 |
 |
|
 |
 |
 |
 |
 |
 |
A Handbook for Kenya
September 2003
By: Oliver Wakelin, Louis Otheno, Kirugumi Kinyua
Table of Contents
This booklet forms part of a DFID funded project under the Enterprise Development Innovation Fund. Intermediate Technology Consultants (ITC) are the project managers and work with Development Outcomes Limited and ITDG East Africa in implementing the project in Kenya. Please contact Development Outcomes for more information on leasing.1.0 INTRODUCTION
2.0 FORMS OF LEASING
2.1 FINANCE LEASE
2.2 OPERATING LEASE
2.3 SUPPLY CHAIN LEASING
3.0 THE REGULATORY ENVIRONMENT FOR LEASING IN KENYA
4.0 LEASING - ITS SPECIAL ATTRACTIONS FOR SMALL BUSINESSES
5.0 SPECIAL CHALLENGES OF LEASING TO SMALL ENTERPRISES
6.0 TAX ACCOUNTING FOR LEASE TRANSACTIONS
6.1 INVESTMENT DEDUCTIONS AND CAPITAL ALLOWANCES
6.2 TAX TREATMENT OF LEASES
6.3 CLASSIFICATION OF LEASES FOR PURPOSES OF TAX ACCOUNTING
7.0 VALUE ADDED TAX
7.1 LESSOR TRANSACTIONS
7.2 LESSEE TRANSACTIONS
8.0 FINANCIAL ACCOUNTING FOR LEASES
8.1 FINANCE LEASE - LESSOR
8.2 FINANCE LEASE - LESSEE
8.3 OPERATING LEASE - LESSOR
8.4 OPERATING LEASE - LESSEE
8.5 COMPARISON BETWEEN ACCOUNTING AND TAX TREATMENT OF LEASES.
9.0 GETTING STARTED IN LEASING
10.0 CONCLUSION
Disclaimer
This booklet is a quick introduction to the concept of leasing and how it
works in Kenya. While every effort has been made to ensure its accuracy
and completeness, neither the authors nor their principals shall be liable
in any way for inaccuracies and omissions in the booklet.
1.0 Introduction
Leasing is a means of helping businesses make use of equipment without having to own them. It eliminates the need for a business to commit capital to purchase equipment by either borrowing, or using its own resources. Businesses that have realized that profits are made not from owning, but from using equipment, often consider leasing equipment rather than purchase them. In a lease, the equipment that is leased is at all times wholly owned by the lessor. A lease is therefore not an arrangement for buying equipment.
An equipment lease is a contract between the owner of the equipment (the lessor) and the user (the lessee). It gives the lessee a right to have and use the equipment in return for periodic payments over an agreed period. An equipment lease has the following main attributes:
- There has to be an agreement between the owner of the equipment (the lessor) and the prospective or current user of the equipment (the lessee)
- The agreement gives the lessee the right to possess and use the equipment without necessarily owning it.
- The lessee pays the lessor for the use of the equipment usually by regular payments during the lease period.
- After a pre-determined period of use (the lease term), the lessee returns the equipment to the lessor or, depending on the lease arrangement, may decide to buy it, or continue to lease it for a secondary period, often at a lower fee.
At the root of leasing is the clear separation of legal ownershipfrom economic use of an asset. Leasing should not be confused with hire purchase. In hire purchase, ownership transfers incrementally to the user with every instalment made to the lessor during the term of the contract.
There are several ways in which leasing is advantageous to small businesses.
One of the most important is that the leased equipment is usually the security
for the lease. 
Since
it is clear that the equipment remains wholly and at all times the property
of the lessor, the lessor is secure in the knowledge that they can repossess
the equipment easily, cheaply and without delay if the lessee defaults in
payment.
Chattels mortgages are another form of financing through which a business may borrow money to buy equipment with, and then offer the equipment as security for the loan. From a security point of view, chattels mortgages are similar to leases. The advantage of leasing over chattels mortgages lies in their treatment for tax purposes. These will be dealt with fur ther on in this handbook.
2.0 Forms of Leasing
Leases may be classified in several different ways. All leases are however, in principle, either “finance” or “operating” leases depending on how the lease agreement shares out the risks and rewards incident to ownership of the equipment between the lessor and the lessee.
2.1 Finance lease
In Kenya, a lease contract in which the risks and rewards associated with
ownership of leased equipment are substantially transferred from the lessor
to the lessee, but where the lessor retains ownership of the equipment, is
classified, for income tax purposes, as a finance lease. This means that
the lessor is not responsible for the merchantability and suitability of
the leased equipment, and the lessee has to continue paying the lease instalments
even if the equipment does not perform as expected. The role of the lessor
in a finance lease is limited to financing the lease. This class of leases 
was
created to enable financial institutions, which traditionally do not have
equipment knowledge, to be able to finance equipment leases without taking
on risks associated with the technical suitability of the leased equipment.
Finance leases are sometime called capital leases. This term alludes to the fact that, for purposesof financial accounting, the lessee is required to reflect the leased equipment as a capital item in their balance sheet. According to the International Accounting Standards (IAS) 17, which is the accounting standard applied in Kenya, a lease is a capital lease if it transfers substantially to the lessee all the risks and rewards incidental to the ownership of the equipment, whether or not ownership transfers to the lessee. Such a transfer of risks and rewards is presumed to occur if at the inception of the lease, the present value of minimum lease payments, including any initial payment, amount to substantially all (over 90%) of the value of the leased equipment. Generally, a finance lease works very much like a loan in economic terms, although it is not loan in legal terms. Under a capital lease, the rents paid by the lessee during a fixed or minimum lease term sometimes called the primary period include the cost of the equipment together with interest. If the lease continues after the primary period, the rent reduces because the lessor has been paid back. In Kenya, large companies commonly acquire use of motor vehicles through finance leases.
2.2 Operating lease
In an operating lease, the risks and rewards associated with ownership of the leased equipment are substantially borne by the lessor. An operating lease usually involves the lessee paying a rental for the hire of equipment for a period of time, which is normally substantially less than its economically useful life. The lessor effectively retains a significant amount of the risks and rewards of ownership of the equipment. In an operating lease, the present value of minimum lease payments, including any initial payment, amounts to substantially less than the fair value of theleased equipment. For purposes of accounting, the leased equipment in an operating lease is not held as an capital item in the lessee's balance sheet. However, for tax purposes, the leased asset is always held in the lessor's balance sheet, whether the lease is a finance or operating lease.
Operating
leases come in many forms, e.g. hiring a car for a few days, a few weeks
or months.
In Kenya, many operating leases work on an informal basis, such as taxi drivers and owners, boda boda schemes and construction tools and equipment. Drinking water dispensers and soda, beer and ice cream coolers often seen in retail stores and public places are most commonly acquired through operating lease contracts.
2.3 Supply chain leasing
Supply chain leasing is a type of leasing that relies on the existing supply chains of the lessee. Supply-chain leasing is a model conceived to specifically target industries where numbers of small enterprises produce/supply inputs on a regular and predictable basis for much larger companies. Further down a supply chain are the distributors, e.g. retailers or consumers of products from much larger suppliers. It is through these chains that the lease rentals are conducted. It has the advantage of much lower administrative 2.3 Supply chain leasing 6 1 All subsequent reference to finance or operating leases will, unless otherwise specified, mean as classified for tax purposes costs, a ready market for the increased output the equipment is producing for the lessee, less risk of default due to the rental being taken before the lessee has received payment and the fact that the lessee is often paid several weeks in arrears.
There are several other types of specialized leasing. These include sale and leaseback, leveraged leases, bundled leases, net leases, closed-end and open-end leases. These are generally finance or operating leases with certain characteristics. They are not covered in this handbook.
All subsequent reference to finance or operating
leases will,
unless otherwise specified, mean as classified for tax purposes
3.0 The regulatory environment for Leasing in Kenya
Although there is no specific statute dealing with leasing, it is not a new concept in Kenya. Original leasing regulation (section 12) was repealed in 1994 due to concern over misuse of the legislation. The leasing industry in Kenya has recently been given a new lease of life with the gazetting in April 2002 (vide THE INCOME TAX LEASING RULES, 2002, contained in Legal notice No. 52 of the Kenya Gazette) of new leasing rules by the Minister of Finance. Some institutions have already started leasing schemes, although they target the up market.
In the absence of a statute specifically governing leasing, common law, the Income Tax Act (CAP 470) and VAT Act (CAP 476) combine to define the legal and tax effects of lease transactions in Kenya.
4.0 Leasing - Its special attractions for small businesses
There are a number of reasons why small businesses consider leasing over other alternatives in acquiring use of business equipment.
Small businesses faced with the option of using their own resources to purchase equipment realize they can improve their cash flow if they leased the equipment instead. Outright purchase is in essence equivalent to paying in advance (and at once) for the service that the equipment will offer throughout its life. Outright purchase therefore ties up cash, yet many small businesses are known to fail, not because of unprofitability, but rather due to cash flow constraints.
Businesses that do not have their own resources for outright purchase find leasing favourable. Unlike for a loan where traditional securities are required, the leased asset is the principal security in a lease. This enables businesses unable to come up with traditional securities to nevertheless secure equipment finance.
Leasing is a highly flexible form of equipment financing. The overriding consideration for the financier when evaluating a lease application is satisfaction that deployment of the equipment into the market in which it is to be used has the potential to generate sufficient cash to cover the lease instalments irrespective of who the lessee is. Where the leased equipment produces increased cash inflow, the lease rentals can be tailored toparallel that income, meaning that the equipment is “selffunding”, with payment periods broadly matching the economic life of the equipment. Where the income is seasonal, rental can be structured by taking this into account to ensure that payments are made at the time the lessee expects to have received income, e.g in the agricultural and tourist trades.
The total amount of tax payable by the parties to a lease may be higher or lower depending on
the tax classification in which a lease falls. The total income tax payable is calculated as a percentage of the total profits of the business. The Income Tax Act defines circumstances under which the taxpayer is allowed to make certain deductions from this total before working out the tax due from them, the timing of those deductions and which party in a lease (whether lessor or lessee) is entitled to make those deductions. By deliberately structuring leases in such a manner that the lessor is the one to make tax deductions, leases become attractive to small businesses, most of which fall below or outside the tax net. This is because the income gains from reduction in tax obligations realized by the lessor are shared through lower lease premiums to lessees. This improves the competitiveness of leasing when compared with alternative systems for financing business equipment. Small businesses that purchase equipment using their own resources or borrowed funds cannot enjoy these benefits since they do not pay income tax.
Leasing is an effective credit tool as it ensures that the funds provided are used solely for the intended purpose. The lessor is responsible for purchase of the equipment, thus eliminating any possibility of diverting the funds to other uses.
Unlike some forms of loan finance repayable on demand, or subject to annual review, leasing finance cannot be reduced or withdrawn in the event of a credit squeeze or a change in economic conditions. This is because so long as the lesseecomplies with the terms of the lease, they will be able to keep the equipment throughout the lease term. It is much more difficult to alter lease payments due to changes in interest rates, since, unlike in loans, the interest component of repayment is not separately recognized.
Operating leasing preserves the borrowing capacity of a business to maintain its working capital or to finance other requirements. This is because the leased equipment does not appear as a debt in the lessee's balance sheet. (In Kenya, this is so for financial accounting purposes only. For tax accounting purposes, leased assets are capitalized in the lessor's balance sheet for both operating and finance leases). Financiers will not usually finance a business that is already heavily in debt as reported in its balance sheet.
When a leasing company agrees to lease a particular equipment to a small business, it is implicitly expressing confidence that there is sufficient business in the market to profitably engage the equipment, and backs this up by its willingness to take a risk for this. By staking the
profitability of the lease on the value of the equipment at the end of the lease, the lessor is further implicitly expressing reasonable satisfaction that the equipment is technically sound and will perform throughout the lease period. Small businesses taking out a lease are comforted in the knowledge that a much better resourced party has e v a l u a t e d t w o important risks that in an outright purchase they would have hadto bear. Leasing intrinsically dilutes two important business risks that small businesses face when investing in equipment, thereby encouraging investment.
To minimize financial risk to a business, the repayment period for funds borrowed to purchase equipment should be matched to the economic life of the equipment. Most institutions from which small businesses may borrow only offer relatively short repayment periods (usually 18 months and below). Any small business that relies on these sources of finance to purchase
equipment is then forced to repay the loan more aggressively than the business can afford, and they may have to borrow again to cover the initial loan repayments. Leasing is in this sense safer since by definition a lease is matched to the economic life of the equipment.
Where both lease and loan finance is available, it is usually much easier for small businesses to secure lease finance. This is because leasing has less strict requirements for historical balance sheets, which many small or young enterprises usually do not have.
Lease agreements are simpler, faster and cheaper to conclude than loan agreements. Deposits required in leasing are in general lower than those for loans or hire purchase. Unlike loans, it is possible to bundle several related services such as e q u i p m e n t i n s u r a n c e , maintenance and service into a single lease contract, thereby cutting transaction costs associated with equipment acquisition.
5.0 Special Challenges of Leasing to Small Enterprises
Viable leasing depends to a greater extent, unlike other kinds of financing - on accurate appraisal of the markets for lessees' products and services. Lessee self-assessment alone is inadequate, particularly given the propensity of small enterprisedominated trades to be swamped by excessive new entrants. Sound appraisal of small-scale business sectors requires specialized knowledge and skills, and most financing institutions servicing the small enterprise markets are not particularly familiar with these markets.
Successful leasing is based on the possibility of calculating and structuring lease installments in such a way that the fair market value of the leased asset remains at all times above the amount the lessee would need to pay in order to purchase the asset from the lessor. This calls for high levels of skill and knowledge about equipment.
Administering large numbers of small-value contracts generates high overheads. 
Monitoring
business performance in order to anticipate and pre-empt repayment problems
can prove costly depending on the Management Information Systems in place.
For security reasons and effectiveness, lessors prefer to lease items that are easy to move and liquidate. This, unfortunately, also makes assets more prone to theft or absconding by the lessee. In practice, lessors need additional forms of guarantee for contracts with small enterprise operators.
The market research capacity of most small enterprises is limited. Therefore, when they want to invest in new equipment, they are often not fully aware of the full costs, sales volumes and markets available. Since the leasing company also has an interest in seeing the leased assets are used to their full capacity, market research into the markets for the leased equipment should not be left to the small enterprises alone.
6.0 Tax accounting for lease transactions
Accounting for purposes of calculating tax differs in some ways from what
is generally referred to as financial accounting.
Financial
accounting is intended and designed to give shareholders a fair picture of
a company's health. Tax accounting on the other hand is intended to give
the tax authority the flexibility to encourage capital investment. Most countries
have tax regimes preferential to capital investment, and to small businesses.
It is in this spirit that tax-based incentives and finance to new and small
businesses are offered. Section 15(2)(t) of the income Tax Act (CAP 470)
and the VAT Act (CAP 476) together define how lease transactions in Kenya
are to be treated by the lessor and the lessee to calculate tax. T h e a
c c o u n t i n g treatment of lease transactions is however g o v e r n
e d b y t h e I n t e r n a t i o n a l Accounting Standards 17 (IAS 17).
6.1 Investment deductions and capital allowances
Capital allowance is a tax-based incentive central to 
leasing
transactions in Kenya. The government of Kenya is encouraging investment
in new business equipment by allowing businesses to deduct from their taxable
income an amount for wear and tear of the equipment invested in. The equipment
covered must be depreciable, but instead of using the various methods provided
for in accounting conventions, the income tax department standardizes a capital
allowance in place of depreciation. The amount is worked out as a proportion
of the value of the equipment, and depends on the class or type of the equipment.
In the case of machinery, capital deductions are given in respect to wear
and tear at the rate of 12.5% of the value of machinery residual after investment
deduction (explained below). Incentives based on capital allowances were
instrumental in the rapid growth of leasing in the UK in 1960s and 70s.
Under Kenyan income tax regulations, the lessor is allowed to deduct from his profits in the same tax year in which investment is made, 60% of the cost of investing in (buying and installing) machinery leased to a taxable lessee, and who uses it for the purpose of manufacture. This enables the lessor to realize depreciation income sooner than the natural depreciation rate (also called accelerated depreciation), further improving attractiveness to the lessor and the lessee.
6.2 Tax treatment of leases
In Kenya, there is no distinction between operating and finance leases as far as deductions from taxable income is concerned. The lessor takes wear and tear allowance and investment deductions as long as this expenditure (the wearing down of the equipment) came about wholly and exclusively as a result of employing the equipment in the generation of taxable income. This means that leases to non-tax paying institutions, e.g. NGOs, do not yield wear and tear benefits to the lessor, and are therefore more expensive. 6.2 Tax treatment of leases 16 The lessee is allowed to deduct the entire lease instalment from their taxable income as long as the Commissioner of Income Tax is satisfied that the sole purpose for making the payment is for the use of the equipment.
6.3 Classification of leases for purposes of tax accounting
The Income Tax Act guides the classification and treatment of leases in the books of lessees and lessors for tax purposes. The income tax leasing rules have identified and defined three different types of contracts: Operating leases, Finance Leases and Hire Purchase Agreements.
Operating Leases are treated for tax as they would be for accounting purposes.
For tax purposes, the 
equipment
in a finance lease must at all times remain with the lessor. Under accounting
treatment, the title may or may not pass to the lessee. A Hire Purchase Agreement
is defined as a contract where the agreement is for a specified period, with
the intention to transfer ownership on the expiry of the agreement. Leases
that would ordinarily qualify as finance leases, but in which either there
was an intention to transfer ownership, or the substance of the contract
effectively transfers ownership to the lessee, are judged by the Commissioner
of Income Tax to be similar to hire purchase and are taxed as though they
are hire purchase agreements.
2“Manufacture” here meaning the making (including packaging) of goods and materials from raw or partly manufactured materials or other goods, but does not extend to any activities related to manufacture such as design, storage, transport or administration.
7.0 Value Added Tax
In Kenya, leasing is considered as a service, and lease instalments, being payments for this service, are subject to VAT. However, if an equipment that is the subject of a lease is either exempted from VAT or attracts zero VAT, then the lease payments are similarly exempted from VAT.
In
a finance lease, the role of the lessor is principally financial, and almost
no other services are included in the lease. Lease payments are therefore
mostly repayments of principal cost and interest. Since VAT is charged on
the whole repayment, it means that VAT is also being charged on interest!
In a pure loan, interest does not attract VAT. This tends to increase the
cost to the lessee when compared to loans. This is unlike in hire purchase
where hire purchase instalments are exempted from VAT.
7.1 Lessor transactions
Lessors turning over more than Ksh 3 million annually are by law required to register for VAT. Registration enables them to claim the 18 VAT they pay at the time of acquiring the equipment that they lease. The cost of the leased equipment normally excludes VAT in the lease agreement. This is because including VAT in the agreement would mean that the lessor is also financing the lessee to pay tax, since the payment of tax is spread out over the term of the lease, while the lessor has to pay it all at once! Some lessors require the lessee to pay the VAT on all the lease instalments at once and in full upon signing the lease agreement. Upon termination of the lease, the lessor is required to charge VAT and remit VAT on the price realized upon disposal of the leased equipment.
7.2 Lessee transactions
If VAT registered, the lessee is able to treat the full amount of the VAT charged on the rentals as input tax and to claim a credit in the normal way. However, non-registered lessees (including most small enterprises), and those classified as exempt cannot claim a VAT refund and hence have to bear the cost. Certain categories of equipment including, for example, dairy equipment, are VAT zero-rated, and therefore not subject to VAT on their lease rentals.
8.0 Financial accounting for leases
8.1 Finance lease - Lessor
Financial accounting for finance leases in Kenya is similar to loan transactions. A lease receivable is carried on the lessor's balance sheet as the total net lease investment (gross rentals received, less deferred income and provisions). Deferred income is amortized consistently based on periodic rate of return implicit in the lease. The realized interest portion is treated as revenue.
8.2 Finance lease - Lessee
The lessee, being the economic if not the legal owner of the leased equipment, recognizes it in their balance sheet. The lessee expenses include all the lease installments as well as depreciation of the leased equipment.
8.3 Operating Lease - Lessor
The lessor records the acquisition cost of the leased equipment as an asset on the balance sheet, and notes its depreciation.
| Finance Lease | Operating Lease | |||
| Lessor | Balance Sheet | Income statement | Balance Sheet | Income statement |
| Lease receiveables | Interest income | Equipment | Rent income | |
| Less depreciation expense | ||||
| Lessee | Equipment | Depreciation expense | Rent expense | |
| Debt Liability | Interest expense | |||
Reference to finance or operating lease in this section is as classified under IAS 17.
Rental payments are realized as revenue on an accrual basis. The leased equipment must be shown separate from the lessors' other fixed assets in the balance sheet. Interest expenses and other incidental costs related to acquisition of the leased equipment prior to the inception of the lease may be recorded as part of the capital cost.
8.4 Operating lease - Lessee
Lease rentals are recognized as expenses over the lease term. Though leases are not reflected on the lessee's balance sheet, accounting standards require that adequate disclosures of the transactions are included in the accounts.
8.5 Comparison between accounting and tax treatment of leases
How a lease is actually classified depends on the perspective from which the classification is sought. Specific definitions may cause a lease that, from a financial accounting point of view is an operating lease, to be treated for tax accounting purposes as a finance lease.
| Accounting system | Financial | Tax | Financial | Tax |
| Lease class | Finance | Finance | Operating | Operating |
| Who holds title to the asset | Lessor(Usually) | Lessor | Lesssor | Lessor |
| Who holds asset in balance sheet | Lessee | Lessor | Lessor | Lessor |
| Who takes depreciatio/ wear and tear | Lessee | Lessor | Lessor | Lessor |
| Factor under consideration | Effect on total tax paid | |||
| LESSOR/FUNDER | LESSEE/BORROWER | |||
| Loan | Lease | Loan | Lease | |
| Wear and tear allowance | no effect | lowers | no effect | no effect |
| Lease instalments are VATable | no effect | no effect | no effect | raises |
| Interest is not VATable | lowers | no effect | no effect | no effect |
| Lease rentals are tax deductible | no effect | no effect | no effect | lowers |
9.0 Getting started in leasing
Leveraging companies considering approaching a financier with proposals for leasing to small enterprises will do well to hire a specialized lease brokerage firm to assist in designing an appropriate scheme. Leases involving formal sector companies can usually be structured with the assistance of a competent accounting firm - and there are a number in Kenya.
10.0 Conclusion
It is clear from this handbook that the greatest advantages of leasing lie in the lessor being able to reduce their tax liability. Micro finance institutions understand the business of small enterprises, yet most are exempt from income tax. As such they are impervious to the tax incentives built into leasing rules. Therein lie the advantages of leveraged leasing where smaller enterprises are linked to large companies. The existing legislation provides a good foundation for the leasing industry. The new rules should enable lessors and lessees to conduct business with a high degree of confidence. The market is already seeing interest from several financial institutions. Lessors should note that the incentives in leasing are, for now, only being extended to commercial leasing, and not to consumer leasing.
 |
 |
 |