2003 ELA Lease Accountants Conference

Transcription

1 2003 ELA Lease Accountants Conference Basics of Tax Leasing (1) September 9, 2003 Speakers: Suresh Makam CitiCapital Bankers Leasing Roger Idnani Boeing Capital Corporation

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. 2

3 True Lease Issues 3

4 Income Tax Aspects IRS GUIDELINES As of May 7 th, 2001, the following Revenue Procedures were superseded by Revenue Procedure and Revenue Procedure : Revenue Procedure Revenue Procedure Revenue Procedure Revenue Procedure

5 Income Tax Aspects 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. b. Purchases and sale rights i. No bargain purchase options allowed ii. No Put option to Lessee c. No investment by lessee a. No part of the cost of the property may be furnished by Lessee b. Lessee may pay for certain improvements or additions d. No lessee loans or guarantees e. Profit requirement (complex IRS formula) f. Positive cash flow (complex IRS formula) g. No Limited Use property 5

6 Income Tax Aspects Some conservative tax attorneys and accountants rely on Rev Proc as a bright line test. 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 6

7 True Lease Issue 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 )? 7

8 True Lease Issue 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 8

9 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 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) 9

10 Examples of True Lease Structures 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. 10

11 Examples of Non-True Lease Structures Bargain Purchase option (including $1 out) Synthetic leases: Lessee has purchase option (upside) and guarantees a portion of residual value (the riskiest portion so that Lessee has predominant downside risk). Guarantee amount is limited so that Lessee can obtain operating lease treatment (per FASB 13) but still claim tax ownership. Loans and conditional sales agreements 11

12 Lease Structure Profile: True Lease 100% Stipulated Loss Curve (SLV) Equipment Cost Early Buyout Option (EBO) FMV 20% Residual Year

13 Income Tax Aspects True Lease A. A true lease is accounted for as an operating 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 13

14 Income Tax Aspects 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 Interest Expense LESSOR Allocated between interest income and return of principal Not available to lessor, since it is not the owner for tax purposes Deductible using the interest method LESSEE Allocated between interest expense and payment of principal Yearly deductions (MACRS) 14

15 Depreciation Issues 15

16 Tax Depreciation Depends on the: Type of equipment (Aircraft, Vessel, Manuf Equip) Use of the equipment by lessee (US, Foreign ) Lessee s status (US or non-us entity) 16

17 Income Tax Aspects 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 17

18 Income Tax Aspects 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% decliningbalance 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. 18

19 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 19

20 BONUS DEPRECIATION The Job Creation and Worker Assistance Act of 2002 ( 2002 Act ) provided for a bonus depreciation allowance under which 30% of the cost of certain new property is deductible in the year the property is placed in service. Property does not qualify if there was a binding written contract for the acquisition in effect before September 11, 2001 Acquired and placed in service after September 10, 2001 and before September 11, 2004 (changed to January 1, 2005 by the 2003 Act) The remaining 70% of the basis is depreciated under the usual rules for depreciating such property. The Jobs Growth Tax Relief Reconciliation Act of 2003 ( 2003 Act ) provided for a 50% bonus depreciation allowance for assets acquired and placed in service after May 5, 2003 and before January 1, Property does not qualify if there was a binding written contract for the acquisition in effect before May 6,

21 Bonus Depreciation Qualified property includes: MACRS property with a recovery period of 20 yrs or less Computer Software (other than computer software that must be amortized under section 197) Water Utility property (as defined in section 168(e)(5)) Qualified leasehold improvement property 21

22 BONUS DEPRECIATION Property NOT eligible for Bonus: Property predominantly used outside the United States Property leased to a tax-exempt entity (including foreign persons) 22

23 Comparison of Tax Depreciation Comparison: New vs Prior vs Old Depreciation 7 Year Property 5 Year Property In Service < 9/11/01 > 9/10/01 > 5/5/03 < 9/11/01 > 9/10/01 > 5/5/03 0% Bonus 30 % Bonus 50% Bonus 0% Bonus 30 % Bonus 50% Bonus yr % 40.00% 57.15% 20.00% 44.00% 60.00% yr % 17.14% 12.25% 32.00% 22.40% 16.00% yr % 12.24% 8.75% 19.20% 13.44% 9.60% yr % 8.74% 6.25% 11.50% 8.05% 5.75% yr % 6.25% 4.47% 11.50% 8.05% 5.75% yr % 6.24% 4.46% 5.80% 4.06% 2.90% yr % 6.25% 4.47% yr % 3.12% 2.23% Total % % % % % % 23

24 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. 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 Quarter 10.5 months in service 2 nd Quarter 7.5 months in service 3 rd Quarter 4.5 months in service 4 th Quarter 1.5 months in service 24

25 Example of SITL - Assumptions Asset: Corporate Jet Asset Cost: $10,000, Lease type: Single Investor Lease Term: 120 months or 10 years Delivery Date: 12/15/02 Lease inception: 12/15/02 Early Buy-out Option: 12/15/09 (84 months from Lease inception) Depreciation: 5 year MACRS + 30% Bonus 1 st year 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: 8.5% pre-tax Multiple Investment Sinking Fund 25

26 Example of SITL - Results Customer view: Monthly Payment: $ 81, EBO Amount: $8,015, PV of rents only at 7%: 70.03% PV Rents + EBO: 97.61% (2.39% PV Benefit) Implicit cost (rents + EBO) 6.38% (2.12% benefit to Debt) 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 Optimized 3 Month rent holiday PV of Rents only 70.03% 69.32% 69.89% PV of Rent + EBO 97.61% 97.16% 97.30% Implicit Cost to EBO 6.38% 6.27% 6.34% Impact of depreciation and Lessor s tax position on Lessor s After-tax yield Half Year Convention Mid Quarter Convention AMT from 2002 to 2007 Pre-tax Yield 8.50% 8.37% 6.88% Impact to Lessor 0%.13% 1.62% 26

27 Income Tax Aspects 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 June 1, 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. 2. Material handling equipment (generally) is five-year class property. MACRS depreciation rates (from the IRS table) are (Including 50% bonus depreciation): Year %

28 Income Tax Aspects Operating Lease Example 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 600, ,000 96,000 57,500 57,500 29,000 1,000,000 Tax Income (Loss) (433,500) 62, , , , , ,000 Tax Rate 40% (Combined Federal & State Rate) 40% 40% 40% 40% 40% 40% 40% Tax Liability (Savings) ($173,400) $24,800 $50,400 $65,800 $65,800 $90,600 $124,000 GAAP Books Rental Income $166,500 $222,000 $222,000 $222,000 $222,000 $55,500 $1,110,000 Sale Proceeds 200, ,000 Depreciation Expense 120, , , , , ,000 1,000,000 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 173,400 (24,800) (50,400) (65,800) (65,800) (90,600) (124,000) Deferred Tax Balance 192, , , ,400 84,

29 Income Tax Aspects Operating Lease Example 4. A simple GAAP balance sheet presentation of the lease: GAAP Books 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

30 Income Tax Aspects Direct Finance Lease Example From the standpoint of the lessor, the direct finance lease will have the following incident of earnings: Year ended December 31 Tax Books Total Rental Income $160,699 $241,049 $241,049 $241,049 $241,049 $80,350 $1,205,244 Sale Proceeds , ,000 Depreciation Expense 600, ,000 96,000 57,500 57,500 29,000 1,000,000 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 Lease Income $73,253 $84,247 $67,398 $48,738 $28,074 $3,534 $305,244 Sale Proceeds 0 0 Depreciation Expense 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,

31 Income Tax Aspects A simple GAAP balance sheet presentation of the lease: Direct Finance Lease Example 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

32 Q & A 32