Sep 14, 2015


With Government’s intervention and investment in the Nigerian aviation sector through, among others, the ongoing rehabilitation works at different airports, improvement of navigational facilities, planned floating of a national carrier, provision of airline intervention fund to domestic operators through the Bank of Industry, the Nigerian aviation sector has considerably regained public confidence. Demand for domestic air travels and patronage of Nigeria airlines operating regional and international routes is on the increase. To take advantage of the upsurge, several airline operators are taking steps to increase their fleets and expand their operations and in some cases, cater for new regional and international routes. In view of the prohibitive cost of aircraft acquisition however, practically all the operators are turning to one lease instrument or another. The most common lease options in acquiring an aircraft are operating lease and finance lease.
Of major importance in the choice of lease options by airline operators are tax obligations and benefits. Under the Companies Income Tax Act, Cap C21, Laws of the Federation of Nigeria 2005 (“CITA”), these two types of lease attract different tax incidences in relation to Capital allowance, Withholding Tax, Value Added Tax, Capital Gains Tax etc. The considerations for the choice of lease option by operators however do not change the concerns of Lessor and financiers, mostly foreign aircraft manufacturers, leasing companies and operators whose due diligence and security requirements are usually detailed and wide-ranging.

Lessors’ security requirements and documentation often depend on the structure and dynamics of the lease arrangement and may include Billing System Payment Account Charge, Deregistration Power of Attorney, Irrevocable Deregistration and Export Request Authorisation, Intercreditor Agreement, Assignment of Receivables Agreement, Flight/Aircraft Services Agreement, Engine Warranty Agreement, Airframe Warranty Agreement, Assignment of Insurances, Assignment of Reinsurances etc. However, the due diligence concerns and requirements of Lessors are often the same. Understanding and addressing these concerns and requirements is, from our experience, as important to a seamless lease arrangement as meeting Lessors security requirements.
In this edition, PUC Quarterly highlights the differences between an operating and a finance lease, details the tax regimes applicable to each lease instrument and identifies some of the major queries of Lessor.
Operating Lease or Finance Lease: Understanding the difference
One of the major attractions in operating leases is that they are traditionally for a short-term, usually less than 10 years, although the lifespan of the lease may not be known at the beginning.

The Lessor retains ownership of the aircraft as well as the risks, obligations and benefits associated with ownership in addition to the lease rental that the Lessor receives. The lease may become cancelled or renewed as may become necessary. More importantly, the Lessor is under the obligation to pay such cost as insurance, maintenance and similar charges on the aircraft in addition to his warranties as to the condition and fitness of the aircraft. If the aircraft is lost, rentals cease and the Lessor becomes entitled to payment of the insurance under its policies.

The short duration of an operating lease offers the operator flexibility in the management of fleet size and composition enabling the operator to increase or decrease the number of aircrafts in its fleet over a period of time as it business demands. The Lessee is also able to manage aircraft obsolescence and the dangers associated therewith by keeping only relatively new aircraft in its fleet. On the downside, the Lessor may incur considerable expenses maintaining the aircraft on the Lessor’s stringent terms due to the latter’s interest in ensuring that residual value of the aircraft is not depleted by requiring that the aircraft be returned in almost the same condition as its condition at delivery.
A finance lease on the other hand usually has a longer lifespan. A distinctive feature of a finance lease which ought to attract any Lessee’s interest is that the risks and rewards of ownership are transferred to the Lessee from the commencement of the lease. The Lessee pays cost associated with the lease such as insurance, maintenance and other charges on the aircraft in addition to periodic lease rentals. The primary term of the lease is sufficient to allow the Lessor to recover rentals equal to the capital cost plus an amount equal to interest often over the useful life of the aircraft and thereafter the Lessee may retain ownership of the aircraft at nominal rate.
In a finance lease, the Lessee is almost the “owner” of the aircraft. If the aircraft is sold on a Lessee default, the Lessee may receive any surplus by way of a rebate of rentals. The Lessee however takes the asset “as is” without warranties as to condition or fitness from the Lessor, it must maintain the aircraft, insure it and must continue to pay the Lessor the full rentals, even if the aircraft is damaged or requisitioned, subject to a right to terminate on payment of all the unrecovered capital, usually out of insurance or requisition proceeds payable to the Lessee.
Tax Considerations

Operating Lease under the CITA, the total lease rental received or receivable by the Lessor is income and is wholly taxable in accordance with paragraph 18 (1)(b), 2nd Schedule, CITA. The Lessor is entitled to claim capital allowance on the leased assets. The Lessor is however liable to Withholding Tax (WHT) at 10% of the total rental income due on the lease, computed on the total lease rental must be deducted from the sums due from the Lessee. Lessors resident in countries having tax treaties with Nigeria e.g. Belgium, France, Canada etc, pay WHT at the rate of 7.5%. The lease rental income is also liable to VAT. The Lessor may include a 5% VAT charge on its invoice to the Lessee.

In favour of the Lessee, the lease rental charges and other associated expenses are allowable deductions for tax purposes. The VAT charged by the Lessor on the lease rental charge is not an input tax to the Lessee; it is to be charged to the Profit and Loss Account as an advance payment of tax. However, notwithstanding that the Lessor might have passed the burden unto the Lessee, the Lessee is liable to withhold tax at the rate of 10% of the rental payment to the Lessor to the relevant tax authority. 

Finance Lease in a finance lease, the interest portion of the rent earned by the Lessor constitutes taxable income; the capital portion is a repayment of initial investment and has no tax implications. The Lessor is however not entitled to claim capital allowances on the leased asset; only the Lessee is entitled to make such claims - Paragraph 18 (2) of the 2nd Schedule to CITA. If the aircraft is disposed at the expiration of the lease period, any capital gain realised by the Lessor would be subject to CGT.

WHT is computed only on the interest portion of the total lease payment due from the Lessee. The Lessor will receive lease rent less 10% WHT unless there is tax treaty between Nigeria and the Lessor’s country in which case, WHT is 7.5%. The credit note will be issued in the name of the Lessor who can use it to offset its income tax liability for the relevant period. However, interest earned by the Lessor on finance lease is a return on investment and is not liable to VAT.
To the Lessee’s benefit, the interest portion of the periodic lease rent and other related expenses such as insurance and maintenance cost are deductible expenses for income tax purposes. The Lessee is entitled to claim capital allowance on capital portion of the value of the aircraft. The Lessor however bears liability for remittance of the WHT on the interest portion of the lease rental even where it is prevented from deducting WHT by gross up provisions in the lease agreement. The Lessee may however be liable to CGT if the leased asset was sold by him after exercising the purchase option.

Lessors’ Queries
Tax liabilities under Nigerian law are however not a Lessor’s most important consideration as the Lessor can conveniently pass on the entire tax burden to the Lessee by tax gross up provisions in the lease agreement which may simply require that if the Lessee is required by law to make a tax deduction, the amount of the payment due from the Lessor shall be increased to an amount which (after making the tax deduction) leaves an amount equal to the payment which would have been due if no tax deduction had been required. The Lessor’s more serious concerns relate to repossession, security of rentals, reversional interest and the residual value of the aircraft, validity and enforceability of agreements, etc. In practice, the prospective Lessee approaches an aviation leasing company. After preliminary negotiation, the Lessor and Lessee together with the aircraft owner (if there exist one in this instance) would execute a Lease Agreement among other documentation. Before the execution of these documents and particularly at the negotiation stage, the Lessor will usually contact a Nigerian law firm on some certain areas of concern arising in the lease. These concerns categorised into broad areas are but not limited to:

The Lessor will like to know if Nigeria has ratified any of the conventions bordering on aircraft transportation. Of paramount importance to the Lessor are conventions that grant security on operation of the aircraft as well as repossession of the aircraft in the event that there is a default or termination of lease. Such conventions include the Chicago Convention of 1944 on Internatinal Civil Aviation, the 1948 Geneva Convention on the International Recognition of Rights in Aircraft, the 1933 Convention for the Unification of Certain Rules Relating to the Precautionary Arrest of Aircrafts and more particularly, the 2001 Cape Town Convention on the International Interest in Mobile Equipment and the associated protocols on matters specific to aircraft equipment. Not only will the Lessor be interested on the ratification of these conventions and the associated Protocols but the extent to which they have been enforced or made applicable in the jurisdiction e.g. the extent to which Nigeria has derogated from the Cape Town Convention and the associated Protocol on Matters Specific to Aircraft Equipment (“the Protocol”), the relevant articles of the convention and the Protocol in respect of which Nigeria has made declarations, the relevant applicable law in Nigeria to ensure an effective registration under the Cape Town Convention and the Protocol etc.

Forum and Judgment Enforcement

Closely related to this will be issues dealing with choice of law of the parties and whether same will be respected by the Nigerian courts and whether any judgment of the forum court against the Lessee would be recognised and enforced by the courts in Nigeria without retrial on the merit. Of particular importance in this regard, is whether there is any reciprocity for enforcement of judgments between the chosen forum and Nigeria and the procedure and possible timeline for the recognition and enforcement of such judgments.

Filings and Registration

The Lessor is concerned in this instance in knowing the necessary filings and registrations that is needed to perfect the Lessor/Owners title in Nigeria and the extent to which such interest is vested in the Lessor or any other person holding security over the aircraft. What is the effect of the registration of the lease on the Lessor’s interest; would Nigerian law regard the Lessee as having beneficial interest in the aircraft by virtue of the registration and would this confer any equitable title right or interest in the aircraft. The Lessor is also interested in knowing the necessary documents that need to be filed, the agencies that are involved and the fees that are applicable. This will also cover any other form of taxation that may be payable. This also covers the pre-registration stage where technical inspection is conducted on the aircraft sought to be registered. The duration that these processes will take is also in issue.
This is the most critical area to the Lessor in the lease agreement. This aspect deals with protecting the interest of the Lessor/Owner in the aircraft in the event that there is a default of lease or its termination. The Lessor amongst other things inquires on the lease documentation and other documentations and the Lessor will want to know if stamp duties is payable on lease and if same is registrable with the relevant governmental agencies. One area that gets a large chunk is how deregistration of the aircraft is effected. The Lessor would also want to know if the interim reliefs provided in Article 13 of the Cape Town Convention are applicable. Not to be left out is the validity and applicability of the IDERA. The effect of bankruptcy and insolvency on the Lessee would also be of concern to the Lessor. At this stage also plays out the concept of Security Trustee. The Security Trustee will border more on the administration and disbursement of receivables received in respect of the lease.
Deregistration/Exportation Power of Attorney

The Lessor would be interested in any export control restrictions applicable in Nigeria and the extent of such restrictions. This would include whether a Deregistration Power of Attorney empowering the Lessor to export the aircraft from the Nigeria upon the occurrence of an event of default of by Lessee, the expiration or early termination of lease agreement would be enforceable under Nigerian law, notwithstanding that the governing law of the Power of Attorney may be a foreign law. Other concerns of the Lessor relating to the deregistration and exportation Power of Attorney include whether the occurrence, declaration of insolvency or commencement of winding-up proceedings against the Lessee would negative or invalidate the Deregistration Power of Attorney. The Lessee also wants to know if the DPOA is revocable, the circumstances where it will be revoked and if the DPOA will be recognised and enforced in the Nigerian jurisdiction. All of these are valid anxiety arising from the inherent right granted under Chapter III of the Cape Town Convention.

Liens and Repossession
The Lessor would want to know whether the non-payment by the Lessee of statutory fees and duties e.g. landing fees create a statutory lien over the aircraft which would entitle the relevant authority to take possession of the aircraft and whether this creates a concomitant liability on the Lessor to discharge such payments. In such case, whether such authority would have the right to sell the aircraft to recover whatever payment is due from the Lessee. Is the Lessor entitled to resort to self helps e.g. take physical possession of the aircraft upon the termination of the lease or must commence legal proceedings for this purpose? What would be the duration and potential cost of such legal proceedings? Would be Lessor be entitled to obtain interim order for the repossession of the aircraft?
The Lessor is concerned here on what happens to the aircraft in the event that the Lessee becomes insolvent. In specific terms, whether the commencement of insolvency proceedings automatically precludes the Lessor from repossessing the aircraft; what would be the ranking of the Lessor’s rights and interests over the aircraft vis-à-vis creditors and other persons who have claims over the Lessee’s assets; and whether a receiver or liquidator appointed in such proceedings would be bound to give effect to the lease agreement between the Lessor and Lessee including respecting the right of the Lessor to terminate the lease agreement consequent upon the commencement of the insolvency proceedings etc.
Insurance and other General Matters

The Lessor inquires if the AVN52C insurance coverage is applicable in Nigeria. The Lessor is also of concern is if the aircraft must be insured or reinsured in Nigeria alone or if same can be done outside jurisdiction and if National Insurance Commission’s approval is required. As stated earlier, the aviation business is a capital intensive venture and the Lessor would like to know if the insurance can be carried out outside the jurisdiction or whether same can be carried out partly outside jurisdiction and within jurisdiction and whether an assignment of the rights of the Lessee in the insurance taken in Nigeria would be enforceable under Nigerian law.
Other general matters that may be referred to are issues on the ability of the Lessor to sell the aircraft during the pendency of the lease, Lessor and Lessee liability in tort, if there are additional documentation required for the aircraft registration in Nigeria, repatriation of funds and aircraft engine.

The areas identified above are a non-exhaustive list of concerns that the Lessor has in leasing an aircraft to a Lessee. Ultimately, the Lessor’s concern is on realising the lease sum, ensuring the proper safety and maintenance of the aircraft as well as a cordial relationship between the Lessor and the Lessee. . If the issues identified above are put into consideration by the operators intending to take the lease option before commencement of negotiation with lessor and the lessee obtains proper advice and guidance in respect thereof, potential dispute areas would be reduced and the lease process would be seamless.

By: Olumide Oyinloye