In the previous article, we have studied about how vendor financing is being used as an alternate mechanism of finance in the infrastructure financing community. Similarly, leasing is also being used as a method of raising finances for infrastructure projects. Leasing is primarily used because this method allows conserving capital as well as provides many tax benefits.
Investors often get confused between leasing and build-operate-transfer models. It needs to be understood that leasing is purely a mechanism of raising finances and does not give any control to the lessor. On the other hand, build operate, and transfer models provide significant control to the contractor. Also, they are operational arrangements and have very little relation to financing activity.
The different types of lease and the benefits of each type of lease have been explained in this article.
How can Leasing be used in Infrastructure Finance?
Leasing is a mechanism under which the lessor owns the equipment. This equipment is then provided to the lessee for use. In return, the lessee has to make periodic (monthly) payments to the lessor. Under normal circumstances, the payments being made on leased equipment will be about the same as the payment being made on purchased equipment.
However, many companies still prefer leasing since it is an off-balance sheet way to raise money. In many cases, the lessee is under no obligation to continue a lease and can stop making payments if they do not intend to use the service in the future. Hence, leasing is a mechanism that makes balance sheets look less leveraged than they actually are. This lower leverage translates into better credit ratings and, therefore, lower interest rates. This creates a beneficial scenario for the lessee.
Another benefit of the lease arrangement is that it provides 100% financing. It is probably, the only mode of financing that can be accessed without having any upfront capital. However, that may not be true in the case of infrastructure projects. This is because any infrastructure project involves the use of a significant amount of land, and financial leases are generally not provided on land. Also, the soft costs, such as processing charges on loans as well as the interest on under construction equipment is not generally covered in the lease financing arrangement.
From the lessee’s point of view, the only disadvantage has been that they lose out on the residual costs which are gained when the equipment is scrapped. These costs may not be much. However, they should still be taken into account while making a decision related to leasing.
Leasing is a beneficial arrangement for the lessor as well. The lessor is able to claim tax deductions for the interest and depreciation which accrue on the equipment. This helps them lower their tax liability in the short run. In the long run, the lease is paid off by receiving payments from the lessee, and the salvage value of the equipment is the company’s gain. Since these equipment is expensive and rare, their salvage values tend to be higher. Companies can use accelerated depreciation in order to claim maximum tax advantages in the first few years and gain as a result of the time value of money.
Types of Leases used in Infrastructure Projects
Generally, leases are divided into operating lease as well as a financing lease. However, in the case of infrastructure projects, all leases are purely financial in nature. These financial leases can be further subdivided into various types.
- Leveraged Lease: A leveraged lease is where the finance for purchasing the equipment is provided by the leasing company. In such cases, the company may not have a leasing business. Instead, a financial company may enter into a leasing contract just because the tax benefits make leasing seem like a more attractive proposition.
- Synthetic Leases: Synthetic leases are relatively new and are used only in developed countries like the United States. Under a synthetic lease, the ownership of the equipment is shown to be in the name of the lessee for tax purposes. Hence as far as the tax authorities are concerned, there is no lease agreement at all. The lessee is the owner and, therefore, can claim all the tax benefits which come along with the ownership. However, for accounting purposes, the same lease is considered to be an operating lease. Hence, it is not shown in the balance sheet at all.
- Guaranteed Lease: The guaranteed lease is just like a leveraged lease. However, in some countries, direct lease arrangements are prohibited by law. Hence, the lessor and the lessee involve the service of a bank. In theory, the bank leases out the equipment to a lessee. However, the money spent on buying the equipment is often protected by a fixed deposit provided by the actual lessor. The bank generally does not have the know-how required for lease financing. It only acts as an intermediary because of legal reasons. The banks’ interests are guaranteed. This is the reason that such a lease is known as a guaranteed lease.
The bottom line is that leasing is a purely financial arrangement used in infrastructure financing. The purpose of leasing is to obtain tax benefits and/or reduce financing costs. The fundamental interests of investors, as well as their risk/return profile, are generally not altered by leasing arrangements.
