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Income-tax Issues in Leasing and hire-purchase

This section will summarize the income-tax treatment of lease and hire-purchase transactions.

Details of income-tax issues relating to lease and hire-purchase can be found in Vinod Kothari's Lease Financing and Hire-purchase, Chapters 16 and 17.

The applicable law is dealt with under the following captions:

  1. Basic tax treatment of lease and hire-purchase transactions
  2. What distinguishes between lease and hire-purchase
  3. Allowability of depreciation on lease transactions
  4. Depreciation rates
  5. Sale and leaseback transactions
  6. Taxation of income in case of hire-purchase transactions
  7. Lessee's claim for lease rentals
  8. Hirer's claim for depreciation
  9. Deduction of tax at source
  10. Leases by cross-border lessors. 

1. Basic tax treatment of lease and hire-purchase transactions:

The tax treatment of lease transactions in India is based on whether the lease qualifies as a lease or will be treated as a hire-purchase transactions.

If the transaction is treated as a lease, the lessor shall be eligible for depreciation on the asset. The entire lease rentals will be taxed as income of the lessor. The lessee, correspondingly, will not claim any depreciation and will be entitled to expense off the rentals.

If the transaction is a hire-purchase or conditional sale transaction, the hirer will be allowed to claim depreciation. This is based on an old Circular of the Deptt issued in year 1943. The financing charges inherent in hire instalments will be taxed as the hire-vendor's income and allowed as the hirer's expense.

2. What distinguishes between lease and hire-purchase:

Being the sole determinant of the tax treatment of leases, the distinction between lease and hire-purchase transactions becomes extremely important.

Essentially, the distinction is based on the beneficial ownership of the asset. In order to qualify for depreciation, the lessor has to establish himself to be both the legal and beneficial owner of the asset. As in a hire-purchase transaction, the lessor allows to the lessee the right to buy the asset at a nominal price, it can be seen that the lessor has parted with the whole of his beneficial interest in the asset. The lessor will not be able to benefit from the asset during the lease period (as there is a committed right to use to the hirer), and beyond the lease period (as there is a right to buy the asset with the hirer). Having thus permanently divested himself of his beneficial rights, the lessor becomes ineligible to claim depreciation.

As it is the beneficial ownership rights of the lessor that is crucial, the distinction between lease and hire-purchase goes beyond the mere existence of option to buy in the lease. If, explicitly or implicitly, it is apparent that the lessor has agreed to a permanent beneficial enjoyment of the asset by the lessee, the lease may be treated as a hire-purchase or a plain financing transaction.

Based on the above, the conditions for a true lease transaction have been summarized by the author. Click here for the true lease conditions.

3. Depreciation allowance on lease transactions:

A lease qualifying as true lease will entitle the lessor to claim depreciation. The true lease conditions and the conditions generally applicable for depreciation as such are not independent - the former are drawn essentially from the latter.

The tax-payer claiming depreciation should own the asset. No doubt, the lessor owns the asset, but as discussed earlier, it is not legal ownership alone that is sufficient; the lessor must establish himself to be the beneficial owner as well. It is on the failure of the condition of beneficial ownership that the legal owner in case of hire-purchase is not allowed depreciation.

The lessor's beneficial ownership of the leased asset is proved essentially by the right of reversion of the asset at the end of the lease period - this highlights the significance of proving that the lessor has a substantive and not merely notional or technical right of reversion of the asset.

The lessor may be a joint owner or a single owner. In case of joint ownerships, depreciation was not allowable until 1996 when a specific amendment was inserted to make syndicated leases possible; confusion, however, persists on whether two or more lessors jointly leasing an asset will be treated for tax purposes as a separate assessable entity.

When a movable property becomes a permanent fixtures to land not belonging to the lessor, the lessor ceases to be the legal owner of such fixture. This basic legal tenet is common in England and India, and therefore, the recent English decision of the House of Lords in BMI Investments might create problems for Indian lessors leasing out assets that are in the nature of permanent fixtures to ground. Such an intent is even reflected from the recent Supreme Court ruling in First Leasing Company of India where the Supreme Court distinguished a lease from hire-purchase on the ground whether the transfer of right to use in a lease resulted into a permanent effective right of use being transferred, preparatory to a sale.

The other condition for depreciation is that the tax payer should be using the asset. It is understood clearly that the tax payer uses the asset in the business of leasing; hence, it is on the strength of the lessor's use that depreciation is claimed and not on the strength of the lessee's use. Use or its absence by the lessee should not, therefore, cast any implication on the lessor's depreciation claim.

Depreciation is allowed in India on a pooling basis: all assets eligible for the same rate of depreciation under a particular class of assets will be treated as one pool, or block of assets. Acquisition of fresh assets is treated as addition to the block, and the sales or transfers, at whatever be their transfer consideration, are netted off from the block. Therefore, no regard is had to the profit or loss on sale of an individual asset.

4. Rates of depreciation:

Rates of depreciation are listed in the Schedule to the Income-tax Rules.

Like under the English system, India makes distinction between "plant or machinery" and other assets based on the functional test. The age-old functional test in Yarmouth v. France holds in India. Based on this test, any assets that the lessor leases out are obviously income-earning tools in his business, and would therefore, be regarded as plant or machinery for his business.

Under this caption, the applicable depreciation rates on some of the generally leased assets are given in the Table below:

Motor cars

20%

General plant or machinery (residuary rate)

25%

Lorries, buses or taxies plying on hire, aeroplanes, moulds used in plastic or rubber factories

40%

Bottles and crates

50%

Computers (proposed)

60%

Pollution control devices, energy saving devices, renewable energy devices, rollers in flour mills, gas cylinders, etc.

100%

 

5. Sale and leaseback transactions:

Sale and leaseback transactions came under a lot of flak during 1995-96, when transactions in junk funding were being labeled as sale and leasebacks at phenomenal values.

The Income-tax law was amended to insert a specific provision about sale and leasebacks, which now restricts the amount with reference to which depreciation can be claimed in a sale and leaseback transaction, to the written down value in the hands of the seller-lessee. That is, the actual cost of the asset to the lessor will be ignored, and instead, depreciation will be allowed on the seller's depreciated value.

This provision is applicable only where the seller is the lessee; in other words, not applicable for every lease of second-hand assets. However, in such cases, the fair valuation rule that existed earlier, in Explanation (3) to sec. 43 (1) shall continue to apply.

6. Tax treatment in case of hire-purchase transactions:

In case of hire-purchase transactions, the hire-vendor pays tax on the income inherent in hire instalments, not on the whole of the hire rentals. Thus, the tax is charged only on the income, and not the inflow.

There are no well-defined rules on determination of income in case of hire-purchase transactions - therefore, accounting method adopted by the tax payer will generally be followed. Thus, either of the straight-line, sum-of-digits, or actuarial or IRR basis can be adopted for income allocation.

In the case of Nagarjuna Investment Trust, recently, the Hyderabad Tax Tribunal has made a detailed analysis of the straight-line method. Though this was a case where the tax payer sought to follow different methods of income allocation for tax purpose and for accounting purposes, the case has brought to fore the possible interpretation of the word "evenly" (not necessarily meaning "equally") as used in the 1943 Circular relating to hire-purchase tax treatment.

7. Deduction of rentals by the Lessee:

In general, in a lease, the lessee will be allowed to claim the rentals as an expense.

This is subject to general rules of reasonableness and the power of the tax officer to invoke substance of a transaction ignoring its legal form.

One important case where the claim by the lessee for rental was disallowed is Centre for Monitoring of Indian Economy case, where based on the fact that the lease had partaken the character of acquisition of the asset by the lessee, the lessee's claim for lease rentals was disallowed.

This case cannot be taken to be a trend-setter because the facts in this case were not materially different from most other financial leases. If this case is a precedent, then lease rentals are not tax-deductible in any single financial lease. However, even the Supreme Court has differentiated between lease and hire-purchase in the latest First Leasing Company of India case. Therefore, most likely the Centre for Monitoring of Indian Economy case will not be able to withstand at higher judicial forums.

8. Depreciation claim by the Hirer:

The 1943 Circular of the Department allows depreciation in case of hire-purchase to the hirer of the asset.

Inspite of the old Circular, there have been problems once in a while in claiming depreciation. There have been problems on the part of the hirers in getting depreciation allowed; and there has been a unique case where the financier has claimed depreciation in a hire-purchase transaction [A P Paper Mills].

However, in general, Departmental circulars are understood as binding on lower tax authorities, and therefore, the Circular can be safely treated as decisive.

9. Deduction of tax at source:

Deduction of tax at source by the payer is applicable for several payments, including interest on loans.

There is no question of there being any loan or interest in case of lease transactions. In case of hire-purchase transactions, a controversy was created recently in the context of Interest-tax Act. The resolution of the controversy seems to go into the vexatious question of substance of hire-purchase transactions.

Hire-purchase agreements should provide the hirer with an option to buy the asset and an option to retire the asset during the tenure of hire. Such agreements obviously spell an asset-based risk for the financier, and hence, cannot be viewed as financial transactions.

However, if hire-purchase has no asset-based risks or rewards for the hire-vendor, it may be treated as a financial transaction with all the attendant consequences - deduction of tax at source, interest-tax, and more significantly, the transaction not being viewed as a true hire-purchase transaction even from legal viewpoint. See here for details of requirements of true hire-purchase and case law on the point.

10. Leases by cross-border lessors:

To know more about India as a host-market for cross-border leases, click here.

There is no major difference between leases by Indian lessors and cross-border lessors.

India goes by the universal basis in computing and taxing income - therefore, income deemed to accrue and arise in India, even for entities not resident in India, will be taxable here. Income arising out of an asset in India will be deemed to accrue and arise in India. Hence, in a lease, or in a hire-purchase transaction, the hire rentals, will be deemed to accrue or arise in India if the either the asset or the tax-payer is domiciled in India.

The principles for computation of income to be taxed remain the same as in case of resident tax payers.

The only significant issue is withholding tax. Any payment to a non-resident requires deduction of tax at source.

The problem of withholding tax and double taxation (tax on territorial basis in India and universal basis in country of residence) is partly resolved by double tax avoidance treaties.

India has double tax avoidance treaties with many countries, but one of the most effective jurisdictions is Mauritius with which India has a comprehensive treaty. For entities domiciled in Mauritius, there will be no deduction of tax at source in India.

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