus damage that
renders an asset unusable does not
exempt the lessee from financial
liabilities before the lessor.
• The goal of the lessee is either to
corresponding rights and
responsibilities are borne by the
lessor.The lessor buys insurance
and undertake responsibility for
maintenance.
• The goal of the lessee is usage of
the leased asset for a specific
temporary need, and hence the
operating lease contract covers
only the short-term use of the

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 acquire the asset or at least use asset. Further, the duration of an
the asset for most of its economic operating lease is usually much
life. As such, the lessee will aim shorter than the useful life of the
to cover all or most of the full asset.
cost of the asset during the lease • It is not the lessee’s intention to
term and therefore is likely to acquire the asset, and lease
assume the title for the asset at the payments
end of the lease term. The lessee are determined accordingly. In
may gain the title for the asset addition, an asset under an
earlier, but not before the full cost operating lease may subsequently
of the asset has been paid off. be rented out.
• The lessor retains legal ownership • The present value of all lease
for the duration of the lease term, payments is significantly less
though the lessee may or may not than the full asset price.
buy out the leased asset at the end
of the lease, with the lessor
charging only a nominal fee for
the transfer of asset to the lessee.
• The lessee chooses the supplier of
the asset and applies to the lessor
for funding. This is significant
because the leasing company that
funds the transaction should not
be liable for the asset quality,
technical characteristics, and
completeness, even though it
retains the legal ownership of the

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 asset. The lessee will also
generally retain some rights with
respect to the supplier, as if it had
purchase asset directly.

SALE AND LEASEBACK

In a sale and leaseback transaction, the owner of equipment sells it to a
leasing company which in turn leases it back to the erstwhile owner (the lessee).
The 'leaseback' arrangement in this transaction can be in the form of a 'finance
lease' or an 'operating lease'.
A classic example of this type of transaction is the sale and leaseback of safe
deposit vaults resorted to by commercial banks is Under this arrangement the bank sells
the safe sells the safe deposit vaults in its custody to a leasing company at a market
price which is substantially higher than the book value.

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 SELLER SALE TRANSACTION BUYER
SALE VALUE

LEASE TRANSACTION
LESSEE LESSOR
LEASE RENTALS

Sales and Leaseback

The leasing company offers these lockers on a long-term lease to the bank.
The advantages to the bank are:
a. It is able to unlock its investment in a low income yielding asset.
b. It is able to enjoy the uninterrupted use of the lockers (which can be leased to its
customers).
c. It can invest the sale proceeds (which are not subject to the reserve ratio
requirements) in high income yielding commercial loans.
In general, the 'sale and leaseback' arrangement is a readily available
source of funds for financing the expansion and diversification programs of a firm.
In case where capital investments in the past have been funded by high cost
short-term debt, the sale and lease back transaction provides an opportunity to
substitute the short-term debt by medium-term finance (assuming that the
leaseback arrangement is a finance lease).
From the leasing company's angle a sale and leaseback transaction poses certain
problems. First, it is difficult to establish a fair market value of the asset being
acquired because the secondary market for the asset may not exist; even if it exists,

25
it may lack breadth. Second, the Income Tax Authorities can disallow the
claim for depreciation on the fair market value if they perceive the fair market
value as not being 'fair'.

DIRECT LEASE
A direct lease can be defined as any lease transaction which is not a "sale
and leaseback" transaction. In other words, in a direct lease, the lessee and the
owner are two different entities. A direct lease can be of two types: Bipartite
Lease and Tripartite Lease.

Bipartite Lease
In a bipartite lease, there are two parties to the transaction - the equipment
supplier cum-lessor and the lessee. The bipartite lease is typically structured as an
operating lease with in-built facilities like up gradation of the equipment (upgrade
lease) or additions to the original equipment configuration. The lessor
undertakes to maintain the equipment and even replaces the equipment that is in
need of major repair with similar equipment in working condition (swap lease).
Of course, all these add-ons to the basic lease arrangement are possible only if the
lessor happens to be a manufacturer or a dealer in the class of equipments covered
by the lease.

Tripartite Lease

A tripartite lease on the other hand is a transaction involving three different

parties -the equipment supplier, the lessor, and the lessee. Most of the equipment
lease transactions fall under this category. An innovative variant of the tripartite
lease is the sales-aid lease where the equipment supplier catalyzes the lease

26
transaction. In other words, he arranges for lease finance for a prospective
customer who is short on liquidity. Sales-aid leasing can take one of the following
forms:
a.. The equipment supplier can provide a reference about the customer to the
leasing company.
b. The equipment supplier can negotiate the terms of the lease with the
customer and complete the necessary paper work on behalf of the leasing
company.

c. The supplier can write the lease on his own account and discount the lease
receivables with the designated leasing company.

The effect of the transaction is that the leasing company owns the equipment
and obtains an assignment of the lease rental. By and large, sales-aid lease is
supported by recourse to the supplier in the event of default by the lessee. The
recourse can be in the form of the supplier offering to buyback the equipment from
the lessor in the event of default by the lessee or in the form of providing a
guarantee on behalf of the lessee.

LEVERAGED LEASE
In a leveraged lease transaction, the leasing company (called equity
investor) invests in the equipments by borrowing a large chunk of the investment
with full recourse to the lessee and without any recourse to it. The lender (also
called the loan participant)

Obtains the assignment of the lease and the rentals to be paid by the lessee, and
a first mortgage on thee leased asset. The transaction is routed through a trustee who
looks after the interests of the lender and the lessor. On receiving the rentals from the
lessee, the trustee remits the debt- service component of the rental to the loan

27
participant and the balance to the lessor. A schematic representation of transaction is
represented in the figure:

Leveraged Lease

Sells Asset Leases Assets

Manufacturer Lessor Lessee

Lender

Domestic Lease & International Lease

A lease transaction is classified as a domestic lease if all parties to the

transaction to the equipment supplier, the lessor and the lessee are domiciled in the
same country. On the other hand, if the parties are domiciled in different countries,
the transaction is classified as an International Lease Transaction.

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

28
 b. Knowledge of the tax and the regularity framework governing these
transactions in the countries concerned.

Second, as the payments to the supplier and the lease are denominated in different
currencies, the economies of the transactions from the points of view of both the
lessor and the lessee tend to be affected by the variations in the relevant exchange
rates. In short, international lease transactions unlike domestic lease transactions
are affected by two additional sources of risk – country risk and currency risk.

6) LEASING TO LESEE AND LESSOR

Advantages of ‘LEASING’ to ‘LESSEE’

There are several extolled advantages of acquiring capital assets on lease:

(1) Saving of capital:

Leasing covers the full cost of the equipment used in the business by providing
100% finance. The lessee is not to provide or pay any margin money as there is no

down payment. In this way the saving in capital or financial resources can be used
for other productive purposes e.g. purchase of inventories.

(2) Flexibility And Convenience:

The lease agreement can be tailor- made in respect of lease period and lease
rentals according to the convenience and requirements of all lessees.

(3) Planning Cash Flows:

29
Leasing enables the lessee to plan its cash flows properly. The rentals can be paid
out of the cash coming into the business from the use of the same assets.

(4) Improvement In Liquidity:

Leasing enables the lessee to improve their liquidity position by adopting the sale
and lease back technique.

(5) Shifting of Risk of Obsolescence:

The lessee can shift the risk upon lessor by acquiring the use of asset rather than
buying the asset.

(6) Maintenance And Specialized Services:

In case of special kind of lease arrangement, Lessee can avail specialized services
of lessor for maintenance of asset leased. Although lessor charges higher rentals for
providing such services, lessee’s overall administrative and service costs are
reduced because of specialized services of the lessor.

(7) Off-The-Balance-Sheet-Financing:
Leasing provides "off balance sheet" financing for the lessee, in that the lease is
recorded neither as an asset nor as a liability.

Disadvantages of ‘LEASING’ to ‘LESSEE’

(1) Higher Cost:

30
The lease rental include a margin for the lessor as also the cost of risk of
obsolescene, it is, thus regarded as a form of financing at higher cost.

(2) Risk of being deprived the use of asset in case the leasing company winds

up.
(3) No Alteration In Asset:

Lessee cannot make changes in asset as per his requirement.

(4) Penalties On Termination Of Lease:

The lessee has to pay penalties in case he has to terminate the lease before expiry o
lease period.

Advantages of ‘LEASING’ to ‘LESSOR’

(1) Higher profits:

The lessor can get higher profits by leasing the asset.

(2) Tax Benefits:

The lessor being owner of asset can claim various tax benefits such as depreciation.

(3) Quick Returns:

By leasing the asset, the Lessor can get quick returns than investing in other
projects of long gestation period.

Disadvantages of ‘LEASING’ to ‘LESSOR’

31
 (1) High Risk of Obsolescence:

The lessor has to bear the risk of obsolescence as there are rapid technology
changes.

(2) Price Level Changes:

In case of inflation, the prices of asset rises but the lease rentals remain fixed.

(3) Long term Investment:

Leasing requires the long term investment in purchase of an asset, and takes long
time to cover the cost of that asset

7) LEGAL ASPECTS OF LEASING

As there is no separate statue for equipment leasing in India, the provisions

relating to bailment in the Indian Contract Act govern equipment leasing
agreements as well section 148 of the Indian Contract Act defines bailment as:

“The delivery of goods by one person to another, for some purpose, upon a
contract that they shall, when the purpose is accomplished, be returned or

32
otherwise disposed off according to the directions of the person delivering them.
The person delivering the goods is called the ‘bailor’ and the person to whom they
are delivered is called the ‘bailee’.

Since an equipment lease transaction is regarded as a contract of bailment,

the obligations of the lessor and the lessee are similar to those of the bailor and the
bailee (other than those expressly specified in the least contract) as defined by the
provisions of sections 150 and 168 of the Indian Contract Act. Essentially these
provisions have the following implications for the lessor and the lessee.

1. The lessor has the duty to deliver the asset to the lessee, to legally authorise the
lessee to use the asset, and to leave the asset in peaceful possession of the lessee
during the currency of the agreement.
2. The lessor has the obligation to pay the lease rentals as specified in the lease
agreement, to protect the lessor’s title, to take reasonable care of the asset, and
to return the leased asset on the expiry of the lease period.

8) CONTENTS OF A 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:

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

2. Amount, time and place of lease rentals payments.

33
 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. Options of lease renewal for the lessee.
10. Return of equipment on expiry of the lease period.
11.Arbitration procedure in the event of dispute.

9) STRUCTURE OF LEASING INDUSTRY

The present structure of leasing industry in India consists of (1) Private

Sector Leasing and (2) Public Sector Leasing.

The private sector leasing consists of:

i. Pure Leasing Companies.
ii. Hire Purchase and Finance Companies and
iii. Subsidiaries of Manufacturing Group Companies.

34
 The public sector leasing organisation are divided into:
i. Leasing divisions of financial institutions.
ii. Subsidiaries of public sector banks.
iii. Other public sector leasing organizations.

I. Pure Leasing Companies:

These companies operate independently without any link or association with
any other organisation or group of organization. The First Leasing Company of
India Limited. The Twentieth Century Finance Corporation Limited, and the
Grover Leasing Limited, fall under this category.

II. Hire Purchase and Finance Companies:

The companies started prior to 1980 to do hire purchase and finance business
especially for vehicles added leasing to their activities during 1980. Some of them
do leasing as major activity and some others do leasing on a small scale as a tax
planning device. Sundaram Finance Limited and Motor and General Finance
Limited belong to this group.

III. Subsidiaries of Manufacturing Group Companies:

These companies consist of two categories,
(a). Vendor leasing
(b). In house leasing
(a). Vendor leasing: This type of companies are formed to boost and promote the
sale of its parent companies’ products through offering leasing facilities.

35
(b). In House Leasing: In house leasing or capture leasing companies are set up to
meet the fund requirements or to avoid he income tax liabilities of the group
companies.

10) PUBLIC SECTOR LEASING

(i). Financial Institutions: The financial institution such as IFCI, ICICI, IRBI and
NSIC have set up their leasing divisions or subsidiaries to do leasing business. The
shipping credit and Investment Company of India offers leasing facilities in foreign
currencies for ships, deep seas fishing vehicles and related equipment to its clients.

(ii). Subsidiaries of Banks: The commercial banks in India can, under section
19(1) of the Banking Regulation Act, 1949, setup subsidiaries for undertaking
leasing activities. The SBI was the first bank to start a subsidiary for leasing
business in 1986.
Leasing in SBI is transacted through, Strategic Business Unit (SBU) of the bank.
Each SBU is manned by specially trained staff and is equipped with the latest
technological aids to meet the needs of top corporate clients. For the bank as a
whole, leasing is considered as a high growth area. Now the bank is concentrating
only on ‘Big Ticket Leasing’ which is generally of Rs.5 crore and above. So far
SBI disbursed more than Rs.300 crores by way of leasing with the average size of
deal being Rs.25 crores.

(iii). Other Public Sector Organizations: A few public sector manufacturing

companies such as Bharat Electronics Limited, Hindustan Packaging Company
Limited, Electronic Corporation of India Limited have started to sell their
equipment through leasing.

36
 11) ACCOUNTING FOR NON PERFORMING LEASES

TAXATION IN TERMS OF 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 transaction.
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.
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 Dept. issued
in year 1943. The financing charges inherent in hire instalments will be taxed as
the hire-vendor's income and allowed as the hirer's expense.
2. Depreciation in case of Leasing and hire-purchase transactions:
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. The
lessor will not be able to benefit 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

37
to buy the asset with the hirer). Having thus permanently divested himself of his
beneficial rights, the lessor becomes ineligible to claim depreciation.
As it is the beneficial 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 beneficial enjoyment of the asset by the lessee, the lease may be treated
as a hire purchase or a plain financing transaction.

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. 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

38
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

39
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, 100%
renewable energy devices, rollers in flour mills, gas
cylinders, etc.

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. 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.

40
 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. 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.

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

12) SALES TAX PROVISION PERTAINING TO LEASING:

The major sales tax provisions relevant for leasing are as follows:

41
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.

a. Levy of Sales Tax:

Sales Tax is leviable when goods are sold. Thus there must be " Goods and
there must be a sale. "Goods” include all types of movable property. “Sale " means
a transfer of property in goods from one person to another for a consideration. But
Sales Tax is leviable only on a person who is a dealer. A casual transaction by a
non-dealer is not subject to Sales Tax. Thus, if an individual salary earner sells off
his personal car, there is no Sales Tax attracted. To summarize, Sales Tax is
leviable on sale of goods by a dealer.

b. Sales Tax on financial leases:

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.

42
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.

 Sales Tax Rates :

Since under the sharing arrangement all the CST collections are
retained by the state concerned, states have been allowed to reduce the CST
rates and also give exemptions. So while as a general rule CST is 10% or
such higher rate if the State charges a higher rate of tax on the local sale of
the subject goods; or 4% with C Form, this could vary from state to state.
But the State Government cannot increase the Central Sales Tax from 10/4
% in any case. Therefore, NBFC’s will have multiple CST assessments, one
in each state from where goods move.

Service Tax on Lease Transactions

Service Tax on Lease Transactions with effect from 1st July, 2001:
Everyone knew, though without any clue to the reasons that the Finance Ministry
officials are not particularly very sympathetic to leasing and hire purchase, but no
one ever thought that the Finance Minister had this provision up his sleeve. No one
could have even apprehended this hearing him deliver his Budget Speech. But it is
there in the fine print - a 5% service tax on the gross receivables of leasing and hire
purchase companies.

43
 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.

13) INCOME TAX PROVISIONS RELATING TO LEASING:

The principal income-tax provisions relating to leasing are as follows:

1. The lessee can claim lease rentals as tax-deductible expenses.

2. The lease rentals received by the lessor are taxable under the head of ‘Profits and
Gains
. of Business or Profession’
3. The lessor can claim investment allowance (this may be doubtful) and
depreciation on the
Investment made in leased assets.

14) LEASING IN RELATION TO BANK FINANCE

44
 With both leasing and bank financing involving credit decisions and
financial risks, the key differences are that two additional factors apply to leasing
companies:
First, they have knowledge of the asset (and often the industry), and hence
are lending to some degree on an asset basis. This is different from collateral-based
lending, however, in that they are lending based on the ability of the asset to
contribute to cash flow (either to the lessee or in case of forced sale/liquidation).
Banks and other lenders tend to look at the balance sheet value of collateral.
The second is that leasing companies are more sales and service oriented—they are
using their specialized knowledge to “bridge the gap” between suppliers and
purchasers, and the specialized knowledge of leasing companies may also give
them an advantage in disposing of the repossessed leased assets. Suppliers are
generally not specialists in finance or credit decisions, while lessees are not
specialists in finance or equipment acquisition; leasing companies specialize in
finance, credit and equipment acquisition and disposal (equipment dealing). In
effect, both the supplier and the lessee are “outsourcing” certain portions of their
business to a service provider that also happens to have a certain capacity to
borrow and lend money.

15) PROBLEMS OF LEASING

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:

45
 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.

2. Lack of Qualified Personnel:

Leasing requires qualified and experienced people at the helm of its
affairs. Leasing is a specialized business and persons constituting its top
management should have expertise in accounting, finance, legal and decision areas.
In India, the concept of leasing business is of recent one and hence it is difficult to
get right man to deal with leasing business. On account of this, operations of
leasing business are bound to suffer.

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

46
as a pure lease transaction. Accordingly a heavy stamp duty is levied on lease
documents. This adds to the burden of leasing industry.

5. Delayed Payment and Bad Debts:

The problem of delayed payment of rents and bad debts add to the costs
of lease. The lessor does not take into consideration this aspect while fixing the
rentals at the time of lease agreement. These problems would disturb prospects of
leasing business.

16) THE CURRENT PROBLEMS OF INDIAN LEASING

COULD BE LISTED AS FOLLOWS, AGAIN WITHOUT
ANY ORDER OF LISTING:

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.

Generally-bad economic environment:

47
 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; corporate have found themselves in a general cash crunch
resulting into sticky loans.

Poor and premature credit decisions in the past:

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

48
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!

Extraneous problems - frauds, closures and regulation:

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

17) PLAYERYS IN THE INDIAN LEASING INDUSTRY

There is a shakeout in the market at the moment-90% of which is complete.

Today there are close to 800 leasing companies in the market of these, about 50-60
companies operate on a national level. This figure once stood at 4000. This is an
indicator of the enormity of the shakeout in the market. The top ten players in the
market account for about 65% of the market.

49
Company Volume Asset Categories Average Nature Of
Name Of Leased Lease Tenor Leases
Business
(Rs. In
Crores
approx)
TATA 500 Aircrafts 8-10 Years Financial
FINANCE 100% Depreciable Operating
Assets
Infrastructural
Equipment
L&T 30 Equipment 5 Years Financial
FINANCE Computers Operating
KOTAK 20 Commercial 3-4 Years Financial
MAHINDRA Vehicles

ICICI 1500 Capital Equipment 5-10 Years Financial

Ships
Aircrafts
Railway Wagons
FIRST 150 Vehicles 3-5 Years Financial
LEASING Equipment
Computers
IL & FS 500 Plant & Machinery 5-7 Years Financial
Ships Operating
Aircrafts
Power Equipment
ASHOK 50 Vehicles 5-7 Years Financial
LEYLAND Plant & Machinery

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FINANCE
CHOLA- 50 Vehicles 5 Years Financial
MUNDULUM Computers Operating
FINANCE Equipment
SREI 30 Construction 5 Years Financial
INTERNATI Equipment
ONAL 100% Depreciable
Assets

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 18) FACTORS THAT CONTRIBUTED TO GROWTH OF
INDIAN LEASING:
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.

• Buoyant growth in capital expenditure by companies :

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:

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 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.

• Optimistic capital markets:

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.

• Access to public deposits:

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.

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 19) LEASING IN EMERGING ECONOMIES:

Emerging economies face several challenges, including the need for

investment. This is compounded by an under-capitalized banking system that is
only able to offer its potential clients a limited range of products. In turn, small and
medium-size companies possess insufficient collateral or credit history to access
more traditional bank finance. This results in a shortage of credit available to
domestic entrepreneurs. Developing the leasing sector as a means of delivering
finance increases the range of financial products in the marketplace and provides a
route for accessing finance to businesses that would otherwise not have it, thus
promoting domestic production, economic growth, and job creation. In addition,
many developed countries suffer from underdeveloped or imperfect legal
institutions. Although in principle secured lending and leasing should be roughly
equivalent in terms of risk, in many jurisdictions experience has shown that legal
ownership is recognized by all participants, especially courts, more readily and
consistently than secured lending. This can reduce the risk to lenders (lessors)
considerably. The value of this advantage of leasing should not be underestimated,
particularly in more challenging environments.

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Figure 1-1 shows the role leasing plays in emerging economies and in developed
economies and the room for growth in the use of leasing in emerging economies.
The chart shows that leasing can provide a valuable additional source of finance
within these markets. The effect of leasing can be further accelerated and
strengthened where the in country conditions allow for investment by IFC and
other international financial institutions, with these institutions recognizing the
positive effects of leasing and introducing medium-term finance into markets
where no alternative currently exists.
In many markets, discussion of leasing often focuses on “large-ticket” leasing,
cross border structures, or tax implications. While these are also important, any
discussion of leasing should be kept as broad as possible and consider the effects
for all businesses, including small and medium-size enterprises.

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 20) LEASING COMPANIES- CASE STUDY

a) CSI LEASING COMPANY

CSI Leasing Customer:

• Leading supplier to the automotive industry

• 2,500 employees in 50 locations worldwide

The Problems

By using several technology lessors, this IT department found itself in asset

management chaos. By choosing to lease its PC’s and laptops directly from the
captive finance arm of the manufacturer, this $600 million company believed it had
found the most convenient solution for its IT leasing needs. It quickly learned,
however, that its organization was not quite big enough to garner much attention
from the captive leasing company. Equipment orders were delayed. Shipment
locations were consistently incorrect. Invoices were confusing and often late. Since
no single dedicated account manager was assigned to the business, it took multiple
calls to multiple departments at the captive finance company to correct ongoing
errors.

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

56
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.

How CSI did it:

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.

b) HARDWARE LEASING COMPANY

The Leveraged Lease

Spacemakers of Kuwait is the largest independent owner-operator of large-

scale automated self-storage complexes in the greater Kuwait City area. The
company opened its first self-storage complex in Kuwait in 1994 and now has
facilities throughout downtown Kuwait City and nearby residential areas. The
business is based on a franchise management company based in Cincinnati, USA.

Hamid Lahcen, Chairman and CEO of Spacemakers, was considering

57
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.

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 21) CONCLUSION: FUTURE OF LEASING

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; corporate 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!

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 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

60
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.

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 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.

22) ANNEXURES

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.

LEASE RATE (Rental Payment)

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

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 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

In this type of lease, the lessor provides an equity portion (usually 20 to 40

percent) of the equipment cost and lenders provide the balance on a
nonrecourse debt basis. The lessor receives the tax benefits of ownership.

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

The value of an asset at the conclusion of a lease.

SALE-LEASEBACK

An arrangement whereby equipment is purchased by a lessor from the

company owning and using it. The lessor then becomes the owner and leases
it back to the original owner, who continues to use the equipment.

SALES-TYPE LEASE

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 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

A working relationship between a financing source and a vendor to provide

financing to stimulate the vendor's sales. The financing source offers leases
or conditional sales contracts to the vendor's customers. The vendor leasing
firm substitutes as the captive finance company of a manufacturer or
distributor through the extension of leasing to customers, provisions of credit
checking, and performance of collections and operational administration.
Also known as lease asset servicing or vendor program.

. 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

64
 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.)

CERTIFICATE OF ACCEPTANCE (Delivery and Acceptance)

A document whereby the lessee acknowledges that the equipment to be

leased has been delivered, is acceptable, and has been manufactured or
constructed according to specifications

DIRECT FINANCING LEASE (Direct Lease)

A non-leveraged lease by a lessor (not a manufacturer or dealer) in which the

lease meets any of the definitional criteria of a capital lease, plus certain
additional criteria.

ECONOMIC LIFE (Useful Life)

The period of time during which an asset will have economic value
and be usable.

EFFECTIVE LEASE RATE

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.

FIRST AMENDMENT LEASE

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 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

Typically, a finance lease is a full-payout, noncancellable agreement, in

which the lessee is responsible for maintenance, taxes, and insurance.

FULL PAYOUT 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.

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