Taxation of the Leasing industry: an ideal capital allowance regime:

Taxation of the Leasing industry: an ideal capital allowance regime

Vinod Kothari

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The CBDT is reportedly considering re-writing tax rules for lease transactions. It is believed that CBDT wants to incorporate the distinction between "financial leases" and "operating leases" prevalent in accounting standards for the purpose of tax treatment. There was a similar proposal by the CBDT in Nov. 1995 which was later scrapped. This article highlights that any attempt to import accounting distinction between financial and operating leases into the tax laws would be fatal to the leasing industry without being benevolent for the revenue.

This article establishes that:

The present system that allows depreciation to the owner of the asset in case of a lease transaction is both just as also in accordance with international practices.
There is ample scope, even under the current law, that transactions which are solely financial transactions but documented as lease transactions are not admitted to tax benefits. The test laid down by the Supreme Court in Narang Dairy Industries affirming Blue Bay Fisheries is good enough as a guide to core intent of the revenue.
What India needs is not the accounting standards-based distinction between financial leases and operating leases but easy-to-apply objective criteria for assessing whether a transaction is a true lease for tax purposes or not.
The determination as to whether a lease is a true lease or not should not be left to the discretion of the taxing officer as such discretion has led to wildly different and sometimes preposterous approach to treating leases by tax officers across the country.

The present system: distinction between lease and financial transactions:

At present, Indian tax law allows the benefit of depreciation to the owner and the user of the asset. The lessor being the owner of the asset is considered eligible for depreciation.

However, in case of hire-purchase transactions, a departure from the above rule is made and the legal owner is not allowed depreciation. The hirer, that is, actual user of the asset, is considered as the beneficial owner of the asset and is allowed depreciation.

Thus, the present rule in India that generally allows depreciation to the lessor is subject to a number of limitations, as follows:

If the transaction results into an automatic transfer of title to the user, it is treated as a conditional sale and hence depreciation is not allowed to the lessor.
If the transaction creates an option to buy the asset in favour of the hirer, it is treated as a hire-purchase transaction and hence depreciation is not allowed to the lessor.
If the transaction results into creation of permanent beneficial interest in the asset in favour of the lessee, such that the lessor would never get to have the asset with no right or claim of the lessee over it, and the lessor would never get independent discretion to use or dispose of the asset as his own asset, that the lessor is not treated as the beneficial owner of the asset, and depreciation is not allowable to the lessor.
Allowability of depreciation is subject to the normal preconditions: asset existing, asset having been used, transaction not being bogus, etc.
In case of sale and leaseback transaction, a safeguard has already been incorporated in the law to the effect that the lessor's acquisition price of the asset will be ignored and the seller's tax depreciated value will be taken as the depreciable cost.

This is the present system of grant of capital allowances to the lessor, and it would be evident that if a transaction is predominantly a financial transaction, it would not be eligible for depreciation on one or more of the exceptions listed above. A financial transaction either would not result into creation of ownership interest in favour of the lessor, or even if it does, it would always ensure that the ownership flows back to the actual user, viz., the lessee, once the lessee has paid back all that was due. Thus, as characteristic in conditional sales or hire-purchase transactions (which are financial transactions), it is easy to see that there is a contracted or promised transfer of title. It would be rare to see a financial transaction which reserves, permanently, ownership with the lessor, since no lessee would afford to let the asset be owned by the lessor even after the lessee has satisfied his financial obligations, and if the lessee does so, the transaction is surely not a financial transaction.

If the above system is good enough to distinguish between financial transactions and genuine lease transactions, then what is wrong with the present system? The trouble is that to reach to the above rules, one has to digest a law that is scattered over numerous rulings of Courts and the generic principles of genuine commercial transactions. The rules for distinguishing between financial and true lease transactions have not been codified. This is what is required to be done.

International practices: tax laws versus accounting standards:

In Nov., 1995, the CBDT came out with an Approach Paper which intended to import the distinction between "financial" and "operating lease" into the tax laws so that it is only operating leases which are eligible for tax benefits. It was contended that India was one of the very few countries which did not make such a distinction.

This is an absolutely mistake belief on two counts. First, the distinction between financial and operating leases is inherent in Indian law as well. A financial lease is an accounting term. A hire-purchase transaction is also a financial lease transaction. Under conventional accounting standards, a lease is treated as a financial lease if any of the following 4 tests are satisfied:

(a) there is a transfer of title at the end of the lease period;

(b) the lease contains an option to buy at a bargain price;

(d) the present value of non-cancellable lease payments covers the whole or substantially the whole of the lessor's investment.

Notably, the first two are already covered by the tax distinction between hire-purchase and lease, and the latter two are essentially accounting issues which are not usually incorporated into tax statutes as discussed below.

Second, it is miles away from truth that a lot many other countries have incorporated the accounting distinction between financial and operating leases into their statute. In fact, the largest of leasing markets in the World. USA, has separate standards for distinguishing between "true leases" and "financing transactions" for tax purposes, which are distinct from the accounting standards.

United Kingdom has for long applied accounting standards that distinguish between financial and operating leases. The UK Accounting standard SSAP-21, recently enhanced by FRS-5, does require financial leases to be capitalised on the books of the lessee, but coming to tax treatment, depreciation continues to be allowed to the lessor. In fact, as late as in 1997, certain protective amendments were made to the Finance Act containing specific provisions about financial leases, but claim for depreciation is still granted to the lessor.

In France, depreciation is allowed to the lessor. In Australia, depreciation on financial leases is allowed to the lessor. Closer home, Sri Lanka has applied IAS-17 for long number of years, but continues to allow tax depreciation to the lessor.

Therefore, it is rare, rather than a rule, to find the accounting rules being applied for tax purposes. Some countries have tried doing this also: e.g., Singapore, but the leasing industry has consistently had a negative growth there ever since the new rule was incorporated.

Why accounting approach is not proper for tax laws:

Applying accounting standards to tax rules would be a sure prescription for disaster. As is well known, accounting standards are driven primarily by the substance of a transaction. In other words, the form of a transaction is unimportant and is ignored, and the transaction is accounted for based on its substance. In case of lease transactions, accounting standards have for long recognised that financial leases be capitalised and depreciated by lessees. In fact, latest amendments to IAS-17 also require operating leases to be capitalised by the lessee. Therefore, accounting standards can be no guide to tax treatment of a transaction.

No doubt, tax treatment is also driven by substance rather than by the form, but that is where the legal form of the transaction is completely devoid or unrepresentative of the substance. It is well agreed that the tax officer cannot all the sit on transactions with a probing microscope and keep exploring substance even where there is no suggestion that the legal form is a sham. Colourable transactions will be ignored for tax purposes, but that cannot lead to a roving investigation behind substance of each and every transaction. If that were to be done, taxpayers will find themselves in absolutely unsafe waters, because the tax treatment of any transaction would be uncertain. Needless to elaborate, while the legal form of any transaction is apparent and objective, substance is exploratory and subjective.

The present world of finance offers thousand different varieties of financial instruments, the ultimate quintessential substance of which is the same: financing. Does that ever mean all such instruments be treated as alike for tax purposes?

Hence, the well accepted rule in tax jurisprudence is: the legal form of a transaction will be accepted, unless there is a suggestion that the legal form is a complete sham, devoid of any substance, is a merely nomenclature, or is driven by a tax avoidance motive.

The test laid down by Blue Bay Fisheries:

As far as depreciation is concerned, the Kerala High Court in Blue Bay Fisheries laid down the golden rule which has been affirmed by the Supreme Court in Narang Dairy Industries. If there is a permanent transfer of beneficial interest in the asset such that the owner would never occupy the position of a full fledged owner, then the transaction of lease can be regarded as "transfer", that is transfer of beneficial interest.

This leads to the categoric rule as far as India is concerned: if the lessor has reserved reversionary interest in the asset, the lease is a true lease; if the lessor has provided the asset for permanent beneficial enjoyment by the lessee, the lessor's ownership is no more than the chaff of a grain.

The best way to assess whether the lessor has to transferred beneficial interest in the asset or not is to follow certain easy-to-apply tests. In USA, the Inland Revenue Service has over time come out with tests to decipher between transactions which are true leases and those which are not. The essential touchstone is the reversion of ownership interest by the lessor.

Test for true leases

Based on the rulings of the Supreme Court, general preconditions for grant of depreciation and the economic logic of leasing, the following true lease conditions may be standardised by the CBDT as the preconditions for grant of depreciation on lease transactions.

It is important that these conditions be given a prospective application. Over past 10 years or so, thousands of crores of lease transactions have been written in the country and the CBDT was sitting pretty inspite of continuous reminders every year by the Association of Leasing Companies that the rules for tax-admissibility of leases should be formalised. Banks, financial institutions and financial companies have written such leases and invested crores of rupees. All these transactions cannot be put on the butcher's block now by applying retrospective or retroactive guidelines.

True lease conditions should be formalised and the CBDT must frame objective rules with no scope for arbitrary rulings. Notably, discretionary assessment powers breed corruption and inconsistency: it neither favours the tax payers nor the tax department.

Suggested true lease conditions are enclosed in Appendix A. These are the author's personal views, and are open for discussion.

Misuse of depreciation by the leasing industry:

While coming to conclusion, it must be pointed out that there is a school of thought that leasing has been misused in India as a tax avoidance exercise. This feeling is based on several impressions, most of which are completely misplaced. A few such impressions and their straight answers follow.

By leasing, a lessor is able to claim tax benefits not available to him as a plain financier.

Not really. Does leasing give to the lessor an undiluted tax benefit? No. The lessor gains on taxes, but he also loses on taxes. His gain is his ability to write depreciation. His loss is that he offers the capital recovery element inherent in rentals also to taxable income. As a universal tautology, the sum total of depreciation claimed by the lessor is numerically equal to the sum total of tax paid on recovery of capital in a financial lease. Therefore, there is not a penny gained in taxes, nor a penny lost. There is no exception to this rule.

By leasing, a lessee is able to write-off the asset cost faster by way of lease rentals.

This argument, in fact, demolishes the previous, but both are any way wrong. Like for a lessor, a lease means for the lessee too a tax benefit and a tax loss. The tax benefit is the deductibility of the principal component inherent in lease rentals, and the tax loss is the depreciation the lessee is disentitled to.

Leasing means duplication of tax benefits.

Impossible, in this country and in any other nation. Duplication of tax benefits is possible only in case of cross-border transactions, due to diversity of laws. Within a country, it is impossible for any lease to generate a tax shelter for the lessor and for the lessee. The lessor’s tax benefit (depreciation) is the lessee’s tax loss, and the lessee’s tax benefit (deductibility of capital repayment inherent in lease rentals) is the lessor’s tax loss. In other words, as between the two, there is no generation of a tax shelter. It is impossible for a lease to create any tax shelter: it only results into its transfer from one to another.

If there is no tax benefit in leasing, why is it that lessors have not been paying taxes in the past?

This is the most crucial issue, and its understanding only requires a look at the history of Indian leasing for last 10 years or so. It is a tautology that given the WDV system of depreciation, if a leasing company continues expanding its volumes at a certain rate, it would be able to keep taxes away for some years. This would be the case even with a manufacturing company that continues adding fixed assets at an increasing rate every year. There is a deferral of taxes when capital assets are bought.

However, when the rate of growth declines, deferred taxes of the past hit back. So far, leasing in India has been growing at a rate of 40% or more every year, but in 1998-9, there has been a dip in volumes. 1999-2000 is expected to be worse. No doubt, leasing companies will be serious tax payers in these years.

Leasing companies have been claiming depreciation on non-existing assets. Yes, there have been, unfortunately, many such cases. The leasing company was more of a victim than the perpetrator of this crime against society. It serves no interest of a leasing company to lease an non-existing asset. No one would throw into trash hard money merely for the sake of a tax benefit, and it is an obvious fact that where non-existing assets were leased, lessors have not been able to realise their money.

It was on account of nascence or over-optimism in building books that leasing companies followed an easy-money policy, and they have learnt from their mistakes in a very hard way.

No amount of complacency needs to be shown by the Department in such cases, and irrespective of the hardship it involves, if the existence of the asset cannot be proved, depreciation need not be allowed on the lease.

Appendix: True lease conditions in India

The asset should not be non-returnable by contract or facts.

The estimated economic life of the asset should not be shorter than the non-cancellable lease period.

The asset should not be a wasting asset, or unlikely to be in its present commercial form at the end of the lease period.

The asset should remain identifiable till the end of the lease period.

The asset should remain severable till the end of the lease period. If affixed to something, the lessor must have a right, license or servitude in the object to which the asset is attached.

The lease period should not be perpetual.

No option to buy should be given to the lessee or any one with economic interests common to the lessee. No such intent should transpire from conduct.

Asset should exist.