Table of Contents:-
- What is leasing?
- Features of Leasing
- Benefits of Leasing
- Types of Leasing
- Clauses in Leasing Agreement
- Buying or Leasing?
- Major Leasing Institutions in India
What is Leasing?
What is Leasing? Leasing is a contract in which the owner of an asset (the lessor) grants exclusive rights to another person (the lessee) to use the asset for an agreed-upon period, in exchange for the payment of rent, referred to as lease rental. Capital assets like land, buildings, equipment, machinery, and vehicles are the usual assets which are generally acquired on a lease basis. The lessor remains the owner of the asset, but the possession and economic use of the asset is vested in the lessee.
In India, as there is no distinct statute governing leasing contracts, which are analogous to contracts of bailment, the provisions of the Indian Contract Act are applicable.
Bailment Contracts and Indian Contract Act
According to Section 146 of the Indian Contract Act, of 1872, bailment is defined as “the delivery of goods by one person to another person for some purpose, upon a contract that they shall, when the purpose is accomplished, be returned or otherwise disposed of according to the directions of the person delivering them.” The person delivering the goods is referred to as the bailor, and the recipient is known as the bailee.
Since an equipment lease transaction falls within the category of a bailment contract, the obligations of the lessor and the lessee are similar to those of the bailor and the bailee, unless expressly specified otherwise in the lease agreement, as outlined in the Indian Contract Act.
In summary, these obligations can be stated as follows:
1) The lessor is obligated to deliver the asset to the lessee, granting legal authorization for the lessee to use the asset and maintain peaceful possession of the asset throughout the lease period.
2) The lessor must fulfil the payment of lease rentals as specified in the lease agreement. This is to safeguard the lessor’s title, ensure reasonable care of the asset, and facilitate the return of the leased asset at the expiration of the lease period.
Features of Leasing
The essential features of a leasing contract are given as follows:
- A Valid Lease Contract
- Delivery of Goods
- Return of the Goods
1. A Valid Lease Contract
A leasing arrangement is established by entering into a valid contract between the lessor and the lessee. Both parties must be competent to contract. The lessor must possess a clear and undisputed title to the assets intended for lease. The agreement must meet the essential requirements of a valid contract as per the Indian Contract Act.
2. Delivery of Goods
The movable property, commonly referred to as ‘goods,’ must be delivered by the lessor to the lessee. The delivery of goods may take the form of either actual delivery or constructive delivery. The former case involves handing over physical possession of the goods to the lessee.
In the latter case, there is no change in physical possession, but the possessor of the goods receives instructions or directions to hold them on behalf of the lessee rather than the lessor.
Goods are delivered to the lessee with the specific purpose of being used for their specified lawful activity throughout the lease period.
The lessee undertakes to regularly pay the lessor lease rental as compensation for the use of the goods.
5. Return of the Goods
The goods must be returned to the lessor in the same form after the lease period is over.
The lessor, after handing over possession of the leased asset, remains the owner of the asset throughout the lease period and even thereafter.
The prospective lessee identifies the equipment to be leased and its supplier, entering into a lease arrangement with a leasing company. They provide certain particulars, such as their name, address, details about their business, the name and address of the guarantor if any, description of the equipment (model, make, size, specification, etc.), the name and address of the supplier, the price quoted by the supplier, place of installation, duration of the lease, etc.
The lessor examines the lease proposal, evaluating the creditworthiness of the applicant, their past performance in the business, and their capacity to pay the periodic rentals. This evaluation takes into account the profitability and projected cash flows of their business, as well as their reputation, etc.
Benefits of Leasing
Several benefits are derived by the lessee by acquiring the assets on a lease basis, as compared to buying the same. The benefits are as follows:
- Convenience in Case of Short-Term Needs
- No Risk of Technological Obsolescence
- Efficient Maintenance Services
- Low Administrative and Transaction Costs
- Debt-Equity Ratio Remains Unchanged
- Benefit of Tax Shield
1. Convenience in Case of Short-Term Needs
If a capital asset is required for a short period, such as a year or two, leasing is a convenient and appropriate method of acquisition. It eliminates the formalities and expenses associated with purchasing the asset and subsequently selling it once the need is fulfilled.
2. No Risk of Technological Obsolescence
In the case of owning the asset, the firm bears the risk of the asset becoming obsolete. In the present age of technological innovations, the risks associated with owning an asset with outdated and old technology cannot be ignored. With such equipment, the firm may struggle to compete with its counterparts and may incur heavy losses. Leasing provides a shield against all these hazards by transferring the risk of equipment obsolescence to the lessor. This is particularly true for operating leases, which are of short duration and cancellable at the option of the lessee. The lessee can cancel an old lease agreement and enter into a new one if a technologically superior product becomes available in the market. Although lease rentals for such equipment may be higher, this disadvantage is more than offset by the benefits the lessee derives from passing on the risk of obsolescence to the lessor.
3. Efficient Maintenance Services
Under an operating or full-service lease, the lessee benefits from maintenance and other services provided by the lessor, who is well-equipped, qualified, and experienced to deliver such services efficiently. Naturally, the lessee covers the cost of these services through higher rentals.
4. Low Administrative and Transaction Costs
Many leasing companies specialize in leasing specific types of equipment, machines, or vehicles only. They can easily negotiate with suppliers/manufacturers, acquire assets at better prices, and economize on other administrative expenses. The lessee may receive a concession in lease rent based on the economies achieved by the lessor.
5. Debt-Equity Ratio Remains Unchanged
When an asset is acquired on a lease basis, lease rentals are recorded as an expense in the firm’s profit and loss account. Neither the leased asset nor the liability under the lease agreement is shown in the balance sheet. Hence, the debt-equity ratio remains unaffected compared to a firm that buys the asset with borrowed funds.
6. Benefit of Tax Shield
The lessee claims lease rentals as tax-deductible expenses every year during the lease period, reducing their tax liability to that extent.
In case the lessee buys the asset with borrowed funds, they can claim the following:
(i) Depreciation and
(ii) Interest on borrowed funds as tax-deductible expenses.
If the lease rental exceeds the depreciation and interest burden, their deductible expenses are larger, resulting in a lower tax liability. The net burden, in such cases, is neutralized by the benefits derived by the lessee.
Types of Leasing
The terms and conditions on which an asset is leased, as well as the rights and obligations of the lessor and the lessee, are incorporated in the Lease Agreement. Based on variations in all these aspects, leases are classified into the following categories:
- Operating Lease
- Financial Lease
- Sale and Lease Back
- Leveraged Lease
- Domestic Lease and International Lease
In the case of an operating lease, the lessor not only leases the asset of which they remain the owner throughout but also undertakes to provide services attached to such assets, such as maintenance, repairs, technical advice, etc. This type of lease is also known as a service lease. Computers, office equipment, automobiles, and trucks are typical capital assets leased under an operating lease arrangement.
The main features of an operating lease are given as follows:
i) The lease contract is generally for a period considerably shorter than the useful life of the leased asset. For example, a machine may be acquired on lease for 5 years, while its useful life maybe 10 years.
ii) Consequently, the lessor does not recover the full cost of the asset from only one lessee. The leased asset is returned to the lessor at the end of the lease period and is then leased again to another lessee for another lease period. After its useful life is over, it is sold, and the lessor realizes its scrap value.
iii) An operating lease typically contains a cancellation clause, allowing the lessee to terminate the lease any time before the lease period ends. This clause is beneficial to the lessee if the asset becomes obsolete or if their need for the asset is fulfilled.
iv) The lease agreement includes a maintenance clause requiring the lessor to maintain the leased assets. Thus, necessary repairs, fuel, and support staff may be provided by the lessor, as agreed upon.
v) The lease rental includes:
- As part of the amortization of the cost of the equipment,
- The cost of the maintenance services provided, and
- The profit of the lessor.
In the case of a financial lease, the lessor remains the owner of the leased asset during the lease period but does not undertake its necessary maintenance. The rental received by the lessor fully amortizes the cost of the equipment and earns a profit for them. These leases are non-cancellable. Ultimately, ownership of the leased asset may be transferred to the lessee at an agreed-upon price. The lessor thus acts as a financier only and earns a return on their investment in the leased asset through rentals. Financial leases typically cover the major part of the useful life of the asset.
Sale and Lease Back
This is another type of lease arrangement wherein the lessee, who already owns the assets, sells the same to the lessor and thereafter takes the same asset from him on a lease basis. This is called a ‘Sale and Leaseback arrangement’. Under this arrangement, the lessee immediately recovers the value of his already-owned assets from the lessor. Afterwards, the lessee makes periodic lease rental payments as usual. Such a lease arrangement enhances the liquid resources of the lessee immediately, which can be utilized otherwise to meet his working capital requirements or to purchase another asset on a cash payment basis. This type of lease serves as an alternative to mortgaging the assets.
In the case of an ordinary lease, the lessor purchases the asset with an appropriate mix of debt and equity. However, the creditor (i.e., supplier of the debt funds) does not have recourse to the lessee. In other words, if the lessor defaults in making repayment of the debt, the creditor cannot claim the same from the lessee; recourse is limited to the lessor.
A leveraged lease is the opposite of the above. In such a case, the creditor remains entitled to have recourse to the lessee, i.e., they can recover their claims from the lessee as well. The lease rental is assigned to the creditor, and the lessee is required to pay the lease rental directly to the creditor of the lessor. Generally, this transaction is undertaken through a trustee, who receives the lease rental and appropriates it as a debt service component to the creditor and the balance amount to the lessor.
Domestic Lease and International Lease
This category is based on the domicile of the parties to a lease contract. If all the parties, namely the equipment supplier, lessor, and the lessee, are residing in the same country, the lease is called a domestic lease. It is called an international lease if they reside in different countries. If the lessor and the lessee are domiciled in the same country, and the equipment is imported from another country, it is called an import lease. If the lessor and lessee are domiciled in different countries, the lease is called a cross-border lease. In such cases, the equipment supplier may be a resident of any country. In the case of an international lease, there are two additional risks: country risk and currency risk.
Clauses in Leasing Agreement
After the lease transaction is finalized, a lease agreement is prepared and executed by the parties. The lease agreement incorporates the legal rights and obligations of the lessor and the lessee to bind them and serve the purpose of evidence in case any dispute arises during the lease period.
The main clauses usually incorporated in a lease agreement are as follows:
1) Nature of the Lease
This clause specifies the nature of the lease (i.e., operating lease, financial lease, or a leveraged lease) and the names of the parties to the Agreement.
2) Description of the Asset
This clause describes the equipment to be leased, including its make, model, size, specification, etc.
3) Duration of Lease Period
This clause specifies the period for which the asset is leased, known as the primary period. The clause generally also gives the lessee an option to renew the agreement for a further period, referred to as the secondary period.
4) Lease Rentals
This clause specifies the lease rental payable by the lessee, taking into consideration the cost of funds, depreciation, repairs, expected profit, and the risk involved in the lease transaction, etc. The rent may be payable monthly or quarterly, and this clause stipulates the quantum of such rental, the time within which it is payable, and the consequences of failure to pay the same.
5) Delivery and Re-delivery
This clause mentions when and how the leased equipment will be delivered to the lessee and how it will be delivered back to the lessor on the completion of the lease period.
6) Right to Use
This clause allows the lessee to make proper and lawful use of the equipment.
7) Repairs and Maintenance
Usually, this clause states that the lessee shall maintain and repair the equipment, keeping it in good and working condition. The cost of such maintenance shall be borne by the lessee.
8) Alterations/Additions to Equipment
This clause states that the lessee shall not make any alterations or additions to the equipment or remove it from the premises without the written consent of the lessor.
9) Right to Inspect Equipment
This clause gives the lessor the right to enter the premises of the lessee and inspect the equipment as and when desired.
10) Damage to Equipment
It is usual to stipulate that the lessee will bear all risks, losses, damages, theft, or destruction of the equipment as long as it is in his custody.
11) Prohibition of Sub-leasing
This clause prohibits the lessee from sub-leasing the equipment or selling it to any party.
12) Default by Lessee and Remedies
This clause indicates specific events of default by the lessee and the remedies available to the lessor in such cases. The remedies may include declaring all unpaid rentals due and payable immediately, suing the lessee for recovery, terminating the lease agreement, and seizing the leased equipment.
This clause requires the lessee to take out a fire insurance policy in respect of the equipment in the joint names of the lessee and the lessor (named therein as the owner). The lessee shall pay the premium and renew the policy every year.
14) Other Charges
This clause specifies which party will pay various expenses and charges in connection with the purchase and installation of equipment.
Buying or Leasing?
A firm faced with the decision to acquire a capital asset must carefully consider whether to purchase it outright or acquire it through a lease. In the former case, the firm needs to raise funds through debt or equity if it lacks surplus funds. The firm’s decision should be based on evaluating both proposals and comparing the costs involved.
The following steps outline the evaluation process:
1) Capital Budgeting Decision
The decision to acquire a particular asset is essentially a capital budgeting decision, requiring careful consideration using appropriate methods.
2) Choosing Between Buying and Leasing
After deciding on the asset, the firm must choose between buying or leasing, considering the relative costs involved.
3) Funds for Outright Purchase
For outright purchase, the company needs funds equal to the cost of the asset at the time of acquisition. If the company has sufficient funds, it may opt for an outright purchase.
4) Raising Sufficient Funds
If funds for outright purchase are insufficient, the firm needs to raise them through share issuance or long-term borrowings, each incurring costs that must be realistically estimated.
5) Tax Considerations for Outright Purchase
With outright purchase, the firm can charge depreciation on the asset and interest on borrowed funds as deductible expenses for Income Tax purposes. The after-tax cost of the buying decision is considered for comparison with leasing.
6) Scrap Value Consideration
The scrap value of the asset is also considered in the case of purchase.
7) Leasing Option and Tax-Deductible Expenses
For the leasing option, the firm needs to make regular lease rental payments over the lease period. The entire lease rental amount is a tax-deductible expense.
8) Calculation of After-Tax Cost of Lease Rentals
Calculate the after-tax cost of lease rentals (cash outflows) each year.
9) Equalizing the Period of Cash Outflows
Ensure that the period of total after-tax cash outflows in both alternatives is identical. For example, if the lease period is 10 years, calculate the net cash outflows for the buying decision over 10 years.
10) Comparison of Present Values
Compare the present value (PV) of cash outflows under the leasing decision with the PV of the buying alternative, using the after-tax cost of debt as the discount rate.
11) Decision Criterion
Select the alternative with the lower present value of cash outflows. The decision criterion is:
- If the PV of cash outflows under the leasing alternative is greater than the PV of cash outflows under the buying alternative, buy the asset.
- If the PV of cash outflows under the buying alternative is greater than the PV of cash outflows under the leasing alternative, lease the asset.
Major Leasing Institutions in India
In India, the business of leasing is conducted by the following entities:
1) Equipment Leasing Companies
Equipment Leasing Companies primarily focus on equipment leasing and are categorized as Non-Banking Finance Companies (NBFCs). The Reserve Bank of India, the regulatory authority for all NBFCs, oversees and controls these companies. According to the Reserve Bank of India Act, 1934, all NBFCs must obtain a Certificate of Registration from the Reserve Bank of India to conduct business. The statutory requirement for minimum net owned funds for registration was set at Rs. 25 lakh for existing companies and Rs. 2 crore for new companies seeking registration after April 21, 1999.
The number of Equipment Leasing Companies increased from 56 as of the end of March 2002 to 58 as of the end of March 2003. However, their assets decreased from Rs. 3112 crore to Rs. 2011 crore during the same period. These companies also solicit public deposits, which declined from Rs. 668 crore to Rs. 511 crore during the same period. The Reserve Bank of India supervises these companies through on-site inspection, off-site monitoring, market intelligence, and exception reports from statutory auditors.
2) All India Financial Institutions
While these institutions mainly provide financial assistance in the form of project finance, they also engage in offering non-project finance to industries. Equipment leasing is one of how they provide non-project finance.
3) Commercial Banks
The Reserve Bank of India has specified that commercial banks can participate in equipment leasing businesses and/or invest in the shares of equipment leasing companies within defined limits through their subsidiary companies. Consequently, subsidiaries of commercial banks are involved in leasing to a limited extent.