Leasing is a process by which a firm can obtain the use of a certain fixed assets for which it must pay a series of contractual, periodic, tax deductible payments. The lessee is the receiver of the services or the assets under the lease contract and the lessor is the owner of the assets. The relationship between the tenant and the landlord is called a tenancy, and can be for a fixed or an indefinite period of time (called the term of the lease). The consideration for the lease is called rent.
Evolution of Leasing
Leasing activity was initiated in India in 1973. The first leasing company of India, named First Leasing Company of India Ltd. was set up in that year by Farouk Irani, with industrialist A C Muthia. For several years, this company remained the only company in the country until 20th Century Finance Corporation was set up - this was around 1980.
By 1981, the trickle started and Shetty Investment and Finance, Jaybharat Credit and Investment, Motor and General Finance, and Sundaram Finance etc. joined the leasing game. The last three names, already involved with hire-purchase of commercial vehicles, were looking for a tax break and leasing seemed to be the ideal choice.
The industry entered the third stage in the growth phase in late 1982, when numerous financial institutions and commercial banks either started leasing or announced plans to do so. ICICI, prominent among financial institutions, entered the industry in 1983 giving a boost to the concept of leasing. Thereafter, the trickle soon developed into flood, and leasing became the new gold mine. This was also the time when the profit-performance of the two doyen companies, First Leasing and 20th Century had been made public, which contained all the fascination for many more companies to join the industry. In the meantime, International Finance Corporation announced its decision to open four leasing joint ventures in India. To add to the leasing boom, the Finance Ministry announced strict measures for enlistment of investment companies on stock-exchanges, which made many investment companies to turn overnight into leasing companies.
As per RBI's records by 31st March, 1986, there were 339 equipment leasing companies in India whose assets leased totaled Rs. 2395.5 million. One can notice the surge in number - from merely 2 in 1980 to 339 in 6 years.
Subsequent swings in the leasing cycle have always been associated with the capital market - whenever the capital markets were more permissive, leasing companies have flocked the market. There has been appreciable entry of first generation entrepreneurs into leasing, and in retrospect it is possible to say that specialized leasing firms have done better than diversified industrial groups opening a leasing division.
Another significant phase in the development of Indian leasing was the Dahotre Committee's recommendations based on which the RBI formed guidelines on commercial bank funding to leasing companies. The growth of leasing in India has distinctively been assisted by funding from banks and financial institutions.
Banks themselves were allowed to offer leasing facilities much later - in 1994. However, even to date, commercial banking machinery has not been able to gear up to make any remarkable difference to the leasing scenario.
The post-liberalization era has been witnessing the slow but sure increase in foreign investment into Indian leasing. Starting with GE Capital's entry, an increasing number of foreign-owned financial firms and banks are currently engaged or interested in leasing in India.
Evolution of Hire-purchase
The British concept of hire-purchase has, however, been there in India for more than 6 decades. The first hire-purchase company is believed to be Commercial Credit Corporation, successor to Auto Supply Company. While this company was based in Madras, Motor and General Finance and Installment Supply Company were set up in North India. These companies were set up in the 1920s and 1930s.
Development of Hire-purchase took two forms: consumer durables and automobiles.
Consumer durables hire-purchase was promoted by the dealers in the respective equipment. Thus, Singer Sewing Machine Company, or Murphy radio dealers would provide installment facilities on hire-purchase basis to the customers of their products.
The other side developed very fast - hire-purchase of commercial vehicles. The dealers in commercial vehicles as well as pure financing companies sprang up. The value of the asset being good and repossession being easy, this branch of financing activity flourished fast, although until recently, most of automobile financing business was in hands of family-owned businesses.
Hire-purchase, essentially a British form, entered India during the Colonial era, and thrived as almost the only form of external finance available for commercial vehicles. For the financiers, as witnessed World-over, commercial vehicles were the natural choice for several asset-features he loves: lasting value, ready secondary market, self-paying feature, etc. Hence, the industry of hire-purchase became synonymous with truck-financing. Besides, the motor vehicles laws gave the surest legal protection any law could give to a financier: the financier would not have to carry any of the operational risks of a motor vehicle, and yet, any transfer of the vehicle would not be possible without the financier's assent.
Leasing, essentially a US-innovation, entered the country significantly in the early 80s, and was propagated as an alternative to traditional modes of industrial finance. Besides, the early motivation (which continues with a number of players even now) of leasing was capital allowances, more significantly the investment allowance, which was not available for transport vehicles. Hence, the leasing form historically clung to industrial plant and machinery.
For several years, there was no lease of vehicles, because the Motor Vehicles law protection was not applicable to a lease, and there was no investment allowance on vehicles and for reciprocal reasons, there was no hire-purchase of industrial machinery.
These reasons have vanished over time.
The Motor Vehicles law now treats leases and hire-purchase at par from the viewpoint of financier-protection.
Investment allowance has been abolished, and hence, there are no predominant tax-preferences to a lease.
The RBI treats lease and hire-purchase at par and has stopped giving a distinctive classification to leasing and hire-purchase companies.
The accounting norms lead to the same effect on pre-tax income, as also balance sheet values, be it a lease or hire-purchase transactions.
Therefore, income-tax and sales-tax treatment apart, there is not much that is different between lease and hire-purchase. The choice between the two is by and large open, subject to tax consequences.
On its way, leasing has passed through several twists and turns. Financial industry World-over has a very high beta factor: it is hyper-sensitive to changes in economic scenario. Periods of general prosperity are extremely good for the leasing industry; downturns in economic cycle cost are extremely high. That apart, financial system is invariably affected by the contagion effect: failures of a few players affect even the healthy ones.
Leasing has had an undeniable role in Indian economy. From consumer finance to small industry, heavy industry to automobiles, from railways to electricity boards, almost every sector of the economy has utilized leasing as its source capital. Having attained an average over-30% growth rate over past 7 years, Indian leasing has reached the 14th largest place in the World, a fact which is least realized by most.
Center for Monitoring of Indian Economy compiles data about Indian leasing volumes, which is carried as a part of India Leasing Yearbook published by the Association of Leasing and Financial Services Cos. The data compiled by the Center shows aggregate balance sheet value of leased and hired assets (though for balance sheet purposes, lease and hire-purchase transactions are distinguished, there is no material difference between the two - hence the volumes have been clubbed here) at about Rs. 261 billion (End March 1997). This is based on reporting by 226 companies, whereas the business, particularly hire-purchase, is spread amongst some 3000 large and small companies. Estimated outstanding business done by these firms is about Rs. 15 billion (at Rs. 5 million per such firm).
That apart, the data also excludes the massive annual volume of business by the Indian Railway Finance Corporation (IRFC). IRFC is a hundred percent subsidiary of Indian Railways, and its leases are dedicated to the parent Railways only. Of late, almost entire floating stock acquisition by Railways is being acquired on lease from IRFC. The outstanding value of leases done by IRFC adds to about Rs. 120 billion.
Thus, the aggregate volume comes to about Rs. 396 billion, which is about USD 11 billion as per then-prevailing exchange rates. USD 11 billion of outstanding volume cannot by itself give India a ranking in the London Financial Group data, since these rankings are based on incremental volume. However, a rough estimate of new business can be made from the above data (unfortunately, the Centre for Monitoring of Indian Economy data do not give any idea of new leasing and hire-purchase volume). Supposing 30% of the outstanding business of last year was paid, and there was a 20% growth in net business (as can be seen from the Chart above), there was a 50% new business, over the volume outstanding at the beginning of the year. Relative to the business at the end of the year, the incremental volume should have been about 33% (50/150).
Therefore the annual leasing volume in India is estimated at about USD 3.67 billion, on a rough and conservative estimate. In London Financial Group data, this should put India at 12-13th place, close to Hong Kong. This would also be the third largest market in Asia, next only to Japan and Korea.
The only infirmity in the above ranking is that the London Financial Group data are not as of March 1997 - that, however, should not seriously disrupt the ranking of India, because other Asian markets in 1996-7 period have generally registered a negative growth.
Factors that contributed to growth of Indian leasing
With the exception of 1996-97 and 1997-98, the 1990s have generally been a good decade for Indian leasing. The average rate of growth on compounding basis works out to 24% from 1991-92 to 1996-97. Broadly, the following factors have been responsible for the growth of Indian leasing, in no particular order:
No entry barriers - any one could float a leasing entity, and even an existing company not in leasing business can write a lease purely for tax shelters.
Buoyant growth in capital expenditure by companies - The post -liberalization era saw a spate of new ventures and fresh investments by existing venturers. Though primarily funded by the capital markets, these ventures relied upon leasing as a source of additional or stand-by funding. Most leasing companies, who were also merchant bankers, would have funded their clients who hired them for issue management services.
Fast growth in car market: Needless to state with facts, the growth in car leasing volume has been the highest over these years - the spurt in car sales with the entry of several new models was funded largely by leasing plans.
Tax motivations: India continues to have unclear distinction between a lease that will qualify for tax purposes, and one which would not. In retrospect, this is being realized as an unfortunate legislative mistake, but the absence of any clear rules to distinguish between true leases and financing transactions, and no bars placed on deduction of lease tax breaks against non-leasing income, propelled tax-motivated lease transactions. There was a growing market in sale and leaseback transactions, which, if tested on principles of technical perfection or financial prudence, would appear to be a shame on everyone's face.
Optimistic capital markets: Data would establish a clear connection between bullish stock markets and the growth in both number of leasing entities and lease volumes. Year 1994-1995 saw the peak of primary market activity where a company, even if a new entrant in business, could price itself on unexplainable premium and walk out with pride.
Access to public deposits: Most leasing companies in India have relied, some heavily, on retail public funds in the form of deposits. Most of these deposits were raised for a 1 year tenure, and on promise of high rates of interest, at times even more than the regulated rate (which was lifted in 1996 to be reintroduced in 1998).
A generally go-go business environment: At the backdrop of all this was a general euphoria created by liberalization and the economic policies of Dr. Manmohan Singh.
Current Problems of Indian leasing
In 1996-97, the profits of Indian leasing came down a bit -this was the year of the minimum alternative tax: so everyone thought, there was nothing serious to be concerned about.
However, 1997-98 proved to be a year of debacle. Several things combined to make this year one of worst years in history so far, including the sudden and serious breach in public confidence caused by the collapse of CRB Capital Markets (if this could be attributed to an organized fraud, how about ITC Classic, a company promoted and supervised by the tobacco giant ITC), generally bad economic environment due to political uncertainty, hesitation on part of banks to continue to finance leasing ventures, and closer to the end of the fiscal year, the Reserve Bank of India (RBI) came out with one of the least thought-about, most casually-drafted regulations on Non-banking finance companies (NBFCs). The RBI is still not sure of what it wants to regulate and how, and has changed in the regulations 3 times in 5 months, and there are still Committees and Task Forces on the reconstruction job. There could not have been a worse way of handling a sensitive sector of the economy, already in a crisis of public confidence! The current problems of Indian leasing could be listed as follows, again without any order of listing:
Asset-liability mismatch: Most non-banking finance companies in India had relied extensively on public deposits -this was not a new development, as the RBI itself was constantly encouraging and supporting the deposit-raising activities of NBFCs. If the resulting asset-liability mismatch, to everybody's agreement, is the surest culprit of all NBFC woes today, it must have been a sudden realization, because over all these years, each Governor of the RBI has passed laudatory remarks on the deposit-mobilization by NBFCs knowing fully well that most of these deposits were 1-year deposits while the deployment of funds was mostly for longer tenures. It is only the contagion created by the CRB-effect that most NBFCs have realized that they were sitting on gun-powder all these years. The sudden brakes put by the RBI have only worsened the mismatch.
Generally-bad economic environment: Over past couple of years, the economy itself has done pretty badly. The demand for capital equipment has been at one of the lowest ebbs. Automobile sales have come down; corporates have found themselves in a general cash crunch resulting into sticky loans.
Poor and premature credit decisions in the past: Most NBFCs have learnt a very hard way to distinguish between a good credit prospect and a bad credit prospect. When a credit decision goes wrong, it is trite that in retrospect, it invariably seems to be the silliest mistake that ever could have been made, but what Indian leasing companies have suffered are certainly problems of infancy. Credit decisions were based on a pure financial view, with asset quality taking a back-seat.
Tax-based credits: In most of the cases of frauds or hopelessly-wrong credit decisions, there has been a tax motive responsible for the transaction. India has something which many other countries do not- a 100% first year depreciation on several assets. Apparently, the list of such assets is limited and the underlying fiscal rationale quite holy and sound - certain energy saving devices, pollution control devices etc qualify for such allowance. But that being the law, it is left to the ingenuity of our extremely competent tax consultants to widen the range with innovative ideas of exploiting these entries in the depreciation schedule. Thus, there have been cases where domestic electric meters have been claimed as energy saving devices, and the captive water softenizer in a hotel has been claimed as water pollution control device! As leasing companies were trying to exploit these entries, a series of fraudsters was successful in exploiting, to the hilt, the propensity of leasing companies to surpass all caution and all lending prudence to do one such transaction to manage its taxes, and thus, false papers for non-existing wind mills and never-existing bio-gas plants were fabricated to lure leasing companies into losing the whole of their money, to save the part that would have gone as government taxes!
Extraneous problems - frauds, closures and regulation: As they say, it does not rain, it pours. Several problems joined together for leasing companies - the public antipathy created by the CRB episode and subsequent failures of some good and several bad NBFCs, regulation by the RBI requiring massive amount of provisions to be created for assets that were non-performing, etc. It certainly was not a good year to face all these problems together.
The law of leasing in India
1. Sources of Law on leasing and hire-purchase
Leasing and hire-purchase are essentially hiring transactions - transactions in which possession of goods is handed over along with right to use, for a stated period and for consideration. Hiring transactions are species of bailments in contract law - therefore, the transactions of lease and hire-purchase are governed by the common law of contracts dealing with bailment transactions.
Contracts law, being common law, is codified in the Indian Contracts Act 1872 but is enriched by history of precedents from both English and Indian Courts. Notably, the common law of contracts in India is based largely on the British legal principles, which have by and large been accepted as applicable to India.
Therefore, the principal sources of applicable law on lease and hire-purchase transactions are sections 148 to 171 of the Indian Contracts Act dealing with bailments, and a long series of Court rulings, principally on hire-purchase transactions, but of late, on lease transactions as well.
The law of hire-purchase, essentially with a view to standardize procedures and eliminate malpractice, on the lines of the English Hire-purchase Act, was enacted in 1972. However, it has not been enforced as yet. In the meantime, there has been an attempt to amend it and make it applicable. Reportedly, the Law Commission is again considering it fit to amend and implement the law, but unfortunately, over years, there have been so much change in commercial reality of hire-purchase business that the concepts and calculations relevant in 1972 have become absolutely redundant close to Y2K. Besides, there is no sanctity today to implement a law dealing with hire-purchase, and not lease, or any such instrument in isolation - if at all necessary, India needs a law on consumer credit. Even UK has scrapped the Hire-purchase Act and merged it with consumer credit law.
2. Leasing and Hire-purchase
From legal rights and obligations viewpoint, there is no difference between lease and hire-purchase transactions. Both are viewed as bailment transactions.
Accordingly, most of the common law applicable to hire-purchase transactions is also applicable to leases, and vice versa. The difference between the two is principally the non-existence of option to buy in case of lease transactions. In other words, lease transactions carrying an option to buy, explicitly or implicitly, will be treated as hire-purchase transactions. This may lead to differences in taxation treatment, but there is no appreciable difference in legal rights of parties.
Hire-purchase is treated as distinct from conditional sale, since it provides the hirer with an option to buy, and does not impose an obligation to buy. The usual option to buy in case of hire-purchase transactions is for a nominal price of Re.1. If hire-purchase transaction were to force the hirer to continue paying the hire installments through the term of hire, and offer an option to the hirer only for the nominal purchase price of Re. 1, the optionality will be meaningless, and such hire-purchase transaction may be treated as a conditional sale.
3. Requirements of a valid lease or hire-purchase:
Both lease and hire-purchase, to be valid, must be valid bailment transactions. Therefore, all the preconditions of a valid bailment will be applicable to lease and hire-purchase transactions too. The requirements for a valid hire-purchase are the same as those in case of a lease, but the additional requirement about an option to terminate the hiring by returning the goods, mentioned above, have been dealt with in detail in the online article on true leases.
4. Goods features in lease/hire-purchase:
No bailment, and hence, no hiring can take place where there are no goods delivered by the hire-grantor to the hirer. In case of a sale and leaseback transaction, a leasing company bought and leased goods which were later found to be non-existent. No lease was held to be created by the agreement, since a lease without goods is not even initiated. [Associated Japanese Bank v. Credit Nuford (1988) 3 All E R 902]
As the lease contract envisages a delivery of goods to the lessee, to be terminated by redelivery of goods at the end of the lease period, the goods must have the following features:
Durability: The goods must last for at least as long as the lease period. Unless the lessor, or the lessee being under obligation to do so, replaces them and the goods so replaced become the subject matter of the lease, the contract of lease comes to an end as soon as the subject matter of the lease, viz., the leased goods, cease to exist.
The goods constitute the very string of relation between the lessor and the lessee, and the relation is snapped the moment the string is broken. There may be doubts as to the existence of an intended lease where the goods leased are known not to have an estimated life at least equal to the lease period. For example, a lease of an umbrella could be intended, but not the lease of an ice cream. That is to say, goods which are consumed in the process of using them are incapable of lease.
Movability and severability: The goods leased are to be returned at the end of the lease period, since the possessory interest is only for a specific period. At the end of the period, the goods must redeliverable. This requires two attributes: that the goods must not have been permanently attached or affixed to an immovable property and hence rendered immovable, nor must they have been attached unseverably to any other property. The law of movable and immovable properties in India is by and large the same as in England - the character of a property is determined by the degree of annexation with land, and the intent of annexation.
Identifiability: To ensure that the bailee holds the goods owned by the bailor, the goods possessed by the lessee must be held distinct and ascertainable; in other words, the leased goods must not be mixed to render them unascertainable. The law of contracts distinguishes between mixture with or without the bailor's consent. Where the mixture is with the bailor's consent, the bailor and bailee will have proportionate interest in the lot. [Sec. 155]. Where the mixture is without the bailor's consent and the goods are unseverable, the bailor becomes entitled to be compensated by the bailee for the loss of goods.
5. Supreme ownership rights of the lessor
Indian Courts have generally recognized the ownership rights of a lessor over the leased asset. Even if the lease is avowedly a financial lease, such as in case of a hire-purchase transaction, the Courts respect the way the parties have sought to create and protect their rights.
6. Obligations relating to the goods:
While enjoying all the rights of ownership, the lessor may virtually escape all obligations relating to the goods - conditions of fitness, quality, usefulness for purpose, or any damages on account of defects in goods, can be effectively avoided by a disclaimer clause in the agreement backed by evidence that the lessor was not involved in selection of the goods nor did he influence the lessee's decision as to the goods or the supplier.
7. Obligations regarding operation and use of the goods
While being the owner of the goods, the lessor may completely distance himself from obligations relating to the operation and use of the goods. This issue is very comfortably settled in India though there is a raging controversy on this point in number of other markets. The lessor is not in effective possession and is not the user of the goods. The lessee cannot be taken to be the agent of the lessor. See the following instances:
A bus given on hire-purchase collided with a tree and killed several people. Hire-purchase financier as owner was not responsible. The driver of the bus was not to be taken as agent and the financier a "master". [Sundaram Finance Ltd. v. D G Nanajappa and Others]
A truck given on hire-purchase was found carrying opium. The financier cannot be held responsible as the misuse of the vehicle could not have been with his consent and there was no possibility of the financier having control over the actual use by the hirer. [Great Finance (P) Ltd. v.The State]
While the owner of the asset has been held not to be responsible for misuse, he still claims right to be notified before confiscation of his asset. [Pradeep and Co. v. Collector of Customs AIR 1973 Cal 131.]
8. Repossession of the goods
On the lessee committing a breach of contract, the lessor being the owner of the goods is entitled to terminate the agreement of lease or hiring and repossess the goods. No judicial intervention is required in case of repossession of goods - however, the practice depends upon the physical ease in repossession and the need to enter private premises or enclosures.
Repossession being an extra-ordinary remedy should be resorted to with great caution and with full force to the rules of fair play. In case of UP State Financial Corporation, the Supreme Court set a number of preconditions for possession and sale of confiscated properties - though those conditions were imposed due to the benevolent position of the Corporation, to a large extent, these conditions apply to every repossession. Hence, it is considered appropriate that before sale of the confiscated goods, the lessee should be given a right of buying the goods at the best available price.
9. Motor vehicles law on lease and hire-purchase
Motor vehicles law in India contains specific provisions relating to lease and hire-purchase transactions. In respect of all motor vehicles, registration with motor vehicles authorities is compulsory.
The motor vehicle is given a registration certificate, which contains the name of the "owner". Owner, for the purposes of the motor vehicles law, is defined as the person effectively using the asset- obviously therefore, the name of the lessee/hirer is reflected as owner there. The name of the legal owner, viz., the lessor or hire-vendor, is reflected merely by way of an endorsement. However, it is clear understanding of the law that the neither the name on the registration certificate, nor the endorsement therein, have any reflection on the legal ownership of the vehicle.
10. Lease and Hire-purchase documentation:
The documentation recommended for an ordinary lease/hire-purchase transaction is a simple lease or hire-purchase agreement. Evidence of having received delivery of goods should be obtained from the lessee/hirer. In general, it is advisable that the lessor limits himself to giving delivery of the leased asset, and commences the lease/hire instantly on delivery of the goods.
Latest Updates on Leasing in India
Withholding tax on lease rentals reduced to 2%
Sec 194I of the Income-tax Act provides for a withholding tax on lease rentals in respect of plant machinery or equipment. The rate was hitherto 10%.
The rate has now been reduced to 2% - this is a substantial relief for the leasing industry. As lease transactions are clearly reviving, this would further usher the growth of the leasing industry.
Factoring in India
Factoring is a financial transaction whereby a business sells its accounts receivable (i.e., invoices) to a third party (called a factor) at a discount in exchange for immediate money with which to finance continued business. Factoring differs from a bank loan in three main ways. First, the emphasis is on the value of the receivables (essentially a financial asset), not the firm's credit worthiness. Secondly, factoring is not a loan - it is the purchase of a financial asset (the receivable). Finally, a bank loan involves two parties whereas factoring involves three.
Evolution of Factoring
The eighties in India was witness to a virtual deregulation of capital market a number of innovative financial instruments and schemes were born. The policy of the power- that - be also helped in the development of money market. The capital market mutatis mutandis tried to transplant some of the successful schemes of the west. The working group (1987) on the money market, headed by Vaghul, observed: "Despite various measures taken over the years to enable the small-scale sector to recover its dues from the medium and large industries (and in particular the public sector) the small-scale units face a liquidity bind because of their inability to collect the dues".
Since the earlier efforts to popularize a bill market in India did not have the desired results an alternative had to be found. Available data reveal that funds locked up in book debts have been increasing at a faster rate than growth in sales turnover or build-up in inventories (Anantha Krishnan, 1990). Thus, factoring as a remedy became a fait accompli.
Banks do provide non-banking financial services such as housing finance, leasing and hire-purchase, factoring and forfeiting. An amendment was made in the Banking Regulation Act in 1983, whereby banks were permitted to provide these services either through their own departments or divisions or through their subsidiaries. Direct and indirect lending services were provided by setting up merchant banking and mutual funds subsidiaries. Factoring and forfeiting services were of recent origin following the recommendation of the Kalyansundarm Committee, set up by the RBI in 1988.
The Committee was constituted to examine the feasibility of factoring services in India, their constitution, organizational setup and scope of activities. The group recommended setting up of specified agencies or subsidiaries for providing the factoring services in India.
While attempting to assess the potential demand for factoring services in India, the study group under the leadership of Mr. C. S. Kalyansundram estimated the value of outstanding open account credit sales available for financing during 1989-90 at Rs. 12,000 crores in respect of SSI and Rs. 4500 crores for medium and large scale sector. Assuming only 50% of the above business will be available for factoring; the aggregate potential demand for factoring was expected to be around Rs. 4000 crores per annum mainly emerging from the SSI and large and medium companies.
Major Players
The first factoring company was started by the SBI in 1991 namely Factors and Commercial Ltd. (SBI FACS) followed by Canara Bank and PNB, setting the subsidiaries for the purpose. While the SBI would provide such services in the Western region, the RBI has permitted the Canara Bank and PNB to concentrate on the Southern and Northern regions of the country, for providing such services for the customers. The major players since 1991 are Canbank Factors, SBI Factors and later Foremost Factors. The new entrants in the market include ICICI, HSBC and Global Trade Finance. Canbank Factors leads in the domestic market with about .65%-70%of the share. The Vaghul Committee Report on Money Market Reforms has stressed on the need for factoring services to be developed in India as part of the money market instruments. Many new instruments had already been introduced like Commercial Paper (CP), Pm1icipation Certificates (PC), Certificates of Deposits etc. but the factoring service has not developed to any significant extent in India. The commission charged varies between 1-2 percent of the value of receivables and the discount charge varies between 19-22 percent per annum.
Country profile
Number of Factoring companies:
10
Domestic Factoring Turnover (in Millions of EUR):
2,500
International Factoring Turnover (in Millions of EUR):
150
Total Factoring Turnover (in Millions of EUR):
2,650
Legal Aspects
The legal status of a factor is that of an assignee. Once the factor purchases the receivables of a firm and this fact is notified to the customers, they are under a legal obligation to make all remittances to the factor' A customer who by mistake remits the payments to the firm is not discharged from his obligations to the factor until and unless the firm remits the proceeds to the factor. The factoring agreement governs the legal relationship between a factor and the firm whose receivables are to be factored, and is so drawn as to suit the various needs specifying the period of validity of the contract and modalities of termination.
Financial Aspects
Factoring involves two types of costs: (a) factoring commission; and (b) interest on funds advances. Factoring commission represents the compensation to the factor for the administrative services provided and the credit risk borne. The commission charged is usually 2-4 per cent of the face value of the receivables factored, the rate depending upon the various forms of service and whether it is with or without recourse.
The factor also charges interest on advances drawn by the firm against uncollected and non-due receivables. In the Ul (, it is the practice to advance up to 80 per cent of the value of such outstanding at a rate of interest which is 2-4 per cent above the base rate. This works out to near the interest rate for bank overdrafts. The cost of factoring varies, from 15.2 to 16.20 per cent (Singh, 1988), 15.6 to 16.0 percent (SBI Monthly Review, 1989), and the margins in which the factors will have to operate would be extremely narrow. The strategy of factors, therefore, must be to carve out a niche in the services segment namely, receivables management and generate revenues by way of commission rather than concentrate on lending and financing activities where the margins are low.
Factoring offers the following advantages from the firm's point of view:
Advantages
Firms resorting to factoring also have the added attraction of ready source of short-term funds. This form of finance improves the cash flow and is invaluable as it leads to a higher level of activity resulting in increased profitability. By offloading the sales accounting and administration, the management has more time for planning, running and improving the business, and exploiting opportunities. The reduction in overheads brought about by the factor's administration of the sales ledger and the improved cash flows because of the quicker payments by the customers result in interest savings and contribute towards cost savings.
Disadvantages
Factoring could prove to be costlier to in-house management of receivables, especially for large firms which have access to similar sources of funds as the factors themselves and which on account of their size have well organized credit and receivable management. Factoring is perceived as an expensive form of financing and also as finance of the last resort. This tends to have a deleterious effect on the creditworthiness of the company in the market.
Potential of Factoring
In the Indian context, factoring is being viewed as a source of short-term finance. The estimated aggregate potential demand for factoring (finance) would be about Rs 4,000 crores (SBI Monthly Review, 1989). There seems to be a tendency to view factoring primarily as a financing function - a source of funds to fill the void of bank financing of receivables for small-scale industries and others. This attitude is fraught with dangers and could lead to a "catch 22" situation. In launching factoring service, the thrust should be in the twin areas of receivables management, and credit appraisal; factoring agencies should be viewed as vehicles of development of these skills. Since the small-scale sector lacks these sophisticated skills, factors should be able to fill the gap. Giving priority to financing function would be self-defeating as receivable management would be given the back-seat. It is for the factors to generate the necessary surpluses to mop up the additional resources and then embark on financing function. However, for policy reasons, should these go hand in hand, then the accent should be on receivable management otherwise, these agencies would end up as financing bodies. From the firm's point of view, factoring arrangements offer certain financial benefits in the form of savings in collection costs, reduction in bad debt losses, and reduction in interest cost of investment in receivables. On the other hand, the firm incurs certain costs, in the form of commissions and interest on advances. Therefore, to assess the financial desirability of factoring as an alternative to in-house management of receivables, the firm must assess the net benefit of this option, using the profit criterion approach. The factors have to establish their credibility in offering better management of receivables and financing at competitive rates to the clients.
Export-Factoring in India
Factoring is a fund-based facility. RBI as a measure to solve the problem of the working capital of the suppliers extended the factoring as the new form of the financial services in India. It was set up after the recommendation of the Kalyanasundaram Committee in 1988. They initially developed the concept of the inland Factoring, but later on Export Financing become one of their emphasized areas. The factoring in India can be done for invoices as low as 1000Rs.
Considering the growth of the International markets and globalization there was the need to lay emphasis on the Export factoring. In the international trade it is customary to use two-factor system, i.e. system constituting the Export factor and Import factor. Under this arrangement,
Exporter sells goods on open credit.
Export receivables are factored to the factor on the non-recourse basis (generally). All the supporting documents relating to the export transaction are given to the export factor.
Export factor performs its function of credit collection, sales ledger accounting and collection to the import factor with respect to the customers located in the importing country.
Import factor collects the money due from the customers concerned.
Import factor effects the payments to the export factor on assignment or maturity or collection or as per the agreement.
Export factor makes payment to the exporter upon assignment or maturity or collection or as per the agreement.
Advantage over the other Export Financial Services:
Factoring is still at the growing stage in India, though gaining popularity but it has been compared to the long followed financial service of Bill Discounting, though they both make finance available to the exporter against the accounts receivables held by the client. There are a few advantages that the factoring enjoys over bill discounting.
Factoring involves a pre-payment against all unpaid and not-due invoices purchased by the factor, where as in bill discounting, each bill is separately assessed and discounted by the financial intermediary.
Factoring involves other facilities also like collection of debts and sales ledger administration and advisory, whereas these facilities are unavailable in a bill discounting arrangement.
Factoring can be a non-recourse type of an arrangement while bill discounting is usually a recourse type of an arrangement.
Export:
Introduction of export factoring in India will certainly provide an additional window of facility to the exporters. Further, the position of realization of export proceeds of shipment made by the Indian exporters is sufficiently encouraging for the interested organizations to offer factoring services to exporters from India. There are many companies offering export-factoring services, a few like:
SBI Factors and Commercial Services Pvt. Ltd.:
SBI Factors, a subsidiary of State Bank Of India, is one of the leading factoring companies in India with an asset base of Rs.919.36 crores as on March 31, 2006. It is the first factoring company to be set up in India. It was incorporated in February 1991 and commenced business operations from April 1991. State Bank of India and its 2 associate banks have a 70% stake in SBI Factors while 20% is held by Small Industries Development Bank Of India (SIDBI) and 10% by Union bank of India. As on March 31, 2006, it has a market share of approximately 40% in the factoring business.
Global Trade Finance Limited (GTF):
Global Trade Finance Limited (GTF) is the only provider of international factoring, domestic factoring and forfeiting services under one roof in India. GTF is headquartered in Mumbai. GTF commenced its operations in September 2001, as a joint venture between WestLB, Germany (40%), Export-Import Bank of India (35%) and International Finance Corporation, Washington (25%), which is the private sector arm of the World Bank. Effective December 24, 2004, GTF's shareholding is now 40% with Export- Import Bank of India, 38.5% with FIM Bank, Malta, 12.5% with IFC, Washington and 9% with Bank of Maharashtra.
GTF is a member of Factors Chain International, a global association of international factoring companies Established in 1968, FCI has played a major role in bringing factoring into most countries and today has a membership of 211 factoring companies operating in 61 countries.
Factoring and its Significance in Indian Economy
With the advent of globalization and opening up of Indian economy, Export Factoring will play a crucial role in encouraging the international trade. It has gained popularity among the international traders due to the diverse services provided by it. The major boost to the economy in the future will be through the advice or suggestions given to the various traders that will facilitate them to perform better. Factoring will also promote a prompt payment culture among industrial and trading units by facilitating the overall acceleration of the receivables turnover. The impact of this accelerated receivables turnover will be better return on capital because of the facilitation of greater volume of business on the same amount of capital or the same amount of business on smaller amount of capital. Thus, such a prompt payment culture prompted by factoring among industrial land trading units and the resultant overall accelerated receivables turnover will ultimately have a multiplier effect on production, employment and economic growth.
