The Ukrainian Realities of Financial Leasing
Until the global financial crisis reached Ukraine, the local leasing market had demonstrated significant growth. Foreign banks and financial institutions had entered the market, increasing the availability of various financial instruments, including that of leasing. However, the crisis made the situation much more complicated. On the one hand, the general positive trend was undermined; on the other hand, the great difficulties with the accessibility of loans shifted the attention of customers in favor of financial leasing. International practice has proven that leasing is an effective investment mechanism and an important component of a state’s economic and investment policy.
Notwithstanding the general attractiveness, this instrument may be used only after thorough analysis of applicable legislation and examination of business techniques elaborated by the market. For stability of relationships that arises out of or in connection with financial leasing, the consistency of legislation and of the application of respective legislation by the court system is also important. Below we will consider in general terms the Ukrainian legislation which governs financial leasing and the most serious barriers hindering the development of financial leasing.
Applicable Legislation
The year 2004 was a crucial year for the development of leasing in Ukraine. In that year the Civil Code of Ukraine (the Civil Code), the Commercial Code of Ukraine (the Commercial Code), and the new version of the On Financial Leasing Act of Ukraine (the Leasing Act) all came into force. These are the main documents which regulate financial leasing in Ukraine. As of the end of 2009 there are no essential amendments to the above acts related to leasing. The Leasing Act combined the legal nature of financial leasing with the economic essence of leasing. The Leasing Act is a positive step toward creating a legal framework for leasing.
According to the Leasing Act, financial leasing means a type of civil relation arising from a financial leasing agreement under which the lessor shall be obliged to acquire an asset into ownership from a seller (vendor) pursuant to specifications and conditions established by the lessee, and transfer it to the lessee for a specified term not less than one year for an established fee (lease payments). The above definition provided by the Leasing Act is a definition of indirect leasing, while Articles 806 of the Civil Code and 292 of the Commercial Code concern both indirect and direct leasing (where the assets are already purchased by the lessor and the lessee gives no instructions on the assets).
While both an individual person and a legal entity may be a lessee, a legal entity can only enter into a financial leasing agreement as a lessor.
The parties to financial leasing should come to an agreement concerning the object of the financial leasing agreement, the term of the leasing, leasing payments and other provisions on demand of the party. Should the parties fail to set out in the agreement all essential terms and conditions the agreement may be regarded as not executed.
Land plots and other natural objects (forests, water objects, natural resources, etc.), integrated property complexes (production facilities) of enterprises and their separate divisions (branches, departments, and units) cannot be the object of financial leasing.
Another important issue to be agreed by the parties is the amount and composition of leasing payments. Pursuant to legislation leasing payments may include:
(1) the amount that reimburses the cost of a leased asset;
(2) the lessor’s commission (fee);
(3) compensation of interest on a bank loan;
(4) other expenses of the lessor connected with the fulfilment of its obligations under the financial leasing agreement.
At the same time, market practice recommends dividing the payments into two parts: the reimbursement of the cost of the leased asset, and the lessor’s commission (fee). Such division is evoked by the provisions of Ukrainian tax legislation, in particular, the difference in taxation of these two types of payments.
In case of financial leasing, the risk of casual loss of and damage to the leased assets passes to the lessee, unless otherwise envisaged by the agreement. Thus, it would be advisable to insure the asset against the mentioned losses or damages. In certain cases insurance is mandatory.
It should be noted that by executing the financial lease agreement the lessee obtains only the right to use the assets but not the right of ownership. Thus, one of the important barriers hampering development of finance leasing is a clause (point 7 part 2 Article 11) of the Leasing Act, according to which an object of leasing must be returned to the lessor upon termination of the financial leasing agreement. Meanwhile, the law allows repayment of the lease asset’s value by the lessee within the leasing payments (point a part 2 Article 16 of the Leasing Act). Therefore, the lessee is obliged to return the asset to the lessor irrespective of the fact that he/she may have repaid the cost of the asset fully or partially during the term of the financial leasing agreement. The parties to the financial leasing agreement may sell the asset to the lessee by executing a separate sale-purchase contract. To improve this situation changes to the Leasing Act complementing point 5 part 2 article 10 and point 7, part 2 article 11 with the following phrase “…unless otherwise provided by the financial leasing agreement”, are necessary.
Tax Issues
A review of Ukrainian legislation on financial leasing would not be complete if we omitted the issue of taxation. A financial leasing agreement should be executed with due attention given to tax legislation, since the consequences of improper tax treatment of a transaction may well outweigh the benefits thereof. First of all, tax legislation contains specific criteria to define financial leasing (See the On Corporate Profit Tax Act of Ukraine, hereinafter — the CPT Act). Consequently, the contemplated transaction should be considered from the perspective of the CPT Act prior to execution of the financial leasing agreement.
The following issues should be considered in advance: the profit taxation of the transfer of the leased asset from the lessor to the lessee, corporate profit tax treatment of the lessor’s commission, of insurance costs, of costs for improving the assets, the notary fee, etc. The issue of value added tax are also important in view of the application of the ‘usual price’ rule to determining VAT obligations in connection with the transfer of leased assets and the existing limitation on the amount of the lessor’s commission that is not subject to VAT.
The issue of payment of the 1% Pension Fund duty in case of financial leasing of real estate should also be considered.
Notwithstanding positive developments, there are still a number of factors restraining the development of leasing in Ukraine. The major one is imperfect legislation, particularly taxation. We understand that the ground of tax pressure on leasing business is the justified striving of the state to eliminate any chance to shadow cash flows through a financial leasing mechanism.
Provision of such a powerful and worldwide acknowledged tax benefit as accelerated depreciation to lessors only, may create strong incentives for tax optimization.
In other words, in order to reduce tax liabilities, nearly every business may feel the urge to formally treat any purchase of capital assets as finance leasing, which may be enforced either via its “captive” lessor, or via another company involved in “pseudo leasing”. This situation may be addressed in two ways: (1) accelerated depreciation introduced for certain categories of fixed assets regardless of the way in which they were purchased; or (2) strict government control exercised over the operations of lessors, in order to preclude the formation of a large “pseudo-leasing” market. As the means of the government budget are not likely to allow the introduction of fast-track depreciation for certain types of fixed assets irrespective of the way they were acquired, option (2) looks more feasible.
UNIDROIT Convention on International Financial Leasing. The year 2007 was marked by Ukraine’s accession to the UNIDROIT Convention on International Financial Leasing (Ottawa, 28 May 1988). The Convention applies in case the lessor and the lessee have their places of business in different states and (a) those states and the state in which the supplier has its place of business are contractual states that ratified the Convention; or (b) both the supply agreement and the leasing agreement are governed by the law of a contractual state. The party’s place of business, if it has more than one place of business, means the place of business which is most closely connected to the relevant agreement and to its performance. The Convention, compared with Ukrainian legislation, contains detailed regulation of some aspects of financial leasing, e.g. relations between the lessor and the lessee’s trustee in bankruptcy, the lessor’s liability to third parties for death, personal injury or damages to the property caused by the leased asset, duties of the supplier, issues of liability for default, etc. And it is believed that the development of Ukrainian leasing legislation in line with standards accepted worldwide will be further promoted and supported. This review should be regarded as general guidance through legislation on financial leasing, but not a detailed piece of research. Each situation is unique and attracts special consideration and treatment. Thus, investment by means of financial leasing requires a great deal of collaboration with a legal adviser. The legal adviser may review the capacity of the parties to be involved in financial leasing, conduct due diligence of the target assets, develop the most appropriate scheme of financial leasing and transaction documents as well as provide transaction support.