COMPUTER LEASING HAS TAX APPEAL, BUT…

Vinod Kothari

With the recent Indian tax law Notification increasing depreciation rates on computers, leasing companies in India have found a sudden spurt in their interest in leasing of computers. This article explains the nuances of computer leasing, the tax appeal, underlying risks and the best way to overcome them.

 Why computer leasing:

To every one’s knowledge, 1998 has been a bad year for Indian leasing – one of the worst-ever.

Wherever leasing is associated with tax deferrals, bad becomes worse. This is easy to understand – since every lease done leads to deferment of tax, a lessor has to be latched on to a high growth curve, to keep taxes at bay. Added business growth every year is required to shelter against current income, as also the reversal of past tax deferments. The moment the rate of growth fattens, past deferred taxes mature into whopping tax liabilities, so much so that in certain cases, the entire profit for the year may be completely wiped off in washing off the sins of history.

That is why, being into leasing is like riding the tiger: you cannot get off its back ever.

The current year, however, has brought along negative growth rates for most of the not-so-many companies that are still in business. Negative growth rates would certainly mean accelerated taxes. While leasing is generally associated with more reported profits with lesser taxable profits, the current year may result into a contrary situation for most companies, due to two significant factors:

  • The RBI’s provisioning norms, which seek to introduce from no-where-in-the-World a unique concept of “reversal” of incomes upon the asset becoming non-performing, which in all probability will form a part of taxable income.
  • Reversal of deferred taxes, as discussed above.

In this situation, leasing companies will be have to fight hard to protect their dwindling incomes against mounting tax burden. Surely, no one will dare, any more, to have wind mills or steel rollers, or similar silly stuff on books.

So, over to computer leasing. Leasing companies must act in time to book business, because there is every chance that there will be rush of lessors closer to the year-end, when most lessors will start balancing their books to discover large uncovered depreciation gaps. Smarter ones should therefore move quick.

 Enough of demand:

Given the fact that bankers do not normally finance computers, even though most companies would have invested substantial money into IT, the scope for financing computers seems substantial. There may be a good demand even for sale and leasebacks of existing stock.

Every where in the World, computer leasing is big business. But then, in most of the developed lease markets, computer leasing is offered with valued-added services, mostly with a cancellation option. Such leasing is normally offered either by the vendors themselves or by independent lessors with vendor tie-ups.

Vendor-leasing, or vendor-aided leasing, has not picked up in India, but computers is one area where active participation of vendors in leasing business will be a very welcome development.

 Attractive post-tax returns:

With a 60% depreciation rate, leasing of computers makes good post-tax sense. There is some scope for passing on of tax benefits in form of reduced IRRs, particularly with some structuring.

The Table below demonstrates the post-tax IRRs in an unstructured lease with 20% pre-tax IRR, for 2 years lease and 3 years lease. Apparently, very few lessors will be prepared to sign a lease for more than 3 years considering the steep commodity risk being taken. It may be noted that the target or hurdle rate of 13% has been taken based on an investment in a non-leasing transaction, say, hire-purchase, with the same IRR, i.e., 20%.

POST-TAX RATES OF RETURN IN COMPUTER LEASING

Assumptions: 20% pre-tax IRR, no structuring, no LMF/RSV, 35% tax rate

Hurdle rate =Post-tax IRR in a non-leasing deal with 20% pre-tax IRR =13%

2 years lease

3 years lease

September

14.76%

16.16%

October

12.80%

14.56%

November

13.16%

14.86%

December

13.55%

15.19%

January

13.98%

15.54

February

14.44%

15.91%

March

14.95%

16.32%

Source: All calculations based on our spreadsheet PTIRR.

As is apparent, as we proceed towards the fiscal year-end, the economics of computer leasing will sharply improve, because of our half-yearly depreciation convention.

It is also worth-noting that a security deposit from the client in a computer-leasing transaction will have a very positive impact on the post-tax IRRs. The impact of security deposit on lease economics is a very intriguing issue in itself, and has been discussed in detail in Vinod Kothari’s Lease Financing and Hire-purchase 4th edition, Chapter 4.

 The tax rule of 60% depreciation:

The Income-tax (12th Amendment) Rules, 1998 [Notification no. 781(E) dated 4th September, 1998] has inserted a 60% depreciation rate for computers in the Depreciation schedule.

The entry includes computers only. It therefore does NOT include:

  • Printers
  • Computer software other than the operating system

However, the operating software, being essential to make a computer operate, would be regarded as a part of the computer. Besides, under present-day computing, plug-N-play devices are an integral part of a computer, and should also be considered as a part of a computer. Notebooks are also computers.

Amount spent on acquisition of software may be taken as acquisition of intangible assets, qualifying for 25% depreciation under the new rate inserted for intangible assets.

Sale and leaseback possibilities:

Almost every large business organisation would have invested millions in computer equipment: therefore, there is a substantial scope for sale and leaseback (SLB) transactions. Notably, for income-tax purposes, a transaction would be covered by this explanation only when the computers are acquired on lease by the seller.

Explanation (4A) to sec. 43 (1) allows a lessor to claim depreciation, in an SLB transaction, at the WDV in the hands of the seller, irrespective of the purchase price of the lessor. This rule can be taken both as a precaution as well as a business opportunity. See illustrations below:

  • A company acquired computers worth Rs. 100 lacs in 1997-98, having claimed 25% depreciation. It proposes a sale and leaseback in 1998-99. The lessor assesses the value to be Rs. 90 lacs.

Caution: Even if you buy the computers for Rs. 90 lacs as assessed, depreciation will be allowed with reference to Rs. 75 lacs being the WDV of the seller-lessee.

  • As above, computers acquired for Rs. 100 lacs in 1997-98, and 25% depreciation was claimed in 1997-98. The lessor assesses the value of be Rs. 60 lacs.

Opportunity: Even if the computers are bought for Rs. 60 lacs, the lessor would be able to claim depreciation with reference to Rs. 75 lacs, being the depreciated value. Note that the Explanation ignores the purchase price and looks at the WDV of the seller only.

While structuring sale and leaseback transactions, sales-tax implications must be carefully studied. In most of the States, computers have been notified as single point items. In Maharashtra, the sale of computers by the lessee may give rise to a VAT refund or set-off as the sale price will be lesser than the purchase price.

However, the sales-tax second-sale treatment would depend on whether the computers were originally acquired from within the State. If not, their sale may give rise to the first tax in the selling State.

Covering against asset obsolescence risk:

One of the biggest risks in computer leasing is the risk of obsolescence of the asset. Though the primary risk of obsolescence in financial leases is passed on to the lessee by a non-cancellability clause in the agreement, this clause may be only a legal protection. As has been learnt out of hard experience in the past, asset-based security is the only protection against errors of judgement.

Therefore, a useful strategy in protecting against asset obsolescence risk is a must in computer leasing. There are two sides of the protection strategy: legal protection, and prudent structuring.

Legal Protection: Assured residual value clause:

Most lease agreements do not provide for an assured residual value clause. Many lease practitioners have a false notion that incorporating such a clause in the agreement will be fatal to the character of the lease. This is, however, misplaced.

A lease may be re-characterised as a hire-purchase transaction if promises a sale to the lessee. However, an assured residual value clause, or stipulated loss value clause, does not do so. All it provides is that should the agreement be terminated at any time before the completion of the lease tenure, the lessee guarantees that the asset will fetch a certain minimum value, depending on the timing of such termination. Incorporation of such a clause will have no adverse implications on the character of the lease, for, it is very natural for the lessor to seek a proper use assurance from the lessee. Given absolute liberty in use of the asset, the lessee may frustrate the lessor’s asset by misusing or abusing the asset. The assured residual value clause is only a quantified proper use assurance.

The assured residual value clause should mention values at different points of time, and should fully cover the lessor for his outstanding investment.

Good structuring of a computer lease: security deposit:

Besides legal protection in the agreement, a lessor should structure a computer lease properly, as to minimise asset-based risk. One of the best ways of securing this end is to collect an upfront security deposit, with interest at a decent rate.

This recommendation is based on two grounds:

One, an interest-bearing security deposit will increase the amount of deposit to hand with the lessor, thus, giving the lessor an increasing collateral over time.

Two, from post-tax consequences viewpoint, an interest-bearing security deposit will offer a better post-rate of return in the present case. This would be clear from an understanding of the 4 intricate rules of security deposit, elaborated in detail in Vinod Kothari: Lease Financing and Hire-purchase 4th edition, Chapter 4.

Lessors would be advised not to go very optimistic on security deposits, as a refundable security deposit leads to negative balances towards the end of the lease period, resulting into financial losses.

However, one of the best ways of achieving the positive aspects of interest-bearing security deposit, explained above, without facing the adverse consequence of financial losses, is to amortise the deposit against rental payments as soon as the accumulated balance equals the outstanding amount of rentals.