Aircraft leasing in IFSC

Team Finserv | finserv@vinodkothari.com

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Our other resources on IFSC

  1. Ship leasing from IFSC: A new business takes shape
  2. Financial entities in IFSC: A primer
  3. Finance Companies / Units in International Financial Services Centre (IFSC)
  4. Budget 2023 and Gift IFSC: Making Things Happen
  5. Consultation paper on the proposed IFSCA (Payment Services) Regulations, 20XX: An Analysis
  6. IFSC Banking Units allowed to deal in Structured Finance Products
  7. Banking & Finance units in IFSC- A regulatory overview

Ship leasing from IFSC: A new business takes shape

Team finserv | finserv@vinodkothari.com

The International Financial Services Centre, from Gift City, was intended to enable leasing of aircrafts as well as ships. Such leases have traditionally been done from offshore jurisdictions, and the admitted intent of IFSC was to bring these businesses to IFSC.

Ship financing business in India and the world

India is a very important player in the global shipping market, and is ranked no 17 in terms of shipping volume. It has a coastline of about 7,517 km, with 12 major and 205 minor ports. Additionally, it is estimated that about 95% of India’s goods trade by volume and 70% by value is done through maritime transport.

Ship financing volume globally is about USD 500 billion, largely consisting of bank finance. There are two types of leases against ships: bare board charter, and voyage or time charter. In case of the former, the lessor merely provides the vessel, with neither the crew or any other services, whereas in case of the latter, the ship is provided on time basis, with all services.

India is a substantial importer of shipping freight. It is estimated that annually, Indian companies pay about $75 billion for seaborne freight to foreign shipping companies. 

Read more

GoAir Insolvency: Lessors’ rights gone in thin air?

– Financial Services Division, finserv@vinodkothari.com

A Special Bench of NCLT,  New Delhi admitted the insolvency of Go Airlines (India) Ltd, popularly known as GoAir, on the 10th May 2023. The insolvency was admitted on an application of the company itself, on the ground of a self-admitted default of Rs. 11.03 crores towards interest to financial creditors, out of a pile of debt, that is, Rs. 2660 cr towards aircraft lessors and Rs. 1202 cr towards its vendors. The application was admitted in the face of strong opposition by the financial creditors and the lessors of aircrafts taken on lease by the company.

Subsequently, on an appeal before the NCLAT, the appellate forum affirmed the order of the NCLT, rejecting the contention that the filing of the insolvency application was malicious. The matter may still be taken up to higher or other forums, but in the meantime, there are question marks on India as a favoured jurisdiction for aircraft leasing. Aircraft lessors need certainty as to the exercise of their rights over the leased aircraft in the event of a lessee default, and the Cape Town Convention (CTC), signed under the auspices of UNIDROIT way back in 2021, is a set of minimum assurances that the countries signing that convention have provided to aircraft lessors. The question is, India having actually been a signatory to the Convention, is it okay to have stayed the rights of the lessors by way of a moratorium during the entire period of insolvency resolution?

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Guide to Structured Finance

Get your copy now!

Order here – https://rzp.io/l/R2RRY0P

A comprehensive treatise, running over 1000 pages, on four contemporary topics in structured finance.

Key highlights of the book:

– Delves deep to create fundamental understanding of the topic, evolving conceptual clarity.
– Discusses global practices, along with specific focus on Indian market.
– Blend of legal, accounting and regulatory discussions, while fully explaining the underlying financial structures.
– Evolution as well as temporal developments discussed, to allow readers to understand the trajectory and future path of the instruments.
– Sufficient discussion on structuring. Use of spreadsheet-based examples to provide practical understanding. Spreadsheets underlying the computations can be accessed on a URL.
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Budget 2022: Government to roll out battery swapping policy for EVs

Electric Vehicles slowly getting into priority list of the Government

Qasim Saif | Manager <finserv@vinodkothari.com>

­­­With a growth of more than 100% in sales of Electric vehicles (EVs) from FY21 to FY22 and 9,13,532 EVs currently registered since FY12 and expected sales of 14.8 million EVs by FY30, a comprehensive framework and government support to the industry is no longer an option rather a necessity.

Read more

Financing electric mobility: Evaluating BaaS structures

  • Qasim Saif | finserv@vinodkothari.com

The penetration of EVs in Indian vehicle market have gone up from 0.01% to 1.66% from FY 15 to September, 2021[1]. However, the growth of EVs faces several resistances in form of high upfront cost, the lack of public charging infrastructure, and travel range. In order to catapult the growth of EVs in India, there is need to increase infrastructural support to the industry in the form of charging stations, battery units etc.

The dire need of financing is felt in the entire supply chain of EVs beginning from the speciality chemicals used in batteries to the finished vehicle purchased by the end user. Read more

Are financial leases subjected to TDS?

Yutika Lohia

yutika@vinodkothari.com 

Introduction

In today’s time, leasing has become an indispensable element of businesses – Any and every asset movable or immovable, equipment or software can be taken on lease. Colloquially, lease refers to an arrangement where a property owned by one is given for use by another, against regular rentals. In India, there are two types of lease transactions-financial lease and operating lease. Typically, a financial lease is a disguised financial transaction whereas operating lease is akin to rental contracts.

While leasing has gained much importance and relevance over the years, its feasibility and viability depends a major deal on its tax implications – they could easily make or break the deal. The technical aspects with respect to taxation on implementation makes it all the more significant.   Issues like depreciation, lease rentals, tax deduction at source and exposure to GST are key concerns. Further, though leases are classified as finance or operating, it is important to note that such distinction is essentially from an accounting perspective – the Income Tax Act, 1961, however, does not distinguish between the two.

A rather significant but overlooked aspect of leasing is the ‘tax deduction at source’ (‘TDS’). As is known TDS is a key element of the Indian taxation framework which aims to collect tax at the source of generation of income. In case of a lease transaction, the lessee is required to deduct tax under 194-I of the Income Tax Act at the time of payment of lease rentals to the lessor.

While there are several judicial precedents dealing with TDS vis-à-vis lease transactions, the Hon’ble High Court of Karnataka in a recent order, in the case of Commissioner of Income Tax vs. Texas Instruments India Pvt Ltd (2021),[1] concluded that in case of a financial lease, the lease financing company did not provide any particular service as a driver or otherwise for the purpose of usage of the car. The only transaction entered between the assessee and the lease financing company was to make payments of the amount due to the company. To say there was a mere financing arrangement and therefore section 194-I of the IT Act shall not be applicable in case of a financial lease transaction.

In this article we shall discuss the above stated ruling in detail.

The case of Texas Instruments India Pvt Ltd

The Assessee, Texas Instruments India Pvt Ltd being in the business of manufacture and export of computer software had taken motor vehicle on finance lease for its employees. It considered the lease rentals as business expenditure and claimed deduction of the same under the head income from business and profession. TDS was not deducted on the finance lease rentals as the assessee contested that the same did not fall under the provision of section 194-I or 194-C of the IT Act.

However, the Assessing Officer disallowed the claimed expenditure on the grounds that the lease rentals were being paid to the vendor under the contract and therefore the payment/ expenses would be attracting the provisions of section 194-C.

Aggrieved by the order of the A.O., the Assessee preferred an appeal before to the CIT(A). Upon such appeal, the CIT(A) overturned the A.O’s order and held that the payments made by assessee were not in the nature of service rendered by the leasing company for the carriage of goods or passengers. The CIT(A) also held that the assets were in the disposition of the Assessee.

Following such order, the matter was appealed before the Income tax Appellate Tribunal (ITAT) where it was held that provisions of Section 194-C will not be applicable on lease rentals.

Once again, the matter was taken for appeal before the Hon’ble Karnataka High Court where it was held that the leasing financing company did not provide any particular service as a driver or otherwise for the purpose of usage of car. The maintenance was carried by the employees of the assessee. The only transaction entered between the assessee and the leasing company was to make payments of the amount due to the company. Since no services were being provided by the leasing company and is a mere financing agreement, provisions of section 194-C and 194-I shall not be applicable.

Understanding the Provisions of Law

Section 194-I of the Income Tax Act, 1961: TDS on Rent

Section 194-I of the IT Act 1961 governs tax deduction at source in case of lease rentals. As already mentioned, Income Tax Act does not draw any line of distinction between financial lease and operating lease, let us understand whether TDS needs to deducted on lease rentals in case of both financial lease and operating lease.

Section 194-I of the IT Act explains rent as follows:

“rent” means any payment, by whatever name called, under any lease, sub-lease, tenancy or any other agreement or arrangement for the use of (either separately or together) any

(a)  land; or

 (b)  building (including factory building); or

 (c)  land appurtenant to a building (including factory building); or

 (d)  machinery; or

 (e)  plant; or

 (f)  equipment; or

 (g)  furniture; or

 (h)  fittings,

whether or not any or all of the above are owned by the payee;

Rent has been broadly defined under section 194-I and shall be applicable when asset is given for use for any payment under lease, sub lease, tenancy, or any other arrangement or agreement.

Section 194-C of the Income Tax Act, 1961: Payment to contractors

(1) Any person responsible for paying any sum to any resident (hereafter in this section referred to as the contractor) for carrying out any work (including supply of labour for carrying out any work) in pursuance of a contract between the contractor and a specified person shall, at the time of credit of such sum to the account of the contractor or at the time of payment thereof in cash or by issue of a cheque or draft or by any other mode, whichever is earlier, deduct an amount equal to—

 (i)  one per cent where the payment is being made or credit is being given to an individual or a Hindu undivided family;

(ii)  two per cent where the payment is being made or credit is being given to a person other than an individual or a Hindu undivided family,

of such sum as income-tax on income comprised therein.

XX

Conclusion

The judgement highlights that by virtue of the fact that no services were provided by the leasing company and that it was a mere financing agreement, section 194-C and 194-I would not be applicable in the given case.

Therefore, it seeks attention on the fact whether TDS has to be deducted on financial lease rentals.

Also, one must contemplate whether TDS should have been deducted under section 194-A of the IT Act as the lease transaction was considered as a mere finance agreement. This remains unanswered.

 

 

 

 

 

 

 

[1] https://indiankanoon.org/doc/59654437/

XaaSing of assets: Understanding essential differences between subscription and lease

-Vinod Kothari and Sikha Bansal (finserv@vinodkothari.com)

Just as you may subscribe to digital content, cellphone services, or software-as-a-service, you may subscribe to a car, or home durables. The business of availing equipment as a subscription is growing monotonic and steep, and currently, in the realm of passenger vehicles, it is already a rage. A report by BCG estimates that the subscription market for passenger vehicles may achieve a penetration of 15% of new car sales, and volumes of about USD 30 to 40 billion, by 2030[1].

This article seeks to touch upon the fundamental understanding of subscription and how it is different (or not different?) from a lease. There are several other similar contracts – which may be looking elusively similar – asset capacity sharing contracts, asset timeshare contracts, etc. Each of these might have shades of difference; however, our present write-up focuses on subscription services for assets, versus lease transactions.

What is “subscription”?

It is difficult to find a legal definition of the word “subscription” as the word is used in widely different contexts. “To subscribe” may mean to write your name or put your signature under a written document, (common example is ‘subscribing’ to a memorandum of a company). However, in the present context, the following dictionary  meaning of ‘subscription’ would become relevant: “A written contract by which one engages to contribute a sum of money for a designated purpose, either gratuitously, as in the case of subscribing to a charity, or in consideration of an equivalent to be rendered, as a subscription to a periodical, a forthcoming book, a series of entertainments, or the like.”[2]  Hence, a ‘subscriber’ is “a person who agrees to receive something on a regular basis, e.g. a newsletter, a newspaper, a delivery of goods, a subscriber to a mailing list.”

The context of this article is subscription to equipment – hence, the definition below from an Indiana law may be relevant: “‘subscription program’ means a subscription service that, for a recurring fee and for a limited period of time, allows a participating person exclusive use of a motor vehicle owned by an entity that controls or contracts with the subscription service. The term does not include leases, short term motor vehicle rentals, or services that allow short term sharing of a motor vehicle”. See, IND. CODE § 9-32-11-20(e) (2019)[3].

Under a vehicle subscription, a customer typically pays a “joining fee” plus a monthly subscription fee to have the right to use a vehicle from the company’s fleet of vehicles and to swap the vehicle for a different type of vehicle. Depending on the pricing tier, a customer may have unlimited swaps or may be limited to a certain number of swaps. A customer can initiate an exchange through the company’s mobile application, and the company will deliver the new vehicle and retrieve the vehicle currently in the customer’s possession. The company provides insurance coverage and access to roadside assistance and performs routine maintenance and repairs on the vehicles. See, House Bill, 537 (Northern California)[4] defining “vehicle subscription” for the purpose of applicability of alternative highway use tax.

Hence, one may define a subscription as follows:

A subscription contract is a contract where a subscriber avails a service, whether with or without a related asset, equipment or property, tangible or intangible, for a charge known as subscription fee, where the service provider agrees to provide, for a specified period, generally renewable at the option of the subscriber, a specific service. If an asset or equipment is put in the possession of the subscriber as a part of the service, the subscriber’s control over the same will be limited to the terms of the service, and generally, the service-provider shall have the ability to replace the same, whether for the purpose of a more effective service or otherwise.

Lease vs. subscription

The words lease, rent or hire mean the same thing – that is, transferring the right to use an asset. The act of ‘transferring’ right of use would mean that the lessee would have the exclusive right to use the asset and for that the asset as well as the control of the asset moves from the lessor to the lessee for the period of lease.

As one wonders, all of these would also happen in case of ‘subscription’ as discussed above; however, a fundamental difference is that, the customer’s intent in case of lease, is to have the ‘asset’ while in case of subscription, it is to have the ‘experience’ of the asset. Former is an ‘asset-oriented’ transaction, while the latter is a ‘service oriented’ transaction. Further, another important distinction lies in “commitment” to “an asset”. In a lease, the parties are committed to a particular asset identified at the beginning of the contract – replacements would only occur is the asset gets damaged or otherwise goes into an unusable state; however, inherent idea of ‘subscriptions’ is ‘choice’ and ‘flexibility’[5].

Hence, leases are different – differences are being tabulated below:

Point of Comparison Lease Subscription
Subject matter of the contract Transfer of right to use of an asset Provision of a service
Description of parties Lessor, lessee or renter Service Provider, Subscriber
Consideration Lease rentals or hire charges Subscription fee
Typical period Normally long enough to serve as an alternative mode of acquisition of an asset Normally short and flexible, such it is an alternative to acquisition itself. It focuses on experience, rather than acquisition
Identification of the asset Specifically identified Generically identified – such as a car of a particular type or category or class.
Ownership of the asset Throughout the term, remains with the lessor. EoT options may include an option to buy A subscription contract moves completely from the domain of asset acquisition – asset acquisition becomes irrelevant for a subscriber, as the subscriber continues to avail the service on a continuing/recurring basis
Provision of asset-related services by the owner Usually limited; however wet leases are also there Usually, the bundle of service makes it a service contract.
Control over the asset Remains with the lessee during the lease term Remains with the owner/service provider. Subscriber’s control is limited to what is required for the enjoyment of the service
Vehicle registration Normally, in the name of the lessee, with endorsement in the name of the lessor Normally, in the name of the lessor, under a rental contract
Vehicle number plate As in case of a private use vehicle, black colour in white background Commercial use- hence, black colour on yellow background
GST applicability A lease, being a transfer of right to use goods, is taxable at the same rate as applicable to the sale of the goods A subscription service, not involving a transfer of right to use, being a service, is taxable at the residual rate, viz., 18%
Asset recognition by customer Yes, as under the accounting standards No

Legal Implications

Legal classification of a transaction is important as the same would impact the legal rights and obligations of the parties.

Since a subscription is a bundle of services, it may also have elements of lease. A subscription is essentially a package; hence, the use of an asset is also embodied in a subscription. Hence, to the extent a subscription entails a right of using an asset, there is a bailment contract in a subscription too. Hence, bailment is a common feature of both leases and subscription contracts. Therefore, the rights and obligations of the bailor and bailee as per law of contracts may be applicable in case of subscription too.

Thus, from a broader perspective, both a lease and a subscription are forms of bailment contracts only as the possession passes to the customer. Hence, general contractual rules as are applicable to bailment contracts would apply in both the cases. Besides, from a legal perspective, the following may be noted  –

  • The supplier is the owner in both the cases, the customer only gets certain rights. In case of a lease, the customer is a conveyee of the right to use to the asset; however, in subscription, the customer only gets the right to use the service on payment of subscription fee. As such, supplier’s control on the asset in a subscription is higher than in a lease. Hence, vis-a-vis, the asset, the customer will have ‘better’ rights in a lease than in a ‘subscription’.
  • With respect to risk and rewards, as a lease transfers a right to use, a part of the risks and rewards (if not substantial) associated with the asset is transferred to the lessee. However, in a subscription, the risks and rewards would remain with the supplier, except that the contract would provide for normal liabilities in case of accidents, negligence, rash driving, unlawful use of the vehicle, etc.
  • Besides, there can be differences with respect to service and maintenance obligations. A subscription contract comes with bundled services; however, in lease, the obligations may pass to the lessee.

Note that due to the features as discussed above, in India, a subscription service may get covered under Rent a Cab Scheme, 1989. Thus, as under the Motor Vehicles Act and rules thereunder, the vehicle would be registered in the name of subscription provider and the number plate of the vehicle shall bear yellow alpha-numerals with black background registration mark. However, in case of leases, the vehicle would generally be registered in the name of the lessee, and shall bear black colour in white background.

Accounting perspective

For accounting purposes, does a subscription of an asset amount to a lease? If it does, the accounting standard on leases IFRS 16/ Ind AS 116 applies. The standard will require on-balance sheet treatment of the non-cancellable lease rentals in the books of the subscriber in most cases. Hence, the characterisation of the transaction as a “lease” for the purpose of the accounting standard becomes critical.

Ind AS 116 provides guidance on assessing whether a contract is a lease. A lease is defined in Para 9 as follows: “A contract is, or contains, a lease if the contract conveys the right to control the use of an identified asset for a period of time in exchange for consideration” Therefore, there has to be a conveyance of the right to use an asset, which implies an identified asset.

In order for the contract to be a contract of lease:

  • there must be an identified asset;
  • the customer must have the right to direct use of the asset – where the supplier has substantive substitution rights (a combination of practical ability + economic benefits), the customer’s right to use is curtailed – see

It is notable that accounting standards quite often deviate from the legal form of the contract – hence, even if the legal form of the contract is a subscription, the accounting standards may still treat the contract as a lease. For example, IndAS 116, para B14 provides for the supplier to have substantive rights of substitution, that further, such right to be economically beneficial to the supplier.

Hence, for the purposes of accounting standards:

  • If the right of substitution or swapping the asset is with the subscriber, and not with the provider, such right is disregarded. That is to say, subject to other conditions, the transaction is still regarded as a lease.
  • If the right is right with the provider, that right has to be (i) substantive and practically implementable; (ii) The exercise of the right should be beneficial to the provider; (iii) the right should be available throughout the term of the lease; (iv) the substitution right should not be pertaining to such contingencies as the vehicle being under repairs, etc. As regards the economic benefits of the substitution rights, the economic benefits should be demonstrable without reference to uncertain future events. Further, since the vehicle is in possession of the subscriber, the provider will incur costs to replace the same – therefore, it should be clear that the benefits will outweigh such costs.
  • Assuming the conditions of substantive substitution rights as above are not satisfied, the contract may be regarded as one of lease, deviating from its legal nature. However, if the lease is within a term of 12 months, the provisions as to capitalisation of an RoU asset and OTP liability are not applicable to short term leases.

Hence, a typical subscription contract, which enables the subscription provider to provide service to the customer by using different vehicles (which belong to the preferred class/category chosen by the customer), it may be contended that the customer’s right to use is not perfected in such contracts. Further, given that the customer can ‘swap’ vehicles during the subscription period, it can be said that a subscription contract does not have an ‘identified asset’, per se.

Notably, accounting standards emphasise on substance over form. Hence, a pure subscription contract may not fall under Ind AS 116 (for reasons as above).

GST Implications

The GST law has different rates for motor vehicles. There are broadly 4 classes:

  • Hiring services (normally meaning the vehicle is under control of the hire vendor, and the hire vendor is running the asset on hire):
    • Transport of passengers by any motor vehicle designed to carry passengers where the cost of fuel is included in the consideration charged from the service recipient- GST rate is 5% (provided no ITC is availed by the supplier)
    • Transport of passengers by any motor vehicle designed to carry passengers where the cost of fuel is included in the consideration charged from the service recipient- GST Rate is 12%
  • Leasing or Rental services – indicating short term rentals: GST Rate is 18%
  • Transfer of right to use, that is, a service equivalent to sale of the same goods: Same GST rate as in case of sale of the goods with transfer of ownership [Refer, Notification No. 11/2017- dated 28th June, 2017[6]]

The GST rate on the various subscription models prevalent in the market varies and depends on the nature of transaction between the dealer and the end user. In our view, the subscription-based model is close to a rental service, and therefore, the rate will be 18%. Alternatively, if it is taken as an independent service the rate of tax is still 18%. On the question whether such a subscription service may be regarded as a ‘composite supply’, the tax rate on the principal supply shall determine the tax rate on the conjugate services. However, since the principle supply is still a lease or rental and not a transfer of right to use akin to purchase of the asset, the rate would still stand as 18%.

Closing remarks

It is not that subscription contracts per se  are a technological innovation, but the idea of an asset being converted into a subscription service is quite new, relative to the idea of leasing or hiring. Hence, the first predicament for one trying to state the law of subscription vs. lease is that there is no authoritative definition of a subscription, as compared to a lease.

The discussion is an attempt to identify key differentiators between lease and subscription. Essentially, a subscription contract is ‘service’ based while a lease is ‘asset’ based. However, classification of a particular contract would depend on the substance of the transaction rather than the form. A contract may be a subscription by name, but may have predominantly lease-type features. However, merely because a contract has some lease-type features would not lead to its classification as lease. Hence, one will have to assess what is the predominant flavour of the contract and of course, intent of the parties to the transaction to determine whether the contract is a lease or a subscription.

[1] https://www.bcg.com/en-in/publications/2021/how-car-subscriptions-impact-auto-sales

[2] https://dictionary.thelaw.com/subscription/

[3] https://law.justia.com/codes/indiana/2019/title-9/article-32/chapter-11/section-9-32-11-20/

[4] https://dashboard.ncleg.gov/api/Services/BillSummary/2019/H537-SMSV-44(e4)-v-2

[5] See an article titled “Insurers are Teaming up with Car Subscriptions”, published in CBInsights (2018). Per Porsche North America CEO Klaus Zellmer, younger people “do not want to engage with a commitment for three years. They want to change their phones; they want to change their TV channels. It’s all about subscriptions.”

[6] https://www.cbic.gov.in/resources//htdocs-cbec/gst/Notification11-CGST.pd

 

Our other articles on leasing:

https://vinodkothari.com/leasing/

https://vinodkothari.com/leashome/

https://vinodkothari.com/staff-publications-leasing/

Sale and leaseback transactions: Walking once again on Achilles’ Heels

Vinod Kothari ( finserv@vinodkothari.com)

Sale and leaseback (SLB) transactions are one of the most innovative, and in the past history of lease transactions, one of the most maligned transaction types. All over the world, there have been hundreds of rulings where SLB transactions have been challenged; in many cases, there were upheld and their sanctity was preserved, in many other cases, they have been treated either as no valid lease transactions, or pure financing transactions.

Motivations

There may be various motivations for a lessee to get into an SLB:

  • Liquidity – while normal lease transactions do not lead to cash in the hands of the lessee, SLBs do, SLBs extend leasing to a device of unlocking of investment. The  money raised by SLBs is like general purpose corporate funding – it may be used for any purpose as the lessee may choose.
  • Putting assets off the books – A selling lessee may put the asset being sold off the books, if the SLB is properly structured as a sale and operating leaseback.
  • Financial restructuring – if the money raised by an SLB is used to pay off on-balance sheet liability, the SLB may have twin effects on the balance sheet. By putting fixed assets off the books, it reduces operating leverage, and by reducing liabilities, it reduces financial leverage.
  • Capturing revaluation gains – assume there are assets where the carrying values as per books are significantly lower as compared to the fair market value. In such cases, if the SLB is properly structured as operating leaseback (other conditions also need to be satisfied), the gain on the sale of the asset may be booked as realized gain (not just a revaluation surplus), and may be taken to shareholders’ equity.
  • Tax benefits – many SLBs, such as those of cars, furniture, etc., may be designed to accelerate the tax write off of the lessee by moving from depreciation to rental write off.
  • Acceleration of VAT set off – an entity having substantial amount of carry forward of input tax credit may accelerate the set off by making a sale of capital assets.

Why SLBs walk on Achilles’ heels:

An SLB transaction has the apparent looks of a financial transaction. There is only a transfer of legal title over the asset. The asset stays with the lessee. In practice, parties may take quite callous approach evaluating the asset, and may take a purely lessee exposure, in which case, most often lessor may not bother about valuation of the asset. In many cases in the past, assets have been found not even to be existing.

Besides, in many cases, lessees in SLBs have been motivated either by a funding motive, or one of booking profits on the sale of the asset. Therefore, lessees may have aggressively overvalued assets.

In India, one of the ill-famed example of SLBs has been the SLB of electric meters by state electricity boards (SEBs). SEBs, starved of funding, were advised to use the innovative funding device of leasing back electric meters that were installed in consumers’ premises. Leasing companies (and in fact, many entities not in leasing business at all), starved of tax benefits, were easily attracted to this option, as it was contended that electric meters qualify for 100% depreciation. Many SLB transactions of electric meters happened around 1996-1997. Many of these cases have already traveled long routes of litigation. Some High courts have challenged them as being pure financing devices. Some have respected them, merely based on the legal nature of the contract.

In one of the recent rulings before the Madras High court, electric meters were shown to have been bought on 30th March – hence, used for just one day. In fact, meters actually bought by the selling SEB only a few months back were heavily revalued too. Despite such glaring facts, the Madras High court still went by the legal form, and upheld the lessor’s claim to depreciation.

Electric meters is not the only thing – many weird assets such as glass bottles, gas cylinders, tools, jigs, and so on have been sold and taken back on lease. In recent past, we have noticed transactions structured to give lessees a rental write off – hence, SLBs of sanitary fittings, office fitouts, office interiors, wall panels, false ceilings, etc have commonly been done.

As most of these transactions are factually very weak, SLB transactions continue to look like money lending transactions.

Types of SLBs:

First of all, the most essential distinction will  be on – is it a new asset or old asset? Since it is SLB, sure enough, it is not a new asset being acquired by the lessee, but the moot question is – has the asset been subject to use for a long period? There are cases where lessees might have recently bought assets, and may now want to get them off the books. Needless to say, older the asset, more serious the concerns, as the chances of overvaluation, or sale of decrepit assets purely with financial motives, etc., go up.

From accounting viewpoint, SLBs may be sale and financial leasebacks, and sale and operating leasebacks. We discuss the implications under the caption accounting issues.

Note that the following is not a case of sale and leaseback – X has leased an asset to Y, and X now sells the leased asset to Z, such that now the lease continues between Z and Y.

Lease and leasebacks are also not sale and leasebacks. A lease and leaseback transaction may be structured from variety of viewpoints – longer lease out, and shorter leaseback, or financial lease out and operating leaseback, etc.

Legal issues

First key question is – is an SLB legally valid as a lease? US Supreme Court discussed the legal validity of SLBs in the famous ruling of Frank Lyon and Company. The questions on the legal validity of an SLB are in fact questions which are germane to the validity of any lease. By way of a quick check (each of the factors below are negatives):

  • The asset being sold might have become an immovable property.
  • The asset being sold may have become inseparable part of another asset.
  • The lessor may not have done anything to indicate that the lessor is really interested in the asset, or that the asset is a genuine purchase of an asset. Facts may indicate that the lessor merely went by the financials of the lessee.
  • The asset may have been subject matter of third party rights. For example, the asset might already have been leased to a third party, in which case, it cannot be sold without the concurrence of the third party. The asset might have been encumbered, and so on.
  • In  not-so-extreme cases, the asset may not at all exist, or may have outlived its life.

If facts are strong, there is nothing to challenge the legal validity of an SLB, merely because it is an SLB and not a lease of a new asset. Of course, the lessor must do everything that a prudent man would do, if really buying an asset for good value.

Income Tax issues

In case of assets which have already been depreciated by the lessee prior to their sale, income-tax law has an explanation below section 43 (1) whereby the tax WDV in the hands of the lessor will be the tax WDV in the hands of the selling lessee. That is to say, the actul sale price of the asset will be ignored, and the seller’s WDV will become the WDV of the acquiring lessor. Obvious enough, if the asset has not been depreciated by the seller, the provision does not apply. If the asset has been sold in the same financial year in which it is acquired, the seller does not claim tax depreciation.

Other than the above specific SLB-directed provision, in actual practice, tax officers question eligibility of financial lease transactions to depreciation for the lessor or rental write off for the lessee. The real culprit for tax purposes is not a financial lease, but such a lease which is a disguised financial transaction, particularly transactions containing options to buy at bargain prices. SLB transactions may especially be targeted as engineered to produce an artificial tax shelter – for example, a sale of office furniture which is taken back on lease.

VAT issues

VAT is one of the least understood implications – in fact, for VAT purposes, SLBs are no different from any other sales. Where capital assets are sold by the selling lessee, the sale is a taxable sale (assuming the seller is in some business where he generates taxable sales). Presumably, when the asset was acquired, it might have been acquired either under CST, or it might have been imported, or might have been acquired under some state VAT law (that is, the asset was acquired after introduction of VAT laws in the country). If the asset had suffered VAT at the time of its purchase, such VAT might have been eligible for set off (assuming the capital asset was not one of the negative-listed capital asset). If the asset was bought under CST or was an imported asset, the question of any VAT set off at the time of acquisition would not arise at all.

In any case, the sale of the asset would certainly be a local sale. The question of an SLB being an inter-state sale does not arise at all. The local sale will be chargeable to VAT. Of course, if the selling lessee has carry forward of input tax credit, the same can be claimed against the VAT on the sale of the capital asset.

As the asset is taken back on lease, there is clearly a VAT on lease rentals. This is also off-settable by lessee.

In the hands of the lessor, the VAT paid on the purchase of the asset is off-settable in the same manner as any other VAT.

Accounting standards

Accounting standards distinguish between SLB where the leaseback is financial, and SLB where the leaseback is operating.

If the leaseback is financial, the fact of sale of the asset is completely disregarded. No profit is booked on the sale of the asset, as there is no accounting sale of the asset at all. The amount of funding raised by the sale of the asset appears as a liability on the books of the lessee.

If the leaseback is operating lease, the asset goes off the books, and the funding realized does not come as a liability, Any gain or loss on the sale of the asset is a realized gain, and is taken to profit and loss. In fact, there is something even further: if the sale price is not fair market value of the asset, profits are recognized based on the fair market value of the asset.

Complete Guide to Sale and Leaseback Transactions

A guide to concepts, taxation, and accounting aspects of sale and leaseback transactions.

 

– Qasim Saif (finserv@vinodkothari.com)

 

Contents

Sale and Leaseback transaction. 2

Advantages to the Lessee. 2

Unlocking value, the hidden value of asset 2

Tax Benefits. 2

Legal issues in SLB: 3

Taxation of SLB transactions. 3

Direct Tax Aspect 3

Goods & Service Tax. 5

The Sale. 5

The Lease. 5

Place of supply. 6

Disposal of Capital Asset 6

Example of GST Calculations on Sale and Leasebacks. 6

Sale of Asset 7

Leasing of asset 7

Accounting of Sale and leasebacks. 7

Criteria for Sale. 8

Transfer of asset does not qualify as sale. 10

Transfer of asset qualifies as sale. 10

Sale at Fair Value. 10

Sale at a discount or premium.. 10

Example of Sale and Leaseback Accounting under Ind AS 109. 11

Calculations. 11

Rental Schedule. 11

Accounting Entries at Inception. 12

 

Sale and Leaseback transaction

A Sale and Leaseback (SLB) is a special case of application of leasing technique. Lease is a preferred mode of using the asset without having to own it. In case of leases, the lessee does not own the asset but acquires the right to use the asset for a specified period of time and pays for the usage.

SLB is a simple financial transaction which allows selling an asset and then taking it back on lease. The transaction thus allows a seller to be able to use the asset and not own it, at the same time releasing the capital blocked by the asset.

SLB allows the lessee to detach itself with legal ownership yet continuing to use the asset as well. In effect there is no movement of asset however on paper there is a change in the title of the asset.

Sale and Leaseback transactions are globally common in the Real estate investment trusts (REITs) and Aviation industry.

Advantages to the Lessee

Unlocking value, the hidden value of asset

As is evident from the mechanics of SLB above, SLB results in taking the asset off the books of the lessee and results in upfront cash which could be used for paying off existing liabilities. Hence this does not impact the existing lines of credit the lessee may be availing.

SLB can help entities raise finance for an amount equal to fair market value of the asset which may be significantly higher than its book value. Though there might be taxation challenges attached to it in Indian context. Nevertheless, SLB may bring about a financial advantage as well wherein a high-cost debt can be substituted with a low-cost lease liability.

Most of the assets considered for SLB have been used by the lessee for a substantial period of time and the value of the physical assets may be insignificant. Hence SLB is sometimes referred to as junk financing.

Tax Benefits

SLB may sometimes lead to tax benefits as well (we shall see this in detail in the sections below). This has been one of the major drivers of SLB transactions in India and has its own downsides as well. One of the major pitfalls to SLB is the danger of excess leveraging; the lessee may tend to overvalue the asset. Considering that SLB is a mode of asset-backed lending but the asset has may not have much value and the lessee may exercise discretion on the application of funds poses threat of misuse of the product.

Legal issues in SLB:

The legal validity of SLB was discussed by the U.S Supreme Court in the landmark ruling of Frank Lyon and Company[1]. In Frank Lyon’s case the bank took the building on SLB. Under the lease terms the bank was liable to pay rentals periodically and had the option to purchase the building at various times at a consideration based on its outstanding balance. The bank took possession of the building in the year it was completed and the lessor claimed deductions on depreciation, interest on construction loan, expenses related to sale and lease back and accrued the rent from the bank.

The Commissioner of Internal Revenue denied the claims of the petitioner on the grounds that the petitioner was not the owner of the building and the sale and leaseback was a mere financing transaction. The Hon’ble Court held that –

Where, as here, there is a genuine multiple-party transaction with economic substance that is compelled or encouraged by business or regulatory realities, that is imbued with tax-independent considerations, and that is not shaped solely by tax-avoidance features to which meaningless labels are attached, the Government should honor the allocation of rights and duties effectuated by the parties; so long as the lessor retains significant and genuine attributes of the traditional lessor status, the form of the transaction adopted by the parties governs for tax purposes.

The fundamental principle is that the Court should be concerned with the real substance of the transaction rather than the form of the same. If there are reasons to believe that the form of the transaction and its real substance are not aligned, the Court must not be simply concerned by the form of the transaction nor by the nomenclature that the parties have given to it.

In India too, the legality of SLB transactions have been questioned in several cases; sometimes the transactions have come out clean while in some cases, SLBs were considered an accounting gimmick.

The legality of SLB transactions and analysis of various judicial pronouncements on the same, have been discussed in detail in our write up “Understanding Sale and leaseback

Taxation of SLB transactions

Tax aspects specifically direct tax acts as a major motivation behind such transactions, SLB provides a creative playground for finance professionals to structure transactions in a manner that can lead to substantial benefit to the entity, and taxation acts as a major tool at their disposal.

Direct Tax Aspect

Though tax benefits have been a motivator for SLB transaction, the same has also been the reason for near wipe-out of SLB from Indian markets.

During the 1996-98 period one of the most infamous cases was the sale and leaseback of electric meters by state electricity boards (SEBs). For SEBs it made perfect sense as it amounted to cheap borrowing by the cash starved SEBs who had practically no other source of borrowing.

For leasing companies and others looking for a tax break, it was a perfect deal as there was 100% write off in case of assets costing Rs 5000 or less. Thus, an electric meter will qualify for 100% deduction. Several SEBs had undertaken such transactions in those days. Obvious enough the sole motive was tax deduction no one would care about the value, quality, existence etc of the meters. In some cases, the asset was bought on 30th March to be used only for a day, assets revalued heavily at the time of sale to leasing companies etc. Lease of non-existing assets such as electric meters, computers, glass bottles, tools, etc, lure of depreciation allowances caused the tax authorities to come down hard on sale and leaseback transactions calling them tax evading transactions. The whole fiasco of such sham transactions resulted in leasing going off the market completely. The burns of the past continue to linger even after a decade and half since SLB transactions were completely written off.

The most significant consideration in lease transactions is the depreciation claim. For tax purposes, depreciation is calculated on the block of the assets and not on the written down value of each asset separately.

Section 2(11) of the Income Tax Act, 1961 (IT Act) defines block of assets to mean

“”block of assets” means a group of assets falling within a class of assets comprising—

(a) tangible assets, being buildings, machinery, plant or furniture;

(b) intangible assets, being know-how, patents, copyrights, trade-marks, licences, franchises or any other business or commercial rights of similar nature, in respect of which the same percentage of depreciation is prescribed.”

The sale proceeds of the assets sold are deducted from the written down value of the block. In case of SLB transaction, assets are sold at higher than written down value, and the gain made on such a sale results in reduction in depreciable value of the block of assets. The reduction in depreciation will be allowed over a number of years. Similar would be the case in case the asset was sold at less than written down value, sale consideration would be reduced from the block of the assets.

Once the asset is sold and taken off the books of the lessee, the lessee is able to account for an immediate accounting profit without having to pay tax on it instantly. As under the block concept of depreciation, when the lessee sells the capital assets, the sale proceeds including the profits on sale are allowed to be deducted from the block of assets and hence there is no immediate tax on the accounting profits.

Also, typically the asset is recorded on historical costs which may be lower than the intrinsic value of the asset. SLB sometimes allows the entities to unlock the appreciation in value. However, it is not always necessary that the asset would have appreciated value. In some cases, the asset may have become junk completely.

To avoid the same revenue has introduced following provisions in the IT act, in order to restrict undue benefits being passed by use of sham SLB transactions:

Section 43 (1) provides for treatment of sale and lease back transactions for tax purposes, the relevant extracts are reproduced below –

“Explanation 3.—Where, before the date of acquisition by the assessee, the assets were at any time used by any other person for the purposes of his business or profession and the Assessing Officer is satisfied that the main purpose of the transfer of such assets, directly or indirectly to the assessee, was the reduction of a liability to income-tax (by claiming depreciation with reference to an enhanced cost), the actual cost to the assessee shall be such an amount as the Assessing Officer may, with the previous approval of the Joint Commissioner, determine having regard to all the circumstances of the case.”

“Explanation 4A.—Where before the date of acquisition by the assessee (hereinafter referred to as the first mentioned person), the assets were at any time used by any other person (hereinafter referred to as the second mentioned person) for the purposes of his business or profession and depreciation allowance has been claimed in respect of such assets in the case of the second mentioned person and such person acquires on lease, hire or otherwise assets from the first mentioned person, then, notwithstanding anything contained in Explanation 3, the actual cost of the transferred assets, in the case of first mentioned person, shall be the same as the written down value of the said assets at the time of transfer thereof by the second mentioned person.

Explanation 3 and 4A of Section 43 (1) restricts the consideration at which the lessor purchases the assets to written down value of the asset as appearing in the books of the lessee before it was sold and taken back on lease. The explanation explicitly states that the sale value for such sale and lease back transactions will be ignored and depreciation will be allowed on the first seller’s depreciated value. Take, for instance, A purchased machinery for Rs. 10 crores from B, though the WDV in the books of B is Rs. 2 crores. A can claim depreciation on Rs. 2 crores and not on Rs. 10 crores.

The said provisions removes any motivation for the lessor to carryout transactions at inflated values. Hence preventing junk financing to enter into SLB transactions.

Goods & Service Tax

Pre-GST indirect taxation regime acted as a major road block in the development of leasing industry as a whole, the legal differentiation as well as non-availability of credit among central and state taxes made leasing transactions costly.

Introduction of GST is playing a key role in development of leasing industry, from a stage where it had nearly become extinct. We have further discussed GST implications on leasing.

The Sale

The first leg of the transaction would involve sale of Assets by lessee to lessor.

In terms of section 7(1)(a) “all forms of supply of goods or services or both such as sale, transfer, barter, exchange, licence, rental, lease or disposal made or agreed to be made for a consideration by a person in the course or furtherance of business;”

The taxability under GST arises on the event of supply accordingly the sale of capital assets for a consideration would fall under the ambit of supply and accordingly GST shall be levied.

The Lease

The second part of transaction would lease back that is when the asset is leased back from buyer -lessor to seller lessee. The leaseback would be subject to GST like any other lease transaction.

The term lease has not been defined anywhere in GST Act or Rules. To classify a lease transaction as either supply of goods or supply of service, we have to refer Schedule II of the CGST Act, 2017 where in clear guidelines for classification of a transaction as either “supply of goods” or “supply of services” has been enumerated, based on certain parameters: –

  • Any transfer of the title in goods is a supply of goods;
  • Any transfer of right in goods or of undivided share in goods without the transfer of title thereof, is a supply of services;
  • Any transfer of title in goods under an agreement which stipulates that property in goods shall pass at a future date upon payment of full consideration as agreed, is a supply of goods.
  • Any lease, tenancy, easement, licence to occupy land is a supply of services;
  • Any lease or letting out of the building including a commercial, industrial or residential complex for business or commerce, either wholly or partly, is a supply of services.

Place of supply

Undoubtedly, the SLBs do not involve movement of goods, the seller lessee continuous to be in possession of leased asset even after the sale. Hence, In the case of such sale, there is no physical movement of the asset from the premises of the lessee to the premises of the lessor. The ownership gets transferred in the premise of the lessee.

In terms of Section 10(1)(c) of the IGST Act, the place of supply of goods where the supply does not involve movement of the said goods whether by the supplier or the recipient shall be the location of such goods at the time of delivery to the recipient. Accordingly, the place of supply in this case will be same as the location of the supplier. Accordingly, the sale of the asset will be considered as an intra-state supply as per Section 8 of the IGST Act and will be subjected to CGST + SGST.

Disposal of Capital Asset

Applications of GST on disposal of capital assets is one of the major deterring factors of in SLBs. Section 18(6) of the CGST Act,2017 state that:

In case of supply of capital goods or plant and machinery, on which input tax credit has been taken, the registered person shall pay an amount equal to the input tax credit taken on the said capital goods or plant and machinery reduced by such percentage points as may be prescribed or the tax on the transaction value of such capital goods or plant and machinery determined under section 15, whichever is higher:”

Entry no. (6) Of Rule 44 of CGST Rules, 2017: Manner of Reversal of ITC under Special Circumstances which reads as under: –

“The amount of input tax credit for the purposes of sub-section (6) of section 18 relating to capital goods shall be determined in the same manner as specified in clause (b) of sub-rule (1) and the amount shall be determined separately for input tax credit of central tax, State tax, Union territory tax and integrated tax:”         

“……………..Clause (b) of sub rule 1 of same rules states that :

(b) for capital goods held in stock, the input tax credit involved in the remaining useful life in months shall be computed on pro-rata basis, taking the useful life as five years………….”

Generally, the lessor procures the capital Assets at WDV due to Income tax Act implication. In that case WDV as per Income tax act would be the transaction value.

Example of GST Calculations on Sale and Leasebacks

Let’s consider a numerical example: an Entity A enters into SLB arrangement with an Entity B. A sells its machinery to B for Rs. 5,00,000/- as on 31st May 2021. The entity had purchased the asset for Rs. 6,00,000/- as on 31st March 2019.

B then leases back the asset to A for a yearly rental of Rs, 1,00,000/- for 3 years term with a purchase option at the end of 4th year at Rs. 2,50,000. (Assumed to be exercised)

(GST @ 18%)

Sale of Asset
Disposal of assets

On disposal asset, GST will be charged on the selling price of the asset. However, the amount to be deposited to the government with respect to this sale transaction shall be higher of the following:

  1. GST on the sale consideration;
  2. ITC reversed on transfer of capital asset or plant and machinery based on the prescribed formula

Portion of ITC availed on the asset, attributable to the period during which the transferor used the asset:

6,00,000 * 18% * (5% * 8) = 43200

Remaining ITC = (6,00,000 * 18%) – 43200 = 64800

GST on the selling price = 500000 * 18% = 90000

Therefore, GST to be paid to the government is 90000, that is higher of the two amounts discussed above.

Leasing of asset

As mentioned above GST shall be chargeable to lease rental, at the rate similar to that charged on acquisition of leased asset. Accordingly, Entity B shall charge GST on rentals for an amount of Rs. 18,000/- (Rs. 1,00,000/- * 18%).

Further GST shall also be charged on sale of asset at the end of lease tenure for an amount of Rs. 45,000/-(2,50,000*18%).

Accounting of Sale and leasebacks

IAS 17 covered the accounting for a sale and leaseback transaction in considerable detail but only from the perspective of the seller-lessee.

As Ind AS 116/IFRS 16 has withdrawn the concepts of operating leases and finance leases from lessee accounting, the accounting requirement that the seller-lessee must apply to a sale and leaseback is more straight forward.

The graphic below shows how SLB transactions should be accounted for:

Criteria for Sale

IFRS 16/Ind AS 116 state that

“ An entity shall apply the requirements for determining when a performance obligation is satisfied in Ind AS 115 to determine whether the transfer of an asset is accounted for as a sale of that asset.”

Accordingly, when a seller-lessee has undertaken a sale and lease back transaction with a buyer-lessor, both the seller-lessee and the buyer-lessor must first determine whether the transfer qualifies as a sale. This determination is based on the requirements for satisfying a performance obligation in IFRS 15/Ind AS 115 – “Revenue from Contracts with Customers”.

The accounting treatment will vary depending on whether or not the transfer qualifies as a sale.

The para 38 of Ind AS 115/IFRS 15- Performance obligations satisfied at a point in time, provides ample guidance on determining whether the performance obligation is satisfied.

The para states that:

“If a performance obligation is not satisfied over time in accordance with paragraphs 35– 37, an entity satisfies the performance obligation at a point in time. To determine the point in time at which a customer obtains control of a promised asset and the entity satisfies a performance obligation, the entity shall consider the requirements for control in paragraphs 31–34. In addition, an entity shall consider indicators of the transfer of control, which include, but are not limited to, the following:

(a) The entity has a present right to payment for the asset—if a customer is presently obliged to pay for an asset, then that may indicate that the customer has obtained the ability to direct the use of, and obtain substantially all of the remaining benefits from, the asset in exchange.

(b) The customer has legal title to the asset—legal title may indicate which party to a contract has the ability to direct the use of, and obtain substantially all of the remaining benefits from, an asset or to restrict the access of other entities to those benefits. Therefore, the transfer of legal title of an asset may indicate that the customer has obtained control of the asset. If an entity retains legal title solely as protection against the customer’s failure to pay, those rights of the entity would not preclude the customer from obtaining control of an asset.

(c) The entity has transferred physical possession of the asset—the customer’s physical possession of an asset may indicate that the customer has the ability to direct the use of, and obtain substantially all of the remaining benefits from, the asset or to restrict the access of other entities to those benefits. However, physical possession may not coincide with control of an asset. For example, in some repurchase agreements and in some consignment arrangements, a customer or consignee may have physical possession of an asset that the entity controls. Conversely, in some bill-and-hold arrangements, the entity may have physical possession of an asset that the customer controls. Paragraphs B64–B76, B77–B78 and B79–B82 provide guidance on accounting for repurchase agreements, consignment arrangements and bill-and-hold arrangements, respectively.

(d) The customer has the significant risks and rewards of ownership of the asset—the transfer of the significant risks and rewards of ownership of an asset to the customer may indicate that the customer has obtained the ability to direct the use of, and obtain substantially all of the remaining benefits from, the asset. However, when evaluating the risks and rewards of ownership of a promised asset, an entity shall exclude any risks that give rise to a separate performance obligation in addition to the performance obligation to transfer the asset. For example, an entity may have transferred control of an asset to a customer but not yet satisfied an additional performance obligation to provide maintenance services related to the transferred asset.

(e) The customer has accepted the asset—the customer’s acceptance of an asset may indicate that it has obtained the ability to direct the use of, and obtain substantially all of the remaining benefits from, the asset. To evaluate the effect of a contractual customer acceptance clause on when control of an asset is transferred, an entity shall consider the guidance in paragraphs B83–B86.”

It shall be noted that no single criteria can be taken as a determining factor for concluding that sale has taken place. Each criterion should be individually assessed every case. Needless to say, substance of the transaction should be adjudge based on principles set.

The criteria set out in the para 38 specified above can be summarised as follows:

  • There is a present right to payment has been established.
  • The legal tittle of the asset is transferred. It shall be noted that this shall not conclusively determine sale, rather a to be considered in consonance with another criterion.
  • Physical possession of the asset has been transferred. Now this is a matter of discussion, as under SLB, the possession never leaves the seller. However, in our view even in case of symbolic transfer of possession the criterion can be said to be satisfied subject to the condition that buyer-lessor has an ability to direct the use of asset. Hence, an entity should ensure that the buyer-lessor is not bound by sale agreement or otherwise to leaseback the asset.
  • Significant risk and reward attached to ownership are transferred to the buyer
  • The buyer has accepted the asset

Transfer of asset does not qualify as sale

If the transfer does not qualify as a sale the parties account for it as a financing transaction. This means that:

  • The seller-lessee continues to recognise the asset on its balance sheet as there is no sale. The seller-lessee accounts for proceeds from the sale and leaseback as a financial liability in accordance with Ind AS 109/IFRS 9. This arrangement is similar to a loan secured over the underlying asset – in other words a financing transaction
  • The buyer-lessor has not purchased the underlying asset and therefore does not recognise the transferred asset on its balance sheet. Instead, the buyer-lessor accounts for the amounts paid to the seller-lessee as a financial asset in accordance with Ind AS 109/IFRS 9. From the perspective of the buyer-lessor also, this arrangement is a financing transaction.

Transfer of asset qualifies as sale

Where the transfer qualifies as sale, there can be further two situations:

  1. Sale at Fair value
  2. Sale at discount or premium.
Sale at Fair Value

If the transfer qualifies as a sale and is on fair value basis the seller-lessee effectively splits the previous carrying amount of the underlying asset into:

  • a right-of-use asset arising from the leaseback, and
  • the rights in the underlying asset retained by the buyer-lessor at the end of the leaseback.

The seller-lessee recognises a portion of the total gain or loss on the sale. The amount recognised is calculated by splitting the total gain or loss into:

  • an unrecognised amount relating to the rights retained by the seller-lessee, and
  • a recognised amount relating to the buyer-lessor’s rights in the underlying asset at the end of the leaseback.

The leaseback itself is then accounted for under the lessee accounting model.

The buyer-lessor accounts for the purchase in accordance with the applicable standards (eg IAS 16 ‘Property, Plant and Equipment’ if the asset is property, plant or equipment or IAS 40 ‘Investment Property’ if the property is investment property). The lease is then accounted for as either a finance lease or an operating lease using IFRS 16’s lessor accounting requirements.

Sale at a discount or premium

The accounting methodology shall remain the same, However, Adjustments would be required to provide for the discounted or premium price.

These adjustments would be as follows:

  1. a prepayment would be recorded in order to provide for adjustment in regard to sale at a discount
  2. Any amount paid in excess of fair value would be recorded as an additional financing facility and accounted for under Ind AS 109.

Example of Sale and Leaseback Accounting under Ind AS 109

A sample spreadsheet calculations for the below example can be accessed here

Calculations

 

Particular Amount Remarks
Sale considerations ₹ 10,00,000.00
Carrying Amount ₹ 5,00,000.00
Term 15 year
Rentals/year ₹ 80,000.00 year
Fair Value of Building ₹ 9,00,000.00
Incremental borrowing rate 10%
PV of rentals ₹ 6,08,486.36
Additional Financing ₹ 1,00,000.00 Sale Consideration
– Fair Value
Payments towards Lease Rentals ₹ 5,08,486.36 PV of Rentals
– Additional Financing
Ratio of PV of rentals and
Payment towards lease Rentals
16%
Yearly payments towards Add. Financing ₹ 13,147.38 Rental X Ratio
Yearly payments towards Lease Rental ₹ 66,852.62 Rental – Payment toward Add. Fin.
ROU of Asset ₹ 2,82,492.42 Carrying Amount X
[Payments towards Lease Rentals/Fair Value of Building]
Total Gain on sale ₹ 4,00,000.00 Fair Value – Carrying Amount
Gain recognised Upfront ₹ 1,74,006.06 Total Gain X [(Fair Value of Building-Payments towards Lease Rentals)
/Fair Value of Building]

 

Rental Schedule

 

NPV NPV
₹ 5,08,486.36 ₹ 1,00,000.00
Year Lease Rentals Additional Financing
0
1  ₹ 66,852.62  ₹ 13,147.38
2  ₹ 66,852.62  ₹ 13,147.38
3  ₹ 66,852.62  ₹ 13,147.38
4  ₹ 66,852.62  ₹ 13,147.38
5  ₹ 66,852.62  ₹ 13,147.38
6  ₹ 66,852.62  ₹ 13,147.38
7  ₹ 66,852.62  ₹ 13,147.38
8  ₹ 66,852.62  ₹ 13,147.38
9  ₹ 66,852.62  ₹ 13,147.38
10  ₹ 66,852.62  ₹ 13,147.38
11  ₹ 66,852.62  ₹ 13,147.38
12  ₹ 66,852.62  ₹ 13,147.38
13  ₹ 66,852.62  ₹ 13,147.38
14  ₹ 66,852.62  ₹ 13,147.38
15  ₹ 66,852.62  ₹ 13,147.38

 

Accounting Entries at Inception

 

Buyer-Lessor
Building  ₹            9,00,000.00
Financial Asset  ₹            1,00,000.00
       Bank  ₹         10,00,000.00
*Lease accounted as per Finance or operating lease accounting
Seller-Lessee
Bank  ₹          10,00,000.00
ROU  ₹            2,82,492.42
          Building  ₹            5,00,000.00
          Financial Liability  ₹            6,08,486.36
         Gains on Asset Transfer  ₹            1,74,006.06

 

[1] 435 U.S. 561 (1978)