Applicability of Section 7 under Insolvency & Bankruptcy Code,2016 for Lessor

A Lease is a finance lease or an operating lease?

• A lease is a finance lease, or an operating lease depends on the substance of the transaction rather than the form of the contract. Examples of situations that individually or in combination would normally lead to a lease being classified as a finance lease are

1. The lease transfers ownership of the underlying asset to the lessee by the end of the lease term;
2. The lessee has the option to purchase the underlying asset at a price that is expected to be sufficiently lower than the fair value at the date the option becomes exercisable for it to be reasonably certain, at the inception date, that the option will be exercised;
3. The lease term is for a major part of the economic life of the underlying asset even if title is not transferred;
4. At the inception date, the present value of the lease payments amounts to at least substantially all of the fair value of the underlying asset; and (e) the underlying asset is of such a specialized nature that only the lessee can use it without major modifications.

?“A finance lease is the one where the lessee uses the asset for substantially the whole of its useful life and the lease payments calculated to cover the full cost together with interest charges. It is thus disguised way of purchasing the cost asset with the help of a loan.”

Any lease where lessor takes a risk other than a plain financial risk is an operating lease. User needs the asset for long term, but he does not commit himself to any permanent usage or a very long term. In other words, the lease is long term, but is?cancellable. As the lessor would not have recovered the whole of his investment over the fixed period, he depends on the value of the asset at the end of the lease period, viz.,?residual value?for recovery of the balance. He might make a profit or a loss in the deal depending upon the actual residual value of the asset – therefore, the lessor’s returns in an operating lease carry a?residual dependence.

A creditor to whom a financial debt is owed can file application under section 7 of the Code.

Section 5(8) of the Insolvency And Bankruptcy Code, 2016 –

Financial debt :- Means a debt alongwith interest, if any, which is disbursed against the consideration for the time value of money and includes—

a)??? Money borrowed against the payment of interest;

b)?? Any amount raised by acceptance under any acceptance credit facility or its de-materialised equivalent;

c)??? Any amount raised pursuant to any note purchase facility or the issue of bonds, notes, debentures, loan stock or any similar instrument;

d)?? The amount of any liability in respect of any lease or hire purchase contract which is deemed as a finance or capital lease under the Indian Accounting Standards or such other accounting standards as may be prescribed;

e)??? Receivables sold or discounted other than any receivables sold on nonrecourse basis;

f)???? Any amount raised under any other transaction, including any forward sale or purchase agreement, having the commercial effect of a borrowing;

g)??? Any derivative transaction entered into in connection with protection against or benefit from fluctuation in any rate or price and for calculating the value of any derivative transaction, only the market value of such transaction shall be taken into account;

h)?? Any counter-indemnity obligation in respect of a guarantee, indemnity, bond, documentary letter of credit or any other instrument issued by a bank or financial institution;?

?????? (i) the amount of any liability in respect of any of the guarantee or indemnity for any of the items referred to in sub-clauses (a) to (h) of this clause; ?

Difference between Operational Creditor and Financial Creditor

1. Definition- Financial creditors are defined as any person who has extended any form of the financial facility to the debtor whereas operational creditors are defined as any person to whom an operational debt is owed.
2. Nature of the debt- Financial creditors generally provide credit in some form to the debtor whereas operation creditors provide goods or services to the debtor.
3. Priority- Financial creditors are given priority over the operational creditors in the repayment hierarchy in case of liquidation. Financial creditors are paid before operational creditors.
4. Insolvency Process- In the insolvency process financial creditors are the part of Committee of Creditors. It takes all the necessary decisions about the insolvency resolution process. Operational creditors are not part of the committee and do not have the right to vote.
5. Representation- The financial creditors are represented by their authorized representatives on the Committee of Creditors. On the other hand, operational creditors have a representative on the Committee of Creditors only if their dues exceed a certain threshold.
6. The threshold for Filing- The financial creditors are required to show a minimum threshold of outstanding dues before they can initiate an insolvency process. There is no such threshold for operational creditors.
7. Resolution Process- In case of payment delay, financial creditors can trigger an insolvency process against the debtor, whereas the operational creditors have to first send the demand notice to the debtor and wait for a limited time before they can start the insolvency process.

Provision of the Indian Accounting Standard (IND-AS 116)

1. A Lease is classified as a finance lease if it transfers substantially all the risks and rewards incidental to ownership of an underlying asset. A lease is classified as an operating lease it does not transfer substantially all the risks and rewards incidental to ownership of an underlying asset.
2. Lessee shall, recognize the Finance Lease asset as Right of Use Asset and create a corresponding Lease Liability. Lessee depreciates the asset, over the useful life or lease tenure whichever is earlier, based on its depreciation policy.
3. At the commencement date, a lessor shall recognize assets held under finance lease in its balance sheet and present them as a receivable at an amount equal to the net investment in the lease.
4. A Lessor shall recognize finance income over the lease term, based on a pattern reflecting a constant periodic rate of return on the lessor's net investment in the lease.

Depreciation of Asset Under Finance Lease

• If the lease transfers ownership of the underlying asset to the lessee by the end of the lease term or if the cost of the right-of-use asset reflects that the lessee will exercise a purchase option, the lessee shall depreciate the right-of-use asset from the commencement date to the end of the useful life of the underlying asset. Otherwise, the lessee shall depreciate the right-of-use asset from the commencement date to the earlier of the end of the useful life of the right-of-use asset or the end of the lease term.
• In the statement of profit and loss, a lessee shall present interest expense on the lease liability separately from the depreciation charge for the right-of-use asset. Interest expense on the lease liability is a component of finance costs, requires to be presented separately in the statement of profit and loss.
• Under the ITA, in all lease transactions, the owner of the asset is entitled to depreciation where the asset is used in the business, and ownership is to be determined based on the terms of the contract. accounting standards cannot override the provisions of the ITA and that the entitlement to a deduction depends upon the provisions of the ITA and not the books of account.
• The taxpayer (Lessee) selected the equipment/ asset and Lessor’s role was only to finance the purchase of the equipment’s.
• The taxpayer used the supplied assets for their entire expected economic life and repaid the full cost of the assets over the lease period;
• The taxpayer exercised all rights of ownership over the asset and bore the risk of loss, damage, etc.;
• The taxpayer could not cancel or terminate the lease and return the asset before the end of the lease term; and
• The title of the asset was retained by Lessor for security purposes.
• The arrangement between the taxpayer and Lessor’s was that of a loan or finance arrangement.
• The taxpayer can be entitled to claim a deduction for the interest paid as a revenue expense; and
• The taxpayer would need to treat the Leased assets as capital assets, i.e., the assets could be depreciated.

Definition of “financial debt” under Section 5 (8) of the Insolvency and Bankruptcy Code, 2016 and the? application made under Section 7 by a Lessor under Finance Lease? is a fit case for admission of the Corporate Debtor into CIRP of the Code.

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