On Feb. 25, 2016, FASB issued its new lease accounting standard, Accounting Standards Update (ASU) No. 2016-02, Leases
(Topic 842). This new standard will affect all companies that lease, or sublease, assets in the nature of property, plant or equipment.
The new standard is effective for public business entities in fiscal years beginning after Dec.15, 2018. For most other entities, it is deferred for one year, meaning that most calendar-year private companies will be required to adopt the new standard in 2020. Early adoption is permitted for all entities.
Under the required modified retrospective approach, lessors and lessees are required to adjust the accounting for any leases existing at the beginning of the earliest comparative period presented in the adoption-period financial statements. However, entities may elect to apply a number of optional practical expedients. If elected, an entity will, in effect, continue to account for leases that commence before the effective date of the new standard in accordance with previous GAAP unless the lease is modified. Under the practical expedients, lessees are still required to recognize a right-of-use asset and lease liability for all operating leases at each reporting date based on the present value of the remaining minimum rental payments that were tracked and disclosed under previous GAAP.
Although the effective date of the new lease standard is a few years away, companies should begin their implementation process soon given the expected time it will take, the need to design or redesign processes and controls, the desire to anticipate and manage the impact on their financial statements and ratios, and the requirement to apply a modified retrospective approach to comparative reporting periods. For calendar-year-end public-companies, the three-year comparative income statement will require that 2017 be accounted for under this modified retrospective approach. As a result, companies are well-advised to not delay their implementation efforts.
The new standard does not fundamentally change lease accounting from the lessor’s perspective, even though some changes were made to align the lessor accounting guidance with specific changes made to the lessee accounting guidance and revenue recognition guidance.
From a lessee’s perspective, the most significant change from prior lease guidance is that lessees are required to recognize the rights and obligations resulting from most operating leases as assets and liabilities on their balance sheet. Prior to the new standard, a lessee did not recognize assets and liabilities arising from most operating leases. While recognizing the related expense in the income statement, the lease obligations were off-balance sheet liabilities under previous GAAP. In 2005, the SEC urged FASB to reconsider the accounting guidance for leases given the approximate $1.25 trillion off-balance sheet obligations of SEC registrants at such time. As a result of having to recognize the rights and obligations arising from most leases on the balance sheet, the new standard will have a dramatic impact on the balance sheet of lessees. Accordingly, the following discussion will focus on the tax considerations of the new standard from a lessee perspective.
Deferred tax considerations
The most obvious tax accounting impact of the new lease standard is the creation of new, or changes to existing, temporary differences relating to leases given the change in the GAAP balance sheet. Accordingly, a company will need to consider the deferred tax implications in the implementation of the new lease standard.
Under the new standard, a lease with a term of more than 12 months will result in a “gross-up” on the GAAP balance sheet for the right-of-use asset and related lease liability. The initial measurement of a lease liability equals the present value of the lease payments discounted using the rate implicit in the lease. If that rate cannot be readily determined, the lessee will use its incremental borrowing rate, with nonpublic entities permitted to use a risk-free discount rate as an accounting policy election. The initial measurement of a right-of-use asset equals the initial measurement of the related lease liability, but increased for any lease payments made to the lessor at or before the commencement date (less any lease incentives received from the lessor) and any initial direct costs incurred by the lessee. Accordingly, the balance sheet gross-up does not necessarily mean the amount of the right-of-use asset will equal the amount of the related lease liability. For a lease with a term of 12 months or less without a purchase option that the lessee is reasonably certain to exercise, a lessee is permitted to make an accounting policy election to forgo recognizing the lease asset and lease liability on its balance sheet.
Since the new standard does not change the treatment of leases for income tax purposes, a lessee that is otherwise not required to capitalize the lease for income tax purposes will not have any tax basis in the right-of-use asset and related lease liability recorded for GAAP purposes. Since the differences between the GAAP and tax basis of the right-of-use asset and related lease liability will result in taxable income or deductions upon their reversal, such differences are temporary in nature. Accordingly, a company must recognize a deferred tax liability for the excess GAAP basis in the right-of-use asset and a deferred tax asset for the excess GAAP basis in the related lease liability. Whether the lease is classified as a finance or operating lease under the new guidance, the right-of-use asset and related lease liability are initially measured in the same manner, even though such amounts will not necessarily equal each other. Accordingly, the initial measurement of the temporary differences, while not necessarily equal in amount, will generally be the same regardless of the classification of the lease.
The manner in which the initial temporary differences reverse, however, is dependent on whether the lease is classified as a finance or operating lease under the new standard. Even though the income statement effect of leases under the new standard is largely unchanged from previous guidance, the difference in the reversal pattern between a finance and operating lease will affect the subsequent adjustments to the original deferred tax asset and liability.
- For finance leases, the new lease standard will generally result in an accelerated expense recognition for financial statement purposes. This outcome is due to the subsequent accretion in the lease liability being based on an effective interest rate calculation, similar to a mortgage with higher interest expense being incurred in the earlier years, with less interest expense incurred in later years as the mortgage liability is reduced by payments made.
- For operating leases, the new lease standard will generally result in a constant annual cost similar to the expense pattern under current operating lease accounting. While the subsequent accretion in the lease liability is also based on an effective interest rate calculation, the right-of-use asset is amortized at a rate to ensure that the cost of the lease is allocated over the lease term on a generally straight-line basis.
To illustrate the deferred tax accounting at the initial measurement date, as well as the end of the first year of a lease, let’s assume the following facts:
- Lessee, a calendar-year public company, enters into a 10-year lease agreement, with no option to extend, on Jan. 1, 2019.
- The lease requires annual payments of $5,000 at the end of each year.
- The interest rate implicit in the lease cannot be readily determined; the lessee’s incremental borrowing rate is 5.81%.
- The lessee made no lease payments to the lessor at or before the commencement date of the lease; the lessee incurred no initial direct costs pertaining to the lease.
- The amortization of the right-of-use asset is on a straight-line basis, reflecting the pattern in which the lessee expects to consume the right-of-use asset’s future economic benefits.
- The lessee’s applicable tax rate is 40%.
- The applicable tax law allows the lessee to deduct any lease payments made during the year.
Based on these assumed facts, as of Jan. 1, 2019, the initial measurement of the right-of-use asset, lease liability and related deferred taxes are shown below. As of Dec. 31, 2019, the subsequent measurement of these assets and liabilities, based on the activity during 2019, is also shown below. The illustrations first start with a finance lease, followed by an operating lease.
As illustrated, the new lease standard can have a significant effect on the GAAP balance sheet, even if the income statement effect is not as significant. The new lease standard can have other deferred tax implications, including but not limited to:
- Affecting valuation allowances given the changes to recorded deferred tax assets, changes to recorded deferred tax liabilities and the pattern of reversal of the book-to-tax differences arising under the new lease standard.
- Changing contemplated tax-planning strategies as a source of future taxable income to support the realizability of a deferred tax asset. For example, many sale and leaseback transactions involving real estate will qualify for sale and leaseback accounting that would not have qualified under the previous lease guidance. However, some sale and leaseback transactions involving assets other than real estate that previously would have qualified for sale and leaseback accounting will not qualify under the new standard.
- Affecting the current exception with respect to the tax accounting pertaining to leveraged leases that commence after the effective date of the new standard, because the current accounting model is not retained for leveraged leases that commence after the effective date of the new standard.
Given these deferred tax implications, companies will need to evaluate the necessary changes to their tax-related processes, controls, and systems to identify and record the deferred tax effects arising under the new lease standard.
Other tax considerations
Beyond the impact on deferred tax accounting, the new lease standard may have other tax implications that are not as readily evident, including but not limited to:
- State apportionment
Although many states have adopted a single sales factor, some states still rely — at least in part — on the property factor to apportion taxable income to their state. The computation of the property factor may be affected to the extent that the property factor is computed based on the GAAP basis of property, such as in Mississippi. The property, plant and equipment (PP&E) line item on the GAAP balance sheet will increase to the extent a company presents the right-of-use assets within the same balance sheet line item as the corresponding underlying assets would be presented if they were owned, e.g., a right-of-use asset pertaining to the lease of equipment would be presented as if the equipment was owned. It should be noted, however, that finance lease assets cannot be included in the same balance sheet line item as operating lease assets. For example, if right-of-use assets pertaining to finance leases are included within the PP&E balance sheet line item, then right-of-use assets pertaining to operating leases must be presented in a GAAP balance sheet line item other than PP&E. To the extent that the right-of-use assets are presented in a GAAP balance sheet line item other than PP&E, a company will need to evaluate, under the laws of the relevant tax jurisdiction, whether such assets are includible in the property factor. In that regard, it may be relevant to note that FASB recognized that a lease is not the same as a purchase of the underlying asset, even when the lease is a finance lease. Despite recognizing this distinction, FASB decided that a finance lease, but not an operating lease, is economically similar to an acquisition of the underlying asset.
Additionally, certain states include a multiple of rent expense incurred for the year in the property factor (a multiple of eight times annual rent is fairly common).
- To the extent rent expense is based on the amount as reported for GAAP purposes, such amount may change under the new standard. For example, under previous GAAP, a company reported rent expense resulting from most operating leases. To the extent such operating leases are treated as finance leases under the new standard, rent expense will no longer be reported in the income statement. Instead, the income statement effects of a finance lease will be limited to interest expense and amortization. The lease cost of an operating lease, on the other hand, will be reported as a single line item on the income statement, even though its underlying components consist of interest expense and amortization.
- Even in those states that calculate the multiple of rent expense based on the amounts incurred for tax purposes, the GAAP income statement may no longer be useful to readily identify annual rent expense associated with operating leases. Instead of being able to use the GAAP general ledger balances, a company will need to compute the multiple of rent expense based on the amounts incurred for tax purposes.
To the extent that the computation of the property factor for state apportionment purposes is affected by the new lease standard, the apportionment of a company’s taxable income to the various states that it is subject to state income tax may change. Since the tax rate varies from jurisdiction to jurisdiction, a company’s effective state tax rate will inevitably change. Depending on the company’s particular lease portfolio and the jurisdictions in which the apportionment percentages are affected, a company may experience an increase in its state tax rate if the relative allocation moves from lower-tax to higher-tax jurisdictions. Regardless of whether the impact on the effective tax rate is favorable or unfavorable, a company should determine such impact and include it in the tax rate being applied to determine the deferred tax effects relating to the temporary differences arising under the new lease standard. To the extent that the new lease standard causes a change in the tax rate expected to apply to existing temporary differences unrelated to leases, a company should also adjust the related deferred tax assets and liabilities to reflect the change in its expected tax rate.
It is possible that the new lease standard may result in more “buy” decisions when evaluating the “buy vs. lease” alternative since a company will no longer be able to avoid recording the lease liability on its GAAP balance sheet if the lease term would be more than 12 months. The recent extension of bonus depreciation for federal income tax purposes for property placed in service through 2019 may also be a contributing factor to a “buy” decision. If so, even in states that compute their property factor based on the tax basis of property owned, a company may experience changes in its future apportionment percentages as a result of having more property owned instead of being leased. Of course, this would also result in less of a multiple of rent expense if based on the amount of rent expense incurred for tax purposes.
- Franchise, net worth and other non-income-based taxes
Certain jurisdictions impose franchise taxes or net worth taxes for the privilege of doing business within their jurisdiction. Such taxes are generally based upon the net worth (stockholders’ equity) of a company. However, certain adjustments may be required under the laws of the relevant jurisdiction (e.g., treasury stock, debt, reserves) to arrive at the taxable base. In the case that debt is one of the adjustments, a company will need to consider whether the lease liabilities constitute debt for purposes of this adjustment. The discussion below, regarding the interest expense considerations of the new lease standard, may be relevant in this consideration.
With the gross-up in the balance sheet for GAAP purposes, the new standard may affect the net worth of a company, thereby impacting the amount of franchise tax paid (or other nonincome-based taxes). In Illinois, for example, the value of a company for franchise tax purposes is based on its GAAP balance sheet. Additionally, in states such as North Carolina and Tennessee, where the franchise tax is based on the amount of assets a taxpayer has in the state, a company’s franchise tax liability may be affected by right-of-use assets recorded under the new lease standard.
- Personal property or real estate taxes
Many jurisdictions impose personal property taxes on tangible personal property. To the extent that a company records a right-of-use asset in those jurisdictions, e.g., through a lease of equipment, a company will need to evaluate whether this right to use tangible personal property,itself, constitutes property subject to personal property tax. As previously noted, FASB recognized that a lease is not the same as a purchase of the underlying asset but yet concluded that a finance lease is economically similar to an acquisition of the underlying asset. Whether the right-of-use asset constitutes property subject to personal property tax will need to be resolved based on the laws of each particular jurisdiction.
A company may also record a right-of-use asset arising from a lease of land, building or part of a building. In such a scenario, a company will similarly need to evaluate whether this right to use real property, itself, constitutes property subject to real estate taxes based on the laws of each particular jurisdiction.
At times, property tax assessors have argued that operating leases should be capitalized for property tax purposes. Through requiring the recognition of a right-of-use asset pertaining to lease obligations, the new standard may cause property tax assessors to be more aggressive in making such arguments. Even if property tax assessors were already making adjustments to take into account the value associated with leased property, the new lease standard could cause them to value the property differently than they have in the past through relying on the specific guidance provided by FASB relating to the measurement of the right-of-use asset.
Whether regarding personal or real property taxes, the core question is whether the lessee, which has recorded the right-of-use asset, or the lessor, which has legal ownership of the underlying asset, is liable for paying the property tax on the leased property. Even if a determination is made that the lessee is responsible for the property tax under the laws of a particular jurisdiction, one would still need to determine whether the GAAP value — recorded and amortized in accordance with GAAP — represents the fair market value of such asset for purposes of imposition of the property tax. Of course, the terms of the lease agreement may address whether one party must reimburse the other for property taxes imposed on the leased property.
At a minimum, even if the new lease standard does not affect the amount of personal or real estate taxes being paid, a company may experience increased compliance burdens to account for the differences between GAAP and tax across the various tax jurisdictions to which it is subject. The increased compliance burden arises from having to identify, evaluate, document, record, and track differences between GAAP and tax treatments across the various tax jurisdictions to which the company is subject.
- Sales and use tax
Many jurisdictions impose sales and use tax on rentals of tangible personal property, with a few jurisdictions also imposing such tax on rentals of realty. To the extent that the law in any jurisdiction imposes such tax based on rent incurred for financial statement purposes, the timing of the sales and use tax obligation could change given that the new lease standard may change the timing of the rent expense recognition.
Much worst would be whether any jurisdiction could view the recording of the right-of-use asset as being the equivalent of a purchase of such an asset from the lessor, thereby resulting in an immediate sales tax imposition on a purchase transaction. In that regard, it is important that the Streamlined Sales and Use Tax Agreement, which has been adopted in 24 states, expressly provides that the characterization of a transaction for financial accounting purposes is not relevant for purposes of sales and use tax determinations. Outside of these states, a taxpayer may be subject to an examination in which the taxing authority could assert the lease transaction constitutes a purchase transaction subject to immediate sales and use taxation. Given the annual book expense may exceed the annual cash payments made in the earlier years of a finance lease, a taxpayer could also experience tax increases in those earlier years in those states that assess tax on an accrual basis. This may require the self-accrual of use tax on such excess. Additionally, some states may need to change their tax regulations — to the extent they refer to the GAAP treatment of leases — to align with the changes made in the new lease standard.
Similar to the observation with respect to personal property and real estate taxes, a company may experience increased compliance burdens, even if the new standard does not impact the timing and amount of sales and use tax payments.
- Interest expense considerations
Occasionally, it is difficult to determine if an instrument is classified as debt or equity for tax purposes, particularly with respect to hybrid instruments and intercompany financing arrangements that contain both debt and equity elements. There are various factors derived from case law that are used in making such a classification, with no particular factor conclusive. One is the debt-to-equity ratio of the company.
With the requirement to record lease liabilities as an obligation on the balance sheet, a company’s debt-to-equity ratio will inevitably change. In this regard, it is interesting to note the FASB recognized that liabilities pertaining to finance leases are the equivalent of debt, whereas liabilities pertaining to operating leases are not “debt like” but instead operating liabilities. Given their different nature, the new lease standard prohibits finance lease liabilities from being presented in the same balance sheet line item as operating lease liabilities. Despite this distinction, the debt-to-equity ratio, at least for some purposes, is calculated by dividing all liabilities, including short-term liabilities such as accounts payable, by the total equity of the company. Accordingly, whether or not the lease liabilities are the equivalent of debt, the new lease standard will cause companies to be more leveraged — at least with respect to the GAAP balance sheet. This outcome, along with the other relevant factors, could possibly affect the debt vs. equity classification of an instrument. If so, the tax consequences could be much larger (e.g., an instrument classified as debt otherwise giving rise to tax-deductible interest expense in a particular jurisdiction may instead be classified as equity, with no associated interest expense deductions).
While the change in the debt-to-equity ratio may have more immediate financial statement concerns, including potential violations of existing debt covenants, a company should evaluate whether its debt-to-equity ratio is affected for tax purposes in the various jurisdictions it is subject to tax. If so, the company should determine how the debt-to-equity ratio is determined under the relevant tax law provision. In the U.S., for example, a company’s debt-to-equity ratio is relevant for purposes of certain Internal Revenue Code provisions dealing with the deductibility of interest. One of those provisions is Section 163(j), otherwise known as the earnings stripping rules. For purposes of computing the debt-to-equity ratio under Section 163(j)(2)(C):
- Debt is defined as the amount of the taxpayer’s liabilities determined according to generally applicable tax principles, as opposed to GAAP. Accordingly, the amount of a company’s debt for purposes of this ratio will not increase due to the inclusion of the lease liabilities in the GAAP, but not tax, balance sheet.
- Equity is based on the adjusted basis of assets as determined according to generally applicable tax principles. As a result, the amount of a company’s equity for purposes of this ratio will not increase due to the inclusion of the right-of-use assets in the GAAP, but not tax, balance sheet.
Although the new lease standard does not affect this particular provision, a company should evaluate whether the change in its debt-to-equity ratio for GAAP purposes is relevant for other tax provisions in any jurisdiction it is subject to tax. In that regard, it is relevant to note that the IASB issued its final lease standard (IFRS 16) in January. The IFRS standard is fairly well-aligned with the new GAAP standard with respect to the balance sheet treatment of leases, with both standards resulting in a gross-up on the balance sheet for lease assets and liabilities. As a result, a company may experience a change in its debt-to-equity ratio, or similar computation under a jurisdiction’s respective thin capitalization regime, if determined in accordance with IFRS and relevant in the jurisdictions in which it is subject to tax.
A company should also consider the impact on any interest expense deduction limitations imposed in certain jurisdictions based on a percentage of EBITDA if such limitations are based on reported GAAP or IFRS amounts. For example, the recommended approach under Action 4 of the Organization for Economic Cooperation and Development’s Base Erosion and Profit Shifting Project is based on a fixed-ratio rule, which limits an entity’s net deductions for interest and payments economically equivalent to interest to a percentage of its EBITDA. In such cases, with respect to the GAAP accounting for a finance lease, EBITDA will be favorably affected given the lease expense will be reported as interest and amortization expenses, thereby not affecting the EBITDA determination.
- Foreign income taxes
Some foreign jurisdictions account for lease transactions for tax purposes in accordance with how they are treated for book purposes. Additionally, some foreign jurisdictions base their local income tax liability on the company’s statutory accounting income. As previously noted, the IASB issued its final lease standard in January, with the GAAP and IFRS standards fairly well-aligned with respect to the balance sheet treatment of leases. However, the standards differ in certain aspects of the lessee accounting, including the manner of recognizing the lease expense on the income statement. Depending on the accounting lease standard used for local accounting purposes, a company may experience changes in its local accounting income.
To the extent that a company operates in foreign jurisdictions, which base their local income tax liability on the company’s accounting income, it will need to evaluate the impact of the new lease standard on foreign income tax expense.
- Foreign earnings repatriation
Certain foreign jurisdictions have minimum capital requirements and/or restrictions on dividend distributions. Additionally, certain jurisdictions may impose a branch-level tax on the after-tax earnings of branch operations that are not reinvested. To the extent such jurisdictions view the gross-up in a foreign subsidiary’s balance sheet — whether arising under the GAAP or IFRS lease standard — as being relevant in adhering to such requirements or restrictions, the decision to reinvest the earnings of the foreign subsidiary or branch or to repatriate them to a U.S.-based parent may be affected.
- Transfer pricing
Some companies create special-purpose entities to hold certain property such as real estate, with the objective that such entities will lease the property to related parties. The new lease standard applies to related-party leases based on their legally enforceable terms and conditions, rather than their economic substance as under previous GAAP guidance. In setting forth this requirement, FASB acknowledged that some related-party transactions are not documented and/or the terms and conditions are not at arm’s-length. Regardless of how related-party leases are accounted for purposes of GAAP, transfer-pricing rules may nevertheless require that they reflect an arm’s-length price between the related parties for income tax purposes.
The new lease standard may also affect intercompany lease transactions given the disparate treatment of the lease from the lessee’s and lessor’s perspective. In such cases, a timing mismatch may occur of the related revenues and expenses. It should be noted that the new lease standard, however, does not affect leases of intangible assets. Therefore, it should not affect certain cross-border international tax planning with related parties, such as the leasing of rights to intellectual property.
The new lease standard may indirectly affect transfer-pricing outcomes on other related-party transactions given it will affect certain financial ratios and profit-level indicators of the companies involved.
Years in the making, the issuance of the new lease standard will now require companies to focus on its implementation. From a lessee perspective, the most dramatic impact will be the gross-up on the GAAP balance sheet for the right-of-use assets and related lease liabilities. Depending on the volume and nature of the leases, this impact could be quite sizable. Given that this GAAP balance sheet gross-up will create, or cause differences to existing, temporary differences, a company must consider the deferred tax effects of the new lease standard. This GAAP balance sheet gross-up may cause other tax effects, which are not as readily evident but that a company should assess in its implementation efforts.
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