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Taxation of leases in Sri Lanka:
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The general taxation system in Sri Lanka is characterized by a plethora of taxes: a number of direct taxes and several indirect taxes, some of which have an overlapping application. The Income-tax law, called the Inland Revenue Act is full of incentives and holidays of various sorts, and most significantly, a very high straight-line depreciation system. These must be resulting into a very low share of corporate taxes to total tax revenue of the Govt., forcing the Govt. to depend heavily upon cascading and inflationary taxes on goods and services such as the Goods and Services Tax.
The taxation of lease transactions in Sri Lanka must have been a hot potato for the law-makers over the past so many years. Almost every successive Budget makes so change or the other in the tax provisions relating to leases. The result is an confusion-ridden scenario with plenty of provisions affecting lease transactions.
Inland Revenue provisions:
The provisions of the Income-tax law, relating to lease transactions, can be broadly summarised in the following bullet-points:
On an overview, these provisions present an interesting picture: leasing has been put to quite a lot of incentive in Sri Lanka due to the very fast rate of depreciation write-off. At the same time, a provision has been inserted to ensure that the depreciation allowance is not used by non-leasing entities to write-off their income from non-leasing activities. The limitation on depreciation being claimed against leasing income only would have certainly led to practices of inflated rental write-offs by some lessees: there again comes a balancing provision restricting the rental write-off for leases to 50% in case of machines and 25% in case of vehicles and furniture.
With these incentives, tempered by checks and balances, it can be said that leasing in Sri Lanka has been given powerful growth incentives by the Govt., as far as direct taxes are concerned.
A detailed study of these provisions follows:
No true lease guidelines:
There are apparently no rules in Sri Lanka 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 Sri Lanka 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 Sri Lanka, 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.
Sri Lanka 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 Sri Lanka 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.
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 Sri Lanka, which has a number of statutory definitions of the term "hire-purchase" in several of its laws.
Depreciation:
Depreciation is claimable under sec. 23 (1) (eee).
The allowance as amended in 1997 is
The other depreciation rates in case of buildings, etc., not being relevant here, are not discussed.
Conditions for claiming depreciation:
On a reading of sec. 23 ( 1) (eee), the following conditions apply for claim of depreciation:
First condition: depreciable asset
The first condition implies that the asset must have a natural wear and tear. This is clear from sec. 23 (1) (eee) which says: "an allowance for depreciation by wear and tear of …..". 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: "Acquired" 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 is also provided in Para 2 (3) (b) of the Schedule. 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:
Fourth condition: leasing to exempt entities:
No depreciation can be claimed where a part of the income of the lessee is exempt. There is an obvious difference between the lessee's income being exempt, and no tax being payable thereon due to various incentives under the law. The various exemptions are set out in Chapter III of the Act.
This condition also cannot be read as meaning that depreciation cannot be claimed except where the lessee could have claimed the same himself - for example, a lessee using an asset for personal purposes cannot claim depreciation, but there is no such restraint if the same asset is leased to such lessee.
Fifth condition: sale and leaseback transactions:
If the undertaking for whose use the asset has been leased is owned by the same person who sold the asset to the lessor, depreciation cannot be claimed on such asset.
Though the intent of the law is clear, the exact drafting leaves a lot of scope for indirect leases to the selling entity. For example, if A sells the asset to B, who leases it to C, and C in turn leases the asset back to A, it does not seem that B should have any difficulty in claiming depreciation on the asset.
Secondly, this provision is applicable only if the asset was a business-use asset. For example, if a car was sold by an individual, bought by the leasing company, and given back on lease to the selling individual, the provisions do not seem to be applicable. This is because the word "undertaking" in common parlance means only business undertaking.
Sixth condition: Not a passenger vehicle
This restriction does NOT seem to be applicable to a leasing company. Sec. 24 (2) (a) provides for "travelling for the purposes of his trade", etc. Reading "his trade" as meaning the trade of the leasing company, if the leasing company has let out a passenger vehicle which is used by the lessee for the purposes of travel by the latter's employees, as the use of the vehicle is not for the purposes of travel for the lessor's trade, the restriction should not be applicable.
Seventh condition: not a residential asset:
This condition also, for the reasons discussed above, is not applicable to a leasing company. That is to say, even if the lessor leases out assets which are used by the employees of the lessee at the their residence, no limitation for depreciation will arise under the section.
Year of sale treatment: balancing charge and capital gains:
These provisions are covered by sec. 23 (3). There are provisions for "replacement of a capital asset by a new asset" in which case the capital gains or balancing charge will not be computed, but since a leasing company buying a new asset for an independent lease is not strictly speaking "replacing" the asset, the said provision does not seem to be applicable to a leasing company.
An important provision here is that the "sale proceed" of an asset which is actually sold means the actual selling price, and where the asset is disposed otherwise than by sale, it means the fair market value of the asset. This leaves no scope for attempted rejection of the actual selling price of the asset and its substitution by arbitrary values.
Leasing depreciation: limited to income from leasing:
The second proviso below sec. 23 (1) (eee) was inserted by the Amending Act 1997. This provision enacts that where the depreciation under sec. 23 ( 1) (eee) 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.
Lessee write-off of lease rentals: limitations:
The limitations against a lessee claiming a write-off of lease rentals are contained in sec. 24 (1) (qq) of the Act. This provision, inserted by the 1997 Amendment provides that in any year of assessment, the total rental that can be claimed as expense will be 50% of the total rental payable under the agreement in case of leases of plant or machinery, or 25% of total rentals in case of vehicles and office furniture.
This is a safeguard against structuring of leases from the viewpoint of lessee tax shelters.