FASB’s new lease accounting standard is effective for public business entities for fiscal years beginning after Dec. 15, 2018, and for most other entities for fiscal years beginning after Dec. 15, 2019. While the standard does not significantly affect lessors, the new standard will have a dramatic impact on lessees’ balance sheets; lessees will be required to recognize their rights and obligations from most operating leases as assets and liabilities. Prior to the standard, operating lease-related expenses were reflected on the income statement, but were off-balance-sheet items under GAAP. Companies should already be putting in place the processes, controls and systems necessary to address this change. One of the most surprising aspects of an implementation is that companies are finding just how labor-intensive the new standard can be to accurately determine the balance sheet requirements. The other surprise comes if you haven’t incorporated tax considerations into the process up front.
The following are six key tax issues driven by the new standard that CFOs should consider.
1. Deferred tax considerations
Under the new standard, a lease with a lease term (as defined) of more than 12 months generally will result in recognition on the balance sheet for the right-of-use asset and the related lease liability. Since the new standard does not change the treatment of leases for income tax purposes, a lessee not otherwise required to capitalize the lease for income tax purposes will not have any tax basis in the right-of-use asset or related lease liability. Regardless of whether a lease is classified as finance or operating, the right-of-use asset and the related liability are initially measured for GAAP purposes in the same manner. This is even though such amounts will not necessarily equal each other because of adjustments to the asset for things such as: payments made prior to the commencement date, incentives received from the lessor and initial direct costs incurred. Therefore, the initial measurement of the temporary differences will generally be the same regardless of the classification of the lease for book purposes. However, the amount of the temporary difference may be dramatically different depending on whether the lease is also capitalized for income tax purposes.
Under the new standard, however, the pattern of reversal for those temporary differences depends on whether the lease is classified as an operating or finance lease for GAAP purposes. Therefore, even though the income statement effect of the leases is largely unchanged from previous guidance, the difference in reversal patterns between finance and operating leases will affect the subsequent adjustment to the original deferred tax asset and liability.
- For finance leases, because the subsequent accretion of the lease is based on an effective interest rate calculation, the new lease standard will generally result in an accelerated expense recognition for financial statement purposes.
- For operating leases, while the subsequent accretion is also based on an effective interest rate, the right-of-use asset is reduced in such a way that the cost of the lease is allocated over the lease term on a generally straight-line basis. Therefore, the new lease standard will generally result in a constant annual cost.
The new lease standard can have a significant effect on the balance sheet, even if the effect on the income statement is minimal. The new lease standard can have other deferred tax implications as well, including:
- Valuation allowances may be affected because of 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 standard.
- Taxpayers may have to revisit tax planning strategies involving deferred tax assets. For example, many sale and leaseback transactions involving real estate that would not have qualified for sale and leaseback accounting under the old standard now may qualify, while such transactions involving assets other than real estate may no longer qualify for sale and leaseback accounting.
- To the extent that the tax department has not reviewed the leases, there could exist potentially missed book versus tax treatment differences related to items such as:
2. State income tax apportionment
- Tenant allowances
- Deduction of rental payments
- Acquisition costs
- Certain leasehold termination payments
- Lease classification as either a true lease or a sale/finance lease
If your company has corporate income tax nexus in states that continue to use a property factor as a component in apportioning 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. Some states also use a multiple of rent expense (generally, eight times annual rent) in the property factor. If the rent expense is based on the amount reported for GAAP purposes, that amount may change under the new standard. Your company’s overall effective state tax rate could change, if your company is affected by these apportionment issues.
3. Franchise, net worth and similar taxes
If your company does business in jurisdictions that impose franchise, net worth or similar taxes, which are often based on the net worth (shareholders’ equity) of the company, the recognition in the balance sheet required under the new standard may change your company’s net worth due to required adjustments for debt, which would affect the amount of tax you owe. Other jurisdictions base the franchise tax on the amount of assets a taxpayer has in the state. In these states, your company’s franchise tax obligation may be affected by the right-of-use assets recorded under the new standard.
4. Personal property and real estate taxes
In jurisdictions that impose taxes on personal or real property, companies recording a right-of-use asset through a lease of equipment or real property may find taxing authorities claiming that the right-of-use asset subjects them to tax. While FASB has recognized that a lease is not the same as a purchase of an underlying asset, it has also concluded that a finance lease is economically similar to an acquisition. Therefore, whether a right-of-use asset constitutes property subject to personal or real property taxes will depend on the laws of each jurisdiction and the facts and circumstances of each case. Even if companies face no additional tax expenses, they may face new compliance burdens. Some lease agreements address whether one party must reimburse the other for property taxes imposed on leased property. Therefore, this may be a good time to review your company’s leases to see whether such terms are included and to consider adding these provisions on prospective leases.
5. Sales and use taxes
Many jurisdictions impose sales and use tax on rentals of tangible personal property, with some also imposing such tax on rentals of real property. To the extent such tax is based on rent incurred for financial statement purposes, the new standard could change the timing of the rent expense obligation. In addition, some jurisdictions may consider recording a right-of-use asset as equivalent to a purchase, resulting in an immediate sales tax obligation. (Note that this will not happen in the 24 states that have adopted the Streamlined Sales and Use Tax Agreement, which expressly provides that the characterization of a transaction for financial accounting purposes is not relevant for purposes of sales and use tax determinations.) As with personal property and real estate taxes, even if the new standard does not affect the timing or amount of your obligations, it may still create new compliance issues.
6. Interest expense considerations
The new standard’s requirement to record lease liabilities as an obligation on the balance sheet will inevitably change a company’s debt-to-equity ratio. While FASB recognizes that liabilities pertaining to finance leases are the equivalent of debt, whereas liabilities pertaining to operating leases are not, the debt-to-equity ratio, at least for some purposes, is calculated by dividing all liabilities by the total equity of the company. Accordingly, the inclusion in the debt-to-equity ratio of lease liabilities resulting under the new standard will cause companies to be more leveraged — at least with respect to the GAAP balance sheet. This outcome could raise a variety of tax and other issues, including potential:
- Violations of existing debt covenants
- Limitations of interest expense deductions based on EBITDA
While CFOs should focus on the above six tax issues, they should also evaluate whether the new standard could:
- Change the amount of tax paid in foreign jurisdictions that base their income tax liability on a company’s statutory accounting income.
- Impact restrictions on repatriation of foreign earnings in jurisdictions that have minimum capital requirements and/or restrictions on dividend distributions.
- Indirectly change transfer pricing outcomes to the extent certain financial ratios and profit-level indicators are impacted.
National Managing Partner, Strategic Federal Tax Services
+1 954 224 4171