Regulatory Aspects of Leasing Activities

The paramount job of a regulator is ensuring transparency, professional reliability, and minimum damage to the public interest. In India, the Regulatory body for financial leases is the Reserve Bank of India (RBI).

As per RBI regulations, it is mandatory for a company that is in the business of financing to have a certificate of registration classifying it as a financial services company. As per the National Industrial Classification Code4, financial leases are regarded as financial transactions, considered under “financial services activities” while operating leases, are regarded as rental contracts, and dealt with in a separate section on “renting and leasing activities”.

Since a financial lease is regarded as a financial contract, any entity principally engaged in the business of financial leases is considered to be a Non-Bank Finance Company (NBFC).

The Reserve Bank of India is the regulatory authority for all NBFCs. According to the Reserve Bank of India Act, 1934, all NBFCs to obtain a Certificate of Registration from the Reserve Bank of India to carry on their business. The statutory requirement for minimum net owned funds Fund Based Services for registration was stipulated at Rs.25 lakh for the companies holding certificate of registration before April 20, 1999, and Rs. 2 crore for new companies seeking Certificate of Registration after April 21, 1999.

Reserve Bank of India supervises these companies through (i) on-site inspection, (ii) off-site monitoring, (iii) market intelligence, and (iv) exception reports of statutory auditors.

An entity is considered principally engaged in financial activities if it satisfies the twin “principal business criteria” laid down by the RBI vide its press release dated 8th April 1999.

• At least 50% of the total assets of the Company should be financial assets; and

• At least 50% of the gross income should be derived from the financial assets.

 Foreign Direct Investment (FDI) Regulations:

For capital inflows from non-residents, the following investments are treated as “capital” and come under FDI regulations: investments in equity shares; fully, compulsorily & mandatorily convertible preference shares; fully, compulsorily & mandatorily convertible debentures; and warrants. All other financial instruments, and borrowings, will be regarded as “borrowings”, and will come under external commercial borrowings (ECB) regulations. As per the extant FDI Policy, 100% FDI is allowed under the automatic route for Financial Services activities regulated by financial sector regulations, viz., RBI, SEBI, IRDA, PFRDA, NHB, or any other financial sector regulator as may be notified by the Government of India. In financial services activities that are not regulated by any Financial Sector Regulator where only part of the financial services activity is regulated or where there is doubt regarding the regulatory oversight, foreign investment up to 100% will be allowed under the Government approval route subject to conditions including minimum capitalization requirement, as may be decided by the Government. Entities engaged primarily in operating leases are not covered by financial sector regulators. Operating leases are usually treated as service transactions, close to asset renting services. Financial leases are treated under the caption “financial services”.

Since FDI in the case of the services sector, other than financial services comes under automatic FDI, it is felt that there are no restrictions on FDI in the case of companies primarily engaged in operating leases.

Key RBI guidelines for NBFCs:

The Reserve Bank has been given the powers under the RBI Act 1934 to register, lay down policy, issue directions, inspect, regulate, supervise, and exercise surveillance over NBFCs that meet the 50-50 criteria of principal business. The Reserve Bank can penalize NBFCs for violating the provisions of the RBI Act or the directions or orders issued by RBI under the RBI Act. The penal action can also result in RBI canceling the Certificate of Registration issued to the NBFC prohibiting them from accepting deposits and alienating their assets or filing a winding-up petition.

In terms of Section 45-IA of the RBI Act, 1934, no Non-banking Financial company can commence or carry on the business of a non-banking financial institution without a) obtaining a certificate of registration from the Bank and without having a Net Owned Funds of ₹ 25 lakhs (₹ Two crores since 21 April 1999).

A company incorporated under the Companies Act, 1956 and desirous of commencing the business of a non-banking financial institution as defined under Section 45 I(a) of the RBI Act, 1934 should comply with the following:

i. It should be a company registered under Section 3 of the Companies Act, 1956

ii. It should have a minimum net owned fund of ₹ 200 lakh.

NBFCs whose asset size is ₹ 500 cr or more as per the last audited balance sheet are considered systemically important NBFCs. The rationale for such classification is that the activities of such NBFCs will have a bearing on the financial stability of the overall economy.

Risk-based internal audit system by NBFC

The circular intends, to provide essential requirements for a robust internal audit function, which include sufficient authority, stature, independence, resources, and professional competence, to align these requirements in larger NBFCs/UCBs with those stipulated for Scheduled Commercial Banks,” it said.

According to the RBI circular dated 03.02.2021, “The internal audit function is an integral part of sound corporate governance and is considered as the third line of defence”.  The central bank said that the Risk-Based Internal Audit (RBIA) is an audit methodology that links an organisation’s overall risk management framework. It provides an assurance to the board of directors and the senior management about the quality and effectiveness of the organisation’s internal controls, risk management, and governance-related systems and processes, it added.

Traditionally, the internal audit system at NBFCs/UCBs has generally been concentrating on transaction testing, testing of accuracy and reliability of accounting records and financial reports, and adherence to legal and regulatory requirements, which might not be sufficient in a changing scenario. The RBI’s new guidelines are important in the context of risks and inconsistencies faced by systemically important NBFCs and UCBs as they adopt different audit systems. A shift to a framework that focuses on the evaluation of the risk management systems and control procedures in various areas of operations, in addition to transaction testing, will help in anticipating areas of potential risks and mitigating such risks, the RBI said.

The senior management is responsible for ensuring adherence to the internal audit policy guidelines as approved by the Board and development of an effective internal control function that identifies, measures, monitors, and reports all risks faced, it said. The senior management is also responsible for establishing a comprehensive and independent internal audit function which should promote accountability and transparency, the RBI said.  “It shall ensure that appropriate action is taken on the internal audit findings within given timelines and status on the closure of audit reports is placed before the ACB/Board,” it added.

Prudential norms:

In respect of lease assets, where lease rentals are overdue for more than 12 months, the income shall be recognised only when lease rentals are received. The net lease rentals taken to the credit of the profit and loss account before the asset became non-performing and remaining unrealised shall be reversed.

For this paragraph, `net lease rentals’ means gross lease rentals as adjusted by the lease adjustment account debited/credited to the profit and loss account and as reduced by depreciation at the rate applicable under Schedule XIV of the Companies Act, 1956 (1 of 1956).

 Every non-banking financial company shall, after taking into account the degree of well-defined credit weaknesses and extent of dependence on collateral security for realisation, classify its lease/hire purchase assets, loans and advances, and any other forms of credit into the following classes,  namely :

(i)   Standard assets;

(ii)  Sub-standard assets;

(iii)  Doubtful assets; and

(iv)  Loss assets.

The class of assets referred to above shall not be upgraded merely as a result of rescheduling unless it satisfies the conditions required for the upgrade.

Provisioning requirements

Every non-banking financial company shall, after taking into account the time lag between an account becoming non-performing, its recognition as such, the realisation of the security, and the erosion over time in the value of security charged make provision against sub-standard assets, doubtful assets, and loss assets as provided hereunder

The provisioning requirements in respect of hire purchase and leased assets shall be as follows;

Hire purchase assets

(i)  In respect of hire purchase assets, the total dues (overdue  and  future installments taken together)  as reduced by;

(a)  the finance charges not credited to the profit and loss account and carried forward as unma­tured finance charges; and

(b)  the depreciated value of the underlying asset shall be provided for.

Explanation: For this paragraph,

(1) the depreciated value of the asset shall be notionally  computed as the original cost of the asset to be reduced by  deprecia­tion at the rate of twenty per cent per annum on a straight line method; and

(2) in the case of second-hand assets, the original cost shall be the actual cost incurred for the acquisition of such second-hand assets.

Additional provision for hire purchase and leased assets:

(ii)   In respect of hire purchase and leased assets, additional provisions shall be made as follows;

Where hire charges or lease rentals are overdue up to 12 months: Nil

Where hire charges or lease rentals are overdue for more than 12 months but up to 24 months 10 percent  of the  net book value

Where hire charges or lease rentals are overdue for more than 24 months but up to 36 months: 40 percent of the net book value.

Where hire charges or lease rentals are overdue for more than 36 but up to 48 months: 70 percent of the net book value.

Where hire charges or lease rentals are overdue for more than 48 months: 100 percent of the net book value

(iii)  On the expiry of 12 months after the due date of the last installment of hire purchase/leased asset, the entire net book value shall be fully provided for.

NOTES:

The amount of caution money/margin money or security deposits kept by the borrower with the non-banking financial company in pursuance of the hire purchase agreement may be deducted against the provisions stipulated under clause (i) above, if not already taken into account while arriving at the equated monthly installments under the agreement. The value of any other security available to the hire purchase agreement may be deducted only against the provisions stipulated under clause (ii) above.

The Reserve Bank of India on Monday (15.07.2024) through a Master circular asked lenders including NBFCs to give enough time for defaulters to respond before they are classified as “fraud accounts. The amendment to current rules incorporates a Supreme Court judgment in March last year that a bank cannot unilaterally declare an account as fraud without providing the defaulter the right to be heard.

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