Taxation of leases in Sri Lanka:

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The general taxation system in Sri Lanka is characterized by a plethora of taxes: a number of direct taxes and several indirect taxes, some of which have an overlapping application. The Income-tax law, called the Inland Revenue Act is full of incentives and holidays of various sorts, and most significantly, a very high straight-line depreciation system. These must be resulting into a very low share of corporate taxes to total tax revenue of the Govt., forcing the Govt. to depend heavily upon cascading and inflationary taxes on goods and services such as the Goods and Services Tax.

The taxation of lease transactions in Sri Lanka must have been a hot potato for the law-makers over the past so many years. Almost every successive Budget makes so change or the other in the tax provisions relating to leases. The result is an confusion-ridden scenario with plenty of provisions affecting lease transactions.

 

Inland Revenue provisions:

The provisions of the Income-tax law, relating to lease transactions, can be broadly summarised in the following bullet-points:

• Rate of tax is 35% for all corporates generally
• Depreciation rates are 50% for plant, machinery, computer software, etc., and 25% for vehicles and furniture.
• No depreciation is allowed on vehicles used for passenger travel, or assets put up at the residence of the entity's employees
• In the year of sale, a balancing charge or capital gain arises depending on the sale proceeds
• If the sale proceeds are reinvested in replacing the asset within one year, the amount taxable as above is to be reduced from the cost of the new asset.
• No depreciation is allowed on sale and leaseback transactions
• Rental write-off is also not allowed on sale and leaseback transactions
• Rental deduction in any year by lessee will not exceed 50% of the total contracted rentals, or 25% of total rentals in case of motor vehicles or office furniture.
• Importantly, the depreciation allowance to be claimed by any leasing company will not exceed the income from leasing activity.

On an overview, these provisions present an interesting picture: leasing has been put to quite a lot of incentive in Sri Lanka due to the very fast rate of depreciation write-off. At the same time, a provision has been inserted to ensure that the depreciation allowance is not used by non-leasing entities to write-off their income from non-leasing activities. The limitation on depreciation being claimed against leasing income only would have certainly led to practices of inflated rental write-offs by some lessees: there again comes a balancing provision restricting the rental write-off for leases to 50% in case of machines and 25% in case of vehicles and furniture.

With these incentives, tempered by checks and balances, it can be said that leasing in Sri Lanka has been given powerful growth incentives by the Govt., as far as direct taxes are concerned.

A detailed study of these provisions follows:

 

No true lease guidelines:

There are apparently no rules in Sri Lanka to distinguish genuine lease transactions from plain financing transactions. This is one of the most important rules to have in a developing market and an important lesson can be learnt in this regard from India.

A lease, in order to qualify for tax deduction, has to be different from a plain financial transaction. Evidently, no depreciation benefit can be claimed in case of a transaction of simple financing of an asset. In addition, one must also appreciate that if an agreement has the colour of a lease transaction but in essence is nothing but a financial transaction, the outer form of the transaction will be ignored, and based on its intrinsic substance, it would be reckoned as a financial transaction.

The meaning of the above is that if a lessor in Sri Lanka writes a lease transaction which has the legal form of a lease, but is in substance nothing but a financing transaction on the security of an asset, such lease will not be regarded as a lease but as a secured financing. Obviously, it is not enough to call an agreement a lease agreement: in taxation, nomenclatures are ignored and the reality is looked into.

To guide parties as to what are the important attributes of a lease transaction that would distinguish it from a financial transaction, one would find, in advanced leasing markets, detailed rules or standards that define a true lease. In absence of such guidelines, it is quite common, particularly in nascent stages of development of an industry, for players to make mistakes which turn out to be costly both for the revenue and for the players themselves.

India, like Sri Lanka, does not have true lease guidelines. As a result, around 1987-1989, when leasing grew very rapidly in the country, a number of lessors wrote leases for assets that never existed. There was obviously no intent to cheat the revenue, but such practices were founded on a premature belief that all agreements which look like lease agreements will be acceptable for tax purposes.

Even today, inspite of the fact that India today is a mature market compared to many others, a number of Indian lessors make mistakes which would only prove to be fatal over time.

The trouble with a no-rule regime is that it encourages unintentional malpractices. Of course, tax avoidance and evasion can exist even where there are elaborate rules, but the trouble with absence of rules is that it breeds innocent non-compliance.

Sri Lanka must notify true lease guidelines, and sooner the better. It must, most importantly, educate tax payers on what is the elementary distinction between a lease and a hire-purchase transaction, since in the latter case, depreciation cannot be claimed by the lessor.

 

No clear distinction between lease and hire-purchase

The difference between lease and hire-purchase transactions is a crucial difference for all countries which allow depreciation based on ownership of an asset. It is a basic rule of law that "ownership" for tax purposes is not merely legal ownership - it must be backed by beneficial ownership. Beneficial ownership implies the right to attain benefits of ownership at some point of time. In a hire-purchase transaction, the legal owner (finance company) cannot be treated as beneficial owner, since, having provided the user with a right of purchase, the owner has divested himself of beneficial interest completely.

Currently in Sri Lanka many of the lease transactions are in fact hire-purchase transactions, as the sale of the asset to the lessee, even if not incorporated in the contract of lease, is mostly inherent and pre-agreed.

This practice, which in opinion of the author will be a problem over time as the revenue officials get more of education on lease taxation, can be resolved either by proper training or by a proper law. Treating a lease with an inherent option to buy as hire-purchase will be more easy in Sri Lanka, which has a number of statutory definitions of the term "hire-purchase" in several of its laws.

 

Depreciation:

Depreciation is claimable under sec. 23 (1) (eee).

The allowance as amended in 1997 is

1. 50% for plant machinery or fixtures [other than those covered by (b) below] acquired on or after 1.4.1997;
2. 25% for motor vehicle, lorry, bus, trailer, tractor or office furniture.

The other depreciation rates in case of buildings, etc., not being relevant here, are not discussed.

Conditions for claiming depreciation:

On a reading of sec. 23 ( 1) (eee), the following conditions apply for claim of depreciation:

1. The asset should be a depreciable asset, liable to wear and tear
2. The asset should have been "acquired" by the lessor.
3. The asset should be used for the purposes of business or profession of the tax payer
4. The asset should not have been let out to any undertaking the whole or any part of income whereof is exempt from tax [ sec. 23 (5) (a)]
5. The asset should not have been let out for use in any undertaking carried on by the person from whom the asset was acquired [sec. 23 (5) (b)]
6. The asset should not have been used for travelling for the purposes of his trade, except a motor coach [sec. 24 (2) (a)]
7. The asset should not be a plant or equipment provided for use at the residence of the employee or executive of the entity.

 

First condition: depreciable asset

The first condition implies that the asset must have a natural wear and tear. This is clear from sec. 23 (1) (eee) which says: "an allowance for depreciation by wear and tear of …..". That is to say, the allowance as provided in the Act is to be allowed if there is a depreciation by way of wear and tear in the property. If the asset in question be, for example, land which is not subject to wear and tear, no depreciation will be allowable. On the same logic, intangible assets which are not subject to wear and tear by usage or efflux of time are not depreciable assets.

Second condition: "Acquired" by the tax-payer

The second condition of "acquiring" implies that the lessor must have acquired ownership rights over the asset. Ownership conveys legal as well as beneficial ownership. No doubt, the lessor is the legal owner of the asset, but if the lessor has divested all his beneficial interest in the asset for all time to come, he may be owning the chaff of legal title, which will not entitle him to claim depreciation.

The other notable issues with regard to ownership are:

1. The asset should be proved to be existing. The onus of proof, evidently, lies on the lessor.
2. The asset should not have become an unseverable fixture on land belonging to the lessee or some other person, as that would be fatal to the ownership interest of the lessor. Notable ruling in this regard in the case of Costain v. Stokes Properties and BMI Investment (Newford) v Melluish will be applicable to Sri Lanka too.
3. The asset should be the property of the assessee: it is not enough for the lessor to have ownership interest, that is, joint-ownership interest in the asset. Hence, jointly owned assets will not be eligible for depreciation.

Third condition: "Used" by the tax -payer

The third condition is the condition of use. The Act requires that the asset must have been used for business purposes. It is also provided in Para 2 (3) (b) of the Schedule. It must be understood that the "use" that qualifies a lessor to depreciation is not the physical use by the lessee, but the use by the lessor in his business of leasing. The lessor makes the use of the asset in the lessor's business of leasing the asset, and that use qualifies the lessor to stake a depreciation claim.

Having understood the condition of use in this light, it becomes clear that:

1. If a lessor has let out an asset during the year, depreciation can be claimed even if the asset has not been put to actual use by the lessee.
2. If assets given on lease remain idle for a whole year, that would be no ground to disallow depreciation. Assets on lease are always in use, whether physically used by the lessee or not.
3. The realisation of rentals is also no precondition for claiming depreciation.
4. The classification of assets into furniture, buildings and plant based on functional test held in Yarmouth v. France and a series of English cases has not relevance to Sri Lanka where depreciation rates are based on description, not function. Therefore, an item of furniture remains furniture even in the hands of the lessor. In countries adopting the functional test, the position is different. On functional basis, an asset is treated as plant or machinery if it is used as a tool of trade by the assessee, irrespective of what is its physical attribute or description. For example, a chair used in a cinema hall would be a plant or machinery, while it would be furniture if used in an office.

Fourth condition: leasing to exempt entities:

No depreciation can be claimed where a part of the income of the lessee is exempt. There is an obvious difference between the lessee's income being exempt, and no tax being payable thereon due to various incentives under the law. The various exemptions are set out in Chapter III of the Act.

This condition also cannot be read as meaning that depreciation cannot be claimed except where the lessee could have claimed the same himself - for example, a lessee using an asset for personal purposes cannot claim depreciation, but there is no such restraint if the same asset is leased to such lessee.

 

Fifth condition: sale and leaseback transactions:

If the undertaking for whose use the asset has been leased is owned by the same person who sold the asset to the lessor, depreciation cannot be claimed on such asset.

Though the intent of the law is clear, the exact drafting leaves a lot of scope for indirect leases to the selling entity. For example, if A sells the asset to B, who leases it to C, and C in turn leases the asset back to A, it does not seem that B should have any difficulty in claiming depreciation on the asset.

Secondly, this provision is applicable only if the asset was a business-use asset. For example, if a car was sold by an individual, bought by the leasing company, and given back on lease to the selling individual, the provisions do not seem to be applicable. This is because the word "undertaking" in common parlance means only business undertaking.

Sixth condition: Not a passenger vehicle

This restriction does NOT seem to be applicable to a leasing company. Sec. 24 (2) (a) provides for "travelling for the purposes of his trade", etc. Reading "his trade" as meaning the trade of the leasing company, if the leasing company has let out a passenger vehicle which is used by the lessee for the purposes of travel by the latter's employees, as the use of the vehicle is not for the purposes of travel for the lessor's trade, the restriction should not be applicable.

Seventh condition: not a residential asset:

This condition also, for the reasons discussed above, is not applicable to a leasing company. That is to say, even if the lessor leases out assets which are used by the employees of the lessee at the their residence, no limitation for depreciation will arise under the section.

Year of sale treatment: balancing charge and capital gains:

These provisions are covered by sec. 23 (3). There are provisions for "replacement of a capital asset by a new asset" in which case the capital gains or balancing charge will not be computed, but since a leasing company buying a new asset for an independent lease is not strictly speaking "replacing" the asset, the said provision does not seem to be applicable to a leasing company.

An important provision here is that the "sale proceed" of an asset which is actually sold means the actual selling price, and where the asset is disposed otherwise than by sale, it means the fair market value of the asset. This leaves no scope for attempted rejection of the actual selling price of the asset and its substitution by arbitrary values.

 

Leasing depreciation: limited to income from leasing:

The second proviso below sec. 23 (1) (eee) was inserted by the Amending Act 1997. This provision enacts that where the depreciation under sec. 23 ( 1) (eee) has been claimed by a person carrying on the business of leasing, the allowance for depreciation in respect of assets acquired by the person and given on lease in the course of such business of leasing shall be deducted only in ascertaining the profits and income of such business.

The simplest meaning of this provision is that the depreciation out of leasing business cannot be go on offset the profit out of any other business. As "profit or income" has to be read in the sense of taxable profit or income, it means that after allowing for all allowable deductions and benefits, lease depreciation shall be deductible against leasing income.

The provision was principally intended to restrict leasing being pursued as a tax shelter by persons not fully in leasing business: therefore, the provision is applicable for all entities whether carrying on leasing as a part of their business or otherwise.

It may be noted that the restriction for claiming depreciation set-off is against income of the leasing business, and not necessarily against leasing income. If leasing is the only business carried on by the entity, one cannot still rule out there being other incomes in business. For example, the temporary surpluses in business may be invested for a short-term application, which does not constitute the business of the entity. Though difficulties do arise in distinguishing a business and an incidental activity, it cannot be said that the only source of income against which the leasing depreciation should be offset is the lease rentals. After all , even connected with the leasing business can be incomes such as service charges, management fees, fees earned from lessees, etc.

Lessee write-off of lease rentals: limitations:

The limitations against a lessee claiming a write-off of lease rentals are contained in sec. 24 (1) (qq) of the Act. This provision, inserted by the 1997 Amendment provides that in any year of assessment, the total rental that can be claimed as expense will be 50% of the total rental payable under the agreement in case of leases of plant or machinery, or 25% of total rentals in case of vehicles and office furniture.

This is a safeguard against structuring of leases from the viewpoint of lessee tax shelters.

 

Goods and Services Tax provisions:

One of the most controversial issues in Sri Lanka today, the Goods and Services Tax Act was made effective only on 1^st April 1998.

The intent of the law is to enact a system of comprehensive value-added taxation in line with the UK value-added tax.

Towards this end, the Act imposes a Goods and Services Tax (GST) on supply of all goods, and rendering of all services, except those listed in the Schedule. At the same time, the Act provides for relief on account of GST paid by the tax payer. Thus, the tax is only on value-added.

Basics of the Goods and Services Tax:

The charging section 2 provides for payment of GST on "every taxable supply of goods or services made by a registered person, in a taxable period, in the course of carrying out a taxable activity".

The general definition of "taxable activity" covers all activity carried on as a business, and there is a specific mention to include "hiring or leasing of any movable property": therefore, both lease and hire-purchase transactions are covered as "taxable activity".

Having determined the scope of taxable income, it is important to understand whether a lease or hire-purchase is covered by "supply of goods" or by "supply of services".

Sec. 76 of the Act importantly defines "supply of goods" to mean the transfer of the right to dispose as owner of movable or immovable properties. This is a very important definition from the point of view of lease and hire-purchase transactions. Unfailingly, this definition conveys that neither lease nor hire-purchase can be taken as supply of goods:

• An essential element for a supply of goods is transfer of right of disposal - that is, the transferee should be given the right to dispose the goods;
• In a lease, the lessee is not given a right of disposal;
• In case of hire-purchase also, the hirer is not given the right of disposal - the right of assignment is not a right of disposal.
• Therefore, both lease and hire-purchase transactions are not to be treated as "supply of goods".
• "Supply of services" means all suppliers other than supply of goods - therefore, both lease and hire-purchase activities will be covered by "supply of services".

GST in case of a lease:

Since a lease is taken as a supply of service, it comes under sec. 4 (2) for determination of the tax liability. Sec. 4, it may be noted, fixes the liability based on the time when the supply is deemed to take place, which is the basis of the liability under sec. 2.

Accordingly, in case of a lease, under sec. 2, a supply shall be deemed to have taken place at the earliest of the following:

1. Expiry of a lease period, say, a month;
2. Receipt of a lease rental or future lease rentals;
3. Accrual of lease rentals;
4. Raising of an invoice in respect of lease rentals.

It may be noted that even future lease rentals received will be liable to be taxed: however, if an amount is received and held as a liability or a deposit with the lessor, such deposit will not be taxed.

Thus, the taxable amount of receipts of a lessor is the aggregate of the lease rentals received by him.

Coming now to sec. 22 (2), a registered person is entitled to credit for so much of the "input tax" as is allowable to him. Input tax is the tax paid on the supply of goods "used by the person" for carrying on his business. Undoubtedly, the assets given on lease are the assets acquired by the lessor for the purpose of leasing business, and therefore, the entire input tax paid thereon shall be deductible. Though there should be no dispute on the deductibility of the input tax on purchase of assets, on analogous provisions, in a UK appeal case named Royscot Leasing Ltd v Customs & Excise, decided on 10^th May 1996, there is a ruling to affirm this view.

What this means in sum is that the entire lease rentals accruing within a period, less the total amount of GST paid on purchase of lease assets.

There is obviously no proportionality between the rentals in a period, and the purchase of lease assets in a period. These two are unrelated; yet the law requires a set-off of the latter against the former. This may result into a lessor paying tax on the net income earned by him over a long term; but over short term, it might mean a significant refund claim by lessors.

In view of this, one wonders why should there by an opposition by the leasing industry against the GST enactment.

The leasing industry was also worried about the residual value practices: since the established practice of the industry seems to be transfer of leased goods at nominal values to lessees, whether there will be questions on the value at which such transfers have been effected. There is an important provision in sec. 5 (1) of the Act that in case of any supply of goods or services, the value of the supply shall be the market value of the goods or the supply, subject to exceptions made in the section. In case of leases, unfortunately, the sale of goods to the lessee is never at the market value of such goods.

This worry was answered by the Amendment made on 31.3.1998 by inserting another exception to the market value rule in sec. 5 : sub-section (12) now provides that where the leased goods are transferred at the expiry of the lease to the lessee at a price not exceeding 10% of the total consideration of the lease agreement, such consideration shall be treated as a part of the lease consideration. In other words, the market value rule will not apply. However, the very narrow wording of sec. 5 (12) restricts the scope of this exception only on satisfaction of all the following conditions:

• Transfer at the expiry of the lease, not before or after;
• Transfer only to lessee, not to any one else;
• Transfer at a value upto 10% of total consideration.

We have noted earlier that the essential and the only distinction between a lease and a hire-purchase transaction is the existence, in the latter, of an option to buy. It is also evident that the conduct of the parties may also point to the intention or the option to buy. Thus, if the lessor makes a sale of the leased asset to the lessee, immediately upon expiry of the lease term, at a price which is substantially less than the market value of the property, there is every possibility that such lease will be treated as a hire-purchase transaction, with all the attending consequences.

Therefore, in the opinion of the author, lessors in Sri Lanka will continue to be caught in a catch-22: if they indeed sell the asset to the lessee at a ridiculous or bargain price, it avoids the GST problem, but then it leads to an imputation that the lease was in substance a hire-purchase transaction. On the other hand, if the lessor transfers the asset to a person other than the lessee, at such substantially reduced prices, the GST market value rule certainly applies.

The only solution to this conundrum is to avoid selling assets at the end of the lease, and renew the lease for a secondary period, till the market value of the goods equals or almost equals the transfer price of the asset.

The other grey area is with regard to continuing rentals from leases done in the past: this as a transient problem remains unanswered.

GST on Hire-purchase transactions:

Though a hire-purchase is a supply of service and not goods as noted above, there is a deeming provision in sec. 4 (3) (b): the supply in case of hire-purchase is deemed to take place at the time when the agreement is entered into.

There is also a provision, supporting the above, in sec. 5 (8): the value of goods in case of hire-purchase shall be the cash price of the goods.

Therefore, the tax payable by a hire-vendor is on the cash price of the goods, and obviously, the input tax will also have been paid on such cash price: leading to a NIL liability of the finance company.

As a matter of fact, the provisions of sections 4 (3) (b) and 5 (8) do not even seem to be applicable to a finance company: in the Schedule to the Act [Item (xvi) (h)], there is an exemption for financial services which includes a hire-purchase transaction. Understandably, if the hire-purchase activity is carried on by a finance company, the tax is not applicable; if carried on by a dealer in goods, the tax is applicable.

 

Accounting for leases:

Sri Lanka, unlike India or many other counties at comparable levels of development, has takenteh giant's step of giving effect to the International Accounting Standard no. 17 on Accounting for Leases. The Standard, adopted as SLAS-19, was made effective from 1.4.1987.

Since leasing was only 6 years old baby then, the introduction of the accounting standard was quite a big decision: but in retrospect, leasing companies only seem to have benefited with this, because if the Standard were to be introduced at the current levels of penetration, it might have been more difficult to digest the change.

The current scenario for accounting for leases or related activities in Sri Lanka is as follows:

 

Accounting for leases:

• The Sri Lanka Accounting and Auditing Standards Act, 1995 makes accounting standards of the Institute mandatory for all leasing companies and finance companies.
• The Act requires Gazette notification of the accounting standards.
• All financial leases are to be capitalised by the lessee in accordance with SLAS-19.
• The other provisions of SLAS-19 are similar to IAS-17 (prior to revision).
• There is no distinction between lease and hire-purchase transactions: therefore, the standard applies to a hire-purchase transaction also.
• The lessor would recognise income and asset in a financial lease based on substance.

 

Deferred tax accounting:

Institute of Chartered Accountants of Sri Lanka has also adopted the IAS-12 on Accounting for Taxes on Income as SLAS-14.

Significantly, this standard provides for treatment of a deferred tax liability in books. The effect of this standard on leases is briefly discussed below:

• The deferred tax accounting principle requires accounting for taxes on Tax effect method, that is, irrespective of when is a tax payable, its effect should be recognised in the year in which the relevant income has been recorded.
• Thus, provision for tax is made for all timing differences: that is, reversible differences between the reported income and taxable income.
• Leasing invariably results into deferment of taxes: this is surely the case with Sri Lanka with high depreciation rates.
• Therefore, the deferred tax accounting norms require leasing companies to compulsorily create provision for deferred tax liability.
• Presently, this accounting standard is seen more in breach than in compliance.

Accounting for non-performing assets:

The Institute has also adopted an Accounting Standard no. SLAS-33 being Revenue Recognition and Disclosures in Financial Statements of Finance Companies (based on IAS-30).

The chief features of this standard are discussed below:

• The standard applies only to finance companies, that is, depository entities.
• A finance company shall not accrue income on non-performing assets.
• A finance company should disclose the maturity composition of its assets and liabilities.
• Significant concentrations of assets, liabilities and off-balance-sheet items should be disclosed.

 

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