Leasing Regulatory Framework Analysis and

Intervention Options for the PRIME Project

September 2014

Helen TedlaTeshome

Finance Consultant

E-mail:

TABLE OF CONTENTS

  1. EXECUTIVE SUMMARY……………………….……………………………………..4
  2. Scope of Work
  3. Methodology

2LEASING REGULATORY AND LEGAL FRAMEWORK..……………………..…6

2.1Leasing Overview

2.2Existing Proclamations and Directives

2.3Identified Gaps: Regulatory, Legal, and Other Gaps

2.4Planned Initiatives

3LEASING SECTOR INITIATIVES…….……………………………………………..15

3.1Government Initiated Regional Leasing Companies

3.2Private Sector Initiated Leasing Companies

3.3Outlook for Capital Goods Leasing

4POSSIBLE PRIME INTERVENTION AREAS………………………..…………....18

4.1Overview of PRIME Intervention Areas

4.1.1Oromia

4.1.2Afar

4.1.3Somali

5CONCLUSION………………………………………………………………………....24

ABBREVIATIONS

AMFIAssociation of Micro-finance Institutions

CBECommercial Bank of Ethiopia

FeMSEDAFederal Micro and Small Enterprises Development Agency

GoEGovernment of Ethiopia

GTPGrowth and Transformation Plan

IFCInternational Finance Corporation

MFIMicro-finance Institution

MoFEDMinistry of Finance and Economic Development

MoTMinistry of Trade

NBEThe National Bank of Ethiopia

OCGFCOromia Capital Goods Finance Business Share Company

PRIMEPastoralist Areas Resilience Improvement through Market Expansion

SNNPRSouthern Nations, Nationalities and People Region

TVETsTechnical and Vocational Educational Training Centers

USAIDUnited States Agency for International Development

Annex

Annex 1 Meetings Held: Contact Details

Annex 2 Capital Goods Leasing Business Proclamation (No. 103/ 1998)

Annex 3 Capital Goods Leasing Business (Amended) Proclamation (No. 807/2013)

Annex 4 Minimum Paid up Capital Requirement Directives No. CGFB/01/2013

Annex 5 Requirements for Licensing of Capital Goods Finance Business Directives

No.CGFB / 02 / 2013

Annex 6 Registration and Supervision of Capital Goods and Capital Leasing Agreements Council of Ministers Regulation (Regulation 309/2014)

Annex7 A Proclamation of Investment (No. 769/2012)

Annex 8 A Proclamation to Amend the Investment Proclamation (No. 849/ 2014)

  1. EXECUTIVE SUMMARY

The potential for the development of leasing as an alternative to lending is highin Ethiopia. Access to credit from financial institutions is challenging for many potential borrowers given limited capital and collateral, thus, leasing as an alternative financial product is attractive. There are overall 3 main types of leasing: “operational lease”, finance lease”, and “hire purchase” lease. They generally vary in ownership rights and control of asset rights as well as responsibility for maintenance, damage and insurance. Leasing serves generally all sectors and can be applied for differentsizeequipments.

The leasing sector is undeveloped; however, increasing concerted effort and commitment are demonstrated bytheNational Bank of Ethiopia (NBE) and the government for the development of the leasing sector. This is evidenced by the different actions taken over the last year, and the numerous initiatives that are underway. The regulatory framework for leasing was initially established in 1998, defining the three main types of leases: Operating, finance, and hire-purchase. But there was no leasing operation in the country other than few microfinance institutions conducting micro-leasing usually limited to small equipments to informal businesses. Various proclamations and directives necessary for the leasing sector have either been issued or are planned to be issued. In 2013, a proclamation and directives were issued that covered key elements of leasing operations – licensing and capital requirements. However, these directives by themselves were not adequate to provide the necessary framework and serve as guidance to leasing companies nor were they adequate for supervising and regulating the sector by NBE.

In mid-2014 NBE signed an agreement with the IFC for assistance in the development of Ethiopia’s leasing sector. IFC’s support to NBE focuses on improving the regulatory framework, which includes the development of various directives required to have a robust leasing sector, the development of operational manual (for NBE and leasing companies), and supervisory manual (for NBE). As part of the support to NBE, IFC identified the key gaps that exist in the leasing sector, and has planned some activities to close or minimize these gaps. Among the key gaps to be addressed are lack of capacity to supervise and regulate the leasing sector by NBE, and the lack of know-how in leasing at the leasing companies that have been recently formed by government support. Other legal and regulatory gaps identified (i.e., taxation, investment, accounting etc.) are being referred to the appropriate government agencies by NBE. A number of other gaps are discussed in this report including, lack of appropriate management information systems (MIS), lack of funding, and lack of leasing awareness by the players in the leasing eco-system that includes the potential lessor, lessee, and the supplier.

Five government initiated regional leasing companies have been established to begin leasing operations for the first time in Ethiopia. Driven by its commitment to meet the targets for industrial manufacturing sector, which includes agro-processing sub-sector, the GoE mandated the 5 largest regional administrations to co- invest in a leasing company with the largest MFIs in their respective regions. The 5MFI-affiliated and government supported leasing companies have received their licenses, and are setting up their operations with various capacity building workshops and trainings being provided through NBE and others.Among the PRIME project regions, only OROMIA is served by one of these leasing companies, that is, Oromia Capital Goods Finance Business Share Company (OCGFC).

More recently, there has been an increasing interest from the private sector to establish leasing companies. This was revealed in most discussionsconducted during this study. Evidently, growing number of inquiries are coming to NBE from both domestic and foreign investors pertaining to establishing a leasing company. There are two groups of investors who may be considered to be serious potential investors. At least one group or both may involve foreign co-investors. While the financial sector is closed for foreign investment, the leasing sector has opened recently through a Proclamation to Amend the Investment Proclamation (No. 849/2014). Specific legislation concerning foreign investment in leasing is being drafted by the legislation, and isexpected to be enacted soon. Both groups of investors are looking for more clarity in this area as well as in taxation and accounting. Further, these groups of potential investors are subscribing demand-driven leasing business model, unlike the five MFI-affiliated leasing companies whose focus is primarily the industrial manufacturing sector.

In the context of the current regulatory framework, there are possible options for Mercy Corps’ intervention to support the development of leasing in the PRIME operation areas.

In all the PRIME project regions – Oromia, Afar and Somali, access to credit is limited with somewhat better in Somali. As pastoralists are becoming more settled access to credit, both loans and lease/Ijarah (equivalent to finance lease under the Islamic finance), become more critical. Leasing in particular would be more attractive since it does not tie-up capital and it is overall cost effective for the potential lessee.

Based on the current regulatory framework, the institutional options are limited through which PRIME may support the development of leasing or Ijarah in the PRIME regions.PRIMEcould establish partnerships with: OCFGC, one of the five MFI-affiliated new regional leasing companies, in Oromia; Afar MFI, in Afar; and, Somali MFI and Rays MFI in Somalia. In addition, the private leasing companies that are still at early stages of formation may be potential institutions for Mercy Corp’s partnership for the development of leasing in the PRIME project regions. As mentioned above, these private leasing companies are waiting for a pendinglegislationon further clarity on foreign investors’ participation in the leasing sector and on other issues (e.g., taxation). Thus, it is recommended that Mercy Corps closely monitor the development of private leasing companies. PRIME could also consider facilitating the formation of a leasing company, including the involvement of a foreign co-investor (e.g., private equity firm) in the PRIME project regions.

Based on the current regulatory framework, it isnotan option for PRIME to assist the development of leasing or Ijarah contract activity through a commercial bank. Presently, commercial banks can not engage in leasing activity, but may invest up to 20% of their capital in a leasing company. In line with NBE’slicensing requirements, a leasing company has to be a “stand alone” entity, formed as a share company in accordance with Ethiopia’s commercial code (i.e. requiring at least 7 investors).

In partnership with institutions above-mentioned, PRIME could provide supportinaddressing and closing the leasing sector gaps that currently exist in the PRIME project areas. This would entail the development and support of the leasing eco-system as a whole, to include the “lessor” (the leasing company), the potential “lessees” and the “suppliers”, with the aim to create leasing awareness in the community, identify the demand and supply for leasable assets, and build leasing expertise at the leasing companies. Once leasing operating manual is developed by NBE, it would be necessary to tailor the manual to local context. Technical-on site support, including appropriate MIS development, directly to the institutions would be crucial. Also critical, would be the availability of funding for leasing operations, which Mercy Corps could consider to support in facilitating funds from other sources (e.g., private equity).

Finally, as the PRIME project has already established partnerships with private sector enterprises (e.g., Addis Kidan) and has done much work in the dairy value chain, it would make sense to consider strengthening this value chain through introducing leasing. It is also evident that milk production is important in all the PRIME regions. Further, Mercy Corps could explore forming partnerships with select multi-purpose cooperatives in the PRIME project areas for the purpose of creating lease awareness among potential lessees.

1.1Scope of Work

Scope of work was mainly based on terms of reference; however, analysis was extended to include the wider regulatory and legal framework for leasing such as investment, taxation and accounting policy, as well as the general business environment. To make appropriate recommendations of possible intervention areas for the PRIME project, it was also necessary to synthesis current trend and development in the leasing sector given that the sector is rapidly changing.

1.2Methodology

In preparing this analysis, a desk review was conducted of proclamations and directives pertinent to leasing and investments, as well as studies relevant to leasing sector development in Ethiopia. In addition interviews and phone discussions were held with a number of wide variety of stakeholders (NBE, IFC, leasing companies and others), and key staff members of the PRIME project (for details, see Appendix 1). Options of possible intervention areas for the PRIME project are considered in the context of the existing legal and regulatory framework; however, in-depth analysis and design of the possibilities were outside the scope of this analysis.

2LEASING REGULATORY AND LEGAL FRAMEWORK

Ethiopia’s leasing sector is at an infant stage, currently characterized by inadequate regulatory and legal framework and little know-how of leasing operation by potential key players and byNBE, the regulator. To-date,renting of equipments is more common, typically in the construction sector. Leasing was limited to a few larger microfinance institutions that leased for example, small irrigation equipments and beehives, typically to farmers, with co-operatives co-signing. The slow development of the leasing sector to-date may be due to the uncertainty and lack of clarity surrounding permissible leasing modalities and the authority that mandates the activity in general.

Leasing sector is recently experiencing positive developments. There is a growing interest by the government and NBE, as well as by private sector players, to integrate leasing as a crucial instrument to address the gap in access to finance and meet economic growth targets.

An enabling environment for leasing typically requires appropriate laws and regulations, in terms of taxation, operation and ownership, as well as demand and supply of leasable assets, leasing operation knowledge by leasing companies, suppliers and potential lessees.

The present state of Ethiopia’s leasing regulatory framework is not adequate. The sector is provided with two directives issued recently by NBE, following the issuance of an amended proclamation on leasing. These directives addressminimum capital requirements and licensing requirements, respectively. In addition,Asset Registration policy for leasable assets has been added recently to support the regulatory framework. More directives and operational guidelines, without being cumbersome and bureaucratic, are required. More guidance, primarily in the form of directives, operational and supervisory manuals arein process of being delivered by NBE, with the support of IFC.

Leasing companies are either being formed or in process of formation. Both government and private initiatives are underway, with the former being well ahead. Five regional leasing companies that are MFI-affiliated and supported by the government have been established within the past year. There is also a lot of interest from different private sector groups to establish leasing companies both foreign and domestic. There are taxation, registration and ownership questions among others that remain unanswered. However, NBE is committed to address all key gaps identified to develop a vibrant leasing sector.

2.1Leasing Overview

While one way of accessing equipment needed for production is through purchase the other is through leasing. Typically, in a lease eco-system, there are three key players: a “Leassee”, a “Lessor” and a “Supplier” (refer to Figure 1).

In Ethiopia, the focus is to develop enabling and vibrant environment for finance lease, in particular for hire-purchase lease, as this form of leasing leads to final ownership of the asset. The key characteristics of finance lease (including hire-purchase) are as follows:

  • The LESSEE selects the asset.
  • The procurement of asset is conducted by the LESSOR and not the LESSEE.
  • The LESSOR remains the owner of the asset throughout the lease period, while the

LESSEE has control over the use of the asset.

  • The LESSOR is fully secured in the event of destruction or damage.
  • The LESSEE has the obligation to pay the lease fee.
  • The LESSEE has the obligation to maintain the asset in line with the lease agreement.
  • The lease agreement, among other items is non cancellable.The agreement details,among other things, the actions to be taken in the event there is a default.

Figure 1: Leasing Eco-system

There are numerous advantages to leasing (finance and hire-purchase), and the major financial advantages include:

  • From the perspective of the LESSEE:
  • It is a cost effective instrument that conserves liquidity and does not tie in business capital.
  • Access to equipment, which would have been out of reach, becomes possible.
  • From the perspective of the LESSOR:
  • Leasing is a profitable business. Total Lease payments by the end of lease period can cover all costs and profit margin.

Thus, in absence of assets that can be collateralized, or cash that have to be given up front, finance lease would be a practical alternative option for small and microenterprises.

Under operating lease, the user of the machinery makes payment for a short-term use of the asset. Essentially, operating lease is similar to renting with no ownership rights and control of asset rights transferred to the Lessee.

Finance lease involves long-term leasing contracts. An owner of an asset (the LESSOR) allows another party (the LESSEE) the use of the asset for a predetermined period (lease period) against regular payments (lease payments). At the end of lease period, the LESSEE has

an option to purchase the asset with some additional payment, or can forfeit the option to purchase and return the asset to the owner. Typically, the LESSEE isresponsible for maintenance and all risks usually associated with ownership without actually owning the asset.

Hire-purchase is a variation of finance lease, and one currently promoted in Ethiopia. A LESSEE agrees to pay for an asset in parts or a percentage over a number of months or years towards eventual ownership of the asset. The ownership of the asset remains with the LESSOR until the last payment is made. In effect, hire-purchase is similar to a mortgage system, whereby with each regular payment, the user’s ownership rights increase until the payments are complete (for more details on types of leasing, see Table 1, above).

2.2Existing Proclamations, Directives and Regulations

The regulatory framework for leasing was first established in March1998 by the Capital Goods Leasing Business Proclamation (No. 103/1998). This proclamation was revised by July 2013 proclamation, Capital Goods Leasing Business (Amendment) Proclamation (No. 807/2013)

Proclamations

Below are the key points of the proclamations (for more details on the proclamations, see Annex2 and 3):

  • The first proclamation defined lease operation and associated terms, provided basic guidelines, with all powers and duties regard to leasing operation assigned to Ministry of Trade (MoT). The three types of lease operations: “Finance Lease”, “Operating lease”, and “Hire –purchase” are defined and described by this proclamation. Key lease operation terms are defined, such as “Capital goods”, “Lesasee”, and “Lessor”, and features of “Lease Agreements”. In addition, basic guidelines are provided in the event of lease payment defaults, bankruptcy, and damages. Transfer of ownership rights at the end of lease term, and general termination of lease agreement are described in a general manner. Further, the proclamation briefly mentions basic accounting and tax treatment for depreciation allowance for capital goods, and for regular lease payments under the different lease operations. Finally, the proclamations mandated the MoT to license and supervise all equipment leasing businesses.
  • The amended proclamation nearly 15 years later, clearly differentiated and redefined ‘operating lease’, from ‘hire purchase’ and ‘financial lease’. With the new proclamation, operating lease still remains under the mandate of MOT. Amendments were made definitions of “capital goods finance” to include only financial lease and hire-purchase. As a result, the mandate to license and control “financial lease” and “hire-purchase”isassigned to NBE, with risk management and safety and soundness of leasing companies engaged in these types of leasing being viewed from the financial sector perspective. As financial transactions, financial lease and hire purchase lease are likely to be given increasing attention by the NBE. Further, under this proclamation, an enterprise may only be licensed to engage ineither “operating lease”or “finance lease” but not both. The rationale for this provision is not readily apparent.
  • The issue of “double taxation” is addressed in the amended proclamation. Important taxation issue that the amended proclamation addressed is the lease payments made to the lessor under capital goods finance to be exempted from Value Added Tax. Thus, the proclamation eliminates the risk of double taxation, given that the lessor would pay the VAT when purchasing the equipment.
  • There is an assumption that the “supplier” is also the “importer” who is exempted from import duties on capital goods. However, this is not necessarily always the case – The importer could be different than the supplier. If the supplier is not accorded import tax exemption for a leasable asset, the supplier is likely to pass the high price to the lessee, potentially distorting the residual value of the asset.

Directives