Association of Leasing & Financial Service Companies vs. UOI (Supreme Court)

Difference between Operating Lease, Finance Lease & Hire-Purchase explained

S. 65(12) & 65(105)(zm) of the Finance Act, 1994 levies service tax on leasing and hire purchase transactions. The constitutional validity of the said provisions was challenged primarily on the ground that as under Article 366(29A) of the Constitution hire-purchase and leasing transactions are deemed to be a ‘sale’ and liable to sales-tax, only the State Legislature has jurisdiction to impose tax and not Parliament. HELD dismissing the challenge:

(i) The circulars and guidelines issued by RBI read with AS-19 “Accounting for Leases” issued by the ICAI show that the equipment leasing and hire-purchase are activities undertaken by NBFCs and banks are regulated as para-banking activities by the RBI. Such activities of leasing & hire-purchase are financing activities and that fall within the meaning of the words “banking and other financial services” for purposes of service tax. The taxable event is rendition of service and it is not a tax on material or sale;

(ii) In a hire-purchase, there is a hire of goods with the option to purchase. If that is the real effect of the agreement there is no contract of sale until the hirer has made the required number of payments and he remains a bailee till then. But some so-called hire-purchase agreements are in reality contracts to purchase; the price to be paid by installments and in those cases the contract is a contract of sale and not of hiring. However, if the intention of the financing party in obtaining the hire-purchase and the allied agreements is to secure the return of the loan advanced to its customer the transaction would be merely a financing transaction;

(iii) Funding or financing the transaction of equipment leasing and hire-purchase covers two different and distinct transactions i.e., the financing transaction and the equipment leasing/hire-purchase transaction. While the former is exigible to service tax, the latter is exigible to local sales tax/VAT;

(iv) There is a difference between a “finance lease” and an “operating lease”. A finance lease transfers all the risks and rewards incidental to ownership, even though the title may or may not be eventually transferred to the lessee. In the case of “finance lease” the lessee could use the asset for its entire economic life and thereby acquires risks and rewards incidental to the ownership of such assets. In substance, finance lease is a financial loan from the lessor to the lessee. On the other hand an operating lease is a lease other than the finance lease. In a finance lease, it is the lessee who selects the equipment to be supplied by the dealer or the manufacturer, but the lessor [finance company] provides the funds, acquires the title to the equipment and allows the lessee to use it for its expected life. During the period of the lease the risk and rewards of ownership are transferred to the lessee who bears the risks of loss, destruction and depreciation or malfunctioning. The bailment which underlies finance leasing is only a device to provide the finance company with a security interest [its reversionary right]. If the lease is terminated prematurely, the lessor is entitled to recoup its capital investment [less the realizable value of the equipment at the time] and its expected finance charges [less an allowance to reflect the return of the capital];

(v) A hire-purchase agreement is a vehicle of installment credit. It is an agreement under which an owner lets chattels out on hire and further agrees that the hirer may either return the goods and terminate the hiring or elect to purchase the goods when the payments for hire have reached a sum equal to the amount of the purchase price stated in the agreement or upon payment of a stated sum. The essence of the transaction is bailment of goods by the owner to the hirer and the agreement by which the hirer has the option to return the goods at some time or the other. Further, in the bailment termed “hire” the bailee receives both possession of the chattel and the right to use it in return for remuneration to be paid to the bailor. In the case of hire-purchase agreement the periodical payments made by the hirer is made up of (a) consideration for hire and (b) payment on account of purchase.