Evolution of Leasing in India

Leasing activity was initiated in India in 1973. The first leasing company of India, named First Leasing Company of India Ltd. was set up in that year by Farouk Irani, with industrialist A C Muthia. For several years, this company remained the only company in the country until 20th Century Finance Corporation was set up - this was around 1980.

By 1981, the trickle started and Shetty Investment and Finance, Jaybharat Credit and Investment, Motor and General Finance, and Sundaram Finance etc. joined the leasing game. The last three names, already involved with hire-purchase of commercial vehicles, were looking for a tax break and leasing seemed to be the ideal choice.

The industry entered the third stage in the growth phase in late 1982, when numerous financial institutions and commercial banks either started leasing or announced plans to do so. ICICI, prominent among financial institutions, entered the industry in 1983 giving a boost to the concept of leasing. Thereafter, the trickle soon developed into flood, and leasing became the new gold mine. This was also the time when the profit-performance of the two dozen companies, First Leasing and 20th Century had been made public, which contained all the fascination for many more companies to join the industry. In the meantime, International Finance Corporation announced its decision to open four leasing joint ventures in India. To add to the leasing boom, the Finance Ministry announced strict measures for enlistment of investment companies on stock-exchanges, which made many investment companies to turn overnight into leasing companies.

As per RBI's records by 31st March, 1986, there were 339 equipment leasing companies in India whose assets leased totaled Rs. 2395.5 million. One can notice the surge in number - from merely 2 in 1980 to 339 in 6 years.

Subsequent swings in the leasing cycle have always been associated with the capital market - whenever the capital markets were more permissive, leasing companies have flocked the market. There has been appreciable entry of first generation entrepreneurs into leasing, and in retrospect it is possible to say that specialised leasing firms have done better than diversified industrial groups opening a leasing division.

Another significant phase in the development of Indian leasing was the Dahotre Committee's recommendations based on which the RBI formed guidelines on commercial bank funding to leasing companies. The growth of leasing in India has distinctively been assisted by funding from banks and financial institutions.

Banks themselves were allowed to offer leasing facilities much later - in 1994. However, even to date, commercial banking machinery has not been able to gear up to make any remarkable difference to the leasing scenario.

The post-liberalisation era has been witnessing the slow but sure increase in foreign investment into Indian leasing. Starting with GE Capital's entry, an increasing number of foreign-owned financial firms and banks are currently engaged or interested in leasing in India.

Evolution of Hire-purchase

The British concept of hire-purchase has, however, been there in India for more than 6 decates. The first hire-purchase company is believed to be Commercial Credit Corporation, successor to Auto Supply Company. While this company was based in Madras, Motor and General Finance and Instalment Supply Company were set up in North India. These companies were set up in the 1920s and 1930s.

Development of Hire-purchase took two forms: consumer durables and automobiles.

Consumer durables hire-purchase was promoted by the dealers in the respective equipment. Thus, Singer Sewing Machine company, or Murphy radio dealers would provide instalment facilities on hire-purchase basis to the customers of their products.

The other side developed very fast - hire-purchase of commercial vehicles. The dealers in commercial vehicles as well as pure financing companies sprang up. The value of the asset being good and repossession being easy, this branch of financing activity flourished fast, although until recently, most of automobile financing business was in hands of family-owned businesses.

Leasing and Hire-purchase: A vanishing distinction:

Essentially, asset-based financing in India particularly by non-banking financial companies is split in two documentation modes - lease and hire-purchase. These two are technically different instruments, but in essence, there is not much that differs between the two, except for the caption.

In spite of the substantive similarity, historically, there has been a diametric separation between these two forms. The assets usually subject matter of hire-purchase have been different from those generally leased out. Leasing has been used mostly for plant and machinery, while hire-purchase has commonly been used for vehicles. Even the players have been different.

The reasons for this diametric distinction are more historical than logical. Hire-purchase, essentially a British form, entered India during the Colonial era, and thrived as almost the only form of external finance available for commercial vehicles. For the financiers, as witnessed World-over, commercial vehicles were the natural choice for several asset-features he loves: lasting value, ready secondary market, self-paying feature, etc. Hence, the industry of hire-purchase became synonymous with truck-financing. Besides, the motor vehicles laws gave the surest legal protection any law could give to a financier: the financier would not have to carry any of the operational risks of a motor vehicle, and yet, any transfer of the vehicle would not be possible without the financier's assent.

Leasing, essentially a US-innovation, entered the country significantly in the early 80s, and was propagated as an alternative to traditional modes of industrial finance. Besides, the early motivation (which continues with a number of players even now) of leasing was capital allowances, more significantly the investment allowance, which was not available for transport vehicles. Hence, the leasing form historically clung to industrial plant and machinery.

For several years, there was no lease of vehicles, because the Motor Vehicles law protection was not applicable to a lease, and there was no investment allowance on vehicles, and for reciprocal reasons, there was no hire-purchase of industrial machinery.

These reasons have vanished over time.

The Motor Vehicles law now treats leases and hire-purchase at par from the viewpoint of financier-protection.

Investment allowance has been abolished, and hence, there are no predominant tax-preferences to a lease.

The RBI treats lease and hire-purchase at par and has stopped giving a distinctive classification to leasing and hire-purchase companies.

The accounting norms lead to the same effect on pre-tax income, as also balance sheet values, be it a lease or hire-purchase transactions.

Therefore, income-tax and sales-tax treatment apart, there is not much that is different between lease and hire-purchase. The choice between the two is by and large open, subject to tax consequences.

Indian Leasing: Major components

Lessors:

1. Specialized leasing companies:

There are about 400-odd large companies which have an organizational focus on leasing, and hence, are known as leasing companies.

Till recently, most of them were diversified financial houses, offering several fund-based and non-fund based financial services. However, recent SEBI rules on bifurcation of fund-based and non-fund based activities has resulted into hiving-off of merchant banking divisions of these entities. Most of these companies also offer hire-purchase activities, and some of them might have a consumer finance division as well.

These companies are known, in regulator's jargon, as non-banking financial companies, or NBFCs for short. The terms NBFCs includes several other financial concerns too, and all such companies are regulated by the Reserve Bank of India. There were no entry barriers to leasing business till recently, but the January 1997 amendments to the RBI law now require any non-banking finance company to have a prior registration with the RBI, and the conditions of registration virtually amount to authorization by the RBI.

2. Banks and bank-subsidiaries:

Till 1991, there were some ten bank subsidiaries active in leasing, and over-active in stock-investing. The latter variety was ravaged in the aftermath of the 1992 securities scam.

In Feb., 1994, the RBI allowed banks to directly enter leasing. So long, only bank subsidiaries were allowed to engage in leasing operations, which was regarded by the RBI as a non-banking activity. However, the 1994 Notification saw an essential thread of similarity between financial leasing and traditional lending.

Though State Bank of India, Canara Bank etc have set up leasing activity, it is not currently at a scale to make any difference on the leasing scenario. This is different from the rest of the World, where banks are front-runners in leasing markets.

3. Specialized Financial institutions:

There is a wide variety of financial institutions at the Central as well as the State level in India. Apart from the apex financial institutions, viz., the Industrial Development Bank of India, the Industrial Finance Corporation of India, and the ICICI, there are several financing agencies devoted to specific causes, such as sick-industries, tourism, agriculture, small industries, housing, shipping, railways, roads, power, etc. In most States too, there are multiple financing agencies for generic or focussed cause.

Most of these institutions are using the lease instrument along with traditional financing instruments. Significantly, the ICICI was one of the pioneers in Indian leasing. At State level also, financial institutions are active in leasing business.

4. One-off lessors :

Some of the companies engaged in some other business which gives them huge taxable profits, have resorted to one-off leasing on a casual basis to defer their taxes. These people are interested only in leasing of high-depreciation items, preferably those entitled to 100% depreciation. The major items eligible for 100% depreciation are gas cylinders, certain energy-saving devices, pollution control devices etc. Severe scrutiny by revenue officials into lease transactions at the time of assessment has dampened the enthusiasm in this line of leasing activity, however it carries on. Mostly such lease transactions are syndicated, at times even funded, by active players in leasing markets.

5. Manufacturer-lessors :

This part of the lessor-industry is in highly under-grown form in India, for simple reasons. Vendor leasing is a product of competition in the product market. As competition forces the manufacturer to add value to his sales, he finds the best way to sell the product is to sell it without the buyer having to pay for it instantly. Product markets so far for most durables were oligopolistic, and good products used to sell even otherwise at a premium. With the economy decisively moving towards market orientation, competition has become inevitable, and competition brings in its wake sales-aid tools. Hence, the potential for vendor leasing is truly great.

Presently, vendors of automobiles, consumer durables, etc. have alliances or joint ventures with leasing companies to offer lease finance against their products. However, there is no devoted

vendor leasing of the type popular in most of the advanced markets, where a specific leasing company or leasing program takes exclusive charge of a vendor's products.

 

The lessees 

a. Corporate customers with very high credit ratings: These essentially look at leasing to leverage against assets which are otherwise not bankable, or for pure junk financing.

b. Public sector undertakings: This market has witnessed a very rate of growth in the past. With budgetary grants to the PSUs coming to a virtual halt, there is an increasing number of both centrally as well as State-owned entities which have resorted to lease financing. Their requirements are usually massive.

c. Mid-market companies: The mid-market companies, that is, companies with reasonably good creditworthiness but with lower public profile have resorted to lease financing basically as an alternative to bank/institutional financing, which to them is time-consuming and tedious.

d. Consumers: Retail funding for consumer durables was frowned-upon at one point of time, but recent bad experience with corporate financing has focussed attention towards consumer durables which incidentally, is all the all-time favorite of financiers World-over. Most of the larger companies have expressed interest in consumer funding, with ticket size going as low as Rs. 5000.

e. Car customers: Car leasing World-over is a very big market, and the same is true for India. So long, most car leases were plain-vanilla financial leases but one now finds few instances of value-added car lease services also being offered.

f. Commercial vehicles: Commercial vehicles customers have always relied upon funding by hire-purchase companies. The customer profile ranges from large fleet owners to individual truckers.

g. Earth-moving machinery customers: These customers have also traditionally relied upon lease financing. Their requirements are generally large - each excavators costs more than Rs. 25 lacs. The income-stream is based on contracts they have - at times, the income generation may be sporadic, or the need might itself be temporary. In fact, operating leases would have been ideal in this market, but they are yet to be launched to any serious degree.

h. Govt. deptts. and authorities: One of the latest entrants in leasing markets is the Govt. itself. The Deptt. of Telecommunications of the Central Govt. took the lead by floating tenders for lease finance worth about Rs. 1000 crores. In its reforms programme, India has limits to the extent to which it can resort to deficit financing, and leasing is easily going to appeal to the Govt. , if not for cost reasons, at least for the fact that it will not feature in national accounts as a commercial financing. As a spin-off, it might even help reducing the reported deficit, as the Govt. resorts to what is loved World-over as a tool of off-balance-sheet financing.

Indian Leasing – Current Scenario

Indian leasing is today a central part of the financial system. On its way, it has passed through several twists and turns. Financial industry World-over has a very high beta factor: it is hyper-sensitive to changes in economic scenario. Periods of general prosperity are extremely good for the leasing industry; downturns in economic cycle cost is extremely high. That apart, financial system is invariably affected by the contagion effect: failures of a few players affect even the healthy ones.

Though it is currently passing through a testing time, leasing has had an undeniable role in Indian economy. From consumer finance to small industry, heavy industry to automobiles, from railways to electricity boards, almost every sector of the economy has utilized leasing as its source capital. Having attained an average over-30% growth rate over past 7 years, Indian leasing has reached the 14th largest place in the World, a fact which is least realized by most.

14th Largest place in the World: Wow!:

India at the 14th largest place in World leasing sounds incredible! But it is true, and true contrary to the internationally available statistics published by the London Financial Group. The Group's data, published every year in the World Leasing Yearbook would place India at some 36th place, but admittedly that data is only the estimate of the author thereof, and the author of the data might have ranked Indian leasing volume based on India's per capita income ! When it comes to size, India has the obvious advantage of being such a vast nation.

Center for Monitoring of Indian Economy compiles data about Indian leasing volumes, which is carried as a part of India Leasing Yearbook published by the Association of Leasing and Financial Services Cos. The data compiled by the Center shows aggregate balance sheet value of leased and hired assets (though for balance sheet purposes, lease and hire-purchase transactions are distinguished, there is no material difference between the two - hence the volumes have been clubbed here) at about Rs. 261 billion (End March 1997). This is based on reporting by 226 companies, whereas the business, particularly hire-purchase, is spread amongst some 3000 large and small companies. Estimated outstanding business done by these firms is about Rs. 15 billion (at Rs. 5 million per such firm).

That apart, the data also excludes the massive annual volume of business by the Indian Railway Finance Corporation (IRFC). IRFC is a hundred percent subsidiary of Indian Railways, and its leases are dedicated to the parent Railways only. Of late, almost entire floating stock acquisition by Railways is being acquired on lease from IRFC. The outstanding value of leases done by IRFC adds to about Rs. 120 billion.

Thus, the aggregate volume comes to about Rs. 396 billion, which is about USD 11 billion as per then-prevailing exchange rates.

USD 11 billion of outstanding volume cannot by itself give India a ranking in the London Financial Group data, since these rankings are based on incremental volume. However, a rough

estimate of new business can be made from the above data (unfortunately, the Centre for Monitoring of Indian Economy data do not give any idea of new leasing and hire-purchase volume). Supposing 30% of the outstanding business of last year was paid, and there was a 20% growth in net business (as can be seen from the Chart above), there was a 50% new business, over the volume outstanding at the beginning of the year. Relative to the business at the end of the year, the incremental volume should have been about 33% (50/150).

Therefore the annual leasing volume in India is estimated at about USD 3.67 billion, on a rough and conservative estimate.

In London Financial Group data, this should put India at 12-13th place, close to Hong Kong. This would also be the third largest market in Asia, next only to Japan and Korea.

The only infirmity in the above ranking is that the London Financial Group data are not as of March 1997 - that, however, should not seriously disrupt the ranking of India, because other Asian markets in 1996-7 period have generally registered a negative growth.

Factors that contributed to growth of Indian leasing:

With the exception of 1996-97 and 1997-98, the 1990s have generally been a good decade for Indian leasing. The average rate of growth  on compounding basis works out to 24% from 1991-92 to 1996-97. Broadly, the following factors have been responsible for the growth of Indian leasing, in no particular order:

No entry barriers - any one could float a leasing entity, and even an existing company not in leasing business can write a lease purely for tax shelters.

Buoyant growth in capital expenditure by companies - The post -liberalization era saw a spate of new ventures and fresh investments by existing venturers. Though primarily funded by the capital markets, these ventures relied upon leasing as a source of additional or stand-by funding. Most leasing companies, who were also merchant bankers, would have funded their clients who hired them for issue management services.

Fast growth in car market: Needless to state with facts, the growth in car leasing volume has been the highest over these years - the spurt in car sales with the entry of several new models was funded largely by leasing plans.

Tax motivations: India continues to have unclear distinction between a lease that will qualify for tax purposes, and one which would not. In retrospect, this is being realized as an unfortunate legislative mistake, but the absence of any clear rules to distinguish between true leases and financing transactions, and no bars placed on deduction of lease tax breaks against non-leasing income, propelled tax-motivated lease transactions. There was a growing market in sale and leaseback transactions, which, if tested on principles of technical perfection or financial prudence, would appear to be a shame on everyone's face.

Optimistic capital markets: Data would establish a clear connection between bullish stock markets and the growth in both number of leasing entities and lease volumes. Year 1994-1995 saw the peak of primary market activity where a company, even if a new entrant in business, could price itself on unexplainable premium and walk out with pride.

Access to public deposits: Most leasing companies in India have relied, some heavily, on retail public funds in the form of deposits. Most of these deposits were raised for a 1 year tenure, and on promise of high rates of interest, at times even more than the regulated rate (which was lifted in 1996 to be reintroduced in 1998).

A generally go-go business environment: At the backdrop of all this was a general euphoria created by liberalisation and the economic policies of Dr. Manmohan Singh.

Current Problems of Indian leasing:

In 1996-97, the profits of Indian leasing came down a bit -this was the year of the minimum alternative tax: so everyone thought, there was nothing serious to be concerned about.

However, 1997-98 proved to be a year of debacle. Several things combined to make this year one of worst years in history so far, including the sudden and serious breach in public confidence caused by the collapse of CRB Capital Markets (if this could be attributed to an organized fraud, how about ITC Classic, a company promoted and supervised by the tobacco giant ITC), generally bad economic environment due to political uncertainty, hesitation on part of banks to continue to finance leasing ventures, and closer to the end of the fiscal year, the Reserve Bank of India (RBI) came out with one of the least thought-about, most casually-drafted regulations on Non-banking finance companies (NBFCs). The RBI is still not sure of what it wants to regulate and how, and has changed in the regulations 3 times in 5 months, and there are still Committees and Task Forces on the reconstruction job. There could not have been a worse way of handling a sensitive sector of the economy, already in a crisis of public confidence!

The current problems of Indian leasing could be listed as follows, again without any order of listing:

Asset-liability mismatch: Most non-banking finance companies in India had relied extensively on public deposits -this was not a new development, as the RBI itself was constantly encouraging and supporting the deposit-raising activities of NBFCs. If the resulting asset-liability mismatch, to everybody's agreement, is the surest culprit of all NBFC woes today, it must have been a sudden realization, because over all these years, each Governor of the RBI has passed laudatory remarks on the deposit-mobilization by NBFCs knowing fully well that most of these deposits were 1-year deposits while the deployment of funds was mostly for longer tenures. It is only the contagion created by the CRB-effect that most NBFCs have realized that they were sitting on gun-powder all these years. The sudden brakes put by the RBI have only worsened the mismatch.

Generally-bad economic environment: Over past couple of years, the economy itself has done pretty badly. The demand for capital equipment has been at one of the lowest ebbs. Automobile sales have come down, corporates have found themselves in a general cash crunch resulting into sticky loans.

Poor and premature credit decisions in the past: Most NBFCs have learnt a very hard way to distinguish between a good credit prospect and a bad credit prospect. When a credit decision goes wrong, it is trite that in retrospect, it invariably seems to be the silliest mistake that ever could have been made, but what Indian leasing companies have suffered are certainly problems of infancy. Credit decisions were based on a pure financial view, with asset quality taking a back-seat.

Tax-based credits: In most of the cases of frauds or hopelessly-wrong credit decisions, there has been a tax motive responsible for the transaction. India has something which many other countries do not- a 100% first year depreciation on several assets. Apparently, the list of such assets is limited and the underlying fiscal rationale quite holy and sound - certain energy saving devices, pollution control devices etc qualify for such allowance. But that being the law, it is left to the ingenuity of our extremely competent tax consultants to widen the range with innovative ideas of exploiting these entries in the depreciation schedule. Thus, there have been cases where domestic electric meters have been claimed as energy saving devices, and the captive water softenizer in a hotel has been claimed as water pollution control device ! As leasing companies were trying to exploit these entries, a series of fraudsters was successful in exploiting, to the hilt, the propensity of leasing companies to surpass all caution and all lending prudence to do one such transaction to manage its taxes, and thus, false papers for non-existing wind mills and never-existing bio-gas plants were fabricated to lure leasing companies into losing the whole of their money, to save the part that would have gone as government taxes !

Extraneous problems - frauds, closures and regulation: As they say, it does not rain, it pours. Several problems joined together for leasing companies - the public antipathy created by the CRB episode and subsequent failures of some good and several bad NBFCs, regulation by the RBI requiring massive amount of provisions to be created for assets that were non-performing, etc. It certainly was not a good year to face all these problems together.

From here on, where? :

Having gone through a very bad 1997-98, there is currently nothing that points to a better time - the general business sentiment remains as depressed as before, if not more because of the post-nuke sanctions and continuing political uncertainty, business investments are not picking up, and more NBFCs may fail during the current year when most of them are supposed to tone down their dependence on public deposits very significantly. At the same time, fresh entry from foreign banks and financial institutions has not stopped - on the contrary, one sees a number of foreign players entering India. Perhaps they have found it to be a good time, particularly as vultures on the lookout for failing or falling NBFCs.

The question, therefore, is, what does the future hold?

Much of the following may be pure conjecture, but the author's views on what the future holds for NBFCs in India are as under:

1. Reduced number of players:

Not too many people will dispute the observation that India has far too many finance companies that can possibly sustain in time to come. If we forget about the 37000-odd companies that have registered with the RBI as NBFCs (that number is a miracle – and the entire credit can be taken by the draftsman of the RBI legislation), there are, no doubt, about 500 reasonably large NBFCs in the country. The Association of Leasing and Hire-purchase Cos. (ALFS) itself has over 500 members. If one ignores the honorary members, and those who are not into leasing, but including the members of the Equipment Leasing Association, 500 is a very safe number.

ALFS does not have too many regionally centered smaller players as its members. They have their membership with local hire-purchase associations. There are about dozen hire-purchase Associations in the country, and not all players can be expected to be a member of one of these. The combined membership strength of all of the Associations would be not less than 2000 firms, and an equal number of firms may be taken as those who are not registered with any Association at all.

The number adds to an astounding 4000 players!

This means that at the current juncture, the number of lessors in India is more than the total number of players in USA, which is the largest market in the World!

A number of factors will precipitate the consolidation in Indian leasing, and the process is already on. First, bifurcation of leasing and non-leasing activities, such as merchant banking, will go a long way in breaking the financial conglomerates, who may find themselves better focusing on investment banking rather than dabbling into leasing at the same time. Second, in whichever forms of business, mass distribution is possible, that is, where the customer is more or less homogenous, larger firms will eat up the shares of the smaller ones. This is something everyone can see happening in the car finance market. Three, reduced rates by the industry leaders will set benchmark rates in the market which will force many marginal players out. Fourth, regional players will survive but will find their relevance in a new avtar as "lease brokers", or to use a better word, "lease originators". These firms will originate small ticket leases, sell their portfolios to larger players, thereby encashing their wafer-thin spreads and walking out to originate another transaction. Such activity has flourished in USA, and we will see much of the same story in India too.

2. Cross-border competition:

Cross-border competition will come in two forms: direct cross-border transactions, and cross-border investments in lease transactions. This author estimates that the second variety of transactions will gain momentum before the first. A number of global leasing

giants have already occupied their positions in India. Capital account convertibility measures will precipitate the process. The impact of foreign investments will be greater consolidation activity at home.

3. Segmentation and positioning:

This is a common feature of growth: during the initial phases of growth of any industry, there is a trend towards diversification: firms try to attain growth in numbers by unfocused diversification, but soon realise that diversified presence creates organisational pressures which are difficult to cope with. This leads to a trend towards consolidation and focused growth. Leasing firms of yesteryears were everything: money market players, merchant bankers and discount houses. Gradually, both regulators and industry participants have realised that clearer roles are necessary for stability.

Leasing companies in time to come will not only choose their segment within the financial services industry but also within the leasing industry. Equipment-type focus will also be seen in time to come. This change may take some time to be noticed.

4. End of tax-based leasing:

This author has consistently opined against tax-based leasing, and that advice has so far fallen flat because most of the leasing in the past was triggered by tax motives, sometimes greedy tax motives. Spate of income-tax problems in the past has made some leasing companies wiser, but there will be more of such problems when the disputed questions reach appellate levels. In the opinion of the author, the leasing industry must take the matter across to the Central Board of Direct Taxes and get a set of guidelines on true leases. Not having any guidelines leaves too many things to the discretion of the tax officer which does not provide a safe harbour to the transaction.

5. Emergence of vendor leasing:

There are so many merits in vendor-based leasing that it is surprising that it has not made its debut in India still. For the asset vendor, a leasing plan is a sales-aid, and for the lessor, it is easy access to a vast market, with equipment support from the vendor. In 1997-98 and after, many lessors will be forced to leave general equipment leasing market and line up with suppliers of equipment. Vendor leasing in time to come will be a very significant part of the leasing market.

6. Asset-based funding:

True asset-based funding is an extension of the vendor lease market. The two generally go together to develop into operating leasing. Full scale operating leasing, that is, leases will in-built cancellation options, will take quite some time to develop in India, but features of operating leases will be introduced once vendor tie-ups take place.

7. Price-based competition:

This factor might as well have been placed as the first in order of significance, but its impact on the leasing market is subjective. In the author’s opinion, the intensity of price-based competition will be split between the corporate finance market and the consumer finance market. The latter has always placed emphasis on service, accessibility, and nonquantifiables of that sort, but the corporate finance market consists of a professional treasury manager who will have to justify the cost of money to his boss. So far, leasing has continued to sell itself on several intangibles as speed, smile, and simplicity, but corporate finance quickly moves to a dilemma where every one is fast, everyone smiles and every one is simple enough for the sophisticated audience. It is there the price becomes decisive. Leasing, with all its cost additives as sales-tax and stamp duties, will have to sustain as a cost-competitive financing option.

Progress and Problems of Indian Leasing

 Leasing today forms an integral part of economic activity. There is a wide array of entities resorting to lease financing: Central Govt. owned railways have availed leasing for funding of rolling stock and other movable assets worth about Rs. 150 billion. A number of infrastructural utilities, power plants, industrial users, electricity companies, transporters, small businesses and consumers have availed of leasing from a range of lessors. Click here for a details of the composition of lessee market in India.

There are about 4000 leasing players in India. Of these, about 400 operate on a large scale, from more than one location and offer funding against a variety of assets. The rest are mainly into funding of commercial vehicles and proprietary concerns or family businesses. Click here for details of the composition of lessor market in India. Over years, Indian leasing has grown at an amazing rate and today achieved a pride place in global scene. Click here for data and India's place in World leasing.

Predominantly financial leasing:

Leasing in India is essentially financial leasing: market and regulatory compulsions have yet not forced any major move towards operating leases though a larger number of players today talk about such leases. Within the generic financial leases, there are those, which are respected as leases for tax purposes, and those, which are not. [Click here for details about tax treatment of leases in India] The latter are known as hire-purchase agreements, and these carry a purchase option which is conspicuously absent in case of tax-acceptable lease transactions. Hire-purchase, being a British innovation, is a legacy of the British Raj and the earliest hire-purchase company in India was formed more than 70 years ago. [Click here for a brief history of hire-purchase in India.] Hire-purchase has over time been associated mainly with funding of the vehicles segment, and as an instrument, is clearly understood by the system.

On the other hand, leasing, a product of the eighties found its application mainly to plant and machinery. Historical reasons as to this identification of leasing with machinery segment, and hire-purchase with the vehicles segment, have ceased to exist over time, and the distinction between the two is very often blurred in practice. [Click here for the traditional distinction

between leasing and hire-purchase, vanishing over time.] Most leases, therefore, look like hire-purchase, but it is important for tax purposes to safeguard the distinction. [Click here to go to document containing details of this distinction.]

Operating leases are talked about, not practised. [Click here for basic information about operating leases.] Generally, it is the accounting rules and tax regulations that have shaped market moves towards operating leases. These factors have by and large been absent in India. Accounting rules do make a distinction between financial and operating leases. Financial leases are not capitalised by lessees: they are merely disclosed by way of a note. Lessors’ revenue recognition is such that the net income credited by the lessor is the inherent financial income featuring in rentals, but that is hardly a compulsive enough reason to look at operating leases. The tax rules have so far not drawn any distinction between financial and operating leases: the only relevant distinction is between leases giving an option to buy and those not, or on grounds of a lease lacking genuineness.

 However, stiff competition, particularly in vehicles financing, has set the stage for introduction of value-added features, possibly moving closer to introduction of operating leases.

Stiff competition

 Last two years have not been very easy going: several seemingly-opposite factors have set in at the same time. Entry of several multi-national players – GE Capital, Orix, Citicorp, BNP, etc. – has resulted into stiff competition particularly in the passenger vehicles segment. In the machinery segment, corporate defaults have mounted up due to general recession in the economy. Regulation has been tightened on the liability-sourcing side, resulting into resources crunch as also falling public confidence.

 In 1997-98, a number of leasing entities (NBFCs – non-banking finance companies, as they are called) reported decline in volumes and losses, some of them heavy losses. Many announced exit. Some have been acquired and the outgoing owners had to pay a heavy price –yes, the price was paid by the outgoing owners; incoming management got it virtually for a song. Many might still be waiting potential buyers. Stocks of NBFC s are at never-before lows.

 But this is the right setting for entry of global majors!

Global majors welcome

Rules for entry of foreign companies into financial services have considerably been liberalised and it is now not difficult for global majors to make entry into India. Some of the irresistible features of Indian leasing market are:

A vast market, comprising of variety of user segments, but penetration ratios still low in many key sectors, particularly machinery and infrastructure.

Attractive rates of return: real rates of return close to 10%.

Default rates in consumer loans and vehicles financing appreciably lower than many other markets; corporate defaults mostly due to bad lending decisions and do not form good precedents or of statistical value.

Clean and mature legal system, albeit slow, respecting property rights of the owner as being predominant.

Rupee far more stable than other currencies in the Asian region.

Most of the global majors who entered Indian leasing have focussed on the vehicles segment. Citibank has been active in cars financing for last decade or so; recently branched out in commercial vehicles also. GE Capital began by acquiring a prominent commercial vehicles financing company, and has since been out buying portfolios of many small and regional players through securitisation option.

The machinery segment has unlimited scope for growth, currently not being tapped by lessors due to bad experience in the past. The past experience was due to lack of good credit analysis and management. Acquisition of a corporate financing company by ICICI, one of the premiere development finance companies, should lead to an organised focus on machinery leasing segment. Needless to say, any one that enters this segment with adequate capital and technology, and more significantly, at volumes which justify very sound credit management, would find a huge untapped potential.

Infrastructure financing is another area where foreign entry will be welcome. There is only one company currently devoted to infrastructural needs. With massive government plans to develop infrastructure, long-term investors in infrastructural segment will find good market, secure clientele mostly with government backing, and reasonably good rates of return.

Leasing as a tax-shelter:

Though substance-over-form is the general dictum followed in tax laws in India as for most other countries, India does not have a set of well-defined guidelines as to what constitutes a true lease for tax purposes. Hence, most leases, even though they are intrinsically financial leases, qualify as eligible for capital allowances which are granted to the owner of the capital asset. The only practical exception to this rule is a hire-purchase transaction, where an option to buy is clearly given to the hirer.

In any financial lease, the lessor’s recovery from the lessee is partly his real income and partly realisation of his own capital. The latter, though not an income in true sense, if offered for tax, as part of the whole realised by the lessor and accounted for as lease rental. This is the tax loss the lessor suffers. As against this, the lessor has a tax gain in form of the capital allowances. Over n number of years, the sum total of capital allowances charged necessarily has to equal to the capital recovery which in turn is the capital invested in the transaction. Hence, the tax benefit equals the tax loss, over a number of years. However, by its very nature as the residue left after recovery of the finance income, the capital recovery takes a back-heavy pattern. On the other hand, capital allowances for tax purposes normally, and universally for India, have a front-heavy pattern. This results into a timing difference between the tax gain and the tax loss, the net being a gain in the initial years of the lease and an accelerating loss over the later part of the lease.

The actual value (computed in present value terms) of this tax deferment may not be significant at all, and in Indian situation, it is mostly a zero-sum game. But so great is the psychological value of the tax deferment that there is an irresistible tendency to write leases for the sake of tax benefits.

Thus, it is possible to say that the absence of any cogent rules for distinguishing between true leases and financial leases, the tax system has propelled demand for leases in quite a number of ways: 

1. All non-banking finance companies, and a number of public sector financial institutions have resorted to leasing for the sake of immediate tax relief.

2. There being no restrictions on utilisation of leasing tax shelter against other incomes, a lot of other players – one-off lessors – have also used leasing to a substantial extent.

3. Psychological motivation for deferring taxes, though the difference is merely a timing difference, has been aided by two significant quantitative factors:

o The absence of deferred tax accounting rules, whereby the tax deferred can be claimed by the managers as income earned by them, with all resulting distortions in EPS, reported net worth, etc.

o Over last few years, tax rates have come down from 51.75% to 35%, adding a cash value component to the present-value of tax deferments.

1. All the more significantly, India has continued to have, despite of several reported instances of abject misuse, a 100% depreciation rate attributable to energy-saving devices, pollution control devices, etc. These have obviously been the centre-point of attraction for tax-deferment by leasing.

True lease guidelines:

The explosive growth in tax-triggered lease transactions over past 4-5 years has today made most lessors wiser, albeit in a very hard way. One is the unavoidable realisation that all tax deferments are a transient timing advantage, which, when ultimately reversed, becomes all the more painful being an unprovided liability. Two, and clearly more significantly, the asset and credit quality in tax-oriented lease transactions was sub-standard, in many cases, resulting into total loss of principal for the lessors.

A product which has its economic substratum purely in tax benefits is no healthy development in a system. No one, therefore, favours the current scene where a complete silence on the issue from the Central Board of Direct Taxes leaves every tax officer to use his own discretion in letting a transaction pass. In result, as some of the assessments made in March 1998 would show, there are as many Income-tax laws as are the assessing officers: it is rules of persons and not rule of law that is prevailing.

In November 1995 the CBDT had mooted the proposal of importing the accounting definition of a financial lease into the tax statute and qualifying an operating lease, not a financial lease, for tax benefits. As there was (and is) no operating leasing in the country, this was seen as a debacle

for the leasing industry. There was heavy opprobrium, and this approach was dumped. In retrospect, it is worth arguing whether there was any merit in the CBDT’s approach. There is no doubt that lessors have lost crores of shareholders’ money in chasing tax-based transactions into dead end. So, a possible argument is that if tax benefits to leasing would have been denied, the loss of money in bad tax-motivated deals could have been saved. The fallacy of this argument is that it seeks to kill an instrument because of its possible misuse. It sounds like saying: because there are so many frauds in taxes, therefore, why have taxes?

Any tax benefit, and the possibility of its misuse, would always co-exist, and that is why we need a clear and articulate law and a strong enforcement.

India, therefore, urgently needs a standard for distinguishing a tax-true-lease from a plain financing transaction. Obviously, the hire-purchase-lease distinction is not enough. And such a guideline would be to every one’s advantage: the tax officers would have a clear guidance for themselves, and the tax-payers can have a better idea of whether their lease will have a safe harbour

Sales-tax on lease transactions: the biggest irritant:

Today, the single biggest threat to the leasing industry is sales-tax on lease transactions. While there is no theoretical justification for imposition of sales-tax leases, which is necessarily a multi-point levy, the singularly-revenue-sided approach of the States in taxing, and in most cases without Constitutional authority, lease transactions to a 4% - 15% sales-tax levy makes a lease transaction wholly unviable.

Looked at minutely, sales-tax levy is also responsible for a lot of structural aberrations in the leasing industry, including the motivation to write underpriced tax-oriented transactions noted earlier. It goes as under: since sales-tax on a lease pushes up the cost of the lease by some 4% - 10% points (say, a cost of 20% IRR becomes 24% IRR), it becomes impossible to market a genuine lease to a discerning client with good number of other funding options. Hence, all focus is diverted, either (a) to write tax-based leases where the tax benefit will allow the lessor to underprice the lease and retain its viability inspite of sales-tax; or (b) lessors will be forced to shift to unbankable transactions such as sale and leasebacks.

Under the present system of sales-tax, a lessor would necessarily buy the goods to be leased at the least tax which the lessee would have paid on a direct purchase. Hence, there is no loss of sales-tax to any government because of leasing. So, whatever taxes are charged on lease rentals are additional and multi-point levy.

Currently, sales-tax on lease transactions has not been imposed under the Central Sales-tax Act which is supposed to tax transactions of inter-State nature. Many lease transactions have an inter-State nature, and are thus, outside the taxing competence of the States, and yet, the latter tax them. The States have been taking undue advantage of the prevailing uncertainty in interpretation of what would make a lease an inter-State lease. Normally, in any uncertainty in taxes, it is the tax payer who gains, but here, for some strange reason, the entire uncertainty is operating to the benefit of the State govts.

Leasing, and sales-tax on it, cannot go together for long: they will soon be parted. Therefore, it is urgent that the following be done: 

a. The States need to realise that they do not lose anything that they would have gained in absence of leasing: therefore, they should be contented with the industrial development that leases result into, and not make leasing itself a target of revenue. Hence, the States need to exempt leases of such goods which have already suffered tax in the State. Maharashtra, Tamil Nadu, Karnataka and Gujarat (by set-off) have done so already. Other States need to follow.

b. The Central Govt. needs to define leases under the CST Act, define principles under which lease will be regarded as inter-State, and declare leases as taxable only to a single point levy, and fix the limit therefor.