Basics of Tax Leasing (1)

Transcription

1 Basics of Tax Leasing (1) 2007 ELFA Lease Accountants Conference Suresh Makam Citi Bankers Leasing

2 Single Investor Lease Lessor purchases the equipment with equity or proceeds of recourse loan Lessor s return depends upon Lessee s credit and equipment value Lessor is 100% at risk There are no non-recourse loan amounts

3 True Lease Issues Is the lease a True Lease? 3

4 IRS Guidelines As of May 7th, 2001, the following Revenue Procedures were superseded by Revenue Procedure and Revenue Procedure : Revenue Procedure Revenue Procedure Revenue Procedure Revenue Procedure 79-48

5 IRS Guidelines In Revenue Procedure , the IRS stated that: To qualify for an advance ruling regarding the tax status of a leveraged lease, a lease contract must adhere to the following guidelines: a. Minimum unconditional At Risk investment i. Minimum Investment must remain equal to at least 20% of the cost of the property at all times throughout the entire lease term. ii. Equipment must have a remaining useful life beyond the lease term of the longer of one year or 20% of the originally estimated useful life.

6 IRS Guidelines: Rev Proc (cont d) b. Purchases and sale rights i. No bargain purchase options allowed (established by case law) ii. No Put option to Lessee c. No investment by lessee i. No part of the cost of the property may be furnished by Lessee ii. Lessee may pay for certain improvements or additions

7 IRS Guidelines: Rev Proc (cont d) d. No lessee loans or guarantees e. Profit requirement (complex IRS formula) f. Positive cash flow (complex IRS formula) g. No Limited Use property

8 IRS Guidelines: Rev Proc (cont d) Rev Proc is best understood as a bright line test, but case law has been more flexible Neither the IRS nor the tax courts have worked out a fully comprehensive articulation of the differences between a true lease and a non-true lease Guidelines are safe harbor and are technically applicable only to leveraged leases

9 True Lease Issues Examine all facts and circumstances to determine if lessor has upside residual potential and downside residual risk. Downside risk is weighed heavier than upside potential. Three questions: 1. Is there a bargain purchase option? 2. Is the Lessee economically compelled to purchase the equipment at the end of the lease term or at the fixed purchase option if any ( EBO )? 9

10 True Lease Issues (cont d) 3. Is it commercially feasible that someone other than Lessee will use the property after the lease expires? Limited use property Useful life Residual value 10

11 Examples of True Lease Structures Purchase option fixed at reasonable estimate of FMV Early termination at option of Lessee who guarantees sales price on sales to third party, by way of a cancellation payment Non-bargain purchase option ( EBO ) during the base term; provided that if purchase option is not exercised the term is extended with a Fair Market Value (FMV) option at the end of renewal term (first amendment) 3rd party residual guarantee (not a put) TRAC leases See IRC Sec. 7701(h) 11

12 Examples of True Lease Structures (contd) Leveraged Lease Lessor purchases the equipment with equity and proceeds of non-recourse loans. Cross Border Lease Lessor leases property to be used outside the Lessor s country of domicile. Double Dip Lease A cross border lease in which both lessor and lessee are entitled to tax benefits in their respective countries of domicile as tax owners.

13 Examples of Non-True Lease Structures Bargain Purchase option (including $1 out) Synthetic leases: Product term for a lease that takes advantage of inconsistencies in tax and accounting rules for the benefit of the lessee. Lease is structured as a conditional sale (or financing) for tax purposes, and an operating lease for lessee accounting purposes. Lessee has purchase option (upside) and guarantees a portion of residual value (the riskiest portion so that Lessee has predominant downside risk). Thus, the lessee takes the tax benefits of ownership, but gets off balance sheet accounting Loans and conditional sales agreements 13

14 Lease Structure Profile: True Lease 100% Fair Market Value Curve (FMV) Stipulated Loss Value (SLV) Equipment Cost Early Buyout Option (EBO) FMV Residual Year

15 Tax Accounting: True Lease A. A true lease is accounted for as a lease for income tax purposes: Rent LESSOR Taxable income as earned (advance rents when collected; arrears rents accrue into proper period) LESSEE Deducted as accrued Fees Received Taxable income when collected N/A Residual: Sale/Purchase Taxable income when collected Establishes depreciable basis Re-lease Taxable income as earned Deducted as accrued Depreciation Yearly deductions (MACRS) Not available to lessee Fees paid Up front: Write off straight line over lease term N/A Over life Deducted as paid N/A Interest Expense Deductible using interest method N/A

16 Tax Accounting: Non-True Lease B. A non-true lease or a synthetic lease is accounted for income tax purposes as an installment sale (i.e., a loan or financing): Rent Depreciation LESSOR Allocated between interest income and return of principal Not available to lessor, since it is not the owner for tax purposes LESSEE Allocated between interest expense and payment of principal Yearly deductions (MACRS) Interest Expense Deductible using the interest method

17 Depreciation Issues 17

18 Depends on the: Tax Depreciation Type of equipment (Aircraft, Vessel, Manuf Equip) Use of the equipment by lessee (US, Foreign ) Location of the equipment (US, Foreign) Lessee s status (US or non-us entity) Lessee s status (US tax payer or Not) 18

19 Tax Depreciation Depreciation Methodology 1. Modified Accelerated Cost Recovery System ( MACRS ) applies to all property placed in service after December 31, Under MACRS, there are six classes for personal property; depreciable lives are based on asset class lives: 3-Year Class Includes property with an asset class life of 4 years or less Examples include special tools and over-the-road tractor units. Specifically excluded are automobiles and light trucks. 5-Year Class Includes property with an asset class life of more than 4 years and less than 10 years Examples include computers, data handling equipment (typewriters, calculators, copiers, etc.), heavy general purpose trucks, trailers, general construction equipment. Specific property added to 5-year class includes automobiles, light trucks, qualified technological equipment ( QTE ), computer-based telephone central office switching equipment, research and experimentation property. 7-Year Class Includes property with an asset class life of at least 10 years and less than 16 years Examples include office furniture, fixtures, and equipment and commercial aircraft. Specific property added to 7-year class includes single-purpose agricultural structures, and property with no ADR midpoint that is not classified elsewhere

20 Tax Depreciation Depreciation Methodology (cont.) 10-Year Class Includes property with an asset class life of at least 16 years and less than 20 years Examples include barges, coal gasification equipment, and petroleum refining equipment. 15-Year Class Includes property with an asset class life of at least 20 years and less than 25 years Examples include industrial steam and electric generation and/or distribution systems, cement manufacturing equipment, water transportation property, railroad wharves and docks. Specific property added to 15-year class includes municipal wastewater treatment plants, and telephone distribution plant and comparable equipment used for the two-way exchange of voice and data communications. 20-Year Class Includes property with an asset class life greater than or equal to 25 years Examples include farm buildings, railroad structures, telephone distribution plants. 3. The cost of property in the 3-, 5-, 7-, and 10-year classes is recovered using the 200% declining-balance method over three, five, seven, and ten years, respectively, and the half-year convention, with a switch to the straight-line method in order to maximize the deduction. The cost of 15- and 20-year property is recovered using the 150% declining-balance method over 15 and 20 years, respectively, and the half-year convention, with a switch to the straight-line method in order to maximize the deduction.

21 Depreciation Issues Alternative Depreciation System (ADS) Property used predominantly outside the US, or Lessee is a tax-exempt entity (includes foreign entities) Depreciation under ADS is determined by using Straight line method Applicable convention Recovery period equal to class life, but not less than 125% of the lease term in certain cases 21

22 Mid-Quarter Convention If more than 40% of all personal property placed in service during the year is placed in service in the last 3 months of the taxable year, all personal property placed in service during the year is subject to a mid-quarter convention. Property placed in service and disposed of within the same tax year is excluded in determining the 40% aggregate basis Test applies on a consolidated basis but with respect to partnerships it generally applies at the partnership level

23 Mid-Quarter Convention (cont d) If the taxpayer triggers the mid-quarter convention, the half-year convention no longer applies. The first year depreciation amount for all personal property placed in service that year will be recalculated according to the quarter it was placed in service. 1 st Qtr: 10.5 months 2 nd Qtr: 7.5 months 3 rd Qtr: 4.5 months 4 th Qtr: 1.5 months

24 Recent Changes In Tax Depreciation The Gulf Opportunity Zone Act Of 2005 for small business sector in Louisiana, Mississippi, And Alabama. Provisions of the GO-Zones Law will: Double small business expensing from $100,000 to $200,000 dollars for investments in new equipment; Provide a 50-percent bonus depreciation for businesses that invest in new equipment and new structures.

25 Recent Changes in Tax Laws The Energy Policy Act of 2005 ( the Energy Act ) Congress again chose to encourage renewable energy development in the United States through an array of tax incentives rather than direct grants or subsidies. The Section 45 credit is available for facilities that generate electricity from wind, closed-loop biomass, geothermal deposits, landfill gas and trash combustion. The Energy Act extends the Section 45 production tax credit for additional two years, Allowing qualified facilities placed in service through December 31, 2008.

26 Section 46 Investment Tax Credits The Energy Act adds the following investment tax credits to code Section 46: 30% credit for solar energy property 20% credit for integrated gasification combined cycle projects, 15% credit for other advanced coal-based technologies, 20% credit for certified gasification projects, 30% credit for qualified fuel cell power plants, and 10% credit for qualified stationery micro turbine power plants.

27 Income Recognition Issues IRS Section

28 Rental Income - Section 467 Rental income should be approximately level over the term of the lease. Some forms of uneven rent are acceptable Rents that vary: Due to third party costs With an index With asset use Vary by a small amount 28

29 Rental Income - Section 467 (con t) Rents that vary due to third party costs Property taxes Utility costs Insurance costs Maintenance costs 29

30 Rental Income - Section 467 (con t) Rents that vary with an index Consumers Price Index Producers Price Index Regional Price Index Commodity Index (fuel or food prices) Financial Index 30

31 Rental Income - Section 467 (con t) Rents that vary with asset use or results Variation with output of a leased equipment Mileage on a vehicle With sales (retail store) Variation with profitability (retail store) 31

32 Rental Income - Section 467 (con t) Rents that vary by a small amount The Test 10% variation is allowed Determine the average annual rental rate Lowest annual rental must be at or above 90% of the Average Highest annual rental must be at or below 110% of the average rent Real Estate allows 15% variation ( Test ) 32

33 Rental Income - Section 467 (con t) Rent variation beyond allowable IRS may determine that the agreement is a Disqualified Agreement If a Disqualified Agreement, The IRS may recalculate the rental income pattern ( Levelize ) If the agreement is a Disqualified Agreement, the entire agreement will be levelized. 33

34 Example of SITL - Assumptions Asset: Corporate Jet Asset Cost: $10,000, Lease type: Single Investor Lease Term: 120 months or 10 years Delivery Date: 12/15/06 Lease inception: 12/15/06 Early Buy-out Option: (84 months from Lease inception) Depreciation: 5 year MACRS Depreciation Half year Convention Lessor Tax Rate: 35% Rents: Monthly in arrears Total Residual: 50% or $5,000, Fees Paid:.5% or $ 50, (Portion for Residual Guarantee) Target yield: 6.5% pre-tax Multiple Investment Sinking Fund Lessee s Incremental Borrowing Rate: 6.0% Lessee s comparable debt cost

35 Example of 467 Rent - Results Lessor can structure various rent patterns within the Sec. 467 guidelines to minimize Lessee s cost by increasing the value of tax benefits. Level Payments 90/110 Rental Payment: $72, (1to 120) $66,232.47(1 to 60) $80, (61 to 120) EBO amount: (mo. 84) $6,831,083 $7,206,012 If EBO Exercised: PV of Rent + EBO 95.02% 94.54% Implicit Cost : 4.98% 4.92% If Lease goes to end of term and returns the aircraft to Lessor: PV of min. lease payments 65.92% 65.30% IRR -2.65% -2.31%

36 Example of Lessor s Tax Position Lessor Accounting : Monthly Payment: $ 72, Implicit Rate: 4.88% PV of rents only : 69.29% Lessor s Classification: Operating Lease To re-classify as Direct Finance Lease: Lessor will require 3rd party residual Guarantee: $3,371, PV of Minimum payments: 90.1% Impact on PT Yield and Lessor s tax position and asset acquisition pattern Half Year Mid Quarter AMT Convention Convention 2005 to 2010 Pre-tax Yield 6.50% 6.36% 4.88% Impact to Lessor 0%.14% 1.62%

37 Example of Lessor s Taxable Income

38 Difference Between Accounting and Tax Operating Lease Example E. An example comparing book income to taxable income for an operating lease: 1. Assume an operating lease for GAAP purposes and a true lease for income purposes. a. Lessor enters into a 60 month FMV lease of material handling equipment, having a cost of $1 million, monthly rent of $18,500, a residual of $200,000, and an implicit interest rate of 10%. The first basic rent date is April 1, 20xx. b. There is no automatic transfer of ownership. There is no bargain purchase option. The equipment has an economic life of 10 years, therefore the lease term of 5 years is less than 75% of the economic life. The PV of the rents at the implicit rate of 10% is $878,000, which is less than 90% of the cost of the equipment. Therefore, the lease is an operating lease for financial reporting purposes.

39 Difference Between Accounting and Tax Operating Lease Example (cont d) E. An example comparing book income to taxable income for an operating lease: 2. Material handling equipment (generally) is five-year class property. MACRS depreciation rates (from the IRS table) are: Year % 1 st nd rd th th th 5.76

40 Difference Between Accounting and Tax Operating Lease Example (cont d) 3. From the standpoint of the lessor, the lease will have the following incident of earnings: Year ended December 31 Tax Books Total Rental Income $166,500 $222,000 $222,000 $222,000 $222,000 $55,500 $1,110,000 Sale Proceeds 200, ,000 Depreciation Expense 200, , , , ,200 57,600 1,000,000 Tax Income (Loss) (33,500) (98,000) 30, , , , ,000 Tax Rate 40% (Combined Federal & State Rate) 40% 40% 40% 40% 40% 40% 40% Tax Liability (Savings) ($13,400) ($39,200) $12,000 $42,720 $42,720 $79,160 $124,000 GAAP Books Income before Tax 46,500 62,000 62,000 62,000 62,000 15, ,000 Tax 40% 18,600 24,800 24,800 24,800 24,800 6, ,000 Net Income $27,900 $37,200 $37,200 $37,200 $37,200 $9,300 $186,000 Current Tax Liability 13,400 39,200 (12,000) (42,720) (42,720) (79,160) (124,000) Deferred Tax Balance 32,000 96, ,800 90,880 72,

41 Difference Between Accounting and Tax Operating Lease Example (cont d) 4. A simple GAAP balance sheet presentation of the lease: GAAP Books Total Cash $179,900 $441,100 $651,100 $830,380 $1,009,660 $1,186,000 Equipment under lease 1,000,000 1,000,000 1,000,000 1,000,000 1,000,000 0 Accumulated depreciation (120,000) (280,000) (440,000) (600,000) (760,000) 0 Equipment under lease, net 880, , , , ,000 0 Total Assets $1,059,900 $1,161,100 $1,211,100 $1,230,380 $1,249,660 $1,186,000 Deferred Taxes 192, , , ,400 84,400 0 Stockholder s Equity 867, ,100 1,044,700 1,104,980 1,165,260 1,186,000 Total Liabilities & Equity $1,059,900 $1,161,100 $1,211,100 $1,230,380 $1,249,660 $1,186,000

42 Difference Between Accounting and Tax Direct Finance Lease Example From the standpoint of the lessor, the direct finance lease will have the following incident of earnings: Taxable Income (Loss) (439,301) 81, , , , , ,244 Tax Rate 40% (Combined Federal & State rate) 40% 40% 40% 40% 40% 40% 40% Current Tax Liability (Savings) (175,720) 32,420 58,020 73,420 73,420 60, ,098 GAAP Books Income before Tax 73,253 84,247 67,398 48,738 28,074 3, ,244 Tax 40% 29,301 33,699 26,959 19,495 11,230 1, ,098 Net Income $43,952 $50,548 $40,439 $29,243 $16,844 $2,121 $183,147 Current Tax Liability 175,720 (32,420) (58,020) (73,420) (73,420) (60,540) (122,098) Deferred Tax Balance 205, , , ,316 59,

43 Difference Between Accounting and Tax Direct Finance Lease Example A simple GAAP balance sheet presentation of the lease: Year ended December 31 GAAP Books Cash $196,508 $469,136 $690,566 $881,275 $1,071,984 $1,183,147 Gross Investment 1,024, , , ,311 60,262 0 Unearned Income (231,991) (147,744) (80,346) (31,608) (3,534) 0 Residual 100, , , , ,000 0 Net Investment, Leases 892, , , , ,728 0 Total Assets $1,088,974 $1,204,801 $1,252,580 $1,250,978 $1,228,712 $1,183,147 Deferred Taxes 205, , , ,316 59,126 0 Stockholder s Equity 883, ,500 1,077,340 1,129,662 1,169,586 1,183,147 Total Liabilities & Equity $1,088,974 $1,204,801 $1,252,580 $1,250,978 $1,228,712 $1,183,147

44 Q & A