Leasing in Pakistan
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Leasing in Pakistan, like in many of its peer countries, owes its origin to the efforts of the International Finance Corporation ( IFC), Washington. The first leasing company in Pakistan, the under the specific law relating to leasing companies was the National Development Leasing Corporation, set up in 1984. IFC Washington participated in the equity of this company, besides a domestic DFI (NDFC), and the Asian Development Bank.
A report on Pakistani leasing by Asif Habib has this to say on the origin of leasing in Pakistan: "The concept of leasing was introduced to Pakistan during Zia-ul-Haq's regime in the early 1980s, as an Islamic form of long term financing. The passage of two ordinances paved the way for the birth of this new concept. These ordinances were the Banking & Financial Service Ordinances 1984, and Banking Companies Tribunal Ordinance 1984, and they required banking institutions in Pakistan to provide financial services in accordance with the Shariat principles of Islam. The Islamic principles prohibit interest-based (Riba) transactions. Since leasing involves a series of fixed rental payments for an asset effectively "rented out", it was understood to be outside the "Riba" category. "
The success of the first comer soon attracted fresh entry.
In 1996, there were 36 leasing companies in the country. Besides, some of the banks and financial institutions also added leasing divisions to their existing operations. In a report before the Asialease, the Leasing Association of Pakistan reported, in early 1998, a membership strength of 41. This is apparently over and above the presence of modarbas, banks and development financial institutions which are also engaged in leasing.
Leasing companies and modarbas:
While talking about the leasing market in Pakistan, one must not forget the typicality of its market place: leasing market is shared by leasing companies as well as the Islamic open-ended funds called modarbas.
Leasing companies are those which are incorporated as companies. There is a certain procedure of licensing of such companies, discussed later. Modarbas, however, are formed under the Islamic system under the Modaraba Companies and Modaraba (Floatation and Control) Ordinance, 1980. Of the 52 registered modarbas, 16 are reportedly engaged in leasing business. The modarbas enjoy certain tax benefits as tax holiday for certain number of years, followed by a significantly reduced tax rate. The tax holiday was withdrawn in 1992 but re-inserted in 1998.
At the same time, modarbas stand to a major disadvantage. Being organised on Islamic principles, modarbas are not allowed to borrow on interest basis: therefore, they have to depend on their participants contribution alone, or short-term musharika (implying participation in profits or losses) or morahaba funds, which limits their leveraging powers. May be facilitative securitisation market can make modarbas the success that they should really speaking have been.
Besides this, there is still a largely a unorganised market by indigenous financiers who mainly give loans or hire-purchase finance for motor vehicles, particularly commercial vehicles. The organised leasing industry statistics do not include these financiers.
The growth of leasing volumes in Pakistan has been impressive - an average rate of growth of about 35% to 40% has been achieved over past 1 decade or so.
The current penetration of leasing in Pakistan is estimated at about 7% with a market of about Rs. 15 -20 billion per annum. Etrat Rizvi reports that "during the year ended 30 June 1997, the LAP member companies [of Leasing Association of Pakistan] (33 leasing companies and 8 leasing modarabas) wrote additional leases amounting to over Rs. 12.00 billion and earned a post tax profit of Rs. 1.23 billion. These companies paid income tax including turnover tax of around Rs. 200.0 million. These companies paid Rs. 7.00 million by of way of dividend".
Leasing companies in Pakistan are currently operating at about 20 -24% pre-tax rates of return. Given the tax incentives, this is not a bad rate of return.
The major asset side concentration of leasing in Pakistan is on plant and machinery, which takes about 2/3rds of the total leasing volume. This is not hard to appreciate, since commercial vehicles, which form the cynosure of financiers all over the World, are still largely under the controls of the unorganised indigenous financiers in Pakistan. May be the legal difficulties associated with the motor vehicles law have stood as the bottleneck.
Pakistani leasing industry operates on an average Debt/Equity ratio of about 3:1. This is evident from the data provided on Association members by Etrat Rizvi.
Pakistani leasing companies depend largely on a short-term retail finance instrument called the Certificate of Investment. Of late, there has been some development on the securitisation front also, but that remains in infancy. A new instrument called Term Finance Certificate is also being talked about recently.
The leasing firms are controlled by the laws and regulations governing Non Banking Financial Institutions. The State Bank of Pakistan [SBP] is responsible for the prudential supervision of all financial institutions. The SBP gets guide lines in the form of Prudential Regulations relating to capital, asset quality, management, profitability, liquidity and solvency. The principal provisions of the prudential regulations pertaining to non-banking financial institutions [NBFIs] are listed below.
Prohibited Activities
NBFIs are prohibited by the SBP from out any of the following activities:
The restriction above on interest-bearing transactions seems strange, because leasing is after all akin to an interest-bearing transaction, and based on technical reasons, a lessor may decide to invest by way of loans instead of leases.
English common law:
Leasing is an asset renting activity, and is therefore, governed by common law. Pakistann legal system as far as commercial law is concerned has a common heritage as that of India: English common law.
Accordingly, the basic principles of bailment law are applicable to Pakistan.
Taxation of leases in Pakistan:
The provisions of the Income-tax law, relating to lease transactions, can be broadly summarised in the following bullet-points:
The residual value practice in Pakistan is typical of any market where hire-purchase as an instrument is less known, and leasing in its current state is predominantly as well as avowedly financial leasing. It appears that it is a consistent practice in Pakistan for lessors to transfer the leased asset to the lessee at the end of the lease period at phenomenally reduced prices. Not have the authorities not objected to this practice as this smacks of a hire-purchase transaction, they seem to have legalised this practice in the tax amendment where transfers to lessees at the end of the lease contract were made unquestionable.
A detailed study of the Pakistan tax provisions follows:
No true lease guidelines:
There are apparently no rules in Pakistan to distinguish genuine lease transactions from plain financing transactions. This is one of the most important rules to have in a developing market and an important lesson can be learnt in this regard from India.
A lease, in order to qualify for tax deduction, has to be different from a plain financial transaction. Evidently, no depreciation benefit can be claimed in case of a transaction of simple financing of an asset. In addition, one must also appreciate that if an agreement has the colour of a lease transaction but in essence is nothing but a financial transaction, the outer form of the transaction will be ignored, and based on its intrinsic substance, it would be reckoned as a financial transaction.
The meaning of the above is that if a lessor in Pakistan writes a lease transaction which has the legal form of a lease, but is in substance nothing but a financing transaction on the security of an asset, such lease will not be regarded as a lease but as a secured financing. Obviously, it is not enough to call an agreement a lease agreement: in taxation, nomenclatures are ignored and the reality is looked into.
To guide parties as to what are the important attributes of a lease transaction that would distinguish it from a financial transaction, one would find, in advanced leasing markets, detailed rules or standards that define a true lease. In absence of such guidelines, it is quite common, particularly in nascent stages of development of an industry, for players to make mistakes which turn out to be costly both for the revenue and for the players themselves.
India, like Pakistan, does not have true lease guidelines. As a result, around 1987-1989, when leasing grew very rapidly in the country, a number of lessors wrote leases for assets that never existed. There was obviously no intent to cheat the revenue, but such practices were founded on a premature belief that all agreements which look like lease agreements will be acceptable for tax purposes.
Even today, inspite of the fact that India today is a mature market compared to many others, a number of Indian lessors make mistakes which would only prove to be fatal over time.
The trouble with a no-rule regime is that it encourages unintentional malpractices. Of course, tax avoidance and evasion can exist even where there are elaborate rules, but the trouble with absence of rules is that it breeds innocent non-compliance.
Pakistan must notify true lease guidelines, and sooner the better. It must, most importantly, educate tax payers on what is the elementary distinction between a lease and a hire-purchase transaction, since in the latter case, depreciation cannot be claimed by the lessor.
No clear distinction between lease and hire-purchase
The difference between lease and hire-purchase transactions is a crucial difference for all countries which allow depreciation based on ownership of an asset. It is a basic rule of law that "ownership" for tax purposes is not merely legal ownership - it must be backed by beneficial ownership. Beneficial ownership implies the right to attain benefits of ownership at some point of time. In a hire-purchase transaction, the legal owner (finance company) cannot be treated as beneficial owner, since, having provided the user with a right of purchase, the owner has divested himself of beneficial interest completely.
Currently in Pakistan many of the lease transactions are in fact hire-purchase transactions, as the sale of the asset to the lessee, even if not incorporated in the contract of lease, is mostly inherent and pre-agreed. As mentioned earlier, the tax authorities seem to have disregarded this distinction completely when they permitted the transfer of the leased asset to the lessee at the end of the lease period.
This practice, which in opinion of the author will be a problem over time as the revenue officials get more of education on lease taxation, can be resolved either by proper training or by a proper law. Treating a lease with an inherent option to buy as hire-purchase will be more easy in Pakistan, which has a number of statutory definitions of the term "hire-purchase" in several of its laws.
Pakistan continues to operate on the Initial depreciation system. India had discontinued initial depreciation more than 1 1/2 decades ago. As a matter of act, even Bangladesh, an off-shoot of Pakistan, has discontinued this allowance in 1998. Nay, there was a proposal to scrap initial depreciation in Pakistan too, but strong industry lobbying persuaded the businessman-turned Prime Minister from not carrying on with the measure.
The initial depreciation system is not considered healthy. By offering a high first year allowance followed by a slow write-off over time, the system encourages companies to over-capitalise themselves, or to prepone their capital expenditure. This apart it builds a heavy deferred tax liability on the balance sheet which is currently not reported by companies in Pakistan.
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The following depreciation rates prevail in Pakistan: |
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Initial |
Annual |
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Machinery |
25% |
10% |
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Commercial vehicles |
25% |
20% |
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Other vehicles |
- |
20% |
Accelerated depreciation: whether claimable by leasing companies?
As an incentive measure, in 1997 Pakistan introduced the concept of "accelerated depreciation". Rule 5A of the Third Schedule for such depreciation for assets installed in eligible industrial undertakings.
It is a pertinent question as to whether leasing companies are eligible to claim accelerated depreciation. If the wording of the law is similar to Bangladesh (author has not been able to lay hands on the exact wording of the law), the conditions specified in the law apply to the industrial undertaking, and there is nothing to indicate that the eligible industrial undertaking should also be owned by the person claiming depreciation. On analogous provisions, investment allowance was held claimable by leasing companies in India - this is the ruling of none less than the Supreme Court of India. As a matter of fact, the intent of the Govt granting this incentive is to encourage new investment in the productive areas, and in doing so, the purpose of the Govt. is not frustrated by allowing the accelerated depreciation to leasing companies. As a matter of fact, if the leasing company enjoys accelerated depreciation, the benefit thereof is passed on to the user by way of reduced rental rates.
Conditions for claiming depreciation:
The usual conditions for claiming depreciation are::
First condition: depreciable asset
The first condition implies that the asset must have a natural wear and tear. That is to say, the allowance as provided in the Act is to be allowed if there is a depreciation by way of wear and tear in the property. If the asset in question be, for example, land which is not subject to wear and tear, no depreciation will be allowable. On the same logic, intangible assets which are not subject to wear and tear by usage or efflux of time are not depreciable assets.
Second condition: "Owned" by the tax-payer
The second condition of "acquiring" implies that the lessor must have acquired ownership rights over the asset. Ownership conveys legal as well as beneficial ownership. No doubt, the lessor is the legal owner of the asset, but if the lessor has divested all his beneficial interest in the asset for all time to come, he may be owning the chaff of legal title, which will not entitle him to claim depreciation.
The other notable issues with regard to ownership are:
Third condition: "Used" by the tax -payer
The third condition is the condition of use. The Act requires that the asset must have been used for business purposes. It must be understood that the "use" that qualifies a lessor to depreciation is not the physical use by the lessee, but the use by the lessor in his business of leasing. The lessor makes the use of the asset in the lessor's business of leasing the asset, and that use qualifies the lessor to stake a depreciation claim.
Having understood the condition of use in this light, it becomes clear that:
Year of sale treatment: balancing charge and capital gains and the "market value" problem:
Pakistan has not adopted the "block of assets" or pooling principle for depreciable assets. Therefore, each asset is seen as an entity and depreciated as such.
An important provision here is that the "sale proceed" of an asset is defined as the actual selling price, or the market value whichever is higher.
This is where the difficulties of the leasing companies come in. As mentioned earlier, leasing companies in Pakistan have a consistent practice of transferring assets to lessees at the end of the lease period. The transfer took place at a nominal, pre-fixed price, miles away from the actual market value of the asset. In this situation, if the tax officer could tax the selling lessor on market value basis, the lessor would be in fact paying tax on something that he never realised.
Based on strong representation by the industry, the law was amended by inserting a rule 8 (5) in the Third Schedule to specifically create an exception to the market value principle for leasing companies, in case they sell their asset to the first lessee of such assets. Another technical glitch in this rule, from the lessee's perspective, was removed in 1998.
Leasing depreciation: limited to income from leasing:
In line with several countries now (notably, Sri Lanka, Malayasia, etc.), Pakistan has enacted that rule that where depreciation has been claimed by a person carrying on the business of leasing, the allowance for depreciation in respect of assets acquired by the person and given on lease in the course of such business of leasing shall be deducted only in ascertaining the profits and income of such business.
The simplest meaning of this provision is that the depreciation out of leasing business cannot be go on offset the profit out of any other business. As "profit or income" has to be read in the sense of taxable profit or income, it means that after allowing for all allowable deductions and benefits, lease depreciation shall be deductible against leasing income.
The provision was principally intended to restrict leasing being pursued as a tax shelter by persons not fully in leasing business: therefore, the provision is applicable for all entities whether carrying on leasing as a part of their business or otherwise.
It may be noted that the restriction for claiming depreciation set-off is against income of the leasing business, and not necessarily against leasing income. If leasing is the only business carried on by the entity, one cannot still rule out there being other incomes in business. For example, the temporary surpluses in business may be invested for a short-term application, which does not constitute the business of the entity. Though difficulties do arise in distinguishing a business and an incidental activity, it cannot be said that the only source of income against which the leasing depreciation should be offset is the lease rentals. After all , even connected with the leasing business can be incomes such as service charges, management fees, fees earned from lessees, etc.
Tax authorities in many countries frown down upon sale and leaseback transactions, but in Pakistan, they simply seem to have no complaint. As a matter of fact, they have only sought to clear some hurdles along the way.
There were two problems in the way of sale and leaseback transactions: sec. 80C and 80D. These provisions required a deduction of withholding tax on sale of capital assets, and also imposed a presumptive tax stipulation based on turnover of the selling unit. Since a lessee under a sale and leaseback would sell his assets, he would be subject to the presumptive tax problem, as also be required to deduct tax at source and leave it for the leasing company to claim a refund over time. These provisions acted as deterrant for sale and leasebacks.
The problem has been cleared with the latest law changes excluding a sale and leaseback transaction from the operation of the two provisions mentioned above.
Sales-tax:
Pakistan introduced the Sales-tax Act 1990 with the predominant objective of moving towards a global value-added tax (VAT) system.
Apparently, the Act covers leasing companies also.
Pakistan, like India or many other counties at comparable levels of development, has not still adopted the International Accounting Standard no. 17 on Accounting for Leases. Hence, Pakistan continues to account for leases on the operating method: that is, leased assets are capitalised and depreciated on the books of the lessor.