Finance leasing is a form of title financing or ‘lessor – security.’ The financier (lessor) has title to, or ownership of, an asset (instead of a mortgage over such asset). It is often an alternative form of finance to a secured lending transaction.
The basic principle of a finance lease is relatively simple. The manufacturer or supplier of the asset sells to a financier (lessor). The seller gets immediate payment from the financier. The financier then leases the asset to the buyer (lessee) in return for rental payments for a period equal to the useful life of the asset. The rental payments cover the cost of acquisition plus interest or profit. The seller and the lessee may be the same person – a sale and leaseback arrangement. If the lessee (buyer) becomes insolvent, the lessor forfeits the lease, sells the asset and accounts to the lessee for any excess amounts (sale proceeds less accelerated rental payments), usually in the form of a rebate.
In brief:
- The UAE has issued Federal Law No 8 of 2018 (Law) which came into effect on 1 January 2019 and now regulates many aspects of lease financing in the UAE. A regulated finance company (as the owner of an asset) may lease the asset to a buyer/lessee in return for rental payments. The lessee is given an option to purchase the asset (usually at the end of the contract period).
- The Law does not deal with conflict of law issues that may arise in the context of dealing with rights of ownership, use and possession of assets contained in a typical finance lease contract (and therefore the circumstances in which the Law will apply). These are left to be determined by normal conflict of law rules set out in other UAE federal laws. These are neither obvious or apparent from a reading of the Law itself.
- Where the provisions of the Law do apply, the Law specifies the rights and obligations of lessors and lessees under the lease contract, including those concerning ownership, use, possession and transfer of ownership of the asset at the end of the contract period.
- Existing finance lease providers will be required to conform to the requirements of the Law, including registration in a pubic register and annotation of previously concluded finance lease contracts within one year from the Law coming into force.
Lease financing usually brings into play a number of different considerations. The most important (leaving aside specific commercial factors) are legal, accounting treatment and tax. For accounting purposes, leases have historically been categorized as either (i) finance leases; or (ii) and operating leases. Although the UAE has no current corporate tax regime, accounting treatment will usually play an important role in the ‘lease-buy’ decision in the UAE.
There has been relatively little legal commentary to date on the Law. However, it can be of no coincidence that the Law came into effect just a few days before key changes to accounting rules for both lessees and lessors came into effect on 1 January 2019 (specifically IRS16).
In addition, the requirement to regulate finance lease providers and to register concluded finance lease contracts brings into play an additional area of regulation to a sector which, until now, has gone largely unregulated in the UAE.
Why is accounting treatment important?
The main purpose behind preparing financial statements of a company (and the accounting rules and statements of practice that are applied in doing so) is to show a true and fair view of its financial position. Accounting treatment will often reflect the company’s legal position (including asset ownership).
A finance lease is structured so that the lessee has all of the risks and rewards associated with asset ownership (even though he does not have legal title). As the ‘economic owner’ of the asset, the lessee’s balance sheet will show the capitalized value of the rental payments (on the liability side) and value of the asset itself (on the assets side) – ‘on-balance-sheet’ financing.
In contrast, the operating lease is typically of shorter duration (less than the useful life of the asset). The lessor (and not the lessee) takes on the main risks and rewards associated with ownership – for example, the obligation to maintain and insure. After the lease period comes to an end, the lessor can then re-lease the asset (and therefore takes on any ‘residual value’ risk associated with such exercise). Accounting treatment has historically allowed the rental payments to be shown as a current liability in the balance sheet – ‘off-balance sheet’ financing.
Whilst this distinction is maintained for lessors, the distinction between operating and finance leases is now eliminated for lessees under the new accounting rules referred to above. Subject to a few exceptions (short term leases, leases of low value and leases of certain asset types), all lease transactions must now be brought ‘on-balance sheet of the lessee, based on a ‘right-to-use’ model (rather than the historical ‘risk and reward’ model).
The practical implications for lessees will be that balance sheets will grow because of the need to record transactions on (and not off) the balance sheet. Consequently, financial covenants in loan and credit agreements (gearing ratios, interest cover, cash-flow covenants and the like) may be affected, as well as credit ratings and borrowing costs. Existing borrowers may be faced with a renegotiation of their borrowing covenants.
Legal issues
Finance leasing potentially offers other advantages over a conventional secured lending arrangement.
Some examples:
- To enhance the prospect of recovery of the asset in a default situation – for example, to avoid the inconvenience of a public auction on enforcement.
- To avoid restrictions on the creation of additional security (negative pledge) often contained in bank financing documents.
- To confer a better priority against a subsequent purchaser of the asset if sold by the buyer/lessee to a third party acting in good faith.
- Less formality than that associated with creating and perfecting a mortgage security.
Practical scope and application of the Law
It should not be assumed that the Law has general application to all lessors and lessees entering into finance lease contracts in the UAE. The conflict of law provisions contained in the UAE Civil Code must first be considered in order to determine whether the Law has application (noting that such laws differentiate between rights and obligations which concern the ownership of an asset (Lex situs) and those which deal with the governing law of a contract (such as a finance lease) which concern the ownership, use and possession of an asset). The nature of asset under lease (as a moveable or immovable item) may also be relevant. These conflict of law rules must first be fully understood in order to decide the circumstances in which the Law may (or may not) apply.
Where the Law applies, what does the Law aim to achieve?
- Features of a Finance Lease
Where the Law applies, it regulates the formation rights and obligations of the parties arising under a finance lease. The lessee generally has the option to own the Leased Property or to return the Leased Property to the lessor (without exercising the option). The key feature is the right to purchase. The definition would therefore cover a hire-purchase agreement (a lease coupled with an option which allows the lessee to purchase the asset at the end of the agreed lease period or earlier if all of the rental payments have been made) and, it would appear, a sale and leaseback arrangement as well as certain Islamic finance lease structures such as ijaza (lease with ownership). A sale and leaseback in particular may nonetheless still be open to objection as a form of secured lending arrangement under UAE law.
- Assets
Leased Property includes both real and personal property. Real property in this context includes land (as well as buildings and any plant and equipment attached to the land). Land on its own has an indefinite economic life so the accounting treatment is usually different from buildings and plants.
- Contracts
- Under the Law, any contract (i) concluded with a lessor who is not licensed by the UAE Central Bank; or (ii) is not in writing and registered or annotated in its applicable register will be deemed null and void. The UAE Central Bank will issue separate regulations to deal.
- Anyone engaging in a finance lease activity prior to the issuance of the Law is required to comply with the provisions of the Law within a year from its entry into force. Previously concluded contracts are also required to be registered or annotated in the relevant registers (see below) within one year from the effective date of the new Law.
The requirement of the lessor to be licensed in the UAE will depend upon a number of factors, including, for example, where the finance contract is concluded and the residency status of the lessor and the lessee (noting that the activity of finance leasing itself must be carried out in the UAE for it to amount to a regulated activity in the UAE).
- Registration of Contracts
- A register for registering a lease contract of movable property will be created by a resolution of the Cabinet, specifying the body responsible for managing the register and the data to be included. This will be a separate register to that currently in use under the Movable Property Law (which caters for the registration of mortgage security over movable assets).
- An annotation of a lease contract for real property is to be made with the Land Registry in each Emirate.
- Registration or annotation of a contract of any Special Movable is to be made in the register available for such purpose with the competent body in each Emirate. Special Movables are those which require registration in special registers – for example, aircrafts and ships.
Registration makes a finance lease binding against third parties. It will also preserve priority against competing creditors. The obligation to register lies with the lessor (and not the buyer/lessee).
It is unclear how existing registers will make the distinction between registration of a security interest over an asset and a title financing registration (which has a different legal structure).
The requirement for registration is presumably driven by the need to deal with issues of ‘false wealth.’ A lessee may have use and possession of many assets but may never own any of them. If creditors cannot properly distinguish between ownership and use, they may be more inclined to give extra credit based on apparent ownership. Registration largely eliminates this risk.
- Right and Obligations
The Law sets out the respective rights and obligations of both lessor and lessee under a finance lease (and therefore the risks and rewards associated with ownership and also use and possession of the Leased Property). These provisions may, however, be modified where the parties agree. It may be expected that such rights and obligations will be allocated in a manner which closely reflects the ‘right-to-use’ accounting model (from the lessee’s perspective) and the ‘risk and reward’ model (from the lessor’s perspective).
Lessee
- The lessee may, prior to the conclusion of the contract and with the prior written approval of the lessor, nominate the supplier and negotiate the specification of the Leased Property.
- The lessee, once in possession of the Leased Property, must then ensure that it uses the Leased Property in accordance with its intended purpose, keeps and maintains the Leased Property in the same condition as received, pays all financial costs imposed on the Leased Property to the concerned relevant government bodies and renews all annual licenses of the Leased Property, if and when required.
- The lessee will be liable to the lessor for any damage incurred by the lessor or third party as a result of its possession or use of the Leased Property.
Lessor
- Throughout the term of the contract, the lessor has the right to inspect the Leased Property, and to recover possession if the lessee is in breach of any of its obligations under the contract.
- The lessor is required to insure the Leased Property, notify the supplier of the Leased Property of its intention to lease to the lessee and must convey the Leased Property to the lessee if it exercises the option of ownership under the contract.
- Termination
The grounds for default termination are set out in Law and apply to both lessor and to lessee. Although these cannot be modified or amended, the parties are free to add other grounds for termination where they so wish.
The Law refers to ‘Special Accounting Standards’ which are to be determined by further Ministerial Resolution. It’s anticipated that these Standards (when published) will deal with calculation of termination payments on breach (as liquidated damages).
- Other provisions
There are other provisions common to both lessor and lessee dealing with assignment of rights and obligations, remedies on default, seller liabilities, effect of bankruptcy and liquidation, sub-leasing and sale to third parties.
Other aspects of finance leasing such as the manner in which supplier warranties may be conferred on lessee or lessor are mentioned but not fully developed.
Summary
The Law governs many legal aspects of finance leasing which in many other countries remain relatively free from legal regulation.
However, it’s crucial to first understand the circumstances in which the Law may (or may not) have effect. To do this, it’s necessary to have a thorough knowledge and understanding of the laws which determine issues concerning rights of ownership, and the governing law of contracts concerning rights of ownership, use and possession of both moveable and immovable property which are set out in other UAE laws. Once these have been considered, the parties can then decide whether the Law applies to their lease contract and what changes they may wish to make to its contractual provisions, within the boundaries set out in the Law.
