Financial Leases getting a new lease of life?

– Kanakprabha Jethani, Senior Manager | kanak@vinodkothari.com

Background

Leasing industry in India started and grew, as in several other countries, with financial leasing. However, over last several years, it seemed as if financial leases had lost their relevance, for reasons discussed below. While activity in the leasing space was not very brisk, but whatever activity was there was seen mostly in operating leases. Operating leases were sold on the strength of either off-balance sheet treatment, or with lower monthly rentals, or residual value management etc. In case of financial leases, on the other hand, there seemed very little motivation.

Some recent developments seem to be rekindling the interest in financial leases, and if the tax ruling by the ITAT Chennai either goes unchallenged or is affirmed on further appeal, there may be just a new lease of life for financial leases. Coupled with other benefits such as bankruptcy remoteness etc., there may be strong reasons for looking at financial leases, both by lessors and lessees.

In financial year 2021-22, the volume of financial leasing reached to around 7% of the total leasing volumes in the country, compared to 20% in the financial year 16-17^[1]. Considering the legal and regulatory construct in India, the reducing volumes of financial leasing make complete sense. However, the recent rulings on taxation of leases may reverse the long known reasons for not doing financial leases.

In this article, the author discusses the reasons why financial leases do not appeal to lessors and lessees and how the recent developments on the taxation aspects of leasing may seem to be bringing financial leases back to life.

Inefficiencies in Financial Leases

Before we try to understand why financial leases are considered to be inefficient, let us first understand their construct.

Also known as capital lease of full-payout lease, this is a type of lease which can provide an alternative to borrowing. Here, the device of leasing is deployed for what is effectively a secured lending transaction. The following features can be seen in a financial lease:

• Similar to a secured loan, here the lessee is intended to be the de-facto owner of the asset; hence, the lease involves transfer of all major risks and rewards of ownership from the lessor to the lessee.
• The lease period is long enough to provide use of the asset by the lessee for almost whole of the economic life of the asset.
• The lessor merely finances the acquisition of the asset and keeps his title over it.
• Financial lease typically transfers ownership of the equipment from the lessor to the lessee at the end of the lease.
• Generally, total payments (lease rentals) other than the residual value cover the lessor’s total equipment cost. The lessor does not carry substantial risk in residual value of the asset and recovers nearly the full value of the asset along with interest during the lease term by way of rentals. Hence, the lessor’s residual risk is negligible and is not likely to affect the yield of the lessor.

From the above, it can be understood that financial leases are a blend of secured loans and rental transactions. Which is why their accounting and taxation treatment exhibits a blend of the two. Let us read further and understand how.

• Accounting Treatment: The distinction of financial leases and operating leases comes from accounting standards. Since financial leases are akin to a financial transaction, the accounting treatment is close to a loan transaction. The leased asset is not capitalised in the books of the lessor, and accordingly, no depreciation is charged. Rather, the lessor records receivables of an amount equalling to the net investment in lease. On the other hand, the lessee records the asset, as fixed asset, and depreciates the same as per usual depreciation policies of the lessee^[2]. A corresponding lease liability is also created.

Thereafter, during the lease tenure, the lessor takes to revenue, only the interest or finance charges inherent in lease rentals, which will also be debited as expense by the lessee. The principal portion of the lease rentals is utilised to amortize the liability created.

In an era where organisations are moving to asset-light balance sheet models, taking financial assets into books is a demotivation for lessees. Ofcourse, for Ind AS compliant entities, this will be the case irrespective of the type of lease.

• Taxation Treatment: Tax laws do not differentiate between financial lease and operating lease. Rather, the distinction is based on whether the transaction demonstrates features of a purely rental transaction or true lease. Generally, financial leases are considered akin to loan transactions by taxation authorities. This means, under Income Tax laws, the lessee is treated as the owner and is able to claim depreciation as an expense. Only the interest portion of the lease rentals is allowable as an expense.

As for the lessor, the interest portion of lease rentals is charged to income tax. However, under the indirect tax regime, financial lease is considered a taxable supply and GST is charged on the entire lease rentals^[3]. Due to this an anomaly in the taxation treatment, the entire lease rentals end up being charged to GST, while at the same time, not being treated as an expense for Income Tax purposes.

It is the interplay between accounting and taxation treatment, which is of utmost importance while determining the reasonability of carrying out a lease transactions. Evidently, a financial lease suffers from the following inefficiencies:

• From accounting perspective, the lessee does not get an off-balance sheet treatment. There is a fixed asset in the books of the lessee and lessor also needs to keep a receivable in its books (As specified earlier, there is no difference for an Ind AS compliant lessee).
• From taxation perspective, entire rental is chargeable to GST (as opposed to GST exemption to loan transactions). From an income tax perspective, the lessee gets to claim depreciation as an expense and interest portion is chargeable to tax as expense. In case of an operating lease, the lessee gets to expense out the entire lease rental, which ofcourse is higher than the sum of depreciation and interest portion of lease rentals as allowed in case of financial leases. Hence, financial leases tend to be tax inefficient.

A new perspective to taxation of financial leases

Recently, the taxation authorities have started to understand the difference between accounting and taxation aspects of leases. As one can see, the recent rulings on financial leases, seem to be paving a positive way for financial leases.

One such instance is the ruling in the case of M/s. Sundaram Infotech Solutions Ltd. vs. ITO^[4]. In this case, the ITAT Chennai allowed the lessee to claim lease rentals as an expense, even though the lease was recognised as a financial lease in the books of the lessee and the leased asset was shown as an asset in the books of the lessee. At the same time, lessor was allowed to claim depreciation as an expense, despite not having the asset in its books. The said ruling was based on the consideration that the lessee is obligated to the lessor for any loss, damage, destruction, etc. to the asset beyond normal wear and tear. In the event of of these happens, the rentals would terminate and the lessor receives an amount equal to the balance of the rent owed for the remainder of the term from the lessee. The agreement also required return of the asset of the lessor at the end of the term.

There have been several such instances when a financial lease transaction was treated as a true lease for taxation purposes. Key takeaways from some of the important rulings are produced below:

• The asset is a vehicle and registered under the name of lessee under Motor Vehicles Act, 1988– In the case of M/S. I.C.D.S. Ltd vs Commissioner Of Income Tax & Anr^[5], the Supreme Court held that in view of the fact that the vehicles were not registered in the name of the assessee, and that the assessee had only financed the transaction, it could not be held to be the owner of the vehicles, and thus, was not entitled to claim depreciation in respect of these vehicles. Here, the lessor was allowed to claim depreciation as an expense and the lessee was allowed to take lease rentals as an expense.
• The lessee has the right to buy the asset at a nominal price at the end of the lease term– In case of Minda Corporation Ltd., New Delhi vs Assessee^[6], the ITAT Delhi referred to the principles laid down in the aforementioned ruling in the case of M/s I.C.D.S – as long as the assessee has a right to retain the legal title of the vehicle against the rest of the world, it would be the owner of the vehicle in the eye of law. A scrutiny of the sale agreement cannot be the basis of raising question against the ownership of the vehicle. The clues qua ownership lie in the lease agreement itself, which clearly point in favour of the assessee.

From the aforementioned rulings, one can see that even though a lease is considered financial lease for accounting purposes, the same can qualify for true lease treatment under taxation laws. Resultantly, the inefficiency due to taxation treatment goes away. The lessee can claim the entire lease rentals as expense, rather than claiming merely the interest portion of rentals and depreciation on the asset. Of course, this motivates the lessee because the former shall work out to be higher than the sum of the latter two.

Are financial leases the way forward?

If one was to take a 360-degree perspective, financial leases are better placed, considering the following:

For the Lessee

• Tax inefficiencies eliminated as discussed above
• Interplay of accounting and taxation: If the aforementioned ITAT Chennai ruling is relied on, a lessor can claim depreciation expense even without having the asset in its books. At the same time, the lessee gets to claim entire lease rentals as an expense, which, considering that the lease is a financial lease, will cover almost entire value of the asset.

• Not a loan transaction: When a lessee intends to take asset on financial lease, it will not appear as borrowing in its books. Hence, the lessee will not be required to obtain a No Objection Certificate from its existing lenders for entering into such financial lease transaction; which would have been required, had the lessee been entering into a loan transaction. Therefore, even if one were not to get into tax issues, this becomes a way for the lessor to make an inroad into a borrower with strong credit standing. Had this been a lender (rather than a lessor) banks would never have allowed it access to the borrower.

For the Lessor

• Income Recognition: The income recognised in the case of financial leases shall be consistently proportionate to the corresponding receivables outstanding in the books. Hence, representing consistent returns on the asset.
• Treatment for Regulatory Purposes: For NBFCs, financial leases are considered financial activity and accordingly, all regulatory prescriptions applicable to lending transactions become applicable. They are also considered as financial activity for the purpose of computation of Principal Business Criteria for NBFCs^[7] (‘PBC’). Hence, financial entities may carry out financial leases, without negatively impacting their PBC.

Even non-financial sector entities can provide assets of financial lease until they breach PBC. For PBC computation, only interest portion of the lease rentals is considered financial income.

• Transferability: Being considered financial transactions, financial leases are amenable to securitisation and transfer of loan exposures.
• Treatment during insolvency: A financial lease is considered financial debt for the purposes of Insolvency and Bankruptcy Code, 2016, hence, according priority to the lessor above operational creditors. Further, the leased assets do not form part of the liquidation estate of the lessee^[8]. Hence, the lessor only has rights over the leased assets and can repossess the same in case of insolvency proceedings^[9].

For the aforementioned reasons, combined with tax efficiencies, financial leases may again start attracting lessors as well as lessees.

All Roses, No Thorns?

We discussed how financial leases can be seen from a fresh perspective, one must remember that certain differences still exist. For example, financial leases do not provide off-balance sheet treatment, even for entities not required to adhere to Ind AS. Non Ind AS compliant entities wanting an asset-light balance sheet may still look at this as a hurdle. 

Further, the difference in accounting and taxation treatment may show a visual anomaly between the profit/loss shown in the books of accounts and that in the taxation returns.

It must also be noted that we discussed inefficiencies under direct tax treatment, however, indirect taxation inefficiencies remain; i.e. GST is still chargeable on the entire lease rental. HOwever, that inefficiency is a common factor between financial and operating leases, and will be relevant only while comparing financial leases with loans.

Conclusion

The recent ITAT rulings seems to be in favour of financial leases. Hence, one may look at financial leases from a new perspective. Obviously, the rulings discussed in this article are passed by ITAT, hence, the same is not the final ruling of law. The taxation authorities may take different views based on specific facts of the case.

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^[1] Source: World Leasing Yearbook 2023. In India, a major chunk of leasing transactions are carried out by the Indian Railway Finance Corporation (IRFC), which dedicatedly transacts for the purpose of Indian Railways. In order to ensure that the data is representative of the industry as a whole, the volumes of IRFC have been excluded.

^[2] In case the lessee is Ind AS compliant, it shall lmeasure the right-of-use (ROU) asset and a corresponding lease liability at present value of the lease payments discounted at the interest rate implicit in the lease or the incremental borrowing rate and a corresponding lease liability. Further, during the tenure, the ROU will be depreciated and the carrying amount of the lease liability will increase by the amount of interest accrued and reduce on account of the payments made towards the lease liability. The interest expense, being a component of finance cost will be presented separately as a charge in the income statement. See our detailed presentation on accounting of leases here- https://vinodkothari.com/2019/02/accounting-for-leasing-transactions-indas-116-and-ifrs-9/

^[3] Refer FAQs on Banking, Insurance and Stock Brokers Sector (https://www.cbic.gov.in/resources//htdocs-cbec/gst/27122018-UPDATED_FAQs%20ON%20BANKING,%20INSURANCE%20AND%20STOCK%20BROKERS.pdf)

^[4] ITA No.2517/Chny/2019, M/s. Sundaram Infotech Solutions Ltd. vs. ITO, July 07, 2022 (https://itat.gov.in/files/uploads/categoryImage/1657176319-ITA%202515%20OF%20SUNDARAM.pdf)

^[5] M/S. I.C.D.S. Ltd vs Commissioner Of Income Tax & Anr, January 14, 2013 (https://indiankanoon.org/doc/48572667/)

^[6] ITAT Delhi. Bench in M/s. Minda corporation Limited vs. DCIT ITA No.1962/ Del. /2012,(https://itat.gov.in/files/uploads/categoryImage/-70175859118196811851351REFNO1962-2012-Minda_Corporation_Ltd.pdf)

^[7] Refer our write-up for understanding the meaning of Principal Business Criteris- https://vinodkothari.com/nbfcs/definition-of-nbfcs-concept-of-principality-of-business/

^[8] Refer our write-up for details- https://vinodkothari.com/2018/03/inclusion-of-assets-taken-on-lease-in-the-liquidation-estate-of-the-lessee/

^[9] However, where a leased asset is essential for sustenance of the corporate debtor, a contrary view may be taken. Refer our write-up on this subject here- https://vinodkothari.com/2022/01/treatment-of-lease-transactions-under-insolvency-and-bankruptcy-proceedings/