Indian Leasing: Thriving amidst nagging taxation infirmities by Vinod Kothari
On 10th September, 1998 this year, Indian leasing will celebrate its silver jubilee. [Click here for page titled 25 Years of Indian Leasing] It was on this day 25 years ago that Farouk Irani, an ex-Citibanker, incorporated the first leasing company of India, also named accordingly. It took almost a decade for any significant momentum, but the growth engine that picked up in 1983-84, and thereafter, intermittently through good times and bad, has today brought Indian leasing to the centre-stage of economic activity.
Leasing today forms an integral part of economic activity. There is a wide array of entities resorting to lease financing: Central Govt. owned railways have availed leasing for funding of rolling stock and other movable assets worth about Rs. 150 billion. A number of infrastructural utilities, power plants, industrial users, electricity companies, transporters, small businesses and consumers have availed of leasing from a range of lessors. Click here for a details of the composition of lessee market in India.
There are about 4000 leasing players in India. Of these, about 400 operate on a large scale, from more than one location and offer funding against a variety of assets. The rest are mainly into funding of commercial vehicles and proprietary concerns or family businesses. Click here for details of the composition of lessor market in India. Over years, Indian leasing has grown at an amazing rate and today achieved a pride place in global scene. Click here for data and India’s place in World leasing.
Predominantly financial leasing:
Leasing in India is essentially financial leasing: market and regulatory compulsions have yet not forced any major move towards operating leases though a larger number of players today talk about such leases. Within the generic financial leases, there are those, which are respected as leases for tax purposes, and those, which are not. [Click here for details about tax treatment of leases in India] The latter are known as hire-purchase agreements, and these carry a purchase option which is conspicuously absent in case of tax-acceptable lease transactions. Hire-purchase, being a British innovation, is a legacy of the British Raj and the earliest hire-purchase company in India was formed more than 70 years ago. [Click here for a brief history of hire-purchase in India.] Hire-purchase has over time been associated mainly with funding of the vehicles segment, and as an instrument, is clearly understood by the system.
On the other hand, leasing, a product of the eighties found its application mainly to plant and machinery. Historical reasons as to this identification of leasing with machinery segment, and hire-purchase with the vehicles segment, have ceased to exist over time, and the distinction between the two is very often blurred in practice. [Click here for the traditional distinction between leasing and hire-purchase, vanishing over time.] Most leases, therefore, look like hire-purchase, but it is important for tax purposes to safeguard the distinction. [Click here to go to document containing details of this distinction.]
Operating leases are talked about, not practised. [Click here for basic information about operating leases.] Generally, it is the accounting rules and tax regulations that have shaped market moves towards operating leases. These factors have by and large been absent in India. Accounting rules do make a distinction between financial and operating leases. Financial leases are not capitalised by lessees: they are merely disclosed by way of a note. Lessors’ revenue recognition is such that the net income credited by the lessor is the inherent financial income featuring in rentals, but that is hardly a compulsive enough reason to look at operating leases. The tax rules have so far not drawn any distinction between financial and operating leases: the only relevant distinction is between leases giving an option to buy and those not, or on grounds of a lease lacking genuineness.
However, stiff competition, particularly in vehicles financing, has set the stage for introduction of value-added features, possibly moving closer to introduction of operating leases.
Last two years have not been very easy going: several seemingly-opposite factors have set in at the same time. Entry of several multi-national players – GE Capital, Orix, Citicorp, BNP, etc. – has resulted into stiff competition particularly in the passenger vehicles segment. In the machinery segment, corporate defaults have mounted up due to general recession in the economy. Regulation has been tightened on the liability-sourcing side, resulting into resources crunch as also falling public confidence.
In 1997-98, a number of leasing entities (NBFCs – non-banking finance companies, as they are called) reported decline in volumes and losses, some of them heavy losses. Many announced exit. Some have been acquired and the outgoing owners had to pay a heavy price –yes, the price was paid by the outgoing owners; incoming management got it virtually for a song. Many might still be waiting potential buyers. Stocks of NBFC s are at never-before lows.
But this is the right setting for entry of global majors!
Global majors welcome
Rules for entry of foreign companies into financial services have considerably been liberalised and it is now not difficult for global majors to make entry into India. Some of the irresistible features of Indian leasing market are:
- A vast market, comprising of variety of user segments, but penetration ratios still low in many key sectors, particularly machinery and infrastructure.
- Attractive rates of return: real rates of return close to 10%.
- Default rates in consumer loans and vehicles financing appreciably lower than many other markets; corporate defaults mostly due to bad lending decisions and do not form good precedents or of statistical value.
- Clean and mature legal system, albeit slow, respecting property rights of the owner as being predominant.
- Rupee far more stable than other currencies in the Asian region.
Most of the global majors who entered Indian leasing have focussed on the vehicles segment. Citibank has been active in cars financing for last decade or so; recently branched out in commercial vehicles also. GE Capital began by acquiring a prominent commercial vehicles financing company, and has since been out buying portfolios of many small and regional players through securitisation option.
The machinery segment has unlimited scope for growth, currently not being tapped by lessors due to bad experience in the past. The past experience was due to lack of good credit analysis and management. Acquisition of a corporate financing company by ICICI, one of the premiere development finance companies, should lead to an organised focus on machinery leasing segment. Needless to say, any one that enters this segment with adequate capital and technology, and more significantly, at volumes which justify very sound credit management, would find a huge untapped potential.
Infrastructure financing is another area where foreign entry will be welcome. There is only one company currently devoted to infrastructural needs. With massive government plans to develop infrastructure, long-term investors in infrastructural segment will find good market, secure clientele mostly with government backing, and reasonably good rates of return.
Click here for a detailed write-up on scope for cross-border leases into India.
Leasing as a tax-shelter:
Though substance-over-form is the general dictum followed in tax laws in India as for most other countries, India does not have a set of well-defined guidelines as to what constitutes a true lease for tax purposes. Hence, most leases, even though they are intrinsically financial leases, qualify as eligible for capital allowances which are granted to the owner of the capital asset. The only practical exception to this rule is a hire-purchase transaction, where an option to buy is clearly given to the hirer. [Click here for detailed write-up on taxation of leases in India]
In any financial lease, the lessor’s recovery from the lessee is partly his real income and partly realisation of his own capital. The latter, though not an income in true sense, if offered for tax, as part of the whole realised by the lessor and accounted for as lease rental. This is the tax loss the lessor suffers. As against this, the lessor has a tax gain in form of the capital allowances. Over n number of years, the sum total of capital allowances charged necessarily has to equal to the capital recovery which in turn is the capital invested in the transaction. Hence, the tax benefit equals the tax loss, over a number of years. However, by its very nature as the residue left after recovery of the finance income, the capital recovery takes a back-heavy pattern. On the other hand, capital allowances for tax purposes normally, and universally for India, have a front-heavy pattern. This results into a timing difference between the tax gain and the tax loss, the net being a gain in the initial years of the lease and an accelerating loss over the later part of the lease.
The actual value (computed in present value terms) of this tax deferment may not be significant at all, and in Indian situation, it is mostly a zero-sum game. But so great is the psychological value of the tax deferment that there is an irresistible tendency to write leases for the sake of tax benefits.
Thus, it is possible to say that the absence of any cogent rules for distinguishing between true leases and financial leases, the tax system has propelled demand for leases in quite a number of ways:
- All non-banking finance companies, and a number of public sector financial institutions have resorted to leasing for the sake of immediate tax relief.
- There being no restrictions on utilisation of leasing tax shelter against other incomes, a lot of other players – one-off lessors – have also used leasing to a substantial extent.
- Psychological motivation for deferring taxes, though the difference is merely a timing difference, has been aided by two significant quantitative factors:
- The absence of deferred tax accounting rules, whereby the tax deferred can be claimed by the managers as income earned by them, with all resulting distortions in EPS, reported net worth, etc.
- Over last few years, tax rates have come down from 51.75% to 35%, adding a cash value component to the present-value of tax deferments.
- All the more significantly, India has continued to have, despite of several reported instances of abject misuse, a 100% depreciation rate attributable to energy-saving devices, pollution control devices, etc. These have obviously been the centre-point of attraction for tax-deferment by leasing.
True lease guidelines:
Click here for a detailed article on the concept and features true leases.
The explosive growth in tax-triggered lease transactions over past 4-5 years has today made most lessors wiser, albeit in a very hard way. One is the unavoidable realisation that all tax deferments are a transient timing advantage, which, when ultimately reversed, becomes all the more painful being an unprovided liability. Two, and clearly more significantly, the asset and credit quality in tax-oriented lease transactions was sub-standard, in many cases, resulting into total loss of principal for the lessors.
A product which has its economic substratum purely in tax benefits is no healthy development in a system. No one, therefore, favours the current scene where a complete silence on the issue from the Central Board of Direct Taxes leaves every tax officer to use his own discretion in letting a transaction pass. In result, as some of the assessments made in March 1998 would show, there are as many Income-tax laws as are the assessing officers: it is rules of persons and not rule of law that is prevailing.
In November 1995 the CBDT had mooted the proposal of importing the accounting definition of a financial lease into the tax statute and qualifying an operating lease, not a financial lease, for tax benefits. As there was (and is) no operating leasing in the country, this was seen as a debacle for the leasing industry. There was heavy opprobrium, and this approach was dumped. In retrospect, it is worth arguing whether there was any merit in the CBDT’s approach. There is no doubt that lessors have lost crores of shareholders’ money in chasing tax-based transactions into dead end. So, a possible argument is that if tax benefits to leasing would have been denied, the loss of money in bad tax-motivated deals could have been saved. The fallacy of this argument is that it seeks to kill an instrument because of its possible misuse. It sounds like saying: because there are so many frauds in taxes, therefore, why have taxes?
Any tax benefit, and the possibility of its misuse, would always co-exist, and that is why we need a clear and articulate law and a strong enforcement.
India, therefore, urgently needs a standard for distinguishing a tax-true-lease from a plain financing transaction. Obviously, the hire-purchase-lease distinction is not enough. And such a guideline would be to every one’s advantage: the tax officers would have a clear guidance for themselves, and the tax-payers can have a better idea of whether their lease will have a safe harbour. Click here for the author’s list of true lease conditions in India.
Sales-tax on lease transactions: the biggest irritant:
Today, the single biggest threat to the leasing industry is sales-tax on lease transactions. While there is no theoretical justification for imposition of sales-tax leases, which is necessarily a multi-point levy, the singularly-revenue-sided approach of the States in taxing, and in most cases without Constitutional authority, lease transactions to a 4% – 15% sales-tax levy makes a lease transaction wholly unviable.
Looked at minutely, sales-tax levy is also responsible for a lot of structural aberrations in the leasing industry, including the motivation to write underpriced tax-oriented transactions noted earlier. It goes as under: since sales-tax on a lease pushes up the cost of the lease by some 4% – 10% points (say, a cost of 20% IRR becomes 24% IRR), it becomes impossible to market a genuine lease to a discerning client with good number of other funding options. Hence, all focus is diverted, either (a) to write tax-based leases where the tax benefit will allow the lessor to underprice the lease and retain its viability inspite of sales-tax; or (b) lessors will be forced to shift to unbankable transactions such as sale and leasebacks.
Under the present system of sales-tax, a lessor would necessarily buy the goods to be leased at the least tax which the lessee would have paid on a direct purchase. Hence, there is no loss of sales-tax to any government because of leasing. So, whatever taxes are charged on lease rentals are additional and multi-point levy.
Currently, sales-tax on lease transactions has not been imposed under the Central Sales-tax Act which is supposed to tax transactions of inter-State nature. Many lease transactions have an inter-State nature, and are thus, outside the taxing competence of the States, and yet, the latter tax them. The States have been taking undue advantage of the prevailing uncertainty in interpretation of what would make a lease an inter-State lease. Normally, in any uncertainty in taxes, it is the tax payer who gains, but here, for some strange reason, the entire uncertainty is operating to the benefit of the State govts.
Leasing, and sales-tax on it, cannot go together for long: they will soon be parted. Therefore, it is urgent that the following be done:
- The States need to realise that they do not lose anything that they would have gained in absence of leasing: therefore, they should be contented with the industrial development that leases result into, and not make leasing itself a target of revenue. Hence, the States need to exempt leases of such goods which have already suffered tax in the State. Maharashtra, Tamil Nadu, Karnataka and Gujarat (by set-off) have done so already. Other States need to follow.
- The Central Govt. needs to define leases under the CST Act, define principles under which lease will be regarded as inter-State, and declare leases as taxable only to a single point levy, and fix the limit therefor.