Lease Finance

Author: | Published: 12 Jul 2001
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Introduction

Lease finance is a viable financing alternative whereby project costs are met by procuring assets and equipment on hire. Lease financing enables the use or services of assets, without locking up capital. Leasing is now playing a pivotal role not only in large ventures but also start-up enterprises.

Lease finance is not a new idea. The concept has been around for a long time. The needs of big business, favourable tax treatment and other advantages have now given it a fillip. Some of its advantages are:

  • simple documentation;
  • a self-designed and convenient rental payment schedule that can be suitably modified to suit parties' cash flow and tax management requirements;
  • mobilization of scarce financial resources;
  • releasing capital for working and other needs;
  • reliable source of supply of capital in times of credit control by the Reserve Bank of India (RBI);
  • easy finance on account of non-interference character of lenders;
  • tax write-off of lease rentals as operating expenses. In the case of rentals paid to foreign residents, it may be possible to obtain exemptions from withholding taxes; and
  • unaffected by statutory bindings and restrictions as in small-scale industries, and an enterprise can continue to grow further without crossing the statutory limits or bypassing the legislative provisions.

Leases are of various kinds, and can broadly be classified as:

  • equipment leases; and
  • real estate leases

Equipment leasing forms the bulk of trading activities.

Equipment leases are of two types: finance leases and operating leases. A finance lease broadly involves hiring an asset for almost all of its economic life on a non-cancelable basis (see below), whereas an operating lease involves hiring assets for a short or medium term (see below).

Lease classifications: both finance and operating leases may be analyzed or further divided into the categories described next.

(a) Finance lease:

  1. Finance lease and purchase option
  2. Finance lease where lessee enjoys residual benefits
  3. Finance lease where lessor retains residual interest
  4. Finance lease by manufacturer lessor
  5. Tax-based financial lease
  6. Leveraged lease
  7. Non pay-out lease
  8. Full pay-out lease
  9. Big ticket lease
  10. Single investor lease
  11. Domestic and interntional lease
  12. Indirect international lease
  13. Cross-border lease in the orm of an export lease or an import lease.

(b)Operating lease:

  1. Simple operating lease
  2. Specialized service operating lease.

Finance lease

A finance lease is a long-term lease of fixed assets. It would rarely be cancelled by either party. It is a source of long-term funds and serves as an alternative to long-term debt financing. It is a full payment lease involving obligatory payment by the lessee to the lessor that exceeds the purchase price of the leased asset and finance cost. All risks and rewards incidental to the ownership of an asset are transferred even though the title is not.

Financial leases have the following basic characteristics that differentiate them from operating leases:

  • the lease is not cancelable by the lessee prior to its expiration date;
  • the lessor may or may not provide service, maintenance and insurance for the asset;
  • the asset is fully amortized over the life of the lease;
  • the lessee has the use of the asset for 75% or more of the estimated economic life of the leased property; and
  • the present value at the beginning of the lease term of the minimum amounts payable under the lease (exclusive of amounts payable for insurance, maintenance and similar normal outgoings) is at least equal to 90% of the cost of the leased asset.

Features of a finance lease

 A transfer of all major risks and rewards of ownership in the asset is the essential feature of this kind of lease. Such a lease has to be long enough to provide the lessee judicious use of the asset for almost the whole of its economic life. Since the lessee is interested in the lease only as a device of financing, the lessor limits its role to that of a financier. The lessor therefore does not provide the services of repairs or maintenance, and bears no insurance or other expenses in relation to the asset. The lessor merely finances the acquisition of the asset and keeps title over it, as a matter of security. The rentals are pre-fixed, and are not related to the use or quality of the asset. The rentals are structured so as to repay the lessor principal as well as interest accrued during the desired pay back period, which corresponds to the primary lease period. During this period, the lessee does not have the option to return the asset. The rest of the lease period is only a paper transaction, in which notional rentals are paid to prolong the lease agreement until the asset loses its economic utility. The residual scrap then reverts to the lessor, but its value is negligible. For all practical purposes, the lessor's only source of income from the asset that it owns is the prefixed rentals for the prefixed period. In other words, the lessor seeks no reward in being an asset owner, other than earning the rentals, and neither does it bear any other risk.

Lease financiers

 Financing of leases is usually done by banks and term lending institutions. Nationalized as well as non-nationalized banks and financial institutions act as financiers of lease transactions. Banks provide working capital credit to lessors and usually secure their financing by hypothecation of the charge over the assets so leased and also through an assignment of the lease rentals. Besides these institutions, there are a number of one-off financiers who may not specialize in the financing of leases but may be doing so for tax reasons.

Operation of a finance lease

A financial lease transaction would usually go through the following stages:

  1. Capital decision stage – the prospective lessee decides whether to invest in a particular item of equipment or not, and the decisions are taken by the lessee internally as a policy matter. The lessor has only a skeletal involvement at this stage.
  2. Product decision stage – the lessee selects the equipment or the asset and satisfies him or herself about its functional fitness and specifications. The lessor has no participation at this stage, except, where he or she has to coordinate with any particular manufacturer.
  3. Financing decision stage – the lessee considers and chooses from amongst the several funding options available.
  4. The lessor's decision stage – on deciding to lease the equipment, the lessee approaches a lessor, either directly, or through a broker.
  5. Crystallization of intent stage - the intended lease and its terms are broadly negotiated and a letter of intent/term sheet is signed.
  6. Approvals stage – this stage is generally relevant and required in cases of cross-border leasing, where the asset to be leased is to be imported and therefore invariably requires approvals and consents from various governmental authorities and ministries. Additional approvals might be needed if the asset/machinery to be leased requires an operating permit such as in the case of aircraft.
  7. Lease agreement stage – the lease agreement and the rental rates are finalized, and thereafter a formal lease agreement is executed between the lessor and the lessee, along with other documentation.
  8. Placement of order stage – after the execution of the lease documents, the lessee instructs the lessor to place an order with the manufacturer of his or her choice. Advance payments may be needed at this stage. Upon placing the order, the lessor makes the advance payments and charges interest on these until the lease commences.
  9. Start of the lease stage – the manufacturer delivers the equipment at the site of the lessee and the latter gives notice of acceptance to the lessor. At this point of time the lease commences. In the lessor's books of account, the advances outstanding are converted into leased assets.
  10. Primary lease stage – the usual primary lease period is the lessor's targeted payback period. At the end of the primary lease period, the lessee is allowed an option to renew the lease at token rentals, usually for an open-ended period. During the lease period, the lessee will:
    • pay rentals regularly at periods agreed, which are usually each calendar month;
    • keep the equipment in good working order; and
    • be entitled to manufacturer's warranties or after sales services.
  11. Terminal stage – at the end of the lease period, the equipment or the asset reverts to the lessor. No purchase option is given to the lessee in the lease agreement itself, this being the characteristic of hire purchase agreements. To ensure that the lessee does not have to suffer a loss on account of repossession or sale of the equipment, the lessee is either allowed to continue the lease on nominal terms, or the lessee is allowed to participate in the sale and enjoy a large part of the sale proceeds, if the equipment is sold to a third party. In India, it is also common practice for lessors to sell leased assets to close affiliates of the lessee, but as the economic interests of the lessee and such affiliates are usually integrated, selling or agreeing to sell the asset to such an affiliate breaches the line of distinction between lease and hire purchase, and is not recommended where the proposed transaction is to be shaped and maintained as a lease.

Thus the lessor provides no real economic service other than financial intermediation, and bears no risk of obsolescence. The lessor has the limited function of:

  • arranging finance from the capital market and making it available to the lessee;
  • acquiring the equipment from the manufacturer or the supplier subsequent to the requirement of the lessee; and
  • holding title to the asset and making it available for use by the lessee.

This leasing is usually limited to financing movable assets, as the leasing of immovable assets calls for stamping and registration, and attracts tenancy and other real estate laws, which in most cases makes it unfeasible for pure financing purposes. However, the leasing of immovable estates is a different industry, having more the features of asset owning than of asset financing.

Finance leasing is intrinsically akin to a lending operation – the lessor may not be prepared to keep the investment at stake for the entire lease period. Hence the intention of the lessor will be to recover the principal and interest (by way of rentals) within a reasonably safe pay-back period, say five years, whereas the life of the asset may necessitate lease agreement to be for eight or 10 years. In such cases, the solution is to break the lease period into two: a primary lease period during which the lessor wants to see the investment paid back with interest, and a secondary period for the balance of the life of the asset, when only nominal rentals are charged to keep the lease agreement operative.

In a finance lease, the intent is known from the conduct of the parties even though it may not be expressly stated anywhere.

Operating lease

The real intent here is the same as documented, ie to provide an asset on rent for a period of time. The asset is of common use and may be used successfully by a number of users in a sequence. The lessee in such leases is provided with the use of the asset for a certain and limited period, and the risks incidental to the ownership belong wholly to the lessor. One peculiar and differentiating feature of the operating lease is that such a lease is may be canceled at the option of the lessee, as the nature of the asset is such that the lessor does not have any practical difficulty in leasing it to another lessee. However, operating leases are contractually non-cancelable except in the case of a default on the lessee's part. For example, in the case of an operating lease for aircraft there are extensive event of default clauses under which the lease can be terminated, and the lessor has the option to repossess the asset without completing the lease period.

The lease period for operating lease is usually small in comparison with those for finance leases. This is so because, in an operating lease, the lessor intends to lease the same asset over and over again to several users, as in the case of aircraft leasing, where normally the lease is operative for a period varying between three and seven years, and the lessor intends to repossess and reconfigure the aircraft and bring it afresh into the market for leasing. In operating leases, the lessor is specialized in handling and operating the particular asset being leases out and usually provides specialized services, albeit at an extra cost.

Limitations of leasing

Despite its various advantages, leasing has some peculiar limitations:

  • Leasing is only another form of debt financing – lease financing is essentially a form of borrowing, perhaps borrowing an asset rather than the funds with which to purchase it, but nevertheless it results in obligations which are substantially the same as those incurred in debt financing. Thus, whether a company uses its credit in the form of direct borrowing or to support lease commitments, the total amount of its obligations will be the same.
  • Higher cost – in most cases, leasing may be more costly than a straight borrowing or even an outright purchase, because the lessor is only a financial intermediary, and borrows from the market at the prevailing or even higher borrowing rates, to which is added the lessor's own profit also. The costs would continue to be high until the lessors achieve a diversified capital structure with greater reliance on primary sources.
  • Loss of tax benefits – a lease may, depending on the relevant depreciation rates and rental structure, lead to a loss of tax benefits and, since the structure spans a considerable period of time, as compared to an outright sale, the risk of changing and amended detrimental tax and other laws always looms large. To cite an example, the Finance Act 2001, which has amended the Indian Income Tax Act, now requires even non-resident lessors to file income tax returns if the source of income, like the leased asset, is situated in India. Moreover, transferring the ownership of the leased asset while it is situated in India leads to further tax implications.
  • Double sales tax – as per the sales tax law of most nations, leasing may result in a transaction being charged to sales tax twice – once when the lessor purchases the asset, and again when the asset is leased out.
  • Loss of residual value – since, upon the termination of the lease period, the asset reverts to the owner, the lessee loses any claim on the residual value. At times, the equipment may have a much higher residual value than what was provided for at the inception of the lease, and the lessee loses a substantial ownership benefit. The sale of residual is sometimes a protection against inflationary erosion of monetary value. This is not true in the case of a pure financial lease where the lease period is either prolonged as long as the asset value is significant, or the lessee is allowed to share a larger part of the residue.
  • Unexpected lapse – in the case that the lessors themselves finance the lease by funds borrowed from banks and financial institutions, and the leased asset is hypothecated to the banks, if the lessor fails to meet obligations to lenders, the asset will be seized by the lenders, causing a loss not contemplated by the lessee.
  • Limited scope – leasing as a mode of finance is limited to equipment needs only. It cannot help a company secure its working capital. Moreover, assets to be leased out must not be consumable, wasting or perishable in nature, because when they are rented they should not have the tendency to be used up and should not become economically less attractive.
  • Other drawbacks – since most leasing companies provide finance based on the strength of the lessee without actually looking into the lessee's requirements, project feasibility, repayment capability, etc, there are grave dangers of the lessee pursuing a policy of over borrowing. To cite an example from aircraft leasing, it has been the case with various private scheduled operators of aircraft that the lessors have incurred tremendous losses when the lessees, in competitive zest, have leased more aircraft then they actually required and consequently defaulted as they were not able to pay the required rentals.
  • Leasing does not provide the lessee with pride of ownership – all said and done, a mere right to use, which is provided under a lease, is short of full and legal ownership.

Despite the drawbacks and the steady erosion of the tax shelters, both finance and operating leases continue to be widely used.


Leasing

Rajinder Narain & Co
F14 Connaught Place
New Delhi-110 001
India
Tel: 91 11 331 3232
Fax: 91 11 332 8319

Maulseri House
Kapashera Estate
New Delhi-110 037
Tel: 91 11 331 3232
Fax: 91 11 332 8319