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)

Leasing: The way forward in the post COVID-19 world

Timothy Lopes, Senior Executive, Vinod Kothari Consultants

finserv@vinodkothari.com

The leasing market has always proven to be strong and growing in emerging as well as developed markets through all stages of an economic cycle. According to a US country survey report by White Clarke Group, the US equipment finance industry at the end of 2018 was roughly US$ 900 billion. This was expected to grow at around 3.9% during 2019.

COVID-19 has disrupted businesses and entities as much as it has affected personal lives. As businesses learn to live the new normal, there have to be lot of realization for acquisition of capital assets in time to come. Businesses will arguably find it much easier to connect their payment obligations to their own revenues, so as to have minimum stress and maximum focus on operations.

Demand for capital equipment, vehicles, software, etc. would have slowed down owing to covid disruption. This lower demand results from lower cash in hand to fund any outright equipment purchases. Going forward too, post the COVID-19 scenario, “buying” equipment, etc. would not be a feasible option.

Leasing on the other hand, has in the past proven to be a strong financing alternative even at times of a depression. During the great depression back in the 1930’s, companies that resorted to leasing out equipment and software performed rather well in stress scenarios. To take an example of IBM Corporation, which then derived well over half of its income from leasing, and of United Shoe Machinery Corporation, which distributed virtually all its machine products through leases while the US GDP took a major hit during the 1930-1935 period.

Figure – Leasing during the great depression (1930)

Source: Lease Financing and Hire Purchase, Fourth Edition 1996 by Vinod Kothari

 

Source: Bureau of Economic Affairs, US Department of Commerce

Under leasing plans, since the buyer does not have to put in any capital investment, he may be able to acquire equipment even during a period of depression. Thus, leasing serves to maintain the growth of a manufacturer’s sales during depressionary climate.[1]

Post COVID-19 scenario – Could leasing be the way forward?

Presently, the global economy has entered into recession which may be comparable to the situation back in the 1930s. It is unlikely that companies would be looking to purchase assets during the post COVID-19 scenario owing to several stress factors.

Thus, leasing equipment/ software/ vehicles, etc. should be the way to go during the depression scenario. Leasing allows one to structure the payments in such a way that the cashflows arising from the asset/ equipment will itself service the rentals associated with the asset/ equipment, which is the likely factor to increase the propensity to finance through leasing.

Properly structured, lease transactions have the potential to turn assets into services – enabling users to get to use assets without having to lock capital therein. It is our belief that leasing provides the way for users of capital equipment to acquire assets, keeping their businesses asset-light.

Further, according to a survey done on the impact of COVID-19 on lease financing by Equipment Leasing & Finance Foundation (ELFF), over the next four months, none of the respondents expect more access to capital to fund equipment acquisitions, while some of the survey respondents believe demand for leases and loans to fund capital expenditures (capex) will increase over the next four months.

The Monthly Confidence Index (MCI) for the Equipment Finance Industry, for the month of May, 2020 was at 25.8%, up from 22.3% in April, 2020.

Further, another report by ELFF suggests that capital investment will suffer due to the pandemic. Leasing, however, would enable the buyer to acquire an asset while not having to put in any capital investment.

Global leasing trends

Leasing volumes have seen strong growth across geographies over the 2002-2018 period. This is reflected by the volumes in major regions reported by the White Clarke Group: Global Leasing Report 2020 shown below –

Conclusion

Leasing would be a feasible solution in the upcoming recovery period. The cashflows generated from the asset on lease would service the rentals on the asset, thereby having the asset finance itself, considering that no one would be willing to put in any major capital investment in the times to come.

In India, the penetration of leasing has been fraction of a percentage, compared to global levels, where average penetration has been upwards of 20% consistently. Several factors, including tax disparities, have been responsible.

With innovation as the working tool, solutions may be designed to provide customers with effective asset acquisition solutions.

See our resources on leasing here –

http://vinodkothari.com/leasehome/

[1] Source – Lease Financing and Hire Purchase, Fourth Edition 1996 by Vinod Kothari

 

IMPACT OF COVID-19 ON FINANCIAL CONTRACTS

-Richa Saraf

[richa@vinodkothari.com]

With the outbreak of COVID pandemic, there have been several instances wherein parties are running to court for various reliefs, whether to obtain injunction from invocation of bank guarantee or to seek extension of letter of credit, but mostly to seek declaration that COVID is a force majeure event and therefore, there is an impossibility of performance of the obligations. While some regulatory relief has been provided by regulators such as RBI, by allowing moratorium on loan repayments/ asset deterioration[1], and SEBI has provided relaxation on disclosure requirements[2], for other matters, the judiciary has been quite proactive in delivering judgments. Below we discuss the impact of COVID-19 on financial contracts.

Read more

Lease Accounting under IFRS 16- A leap towards transparency!

Megha Mittal

mittal@vinodkothari.com

Our mission is to develop IFRS Standards that bring transparency, accountability and efficiency to financial markets around the world”, the International Accounting Standards Board (IASB) is indeed on a way towards fulfilling its mission. The International Financial Reporting Standards (IFRS) have been worldwide acknowledged and appreciated as a benchmark of transparency, trust and growth. In another specimen of its attempt to increase transparency in financial markets around the world, the IASB, back in 2016, introduced the IFRS 16, to be applicable w.e.f. annual reporting period beginning on or after 01.01.2019.

Introduced with the objective of introducing a single lessee accounting model, the IFRS-16, aims at ensuring faithful representation of lease transactions and pioneers the concept of “Right-to-Use” Assets.

In this article, we intend to delve deeper into what IFRS-16 brings to the table, its objective and most importantly its impact.

Understanding the Concept

In the present financial set-up of our economy and business environment, “Lease” is an indispensable element. With the advantages it carries and the flexibility it has provided to financing, the concept of lease has penetrated to every strata of being. However, from an accounting perspective, the nexus of “lease” with “assets” makes it essential to understand the procedure of incorporating the lease transactions in the books of both the lessor (legal owner of the asset) and the lessee (user of the asset); and, IFRS-16 is the answer.

While it does not modify the accounting treatment in the books of the lessors from that laid down in IAS 17, IFRS-16 introduces a single lessee accounting model and requires a lessee to recognise assets and liabilities for all leases with a term of more than 12 months, unless the underlying asset is of low value. A lessee is required to recognise a right-of-use asset representing its right to use the underlying leased asset and a lease liability representing its obligation to make lease payments.

To understand better, let us now take an illustration:

Illustration 1:

A is the legal owner of a car. B, a small businessman, intends to take the car on lease for a period of 3 years. Here, A becomes the Lessor, and B, steps into the shoes of a Lessee. Now that B has the right to use the car, he must identify this car as a right-to-use asset, more colloquially knows as RTU Asset.

Hence, the Lessee records the car along with other non-financial assets like property, plant and building, and the lease liabilities along with other liabilities. It is pertinent to note that the RTU asset must however, be recorded at its present value, arrived at by discounting at its Internal Rate of Return (IRR). As a result, the lessee also recognises depreciation of the RTU Asset and interest on the lease liability in its Statement of Profit and Loss.

Rationale behind IFRS-16:

By what can be called the “5 Rule Check”, IAS 17, distinguishes leases into two broad classesviz. Operational and Financial Leases. While the leased assets wererecorded in the books of the lessor, in case of both operational and financial leases; as per IAS 17, an operational lease in the books of a lessee was treated as an “off-balance sheet” item. Regards the objective with which the new standard was introduced, IASB Chairman, Mr. Hans Hoogervorst, said that “These new accounting requirements bring lease accounting into the 21st century, ending the guesswork involved when calculating a company’s often-substantial lease obligation. The new standard will provide much-needed transparency on companies’ lease assets and liabilities, meaning that off balance sheet lease financing is no longer lurking in the shadows. It will also improve comparability between companies that lease and those that borrow to buy.

Hence, it is clearly a step towards IASB’s vision of transparency, accountability and efficiency.

Impact:

Put simply, IFRS 16 eliminates the distinction between operational and financial lease in the books of a lessee. We shall now analyse its impact in the real field and compare the outcome with the expectations.

Overall Impact:

On the surface, the accounting treatment will have a knock-off effect on financial elements; for instance, Earnings before Interest, Tax, Depreciation & Amortization (EBITDA) and Profit After Tax (PAT).

Let us understand this effect with the help of an illustration:

Illustration 2:

A Ltd., an aviation company, has taken on lease, aircrafts worth Rs. 1000 crore, having residual value (RV) 20%, for 36 months, @ 12% p.a., having revenue of Rs. 15,000 crore

On the basis of the above information, we get the following:

  • Lease Rental p.a. : Rs. 342.86 crores
  • Right to Use Asset (RTU) : Rs. 860.22 crores
  • Depreciation on RTU Asset (on SLM Basis) : Rs. 286.74 crores
  • Annual Interest @ 12% p.a. : Rs. 89.59 crores

Now let us compare the impact of the accounting treatment under IAS 17 vs. IFRS 16:

Note: Unlike IFRS-16, under IAS 17, the entire operating lease transaction remains to be an off-balance sheet transaction. Under IFRS 16, the RTU less depreciation is recorded under the assets side vis-à-vis. Lease payables under the liabilities head.

Hence, as evident from the above illustration, sum towards rentals (fixed cost) under IAS 17, have now been substituted with Interest obligation under IFRS 16, and as such the EBIDTA is higher in the initial years. Further, recording the asset at RTU value also gives way for depreciation, and hence, as a result of depreciation along with interest, the PBT reduces in the initial years. From a bird’s eye view, both the assets and liabilities of the lessees adopting IFRS 16 will increase.

Re-negotiation of Loan Covenants:

Further, now that the lease assets are to be recorded, it will typically result in companies appearing to be more debt leveraged; however, since leases are most likely on the operating transaction side vis-à-vis loan transactions, this is not the true picture. This pseudo-presence of huge liabilities is also likely to take a toll on the lessee’s credit rating. Hence, formal communication with the lenders will become a matter of concern, and a sound two-way communication and transparency with the lenders will be the key to managing the transition from IAS 17 to IFRS 16, smooth and efficient.

Industry-wise Impact:

With the first quarter of F.Y. 2019-20 embarking the first quarter of implementation of IFRS 16, the author makes a humble attempt to study the impact, on the basis of financial results declared by several industry-majors.

BPM Industry-

According to a study by Cushman & Wakefield in June 2019, the Indian markets show a strong presence in office space leasing. It has also been observed that the IT-BPM sector, has a higher share in office lease activities, as compared to its contemporaries. Hence, it is evident that the “leasing” is an essential element in the BPM industry.

As the Mumbai-based BPM giant, WNS Global announced its first quarter results; we observe that while the operating profit increased as a result of IFRS 16, the profit for the quarter has decreased. This increase in the operating margins comes to picture as fixed costs reduce with interests of lease payments replace the rentals; the counter result of which is the increase in finance costs due to which the ultimate profit dips.

It is said that the three objectives of any business is Survival, Profit and then Growth. However, as may be seen from above, application of IFRS 16 has led to fall in the profit. It is apprehended that the fall in profit may hold back companies, in the BPM sector from continuing office-space leasing.

Aviation Industry-

Ever imagined that the airplanes we fly in, are most likely not even present on the company’s balance sheet? This non-appearance in the balance sheets was the outcome of accounting standards laid down under IAS 17. However, with IFRS 16 in the picture, the new financial year will be different from previous fiscals, especially for the aviation industry, as they now have to record all lease transactions in their books.

Adopting IAS 116, the Indian counterpart of IFRS 16, the airline industries now have to capitalise operating leases as RTU assets. While recording lease transactions and its by-products like interest, depreciation, the impact will majorly depend on factors like

  • Proportion of operating lease in the overall asset pool;
  • Duration of leases.

With leasing forming an indispensable element of airline companies, even though accounting should not be the key driver in commercial negotiations, market behaviour might change towards shorter lease tenures to minimize lease liabilities.

Owing to the fall in profits in the initial years, it is expected that there might be fall in operating leases, and sale & lease-back arrangements, which will prompt the airlines to purchase more aircrafts. Mr. Wui Jin Woon, Head of Aviation, Asia Pacific, Natixis CIB, also said that “Airline with sufficient access to liquidity may be more incline to purchase now that there is no difference from an accounting perspective between operating and finance leases.

However, adopting IAS 116, the Indian counterpart of IFRS 16, the airline industry major, IndiGo stated that while there might be changes in the future reported profits, which may necessitate a change in current P/E based valuation methodology, it will not impact IndiGo’s cash profits, cash flows and growth strategy.

Hence, while there is broad consensus on how the standard will affect various financial metrics, there is considerably less agreement on how it might influence operating decisions and market sentiments.

Communication Industry:

Most Communications companies enter into lease agreements both as lessors and lessees, as such, leases in the industry are prevalent. The new standard is likely therefore to have a material impact for Communications companies.

Arrangements which may contain leases could include – customer contracts for using identified network or infrastructure equipment, equipment provided to customers through which the operator delivers communication services such as set top boxes and modems, and data centre services etc.

As a consequence of IFRS 16, the potential business impact could include renegotiation of network development and network sharing agreements. Further, companies already having large asset bases, may be prey to the impairment risk with the addition of further assets in the balance sheet.

Automobile Industry

(a) Corporate Car Leasing

Corporate Car Leasing is a very innovative employee benefit scheme that has cropped up off late. Under this scheme, big corporates provide its employees, car taken on operational lease, which the end of tenure is sold to the employee at a nominal value.Hence, while the car is essentially for the benefit of the employees, the company is the actual lessee. As this set up was in the nature of an operating lease, the lessee, as per IAS 17, was not required to record the car in its balance sheet.

However, will the roll in of IFRS 16, the corporates will be required to record these cars at their RTU as assets and a corresponding lease liability in their books; as a result of which, the balance sheet of the corporate shall increase manifold.

(b) Fleet Management

In the Fleet Management market, leasing, especially operating lease has proven to be a smart move to optimise its costs and maintain adequate ratios, as until now, it was not required to be recognized in the balance sheet of the lessee.

Murray Price, managing director of EQSTRA Fleet Management said, “These include the impact on the company’s financial report, key ratios, disclosures, the cost of implementation, the ability to access desired information, the impact of covenants and debt renegotiations and leasing strategies.

This magnification of balance sheet, by virtue of change in accounting policies is anticipated to be detrimental to this industry. It is expected that this will hold back corporates from entering into such arrangements.

Change in the Lessors’ Approach:

Like every action has a reaction, even though IFRS 16 does not essentially alter or modify accounting methodologies adopted by the lessors,  the lessors may be impacted in their business models due to change in lessees’ behaviour. From the foregoing, a common thread that can be observed is that lessees having better liquidity, will now tend to incline towards purchasing the assets rather than leasing, as such, lessors may be required to revaluate the current portfolio of leases and prospective targets to identify lessees that may seek to alter their strategies as a result of IFRS-16.

Global Scenario:

Moving ahead from the industry wise acceptance, we shall now see how the new standard has been welcomed at the global level.While India has come up with IAS 116, drawn on the same lines and principles as IFRS 16, the United stated shall continue to follow ASC 842, dealing with the same subject.

Further, barring variances in implementation due to local regulatory requirements, IFRS 16 has been relatively consistently adopted in most of the Asia-Pacific markets. In Hong Kong, for example, most companies have a December financial year-end and submit financial statements to in around August in the following year. IFRS 16 impacts may become more apparent when listed companies release interim results in July 2019.

In Australia, most year-ends are in June, so some companies will not technically need to grapple with IFRS 16 until the second half of 2019.Similar patterns are evident in Singapore, Malaysia, India and the Philippines, where common accounting periods and reporting practices mean many companies won’t have to address IFRS 16 until later in the year.

The equivalent standards in Thailand and Indonesia are not effective until January 2020. In China, the Ministry of Finance only released the local version of the standard in December 2018, giving non-listed companies up to 2021 to adopt.

Conclusion:

Given the gravitas and indispensable presence of leases and the fact that it resides on such a large scale ground, to judge with certainty, the impact of IFRS 16 certainly requires more time. The dust around the same has not settled yet, hence one can say the picture is not yet vivid; however, it surely sets up the pace for what might unveil in days to come.

 

Link to our other publication on the above subject are provided below:

 

 

 

Car Leasing In India: ‘Breaking the Stereotypical Definition Of Luxury’

Julie Mehta (julie@vinodkothari.com)

Introduction

Who thought hiring was even an option to enjoy the luxury of having to use a car. But with the world undergoing a paradigm shift, it untapped its energies into providing and establishing better services for its customers, leasing has paved its way into existence. Most of the industries have adopted this concept and structured their services accordingly in order to provide the best they can to their customers, but that requires huge understanding of their needs. A commoner would always be awed by the immensely developing technology and the environment around them but limited resources makes them take a step back from the thought of availing such services. The market had its solution as hiring and renting came into picture. This has ensured dreams do come true.

Car has always been a luxury at least in most parts of India because of the fact that India still in its developing stage and there still remains a big gap between the rich and the poor and the middle income families fall nowhere. Indians have been developed with the mind state that not everyone can afford everything and thus one should limit their demands keeping in mind their pocket potential. The concept of hiring and renting is not only limited to houses and properties but with the advent of MNC’s and startup companies, they have widened the scope of bringing in the concept of hiring even furniture, vehicles, electronic equipment’s, etc.

Earlier, the concept of car leasing was only limited to corporate senior executives that was earlier known as ‘corporate leasing’ and was common for the luxury car brands. But slowly it has trickled down and become accessible to commoners and middle income families. Companies like Mahindra & Mahindra made some of its models available for leasing. Following this concept, several other car brands like Hyundai, TATA group and luxury brands like BMW, Mercedes etc. have also opened their doors to providing the lease facilities.

Car leasing and rental is one of the most lucrative and fast growing segment of the automobile sector in India even though it currently represents only 4-5% of the market in terms of absolute number of vehicles, but its future prospects are strong enough.

Factors like increasing popularity of app-cab providers like Ola, Uber, Zoom car cab booking facilities, rapid urbanization, relocation of rural population into cities, adds on to the potential of car leasing in India.

[1]The growth of the market in India is to ensure manifold growth in its CAGR by 15-20% in the coming ten years and further on making hiring of cars simpler eventually with current worth of Rs. 1500 crores. Most car making companies are making 40% of its business from leasing cars. This has largely helped change the mentality of customers and imbibed the fact that ‘why buy when you can lease it’.

 

Yellow number plates or white number plates?

People remain apprehensive about the color of the number plate they use in the car. While a yellow number plates denotes commercial use, white number represents personal use. People taking cars on lease will of course want white number plates on their cars.

The current legal framework for registration of motor vehicles allow cars taken on lease for personal use to bear white number plates.

In case of a car taken on lease, the lessee is the person having possession of the vehicle and hence, the ‘owner’ as per the Motor Vehicles Act, 1988. Further, since it is the lessee who is actually using the car and the same has not been given on hire or used for any other commercial purpose, the car shall have a white number plate.

 

Global Status of Car Leasing

Globally, car leasing and hiring has been prevalent and growing for many years now. The analysts have forecasted that in the coming years, the global leasing market is to grow at a CAGR of 13-15%. This is gaining momentum due to the development of new mobility concepts by car leasing companies. For example, telematics was introduced in leased vehicles to monitor their usage on the job, another technological development was the installation of navigation in the leased vehicles making it more convenient for the lessor. People want change and with such facilities where there is an added benefit of not burning the pockets of customers, the lease scheme always works to hire cars on lease and cancel the contract anytime to shift on to better and advanced models of cars.[2]

The new trends dominating the global markets are the introduction of electric vehicle leasing and environment friendly cars that lead to sustainable development in the car manufacturing industries as well in the overall environmental situation. Such facilities encourage people to be more socially responsible and to do their bit towards the betterment of the society and also getting the leasing benefit out of it. Governments across the world are offering subsidies and tax benefits to encourage and boost the penetration of electric vehicles in their fleet. They have also introduced the concept of leasing old cars which helps reduce wastage as well as optimum usage. It is offered at a highly considerate premium and is attractive for low income customers. The global leasing market is fast moving with efficient strategies that ensures further growth too.

 

[3]Why has Leasing gained popularity in recent times?

GST introduction has come out to be a source of relief in time of distress for the Indian markets and consumers due to the stiff tax system of the country resulting in poor market functioning. With the introduction of ‘Goods and Services Tax’ on July 1, 2017, times have changed for the consumers, dealers as well as manufactures and has helped bring stability and balance in the economy by considering every person and their transaction at par, with the motive to bridge the gap between rich and poor in the long run. Evaluating their benefits below taking into consideration automobile industry:

  • To the consumers: The new tax regime has resulted in significant reduction in the tax rates imposed on the end consumers in comparison to the previous tax system.
  • To the dealers: The benefit of claiming the tax paid earlier benefits the dealers with the introduction of GST provides an added advantage to the dealers.
  • To the manufacturers: In recent times, car manufacturing companies have marked a fall in their sales which has led to dwindling profits. With the increasing exposure to car leasing, manufacturers have found their resort to stabilise their performance. This option induces customers to opt for leasing, thereby ensuring good business to the car manufacturers.
 CAR TYPE GST RATES COMPENSATION CESS TOTAL
Small Cars 28% 1% or 3% (depending on capacity) 29% or 31%
Mid-segment Cars 28% 15% 43%
Large Cars 28% 17% 45%
Sports Utility Vehicles (SUV’s) 28% 22% 50%
Electric Cars 12% N.A. 12%

Numerical Comparison

To understand the calculation of Loan EMIs and Lease rentals, we structure an example with the concept of residual model to distinguish the calculations of both the alternatives.

Any loan transaction requires an initial down payment to the seller after which installments follow on monthly/quarterly/annually basis. The down payment creates an extra outflow on part of the buyer on loan along with additional installments. While no down payment is required in case of a lease that makes its overall outflow on the lower side in comparison to a loan.

Plus, in case of a lease transaction, the lessor takes an exposure on the residual value of the asset, this brings down the lease rentals per month.

In the example below, with the assumption of different rates of residual value, we understand that with the every increase in the percentage of residual value, the lease rentals of the operating lease borne by lessee comes down. This implies lower the term of the lease contract, lesser value of the asset is used, and thus lesser are thee lease rentals.

Details of the Vehicle  
Unit Cost 1000000.00
GST rate 28%
Compensation Cess 17%
Rate of GST 45%
GST 450000.00
Total 1450000.90
When Residual Value is considered to be 20%
Operating lease arrangement    
Basic price 1000000.00  
Add GST on purchase (ITC eligible) 450000.00  
Funding Amount 1450000.00  
Processing fees 3.80% 55100.00
Expected Residual Value 20% 200000.00
Tenure 48  
IRR 18%  
Lease Rentals (RV not factored) ₹ 42,593.75  
Lease Rentals (before passing GST benefit) ₹ 39,718.75  
Input tax credit percentage 100%  
Less: GST benefit ₹ 9,375.00  
Lease Rentals (after passing GST benefit) ₹ 30,343.75  
Add: GST on rentals ₹ 13,654.69  
Total inflow ₹ 43,998.44  
 
Loan arrangement    
Loan amount 1450000.90  
Processing fees 3.80% 55100.0342
Expected Residual Value 0% 0
Tenure 48  
IRR 18%  
EMI ₹ 42,593.78  

 

When Residual Value is considered to be 25%
Loan arrangement    
Loan amount 1450000.90  
Processing fees 3.80% 55100.0342
Expected Residual Value 0% 0
Tenure 48  
IRR 18%  
EMI ₹ 42,593.78  

 

Operating lease arrangement    
Basic price 1000000.00  
Add GST on purchase (ITC eligible) 450000.00  
Funding Amount 1450000.00  
Processing fees 3.80% 55100.00
Expected Residual Value 25% 250000.00
Tenure 48  
IRR 18%  
Lease Rentals (RV not factored) ₹ 42,593.75  
Lease Rentals (before passing GST benefit) ₹ 39,000.00  
Input tax credit percentage 100%  
Less: GST benefit ₹ 9,375.00  
Lease Rentals (after passing GST benefit) ₹ 29,625.00  
Add: GST on rentals ₹ 13,331.25  
Total inflow ₹ 42,956.25  
When the Residual Value is considered to be 30%
Loan arrangement    
Loan amount 1450000.90  
Processing fees 3.80% 55100.0342
Expected Residual Value 0% 0
Tenure 48  
IRR 18%  
EMI ₹ 42,593.78  

 

Operating lease arrangement    
Basic price 1000000.00  
Add GST on purchase (ITC eligible) 450000.00  
Funding Amount 1450000.00  
Processing fees 3.80% 55100.00
Expected Residual Value 30% 300000.00
Tenure 48  
IRR 18%  
Lease Rentals (RV not factored) ₹ 42,593.75  
Lease Rentals (before passing GST benefit) ₹ 38,281.25  
Input tax credit percentage 100%  
Less: GST benefit ₹ 9,375.00  
Lease Rentals (after passing GST benefit) ₹ 28,906.25  
Add: GST on rentals ₹ 13,007.81  
Total inflow ₹ 41,914.06  

 

Conclusion

The major differentiating factors between a lease and a loan is that the former gives the right to use the asset without any upfront down payment, however, in case of the latter, there is an upfront down payment. Leasing works better when the lessor takes exposure on a handsome amount of residual value. Otherwise, it will turn out to be costlier than loan.

In the coming years, the car leasing market in India will be prospering as most car brands have now started to expand their services to even leasing now, which wasn’t prevalent until the last 4-5 years. With this competitive spirit, many more well developed brands would undertake this strategy to enhance customer base. The statistics of no: of cars being sold is going through a falling spree currently and is expected to fall further. But the leasing market will be flourishing on the other hand. It provides the ‘Best of Both Worlds’ to the customers as well as benefits the owner who still retain the ownership of the cars and gain benefit out of it.

 

[1] http://www.businessworld.in/article/-India-s-Car-Leasing-Market-Is-Worth-Rs-1-5K-Cr-Poised-For-15-20-CAGR-/27-05-2017-119041/

[2] www.statista.com

[3]http://www.cbic.gov.in/resources//htdocs-cbec/gst/notification05-compensation-cess-rate.pdf;jsessionid=B47A84DD8CE463AF356CD17117E2316B

[4]https://www.statista.com/outlook/270/119/car-rentals/india#market-arpu

 

 

Project Rupee Raftaar: An Analysis

-Kanakprabha Jethani | Executive

Vinod Kothari Consultants Pvt. Ltd.

kanak@vinodkothari.com, finserv@vinodkothari.com

BACKGROUND

The Working Group on Developing Avenues for Aircraft Financing and Leasing Activities in India, constituted by Ministry of Civil Aviation submitted its report[1] on measures for developing this industry in the country. The Working Group was formed to examine the regulatory framework relating to financing and leasing of aircrafts. The idea was derived from the Cape Town convention and it has also been proposed to enact a bill in order to fully implement the convention. This project is based on the theme “Flying for All”. The Indian civil aviation market has been exhibiting tremendous growth for past years. There is an overwhelming increase in demand for passenger transportation for which airlines in India have placed orders for more than 1000 aircrafts. Moreover, Indian airlines have been relying on other countries for financing acquisition of aircrafts on export credit, loan or lease basis. This hair-triggers the need for India to have in place its own systems for financing of such acquisitions.

One of the motivations of the project is to ensure that the dependence of Indian aviation industry on import leases is reduced. Currently more than 90% of the aircrafts operating in the country are on import lease basis, and there is a huge monthly outflow of foreign exchange by way of lease rentals, which is not reported as ECB, since it is an operating expense.

GLOBAL PERSPECTIVE TO AIRCRAFT FINANCING AND LEASING

The key players in global aircraft financing and leasing market are Ireland and the US. Countries like China, Singapore, Hong Kong and Japan are emerging competitors in the market. The structures of aircraft financing, however, differ largely in all of these countries. The overall trends in the global arena can be evaluated on following bases:

Regional Outlook: through a research conducted for the Aviation Industry Leaders Report[2], it was concluded that North America is viewed as the most optimistic market player. Europe shows mixed signals due to market being strong and simultaneous slowing down of economy and other political issues. The Middle Eastern countries show a slow pace of growth and their models exhibit signs of stress. African airline market still has a lot of unrealised potential.

Financing Trends: sale and lease back transactions have become the most frequently used medium of aircraft finance over the world. Other forms of financing such as commercial bank debt, pre-delivering payment financing etc. have picked up pace. Also, traditional forms of financing such as export credit continue to be in operation but with reducing levels. Overall, the capital market remains very active and innovative in the aircraft finance sector.

Technology: new technology in aircrafts is being introduced frequently. However, implementation and commercialisation of the same continues to be a challenge. The Aviation Working Group’s Global Aircraft Trading System (GATS) proposed digitisation of transfer of lease deed ownership system which shall be expected to be activated by end of the year 2019.

CURRENT SCENARIO OF AIRCRAFT FINANCING IN INDIA

In terms of growth and advancement, India is far behind other Asian economies such as China, Singapore and Hong Kong. However, the Indian Aviation market has shown exponential rise in the past few years with an annual growth rate of 18.86% in 2017-18 and overall growth of 16.08% in passenger traffic. From 74 operational airports in 2013, it has reached a height of 101 operational airports in 2016. Expectations of having 190-200 operational airports by the end of 2040 are pointed out through various studies.

Currently, India has large aircraft order books, virtually all of which are leased through leasing companies located offshore. Under the regional connectivity scheme Ude Desh ka Aam Nagrik (UDAN), the government has decide to lease out operations, maintenance, and development of certain airports under Public private Partnership (PPP) model.

Overall, India has immense potential for growth in aviation sector but little means to aid the growth. It is in need of systems that aid the growth in a cost-effective and sustainable manner.

AIRCRAFT FINANCING STRUCTURE

Why is it needed?

In the view of increasing demand and non-availability of own sources of aircraft financing, it is essential for India to set up its own structures for the same. Moreover, civil aviation sector is an important sector for development of the economy. In the civil aviation industry, aircraft financing is the most profitable segment and there are no entities in the country exploring this line of business. All the benefits from this gap are being enjoyed by foreign entities.

What will be the structure?

For this structure, GIFT-CITY in Gujarat has been identified as preferred destination for initiation of operations in this industry as it offers a tax regime competitive to that of leasing companies all over the world.

Barriers in the structure

The aforementioned structure will face following barriers:

  • GAAR prevents Indian financers from taking advantage of other jurisdictions.
  • Aircraft financing is not a specifically permitted activity for banks.
  • Units operating in GIFT-CITY not permitted to undertake aircraft financing.
  • Framework for setting-up of NBFCs in GIFT-CITY and provisions as to treatment of income from operating lease is not provided.
  • Taxes and duties:
  • GST of 5% on import of aircraft
  • GST on lease rentals
  • Interest amount which forms part of lease rentals in case of financial lease is not eligible for any tax benefit.
  • No exemptions from withholding taxes
  • Stamp duty on instruments and documents executed.

The working group has proposed corresponding changes and amendments to be made to overcome these barriers. The response of relevant authorities is awaited.

Tax implications of the structure

Particulars

Tax rates

IFSC-GIFT CITY (proposed structure) INDIA (not following the structure)
INCOME TAX
Corporate Tax Rate: 34.94

o   Year 1 to 5

0.00

o   Year 6 to 10

17.47

o   Year 11 onwards

34.94
Minimum Alternate Tax 10.48 21.55
Capital gains on sale of aircraft 0.00 34.94
Withholding tax

o   Operating lease rentals

0.00 2.00

o   Interest payment (USD debt)

0.00 5.46

o   Interest payment (INR debt)

0.00 0.00

o   Other payments

0.00 10.00
Dividend Distribution Tax nil 20.56
GOODS AND SERVICES TAX
Purchase of aircraft 0.00 0.00
Operating lease rentals 0.00 5.00
Underfinance lease(interest portion) 0.00 5.00
Other services nil 18.00
Stamp duty on lease related documents 0.00 3.00

ANALYSIS OF TAX IMPLICATIONS UNDER VARIOUS MODELS OF FINANCING

Following table shows an analysis of indirect tax implications from the point of view of lessee and compares the proposed structure with the existing practice of financing as well as situation if financing is done outside the proposed structure but in India.

This table is based on following assumptions:

  • Value of aircraft- Rs.3500 crores
  • Residual value- Rs.500 crores
  • Rate of interest- 7.5%
  • Lease tenure- 25 years
  • Processing fee- 2%

On the aforesaid assumptions, lease rental per annum would amount to Rs.306.63 crores

Amount (in Rs. crores)

Tax expenditure Ireland IFSC-GIFT CITY Rest of India
GST on lease rentals 15.3315 0.00 15.3315
Stamp duty 0.00 0.00 105
GST on other services 0.00 nil 12.6
Overall indirect tax expenditure 15.3315 0.00 27.9315

OVERCOMING THE BARRIERS

Recommendations have been made by the Working Group to various regulatory authorities in order to overcome various barriers that are a hindrance to establishment of India’s own structure of aircraft financing and leasing. Following table shows some of the major recommendations:

Authority Recommendations
RBI Confirm that the term “equipment” includes aircrafts or notify aircraft financing and leasing as permitted activity for banks or subsidiaries of banks.
Amend IBU circular to include equipment leasing and investment in capital of leasing entities in scope of activities of banks
Confirm that equipment leasing entities shall be eligible to register as NBFC in IFSC
Issue specific directions in regard to investment in or by foreign entities engaged in aircraft financing and leasing activities.
Tax authorities Capital gains on sale of leased aircrafts should be fully exempted.
GST on leasing aircraft should be made zero-rated.
Nil withholding tax should be specified for airline companies.
Transfer/novation of aircraft financing / leasing contracts to units in an IFSC should not be under the purview of GAAR, for both the lessee and lessor
SEBI Amend SEBI (AIF) Regulations to create a separate category of AIFs for investment in aircraft financing/leasing activities or permit greater concentration of investment in aircraft financing/leasing entities.
Clarify whether 25% investment cap by AIFs applies on investment in equipment and grant additional relaxations to AIFs investing in aircraft financing activities.
Create separate category of mutual funds of investment in entities engaged in aircraft financing and leasing activities.
Clarify which institution can invest in entities registered in IFSC.
IRDAI Amend IRDAI regulations permitting companies set up in IFSC to invest in entities engaged in aircraft financing and leasing activities.
Clarify whether investment of funds of policyholders’ in entities registered in IFSC be considered as funds invested in India only.
Others Clarify under aircraft rules that aircrafts of lessors cannot be detained against any statutory or other outstanding dues.
Entities like pension funds, insurance companies, employee provident fund organisations be allowed to invest directly or indirectly in aircraft financing and leasing activities.
SARFAESI Act not be applicable to aircrafts.
Gujarat Stamp Act to exempt aircraft financing and leasing from its purview.
Permit airlines to set up branch in IFSC.

CONCLUSION

It is absolutely evident that aircraft industry is on upsurge and will continue to be rising globally in the coming years. To meet the rising demand and expand the country’s hold in the aviation market the proposed structure provides a well-established groundwork through the proposed structure. All recommendations, if accepted and implemented in a proper manner, will enable India to pioneer a very profitable and growth-oriented aviation market.

 

[1] https://www.globalaviationsummit.in/documents/PROJECTRUPEERAFTAAR.pdf

[2] https://assets.kpmg/content/dam/kpmg/ie/pdf/2019/01/ie-aviation-industry-leaders-report-2019.pdf

 

New lease accounting standard kicks off from 1st April, 2019

Financial Services Division

(finserv@vinodkothari.com)

The Ministry of Corporate Affairs (MCA) has put a small announcement on its website that the new lease accounting standard, IndAS 116 will get implemented from 1st April 2019. The new Standard, globally implemented in several countries from 1st Jan 2019, is called IFRS 16. The Standard eliminates the 6-decade old distinction between financial and operating leases, from lessee accounting perspective, thereby putting all leases on the balance sheet. The phenomenon of off-balance sheet lease transactions was one of the burning analyses after bankruptcy of Enron in 2001, and since then, had been erupting off and on, until the global standard setter decides to push the new standard on the rule book in Jan 2016, effective 1st Jan 2019.

After the introduction of IFRS 16, the ICAI came out with an exposure draft on the new standard in 2017 and kept it open for comments for some days. However, nothing further was heard about it thereafter.

The exposure draft and the final published Ind AS 116 are same except for the below mentioned change which has been incorporated in the final published Ind AS 116:

Para 47 dealing with presentation in books of lessee:
In Exposure Draft Text of published Ind AS 116
Para 47 A lessee shall either present in the balance sheet, or disclose in the notes: Para 47: A lessee shall either present in the balance sheet, or disclose in the notes:
(a) right-of-use assets separately from other assets. (a) right-of-use assets separately from other assets. If a lessee does not  present right-of-use assets separately in the balance sheet, the lessee shall:
(i) include right-of-use assets within the same line item as that  within which the corresponding underlying assets would be  presented if they were owned; and
(ii) disclose which line items in the balance sheet include those  right-of-use assets.
(b) lease liabilities separately from other liabilities. (b) lease liabilities separately from other liabilities. If a lessee does not  present lease liabilities separately in the balance sheet, the lessee  shall disclose which line items in the balance sheet include those liabilities.

(above para is same as para 47 IFRS 16, thereby making IFRS 16 and Ind AS 116 exactly same now, except for the fair value option for investment property- ref para 1 of comparison with IFRS 16 )

Giving the above option makes it clear how the lessee is going to show the asset in books.

For example, if A takes Aircraft-1 on lease and owns Aircraft-2, A can either include both of them in PPE or can show Aircraft-1 in PPE and Aircraft-2 just below PPE under the head ROU.

Correspondingly, a lease liability can be disclosed separately, if not disclosed separately, then disclose which line item in BS includes the lease liability.

Globally, several jurisdictions have implemented the Standard with effect from 1st January, 2019. A list of jurisdictions which have already adopted can be viewed here.

Some of the key takeaways from the implementation of this Standard are:

  • Currently, there are two accounting standards for lease transactions, first, Ind AS 17, which is applicable to the Ind AS compliant companies and second, AS 19, which is applicable to the remaining classes of companies. Ind AS 116 proposes to replace Ind AS 17, therefore, the companies which are not covered by Ind AS shall continue to follow old accounting standard. 
  • The applicability of this standard shall have to be examined separately for the lessor and the lessee, that is, if the lessor is Ind AS compliant and lessee is not Ind AS compliant, then lessor will follow Ind AS 116 whereas lessee will follow AS 19. 
  • The new standard changes treatment of operating leases in the books of the lessees significantly. Earlier, operating leases remained completely off the balance sheet of the lessee, however, vide this standard, lessees will have to recognise a right-to-use asset on their balance sheet and correspondingly a lease liability will be created in the liability side. 
  • Lease of low value assets and short tenure leases (up to 12 months) have been carved out from the requirement of recognition of RTU asset in the books of the lessee.
  • No change in the accounting treatment in case of financial leases. 
  • No change in the lessor’s’ accounting.

While leasing has not been greatly popular in India compared to the world, there has been a substantial pick up in interest over recent years. Therefore, a question comes – will the new standard put a death knell to the feeble leasing industry in India? To the extent the demand for leasing comes from off balance sheet perspective for a lessee, the standard may have some impact. However, there are many economic drivers for lease transactions – such as the ease of usage, tax benefits, better residual realisation, etc. Those factors remain unaffected, and in fact, the focus of lease attractiveness will shift to real economic factors rather than balance sheet cosmetics.

The apparent question that arises here is whether the new standard unsettle the taxation framework for lease transactions in India, especially direct taxes – the answer to this question is negative. The tax treatment of lease transaction does not depend on the treatment of the transaction in books of accounts. Instead, it depends on whether the transaction is case a true lease or is merely a disguised financial transaction. There will be no impact on the indirect taxation framework as well.

GST Council brings down the rate of GST on used cars, besides others

By Abhirup Ghosh, (abhirup@vinodkothari.com, finserv@vinodkothari.com)

The GST Council met for the 25th time on 18th January, 2018 to modify the GST law in order to tackle the difficulties being faced in the market. The Council recommended several changes to the law among and one of the change that has can cause a significant impact on the vehicle industry is reduction of rate of tax on sale or purchase of used motor vehicles. Read more