LEASING

A lease is a contract. By its terms the owner of an asset (the lessor) gives another party (the
lessee) the exclusive right to use the asset, usually for a specified period of time, in return for
the payment of rent. Leases of houses, apartments, offices, or automobiles were common, in
recent decades there is enormous growth in the leasing of business assets, such as cars and
trucks, computers, machinery, and even manufacturing plants. The lessee gets to use the
asset without buying it but has several obligations. First and foremost is the obligation to
make periodic lease payments, usually monthly or quarterly. Also, the lease contract
specifies who is to maintain the asset. Under a full-service (or maintenance) lease, the lessor
pays for maintenance, repairs, taxes, and insurance. Under a net lease, the lessee pays these
costs. Though the rental amount is fixed, the timing of payment of rentals can be tailored to
suit lessee’s cash flows. In up-fronted leases, more rentals are charged in the initial years and
less in later years of contract. The opposite happens in back-ended leases.

Essential Elements
The essential elements of leasing are the following:
Parties to the Contract:
There are essentially two parties to a contract of lease financing, namely, the owner and the
user, called the lessor and the lessee, respectively. Lessors as well as lessees, may be
individuals, partnerships, joint stock companies, corporations or financial institutions.
Sometimes there may be joint lessors or joint lessees, particularly where the properties or
the amount of finance involved is enormous. Besides, there may be a lease broker who acts
as an intermediary in arranging these deals. Merchant banking divisions of certain foreign
banks in India, subsidiaries of some Indian banks and even some private merchant bankers
are acting as lease brokers. They charge a certain percentage of fees for their services,
ranging between 0.50 to 1 per cent. Besides, a lease contract may involve a lease financier,
who refinances the lessor, either by providing term loans or by subscribing to equity or
lending under a specific refinance scheme.

Assets:
The assets, property or equipment to be leased is the subject matter of a lease financing
contract. The asset may be an automobile, plant and machinery, equipment, land and
building, factory, a running business, an aircraft and so on. The asset must, however, be of
the lessee’s choice, suitable for his business needs.

Ownership Separated from User:

The essence of a lease financing contract is that during the lease tenure, ownership of the
asset vests with the lessor and its use is allowed to the lessee. On the expiry of the lease
tenure, the asset reverts to the lessor.

Term of Lease:
The term of lease is the period for which the agreement of lease remains in operation. Every
lease should have a definite period, otherwise it will be legally inoperative. The lease period
may sometimes stretch over the entire economic life of the asset (i.e. financial lease) or a
period shorter than the useful life of the asset (i.e. operating lease). The lease may be
perpetual, that is, with an option at the end of lease period to renew the lease for the
further specific period.
Lease Rentals:
The consideration that the lessee pays to the lessor for the lease transaction is the lease
rental. Lease rentals are structured so as to compensate (in the form of depreciation) the
lessor for the investment made in the asset, and for expenses like interest on the investment,
repairs and servicing charges borne by the lessor over the lease period.

Modes of Terminating the Lease

At the end of the lease period, the lease is terminated and various courses are possible,
namely,
(a) The lease is renewed on a perpetual basis or for a definite period, or
(b) The asset reverts to the lessor, or
(c) The asset reverts to the lessor and the lessor sells it to a third party or
(d) The lessor sells the asset to the lessee.
The parties may mutually agree to and choose any of the aforesaid alternatives at the
beginning of a lease term.

Classification
A lease transaction can differ on the basis of:
(a) the extent to which the risks and rewards of ownership are transferred,
(b) number of parties to the transactions,
(c) domiciles of the equipment manufacturer, the lessor, the lessee and so on.

Risk, with reference to leasing, refers to the possibility of loss arising on account of under-
utilisation or technological obsolescence of the equipment, while reward means the
incremental net cash flows that are generated from the usage of the equipment over its
economic life and the realisation of the anticipated residual value on expiry of the economic
life. On the basis of these variations, leasing can be classified into the following types:
(a) Finance lease and Operating lease,
(b) Sales and lease back and Direct lease,
(c) Single investor lease and Leveraged lease and
(d) Domestic lease and International lease

Operating lease:
Short-term, cancellable lease agreements are called operating leases. Convenience
and instant services are the hallmarks of operating leases. Examples are: a tourist
renting a car, lease contracts for computers, office equipment, car, trucks and hotel
rooms. For assets such as computers or office equipment, an operating lease may
run for 3 to 5 years.
The lessor is generally responsible for the maintenance, insurance of the asset and
other services because of which it is also called as service lease. A single operating
lease contract may not fully amortize the original cost of the asset; it covers a
period considerably shorter than the useful life of the asset. Because of the short
duration and the lessee's option to cancel the lease, the risk of obsolescence
remains with the lessor. Naturally, the shorter the lease period and/or higher the risk
of obsolescence, the higher will be the lease rentals.
Financial lease:
Long-term, non-cancellable lease contracts are known as financial leases.
Examples are plant, machinery, land, building, ships, and aircraft. In India,
financial leases are very popular with high-cost and high technology equipment.
Financial leases amortize the cost of the asset over the term of lease. They are,
therefore, also called capital or full-payout leases. Most financial leases are
direct leases. The lessor buys the asset identified by the lessee from the
manufacturer and signs a contract to lease it out to the lessee.
A finance lease is structured to include the following features:
(i) The lessee (the intending buyer) selects the equipment according to his
requirements, from its manufacturer or distributor;
(ii) The lessee negotiates and settles with the manufacturer or distributor, the price,
the delivery schedule, installation, terms of warranties, maintenance and
payment and so on;
(iii) The lessor purchases the equipment either directly from the manufacturer or
distributor (un-der straight foward leasing) or from the lessee, after the
equipment is delivered (under sale and lease back);
(iv) The lessor then leases out the equipment to the lessee. The lessor retains the
ownership while lessee is allowed to use the equipment;
(v) A finance lease may provide a right or option, to the lessee, to purchase the
equipment at a future date. However, this practice is rarely found in India;
(vi) The lease period spreads over the expected economic life of the asset. The lease
is originally for a non-cancellable period called the primary lease period during
which the lessor seeks to recover his investment along with some profit. During
this period, cancellation of lease is possible only at a very heavy cost. Thereafter,
the lease is subject to renewal for the secondary lease period, during which
rentals are substantially low;
(vii) The lessee is entitled to exclusive and peaceful use of the equipment during the
entire lease period, provided he pays the rentals and complies with the terms of
the lease;
(viii) As the equipment is chosen by the lessee, the responsibility of its suitability, the
risk of obsolescence and the liability for repair, maintenance and insurance of the
equipment rest with the lessee
Sale-and-lease-back:
Sale-and-lease-back is a special financial lease arrangement. Sometimes, a user
may sell an (existing) asset owned by him to the lessor (leasing company) and
lease it back from him. Such sale-and lease-back arrangements may provide
substantial tax benefits. A classic example of this type of leasing is the sale and lease
back of safe deposit vaults by banks. Banks sell the vaults in their custody to a leasing
company at a market price substantially higher than the book value and the leasing
company in turn offers these lockers on a long-term basis to the bank. The bank sub-
leases the lockers to its customers. The lease back arrangement in sale and lease back
type of leasing can be in the form of a finance lease or an operating lease.
Direct Lease:
In direct lease, the lessee, and the owner of the equipment are two different entities. A
direct lease can be of two types: bipartite and tripartite lease.
Bipartite Lease: There are two parties in this lease transaction, namely, (i) the equipment
supplier-cum-lessor and (ii) the lessee. Such a lease is typically structured as an operating
lease with inbuilt facilities like upgradation of the equipment (Upgrade lease), addition to
the original equipment configuration and so on. The lessor maintains the asset and, if
necessary, replaces it with a similar equipment that is in working condition (Swap lease).
Tripartite Lease: Such a lease involves three different parties in the lease agreement: (i)
the equipment supplier, (ii) the lessor and (iii) the lessee. An innovative variant of the
tripartite lease is the sales-aid lease under which the equipment supplier arranges for
lease finance in various forms by:
 Providing reference about the customer to the leasing company;
 Negotiating the terms of the lease with the customer and completing all the
formalities on behalf of the leasing company;
 Writing the lease on his own account and discounting the lease receivables with
the de-signated leasing company. The effect is that the leasing company owns the
equipment and obtains an assignment of the lease rental.
The sales-aid lease is usually with recourse to the supplier in the event of default by the
lessee, either in the form of an offer from the supplier to buy back the equipment from
the lessor or a guarantee on behalf of the lessee

Single Investor Lease:

There are only two parties to this lease transaction: the lessor and the lessee. The leasing
company (lessor) funds the entire investment by an appropriate mix of debt and equity
funds. The debt raised by the leasing company to finance the asset are without recourse
to the lessee, that is, in the case of default in servicing the debt by the leasing company,
the lender is not entitled to payment from the lessee.
Leveraged Lease:
A special form of leasing has become popular in the financing of big-ticket assets, such as
aircraft, oil rigs, and railway equipment. There are three parties to the transaction: (i) the
lessor (equity investor), (ii) the lender and (iii) the lessee.
From the standpoint of the lessee, there is no difference between a leveraged lease and
any other type of lease. The lessee contracts to make periodic payments over the basic
lease period and, in return, is entitled to the use of the asset over that period of time.
The role of the lessor, however, is changed. The lessor acquires the asset in keeping with
the terms of the lease arrangement and finances the acquisition in part by an equity
investment of, say, 20 percent (hence the term “equity participant”). The remaining 80
percent of the financing is provided by a long-term lender or lenders. Usually the loan is
secured by a mortgage on the asset, as well as by the assignment of the lease and lease
payments. The lessor, then, is itself a borrower.
Domestic Lease and International Lease:
Domestic Lease: A lease transaction is classified as domestic if all parties to the
agreement, namely, equipment supplier, lessor and the lessee are domiciled in the same
country.
International Lease: If the parties to the lease transaction are domiciled in different
countries, it is known as an international lease. This type of lease is further sub-classified
into (1) the import lease and (2) the cross-border lease.
Import Lease; In an import lease, the lessor and the lessee are domiciled in the same
country but the equipment supplier is located in a different country. The lessor imports
the asset and leases it to the lessee.
Cross-Border Lease: When the lessor and the lessee are domiciled in different countries,
the lease is classified as cross-border lease. The domicile of the supplier is immaterial.
Operationally, the domestic and international leases are differentiated on the basis of risk.
The latter type of lease transaction is affected by two additional risk factors, that is,
country risk and currency risk. The country risk arises from the need to structure the lease
transaction in the light of an understanding of the political and economic climate and a
knowledge of the tax and regulatory environment governing them in the foreign countries
concerned. As the payment to the supplier and the lease rentals are denominated in
different currencies, any variation in the exchange rate will involve currency risks.