Lease & Finance Accountants Conference. September The Westin Charlotte Charlotte, NC
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1 Lease & Finance Accountants Conference September The Westin Charlotte Charlotte, NC H A N D O U T S
2 Lease & Loan Pricing - Advanced 2017 ELFA Lease & Finance Accountants Conference David Holmgren, Ivory Consulting Corporation Carrie Na, SunTrust Equipment Finance Scott Thacker, Ivory Consulting Corporation 1
3 Introductions EQUIPMENT LEASING AND FINANCE ASSOCIATION Panelists Participants 2
4 Disclaimer Ivory Consulting and SunTrust do not provide tax, accounting or legal advice to third parties. Any discussion of U.S. tax matters contained herein (including any attachment) is not intended or written to be used and cannot be used by any taxpayer for the purpose of avoiding U.S. tax-related penalties. If the discussion related to U.S. tax matters is used to promote, market, or recommend any transaction or investment, the discussion was written to support the promotion or marketing of the transaction or matters addressed and each taxpayer should seek advice based on the taxpayer s particular circumstances from an independent tax advisor. 3
5 Objectives This session is a continuation of Lease & Loan Pricing Basics. It is focused on after-tax pricing. It will cover advanced concepts in equipment lease and loan modeling and pricing from the lessor s perspective, including the potential effects of the new accounting for leases. The focus will be on the intersection between economics, tax and accounting in pricing true leases. Questions to be addressed: What factors/assumptions need to be considered in after-tax pricing? What are the tax laws considered in lease pricing? 4
6 Overview For tax and commercial law purposes, a lease contract is characterized as a true lease or a loan (conditional sale). The determination is primarily based on whether the lessor has retained a significant interest in the residual value of the asset, except for over-theroad vehicles (TRAC leases). A true (tax) lease provides the lessor with the same tax benefits of ownership otherwise available to the lessee. Taxable income for a true lease generally includes: Depreciation (computed using MACRS system) Rental income Interest deductions Residual income 5
7 Complex Leasing Products, 1 The leasing continuum ranges from debt-like to true risk-reward shifting leases with each product containing differing economics and book-tax objectives $1-out lease Debt only lease; $1 bargain purchase option (BPO) Also includes a lease with BPO > $1 Full TRAC Applies only to qualified over-the-road vehicles Full lessee residual value guarantee by means of a lease-end terminal rental adjustment clause (TRAC) Tax benefits to lessor 6
8 Complex Leasing Products, 2 Generally Off-Balance-Sheet For Lessees & Capital Leases for Lessors Split TRAC Variation to full TRAC lease Limited lessee guarantee such that lessee s PV < 90% RVI to lessor to qualify for capital lease accounting Tax benefits to lessor Synthetic Same as split TRAC, except tax benefits to lessee True tax lease Tax benefits to lessor, subject to true lease tests Solar lease ITC qualifying true lease; not subject to pretax profit test 7
9 Tax-Affected Pricing 8
10 Definition of a True Tax Lease EQUIPMENT LEASING AND FINANCE ASSOCIATION A lease in which the lessor takes the benefits of ownership, especially depreciation deductions and tax credits. The lessor also must bear associated risks, such as the uncertainty of the economic residual at lease-end. 9
11 Purchase option for less than FMV Basic Parameters True Lease Disqualifiers EQUIPMENT LEASING AND FINANCE ASSOCIATION Lease term and renewals cover more than 80% of economic useful life Little or no (1) overall profit, or (2) positive cash flow apart from tax benefits (exception: solar) Lessee loans or guarantees (except prepaid-deferred) Limited use property Title transfer Lessee funding of any part of cost or improvements (unless readily removable) Insufficient unconditional at-risk investment (residual value) throughout the entire lease term 10
12 Residual Value Book/Tax Finance lessors generally seek to structure a capital lease for book & true lease for tax (and commercial law). Operating lessors rely on the economics of re-leasing, asset exchanges & timely sales which provides tax deferral benefits and opportunities in the ordinary course of their business. Tax/commercial law: Future value = economically meaningful residual interest at time of signing. Residual value insurance and residual guarantees can help to achieve both economic and book objectives. For a small economic cost, RVI can change an operating lease into a capital/finance lease for the lessor. Residual guarantees can do the same while keeping the desired operating status for the lessee. 11
13 Residual Value Pricing The following residual values may be relevant for pricing: IRS represented residual value Priced residual value Booked residual value Fair market value, in-place, in-use (see return provisions) Fair market value in exchange (retail FMV to another end user) Orderly liquidation value (wholesale FMV to a dealer or auction house) Forced liquidation value (work-out) 12
14 Rent Structuring Objective is to make the best use of time-value of money A lessee s IBR that is higher than the lessor s yield is reason to delay payments; for the opposite, accelerate them Rent holiday Arrears instead of advance timing 467 loan to separate cash from allocations and gain further flexibility 13
15 Significant Tax Benefits Other significant tax benefits available to lessors/financiers: Investment tax credit (currently 30% for solar and wind, and 10% for co-gen, by election) Tax basis of asset is reduced by ½ of ITC claimed Basis reduction creates day-1 book issues: amount of ITC realized? Deferred tax asset? Production tax credit (currently 2.3 cents/kwh for wind to producer) Interest income exclusions, subject to interest expense disallowance with a 2% de minimis exception (municipal leasing) Front loaded interest deductions (if leveraged) Like-kind exchange (means of extending the deferral benefit) Investment Tax Credit and Production Tax Credits were extended through 2019, but begin declining in value at the rate of 20% per year beginning in
16 Early Buy-Out (EBO) Background Today s leases commonly provide the lessee with the option to buy earlier than the end of the full term, generally at a fixed price, thus terminating the lease. The EBO yield is generally higher than the full term yield to compensate for the loss of after-tax cash and to ensure the EBO amount is not economically compelling, i.e., a bargain. EBO should be set at the higher of the projected FMV on the exercise date, or the PV of the remaining lease payments plus the asset s residual value (estimated FMV) at lease-end. Multiple EBOs or a fixed EBO/fixed FPPO structure create incremental tax risk (i.e., more than one bite at the apple ). 15
17 Setting the EBO Set the EBO date on a rent payment date If an arrears rent, the EBO and rent amount are both due If an advance rent, only the EBO amount is paid Prepaid/deferred structure creates complexity due to the mismatch between cash rents and allocated rents A prepaid rent: taxation of that rent must be taken into account A deferred rent: a rent payment will be due on the EBO date Set or calculate the EBO The termination value should be a minimum Targeting a yield premium over the full term yield is common A minimum after-tax cash produced by the EBO scenario can also be a constraint Be aware of the Compulsion Test; failure could jeopardize the true lease status of the lease 16
18 Comparison of FMV versus Net Investment Investment higher than FMV PO must be at FMV to retain tax treatment 20% Value for IRS test Optimum PO point Pricing RV 17
19 The Economic Compulsion Test Is it less expensive to exercise the EBO or continue the lease and purchase the leased asset at the end of term? This test compares the EBO to the PV of the cash flows of the forgiven lease payments + estimated FMV purchase price at lease end If EBO < PV, then it may be considered economically compelling The PV discount rate is typically the lessee s cost of capital since the transaction involves an asset acquisition. A break-even discount rate can be used as a starting point A grace amount, an acceptable difference between the PV amount and the EBO amount, can be specified Failing the Economic Compulsion Test might not be fatal if other factors render exercise of the EBO unpredictable. 18
20 Measurements Used in After-tax Pricing Multiple Investment Sinking Fund (MISF) Internal Rate of Return (IRR) Spread over Index (SOI) Return on Equity (ROE) Risk Adjusted Return on Capital (RAROC) 19
21 MISF MISF remains a common yield method used in pricing true leases Using the after-tax cash flows, the nominal after-tax yield (NATY) is computed NATY is convertible into an effective after-tax yield (EAT) by dividing NATY by 12 to capture the benefit of compounding Example: If NATY is 10%, then EAT is % ((0.10 / ) ** 12 1) NATY is convertible into a nominal pretax yield (NPTY) by dividing it by 1 minus the composite tax rate Example: 10% / (1-37.5%) = 16% NPTY will typically be 50 to 120 basis points higher than a corresponding IRR Represents the tax benefit to the lessor 20
22 MISF (cont d) EQUIPMENT LEASING AND FINANCE ASSOCIATION Advantages It s not what you make, it s what you keep (after-tax flows) Provides a unique solution for investments with positive and negative (switching) cash flows principally arising from MACRS depreciation Disadvantages Complex Tax flows before and after the sinking fund phase are assumed to be reinvested at the yield rate Does not map to book (FAS 13) yield on non-leveraged leases 21
23 IRR IRR yield focuses on leverage & accounting considerations Pretax IRR without the residual represents the return from rent payments Pretax IRR with the residual equals the rate used to recognize earned lease income (interest rate implicit in the lease) To capture the tax benefit, a borrowing rate is assigned to deferred taxes in deriving a tax-advantaged nominal pretax yield Pre-tax IRR adjusted for interest savings will typically be about 30 to 70 basis points less than NPTY Comparison to the MISF provides a measure of the tax benefit to the lessor in a true lease Valuable comparison of loan vs. lease investments Widely used in intercompany tax settlement agreements as it is commonly understood and standardized 22
24 Return on Equity EQUIPMENT LEASING AND FINANCE ASSOCIATION ROE incorporates the debt and equity ratios that the financing company will incorporate into its pricing. Tax-oriented leases incorporate deferred taxes into the ROE calculation by assuming that they temporarily pay down internal debt, providing an interest-free loan from Uncle Sam. Some leasing sales staff try to argue that deferred taxes pay down equity, but deferred taxes must be paid back. Practice is less universal regarding permanent differences such as ITC, which are direct subsidies by the government. 23
25 Return on Equity (cont d) EQUIPMENT LEASING AND FINANCE ASSOCIATION Advantages ROE reflects the allocation of scarce equity to various business units Leverage reflects that the company is acting as a financing entity, often in contrast to a non-finance parent Disadvantages Highly leveraged investments must adequately incorporate costs of originating and maintaining a transaction ROE is not always adequate by itself to keep the lights on 24
26 Risk Adjusted Return on Capital Incorporates the inherent risk associated with a particular type of investment, including recovery of underlying asset in the event of repossession. RAROC = Expected return + risk free return / Economic Capital or Value at Risk. RAROC allocates capital from (1) risk management and (2) performance evaluation. Thus, a higher risk investment must provide a greater return to be on par with a lower risk investment. 25
27 Risk Adjusted Return on Capital (cont d) Advantages Includes operational, market and credit risk elements More precise evaluation of risk and required returns Disadvantages Often slows down process when new types of investments arise Often not understood by all in an organization and may limit some types of investments (i.e., banks lending to non-investment grade entities) 26
28 SOI Yield Method SOI yield is calculated as the difference between a selected base yield & a cost-of-funds index: Base yield: MISF, IRR, or FAS-13 Yield Cost of funds index Fixed rate: specified rate or an array of rates (average life or fixed-term lookup table) Variable rate: an array of rates (lookup table) Difference is displayed as the spread Choices depend on whether to more closely model economic or book, including treasury and intercompany tax policies. 27
29 Lease vs. Purchase 28
30 Lease vs. Loan/Purchase Analysis Used to determine net advantage/disadvantage of lease vs. loan/purchase. Calculation is a discounted cash flow analysis of after-tax cash flows: LEASE Quoted rent less the tax benefit of deducting the rent Tax deductions; if applicable, adjusted for impact of NOL and AMT Expected end-of-term scenario is assumed, i.e., asset returned or bought LOAN/BUY 100% debt financing or cost of capital (debt/equity) Loan payments scheduled with same term & periodicity as lease payments Tax benefit from depreciation and loan interest scheduled Tax deductions similarly adjusted for impact of NOL and AMT Same terminal flow assumption as lease Lower PV = preferred scenario; difference = net advantage/disadvantage to lease. 29
31 Break-Even Analysis Drivers Timing of after-tax cash flow favors leasing Total cash flow favors lending or purchasing Break-even measures PV discount rate Residual Tax delay Turning the dials in favor of leasing PV discount rate > break-even PV discount rate Lessee s residual assumption < break-even residual Increasing the break-even tax delay date 30
32 Like-Kind Exchange 31
33 Like-Kind Exchange (LKE) - Background Gain on sale of leased assets is typically taxed at a combined Federal and State tax rate of 38% or more IRC Section 1031 allows taxpayers to defer paying tax on the disposition of business assets where The taxpayer receives Like-Kind replacement assets in exchange for the taxpayer s old assets (generally also recognized by States) Tax rationale (continuity of investment) Taxpayer has not profited from the replacement of an old asset with a new asset Taxpayer remains in business and has simply exchanged one business asset for another Taxpayer has not cashed out of its investment in business assets 32
34 Like-Kind Exchange Definition EQUIPMENT LEASING AND FINANCE ASSOCIATION Property must be exchanged for property of the same kind or class Real property: Generally a single class For example - unimproved land is of like-kind to an office building Personal property: Office furniture and fixtures Computer equipment Automobiles Light-duty truck Over-the-road tractors Railroad cars Construction machinery, surface mining, and logging 33
35 Internal Revenue Code Section
36 IRC 467 Basics Why? EQUIPMENT LEASING AND FINANCE ASSOCIATION Tax lease pricing is most competitive when expenses can be accelerated and revenues can be deferred. Largest expense of a lease is typically tax depreciation. Prior to Section 467, creative lease structuring advisors sought to defer rents as much as possible, effectively sheltering rental income and thus enabling rents and underlying financing costs to be lowered: Example maximum deferral of all rents due on the last day of the lease. Extreme deferral of rents were increasingly looked upon as an abusive tax shelter mechanism. 35
37 IRC 467 Applied Example: Lease for 24-months at $60,000 ($720,000 per year) and then 24-months at $140,000 ($1,680,000 per year); total rents = $4.8 million Average annualized rent = $1,200,000 Basic Section 467 loan activity; Note: Imputed interest expense not included in table Period Average Annualized Actual Rent 467 loan activity Section 467 loan balance 1 1,200, , , , ,200, , , , ,200,000 1,680,000 (480,000) 480, ,200,000 1,680,000 (480,000) 0 36
38 Anyone want to work in tax lease pricing? So that sums it up; an easy topic. Any questions? 37
39 Q&A EQUIPMENT LEASING AND FINANCE ASSOCIATION 38
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