MODARABAS AND LEASING

Government's appreciation of the potential and active encouragement has helped the players

SHABBIR KAZMI, Special Correspondent
Aug 07 - 13, 2006

Leasing business in Pakistan, like in many of its peer countries, owes its origin to the efforts of the International Finance Corporation (IFC). The first leasing company in Pakistan was National Development Leasing Corporation (NDLC) set up in 1984. The IFC participated in the equity of this company along with National Development Finance Corporation (NDFC) and the Asian Development Bank. Leasing business has proliferated in the country due to support of the government. Rules have been clear and also undergone regular scrutiny and change as and when difficulties and impediments were highlighted.

Leasing is big business internationally. According to a report, total lease volumes reported through leasing companies are in excess of $500 billion annually. USA is the predominant market where volumes exceed $200 billion, followed by Japan with $68 billion business volume. The top five countries account for 75% of the world's leasing business. China and India two of the fastest growing economies have very small leasing markets - $2.1 billion and $1.4 billion, respectively. In Pakistan leasing has made good progress and its share of new investment is estimated at 15%.

The main attraction of lease business is that it is asset-based financing as opposed to collateral based approach commonly followed by other financial institutions. The guiding principle is that a business enterprise earns its profit from use of assets, not ownership of these assets. If the cash flow generated by a machine is able to cover its lease rent, the proposition is viable from a leasing company's point of view. This simplistic approach gets a bit complex due to regulatory framework and prudential rules. Therefore audited financial statements, ratio compliance, positive cash flow, etc. become essential tools for appraisal of any financing proposal.

Having said this, the underlying difference between asset-based lending and collateral-based financing does not get distorted. This distinction goes to the advantage of small and medium enterprises (SMEs) which often lack collateral and are thus not able to benefit from the banking sector.

According to leasing sector experts in Pakistan, SMEs have traditionally been core customers of the leasing companies. During the 1980s and early part of 1990s leasing companies were the main source of medium term finance for SMEs and many small enterprises benefited widely from lease financing. Many SMEs came in contact with the formal sector for the first time. New initiatives and innovative lease arrangements helped numerous businesses. Transport sector which was almost entirely captive to the informal lenders was introduced to formal lending by leasing companies. As the transporters were able to understand and comply with the Prudential Rules they began preparing financial statements for the first time. Some even took the step of incorporating their businesses.

Ironically government policies in many countries, including Pakistan, have failed to understand the obvious link between leasing and SMEs' financing needs. Either the problems facing the leasing sector have not been removed, or required level of encouragement has been lacking. Countries which recognized potential of leasing behaved the other way. Before the 1997 financial crisis of South East Asia, the Asian Tigers Korea, Malaysia, Thailand, Indonesia and Taiwan - had vibrant and large leasing sectors. In Korea, leasing share of capital investment was around 28% in 1996 which translated into annual lease volume of $16.3 billion. Main beneficiaries of leasing in these countries were SMEs. After the crisis, banking controls became stringent and leasing, too, became subject to these rules.

In Pakistan and other Muslim countries, leasing has another inherent advantage. According to some Shariah scholars it is an accepted mode of financing. There is a common notion that financial lease is not Shariah compliant but operating lease is. In its purest form Ijara is almost the same as an operating lease. Over the years financial lease or Ijara wa Iktina developed to meet business needs. If the documentation complies with Shariah rules both types of leases are acceptable, otherwise both can be non-compliant.

Leasing companies continue to innovate and take bold steps for increasing their outreach and offering new products and services. However, the general consensus is that they cannot compete with commercial banks and they should not try to do so. One of the largest contributions of leasing sector is manifold increase in car sales. Having enjoyed bulk of the auto financing market, now leasing companies are exploring the agriculture sector through tractor lease, farm loans and operating leases for harvesters. Microfinance is another area which leasing companies have recently started focusing on.

According to an analyst there seems to be no rules to differentiate 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 Pakistan should have learnt 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 is being termed 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 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 because having provided the user with a right to purchase the owner divests himself of beneficial interest completely.