Theoretical and Regulatory Framework of Leasing

- MY KhanPg 2.0 to 2.13

Important Points

Leasing

• Regulatory Framework• Concept• Classification

Regulation

• There is no exclusive law /legislation/Act/Regulation/direction to govern equipment Leasing.

• Framework provided by:– Allied legislations– Lease Agreement

Allied Legislations

• Contract Act• Vehicles Act• Stamp Act• RBI NBFCs directions under the RBI Act

Lease Agreements

• Provide for a number of Obligations on the part of the Lessee

• Which do not form part of his implied obligations under the legislative framework.

Meaning

• Contractual arrangement/transaction• Party owning an equipment – Lessor• Provides the asset• For an agreed period of time – Tenure• For consideration – periodic payments

At end of lease period

• Asset /equipment reverts back to the lessor• Unless there is a provision for the renewal of

the contract

For the Lessee

• It is a device of financing the cost of an asset• Has possession and use of the asset on

payment of specified rentals over a predetermined period of Time

For the Lessor

• It is a Form of Investment• A contract of lending Money

Essential Elements

• Parties to the Contract• Asset• Ownership separated from User• Term of Lease• Lease Rentals• Modes of Terminating Lease

Parties to the Contract

• Lessor• Lessee• Lease Broker acts as an intermediary in

arranging the Lease deal• Lease Financier refinances the lessor

Asset

• Is the subject matter of the Contract• May be an automobile, plant and machinery,

equipment, Land and Building, factory, a running business, aircraft and so on.

Ownership separated from the User

• During Lease Tenure– Ownership with Lessor– Use to the Lessee

• On expiry of Lease tenure, asset reverts to the lessor

Term of Lease

• Period for which agreement for lease remains in operation.

Lease Rentals

• Consideration which the lessee pays to the Lessor for the Lease Transaction.

• Repairs and service charges borne by the Lessor.

• Compensate the lessor for investment (depreciation), interest, repairs, servicing charges etc.

Modes of Terminating the Lease

• Possibilities are:• Lease is renewed on a perpetual basis or for a

definite period.• Asset reverts to the Lessor• Asset reverts to the Lessor and the Lessor sells

it to a third party.• The lessor sells the asset to the Lessee

Perpetual Lease

• A lease in perpetuity is one that is renewable forever at the lessee's option

Classification

• Finance and Operating Lease• Sales and Leaseback and Direct Lease• Single Investor Lease and Leveraged Lease• Domestic Lease and International Lease

Finance Lease and Operating Lease

Finance Lease

• Lessor transfers to the Lessee, substantially all the risks and rewards incidental to the ownership of the asset whether or not the title is eventually transferred.

• Such Leases are also called full payout leases.• Types of assets included in such lease are

ships, aircrafts, railway wagons, lands, buildings, heavy machinery etc.

Lease Agreement

Is there transferof ownership?

Yes

Is there a bargainpurchase option?

Yes No

Is lease term equalto or greater than75% of economic

life ?

Yes

No

CapitalLease

OperatingLease

Is present valueof payments

equal to or morethan 90% FMV?

Yes

No

As per IAS - 17As per IAS - 17

A bargain purchase option • allows the lessee to buy the leased asset • at a price significantly lower than the asset’s

fair value when the option is exercisableThe difference between the option price, and the fair value (when the option is exercisable) as determined at the inception of the lease must render the option reasonably assured.

The Bargain Purchase The Bargain Purchase OptionOption

IAS – 17 Operating Lease

• According to IAS – 17, an operating lease is one that is not a Finance Lease.

• The Lessor does not transfer all the risks and rewards incidental to the ownership of the asset.

• Cost of the asset is not fully amortized during the primary lease period.

IAS – 17 Operating Lease

• The Lessor provides repairs and Technical advice

• For this reason, operating lease is also called service lease.

• The lease rentals include a cost for the services provided.

• Generally for Computers, office equipments, automobiles, , trucks and some other equipment like phones etc.

IAS – 17 Operating Lease

• Generally for a period significantly shorter than the expected life of the asset.

• Lease rentals are not sufficient to totally amortize the cost of the asset.

• The lessor does not depend upon a single lessee for recovery of investment.

• He has an interest in the residual value and can lease it to a different lessee upon expiry of the term.

IAS – 17 Operating Lease

• Operating lease normally include maintenance clause requiring the lessor to maintain the leased asset and provide services such as insurance, support staff, fuel and so on.

AS -19

• Classified as Finance Lease if it transfers substantially all the risks and rewards incidental to ownership.

• Classified as Operating lease if it does not substantially transfer all the risks and rewards incidental to ownership.

Sale and Leaseback and Direct Lease

Sale and Leaseback

• An indirect form of Leasing.• The owner of the equipment sells it to the

leasing company ( lessor) which eases it back to the owner (lessee).

Example

• Sale and Leaseback of safe deposits vaults by Banks.

• Banks sell them to a leasing company at a price substantially higher than book value.

• The leasing company in turn offers these lockers to the bank on lease.

• The bank in turn sub leases the locker to its customers.

Direct Lease

• The lessee and the owner of the equipment are two different entities.

• A Direct lease can be of two types – – Bipartite and – Tripartite

Bipartite Lease

• There are two parties in the lease transaction, namely,– Equipment supplier cum lessor and– Lessee

• Typically structured as an operating lease with built in facilities like upgradation of the equipment (Upgrade Lease).

• The Lessor maintains the equipment and if necessary, replaces it with similar equipment(Swap Lease).

Tripartite Lease

• Three Different parties to the Lease agreement:

– Equipment supplier– Lessor– Lessee

Sales aid lease

• Equipment supplier arranges for lease finance • Like car dealer, leasing (financing) company

and buyer.• Usually with recourse to the supplier in the

event of default by the lessee either in the form of an offer to buy back the equipment from the lessor or guarantee on behalf of lessor.

Single Investor Lease and Leveraged Lease

Single Investor Lease

• Only two parties to the transaction i.e.• Lessor and Lessee

Leveraged Lease

• Three parties to the transaction– Lender– Lessor– Lessee

• Lender obtains an assignment of the lease and the rentals to be paid by the lessee and a first mortgaged asset on the leased asset.

Leveraged Lease

• The transaction is routed through a trustee who looks after the interest of the lender and the lessor.

• On receipt of the rentals from the lessee, the trustee remits the debt service component of the rental to the loan participant and the balance to the lessor.

• The lessor can claim tax benefit in the form of depreciation and debt service charges.

Domestic Lease and International Lease

Domestic Lease

• If all parties to the agreement i.e equipment supplier, lessor and lessee are domiciled in the same country.

International Lease

• If the parties to the lease transaction are domiciled in different countries.

• Two types

– Import Lease– Cross Border Lease

Import Lease

• The Lessor and Lessee are domiciled in the same country but the equipment supplier is located in a different country.

• The lessor imports the asset and leases it to the lessee.

Cross Border Lease

• Where the lessor and Lessee are domiciled in different countries.

• The domicile of the supplier is immaterial.

Profile/Structure of Leasing in India

• Independent Leasing Companies• Other Finance Companies• Manufacturer Lessors• Financial Institutions• In house Lessors• Commercial Banks

Independent Leasing Companies

• A major part of their income is derived from Leasing.

• Some of them have collaboration with overseas partners.

• They offer their services through direct advertisement, personal contacts, lease Brokers including Foreign Banks and Merchant Banks.

Other Finance Companies

• Leasing is not their regular Business.• They normally opt for 100 per cent

depreciation items once in a while to defer taxes.

Manufacturer Lessors

• A number of Manufacturing companies have set up independent leasing outfits

• Or separate Divisions• That carry on leasing Business to promote the

sale of their own products.

Financial Institutions

• The Development Finance Institutions both All India and State level provide leasing facility.

In House Lessors

• Some big businesses have formed captive leasing companies for providing lease finance to group companies.

Commercial Banks

• With effect from1994-95, banks have been permitted to directly carry on leasing and Hire Purchase Business.

Salient features

• By and large the structured lease falls in the category of Finance Lease.

• Operating Lease is not very popular primarily because of the non existence of resale market for most of the used equipments.

• The lease transactions do not provide for transfer of ownership to the lessee as such transactions are classified as hire purchase from the tax angle.

Salient features

• The Lease rentals are structured so as to recover the entire investment cost during the primary period.

• They are quite nominal during the secondary period.

• The lease rentals are payable generally in equated monthly instalments at the beginning of every month.

Salient features

• Sale and Leaseback transactions are Rare.• Most of the transactions are Direct Lease.• Most assesses view leasing as a form of

standby Finance for meeting unplanned expenditure.

• Therefore by and large equipment leases are for capital investment not exceeding Rs 1 Crore.

Salient features

• Equipment leasing is popular.• Project leasing for Infrastructure is done on a

very limited scale exclusively by ILFS.• Cross Border Lease transactions are also not

very popular.

Advantages of Leasing

To the Lessee

• No immediate down payment• Can commence Business with Low initial

Investment.• No conditions attached like representation on

the Board etc.• The lease rentals can be structured to

accommodate the cash flow position of the Lessee.

To the Lessee

• The lease period is so chosen as to suit the lessee’s capacity to pay rentals.

• Simple to negotiate • Free from cumbersome procedures • Faster and Simple Documentation.• Institutional Finance and Term loans require

compliance of covenants, formalities and bulk documentation causing procedural delays.

To the Lessee

• By structuring the rentals, tax advantage can be derived from it.

• Rentals may be increased or decreased to decrease or increase tax liability.

• The Lessor does not have the risk of obsolescence.

To the Lessor

• Full Security – Ownership vests with lessor.• Can take possession if the lessee defaults• Tax Benefit– Depreciation – Assets with High depreciation

rates.– Suitable structure rentals

• High Rate of return as compared to borrowing.

To the Lessor

• For Leveraged Lease – High rate of return on Equity.

Limitations of Leasing

• A lease arrangement may impose certain restrictions on use of the equipment or require compulsory insurance and so on.

• If the lessee opts for premature termination in a financial lease, it may entail higher payout obligations.

• Lessee is deprived of the residual value of the asset.

Limitations of Leasing

• In case of default, lessor may terminate the lease and take over possession of the leased asset.

• Lessee may be required to pay damages.• Since the leased assets in case of an operating

lease do not appear as assets of the lessee, there may be an understatement of the lessee’s assets.

Limitations of Leasing

• A lease financing transaction may be charged to sales tax twice – once when the lessor purchases the equipment and again when it is leased to the lessee.

Lease Documentation and Agreement

• Lease Transactions involve a number of formalities and various documents.

• The documentation is significant because:• It provides proof of indebtedness• Brings to sharp focus, the terms and conditions

agreed between the borrower and Lender.• Enables the leasing company to take appropriate

legal action in case of default.

Essential Reqirements

• The person executing the document should have the Legal capacity to do so.

• The documents should be in prescribed format.

• Should be stamped and witnessed.• Where necessary, the stamped documents

should be registered with appropriate authorities.

Lease Approval Process

• Letter of offer• From the Lessor to the Lessee, which is in the

nature of commitment spelling out the main terms of the Lease facility.

• The lease offer is normally kept open for a specified period of time.

• The Lessee is asked to sign , date and return a copy of the offer letter within the stipulated time

• And also to pass a resolution at a Board Meeting accepting the offer and approving the financial arrangement.

• Board Resolution is not a legal requirement, but commercial prudence neccesitates it.

Commercial Documents Required

• Purchase Order• Invoice• Delivery Note• Insurance Policies• Import License• Etc• All these documents should be obtained by the

Lessor from the Lessee.• They are called ‘Attendant Lease Documents’.

Insurance

• The equipment/asset leased out should be properly insured irrespective of the fact who pays the premium.

• The insurance Policy should be in the name of Lessor account Lessee.

• All Insurance Policies should be in the custody of the Lessor.

Master and Supplemental Lease Agreement

• Usually a master lease agreement is signed which stipulates all the conditions that govern the lease.

• The qualitative terms are in the main part of the document while the equipment details, credit limits rental profile and all other details are provided in the attached schedules.

Supplemental Lease Agreement

• Additional Lease facilities, as and when finalized, are documented under supplemental lease agreements.

Clauses in Lease Agreement

• There is no standardized lease agreement. The contents differ from case to case.

• A typical lease agreement has the following clauses.

Nature of the Lease

Operating/Financial/Leveraged

Description

Description of Equipment, its actual condition, size, components, estimated useful life and so on

Delivery and Redelivery

• When and How the equipment would be delivered to the Lessee and redelivered to the Lessor on expiry of the lease contract.

Period

• Term• Renewal

Lease Rentals

• Rates• Late Payment charges

Use

• Enjoins upon the Lessee the responsibility for proper and lawful usage.

Title

• Identification of ownership of the equipment.

Repairs and Maintenance

• This clause specifies the responsibility for repairs and maintenance, insurance and so on.

Alteration

• It specifies that no alteration to the leased equipment may be made without the written consent of the Lessor.

Peaceful Possession

• This clause guarantees the lessee peaceful possession of the leased equipment clear of any charges, liens or any other encumbrances.

Charges

• Which party would bear the delivery, redelivery , customs, transport, income tax, sales tax etc.

Indemnity Clause

• Indemnifies the Lessor from any consequential losses arising on account of non performance of the leased equipment.

Inspection

• It gives the Lessor or his representative a right to enter the Lessee’s premisesfor the purpose of confirming the existence, condition and proper maintenance of the equipment.

Prohibition of Sub Leasing

• This clause prohibits the lessee from the subleasing or selling the equipment to third parties.

Events of Defaults and Remedies

• This clause specifies the consequences of defaults by the Lessee and recourse available to the Lessor. This clause may also specify other remedies if any.

Applicable Law

• This clause specifies the country whose laws will prevail in case of a dispute. It may also provide for arbitration.

Tripartite Lease Agreement

• A tripartite lease involves three parties namely the manufacturer, the lessor(financier) and the Lessee.

• A common agreement may be made between the parties, specifying their respective obligations and so on.

Guarantee Agreement

• The Guarantor guarantees the obligations of the lessee in the event of default by the Lessee, in which event the guarantor assumes responsibility as a principal debtor.

Promissory Note

• As a matter of abundant precaution, the lessee is also required to execute an unconditional Promissory Note in favof the Lessor or his order, for the full amount of Lease Rentals payable under the agreement.

• The Promissory Note is counter guaranteed by the guarantor.

Receipt of Goods

• The equipment is delivered by the Lessor or the Manufacturer / supplier in a tripartite Lease, to the Lessee. The lessee thus executes a receipt for the goods.

Power of Attorney

• The lessee executes an irrevocable power of attorney constituting the lessor

• to be the lawful attorney for and on behalf of the lessee

• to do certain acts such as, • to take delivery, to transfer, to sell or dispose off the

equipment, to engage broker for effecting such sale and to receive any consideration.

Collateral Security / Hypothecation Agreement

• Sometimes the Lessor may require the Lessee to provide a collateral security by way of pledge or Hypothecation of other assets.

• A collateral is normally required when the financial position of the lessee is considered to be weak and the risk associated with the leased asset is high.

Hypothecation

• Generally, a hypothecation is a contract which pledges or creates a lien on collateral to secure a debt, where possession of the collateral is not given to the creditor.

• In law, a lien is a form of security interest granted over an item of property to secure the payment of a debt or performance of some other obligation.

Questions for Revision

• What is a lease ? What are the essential elements of a lease ?

• Describe the regulatory framework of leasing ?

• What is a Finance Lease ? How is it different from an operating lease ?

Questions for Revision

• What are the advantages of leasing to the lessee and to the lessor ?

• What is a contract ? What are the essential elements of a contract ?

• Write a short note on Lease Documentation and agreement ?

• Critically analyze the statement ‘ Lease is a form of asset funding’. Describe how you would evaluate a lease option vis a vis a buy option?

The End