Lease Financing

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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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 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.

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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.

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 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.

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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.

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:

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.

Ownership is no Technically, in order to be a lessor, one does not

pre-condition for have to own the asset: one has to have the right to use
leasing:

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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".
2. While lease of movable properties can
Leasing of immovable
properties may have be affected by mere delivery,
complications: 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, 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.
3. 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

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must be capable of re-delivery: it must be durable (at least during the lease
period), identifiable and severable.

Leased asset is a The existence of the leased asset is an essential

necessary pre- element of a lease transaction - the asset must exist at
condition: 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 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.

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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.

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

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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.

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

Buyout option may
characterize the lease such buyout option that demarcates between lease and
as hire-purchase:

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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 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

Margins in leases
are taken as initial more common in case of hire-purchase transactions)
rental: 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.

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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 - 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.

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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:
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)

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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

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 primary
and secondary the extended period is called the secondary lease period.
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.

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Full payout The lessor too has no significant risk/reward other than that
lease: 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

The IRR: 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:

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.

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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 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 Hire-purchase is decisively a financial lease transaction, but

and financial in some cases, it is necessary to provide the cancellation
leases
option in hire-purchase transactions by statute: that is, the
compared
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

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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 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 of

Meaning commercial arrangement, whereby installment credit under

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

No option is provided to the lessee Option is provided to the

Option To User (user) to purchase the goods. hirer(user).

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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 installments

Components elements (1) finance charge and (2) comprise of three
capital recovery. elements (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 :

• 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

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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.

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.

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 Lease Financing

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.
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".

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OPERATING 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.

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

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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;
• 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

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Differences between Finance and Operating Leases
Financial Lease
• Risks and rewards of
ownership 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 acquire the asset or at least
use the asset for most of its
economic life. As such, the
lessee will aim to cover all or
most of the full cost of the asset
during the lease term and
therefore is likely to assume the
title for the asset at the end of
the lease term. The lessee may
gain the title for the asset
earlier, but not before the full
cost of the asset has been paid
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Lease Financing
Operating Lease
• Economic ownership with all
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
asset. Further, the duration of an
operating lease is usually much
shorter than the useful life of the
asset.
• It is not the lessee’s intention to
acquire the asset, and lease
payments
are determined accordingly. In
addition, an asset under an
operating lease may
subsequently be rented out.
• The present value of all lease
payments is significantly less
 Lease Financing

off. than the full asset price.

• The lessor retains legal
ownership for the duration of
the lease term, though the
lessee may or may not 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 asset. The lessee will also
generally retain some rights
with respect to the supplier, as
if it had purchase asset directly.

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 Lease Financing

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.

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

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 Lease Financing

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, 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

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 Lease Financing

lease is the sales-aid lease where the equipment supplier catalyzes the lease
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
participant and the balance to the lessor. A schematic representation of transaction is
represented in the figure:

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 Lease Financing

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

b. Knowledge of the tax and the regularity framework governing these

transactions in the countries concerned.

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 Lease Financing

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.

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 Lease Financing

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:

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.

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 Lease Financing

(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:

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.

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 Lease Financing

(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’

(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

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 Lease Financing

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
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.

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:

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 Lease Financing

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

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

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.

The public sector leasing organisation are divided into:

i. Leasing divisions of financial institutions.
ii. Subsidiaries of public sector banks.

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 Lease Financing

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.

(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.

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 Lease Financing

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.

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 Lease Financing

ACCOUNTING TREATMENT OF LEASE

Presently the accounting treatment of lease transactions in India is as follows:

1. The leased asset is shown on the balance sheet of the lessor.

2. Depreciation and other tax shields associated with the leased asset are claimed
by the lessor.
3. The entire lease rental is treated as income in the books of the lessor and as
expense in the books of the lessee.

In nutshell, from the point of view of the lessee, a lease transaction represents an
off-the balance-sheet transaction and this appears to be an important advantage
associated with leasing. It may be noted that in countries like the United States
and the United Kingdom, where leasing is very popular, leases which meet certain
criteria are capitalised in the books of the lessee. This essentially implies that:

a. The leased asset and the corresponding liability (reckoned at the present
value of the stream of rental payments) are shown on the balance sheet of the
lessee.
b. Depreciation charges are claimed by the lessee, and
c. The lease rental is split into two parts, the interest component (which is
charged to the profit and loss statement) and the principal repayment
component.

Background and international accounting changes on lease

accounting:

There were some 500 odd leasing companies in India about 5 years ago. Now, not
more than 50 serious operators are left, who are searching for ways to survive in
the coming 5 years. In my view, it is high time for those 50 players to join hands

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together, and cry out loud: "We will not write a single penny of lease transactions
in India, unless the Government speaks out its mind. Enough is enough. A
business can survive taxes, and duties, and sanctions, but no business can survive
uncertainty. So, unless the Government clarifies what does it have in mind
regarding income-tax, sales-tax, accounting and other issues that have been
drifting like the nebula for last 20 years, we cannot, and shall not write a single
lease."

Leasing in India would go down in history as a clear victim of legislative inaction.

It is true that governments have their own way: they do not act; they react. But it
is perplexing as to how could the government sleep over the fate of multi-billion
dollar industry for so many years. Look at the following hard facts:

• Controversy erupted regarding leasing companies' claim for depreciation

in 1995 as some companies were found to have made exaggerated claims
or claims that were not genuine. The Association of Leasing and Financial
Services Cos. (ALFSC) has been pleading for last 5 years that the CBDT
frame rules that would help the assessing officers distinguish between
genuine leases and garbed financial transactions. ALFSC has also
suggested model rules drawing from several other countries. Obviously
enough, there was nothing that the CBDT would have lost by enacting
these rules, and nothing stood to gain by not enacting them. However,
nothing has been done for last 5 years. Result: as there is no rule from the
CBDT, every assessing officer, and every appellate commissioner, has
framed his or her own rule. Most of these officers have looked at lease
transactions with a kind of inherent vengeance: therefore, the end result is
common but the reasoning is different. That is, depreciation is disallowed,
for reasons that differ from case to case.
• Sales-tax was imposed on lease transactions some 16 years ago. No one
was clear as to how would the jurisdiction and incidence of tax be
determined. We allowed the controversy to linger for all these years
waiting for the Supreme Court to give a ruling only in year 2000. In the

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meantime, some Rs 20000 crores worth lease transactions would have

been signed in the country, and obviously enough, the Supreme Court
ruling that operates 16 years back in history cannot be favourable to them
all. At the same time, it cannot be favourable to the States as well. Any
one who understands the ruling would agree that the States would not be
happy with the ruling and would force the Central Govt to alter the law,
possibly with retrospective effect. Again - we let things loose and
unsettled for years, and wait for a crisis-like situation, and then correct our
mistakes in history.
• Accounting standards for lease transactions have been in the limelight for
quite a while. The ICAI has expressed its resolve to adopt in India
something akin to the pre-1999 version of IAS-17. This is exactly what the
Institute proposed sometime in year 1983-4. For last 16 years, the framing
of accounting standards has been lurching, hit by a Court-stay for some
time, uncertainty for a larger time. In the meantime, IAS 17 has already
been amended. There is a new thinking internationally about lease
accounting, and the pre-1999 version of IAS-17 that the Institute is
seeking to adopt is in the process of being discarded world-over. In other
words, we would be adopting a standard, just when the rest of the world is
about to reject it.

Every industry needs a safe harbour: more so for lease transactions which
envisage long term investments. It is the duty of the State to define what is it
policy towards a business.

In the current controversy relating to accounting standards for lease transactions,

some interesting issues have cropped up.

Will change of accounting standard deny tax depreciation to leases?

This is absolute rubbish. Accounting standards are meant for preparation of books
for account, not for guidance of tax officers. As things exist, accounting

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 Lease Financing

depreciation and tax depreciation are miles apart. There are plenty of countries all
over the world where leases may be capitalised for accounting purposes by
lessees, and yet depreciated for tax purposes by lessors.

UK itself is a prominent example. South Africa is yet another. Even in the largest
leasing market in the World, USA, tax and accounting principles for leasing
depreciation are markedly different and the difference is honoured and settled
over time.

So, there is no scope for the popular fear that if India adopts IAS-17-type
capitalization by lessees, it would lead to loss of tax depreciation. Unless the tax
department also thinks alike (which would be a disaster, as I explain below), there
is no linkage between tax treatment and accounting treatment when it comes to
depreciation. Merely because a lease is capitalized by the lessee for accounting
purposes does not entitled the lessee, or disentitled the lessor to claim
depreciation.

Has the accounting distinction between financial and operating leases served
any purpose?

It is today almost universally agreed that the accounting distinction between

financial and operating leases has not served any purpose. As the accounting
difference is based on fine mathematics, lessors and lessees world-over have
devised leases which in essence are financial leases but qualify for operating lease
definition. This is what prompted an Australian gentleman -McGregor - to make a
cothetic argument against the financial-operating lease distinction. McGregor
study became the basis for what is called "the new approach" to lease accounting.
It is based on this approach that IAS 17 was revised with effect from 1999.

Under the revised standard, disclosure is required for non-cancellable leases in the
books of the lessee, irrespective of whether the lease is a financial lease or
operating lease. In other words, as far as the lessee is concerned, accounting
standards no more distinguish between a financial and an operating lease.

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 Lease Financing

Can the accounting distinction be used for tax laws?

It would be disastrous to adopt the accounting distinction between financial and

operating leases for tax purposes. As mentioned above, the accounting distinction
is based on fine mathematics which is extremely complicated and subjective. The
primary test used for accounting purposes is the "present value" test. Apart from
being complicated, the present value test is:

• Different for the lessor and the lessee (in case of the lessor, his IRR is
used; in case of the lessee, his incremental borrowing rate is used)
• Subjective, as the incremental borrowing rate for the lessee is an arguable
issue
• Prone to manipulation by using structuring elements like security deposit
which are not used in computing the present value test.

Should India adopt IAS-17?

Almost the whole of civilized world has adopted. Much smaller and lesser
developed economies have adopted IAS 17, many years ago, and leasing has
continued to grow there. Leave aside unfamiliar names, all our neighbors - Bangla
Desh, Sri Lanka and Pakistan, adopted IAS 17 several years back. That has not
deterred the growth of leasing in any way in any of these countries.

So there should be no apprehension as to leasing meeting an untimely death due

to accounting standards being revised to meet internationally accepted norms. If
anything will cause the untimely death of the industry, it is lack of regulation,
leading to lack of certainty.

What kind of tax treatment should be applicable to leases?

As discussed before, the financial lease/ operating lease distinction would be a

disaster for tax laws. For tax purposes, what is more relevant is the test of a "true
lease", meaning a lease that does not reflect intent of owning and letting out an

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asset, but one of mere funding. There are tests in many countries to distinguish
between true leases and financial transactions, which can be used in our country.

Besides this, it might make sense to use a simple but very powerful limitation:
leasing tax shelter not being used against non-leasing incomes. Several countries,
such as Malaysia, Sri Lanka, South Africa, have enacted this rule. This rule
allows the leasing tax shelter to be absorbed within the leasing business, but not to
be used against other incomes. This by itself would curb the misuse of leasing
depreciation.

The Institute of Chartered Accountants of India (ICAI) recently issued a new

accounting standard no AS 19 on leases, replacing the existing Guidance Note on
lease accounting. The new standard is applicable for all leases entered on or after
1st April 2001: from this, it is understood that the statement will not affect past
leases. However, for practical considerations, it will be advisable for
companies to switch over to the new method in respect of all lease transactions,
including those which are running.

It has been made out that the new accounting standard is drawn in accordance
with international accounting standard no. 17. However, this is not true as the IAS
17 itself underwent revision in 1997. ICAI's AS 19 is based on the pre-1997
version of IAS 17.

Internationally, lease accounting continues to be in a state of flux ever since

McGregor published a new approach to lease accounting under which the
traditional distinction between financial and operating leases is to become
irrelevant and companies are required to record as asset or liability the fair value
of benefits to be derived from a leased asset and the fair value of payments to be
made under the lease agreement. In other words, if during the lease period, the
benefits arising from an asset exceed the lease payments, the lease is an asset even
if it is an operating lease. This would, inevitably, be true in case of a financial
lease anyway.

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 Lease Financing

To partly implement the McGregor approach, lease accounting standards in most

countries, including IAS 17, have already been revised which now requires
disclosure operating leases on the balance sheet of the lessee. Further changes
may be on the way, as IASB as well as the UK's Accounting Standards Board
have issued approach papers to implement the McGregor approach in full.

Application of Lease In Transfer of Right And Service

The new statement applies to all lease contracts - financial or operating.

As an important point, the statement also applies to all hire purchase
contracts, which are essentially financial leases.

The standard is applicable to all lease contracts, even if such lease

involves substantial services by the lessor. On the other hand, the standard
does not apply to service contracts, even if the same involve provision of
right to use. The distinction between a transfer of right to use, and a
service contract, is relevant for several purposes and there are some very
nice interpretations of this difference. There is a lease, if I transfer the
right to my asset to you. There is a service, if I use my asset for your
benefit. In other words, the distinction between lease and service is based
on whether the use of the asset is made by the lessee, or for the lessee's
benefit by the lessor.

What are the main ingredients ?

The main ingredients of the accounting standard are:

• As for lease transactions which are currently capitalised on the books of

the lessor, the accounting will be based on financial/ operating leases.
• For a financial lease, the lessor will not capitalise or depreciate the asset
on his books: the lessor will merely record a receivable, at the outstanding
principal value. The lessee will record the asset, as his fixed asset, and
depreciate the same as per usual depreciation policies of the lessee. The

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lessee will record, as a liability, the present value of lease rentals payable,
in other words, the principal inherent in future lease rentals.
• The lessor will take to revenue only the interest or finance charges
inherent in lease rentals, which will also be debited as expense by the
lessee.
• In case of operating leases, the lessor will account for the asset as his own
asset, and depreciate the same as per regular depreciation policy of the
lessor. The rentals will be recognised as income by the lessor and expense
by the lessee, subject to evening out in case of structured rentals. The
asset/liability will be off-the-books of the lessee.
• If a sale and leaseback transactions results into a financial lease, no profit
on sale will be booked by the seller-lessee who will treat the sale proceeds
as a liability.
• If a sale and leaseback transaction results into an operating lease, a lessee
will book profit/loss on sale irrespective of the sale price of the asset,
depending on the fair value of the asset.

1. Will it have tax implications ?

The fears expressed before that the new method of accounting will result
into loss of tax benefits by the lessor have now been allayed. In Feb.,
2001, the CBDT issued a circular clarifying that the change of accounting
rules will have no bearing on the tax treatment.

That is to say, subject to other conditions for depreciation allowance, a

lessor in a lease will claim tax benefits, even though he will not be
reflecting the asset as his fixed asset on balance sheet. This also means
that the lessor will be subjecting his gross rentals as income, even though
he takes to profit and loss a/c only the finance charges inherent in rentals.

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 Lease Financing

In other words, to the profit as reported in profit and loss account, the
principal portion of lease rentals not recognised as income will be added
for tax purposes and depreciation will be allowed.

As for the lessee, though he capitalises the asset on his financial

statements, he will not be able to depreciate the asset for tax purposes.
Though he takes to earnings statement only the finance charges inherent in
lease rentals, he will claim the whole of the rentals as expense.

Thus, the new accounting standard leads to a new era of dichotomy

between tax and accounting principles, and it will

be quite a tough time for the tax officers to negotiate through this
dichotomous rule. In essence, when things are tough for the tax officers,
they are tougher for the tax payers!

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ACCOUNTING FOR NON PERFORMING LEASES

There is no information in the guidance note on lease accounting, 1995, for non-
performing assets. The general accounting principles for non-performing assets is
contained in accounting standard 9 on Revenue Recognition which is more or less
on the lines of the International Accounting Standards on the issue.

The Standard provides that whereas, in general, incomes are to be recognized on

the basis of accrual, in case of an uncertainty in the ultimate realization of an
income, the treatment is as follows:

• If the uncertainty is prevalent at the time of raising the claim for the income,
the recognition of the income shall be postponed
• If the uncertainty arises subsequent to the claim being made, there shall be a
provision made to the extent of the uncertainty.

This statement lays down the basic difference between a provision against an
income, and non-recognition of income, which is very significant. The
accounting for non-performing assets is guided by the Prudential Norms of the
RBI

A lease will be regarded as a non-performing asset based on overdues for more

than 12 months. That is, if dues under a lease or hire purchase transaction remain
unpaid, fully or partly, for more than twelve months, the transaction will be
treated as a non-performing asset. The twelve month time frame is markedly
longer than the general international standard of 3 months only.

If the lease transaction is a non-performing asset, there is a four-fold impact on

the revenue/provisioning requirements:
No income shall be recognized on an accrual basis-income recognition will shift
to cash or accrual basis.

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Income already recognized, and lying unrealized, will be reversed-this, in

accounting sense means the income recognized will be provided for. Notably, in
case of lease transactions, the income that requires reversal is only the financial
charge element inherent in the rentals, not the entire rental.

A provision shall be made to mark the deterioration in the under lying security
value on the basis of the depreciation of the asset as per the Companies Act.

The NBFCs should make provisions against NPAs with correlation to the net
book value of the assets in four stages at 10, 40, 70 and 100 per cent as follows :

⇒ Rentals are overdue up to 12 months Nil

⇒ Sub-standard assets :
where any amounts of hire charges or 10 percent of the lease
rentals are overdue for more than 12 months net book value
but up to 24 months

⇒ Doubtful assets :
Where any amounts of hire charges or lease 40 percent of the
rentals are overdue for more than 24 months net book value
but up to 36 months

⇒ Where any amounts of hire charges or 70 percent of the rentals

lease are overdue for more than 36 months net book value
but up to 48 months
⇒ Loss assets:
Where any amounts of hire charges or lease 100 percent of the
rentals are overdue for more than 48 months net book value

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 Lease Financing

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 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

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 Lease Financing

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
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

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 Lease Financing

of right to use in a lease resulted into a permanent effective right of use being
transferred, preparatory to a sale.

The other condition for depreciation is that the taxpayer should be using the asset.
It is understood clearly that the taxpayer uses the asset in the business of leasing;
hence, it is on the strength of the lessor's use that depreciation is claimed and not
on the strength of the lessee's use. Use or its absence by the lessee should not,
therefore, cast any implication on the lessor's depreciation claim.
Depreciation is allowed in India on a pooling basis: all assets eligible for the same
rate of depreciation under a particular class of assets will be treated as one pool,
or block of assets. Acquisition of fresh assets is treated as addition to the block,
and the sales or transfers, at whatever be their transfer consideration, are netted
off from the block. Therefore, no regard is had to the profit or loss on sale of an
individual asset.

4. Rates of depreciation:
Rates of depreciation are listed in the Schedule to the Income-tax Rules. Like
under the English system, India makes distinction between "plant or machinery"
and other assets based on the functional test. The age-old functional test in
Yarmouth v. France holds in India. Based on this test, any assets that the lessor
leases out are obviously income-earning tools in his business, and would
therefore, be regarded as plant or machinery for his business.
Under this caption, the applicable depreciation rates on some of the generally
eased assets are given in the Table below :
Motor cars 20%
General plant or machinery (residuary rate) 25%
Lorries, buses or taxies plying on hire, aeroplanes, moulds used in 40%
plastic or rubber factories
Bottles and crates 50%
Computers (proposed) 60%
Pollution control devices, energy saving devices, renewable energy 100%
devices, rollers in flour mills, gas cylinders, etc.

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 Lease Financing

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.

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

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the Centre for Monitoring of Indian Economy case will not be able to withstand at
higher judicial forums

SALES TAX PROVISION PERTAINING TO LEASING:

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

1. The lessor is not entitled for the concessional rate of central sales tax because the
asset purchased for leasing is meant neither for resale nor for use in manufacture.
(It may be noted that if a firm buys an asset for resale or for use in manufacture it
is entitled for the confessional rate of sales tax).
2. The 46th Amendment Act has brought lease transitions under the purview of ‘sale’
and has empowered the central and state government to levy sales tax on lease
transactions. While the Central Sales Tax Act has yet to be amended in this
respect, several state governments have amended their sales tax laws to impose
sales tax on lease transactions.

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:

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 Lease Financing

In a Finance Lease, NBFCs are the owner of the Goods and the lessee only has
the right to use the goods on payment of lease rentals. It is a contract of hiring or
bailment. Hence there is no “sale “as defined.

However, there is a transfer of the right to use the goods from us to the lessee.
And this has become taxable as a deemed sale. The Sales Tax, also called "Lease
Tax ", is leviable on the Transfer of Right to Use the goods from us to the lessee.
And the tax is charged as each rental for use of the lease asset becomes due and
payable.

It may be noted that Lease Tax is a case of taxing a non-sale -the consumption of
utility of goods - though there is no transfer of title. . Whether it is good law or
will the Courts strike down this Tax ? We are not sure, but NBFCs are agitating
the matter in a Court.

c. Sales Tax on Lease V/s. Hire Purchase Transactions:

Lease is a sale followed by a transfer of right to use. Supplier S sells to the NBFC
and the NBFC gives the goods on lease to Customer C (Transfer of the right to
use the goods). Hence, there are two sale transactions - the sale proper, and the
lease.

In HP, also, there are 2 sales. Supplier S sells to the NBFC and the NBFC
simultaneously sells to the Customer C by entering into a hire purchase
agreement. Commercially speaking, the two transactions are not different. There
are two contracts in either case, usually bundled in a single delivery from the
supplier to the end-user.

Therefore, in a Lease, there will be a Sales Tax on the Sale and a Lease Tax (if
any) on the transfer of the right to use. In a Hire Purchase there will be 2 Sales
Taxes applicable on 2 separate sales. However, sales-tax laws (for historical

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 Lease Financing

reasons only) treat lease and hire purchase substantially differently. Since the
choice of the instrument, viz., lease or hire purchase, may lead to material sales-
tax difference, it is important that the sales-tax implications are analyzed before
choosing the instrument or concluding the transaction.

Government Jurisdiction in levying Sales Tax :

 In a sale outside India or in the course of import into or export out of
India.
If the sale is outside India or in the course of import into India or export
out of India , India cannot tax such a sale.
 Sale within a State :
If the sale is within a state then that state has the power to tax it.
 Sale in the course of inter state trade:
If the sale takes place in the course of Inter state trade, the Central
Government can tax such a sale. However, there is no administering
machinery of the Central Government to administer inter state sale tax.
The same is delegated to the state governments.

That state where the inter state movement commences has the jurisdiction and the
rate chargeable is also that applicable in that state for CST transactions.

 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.

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 NBFC’s shifting jurisdiction:

As explained, the jurisdiction in Inter state transaction is in the state where
movement of goods commences. But NBFCs can shift the jurisdiction
from all states to say Maharashtra.

This can be done by endorsement of the LR during transit. If endorsement is done

the jurisdiction shifts to the place where endorsement was made. Thus NBFCs
could instruct the Supplier to send goods physically to Customer and hand over
the LR in our name at our Bombay address. NBFCs will then endorse the
Consignee copy of the LR in favour of the Customer and forward it to the
Customer. The Customer will claim the goods from the transporter by producing
this endorsed LR.

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.

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.

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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.

Constitutional validity to be questioned:

Surprisingly enough, leasing as well as hire purchase are not a part of services
under the Constitution - as they are defined as "sales" in the Constitution and are
liable to sales-tax. Service tax cannot be imposed on leasing and hire purchase
activities as they are defined as sales under the Constitution and the Constitution
places restrictions on tax on sale or purchase of goods - leasing and hire purchase
being defined as sale and purchase of goods. The Central Govt's right to tax such
sales is only limited to inter-state transactions with the States having the right to
tax intra-state transactions. The receivables from lease and hire purchase
transactions are therefore, sale revenues under the Constitution, and they cannot
be taxed as value for services.

Gross value of services

Does this mean, in case of a bank, even the repayment of the loan is to be charged
to service tax? Not really. First of all, because bank loans are not even included in
the definition of financial services. And two, because the splitting of interest and
principal is defined in the bank's loan agreement. In case of hire purchase, the
splitting of interest and principal is an accounting adjustment, and is not
recognized in law as interest or principal. In case of lease transactions, the lease
rental is surely the gross value for the leasing service.
So as it seems, leasing and hire purchase companies better pack up - since they
have to shell out a 5% of their own principal, and 5% of their income, to the
Government before they can take up anything to their revenue account.

INCOME TAX PROVISIONS RELATING TO LEASING:

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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.

LEASING IN RELATION TO BANK FINANCE

With both leasing and bank financing involving credit decisions and financial
risks, the key differences are that two additional factors apply to leasing
companies:

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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.

The Difference between Financial Leasing and Loans

From the lessee’s perspective, there is only one substantive difference between a
loan and a lease: with a loan, the asset belongs to the borrower, whereas with a
lease, the asset belongs to the lessor.
The many similarities between a loan and a financial lease include:
■ The lessee and borrower have the choice over the acquisition of the asset.
The borrower and lessee (providing the terms of the lease are met) would be
able to retain the asset once payments are complete.
■ Over the period of both a loan and a lease, interest and capital (equipment
cost) are repaid.
■ Should there be default on either a loan or a lease, as long as the loan is secured,

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both the lender and lessor have legal rights to reclaim/repossess assets.
■ The risks and costs of ownership, including maintenance and obsolescence,
remain with the borrower and lessee. Also, under both a loan or a financial
lease, if the asset appreciates, neither the lender nor the lessor benefits.
■ The agreements are non-cancelable until either the lessor or the lender has
recovered its outlay.
■ The borrower or lessee can either settle the agreement (in the case of the
lease) or repay the loan early.

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.

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1. Unhealthy Competition:
The market for leasing has not grown with the same pace as the number
of lessors. As a result, there is over supply of lessors leading to competitor. With
the leasing business becoming more competitive, the margin of profit for lessors
has dropped from four to five percent to the present 2.5 to 3 percent. Bank
subsidiaries and financial institutions have the competitive edge over the private
sector concerns because of cheap source of finance.

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

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treated 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.

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:

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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
companies to surpass all caution and all lending prudence to do one such

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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

PLAYERYS IN THE INDIAN LEASING INDUSTRY

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There is a shake out 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.

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

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IL & FS 500 Plant & Machinery 5-7 Years Financial

Ships Operating
Aircrafts
Power Equipment
ASHOK 50 Vehicles 5-7 Years Financial
LEYLAND Plant & Machinery
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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LEASING: TOUCHING THE PEAK

Twenty five years ago, Farouk Irani quit his high profile job in
Citibank to launch his dream project: a leasing company in India. On 10th Sept.,
1973, Irani was able to convince Dr A C Muthia, Industrialist, to have the First
Leasing Company of India incorporated.

For several years, First Leasing Company remained the Only Leasing Company.
Ever since IFC, Washington decided to support Indian leasing with investment in
companies in 4 metros, Indian leasing has never looked back. This was about
1980. Early eighties' capital market boom found many young entrepreneurs riding
the leasing wave.

As it celebrates its 25th Birthday, Indian leasing is today a central part of the
financial system. On its way, it has passed through several twists and turns.
Financial industry World-over has a very high beta factor: it is hyper-sensitive to
changes in economic scenario. Periods of general prosperity are extremely good
for the leasing industry; downturns in economic cycle cost is extremely high. That
apart, financial system is invariably affected by the contagion effect: failures of a
few players affect even the healthy ones.

Though it is currently passing through a testing time, leasing has had an

undeniable role in Indian economy. From consumer finance to small industry,
heavy industry to automobiles, from railways to electricity boards, almost every
sector of the economy has utilized leasing as its source capital. Having attained an
average over-30% growth rate over past 7 years, Indian leasing has reached the
14th largest place in the World, a fact which is least realized by most.

India at the 14th largest place in World leasing sounds incredible! But it is
true, and true contrary to the internationally available statistics published by the
London Financial Group. The Group's data, published every year in the World

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Leasing Yearbook would place India at some 36th place, but admittedly that data
is only the estimate of the author thereof, and the author of the data might have
ranked Indian leasing volume based on India's per capita income ! When it comes
to size, India has the obvious advantage of being such a vast nation.

Center for Monitoring of Indian Economy compiles data about Indian leasing
volumes, which is carried as a part of India Leasing Yearbook published by the
Association of Leasing and Financial Services Cos. The data compiled by the
Center shows aggregate balance sheet value of leased and hired assets (though for
balance sheet purposes, lease and hire-purchase transactions are distinguished,
there is no material difference between the two - hence the volumes have been
clubbed here) at about Rs. 261 billion (End March 1997). This is based on
reporting by 226 companies, whereas the business, particularly hire-purchase, is
spread amongst some 3000 large and small companies. Estimated outstanding
business done by these firms is about Rs. 15 billion (at Rs. 5 million per such
firm).

That apart, the data also excludes the massive annual volume of business by the
Indian Railway Finance Corporation (IRFC). IRFC is a hundred percent
subsidiary of Indian Railways, and its leases are dedicated to the parent Railways
only. Of late, almost entire floating stock acquisition by Railways is being
acquired on lease from IRFC. The outstanding value of leases done by IRFC adds
to about Rs. 120 billion.

Thus, the aggregate volume comes to about Rs. 396 billion, which is about USD
11 billion as per then-prevailing exchange rates.

USD 11 billion of outstanding volume cannot by itself give India a ranking in the
London Financial Group data, since these rankings are based on incremental
volume. However, a rough estimate of new business can be made from the above
data (unfortunately, the Centre for Monitoring of Indian Economy data do not
give any idea of new leasing and hire-purchase volume). Supposing 30% of the

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outstanding business of last year was paid, and there was a 20% growth in net
business (as can be seen from the Chart above), there was a 50% new business,
over the volume outstanding at the beginning of the year. Relative to the business
at the end of the year, the incremental volume should have been about 33%
(50/150).

Therefore the annual leasing volume in India is estimated at about USD 3.67
billion, on a rough and conservative estimate.

In London Financial Group data, this should put India at 12-13th place, close to
Hong Kong. This would also be the third largest market in Asia, next only to
Japan and Korea.

The only infirmity in the above ranking is that the London Financial Group data
are not as of March 1997 - that, however, should not seriously disrupt the ranking
of India, because other Asian markets in 1996-7 period have generally registered
a negative growth.

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 :

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The post -liberalization era saw a spate of new ventures and fresh investments
by existing ventures. Though primarily funded by the capital markets, these
ventures relied upon leasing as a source of additional or stand-by funding.
Most leasing companies, who were also merchant bankers, would have funded
their clients who hired them for issue management services.

• Fast growth in car market:

Needless to state with facts, the growth in car leasing volume has been the
highest over these years - the spurt in car sales with the entry of several
new models was funded largely by leasing plans.

• Tax motivations:

India continues to have unclear distinction between a lease that will

qualify for tax purposes, and one which would not. In retrospect, this is
being realized as an unfortunate legislative mistake, but the absence of any
clear rules to distinguish between true leases and financing transactions,
and no bars placed on deduction of lease tax breaks against non-leasing
income, propelled tax-motivated lease transactions. There was a growing
market in sale and leaseback transactions, which, if tested on principles of
technical perfection or financial prudence, would appear to be a shame on
everyone's face.

• 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.

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• 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.

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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LEASING COMPANIES- CASE STUDY

IL&FS- Infrastructure Leasing & Financial Services Ltd.

Overview
A financial giant, IL&FS’s mandate is to ensure an atmosphere with financial
backing including funding to create a world-class infrastructure. The management
concluded that an important aspect of infrastructure is education and created a
company IL&FS ETS to look after this important aspect.

Business Need
Il&FS ETS created K-Yan Design Center, an independent research group to
create a new approach to learning. Prof. Kirti Trivedi was appointed to head the
project. The KDC team envisaged a comprehensive learning environment and
wanted a software created that would function as the primary resource of this
learning environment.

Challenges and Requirements

The biggest challenge was that the requirements were not clear. It was a dream in
which the achievables were known, but not the deliverables. It was not known
how or what exactly needed to be done, it was not even known for sure whether
it’s possible. To add to that the funds available were limited.

Web Access Role

Web Access decided to test its baseline, “If you can dream it, we can do it”. It
accepted the challenge with a broad outline target. It also agreed to something
unthinkable in the IT industry. An evolving requirement with a locked in time and
cost estimation. We managed to successfully create 3 different software with
multiple modules by working closely with the KDC team in developing the
evolving framework and creating requirement specifications in a iterative and

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evolving manner.

Benefits and Outcome

K-Creator, K-Class and K-Content together constitute a learning environment that
is unique. It uses the latest technologies, but is customised to be used even by
teachers in rural India with zero knowledge of computers. It supports the many
languages that India has, whilst allowing the students to seamlessly use and enjoy
the system, without formal computer training. It is a good example of unity in
diversity that makes India unique.

CSI LEASING COMPANY

Leasing IT Doesn't Have to be Difficult

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.

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The Solution

The captive failed to improve its service. As a result, when faced with the need to
acquire several hundred additional PC’s, the company chose the same brand
equipment, but a different lessor. Following the recommendations of executives
from companies similar to its own, it gave CSI Leasing a test run. These
references attested to the dependability and accuracy of the services they received
from CSI. With CSI, they gained a single point of contact for all ordering, as well
as a local account executive immediately responsive to their various needs.

Four years later, CSI Leasing is handling all of this company’s IT leasing needs.

A remarkable side note to this story - it took the captive leasing company five
months to realize it had lost the company’s business.

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.

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PROLOGIS-Leasing & Property Management

Honda

Honda’s Easy Transition to New ProLogis Distribution Facility:

In September 2005, Honda Logistics UK was based in an old converted factory in

Swindon and planning to move to new premises in the town. ProLogis learned of
Honda’s requirement while in the process of buying 42 acres of land at South
Marston, an established commercial location to the North West of Swindon. Only
five miles from Junction 15 of the M4 – and next door to Honda’s own giant
manufacturing plant producing the new Honda Civic –South Marston would be
Honda’s ideal location.

Armed with a detailed understanding of Honda’s needs, ProLogis explained its

way of working and ability to deliver before the crucial lease break of April 2006.
The ProLogis team demonstrated how it could incorporate fit-out into the package
and still provide substantial savings to Honda.

Crucial lease break:

Working together on the specification for the pre-let, ProLogis and Honda
developed a design which would enhance the functions of office and warehouse,
helping to make Honda’s logistics operations far more efficient. ProLogis then
worked with award-winning architect Michael Sparks Associates to gain planning
permissions and design and deliver a bespoke 350,000 sq ft (32,516 sq m)
distribution warehouse, before Honda’s crucial lease break of April 2006.

The resulting building responds to the aims of Honda Logistics UK. The
company sought a design which would project the division’s status within the
group and display the Honda brand in a dynamic application of the corporate
livery.

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The external design reflects its use as Honda’s state-of-the-art distribution center.
Elevations use crisp detailing, creating a natural rhythm with the alternate use of
different profiles and colors of external cladding.

The warehouse incorporates 21,000 sq ft (1951 sq m) of offices on three stories.

Amenity areas include a canteen, a fully-equipped kitchen, showers, lockers and
administrative accommodation. In addition, Honda required a mezzanine space of
23,400 sq ft (2,175 sq m) inside the warehouse, along with dispatch offices and
extensive plant areas. ProLogis arranged all the fit-out, including gas-fired
ambient heaters and racking along with an area of strengthened slab to
accommodate future racking. The building is fully sprinklered.

Smooth transition:

The layout of the site and the orientation of the building are ideally arranged for
the smooth and efficient operation of a major logistics facility. Offices are
positioned to allow adequate supervision of the service area, while a service road
provides 360-degree circulation. Particular attention was paid both to the
intensive demands of heavy vehicles and to security.

In January 2006, Honda began a smooth transition into its new home. ProLogis
was able to meet Honda’s precise requirements in a timeframe of just ten months.
Honda Logistics UK now uses ProLogis’ state-of-the-art facility to supply car
parts, motorbikes and power equipment nationwide.

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Cherokee Carpet Industries

Company Background:

Cherokee Carpet Industries of Dalton, Georgia is a manufacturer of

residential and commercial carpeting. With 315 employees, Cherokee
Carpet Industries boasts $50 million a year in revenues. In its five years in
business, Cherokee Carpet has grown rapidly. 1999 was the first year that
Cherokee Carpet will have audited financial statements.

As a closely held and highly leveraged S-corporation, to grow its company,

Cherokee was looking for strategic financing methods that would position
the company for the next level. Since its inception, Cherokee has leveraged
the benefits of leasing as a strategy to grow the company. At present, the
company leases $150,000 annually in equipment.

What was the Need?

Rapid growth in its five years in business continues to present a need for
Cherokee Carpet to minimize its capital requirements. Cherokee Carpet
Industries had a need for a Plantex 36 End Extruder for polypropylene and
nylon carpet yarns, an industrial piece of equipment. Cherokee Carpet
considered a straight purchase of $3.5 million for the piece of equipment,
but discovered that leasing afforded them the opportunity to leverage their
financial resources. When the company weighed the opportunity costs of a
straight out purchase against the lease payments, leasing offered a better
solution.

Cherokee recognized equipment leasing would provide tax benefits as well

as preserve operating capital. The primary reason Cherokee Carpet chose to
lease versus purchase the industrial piece of equipment was because as the
company was rapidly expanding, leasing offered Cherokee Carpet the ability
to maximize cash flow. Therefore Cherokee Carpet had more capital

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available for the operation of the company and for business growth
investments.

What were the Terms of the Lease:

CIT Group, the equipment leasing company, structured the lease to

help Cherokee Carpet Industries minimize its capital requirements.
The lease was negotiated to the terms of a seven year capital lease
with an early buy out (EBO) option at three and five years and limits
on fair market value.

Results:

Leasing equipment as a financing option afforded Cherokee Carpets the

ability to leverage their capital, increase cash flow and maintain more funds
for business expenditures. CIT, was able to customize a program to meet
Cherokee Carpet's financial and equipment needs.

East Texas Copy Systems (ETCS) and Canon Financial Services,

Inc. (CFS)

Company Background:

East Texas Copy Systems (ETCS) of Tyler, Texas is an authorized Canon

Dealer of digital networked office equipment. With 15 employees, ETCS
services large quantity accounts, such as hospitals, school districts, city and
county governments and major industries.

One of ETCS' largest customers, a non-profit health system, was looking to

take advantage of leasing equipment as a means to minimize cash outlay and
acquire 400 copiers and facsimile machines, as well as to structure a deal

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that would satisfy the health systems' billing needs. At present, ETCS leases
$500,000 annually in equipment to this customer.

What was the Need?

ETCS recognized that having the hospital lease copiers from Canon
Financial Services would offer more flexible leasing terms, reduce its costs
in procuring the equipment and enable the company to pay for the
equipment as it is being used. Thus, lending to the efficiency and
productivity of the business.

ETCS needed a flexible, all-cost included leasing program in order to meet

its customer's requirements. When considering financing options, the health
system also looked at acquiring the copiers using a bank line of credit;
however, leasing the equipment from Canon Financial proved to be a more
flexible and process efficient solution.

What were the Terms of the Lease:

The challenge of meeting the customers billing needs was to integrate an

aggregate cost-per-copy billing cycle with individual cost center reporting.
Canon Financial structured the lease to meet the billing needs defined by the
health system. Each copier was billed with individual reporting to its own
cost center. Aggregate pricing was based on lease volume within a 60-day
period; thus, lowering the lease price as the hospital continued to order
copiers.

Canon Financial Services' flexible invoicing accommodated the hospital's

payment terms, thus avoiding administrative delinquency, which had been a
problem with the hospitals previous financing source.

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Results:

The flexible lease that ETCS developed with Canon Financial Services,
afforded the hospital the ability to lease six to 10 copiers per month; thus,
reducing monthly capital outlay while affording the hospital the equipment
needed to supply their growing demand for copiers. This arrangement
allowed ETCS to win the hospital's business and steadily increase its volume
leased through Canon Financial Services based on equipment demand.

easing their copiers afforded the health system the ability to both leverage
their capital, in addition to, protecting themselves from technical
obsolescence.

Customer Quote:

"CFS structured the billing cycle to the individual cost centers, making it
more convenient for the hospital's different invoicing needs," said Greg
Walker, ETCS President. "Not all financing sources would be as flexible or
accommodating as CFS. In this industry there are several, national faceless
equipment dealers and leasing companies who have the "me too" attitude.
CFS really proved to be extremely customer service- oriented, just as we
like to be at ETCS."

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.

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Hamid Lahcen, Chairman and CEO of Spacemakers, was considering options for
financing $1 million of new forklifts needed for the commercial storage facilities.
Because there was no corporate tax in Kuwait, Spacemakers could not take
advantage of the equipment's depreciation tax shield. Hence Lahcen was
considering a fifteen year lease of the equipment.

The Canadian lessor, Hardware Leasing Co., had offered to structure a capital
lease for Spacemakers, as long as Hardware Leasing could arrange non-recourse
financing for the equipment. Hardware wished to purchase the forklifts with
$200,000 of its own cash and $800,000 borrowed from ABN AMRO Bank in
Dubai at 7.5%. The leasing company's effective tax rate was 30%, and Canadian
tax laws permit use of the double-declining balance method for leasing
companies. The forklifts had a tax life of seven years.

Hardware Leasing estimated that it could sell the equipment for $200,000 (the
residual value after 15 years). Spacemakers, the lessee, had requested an early
buyout option (an "EBO") after ten years. Immediately upon purchase, the lessor
would lease the equipment to the lessee for fifteen years. Rents would be paid
monthly, on the same day the debt services were due, and the rents always would
be sufficient to pay debt service.

When Lahcen received a fax summarizing the terms of the lease, he could hardly
believe his eyes. The lessor offered Spacemakers a 15-year lease with 180 equal
monthly payments of $8,052. This included an effective interest rate of only 6.5%
per annum. Not only was the rate very attractive, but Spacemakers would also
receive 100% financing with no downpayment. He decided to push his luck and
try for the early buyout option. He scribbled "Accepted, as long as we get the
EBO!" on the term sheet, signed it, and faxed it back to Toronto.

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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; corporates have found themselves in a general cash crunch resulting
into sticky loans.
Most NBFCs have learnt a very hard way to distinguish between a good credit
prospect and a bad credit prospect. When a credit decision goes wrong, it is trite
that in retrospect, it invariably seems to be the silliest mistake that ever could
have been made, but what Indian leasing companies have suffered are certainly
problems of infancy. Credit decisions were based on a pure financial view, with
asset quality taking a back seat.

In most of the cases of frauds or hopelessly wrong credit decisions, there has been
a tax motive responsible for the transaction. India has something which many
other countries do not- a 100% first year depreciation on several assets.
Apparently, the list of such assets is limited and the underlying fiscal rationale
quite holy and sound - certain energy saving devices, pollution control devices etc
qualify for such allowance. But that being the law, it is left to the ingenuity of our
extremely competent tax consultants to widen the range with innovative ideas of
exploiting these entries in the depreciation schedule. As leasing companies were
trying to exploit these entries, a series of fraudsters was successful in exploiting,
to the hilt, the propensity of leasing companies to surpass all caution and all
lending prudence to do one such transaction to manage its taxes, and thus, false
papers for non-existing wind mills and never-existing bio-gas plants were
fabricated to lure leasing companies into losing the whole of their money, to save
the part that would have gone as government taxes!

A number of factors will precipitate the consolidation in Indian leasing, and the
process is already on. First, bifurcation of leasing and non-leasing activities, such
as merchant banking, will go a long way in breaking the financial conglomerates,

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who may find themselves better focusing on investment banking rather than
dabbling into leasing at the same time. Second, in whichever forms of business,
mass distribution is possible, that is, where the customer is more or less
homogenous, larger firms will eat up the shares of the smaller ones. This is
something everyone can see happening in the car finance market. Three, reduced
rates by the industry leaders will set benchmark rates in the market which will
force many marginal players out. Fourth, regional players will survive but will
find their relevance in a new avatar as "lease brokers", or to use a better word,
"lease originators". These firms will originate small ticket leases, sell their
portfolios to larger players, thereby encashing their wafer-thin spreads and
walking out to originate another transaction. Such activity has flourished in USA,
and we will see much of the same story in India too.

Cross-border competition will come in two forms: direct cross-border

transactions, and cross-border investments in lease transactions. A number of
global leasing giants have already occupied their positions in India. Capital
account convertibility measures will precipitate the process. The impact of foreign
investments will be greater consolidation activity at home.

During the initial phases of growth of any industry, there is a trend towards
diversification: firms try to attain growth in numbers by unfocused diversification,
but soon realize that diversified presence creates organizational pressures, which
are difficult to cope with. This leads to a trend towards consolidation and focused
growth. Leasing firms of yesteryears were everything: money market players,
merchant bankers and discount houses. Gradually, both regulators and industry
participants have realized that clearer roles are necessary for stability.

There are so many merits in vendor-based leasing that it is surprising that it has
not made its debut in India still. For the asset vendor, a leasing plan is a sales-aid,
and for the lessor, it is easy access to a vast market, with equipment support from
the vendor. In 1997-98 and after, many lessors will be forced to leave general

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equipment leasing market and line up with suppliers of equipment. Vendor

leasing in time to come will be a very significant part of the leasing market.

True asset-based funding is an extension of the vendor lease market. The two
generally go together to develop into operating leasing. Full scale operating
leasing, that is, leases will in-built cancellation options, will take quite some time
to develop in India, but features of operating leases will be introduced once
vendor tie-ups take place.

The intensity of price-based competition will be split between the corporate

finance market and the consumer finance market. The latter has always placed
emphasis on service, accessibility, and nonquantifiables of that sort, but the
corporate finance market consists of a professional treasury manager who will
have to justify the cost of money to his boss. So far, leasing has continued to sell
itself on several intangibles as speed, smile, and simplicity, but corporate finance
quickly moves to a dilemma where every one is fast, everyone smiles and every
one is simple enough for the sophisticated audience. It is there the price becomes
decisive. Leasing, with all its cost additives as sales tax and stamp duties, will
have to sustain as a cost-competitive financing option.

However, the near future for the NBFC Sector seems to be far from satisfactory.
Given the present state of the economy and industry, lack of confidence by
investors, apathy from banks, chaotic and multiple tax regime, non existence of
effective recovery mechanism and unfair competition provided by MNCs, FI’s,
the surviving NBFCs have a tough time before them. However, the country is at a
turning point and the requirement of capital equipments for industrial expansion
and huge infrastructural projects will once again lead to the spurring demand for
lease and hire purchase finance and the efficient and cost effective NBFCs
therefore, could have a bright future. Moreover with various issues like change in
accounting norms, sales and service tax on lease rentals and tax issues facing the
leasing industry, the future of this sector seems to be very bleak.

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METHODOLOGY

This project is the mixture of theoretical as well as practical knowledge. Also

it contains ideas and information imparted by the guide. The secondary data
required for the project was collected from various web sites and the book of
reputed author. The project started with sorting all the raw data and arranging
them in perfect order. To add value to the project and to understand the
practicality of LEASE FINANCING

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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

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

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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

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.

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. CAPITAL LEASE

Type of lease classified and accounted for by a lessee as a purchase and by

the lessor as a sale or financing, if it meets any one of the following
criteria: (a) the lessor transfers ownership to the lessee at the end of the
lease term; (b) the lease contains an option to purchase the asset at a
bargain price; (c) the lease term is equal to 75 percent or more of the
estimated economic life of the property (exceptions for used property
leased toward the end of its useful life); or (d) the present value of
minimum lease rental payments is equal to 90 percent or more of the fair
market value of the leased asset less related investment tax credits retained
by the lessor. (Also see finance lease.)

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

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include in the cash flows any effect the transactions have on federal tax
liabilities.

FIRST AMENDMENT LEASE

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

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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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