Lease education and consulting by Vinod Kothari

You are visitor number to this site.

Financial leases:

 Here, though the device used is leasing, the purpose and effect is virtually financing - financing by the device of leasing, or leasing for the purpose of financing. However, the generic differences noted above still remain. In other words, the lessor will provide an asset and not the money needed to buy it, the payments by the lessee will be in form of lease rentals, etc.

However, financial leases, though being leases by structure, are financings by contrivance. To achieve the financing purpose, the leasing structure here tries to eliminate the substantive differences between leasing and plain financings.

Let us have a look at the differences between leasing and plain financing, and see how are these sought to be eliminated in financial leases:

Take the following as an illustrative prototype of a financial lease:

As you might notice, in the above example, the lessee has been put virtually in the position of an asset owner - he has the right to use the asset for 5 years, with a power to extend the lease period for another 5 years.

The first 5 years are called the primary lease period and the extended period is called the secondary lease period.

The lease is non-cancellable during the primary lease period - that is, the lessee cannot return the asset and not pay balance of the lessor's rentals. For the secondary period, the lessee will have no incentive of returning the asset, as what the lessee has to pay is nominal, whereas the asset might still carry substantial value. Thus, the asset will be enjoyed by the lessee virtually for the whole of its economic life.

The lessor too has no significant risk/reward other than that of a virtual money-lender: he would continue getting the lease rentals for the primary period which will fully-payout the lessor's investment in the lease as also give him his desired return on investment, irrespective of the state, value or utility of the asset. If the lessee performs as per agreement, the lessor would get no more, and no less, than such pre-fixed return on investment.

Incidentally, in the present example, the lessor gets a return of 12.98% - this is equivalent to the rate of interest in case of loans. As this rate is not explicit, but implicit in the rate of rentals, the rate is implicit rate of return or IRR.

 The above discussion leads to the following features of financial leases:

In some countries, distinction is made between lease and hire-purchase transactions. A hire-purchase transaction is usually defined as one where the hirer (user) has, at the end of the fixed term of hire, an option to buy the asset at a token value. In other words, financial leases with a bargain buyout option at the end of the term can be called a hire-purchase transaction.

Hire-purchase is decisively a financial lease transaction, but in some cases, it is necessary to provide the cancellation option in hire-purchase transactions by statute: that is, the hirer has to be provided with the option of returning the asset and walking out from the deal. If such an option is embedded, hire-purchase becomes significantly different from a financial lease: the risk of obsolescence gets shifted to the hire-vendor. If the asset were to become obsolete during the pendency of the hire term, the hirer may off-hire the asset and close the contract, leaving the owner with less than a full-payout.

Hire-purchase is of British origin - the device originated much before leases became popular, and spread to countries which were then British dominions. The device is still popular in Britain, Australia, New Zealand, India, Pakistan, etc. Most of these countries have enacted, in line with United Kingdom, specific laws dealing with hire-purchase transactions.

If financial leases are substantively so close to secured financing transactions, the categorical issue is: why should they be treated as a lease at all? Why should they not be regulated, taxed and accounted for as plain loan transactions?

This question may be significant from viewpoint of :

• Regulation of financial leasing activity.
• Asset rights of the lessor.
• Taxation of the lessor/lessee.
• Accounting for the lease transaction.

In each case, treating the lease as a lease or, based on substance, a financing transaction, may lead to completely different implications.

• From viewpoint of general regulation of financial leasing activity, if it is taken as financing by another name, it should form a part of overall financial markets regulation - most countries' central banks maintain some control on financial intermediaries.
• The asset-rights of the lessor would also be similar to those of a secured lender, while in a plain lease contract, the lessor is the sole owner of the asset and the lessee is merely its bailee.
• If the lease is treated as a financing transaction, the lessor should not be allowed to claim any asset-related benefit, such as depreciation. His income should be the implicit part of rentals going towards return on investment. Likewise, the lessee, apparently a mere user of the asset, should be treated as a virtual owner and should be allowed all asset-based benefits.
• From accounting viewpoint, if the lease is a mere financing arrangement, the asset should feature on the Balance Sheet of the lessee rather than the lessor, along with a corresponding liability to pay fixed rentals to the lessor.

 Ideally, any system should be able to differentiate or integrate transactions based on their substance, and not nomenclature. So, if financial leasing is so close to lending, it should have been treated as such for every purpose, and the lessor should have been treated as a lender.

However, such ideal is never achieved. There are two reasons to this - one, to an extent, laws, regulators and taxmen are conditioned by the legal fabric of a transaction. And two, lessors would emphasize upon on one or more structural differences between a lease and a loan, and be able to create a situation by which the substance rule fails.

Therefore, financial leasing all over the World continues to live with, or rather thrive on, differing approaches to its character - it being treated at par with loans for some purposes, and distinguished from loans in for some others. Besides, the lease/loan treatment also depends upon the maturity of a country's regulatory system to appreciate the substance of a deal by exploding its form - understandably, doing so is not easy because it would mean going beyond the apparent form of a contract.

Based on the 4 major areas listed above (general regulation, asset rights, taxation and accounting), there might be numerous combinations treating financial leases as loans on security for some purpose and true lease for some other purposes. Accountings standards are the first (perhaps because they are least dependent on a statute) to realize the indifference between leases and loans. Taxation, particularly, income-tax, moves close to accounting standards. General property laws are the last to do so, because often, for enforcement of a contract, the way the parties create their mutual rights apparently is more important than what could have been their intent behind such creation.