Recently my colleague and mentor Bill Bosco of Leasing 101 wrote an Insight article for Bloomberg Tax titled “Should I Lease or Buy? New Tax and Accounting Rules Add Complexity.”
The article describes the benefits of leasing from both financial reporting and tax perspectives, and suggests that companies prepare a lease-versus-own analysis with every asset acquisition. This article will elaborate on the more detailed tax-related reasons why a lease-versus-own analysis is recommended and illustrate how various scenarios may affect its outcome.
THE IMPORTANCE OF TAX FORECASTING
Most corporate taxpayers spend some time forecasting their generally accepted accounting principles (GAAP) income and taxable earnings over both the short-term and the “long-term” (which is often described as five years). The short-term forecast for tax reporting purposes is meant to determine how much the taxpayer will owe or not owe in the coming year so that they may make the required minimum estimated tax payments and hopefully no more. Thus, for a capital-equipment intensive taxpayer, understanding the additions and dispositions (sales) of capital assets becomes an important element in forecasting the estimated tax position at any point in time and for analyzing how to finance the use of an asset. Any lease-versus-own analysis thus makes assumptions about the user’s tax position short-term and long-term.
THE TAX CUTS AND JOBS ACT OF 2017
As background, the end of 2017 marked the passing of the Tax Cuts and Jobs Act (TCJA), which made several changes to the U.S. tax code that has directly affected equipment financing decisions.
Summary of Changes in Tax Code Items that Affect Equipment Financing
The tax code currently includes a variety of rules guiding how income taxes are determined.
The following items that changed as a result of the TCJA may influence the way equipment should be financed.
- Corporate tax rate reduction—Of course we all know that the federal corporate tax rate decreased from 35% to 21%. This is only mentioned because the lease-versus-own analyses is prepared on a present-value after-tax basis and if there is any anticipation of a future rate change, a company may want to consider it in their lease-versus-own modeling.
- Interest expense deduction limitations—Current-year deductibility of interest expense in excess of interest income is now limited to 30% of tax EBITDA. Starting in January 2023 the basis of the limitation changes to tax EBIT which because of the removal of tax depreciation and amortization from the formula becomes a much smaller number for most companies. Any excess interest expense deduction is deferred until such time as future interest expense is less than the 30% cap, at which time the prior deferral is then utilized.
- Bonus depreciation—Bonus depreciation is currently 100% and applies to both new and used equipment (with certain minor limitations). It is scheduled to phase down 20% a year starting in 2023 until it is phased out totally by 2027 and taxpayers will revert in most cases to the standard modified accelerated cost recovery system (MACRS).
- Net operating loss (NOL) carryback and carryforward limitations—Carrybacks of newly created NOLs are no longer permitted, and utilization of carryforwards of new NOLs are now limited to 80% of taxable income in the year being utilized; any unutilized NOL is then further carried forward.
- Elimination of Like-Kind Exchanges (LKE) for equipment—Previously taxpayers could defer the taxable gain on the sale of an asset by rolling that gain into the tax basis of a newly acquired similar asset. The utilization of this longstanding mechanism has been eliminated for equipment (while it remains for real estate).
- Base Erosion Anti-Abuse Tax (BEAT)—BEAT is a new tax targeted mostly towards U.S. subsidiaries of non-U.S. taxpayers, which because of the existence of intercompany loans and royalties paid to their parent, effectively transferred tax earnings out of the U.S. tax base. While there have been prior limitations, BEAT is much more restrictive.
Given the numerous changes in the tax code, it is important to establish a process to analyze the lease-versus-own effects of significant financing decisions. Building on the following basic example, this article will analyze the effect of selected changes in the tax code.
For purposes of this analysis assume a $100,000 asset is needed for seven years and that the user can either lease it for $12,500 per year or buy it financed with 100% debt at 5% for $17,282 per year. The model assumes an effective tax rate (combined federal and state) of 25% and full taxpayer status. At the end of the seven years the asset is returned by the lessee; for the ownership scenario, the user resells the asset for 35% of its original cost.
Base Lease-Versus-Own Model
In this basic example the lessee resale is about 5% less than the assumption used in the lease pricing. Most times the lessee has only a vague idea of what the future resale value of the asset will be; that is often a risk assumed by the lessor.
Note that these are only sample rates used for illustration purposes only.
(a) The large tax effect credit in the first year of the ownership scenario is caused by the 100% bonus tax depreciation plus interest expense deduction creating a temporary tax refund.
(b) The large net proceeds in the last year is from the resale of the asset offset by interest expense.
(c) The negative tax effect in years 2-6 result from the interest expense deductions.
From this example above, absent other considerations such as the cash flow requirements and the risk of the future resale value of the asset, the net after-tax present value (NAT-PV) of leasing is greater than the NAT-PV of owning, and accordingly owning will be the favored financing mechanism.
Using this basic example, we will address how the changes or potential changes in the tax code or the taxpayer’s position could affect this analysis.
Corporate Tax Rate Change
Given the uncertain future of the political environment and suggestions by some presidential candidates that the corporate tax rate should be increased, there is a risk that corporate tax rates may again change after the 2020 election. For purposes of this model we assumed the rate goes back to 35% resulting in a combined federal and state rate of 40%. While it is too early to be relying on predictions, the possibility of a rate change should be considered to determine the effect it may have on the financing decision.
This analysis indicates that if the federal corporate tax rate increased, leasing would provide a lower NAT-PV. This is largely due to the higher tax rate on the taxable gain on the future resale of the asset when owned.
As the 2020 election approaches and more clarity is available on the potential likelihood of a rate change, lessors may likewise start to consider how this would affect their yield on the investment and may seek some form of indemnification or the right to re-price the transaction in the event of a tax rate change.
Possible Actions—Companies should (i) evaluate the risk of a future tax rate change, and (ii) be prepared to consider new lease conditions that ask the lessee to assume some of the tax rate change risk.
Interest Expense Deduction Limitation
Congress apparently had several goals in mind when they introduced a limitation on the amount of interest expense that can be currently deducted. Essentially Congress wanted (i) to limit the frequency of corporate inversions whereby taxpayers move their headquarters and tax base to a foreign country with lower rates, and (ii) to de-leverage entities in general.
Net interest expense (interest expense net of interest income) is currently deductible only to the extent it does not exceed 30% of what is described as adjusted taxable income. Essentially, adjusted taxable income is taxable income adjusted for net interest expense, taxes, tax depreciation and tax amortization, or tax EBITDA.
Any excess net interest expense above 30% will not be currently deductible but can be carried forward indefinitely. Thus, some highly leveraged companies, as well as those that happen to experience a year with reduced earnings will be unable to expense the excess interest expense amount in the current year and will be required to carry a deferred deduction forward. The calculation of the limitation changes to be based on a limit against tax EBIT commencing Jan. 1, 2022, forcing a further de-leveraging of corporate taxpayers in general.
For highly leveraged entities this (in theory) creates an “incentive” to de-lever their capital structure in general. Of course, not all entities are intentionally highly levered; some just happen to be in that situation perhaps because they have recently commenced operations or have run into difficult years. Additionally, some companies (such as equipment rental companies) traditionally used high levels of debt to finance their revenue generating assets.
For modeling purposes, we assumed that the interest expense is not deductible at all, under the assumption that the user is in a current excess interest expense position and will not be able to utilize this excess in the foreseeable future.
The lease-versus-own analyses may need to be prepared with certain other assumptions, for instance that the non-deductible interest expenses are deductible at some time in the future. Of course, the problem with this and many other tax forecasts is that they are often subject to many conditions which may make their reliability questionable.
Possible Actions—By leasing an asset rather than borrowing to finance it, the taxpayer avoids incurring interest expense and instead incurs rental or lease expense.
In some leasing markets and under certain lease structures, the lessor may be able to provide the lessee with a pre-determined fixed-price purchase option that is set at the future projected fair market value of the asset. Under these structures, the lessee thus knows the exact “borrowing” rate inherent in the lease which they can compare to their interest borrowing rate. In the case of motor vehicles, the tax code provides what is known as a terminal rent adjustment clause (TRAC) lease wherein the lessee guarantees the residual value of the asset and can effectively acquire the asset for a predetermined amount.
Essentially by leasing rather than owning these assets, the taxpayer can avoid creating or incurring excessive interest expense deductions.
Caution—Under the new lease accounting standard (ASC 842 for U.S. GAAP and IFRS 16 for International Financial Reporting Standards) virtually ALL leases are now capitalized on the lessee’s balance sheet for book purposes. Under U.S. GAAP, some of those leases are reported as capital leases whereby the asset is recorded on the lessee’s balance sheet with an offsetting lease liability which creates an interest expense element for financial reporting purposes only. Under IFRS 16, all leases are treated as capital leases with an imputed interest expense for financial reporting purposes.
This ASC 842 or IFRS 16 interest expense however may not be the same interest expense that is limited under the tax code. Only if the lessee is deemed to own the asset for tax purposes is this interest expense considered subject to the limitation.
For example, although some of the above described TRAC leases may be capitalized with an interest expense component reported for financial reporting purposes, the interest expense in this case is not subject to the limitation because the lease is treated as a rental for tax purposes.
Although it is commonly called “bonus depreciation,” it is perhaps more properly described as “bonus acceleration of depreciation.” Ultimately a taxpayer can still only deduct total depreciation equal to the value of an asset.
While 100% bonus depreciation on the surface seems beneficial, in some cases it might be “too much of a good thing.” For instance, capital-intensive industries may regularly acquire large quantities of assets which can be written-off immediately. Having “too much” tax depreciation can be detrimental if it creates a tax net-operating loss (NOL) that cannot be used in the current period and is now limited as to how fast it can be utilized.
One approach to avoid creating NOLs is to not claim bonus depreciation. Note that this election is not on an asset-by-asset basis and is subject to other selection rules. For purposes of this lease-versus-own analysis we compared leasing with the cost of owning, however without claiming the 100% bonus depreciation under the ownership scenario.
In this analysis the cost of owning has increased compared to earlier analyses and leasing becomes a more economical approach.
Possible Actions—Consider and analyze the effect of foregoing bonus depreciation in the ownership scenariowhen compared to leasing.
Changes to Net Operating Loss Carryback/Carryforward Provisions
Previously, net operating tax losses (NOLs) could be carried back two-years and carried forward 20-years. TCJA changed this in two ways. First, it eliminated the ability of a taxpayer to carry back current year tax losses to obtain an immediate refund for previously paid taxes by filing an amended tax return. Second, it limits the amount of NOLs that can be used to only up to 80% of the taxable income of each future period. This means a taxpayer that has an NOL can no longer use it to eliminate 100% of the taxable income in any particular year.
The lease-versus-own analysis pertaining to an NOL carryforward is modeled by forecasting when an NOL can be utilized. This is modeled by determining when the company will be out of the NOL position and then using the carried forward deductions (rent or depreciation and interest expense) in a future time frame. We assumed that all such expenses are utilized in the last year (7th year) of the analysis.
In this case we see that a lease produces a lower NAT-PV, because it is based on payments only, which create a smaller carryforward compared to ownership, and assumes the 100% bonus depreciation in year one.
Possible Actions—Taxpayers may seek to limit generating NOLs by leasing rather than owning assets, in order to avoid the large 100% bonus depreciation write-offs available, which may create or add to a tax-loss position.
A taxpayer with existing NOLs may also seek alternative, faster ways of “monetizing” the NOLs. For instance, such taxpayers may potentially execute a sale-leaseback of existing assets to record an immediate taxable gain to utilize the NOL on a current basis (subject to the new 80% limitation). The existence and management of NOL situations are often based on the facts and circumstances surrounding the situation. That is, every taxpayer has their own specific taxpaying situation and views regarding whether and/or when they will be able to utilize the NOLs. For instance, such action may generate an additional sales tax charge that might change the analysis.
Nonetheless, leasing may provide some form of relief to such taxpayers.
Elimination of Equipment Like-Kind Exchanges
Prior to the TCJA, when a taxpayer sold an existing asset such as a truck, and then replaced it with a new asset (another truck), the taxable gain on the sale of the old asset could often be deferred under tax code Section 1031, otherwise known as a like-kind exchange. The tax basis of the new asset would then be adjusted downward for the gain deferral.
This means of taxable gain deferral allowed a taxpayer to utilize the full proceeds of the resale or trade-in of the asset without being required to pay some of those proceeds to the Internal Revenue Service in the form of taxes. The TCJA eliminated the LKE for equipment. Accordingly, when that existing asset is now sold or traded back, a taxable gain is most often reported largely because of accelerated tax depreciation. Of course, while the gain is currently offset by the 100% bonus tax depreciation discussed above, assuming the entity is acquiring a replacement asset, note that bonus depreciation will soon decrease and will be phased out by 2027 so the full gain may no longer be offset by bonus depreciation.
To analyze the elimination of the LKE, we modeled the ownership scenario assuming the owner was able to claim the LKE and then compared that to the base model above which assumes they were not deferring the gain and thus paying tax on the disposition.
For purposes of this modeling, we have assumed the taxes from the deferral of the taxable gain by utilizing the LKE, would be settled seven years in the future.
This example illustrates the effect the elimination of the LKE may have on the cost of financing an asset under an ownership scenario. Entities that regularly utilized the LKE may now be incented to re-examine the lease-versus-own scenario.
Possible Actions—Ensure that current lease-versus-own analyses do not assume any tax deferral from future asset resales.
Base Erosion Anti-Abuse Tax (BEAT)
TCJA created a new form of “minimum tax” known as BEAT. The intent of BEAT was to create a new minimum tax that is charged when a taxpayer (usually a U.S. subsidiary of a non-U.S. taxpayer) effectively “shifts” taxable income out of the U.S. BEAT is calculated by starting with U.S. taxable income and then requires certain add backs to calculate the BEAT modified taxable income, including but not limited to (i) intercompany interest payments made to a non-U.S. related lender entity, (ii) intercompany royalty payments made to a non-U.S. related entity, and (iii) U.S. based tax depreciation from assets transferred in from non-U.S. related parties. The taxpayer pays the greater of the taxes calculated in their normal manner or the BEAT.
Additionally, BEAT also reduces the amount of certain tax credits that a taxpayer may otherwise claim, including but not limited to alternative energy investment tax credits and production tax credits from investing in such alternative energy projects. It is foreseen that such credits will be completely eliminated with respect to BEAT after Dec. 31, 2025.
Unlike the corporate alternative minimum tax (no longer in existence) which created a prepaid tax utilizable in the future, BEAT does not provide for a carryforward credit. An entity subject to BEAT pays that amount, thus resulting in an effective tax rate that is greater than the statutory rate of 21%.
For the lease-versus-own analysis, we assumed that the user is already in BEAT because its debt is from its overseas parent and has triggered the BEAT tax currently at 10% resulting in a combined effective tax rate (state plus federal) of 15%. Since the intercompany interest expense is not deductible under BEAT, the deductibility of that was also eliminated from the analysis.
Therefore, not only is the intercompany interest expense included in what triggers BEAT, but because the tax rate at which the depreciation expenses are then deducted is tax-effected at a lower rate than the statutory rate of 21%, the NAT-PV of both leasing and ownership increases because of the penalty BEAT creates. The more important consideration here may be that lease payments to an unrelated entity are not considered a BEAT payment and do not contribute towards the BEAT penalty.
Possible Actions—Taxpayers potentially subject to BEAT may attempt to restructure their capital structure by seeking U.S. sources of debt financing. However this is sometimes difficult to achieve for a variety of reasons, including but not limited to that (i) the U.S. entity may not prepare separate audited financial statement that lenders may require; (ii) the foreign parent may be unwilling to provide guarantees of the U.S. entity’s debt; and (iii) the foreign parent may be able to access funds less expensively in their local markets.
Leasing assets is one possible means of reducing some of the need for foreign-loaned funds. Because leasing is often “asset-focused,” it may be available without a parent guarantee. Entities subject to BEAT may want to explore whether they have assets that are typically leased and consider how changing this financing approach may help mitigate the BEAT issue.
The U.S. tax code is a complicated doctrine that has seen changes recently and will likely see additional changes in the coming years. In the end the tax code is usually structured to not only raise revenues but to also influence actions in business. It is important to understand the economics of how the tax code influences the after-tax cost of owning or leasing so that a taxpayer can make an informed decision.
This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.
Joe Sebik is a CPA who has worked in the equipment finance industry since 1980. Currently employed by Siemens Corp. and covering Siemens Financial Services, he has worked for PriceWaterhouse, IBM Credit, Citicorp Global Equipment Finance, Chase Equipment Leasing and JP Morgan’s Tax-Oriented Investments group.
Joe is the Chairman of the Equipment Leasing & Financing Association’s (ELFA) Federal Tax Committee, has been on the ELFA’s Accounting Committee for more than 13-years and is a member of the ELFA’s Alternative Energy Subcommittee. He has written extensively about the industry including numerous technical portfolios for Bloomberg/BNA on both lease accounting and the economics of equipment finance.
Acknowledgments—The author would like to thank Ivory Consulting for their support and assistance in preparing this article.
Disclaimer—This article represents the views and interpretations of the author and does not reflect any of the positions, views or opinions of the company for which the author works. None of this information should be viewed as providing of tax or business planning advice. In all cases you should consult with your own tax counsel regarding any actions or positions you take.