Upon providing services to clients doing business in financial leasing, we come across with a variety of issues, relating to regulating a financial leasing agreement. Earlier we wrote on enforcement practices by courts in relation to financial leasing. You may read our previous publications at the following link.
In the present article we will consider one of the important aspects of financial leasing, in particular, possibility and consequences of replacement of a subject of financial leasing. As for consequences, in the present article we will focus on applicability of tax preferences upon replacement a subject of financial lease.
Let's consider the following example. A leasing company ("Lessor") and a construction company ("Lessee") concluded an agreement on financial leasing, wherein Lessor undertook to acquire hydraulic excavator chosen by Lessee ("Leasing subject") according to specification as determined by an agreement of financial leasing, and transfer it to Lessee. For execution of the financial leasing agreement Lessor concluded a sale-purchase agreement with a seller of Leasing subject.
Lessor properly executed its obligation to supply Leasing subject of a proper quality meeting the requirements as required by Lessee. However, after a certain period time Lessor began using Leasing subject, Lessee requested Lessor to replace it for equipment, as it turned out that technical characteristics of the leasing subject did not meet requirements of a specific task for which it was used. Lessor and Seller is ready to replace, however they are not certain whether Kazakhstan legislation allows replacement of leasing subject upon financial leasing and would like to ensure on the potential consequences of such replacement.
Kazakhstan legislation determines the cases where replacement of the leasing subject is allowed.
First, according to Civil Code of Republic of Kazakhstan dated 27.12.1994г. (further «Civil Code») Lessee has a right to require replacement of leasing subject when it is of an improper quality and of an incomplete set .
Secondly, Kazakhstan law «On financial leasing» dated on 05.07.2000г. (further «Financial Leasing Law») provides for a right of a lessor to replace leasing subject, in cases, when the leasing subject (i) is not supplied; (ii) is supplied with a significant delay; or (iii) supplied with irremediable deficiencies preventing use of leasing subject by designation, except cases when the seller and the leasing subject were chosen by a lessee.
Hence, abovementioned legislative norms relating to replacement of the leasing subject do not apply to the situation herein, as Lessee has no claim relating to quality or completeness of the leasing subject.
Moreover, the leasing subject and its seller were chosen by Lessor, and the financial leasing agreement does not contain any provision that would change the right of a Lessee as provided by Financial Leasing Law.
Does it mean that the right of Lessee on replacement of leasing subject is limited to the cases determined by law only?
To the opinion of the authors of the present article, provisions of Kazakhstan legislation, regulating replacement of a financial leasing subject, provide for a minimum scope of rights of lessee. Accordingly, parties of the financial lease deal upon mutual agreement can provide different grounds for replacement of a leasing subject in addition to those provided by the legislation. It can be made at the moment of conclusion of an agreement or during its execution.
Such an opinion is based on the following grounds.
No Civil Code, nor Financial Leasing Law does not prohibit replacement of a leasing subject upon execution of the financial leasing agreement.
Furthermore civil legislation generally allows the parties to determine terms of an agreement upon their as it deems appropriate, except cases when the terms of an agreement are prescribed by law.
Besides, the norms of Financial Lease Law, regulating rights of a lessee to replace a leasing subject are dispositive norms. That implies that parties can exclude its application by agreement or provide for terms, different from those provided in the law.
At the same time, it is tax law requirements, not norms of civil law that should be given due attention upon considering replacement of leasing subject.
According to Code of Kazakhstan «On taxes and other obligatory payments to the budget» dated 25.12.2017г. (further «Tax Code») financial leasing is a transfer of the property under financial leasing agreement, concluded in accordance with Kazakhstan laws for a term no less than three years provided the conditions are met:
1. Transfer of the property for ownership of a lessee and (or) provision of right to lessee to acquire the property at a fixed price by agreement;
2. Term of a financial leasing exceeds 75 percent of a period of useful life of the property granted for financial leasing;
3. Current (discounted) price of leasing payments for the whole period of financial leasing exceeds 90 percent of the price of the equipment provided for financial leasing.
In relation to financial leasing deals that correspond the abovementioned requirements, tax legislation provides for the following tax preferences:
1. Decrease of taxable income for an amount of a fee according to a leasing agreement;
2. VAT exemption in part of the fee, subject to receipt by a lessee;
3. VAT exemption of turnovers upon sale of goods, on which VAT has been paid by credit method.
However, in case when, for some reasons, financial lease transaction ceases to meet the abovementioned criteria (for example, in case of early termination of a financial leasing agreement), such a deal shall not qualify for application of tax preferences. Furthermore, previously applicable VAT and CIT exemptions shall cease to apply, and a lessor shall have an obligation to pay taxes from which it was exempted earlier.
Correspondingly, upon replacement of a leasing subject under a financial lease agreement, parties should be careful as to whether replacement of leasing subject shall lead to incompliance of any of the conditions that are binding to have the deal qualified as financial leasing.
At that, to the opinion of the authors of the article, mere replacement of a leasing subject shall not by default be considered as incompliance with the requirements of Article 197 of Tax Code. From a legal point of view given the absence of direct prohibition in the legislation, we find that a financial lease agreement can be amended to indicate a new leasing subject, its price, the size and schedule of new leasing payments (including credit of the previously-paid leasing payments on the previous leasing subject against obligations in relation to the new leasing subject) and i.e.. In that case the obligations of the parties shall not cease, but continue to be effective in an amended form.
However, it should be considered that the remaining term of the financial leasing agreement after replacement of the leasing subject should be sufficient to exceed 75 percent of the useful life of a new leasing subject.
At the same time, we do not exclude the risk that tax authorities are likely to qualify replacement as incompliance with financial leasing requirements. In particular, they may recognize replacement of the previously-transferred leasing subject as completion of obligations under the said leasing subject. To our opinion, it is difficult to justify such an opinion legally, as in case of amendment of terms of the financial leasing agreement, obligations of the parties shall not cease, but continue to be effective in an amended form.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.