What Is A Lease?

- Lease Types Explained

By James Monahan
A lease, by legal definition, is considered to be a contract that allows the use or
occupation of property for a specific period of time, with a specified amount of
rent. There are different lease types, all with variable conditions and subject to
the laws governing each state.

Different types of lease:

Finance lease:

Also called a financial sale, it allows for the benefits of flexibility as payments are
spread out to a period of several years, often the equivalent of the actual cost of
the equipment or property.

A common misconception is that payments made for a finance lease equals to

ownership, but this is not always true. Nevertheless, the lessee does have the
option to purchase the property after the lease expires, for a significantly much
lower percentage of the actual cost.

This kind of lease, however, is not suitable for individuals who wish to acquire
rapid tax benefits.

True lease:

Also referred to as a tax lease, this is the better choice when one wants to have
rapid tax benefits.

It is also advantageous to professional institutions, as the lessor still remains the

owner of the equipment, thereby trimming down costly investments when it
comes to computers and other office-related gadgets that are prone to becoming
technologically obsolete.

You will get the advantage of lower monthly payments as compared to that of a
financial lease, and in some instances, these could actually be tax-deductible.
When the contract expires, the lessee is given the option of purchasing the
property for a very minimal amount.

Operating lease:

Also referred to as a tax lease, this is the better choice when one wants to have
rapid tax benefits.

This is considered, in general, as a short-term lease, usually three years or less. It

is often associated with high-tech equipment, or property that is prone to
becoming technologically obsolete.

In this type of lease, the lessor takes more of a risk in ownership, therefore
allowing for much lower monthly payments for the lessee. The lessee also has the
advantage of the lease being considered as neither an asset nor a liability when it
comes to taxes.

The lessee also has the option of buying the property at fair market value after
the contract expires, similar to a tax lease.

Skip lease:

Yet another flexible lease type, wherein lessee and lessor agree to a payment
schedule where some months, a set period of time, have no payment and penalty.

This kind of lease is typical for business institutions and organizations whose
operations rely on a seasonal schedule. This is most common in school systems,
and the agricultural and recreational industries.

Sixty or ninety-day deferred lease

This type of lease allows businesses that rely on income-producing equipments

that take several months to generate revenue. A sixty or ninety-day deferred
lease can be similarly structured to a finance and true lease. Lessees are required
to make an advance payment, to be followed by the next ones after a sixty or
ninety-day period.

Pre-paid purchase lease:

This is an option often taken by new businesses which have no credit history.
Lessees are required to make a one-time advanced payment of ten to twenty
percent of the property's total amount, thus reducing the monthly payments
significantly. When the contract expires, the lessee is given the option of
purchasing the property for a very minimal amount.

Sub-lease:

Often termed as "sub-let," this is a lease from one lessee to another.

Forms of Lease Finance

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Generally leases are classified into (i) Financial Lease and (ii) Operating Lease.
However, other types of leases are also prevalent.

1. Financial Lease
A financial lease is also known by various names such as full payment lease, capital
lease, long term lease, etc. In this type of lease, the lease period is generally equal to
the expected economic life of the equipment. One of the important features of
financial lease is that the contract is non-cancellable. The lessee is obligated to pay
lease rents until the lease period expires. The lessee uses the equipment exclusively,
maintains it, insures and avails of the after sales service if any. The lessee pays lease
rentals on a periodic basis over the period of lease.
In financial lease, the lessee may select the equipment, settle the price and terms of
the sale and arrange with a leasing company to buy it. This type of lease transfers
substantially all the risks and rewards incident to ownership from the lessor to the
lessee. The contractual period in a financial lease can be split up into two or three
periods over the life of the equipment. The lease during the first period is called the
‘Primary Lease’, which is for a pre-determined period. Dur ing this period the leasing
company generally recovers the complete cost of the equipment and also interest on
the money invested. The primary lease period may be followed by a ‘Secondary
Lease’ period during which the lease rentals stand substantially reduced. This period
may be followed by a perpetual lease on token rental for the remaining period of the
life of the asset. Under a financial lease, the rate of lease rental would be fixed, based
on the kind of financial lease taken, the period of lease, periodicity of rental payment
and the rate of depreciation and other tax benefits and incentives available. Like other
countries, financial leases are popular in India and high cost equipment are leased
under it. Locomotives, earthmoving equipment, office equipment, plant and
machinery, printing machinery, textile machinery, machine tools, etc. are the
equipments being leased under it.

2. Operating Lease

An operating lease is also known as short-term, service or maintenance lease. In this

type of lease, the lease period is generally less than the full expected economic life of
the equipment. Unlike financial lease, the contract is cancellable with proper prior
notice. The risks and rewards incidental to ownership are retained with the lessor. The
lessor is expected to maintain the assets in good working condition. The lessor does
not recover I tsinvestment during the first lease period. The lease period is usually for
a short period and may stretch from a day to about 5 years, depending on the asset
being leased, its frequency of use and other such factors. The shorter the lease
contract period, the higher will be the lease rentals.
Operating leases are most suitable for equipments which are highly sensitive to
obsolescence. This type of leases are most suitable and popular for computers, copy
machines, electronic equipment, automobiles and other office equipments. Finance
lease and operating lease may be differentiated as follows:

Basis Finance Lease Operating lease

1. Life of contract Approximates the economic life of the asset Shorter than the
economic life of the assets

2. Maintenance provided by the lessee or covered by a separate agreement Provided

by the lessor and included in the lease rentals.

3. Lease Payments Return the cost of the assets and allow a profit to the lessor Not
sufficient to cover the cost of the asset

4. Cancellation May be cancelled only if both the lessor and the lessee agree
May be cancelled before expiring date. It is important to note that the finance lease
and operating lease differ not only on the basis of the length of the contract, but also
with respect to the period of lease as against, the economic life of the asset. Although
the differences between the finance and operating lease are obvious, some lease
arrangements may not fit neatly into any of these two. They may have the features of
both the types and may be called a combination lease.

Other forms of Lease Financing

The other important form of lease financing is:
1. Direct Leasing
2. Sale and Leaseback arrangement, and
3. Leveraged Leasing

These three forms are discussed in detail below.

1. Direct Leasing
Under direct leasing, a company acquires the use of an asset, it did not own
previously. The major types of leassors are manufactures, finance companies, banks
and independent leasing companies. For leasing arrangements involving all but
manufacturers, the vendor sells the asset to the lessor, who, in turn, leases it to the
lessee. A lessee firm may also lease an asset form the manufacturer. A wide variety of
direct leasing arrangements meet various needs of the firms.

2. Sale and Leaseback

Under this type of lease arrangement, a firm, that owns a given asset sells it to the
leasing company and gets it back on lease. Usually the asset is sold at approximately
its market value. The firm (the lessee) received the sale price in cash and the
economic use of the asset during the primary lease period. In turn it agrees to pay
lease rents periodically and gives up title to the asset. Retail stores, office buildings,
multipurpose industrial buildings are frequently financed by this method. Most of the
“Sale and lease back” arrangements are on a net–net basis which means that the lessee
pays all maintenance expenses, property taxes, insurance and lease payments. The
agreement may allow the lessee to repurchase the property at the termination of
the lease. Lessors engaged in sale and lease back arrangement include financial
institutions, banks and independent leasing companies.

3. Leveraged Leasing
In recent years, special form of leasing, known as ‘Leveraged Leasing’ has become
popular in the financing of assets requiring large capital outlays. The equipments
taken under leveraged leasing include aircraft, rail road, coal mining, electric power
generation plants, pipelines, ships, etc. Three parties are involved in leveraged
leasing. They are (i) the lessee (ii) the lessor, and (iii) the lender. From the standpoint
of the lessee, there is no difference between a leveraged lease and other types of lease.
But the role played by the lessor is different here. The lessor acquires the asset in
keeping with the terms of the lease arrangement and finances the asset in part by an
equity investment. The remaining part is financed by a long-term lender or lenders.
Thus, the lessor is the borrower in this type of lease. This loan is secured by a
mortgage on the asset. As owner of the asset, the lessor is entitled to depreciation
associated with the asset and also investment allowance.
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Benefits and costs of Lease Financing
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Let us look at some of the benefits and costs of leasing as a means of financing. It will
facilitate our understanding and evaluation of leasing as an alternative means of
capital financing.

Avoidance of Risk of Ownership

One of the major reasons for acquiring an asset on lease is that the lease offers the
advantage of placing the risk of obsolescence on the shoulders of the owner. When a
firm purchases machinery, it has to bear the risk that the machinery may become
obsolete before the completion of its service life. However, this risk can be avoided
by taking the machinery on lease. It is sometimes argued that this reasoning may not
always be valid because of the fact that leasing firms, who have specialized in the
kind of equipment they own, are generally more knowledgeable than the lessee
regarding the risk of obsolescence and accordingly will charge for bearing that risk.
The risk factor will, therefore, be reflected in appreciably higher rental payments.
This really means that the lessee pays for, and benefits from, the specialist’s services
but nevertheless avoids the risk of ownership.

Convenience
Leasing enables the lessee firm to make full use of the asset without making
immediate payments of the purchase price which it would otherwise have been
required to pay. In view of this, firms experiencing dearth of funds can acquire assets
more quickly under leasing arrangement than through buying. Lease financing is
regarded as more convenient form of financing than debt financing as it relieves the
firm a number of restrictive terms and conditions which are stipulated in bond
indenture. Although lease contracts are tightening, there are still generally few
restrictions on future operations and future indebtedness in a financial lease than in a
loan.

Sustaining Borrowing Position

Leasing is said to be useful to a lessee firm in so far as it strengthens its borrowing
capacity and thereby permits the firm to raise more debt capital than direct borrowing,
given the firm’s existing equity base. Since the obligation created under the leasing
arrangement does not appear as debt on the balance sheet, the firm’s borrowing power
remains intact and the lendersmay extend more credit to such firm even after the lease
is signed, than they would, if the asset were purchased and financed by debt; because
both the asset and the debt incurred would be shown in the financial statement.
Lenders may not fully appreciate the extent of the leasecreated financial obligations
and therefore, they may be more liberal in extending credit facilities.

Tax Advantage
Lease financing is considered as one of the tax planning devices employed to
minimize tax liability. Leasing can provide the tax advantages to the lessee. When a
company acquires an asset on lease, the full amount of the lease payments is
deductible for tax purposes. Alternatively, if the company borrows and buys the same
asset, it would be entitled to deduct depreciation changes and interest expenses
incurred in its financing. Which of the two sets of deductions is more valuable to the
lessee as a tax shield would, in fact, depend on their magnitude and timing. Usually, it
is found that a lessee firm is benefited from lease if it can charge off the cost of an
asset more rapidly through rental payments than through depreciation and interest
changes. Leasing, however, suffers form certain limitations which might have serious
financial implications. Let us briefly point-out these. Many experts hold that leasing is
only another form of debt financing and lies some where in between scoured debt and
unsecured debt. As such, in the long run, all the attendant advantages and
disadvantages of debt financing are bound to be associated with lease also, albeit
in a disguised manner. In some cases, leasing may prove to be costlier than a straight
purchase through the conventional modes of equipment finance. This would happen
particularly in the case of leveraged leasing where the lessor is only a financial
intermediary, who has obtained finance from bank or financial institution and has
added to the cost his own profit. Another disadvantage of leasing is that the lessee
may be deprived of a substantial bonanza on account of appreciation in the value of
assets at the end of the lease tenure, Further, in case of the lessor’s failure to honour
his commitment to repay the loans raised by him from the bank/financial Institutions,
the assets obtained by the lessee through lease may be taken away by the
bank/financial Institutions disrupting the lessee’s production schedule.

Concept of Lease Financing

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A lease is a contract whereby the owner of the asset (know as the ‘lessor’) grants to
another party (known as the ‘lessee’) the exclusive right to use the asset, usually for
an agreed period of time, in return for the payment of rent.

Thus, a lease transaction consists of two parties, the lessor and the lessee. An obvious
advantage to the lessee is the use of an asset without having to buy it. For this
advantage, the lessee has to pay periodic lease payments, usually monthly or
quarterly. A typical lease agreement may contain the following provisions:
Duration: The lease contract may be for any period, from a few hours to the entire
expected economic life of the asset.

Lease rent: As the lessee gets the exclusive right to use the asset during the lease
period, he pays, in return, lease rents in instalments. If the lease period is the same as
the life period of the asset rents are set to enable the lessor to recover the cost of asset
plus a fair return on investment over the period of the lease.

Alternatives at termination: In the lease agreement, option may be given to lessee to

renew the lease for another lease period or to purchase the asset at expiration. If the
lessee does not exercise its option, the lessor takes possession of the asset and is
entitled to, if any, residual value associated with it.

Duties of the parties as to taxes, insurance and maintenance: Either the lessee or
the lessor may bear these obligations or these may be divided between lessee and
lessor according to the terms of the agreement.

Early termination: The lease agreement may grant the right to terminate the contract
on payment of a penalty.

Problems in lease financing

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In spite of the increasing importance, the leasing industry is facing the following
problems.
1. Financial Assistance
There is a lukewarm response from the commercial banking sector for financial
assistance to leasing companies, with the result that many leasing companies find it
difficult to support their fund based operations. Banks and financial institutions are
becoming increasingly selective and stringent in extending refinancing facilities, even
against lease receivables despite the superior repayment performance of leasing
companies as compared to most other borrowers.

Those companies which have recently gone to public are finding it difficult in getting
their issues fully subscribed in the face of inadequate public support. At the same
time, wellestablished leasing companies are finding their margins drastically reduced
as a result of incessant competitions brought about by a flood of new leasing
companies in the market. It is feared that the Indian leasing industry which is not in
dire straits will never be able to recover from the present state of difficult funds
position with them. The reason is keen competition. While rental rates have firmed
up, there are problems in recovery arising from the unsatisfactory financial
performance of many lessees. The inability of the lessors to receive their dues has
exacerbated the cash flow problems.
2. Sale Tax
Consequent to the 46th Amendment to the Constitution, various States have enacted
legislation that subject lease rental to sales tax. This is inequitable as leased assets are
already subject to sales tax at the time of purchase. The problem is further
compounded as the legislation in various states is not uniform, so much so that there
is concern that a transaction, subject to sales tax in one state, may be taxed once again
in another state. Since the cost of effectiveness of leasing is significantly affected,
there is thus, an urgent need to provide relief to the industry from such inequitable
taxation.

3. Risk of Obsolescence
The modern techno-dynamic age has given chance for obsolescence at a high rate due
to technological improvements in production of machinery and process. It will be
beneficial for the lessee to have equipment on operating lease, where the risk of
obsolescence is borne by the leasing company. At the same time, the leasing company
will get much trouble since it has to bear the capital loss in case of obsolescence.

4. Cut Throat Competition

The immediate future of leasing companies in India is bleak, since many companies
entered in field almost at the same time. It leads to cut throat competition and in the
process lease rentals have come down to much uneconomic levels. It has been
reported that the rate of interest is worked out to be 13 to 14 per cent which is very
much below the average cost of capital and as such the survival of many companies is
at stake. A buoyant market did not exist for all these companies in the segments they
wished to operate. With rising competition, the major players are diversifying their
activities to other activities. Further, the leasing industry has been facing competition
from the manufacturing sector. This segment has been concentrating mostly in lease
financing items where 100 per cent depreciation write off is available.

5. Lack of Qualified Personnel

The success or failure or any business depends on the qualifications and experience of
its personnel and leasing business is not an exception. As the nature of leasing
business is nothing but financing the capital equipments, the personnel working in
these organizations must be well versed with all procedures like appraisal, judging,
integrity and capability of the borrowed party legal matters, recovery of rentals,
maintenance of accounts, etc. In Inda, the concept of leasing business is a recent one
and naturally it is very difficult to get the right person to deal with the problems of
this new business. The leasing companies have to develop expertise and sophistication
in handing new types of business.
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10.8 Leasing in India
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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 doyen 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 leased assets totalled Rs. 2395.5 million. One can
notice the surge in number from merely 2 I in 1980 to 339 in 6 years. There has been
appreciable entry of first generation entrepreneurs into leasing, and in retrospect it is
possible to say that specialized leasing firms have done better than diversified
industrial groups opening a leasing division. Another significant phasc in the
development leasing in India was the Dahotrc Committee’s recommendations based
on which the RBI framed 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. As per the data compiled by the Association
of Leasing and Financial Services companies, the value of the leased and hired assets
will be about Rs. 261 billion by the end of March 1997. This data is based on the 226
companies reported to the Association. As a matter of fact, it is estimated that there
will be some 3000 large and small companies involved in the leasing business in India
with an outstanding business of Rs.5 million done by each firm. In addition, the
Indian Railway Finance Corporation (IRFC) – a 100% subsidiary of Indian Railways
does a business of around Rs. 120 billion. Thus, the aggregate volume of leasing
business is estimated to be around Rs. 381 billion.