Equipment Leasing

Equipment Leasing Introduction

Alternatives for financing Equipment • Borrowing • Borrow from a financial intermediary, Buy Equipment from a vendor

• Leasing • Transfer of right of use by the owner (Lessor) to the User (Lessee) for an agreed period of time for rental

• Hire Purchase • Equipment given on hire with an option to buy

• Installment Purchase • Immediate transfer of ownership, payment in installments

Leasing • The owner (Lessor) of an equipment transfers the right to use the equipment to the user (Lessee) for an agreed period of time in return of rental – Lessor – Lessee – Lease Term • Primary – Non-cancellable • Secondary - Renewal period

– Lease Rental – No Transfer of ownership

Types of Leases • Finance Lease – Transfer of ownership at the end of term – Lessee has an option to purchase the asset at a priceFair Market Value at the inception

• `Hell or high water’ • Full payout lease • Maintenance & Insurance

• Operating Lease • Lease other than finance lease is Operating Lease – Wet Lease – lessor provides maintenance, insurance, operating knowhow – Dry Lease – lessee bears the insurance and maintenance

• Right to terminate at a short notice without significant penalty

Types of Leases • Sale and Lease Back

• Direct Lease

– To unlock the investment – Operating or Finance

• Bipartite – Supplier cum Lessor – Lessee – Suitable for Operating Lease • Upgrade Lease • Replacement (swap) Lease

• Tripartite – Supplier – Lessor – Lessee

• Sale-aid Leasing

Types of Leases • Single Investor vs Leveraged Lease (Uses a D/E Mix without recourse) Lessor Trustee Loan Participant (With recourse to the lessee)

• Big Ticket Leasing

• Domestic Vs International Lease • Double Dip Transaction

Lessee

Advantages of Leasing • Flexibility • • • •

• • • •

Equated Stepped – % Increase every year Ballooned – Small rental followed by large payment Deferred – Deferement period

Tax benefits Less Paper Work Convenience Margin Money

Rental Structure • • • • •

Cost of Equipment = Rs.50 lakhs Required rate of return = 16% Lease Period = 5 years Residual Value = Nil Equated LR x PVIFA(16%,5) = Rs.50 lakhs LR = Rs.50 lakhs/PVIFA(16%,5) = Rs.50 lakhs/3.274 = Rs.15.272 L

Rental Structure • Stepped - 10% increase every year Year 1 2 3 4 5

LR

PVIF(16%,y) LR x PVIF (16%,y) L .862 .862 L Lx 1.1 .743 .8173 L L x (1.1)^2 .641 .7756 L L x (1.1)^3 .552 .7347L L x (1.1)^4 .476 .6969 L 3.8865 L 3.8865 L = Rs.50 lakhs L = Rs.12.865 12.865, 14.152, 15.567, 17.123, 18.836

Rental Structure • Ballooned - 5 lakhs for first four years 5 x PVIFA(16%,4) + L x PVIF (16%,5) = Rs.50 lakhs 5 x 2.798 + L x .476 = Rs 50 lakhs 11.192 + .476 L = Rs. 50 lakhs L = (50-11.192)/.476 = Rs.81.53 Lakhs

Rental Structure • Deferred for 2 years L x PVIF (16%,3) + L x PVIF (16%,4) + L x PVIF (16%,5) = Rs.50 Lakhs L x (0.641) + L (.552) + L (.476) = Rs.50 lakhs L (1.669) = Rs.50 lakhs L = 50/1.669 = Rs.29.958

Rental Structure • Advance Installments – Equated Rental with one advance installment ‘ LR + LR x PVIFA(16%,4) = Rs.50 lakhs LR+LR x 2.798 = Rs.50 Lakhs 3.798 LR = Rs.50 Lakhs LR = Rs.50 lakhs/3.798 = Rs.50 lakhs/3.798 = Rs.13.165 L

Rental Structure-Comparison Year Equated Stepped Ballooned Deferred Advance Loan 0 1

15.272

12.865

5.00

Nil

13.165 13.165 18.0

2

15.272

14.152

5.00

Nil

13.165 16.4

15.272 14.8 4 15.272 13.2 5 15.272

15.567

5.00

29.958

13.165

17.123

5.00

29.958

13.165

18.836

81.53

29.958

Nil

3

11.6

Legal Aspects of Leasing • No exclusive legislation to cover equipment leasing • Governed by Indian Contract Act, 1872 • Bailment – delivery of goods by one person to another for some purpose upon a contract that when the purpose is accomplished they should be retuned

Bailment • Obligation of Bailor • To put them in possession of the bailee • Disclose any fault in the goods which he is aware of • To make good any loss to bailee due to a defect in the title

• Obligation of Bailee • • • •

Take reasonable care of goods Not to act in a manner inconsistent with the agreement Return the goods Not to mix with own goods

Process of Lease Documentation • Proposal by Lessee • Lessor gives a Letter of Offer • Acceptance of LOO by the Lessee –Board Resolution • Offer + Acceptance = Lease Agreement • Lease Line – Master Lease Agreement

Contents of a Lease Agreement • • • • • • •

Description – Equipment, Location, Identification Period - Primary/Renewal Rental- Initial deposit, rental, penal Exemption Manufacturer’s warranty – tripartite Ownership Equipment Delivery

Contents of a Lease Agreement • • • • • •

Repair and alteration Insurance Sub-Lease Surrender Default Arbitration

Tax Aspects of Leasing • Income Tax implications for the Lessor • Rental Income – If Leasing being carried out as a Business • Income for Business & Profession

– If given on lease temporarily • Income from Other sources

• Depreciation

Tax aspect of leasing The tax aspect of leasing can be divided into two parts – the income tax aspect and the sales tax aspects. The income tax aspect of leasing are primarily concerned with d) lessee’s claim for lease rentals and the operating costs of the leased assets being treated as tax deductible expenses. e) tax liability on lease rental income in the hands of the lessor, and tax shield on depreciation. The rental income derived by the lessor is included under the head `profit s & gains of business’ for the purpose of assessing the income tax liability. From the lessee’s angle, the rental expenses can be treated as tax deductible . The costs incurred in insuring & maintaining the leased asset are also tax deductible.

By virtue of circular issued by Central Board of Direct Taxes in 1943, the leased agreement must not provide for a transfer of ownership of the leased asset or a bargained purchased option to lessee. Inclusion of these provisions will result in the leased transaction being treated as a hire purchase transaction. Leasing can be used as a tax planning device by • Exploiting the flexibility in structuring the lease rentals • Transferring the investment related tax shields from a firm which has a low appetite for such tax shields to a lessor who can absorb them. The firm transferring the tax shield can be benefit through a reduction in the lease rentals.

SALES TAX ASPECTS Sales tax affects a lease transaction at the following stages: • When the asset is purchased by lessor for the purpose of leasing • When the right to use is transferred to the lessee for a valuable consideration • When the asset is sold by lessor at the end of the lease period. The lessor is at disadvantage with regards to interstate purchase of equipment because the concessional rate of sales tax which applies to such transactions is not made available to an equipment supplier supplier supplying equipments to lessor.

The Constitution (46th amendment) Act, 1981 provides for sales tax on the “transfer of the right to use any goods for any purpose for cash, deferred payment or other valuable considerations”. After this enactment several states have amended their sales tax laws to provide for sales tax on lease rentals. The validity of the provisions to levy sales tax on lease transactions and the other related issues have been challenged by the leasing companies and stay orders have been obtained from different state high courts . Consequently, the lessor’s liability to pay sales tax on rental income remains as a contingent liability.

Income Tax implications for the Lessor • Depreciation • Allowed as an expense – The asset is owned by the asessee – The asset is used for the purpose of business

• Finance Lease • AS -19 Lessee to capitalise the assets in its books of accounts • Circular 2/2001 – Depreciation under Income Tax would continue to be available to the Lessor

Tax Implications • Depreciation on Actual Cost of the asset • Cost of acquisition

• On a Block of Assets • At the rates given in the Income Tax Act • Normal rate on P&M- 25% • Higher depreciation e.g. air pollution control equipments

Income Tax implications for the Lessee • Tax Deductible Expenses • Lease Rental • Insurance and maintenance

Sales Tax Aspects • Central Sales Tax Act – Interstate Sales of goods

• Sales Tax Acts enacted by the States – Sales of goods within a state

• Issues involved – Sales tax on Interstate purchase of Equipment – Sales tax on Lease Rental

Tax Implications • • • • •

Lease does not create tax benefits Depreciation Rate Lease Term Tax rate Upfront payment

Sales Tax on Equipment • Sales tax to be charged by the Vendor is 10% or the rate applicable in the State whichever is higher • U/S 8 of CST – if goods are sold by a registered dealer to another registered dealer to be used by the later for resale or in manufacturing, concessional rate of 4%. • If bought by the Lessor – Sales Tax to be charged by vendor is 10% of state sales tax whichever is higher • If bought directly by the Lessee – Concessional rate of Sales Tax @ 4%

Sales Tax on Lease Rental • 46th Amendment to the Constitution – authorised the states to levy a tax on the transfer of the right to use • Sales Tax a payable on Annual Taxable Turnover of the Lessor - 2% to 5%

Sales Tax Impact • Cost of Equipment = Rs.100 lakhs • If Bought Directly – CST = 4%

• If Leased – CST = 10% – Sales Tax on Lease Rental = 4% – Lease rental = Rs.25 PTPM

Sales Tax Impact • If Bought directly • Equipment Cost = 100 L • Sales Tax = 4L • Total Outflow = 104 L

• If Leased • • • • • •

Cost to the Lessor = 100 L Sales Tax = 10 L Total Cost = 110 L Monthly Lease Rent = 30/1000 * 110 L = Rs.2.75 L Add : Sales Tax on Lease Rental (4%) = 0.11 L Total Monthly Lease Rental Rs. 2.86 L

THE END