FINANCIAL SERVICES

TOPIC: TAX ASPECTS OF LEASING

Submitted by,
K. srinilaya,
160109672015,
MBA 2nd year 3rd SEM,
CBIT.
 LEASING-An Overview

DEFINITION

According to the Institute of chartered Accountants of India, “a lease is an agreement

whereby the lessor conveys to the lessee, in return for rent, the right to use an asset for an
agreed period of time. Lessor is a person who conveys to another person (lessee) the right
to use an asset in consideration of a payment of periodical rental, under a lease
agreement. Lessee is a person who obtains from the lessor, the right to use the asset for a
periodical rental payment for an agreed period of time”.

A financing arrangement that provides a firm with the advantage of using an asset
without owning it may be termed as ‘leasing’.

CHARACTERISTICS OF LEASE

The following are the characteristics of a lease:

The parties

There are two parties to a lease agreement. They are: the lessor and the lessee. Lessor is a
person who conveys to another person (lessee) the right to use an asset in consideration
of a periodical rental payment, under a lease agreement. Lessee is a person who obtains
the right to use the asset from the lessor for a periodical rental payment for an agreed
period of time.

The asset

Leasing is used for financing the use of fixed assets of high value. The asset is the
property to be leased out. It may include an automobile, an aircraft, plant and machinery,
a building, etc. however, the ownership of the asset is separated from the use of the asset.
During the period of the lease, the ownership of the asset rests with the lessor, while the
use is transferred to the lessee.
The term

The term of the lease is called the lease period. It is the period for which the lease
agreement is in operation. It is illegal to have a lease without a specified term. However,
in India, perpetual lease is in operation, where the lease period is for an indefinite period
of time. On expiry of the lease period, the asset reverts to the lessor mentioned in the
‘operating lease’. In the case of a financial lease, the lease period is in consonance with
the economic life of the asset, so that the lessee is given the advantage of exclusive use
throughout its useful period.

Sometimes, the lease period may be broken into primary lease period and secondary lease
period. A primary lease period is a period during which the lessor wants to get back the
investment together with interest. A secondary period comprises the latter part of the
lease period, where only nominal rentals are charged in order to keep the lease agreement
operational.

The lease rentals

Lease rentals constitute the consideration payable by the lessee as specified in the lease
transaction. Rentals are determined to cover such costs as interest on the lessor’s
investment, cost of any repairs and maintenance that are part of the lease package,
depreciation on the leased asset and any other service charges in connection with the
lease.

TAX ASPECTS OF LEASING

Lease transactions have implications under both the Income Tax Act as well as Sales Tax
Act. The various tax aspects of leasing are detailed below:

Income Tax Implications

Leasing, as a finance function, has implications for income tax purposes. It is a device
offering potential tax benefits to both the lessor and the lessee. Leasing arrangements
provide for a significant scope for tax exemptions or, reduction/deferring of tax liability,
and the possibility of sharing tax savings in the event of heavy tax incidence. In fact,
leasing serves as an instrument by which it is possible to conveniently transfer the
benefits of tax incentives from the purchase-owner (lessor) to the user (lessee) of the
asset/equipment.
IMPLICATIONS FOR LESSOR-DEPRECIATION TAX SHIELD

The lessor can use depreciation allowances as tax shield. Accordingly, the lessor can
deduct the amount of depreciation on leased assets from the taxable income. This results
in reduction of the tax liability, thus making available more profits for distribution to
equity shareholders.

The various provisions relating to depreciation allowance are detailed

below:

The purpose
The provision for depreciation is to be made under the rules and provisions prescribed
under the Companies Act for accounting purposes and by the Income Tax Act for
taxation purposes. Under the Companies Act, depreciation is provided for the purpose of
computation of managerial remuneration, dividend payment and disclosures in financial
statements.

The Rates

Leasing companies in India are expected to provide depreciation in the book of accounts
in accordance with section XIV of the Companies Act. For this purpose, separate rates of
depreciation are prescribed for various types of depreciable assets, both on Written Down
Value (WDV) basis as well as on Straight-line basis. The Act also permits leasing
companies to adopt any other method of depreciating the asset as may be approved by the
Central Government from time to time, which has the effect of writing-off 95 percent of
the original cost of the asset on expiry of the specified period. For the purpose of availing
the benefits of tax deductibility and tax incentives, leasing companies in India invariably
follow the rates and methods as prescribed under the Income Tax Act.

Block-wise rates are used for computing depreciation using only the Written down Value
(WDV) method. Accordingly, the relevant rates are as follows:

1. 25%, 40% and 100% for plant and machinery, depending on the value and usage.
2. 10% on office buildings, furniture and fittings.
3. If the actual cost of plant and machinery does not exceed Rs.5, 000, the entire cost
is allowed to be written-off in the first year of its use.
4. If an acquired asset has been used for a period of less than 180 days during the
year, depreciation on such assets is allowed only at 50 percent of the computed
depreciation according to the relevant rate.
Conditions

For leasing companies to avail the depreciation allowances under the Income Tax Act,
the following conditions are to be satisfied in accordance with Section 32:

1. The asset is owned by the lessor-leasing company-assessee

2. The asset is used by the assessee for the purpose of business.
3. The asset is in the form of buildings, furniture, machinery and plants including
ships, vehicles, books, scientific apparatus and surgical equipments, etc.

Lessor’s ownership

The lessor is eligible to claim the benefit of depreciation tax-shield as the legitimate
owner of the asset leased, although the section does not explicitly provide for claims of
depreciation allowance on leased assets by a lessor. In fact, the lessor’s ownership has
been decided very clearly through rulings by courts and appellate tribunals.

Other Allowances

The lessor is not eligible for any other allowances apart from the depreciation allowance.
Hence, the lessor will not be eligible for any tax shield relating to investment allowance.
Moreover, it is not possible for the lessor to take advantage of higher transfer value of the
asset, acquired under the sale-and-lease-back arrangement, with a view to minimize tax
liability. Such a claim may be disputed by the income tax authorities.

Sale and Leaseback

With regard to asset acquired under the sale and leaseback arrangement, depreciation
allowance can be claimed only on the book value, and not on the inflated/revalued
amount of the asset. This took effect from 1996-97

Fractional Depreciation

When a syndicate of leasing companies owns the leased asset jointly, there is no
possibility of fractional depreciation (each syndicate member availing the depreciation
allowance in proportion to their share of investment). The option open to such leasing
companies is to form an association of persons for the purpose of income tax assessment.
The association, as a separate entity of persons, is eligible to claim depreciation shield.
However, with effect from 1996-97, leasing companies are permitted to avail of
fractional depreciation to the extent of their participation in the syndicated
arrangement/consortium.

Amount of Depreciation

The annual depreciation amount will be determined on the basis of the actual cost of the
asset, and its classification in the relevant block of assets. The actual cost of the asset
refers to the purchase price of the asset plus the incidental charges that are necessary to
put the asset in a usable state. Examples of such asset includes freight and carriage
inwards, installation charges, expenses that are incurred to facilitate the use of the asset
such as expenses on the training of operations or on essential construction work. Relevant
block of assets is the group of assets falling within a certain class of assets, such as
building, machinery, plant or furniture, for which the same rate of depreciation is
prescribed.

Capital Gain/loss

When the sale of a categorized block of assets takes place, the terminal depreciation, or
balancing charge, cannot be treated as capital gain. Instead, capital gains will occur only
under the following situations:
1. Where the sale proceeds exceed the WDV of the whole block.
2. Where the entire block is sold out.
3. Where the assets are 100 percent depreciable.

Inadequate Profits

In the event of profits being inadequate or absent, depreciation will go unabsorbed. In

such a case, the unabsorbed depreciation can be set-off against any business income, as a
case of unabsorbed loss. It is possible to carry forward such depreciation without time
limit. For the purpose of such carry forward, a maximum period of eight years is allowed,
with effect from 1996-97. The unabsorbed depreciation, however, cannot be
assigned/transferred/claimed by the transfer of business.

MAT

Under the provisions of Minimum Value Added Tax (MAT) introduced in the 1996-97
budgets, corporation had to pay a tax @ 12.5 percent on book profits. This was, however,
replaced by the Minimum Advance Alternative Tax (MAAT) in the 1997-98 budgets.

Lessor’s income

The relevant provisions, as applicable to the computation of the lessor’s income under the
Income Tax Act are summarized below:
Lease income-Lease rental income is taxable under the head ‘profits and Gains of
Business and profession’, where leasing constitutes the lessor’s (leasing company) main
activity. In all other cases, lease rental income will be taxable under the head ‘Income
from Other Sources’
Allowable expenses- The following expenses are allowed for deduction for the purpose
of determining the taxable income of the leasing company:

1. Depreciation, rent, rates, taxes, repairs and insurance of the leased asset where
such expenditure is borne by the lessor.
2. Amortization of certain preliminary expenses such as expenditure for preparation
of project report feasibility report, market survey, etc
3. Legal charges or drafting/printing of memorandum of association and articles of
association, registration expenses, public issue expenses, other than on debentures
and loans, subject to a maximum of 2.5 percent of the cost of the project/capital
employed, allowable in 10 equal installments.
4. Interest on borrowed capital.
5. Bad debts.
6. All expenses incurred in improving trade/business.
7. Entertainment expenses subject to prescribed limits.
8. Travel expenses on the basis of approved norms.

IMPLICATIONS FOR LESSEE

The relevant tax implications of leasing for the lessee are detailed below:

Allowability of Lease Rentals

Under the Income Tax Act, lease rentals are allowed as a normal business expenditure of
the lessee for assessment purpose. For this purpose, the payment of lease rental should
be:
1. In the nature of revenue.
2. Not personal expense.
3. Wholly and exclusively related to business purposes of the assessee (lessee).

Deduction of Incidental Expenses

The various incidental expenses, such as repairs and maintenance, insurance, finance
charge and so on, that are incurred by the lessee as part of maintenance of the leased asset
are allowed for deduction from taxable income of the lessee by the Income Tax Act.
Similarly, it is possible for the lessee to claim expenses on the installation of equipment
for calculating taxable income. Such expenses need not be capitalized, since the
ownership of the asset is not vested in the lessee-assessee.

TAX PLANNING ASPECTS

Leasing comes handy for both for the lessor and the lessee and helps them plan and save
taxes. The various tax planning implications of lessor and the lessee are detailed below:

For the Lessor

The deductibility of depreciation in the computation of the taxable income is the main
source of tax saving.

For the Lessee

It is the lease rentals that offer the advantage of tax shield. The lessee can use lease rental
deduction as a tax-planning instrument either by way of flexible structuring of lease
rentals or by way of transfer of unabsorbed capital to the lessor.

Flexible structuring of lease rentals- It is possible for the lessee to reduce his
current or future tax liability through flexible structuring of lease rentals. This is possible
by structuring a lease package such that a large part of the lease rentals would become
payable in the first year, when the expected cash flow will be higher, thus reducing tax
liability, and a very small fraction becomes payable during the remaining lease term. This
would be matched with a low volume of cash flows, thus reducing the tax liability again.
Such an arrangement is always subject to approval by the income tax authorities.

Transfer of unabsorbed capital- It is possible for the lessee to transfer investment-

related unabsorbed tax shield to the lessor for absorption. This facility is available to a
lessee who enjoys 100 percent deduction of income for tax, by way of income from
exports, tax shield on fresh capital investment, etc. for such lessees, investment related
tax shields would be of no use, as that would not have any impact on its cash flows.
Instead, if the investment related tax shields could be transferred to a lessor, it is quite
possible to expect that the lessor will pass on the counter benefit to the lessee in the form
of reduced lease rentals, which will in turn enhance the operating cash flows of the
lessee.

FINANCIAL IMPLICATIONS

Lease transactions would have accounting and financial implications for both the lessors
and the lessees as detailed below:

For Lessee
1. Tax shield on lease rentals is available as business expenditure
2. Depreciation tax shield is not available
3. Tax shield on lease rentals represents a cash inflow.
4. Tax shield on depreciation represents cash outflow (cash inflow foregone)

For Lessor
1. Depreciation tax shield is available
2. Tax shield on lease rentals is not available as business expenditure.
3. Tax shield on depreciation represents cash inflow.
4. Tax shield on lease rentals represent a cash outflow (cash inflow foregone)
5. Net salvage value of and equipment is treated as a post-tax cash flow.
IMPLICATIONS UNDER SALES TAX

The sales tax aspects of leasing transactions are governed by the legislative framework of
the Central Sales Tax Act, 1957 (CST), enacted by the Government of India, and Sales
Tax Acts (STA) of various states. Whereas the CST governs the levy and collection of
sales tax on the inter-state sale of goods only, the respective STAs govern the tax on sale
of goods within a state (intra-state sale). The implications of lease transactions are
detailed under the relevant provisions of the concerned Acts as follows:

On Purchase of Equipment

1. A normal rate of sales tax or the appropriate rate as applicable to intra-state

purchase/sale of goods in the respective state, whichever is higher, is imposed
where the purchase of equipment by a lessor involves inter-state sale, the
transaction attracting the provisions of the CST.
2. Where the lessor uses the goods sold by a registered dealer, the dealer is entitled
to a concessional sales tax rate of 4 percent. For this purpose, the goods sold must
be used for the purpose of resale, for manufacturing of taxable goods, for use in
mining, or for use in the generation/distribution of electricity/any other form of
power.
3. The equipment supplier to a lessor is not entitled to a concessional rate of sales
tax but has to pay central sales tax at the normal rate of 10 percent
4. The intra-state purchase of equipment attracts sales tax stipulated in the
appropriate STA.

On Lease Rentals

The concept of sales taxing lease rentals was introduced with the enactment of the
Constitution (Forty-Sixth Amendment) Act, 1982; there was no sales tax on lease rentals.
The Act enabled the respective state governments to levy tax on transaction, which did
not fall in the category of conventional sale/purchase covered by the CST and STAs. The
concept of tax on the sale and purchase of goods was enlarged to enable the state
governments to impose sales tax on lease rentals.

Accordingly, the said Act provided for the levy of tax on the transfer of the right to use
any goods for any purpose (whether or not for a specified period) for cash, deferred
payment or other valuable consideration. This way leasing was also brought within the
ambit of the sales tax net. Accordingly, lease rentals can now be taxed under the STAs in
all the states, except Maharashtra which has enacted a separate legislation under the name
Maharashtra Lease Act, 1985 to tax lease rentals.
Following are the salient features of the sales tax on lease rentals in
general:
1. Annual taxable turnover/aggregate lease rentals of the lessor are the basis of levy
of sales tax, the rates of tax varying from state to state.
2. Additional taxes such as surcharge, additional surcharge, additional sales tax on
turnover, exceeding a specified limit (turnover tax) are also levied on the lease
rentals
3. Registration for lessors as dealers is compulsory, if they have an annual taxable
turnover exceeding a particular limit under the STA. With leasing
companies/dealers having to register in all those states where leasing is done, it
would result in a situation of multiple registrations for leasing companies.
4. Sales tax is leviable only on the use of leased asset by the lessee which requires
legal possession of the goods.

Sale of Asset

Exemptions that are available in respect of normal second sale within the state are usually
not available for lease transactions. For example, a leasing company buys equipment
from a supplier and leases it to a lessee, both within the same state. Local taxes will be
levied on goods sold by the equipment supplier to the leasing company, and such a levy
is called the sales tax on first sale. Second sale or deemed sale, connotes the transaction
between the lessor and the lessee. In respect of such a sale there is no sales tax levied.
However, such an exemption is not available to lease transactions. This way, the
transactions relating to equipment leasing suffer a multiple-point levy, irrespective of the
goods covered by the transaction.

Financial Implications

The financial implications of a sales tax levy will be in the realm of lease-related cash
flow and lease rentals. This is to the extent of tax impact on the lessee.

REFERENCES:
DR.S Gurusamy, FINANCIAL SERVICES AND MARKETS, Thomson publications.