Scrapping depreciation allowance under the Income Tax Ordinance 1984 needs review
Tuesday, 21 August 2007
A. Quadir Choudhury
Government support and patronage is a pre-requisite for the growth and development of any industry anywhere in the world. The role of the govt. is expected to be pro-active and facilitative to open up opportunities to the entrepreneurs aiming to allow them to invest their best in Industrial enterprises for pacing Industrialization. In the budget for fiscal 2007-2008 the govt., in the name of collecting taxes initiated amendment to the third schedule of Ordinance No XXXVI of 1984 withdrawing depreciation allowance to the leasing industry which it had been enjoying during the last twenty two years ever since its inception. The amendment reads as under: "No allowance under this paragraph shall be made for a leasing company on such machinery, plant, vehicle or furniture given to any lessee on financial lease."
It is extremely difficult to understand the rationale behind such sudden suspension of the depreciation allowance, but it appears that, some overenthusiastic officials of the tax deptt. have totally misconstrued the complicacies of IAS-17 and ill-advised the govt. without deeply understanding its grave and diverse consequences that may adversely affect this otherwise, potential sector. It is a peculiar characteristic of our bureaucracies not to consult and discuss, in advance, with the stakeholders before initiating any vital change/regulatory binding on them. It is seen as a common practice that they feel the necessity for dialogue only after they have effected the reform which is often reactive and counter productive. In a modern welfare state, the govt. must have the eyes and ears to see and listen to the mind and soul of the people they work for, otherwise if the reform measures adopted, create distance and divide between the govt. and the governed the very purpose for which the reforms initiated are bound to end in failure.
The non-banking financial institutions (NBFIs) with their focus on leasing business emerged as an alternative source of finance and well-saught-after-arm for credit for all kinds of enterprises, especially for the small and medium enterprises (SMEs) with their state-of-the-art technology and adequately trained manpower. They have moduled systems conducive to the benefit of SMEs which do not normally have easy access to banking system which is why the industry has earned wide measure of popularity and acceptability to different segments of business community.
The NBFIs as a body, aware as they are of their limitation vis-à-vis the banks, endeavour to extend best services to their clients so that they feel more comfortable in doing business with them. In fact, the NBFIs consider service as their only asset to satisfy their clients. They have moduled systems and procedures much more simple and less complicated than other lending institutions to woo and allure their clients.
Needless to mention that, the lease financing, as innovated by the NBFIs, now called the financial institutions (FIs), had its debut in Bangladesh back in 1985 when even they were allowed tax exemption for five years. This facility continued up to year 2000, considering its peculiar business characteristics. From 1985 to 2007, over the last twenty two years, the industry had its growth and expansion and now there are 29 FIs operating in the country which enjoyed depreciation allowance on leased assets all these years. The rationale behind allowing depreciation allowance was to promote leasing as a means of financing and the tax regulations were so formulated as to provide tax advantages to have their cost saved. For example, the tax regulations, hitherto, allowed the lessors (the leasing companies) to claim depreciation deductions on the leased assets and the lessee (user of the leased assets) could deduct full lease payments i.e. lease rentals as expense (tax deductible). Here is where lies the very essence and cardinal borderline on which the survival of this industry hinges.
Before introduction of International Accounting Standard (IAS-17), the financial lease assets were shown as lease assets in the balance sheet of the lessor but following the introduction of IAS-17 these are now shown as receivable assets so that the leasing company can claim depreciation on them. In order to protect and safeguard this industry from the complicacies of IAS-17, the government of both India and Pakistan issued circular in favour of continuation of this benefit to leasing companies for compliance of the tax officials which are quoted below.
"Under the Income Tax Act, in all leasing transactions the owner of the asset is entitled to depreciation if the same is used in the business. The ownership of the asset is determined by the terms of the lease contract. As-19 (AS-19 is the lease accounting Standard in India) requires capitalization of assets by the lessees. By itself, AS-19 will have no implication on the capitalization and depreciation allowance as per Income tax Act". (This is the circular no. 02 of 9th February 2001 of the Central Board of Direct Taxes of India).
Pakistan has also addressed the problem in the similar manner vide their circular no 20 dated 8-10-1988 which reads as under:
"The modern leasing Industry has introduced a third type of lease known as finance lease. A finance lease according to International Accounting Standard 1982 (IAS-17) is a lease, which transfers substantially all the risk and rewards incident to the ownership on an asset. Title may or may not eventually be transferred. However, the most important thing to remember in this behalf is that it is not the form but the substance, which determines whether it is a finance or operating lease.
The present Income Tax law prescribes a treatment of all types of leases. Section 23(1) (Via) introduced by finance ordinance 1988 allows as deduction in the hands of lessee, any sum paid to the lessor …… The Third Schedule (Depreciation of the Income Tax Ordinance) allows depreciation allowance to the lessor…. Neither provision makes any distinction between an operating lease or finance lease."
It may be mentioned here that as per Income Tax Ordinance, depreciation is allowed to the owner of a particular asset. Here legally the lessor remains the owner of leased asset until the final settlement of lease contract. The leasing company, like bank, does not receive interest; it receives rent and payment of rents made to the owner of an asset like land, building, plant, machinery etc. The relationship of Lessor/Lessee is like Landlord/Tenant. As such only because of technically showing the asset in question in the books of the lessee does not change this very essence of this ownership. Hence it has been rightly observed by the Central Board of Revenue of Pakistan and also that of India that it is not the form, but essence/substance which determines whether it is finance or operating lease.
From the above it will be seen that the tax legislation has been kept separate from accounting requirements. From the above point of view, over a period of finance, leasing is tax neutral. This means that, overtime, tax revenue to the Govt. irrespective of who claims depreciation is the same. This critical aspect of IAS-17 was discussed by Bangladesh Leasing and Finance Companies Association (BLFCA) in series of meetings with the officials of NBR in the last couple years urging upon them to treat the issue in line with how it has been sorted out in neighbouring countries like India and Pakistan in the greater interest of this Industry without affecting the tax revenue of the Govt. What is most important in this connection is that, tax deferment and tax evasion is not the same and as such these two should not be mixed up. Here, tax is not at all evaded but only deferred over a period with no revenue loss to the Govt.
The dispensation of the depreciation allowance as proposed in the budget 2007-2008 by amending the ordinance as aforesaid is going to scuttle this otherwise burgeoning industry which has so long been growing at a steady level of 30 per cent over the past few years. The industry has total outstanding amount of about Tk. 90 billion (9,000 crore) as on December 30, 2006 and cumulative lease / loan disbursement of about Tk. 300 billion (30,000 crore) allowing tremendous employment opportunities and paving the way for setting up hundreds of thousands of industrial entities across the country.
The most damaging, consequence that may follow, upon implementation of the above amendment will be the following:
01. Lead to unusual increase of Corporate Tax on the Leasing Companies which will seriously marginalize their profitability making it almost impossible to continue business with existing establishment thereby calling for large scale retrenchment of employees and folding of business.
02. The very existence of the industry will be threatened and the sponsors will lose total interest in continuing this business which will signal a death-blow to this otherwise vibrant sector.
03. The rate of return in the business on the part of the sponsors and shareholders will be so insignificant that it will be found most unattractive to hold on to this business, resulting in horrendously adverse affect on the share value and its impact in the capital market.
04. Due to sharp fall in the share value following low divisible return on the shares, many of the FIs listed with the bourses may be left with no other option but to be grouped with 'z' category in the Stock Market resulting in a 'run' thus creating a most unwanted situation for the Govt. which unfortunately will be its own creation.
05. The FIs with their focus on lease financing will cease to exist as a potential player in the financial market following cancellation of the depreciation allowance which was their only edge over the banks in terms of cost cutting. But placing them at par with the banks will put them in an uneven playing field and make them totally unviable with their high cost of fund averaging at 13.5% to 14.5% as against 9.0% to 10% of the banks. So, how come, with the tax shield being disallowed on depreciation the leasing Companies can stand to survive in sharp contract with low cost fund and multidimensional activities of the banks.
In a judgement in Madras High Court, it was held that the lessor who gives the asset on lease by letting out the same in the course of a business carried on by him, the depreciation allowance shall be admissible to him and not to the lessee. Similarly, in the Bombay Bench of the Tribunal in Mulraj D. Gokuldas VS. DY CIT. it was held that in the case of leasing business the owner / lessor of the asset which was leased out would be entitled to depreciation allowance the moment the asset is introduced in the business notwithstanding the fact that the delivery of possession of the leased out assets is given to the lessee subsequently. Even if the lessee does not put the assets to use for his business and keep them unused in his hands, the lessor is entitled to depreciation. It is even immaterial as to when and where exactly the lessee puts the asset to use physically in his business. Thus the entitlement of the lessor to depreciation allowance is not deniable.
Therefore, from the above discussion it is crystal clear that, it all depends upon the attitude of the Govt. as how it wants to address the problem. Does it want to allow the industry to grow and flourish? Does it want to stifle their growth? If it wants them to flourish, it may better opt for the way Pakistan and India have gone: otherwise, the future of this industry is bound to doom. Remember, deferment of tax is not evasion of tax as stated earlier and all charges and debits in accounts are not always allowed in tax treatment. Thus, if any lessee claims depreciation on account of its having shown the asset in his balance sheet, the concerned Deptt. may well ask for the supporting evidence in favour of ownership which naturally the lessee cannot.
Further it may be mentioned that the amendment has been proposed for not allowing depreciation allowance "for a leasing company" but no mention has been made of a banking company doing leasing although most of the banks are now doing full scale leasing by opening a separate window within the premises which is totally unjustified. Well, if the bank wants to do leasing they should do it through a subsidiary company with full accountability and transparency. But taking advantages of clause (Dha) (4) of U/S 7 of Bank Companies Act 1991 the banks are doing 'Ijara' means leasing. So, if the amendment is meant only for the leasing companies this will very adversely affect them and create a more uneven playing field with the banking companies which are already in a much more added advantage over the leasing companies in terms of cost of fund and diversities of business. The fund cost of the banks are half of those of the leasing companies and diversity of the business are also much more varied and versatile in terms of scale and scope. So how come the same facility i.e. "depreciation allowance" will be retained for the one and denied for the other. I guess there is something seriously wrong somewhere which must be looked into before implementing the amendment.
In view of the foregoing, the leasing companies have strong case for depreciation allowance which the government should allow by amending the Ordinance and restoring the previous position and save the industry from impending collapse. After all, you cannot starve the goose and expect it to lay golden eggs, which means that the leasing companies must be allowed to survive otherwise their very existence will be threatened.
Last but not the least, I would like to take the liberty of suggesting the Govt. to kindly constitute a Committee comprising of representatives from Bangladesh Bank, Ministry of Finance, NBR, Institute of Chartered Accountants of Bangladesh (ICAB) and Bangladesh Leasing and Finance Companies Association (BLFCA) to submit report to the Govt. as what should be appropriate in the context of regional and global scenario of the leasing sector, especially with reference to the measures taken by India and Pakistan to safeguard the interest of this sector.
The author is the Managing Director of Phoenix Finance & Investments Ltd. and former Chairman of Bangladesh Leasing and Finance Companies Association (BLFCA)
Government support and patronage is a pre-requisite for the growth and development of any industry anywhere in the world. The role of the govt. is expected to be pro-active and facilitative to open up opportunities to the entrepreneurs aiming to allow them to invest their best in Industrial enterprises for pacing Industrialization. In the budget for fiscal 2007-2008 the govt., in the name of collecting taxes initiated amendment to the third schedule of Ordinance No XXXVI of 1984 withdrawing depreciation allowance to the leasing industry which it had been enjoying during the last twenty two years ever since its inception. The amendment reads as under: "No allowance under this paragraph shall be made for a leasing company on such machinery, plant, vehicle or furniture given to any lessee on financial lease."
It is extremely difficult to understand the rationale behind such sudden suspension of the depreciation allowance, but it appears that, some overenthusiastic officials of the tax deptt. have totally misconstrued the complicacies of IAS-17 and ill-advised the govt. without deeply understanding its grave and diverse consequences that may adversely affect this otherwise, potential sector. It is a peculiar characteristic of our bureaucracies not to consult and discuss, in advance, with the stakeholders before initiating any vital change/regulatory binding on them. It is seen as a common practice that they feel the necessity for dialogue only after they have effected the reform which is often reactive and counter productive. In a modern welfare state, the govt. must have the eyes and ears to see and listen to the mind and soul of the people they work for, otherwise if the reform measures adopted, create distance and divide between the govt. and the governed the very purpose for which the reforms initiated are bound to end in failure.
The non-banking financial institutions (NBFIs) with their focus on leasing business emerged as an alternative source of finance and well-saught-after-arm for credit for all kinds of enterprises, especially for the small and medium enterprises (SMEs) with their state-of-the-art technology and adequately trained manpower. They have moduled systems conducive to the benefit of SMEs which do not normally have easy access to banking system which is why the industry has earned wide measure of popularity and acceptability to different segments of business community.
The NBFIs as a body, aware as they are of their limitation vis-à-vis the banks, endeavour to extend best services to their clients so that they feel more comfortable in doing business with them. In fact, the NBFIs consider service as their only asset to satisfy their clients. They have moduled systems and procedures much more simple and less complicated than other lending institutions to woo and allure their clients.
Needless to mention that, the lease financing, as innovated by the NBFIs, now called the financial institutions (FIs), had its debut in Bangladesh back in 1985 when even they were allowed tax exemption for five years. This facility continued up to year 2000, considering its peculiar business characteristics. From 1985 to 2007, over the last twenty two years, the industry had its growth and expansion and now there are 29 FIs operating in the country which enjoyed depreciation allowance on leased assets all these years. The rationale behind allowing depreciation allowance was to promote leasing as a means of financing and the tax regulations were so formulated as to provide tax advantages to have their cost saved. For example, the tax regulations, hitherto, allowed the lessors (the leasing companies) to claim depreciation deductions on the leased assets and the lessee (user of the leased assets) could deduct full lease payments i.e. lease rentals as expense (tax deductible). Here is where lies the very essence and cardinal borderline on which the survival of this industry hinges.
Before introduction of International Accounting Standard (IAS-17), the financial lease assets were shown as lease assets in the balance sheet of the lessor but following the introduction of IAS-17 these are now shown as receivable assets so that the leasing company can claim depreciation on them. In order to protect and safeguard this industry from the complicacies of IAS-17, the government of both India and Pakistan issued circular in favour of continuation of this benefit to leasing companies for compliance of the tax officials which are quoted below.
"Under the Income Tax Act, in all leasing transactions the owner of the asset is entitled to depreciation if the same is used in the business. The ownership of the asset is determined by the terms of the lease contract. As-19 (AS-19 is the lease accounting Standard in India) requires capitalization of assets by the lessees. By itself, AS-19 will have no implication on the capitalization and depreciation allowance as per Income tax Act". (This is the circular no. 02 of 9th February 2001 of the Central Board of Direct Taxes of India).
Pakistan has also addressed the problem in the similar manner vide their circular no 20 dated 8-10-1988 which reads as under:
"The modern leasing Industry has introduced a third type of lease known as finance lease. A finance lease according to International Accounting Standard 1982 (IAS-17) is a lease, which transfers substantially all the risk and rewards incident to the ownership on an asset. Title may or may not eventually be transferred. However, the most important thing to remember in this behalf is that it is not the form but the substance, which determines whether it is a finance or operating lease.
The present Income Tax law prescribes a treatment of all types of leases. Section 23(1) (Via) introduced by finance ordinance 1988 allows as deduction in the hands of lessee, any sum paid to the lessor …… The Third Schedule (Depreciation of the Income Tax Ordinance) allows depreciation allowance to the lessor…. Neither provision makes any distinction between an operating lease or finance lease."
It may be mentioned here that as per Income Tax Ordinance, depreciation is allowed to the owner of a particular asset. Here legally the lessor remains the owner of leased asset until the final settlement of lease contract. The leasing company, like bank, does not receive interest; it receives rent and payment of rents made to the owner of an asset like land, building, plant, machinery etc. The relationship of Lessor/Lessee is like Landlord/Tenant. As such only because of technically showing the asset in question in the books of the lessee does not change this very essence of this ownership. Hence it has been rightly observed by the Central Board of Revenue of Pakistan and also that of India that it is not the form, but essence/substance which determines whether it is finance or operating lease.
From the above it will be seen that the tax legislation has been kept separate from accounting requirements. From the above point of view, over a period of finance, leasing is tax neutral. This means that, overtime, tax revenue to the Govt. irrespective of who claims depreciation is the same. This critical aspect of IAS-17 was discussed by Bangladesh Leasing and Finance Companies Association (BLFCA) in series of meetings with the officials of NBR in the last couple years urging upon them to treat the issue in line with how it has been sorted out in neighbouring countries like India and Pakistan in the greater interest of this Industry without affecting the tax revenue of the Govt. What is most important in this connection is that, tax deferment and tax evasion is not the same and as such these two should not be mixed up. Here, tax is not at all evaded but only deferred over a period with no revenue loss to the Govt.
The dispensation of the depreciation allowance as proposed in the budget 2007-2008 by amending the ordinance as aforesaid is going to scuttle this otherwise burgeoning industry which has so long been growing at a steady level of 30 per cent over the past few years. The industry has total outstanding amount of about Tk. 90 billion (9,000 crore) as on December 30, 2006 and cumulative lease / loan disbursement of about Tk. 300 billion (30,000 crore) allowing tremendous employment opportunities and paving the way for setting up hundreds of thousands of industrial entities across the country.
The most damaging, consequence that may follow, upon implementation of the above amendment will be the following:
01. Lead to unusual increase of Corporate Tax on the Leasing Companies which will seriously marginalize their profitability making it almost impossible to continue business with existing establishment thereby calling for large scale retrenchment of employees and folding of business.
02. The very existence of the industry will be threatened and the sponsors will lose total interest in continuing this business which will signal a death-blow to this otherwise vibrant sector.
03. The rate of return in the business on the part of the sponsors and shareholders will be so insignificant that it will be found most unattractive to hold on to this business, resulting in horrendously adverse affect on the share value and its impact in the capital market.
04. Due to sharp fall in the share value following low divisible return on the shares, many of the FIs listed with the bourses may be left with no other option but to be grouped with 'z' category in the Stock Market resulting in a 'run' thus creating a most unwanted situation for the Govt. which unfortunately will be its own creation.
05. The FIs with their focus on lease financing will cease to exist as a potential player in the financial market following cancellation of the depreciation allowance which was their only edge over the banks in terms of cost cutting. But placing them at par with the banks will put them in an uneven playing field and make them totally unviable with their high cost of fund averaging at 13.5% to 14.5% as against 9.0% to 10% of the banks. So, how come, with the tax shield being disallowed on depreciation the leasing Companies can stand to survive in sharp contract with low cost fund and multidimensional activities of the banks.
In a judgement in Madras High Court, it was held that the lessor who gives the asset on lease by letting out the same in the course of a business carried on by him, the depreciation allowance shall be admissible to him and not to the lessee. Similarly, in the Bombay Bench of the Tribunal in Mulraj D. Gokuldas VS. DY CIT. it was held that in the case of leasing business the owner / lessor of the asset which was leased out would be entitled to depreciation allowance the moment the asset is introduced in the business notwithstanding the fact that the delivery of possession of the leased out assets is given to the lessee subsequently. Even if the lessee does not put the assets to use for his business and keep them unused in his hands, the lessor is entitled to depreciation. It is even immaterial as to when and where exactly the lessee puts the asset to use physically in his business. Thus the entitlement of the lessor to depreciation allowance is not deniable.
Therefore, from the above discussion it is crystal clear that, it all depends upon the attitude of the Govt. as how it wants to address the problem. Does it want to allow the industry to grow and flourish? Does it want to stifle their growth? If it wants them to flourish, it may better opt for the way Pakistan and India have gone: otherwise, the future of this industry is bound to doom. Remember, deferment of tax is not evasion of tax as stated earlier and all charges and debits in accounts are not always allowed in tax treatment. Thus, if any lessee claims depreciation on account of its having shown the asset in his balance sheet, the concerned Deptt. may well ask for the supporting evidence in favour of ownership which naturally the lessee cannot.
Further it may be mentioned that the amendment has been proposed for not allowing depreciation allowance "for a leasing company" but no mention has been made of a banking company doing leasing although most of the banks are now doing full scale leasing by opening a separate window within the premises which is totally unjustified. Well, if the bank wants to do leasing they should do it through a subsidiary company with full accountability and transparency. But taking advantages of clause (Dha) (4) of U/S 7 of Bank Companies Act 1991 the banks are doing 'Ijara' means leasing. So, if the amendment is meant only for the leasing companies this will very adversely affect them and create a more uneven playing field with the banking companies which are already in a much more added advantage over the leasing companies in terms of cost of fund and diversities of business. The fund cost of the banks are half of those of the leasing companies and diversity of the business are also much more varied and versatile in terms of scale and scope. So how come the same facility i.e. "depreciation allowance" will be retained for the one and denied for the other. I guess there is something seriously wrong somewhere which must be looked into before implementing the amendment.
In view of the foregoing, the leasing companies have strong case for depreciation allowance which the government should allow by amending the Ordinance and restoring the previous position and save the industry from impending collapse. After all, you cannot starve the goose and expect it to lay golden eggs, which means that the leasing companies must be allowed to survive otherwise their very existence will be threatened.
Last but not the least, I would like to take the liberty of suggesting the Govt. to kindly constitute a Committee comprising of representatives from Bangladesh Bank, Ministry of Finance, NBR, Institute of Chartered Accountants of Bangladesh (ICAB) and Bangladesh Leasing and Finance Companies Association (BLFCA) to submit report to the Govt. as what should be appropriate in the context of regional and global scenario of the leasing sector, especially with reference to the measures taken by India and Pakistan to safeguard the interest of this sector.
The author is the Managing Director of Phoenix Finance & Investments Ltd. and former Chairman of Bangladesh Leasing and Finance Companies Association (BLFCA)