Over the past few years, there have been several recent changes in GAAP and tax rules that impact the treatment of leases. With some of these changes going into effect in 2020, it is an opportune time to review the cumulative effect of these changes.
Caveat – The following discussion is intended to survey only tax and accounting aspects of leases, not the rules that would apply to determine ownership and title under state law, remedies, UCC issues, and the like. Those rules use tests that are often different from the tax and accounting standards and add additional complexity.
Finance or capital leases are arrangements that are characterized as transferring ownership of the underlying asset from the lessor to the lessee. Thus, for accounting purposes, the lessee under a finance lease is treated as owning the underlying asset. The finance lease itself is typically treated as a debt instrument or other type of liability.
For balance sheet purposes the lessee will include the underlying property as an asset and the deemed principal portion of the total lease payments as a liability. The interest portions of the lease payments typically are an expense that flows through the lessee’s income statement. In addition, because the lessee is treated as the owner of the underlying asset, depreciation expense on that asset flows through the income statement as well.
For tax purposes, the same treatment holds. That is, the lessee is entitled to various tax benefits, such as accelerated depreciation, bonus depreciation and expensing. After tax law changes in 2017, these benefits include 100% expensing of a wide variety of non-real estate assets, including used assets. In addition, the interest portion of the lease payments are deductible as interest. Note that the 2017 tax law changes also created a limit on overall tax deductions for interest, so for some taxpayers this benefit may be illusory.
It should be noted that the GAAP and US tax tests for whether a lease is a finance lease or an operating lease are different, which means that hybrid leases can exist. The benefits of hybrid leases are discussed below.
The GAAP treatment of operating leases has changed recently, as discussed below. While public companies are already subject to these new rules, many private companies are not required to adopt them until 2020.
Prior to this change, the main accounting consequence of an operating lease is that the lessee treated the rental payment as an expense on its income statement (rather than only the imputed interest portion). Because the characterization of an operating lease is that the lessee is not the economic owner of the underlying asset, there was no balance sheet interaction.
The new GAAP rules change this treatment and require the lessee to list both an asset and a liability on the balance sheet. Thus, an asset representing the right to use the underlying property is recorded and an offsetting liability for the present value of the payments under the lease. Over time, payments under the lease reduce both amounts. While in many cases, the starting value of the asset and the liability will be similar, there will often be differences due to indirect costs of the lease and lease incentives.
The biggest impact of these new rules, however, will often be on the lessee’s debt ratios. Even in a case where the right-to-use asset and lease liability are equal, an operating lease can increase a lessee’s stand-alone liabilities. Accordingly, lessees should consider a GAAP carve out for operating leases if this would result in a material change in any ratios that could affect bank covenants and the like.
For tax purposes, like GAAP, the lessee is not treated as owning the underlying property. Accordingly, tax benefits such as accelerated depreciation, bonus depreciation and expensing are retained by the lessor and may not be taken by the lessee. The lessee is permitted to deduct the entire amount of the rental payments under the lease. Moreover, no portion of the lease payment is characterized as interest, so the new limitation on interest deductions will not apply.
Because GAAP and US tax rules on lease classification are different, it is possible that a given instrument could be treated as a finance lease for GAAP and an operating lease for tax, or vice versa. Sometimes these arrangements (particularly the first variant) are called synthetic leases. We prefer the term “hybrid” lease, because it can encompass any instance of differing book/tax lease treatment.
In some circumstances, a hybrid lease can resolve lessor/lessee tax inefficiencies. For example, assume a lessor proposes a finance lease to a lessee. Assume further that the lessee cannot fully utilize the tax benefits that would arise under such an arrangement. This could be the case because the lessee has significant NOL carryovers that would moot any new tax benefits, the lessee was subject to the interest expense deduction cap, or the underlying property is not of a type that could generate expensing or accelerated depreciation.
Under this fact pattern, it may be advantageous for the parties to adjust the terms of the proposed lease so that, solely for tax purposes, the lessor is treated as the owner of the underlying property. This would particularly make sense if the lessor could better utilize any resulting tax benefits and was able to reflect this utilization in the economics of the lease.
Similarly, a hybrid arrangement can be used in the context of an operating lease. Assume now that the lessor cannot utilize the tax benefits that would otherwise result from an operating lease. By structuring the lease so that, solely for tax purposes, the lessee is treated as the owner of the underlying asset, a more efficient allocation of tax benefits may occur.
While it is undoubtedly easier to effectuate a hybrid arrangement during the initial negotiation of a lease, it can also be done after the lease term has commenced. This can be particularly helpful if, for example, one party’s projections as to its ability to utilize tax benefits changes over time. Thus, a lessor in a finance lease may determine that, because of tax law changes, economic losses unrelated to the lease, or other reasons, it may become more efficient to shift tax benefits to a lessee. As with new leases, this involves complicated negotiations, but often the parties will share a unity of purpose that may facilitate matters.
It is also worthwhile evaluating the allocation of tax benefits if the lessor or lessee is contemplating an assignment of the lease. In that case, the tax attributes of the assignee may mitigate in favor of shifting the tax benefits under the lease to a new party.
- new leases – quantify potential tax benefits and evaluate whether lessor or lessee can better utilize them
- existing leases – quantify whether current tax benefits are being utilized as planned and evaluate whether a different party (lessor or lessee) can better utilize them
- lease assignments – evaluate whether tax attributes of assignee indicate that a shift in tax ownership would result in more efficiency