‘Lease Loopholes’ in DAP 2020: Need for a Relook

The recent arrangement enabling lease of military equipment by the Indian armed forces, as against the ‘buy’ option, requires a closer re-examination

Opinion

By Cdr Raghvendra Chaturvedi (Retd)

The new Defence Acquisition Procedure (DAP) released in September 2020, while continuing with the focus on indigenisation, added piquancy to the tale by including “Leasing” as a mode of induction of military equipment. Indian defence forces as an antecedent have relied on the purchase option to acquire military equipment, having the ownership right of all equipment inducted. There were some rare exceptions like the lease of Akula class (INS Chakra) nuclear submarine from Russia; however, these were one-off exceptions mainly for strategic reasons and processed on a case-to-case basis via the Government-to-Government (G2G) agreements.

A lease is a hire-purchase agreement, which allows the lessee (user) to use the asset (like property, equipment and vehicle) in return for regular rental payments to the lessor (owner). The lessee may or may not buy the asset after completion of the lease term.

The arrangement has been a standard mode of acquiring expensive equipment in the non-military acquisition, which allowed companies to reduce the risk of obsolescence, manage their cash flow, keep maintenance costs low, and accrue tax benefits.

Leasing arrangements in defence acquisition date back to the Second World War, wherein US Navy contracted merchant ships to support the war efforts. The US armed forces and western European countries, thereafter, have been sporadically utilising lease options to bridge their capability gaps, mainly on account of shirking defence budgets and the ever-increasing cost of defence equipment, which precluded outright purchase.

The inclusion of leasing is defining, as now it allows a back-door entry to foreign-made equipment in the Indian armed forces, which had been next to impossible without tangible and quantifiable technology transfer

The inclusion of the “Lease” option in defence purchases by India, thus, was a logical turn, with the languid pace of indigenisation, unrelenting red-tape, almost fixed capital outlays and ‘Atmanirbhar’ focus; armed forces had long-pending critical capability gaps and no patience.

While not creating much flutter in the Indian defence industry, the inclusion has created much interest among the foreign OEMs, similar to what the Offset regulations did when first included in 2005. The inclusion of leasing is defining, as now it allows a back-door entry to foreign-made equipment in the Indian armed forces, which had been next to impossible without tangible and quantifiable technology transfer.

Another reason for the euphoria among the foreign OEMs is that the regulations themselves are elemental and with Indian armed forces having nil experience in handling complex lease agreements, allows them to make huge profits.

By the time the Ministry of Defence corrects itself and gains experience in this complex trade arrangement, the horse would have bolted, repeating the Offset story once again.

Lease agreements are intricate agreements at all stages—processing, contracting and monitoring. Therefore, the lessor endeavour is to make a well-informed decision, factoring in cost-benefit and cost-effectiveness of the decision over time.

Net Present Value (NPV) is a highly critical criterion used to decide if any leasing programme is justified economically. Defined as the difference between the present value of cash inflows and the present value of cash outflows over a defined period, NPV is estimated by calculating future benefits and costs using an appropriate discount rate.

As a common rule, proposals with positive NPV are generally acceptable, while those with negative NPV rejected.

Another reason for the euphoria among the foreign OEMs is that the regulations themselves are elemental and with Indian armed forces having nil experience in handling complex lease agreements, allows them to make huge profits

Another vital factor in lease decision is the Cost-Effectiveness analysis of the proposal, which compares the relative costs to the outcomes of two or more courses of action based on life cycle cost analysis, expressed in present value terms; buy or lease in this case.

Highlighting the importance of the analysis, the US government Office of Management of Budget lays down that in the case of operating leases, the present value of payments over the life of the lease should not exceed 90 percent of the fair market value of the asset at the beginning of the lease term.

Any lease case should be justified as a preferred decision against a buy decision, not only on account of urgency but a detailed analysis indicating an advantageous option to the government, accruing maximum benefit and least cost.

Important factors considered while deciding any lease include—life cycle cost, economic life, purchase price, taxes and tax benefits to the lessee, insurance, residual value of asset and renewal options.

In addition to financial analysis, managing technology obsolescence has become a critical component of any lease owing to the rapid pace at which technology is changing. Therefore, the leased asset would require regular technology updates and upgrades over its expected long lease term; If not specified in the lease agreement, these items would be the responsibility of the lessee—MoD, in this case—resulting in expensive recurring payments.

Financial accounting of the impact of a lease is something which experienced lessors are well aware of, specifically those related to tax benefits. The lessor claims tax savings from depreciation, which is mainly to an accelerated rate. For example, in the early 1980s, the US Navy leased five transport tankers for the Military Sealift Command Program for 25 years with a purchase option at the end of the lease term. The arrangement allowed the owners of the ship special tax benefits, which included accelerated depreciation of the cost and deductions of the ship on interest payments that lowered the taxes to the owner.

In addition, large lease contracts, like what is being contemplated by Indian armed forces (helicopters and air-to-air refuelling aircraft), are generally open contracts wherein the lessor/owner opens its books to the audit of the lessee. Post agreed profits, any excess gains to the lessor are shared between the lessee and lessor or used to reduce lessee payments.

Present regulations, fall short on many accounts especially those related to NPV and its calculations, the tax benefit to the lessor, audit of books, equitable adjustment clause, cost-effectiveness etc

Inclusion of the non-equitable adjustment clause further protects the lessee from any price reduction by the lessor/OEM of the asset to any other customer, during the course of the lease term.

Lease contracts are peculiar since they do not involve any advance payment. Any advance payments in a lease are made only to cover the cost of special features (if so added); unlike a buy contract wherein the manufacturer has to order raw material and place suborders to start the production line, the asset in a lease contract is readily available. Therefore, payment more than what is required, like 15 percent as stipulated in DAP 2020, is nothing but an icing on the cake for the lessor/owner.

DAP 2020, while describing lease contracts and situations where it would be applicable, is silent about the justification and analysis of such proposals. Leasing in defence acquisition especially involving foreign manufacturers is big and complex decisions and should include careful and deliberate analysis involving a multitude of factors.

Present regulations, fall short on many accounts especially those related to NPV and its calculations, the tax benefit to the lessor, audit of books, equitable adjustment clause, cost-effectiveness etc. Therefore, the MoD should re-examine the entire lease chapter of DAP in consultation with experts in this field, including the Ministry of Finance and equip the proposing agencies (the service HQ in this case) with tools to arrive at a decision judiciously and with financial prudence.

– The writer is voluntarily retired from active service after more than 21 years of commissioned service. He is an alumnus of Naval Academy (first course 10+2 X) and Defense Services Staff College and a specialist in Anti-Submarine Warfare. Presently, he is pursuing PhD in Defense Industrialization and Exports (India) from Indian Institute of Foreign Trade (IIFT). New Delhi. The views expressed are personal and do not necessarily reflect the views of Raksha Anirveda.

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