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AVIATION LEASING AND FINANCING: AN OVERVIEW
Hamsathul Haris K
New aircraft are the lifeblood of a growing industry intent on delivering improvements in reliability, environmental performance and fuel efficiency. Some 12,000 new aircraft are scheduled to be delivered through 2020. They are expensive machines that represent an investment of $1.3 trillion. For an industry that has averaged a loss of $5 billion a year over the past decade, paying for those aircraft is a considerable undertaking. An airline looking to obtain a new aircraft has a number of options, but each one comes with its challenges. Whether buying an aircraft directly through a secured loan or using one of a variety of leasing opportunities, airlines need to find the right financing vehicle for their business model. Long waiting periods for acquiring new aircrafts further makes it an unattractive proposition for airline operators to buy aircrafts. Therefore, it is a common practice in the airline business to take aircrafts on lease.
Leasing not only helps in increasing the fleet size at a fairly quick rate but also, and more importantly, reduces the cost of airline operators. There are different types of leases depending on the terms and conditions of the agreement. Driven by operating and cost efficiencies, many airlines acquire new aircraft through leasing rather than shoulder the burden of direct purchase. Increasingly, as airlines consolidate, grow larger and focus on core competencies, there has been an ever-deepening trend toward leasing, even within the world’s largest airlines.
Aircraft leasing is a significant portion of the financing and accounting of airline companies in terms of both the size of capital and the complexity of lease classification. Due to its capital intensive nature most airlines depend on external resources for aircraft purchasing. Leasing is an important tool used by airlines to take delivery of aircraft, especially when facing financial distress. In this regard lease classification and the related accounting treatments are critical to the airline and the industry.
In India, like across the world, aircraft leasing is quite prevalent. There is an entire gamut of legislations, viz. Directorate General of Civil Aviation (“DGCA”), the Reserve Bank of India, Income Tax regulations, which lessors and lessees have to consider in an aircraft leasing transaction in India.
There are a number of types of leases used by airlines and other aircraft operators. Airlines lease aircraft from other airlines or leasing companies for two main reasons; to operate aircraft without the financial burden of buying them, and to provide temporary increase in capacity. The industry has two main leasing types, wet leasing which is normally used for short term leasing and dry leasing which is more normal for the longer term leases. The industry also uses combinations of wet and dry when for example the aircraft is wet-leased to establish new services then as the airlines flight or cabin crews become trained they can be switched to a dry lease.
2.1 WET LEASE
A wet lease is a leasing arrangement whereby one airline (lessor) provides an aircraft, complete crew, maintenance, and insurance (ACMI) to an airline [or other type of business acting as a broker of air travel] (the lessee), which pays by hours operated. The lessee provides fuel and covers airport fees, and any other duties, taxes, etc. The flight uses the flight number of the lessee. A wet lease generally lasts one month to two years; anything less would be considered an ad-hoc charter. A wet lease is typically utilized during peak traffic seasons or annual heavy maintenance checks, or to initiate new routes. A wet leased aircraft may be used to fly services into countries where the lessee is banned from operating.
They can also be considered as a form of charter whereby the lessor provides minimum operating services, including ACMI, and the lessee provides the balance of services along with flight numbers. In all other forms of charter, the lessor provides the flight numbers. Variations of a wet lease include a code share arrangement and a block seat agreement. Wet leases are occasionally used for political reasons; for instance, Egypt Air, an Egyptian government enterprise, cannot fly to Israel under its own name, as a matter of Egyptian government policy. Therefore, Egyptian flights from Cairo to Tel Aviv are operated by Air Sinai, which wet-leases from Egypt Air to get around the political issue. In the United Kingdom, a wet lease is when an aircraft is operated under the Air Operator's Certificate (AOC) of the lessor. When an air carrier provides less than an entire aircraft crew, the wet lease occasionally is also sometimes referred to as a damp lease, especially in the UK. A wet lease without crew is occasionally referred to as a "moist lease".
2.2 DRY LEASE:
A dry lease is a leasing arrangement whereby an aircraft financing entity, such as GECAS and ILFC (lessor), provides an aircraft without insurance, crew, ground staff, supporting equipment, maintenance, etc. Dry lease is typically used by leasing companies and banks, requiring the lessee to put the aircraft on its own AOC and provide aircraft registration. A typical dry lease starts from two years onwards and bears certain conditions with respect to depreciation, maintenance, insurances, etc., depending also on the geographical location, political circumstances, etc. A dry lease arrangement can also be used by a major airline and a regional operator, in which the regional operator provides flight crews, maintenance and other operational aspects of the aircraft, which then may be operated under the major airline's name or some similar name. This saves the major airline the expense of training personnel to fly and maintain the aircraft, along with other considerations. FedEx Express uses an arrangement of this type for its feeder operations, contracting to companies such as Empire Airlines, Mountain Air Cargo, and others to operate its single and twin-engined turbo-prop "feeder" aircraft. DHL has a joint venture in the United States with Polar Air Cargo, a subsidiary of Atlas Air, to operate their domestic deliveries.
Aircraft finance refers to financing for the purchase and operation of aircraft. Complex aircraft finance (such as those schemes employed by airlines) shares many characteristics with maritime finance, and to a lesser extent with project finance. Aircraft are expensive. A Boeing 737-700, is priced in 2008 USD in the range of $58.5 - $69.5 million (although very few airlines actually pay this much). Airlines also typically have low margins so very few airlines can afford to pay cash for all their fleet. Commercial aircraft, such as those operated by airlines, use more sophisticated leases and debt financing schemes. The three most common schemes for financing commercial aircraft are secured lending, operating leasing and finance leasing. However, there are other ways to pay for the aircraft:
2. Operating leasing and sale/leasebacks
3. Bank loans/finance leases
4. Export credit guaranteed loans
5. Tax leases
6. Manufacturer support
These schemes are primarily distinguished by tax and accounting considerations, particularly tax-deductible depreciation, interest and operating costs which can reduce tax liability for the operator, lessor and financier.
3.1 DIRECT LENDING
An airline may simply take out a secured or unsecured loan to buy a commercial aircraft. In such large transactions, a syndicate of banks may collectively provide a loan to the borrower. Because the cost of a commercial aircraft may be hundreds of millions of dollars, most direct lending for aircraft purchases is accompanied by a security interest in the aircraft, so that the aircraft may be repossessed in event of nonpayment. It is generally very difficult for borrowers to obtain affordable private unsecured financing of an aircraft purchase, unless the borrower is deemed particularly creditworthy (e.g. an established carrier with high equity and a steady cash flow). However, certain governments finance the export of domestically-produced aircraft through the Large Aircraft Sector Understanding (LASU). This interstate agreement provides for financing of aircraft purchases at 120 to 175 points over prime rate for terms of 10 to 12 years, and the option to "lock in" an interest rate up to three months prior to taking out the loan. These terms are often less attractive for larger operators, which can obtain aircraft less expensively through other financing methods. By directly owning their aircraft, airlines may deduct depreciation costs for tax purposes, or spread out depreciation costs to improve their bottom line. For instance, in 1992, Lufthansa adjusted its accounting to depreciate aircraft over 12 years instead of 10 years; the resulting drop in depreciation "expenses" caused the company's reported profits to rise by DM392 million. JAL made a similar adjustment in 1993, causing the company's profits to rise by ¥29.6 million. On the other hand, prior to the advent of commercial aircraft leasing in the 1980s, privately-owned airlines were highly vulnerable to market fluctuations due to their need to assume high levels of debt in order to purchase new equipment; leases offer additional flexibility in this area, and have made airlines increasingly less sensitive to cost and revenue fluctuations, although some sensitivity still exists.
3.2 OPERATING LEASING
Commercial aircraft are often leased through a Commercial Aircraft Sales and Leasing (CASL) company, the two largest of which are International Lease Finance Corporation (ILFC) and GE Commercial Aviation Services (GECAS). Operating leases are generally short-term (less than 10 years in duration), making them attractive when aircraft are needed for a start-up venture, or for the tentative expansion of an established carrier. The short duration of an operating lease also protects against aircraft obsolescence, an important consideration in many countries due to changing noise and environmental laws. In some countries where airlines may be deemed less creditworthy (e.g. the former Soviet Union), operating leases may be the only way for an airline to acquire aircraft. Moreover, it provides the flexilibility to the airlines so that they can manage fleet size and composition as closely as possible, expanding and contracting to match demand.
Conversely, the aircraft's residual value at the end of the lease is an important consideration for the owner. The owner may require that the aircraft be returned in the same maintenance condition (e.g. post-C check) as it was delivered, so as to expedite turnaround to the next operator. Like leases in other fields, a security deposit is often required. One particular type of operating lease is the wet lease, in which the aircraft is leased together with its crew. Such leases are generally on a short-term basis to cover bursts in demand, such as the Hajj pilgrimage. Unlike a charter flight, a wet-leased aircraft operates as part of the leasing carrier's fleet and with that carrier's airline code, although it often retains the livery of its owner. US and UK accounting rules differ regarding operating leases. In the UK, some operating lease expenses can be capitalized on the company's balance sheet; in the US, operating lease expenses are generally reported as operating expenses, similarly to fuel or wages. A related concept to the operating lease is the leaseback, in which the operator sells its own aircraft for cash, and then leases the same aircraft back from the purchaser for a periodic payment. The operating lease can affords the airlines flexible to change the fleet size, and created a burden to the leasing companies.
3.3 FINANCE LEASING
Finance leasing, also known as "capital leasing," is a longer-term arrangement in which the operator comes closer to effectively "owning" the aircraft. It involves a more complicated transaction in which a lessor, often a special purpose company (SPC) or partnership, purchases the aircraft through a combination of debt and equity financing, and then leases it to the operator. The operator may have the option to purchase the aircraft at the expiration of the lease, or may automatically receive the aircraft at the expiration of the lease. Under American and British accounting rules, a finance lease is generally defined as one in which the lessor receives substantially all rights of ownership, or in which the present value of the minimum lease payments for the duration of the lease exceeds 90% of the fair market value of the aircraft. If a lease is defined as a finance lease, it must be counted as an asset of the company, in contrast to an operating lease which only impacts the company's cash flow.
Finance leasing is attractive to the lessee because the lessee may claim depreciation deductions over the aircraft's useful life, which offset the profits from the lease for tax purposes, and deduct interest paid to those creditors who financed the purchase. This has made aircraft a popular form of tax shelter for investors, and has also made finance leasing a cheaper alternative to operating leases or secured purchasing for many operators. The various forms of finance leasing include:
3.4 EQUIPMENT TRUST CERTIFICATE (ETC):
Most commonly used in North America. A trust of investors purchases the aircraft and then "leases" it to the operator, on condition that the airline will receive title upon full performance of the lease. ETCs blur the line between finance leasing and secured lending, and in their most recent forms have begun to resemble securitization arrangements.
3.5 EXTENDABLE OPERATING LEASE:
Although an EOL resembles a finance lease, the lessee generally has the option to terminate the lease at specified points (e.g. every three years); thus, the lease can also be conceptualized as an operating lease. Whether EOLs qualify as operating leases depends on the timing of the termination right and the accounting rules applicable to the companies.
3.6 US LEVERAGED LEASE:
Used by foreign airlines importing aircraft from the United States. In a US lease, a Foreign Sales Corporation (FSC) purchases and leases the aircraft, and is tax-exempt so long as at least 50% of the aircraft is made in the US, and at least 50% of its flight miles are flown outside the US. Because of the extensive documentation required for these leases, they have only been used for very expensive aircraft being operated entirely outside the US, such as Boeing 747s purchased for domestic routes within Japan.
3.7 JAPANESE LEVERAGED LEASE:
A JLL requires the establishment of a special purpose company to acquire the aircraft, and at least 20% of the equity in the company must be held by Japanese nationals. Wide body aircraft are leased for 12 years, while narrow body aircraft are leased for 10 years. Under a JLL, the airline receives tax deductions in its home country, and the Japanese investors are exempt from taxation on their investment. JLLs were encouraged in the early 1990s as a form of re-exporting currency generated by Japan's trade surplus.
3.8 HONG KONG LEVERAGED LEASE:
In Hong Kong, where income taxes are low in comparison to other countries, leveraged leasing to local operators is common. In such transactions, a locally-incorporated lessor acquires an aircraft through a combination of non-recourse debt, recourse debt and equity (generally in a 49-16-35 proportion), and thus be able to claim depreciation allowances despite only being liable for half of the purchase price. Its high tax losses can then be set off against profits from leasing the aircraft to a local carrier. Due to local tax laws, these investments are set up as general partnerships, in which the investors' liability is mainly limited by insurance and by contract with the operator.
One of the fundamental principles of the Convention on International Civil Aviation (the Convention) is that the aircraft have the nationality of the State in which they are registered. Therefore, each contracting State is responsible for ensuring that the aircraft on its civil register follow its laws and regulations in certain respects, especially airworthiness, even if the aircraft is operated outside its territory. However, with the growing trend in aircraft leasing, the operational bases of aircraft sometimes transcend national boundaries and it becomes difficult for the State of Registry to exercise the desired control over its aircraft. In order to address this concern and to ensure that adequate regulatory control is exercised over aircraft, the Convention was amended to incorporate Article 83 bis therein. Article 83 bis provides that when an aircraft registered in a contracting State is operated pursuant to an agreement for the lease, charter or interchange of the aircraft or any similar arrangement by an operator who has his principal place of business or, if he has no such place of business, his permanent residence in another contracting State, the State of Registry may, by agreement with such other State, transfer to it all or part of its functions and duties as State of Registry in respect of that aircraft. It is noteworthy that Article 83 bis is only an enabling provision which provides full flexibility to the contracting States to transfer all or any of the functions envisaged therein. It also establishes that agreements for the transfer of certain oversight functions from the State of Registry to the State of the Operator shall be recognized by all other Contracting States which have ratified Article 83 bis. India has ratified Article 83 bis and is among more than 150 countries who have done so. Accordingly, the relevant provisions of the Aircraft Rules, 1937 have been amended whereby certain rules shall apply to a foreign registered aircraft or shall not apply to an Indian registered aircraft, depending upon the terms of the agreement between the Government of India and the State of Registry or the State of the Operator, as the case may be, for transfer of certain oversight functions.
4.1 FOREIGN REGISTERED AIRCRAFT LEASED TO INDIAN OPERATOR
In case an Indian operator intends to take a foreign registered aircraft on lease, charter or any similar arrangement from a person holding AOC issued by another contracting State, it shall provide the following information to DGCA at least 45 days prior to the proposed date of operation with leased aircraft, namely:-
Д. Ю. Пискулов. Теория и практика валютного дилинга. (Foreign Exchange and Money Market Operations). Прикладное пособие.— М