2020 and Beyond – Keep an Eye on the Tax Code!

by Joe Sebik Mar/Apr 2020

2020 may see many changes to the political arena and possible changes in the Tax Code. This article will examine areas of the Tax Code that lessors should monitor for opportunities as well as with caution.

Joe Sebik, CPA Director, Tax Reporting, S iemens Financial Services
Joe Sebik, CPA Director, Tax Reporting, Siemens Financial Services

2020 may see many changes to the political arena and possible changes in the Tax Code. This article will examine areas of the Tax Code that lessors should monitor for opportunities as well as with caution. 

Be on the watch for potential corporate tax rate increases and other changes!

As the Democratic debates and primaries continue, a common theme is coming through; corporate income tax rates and the Tax Code in general are again subject to change.

Keep in mind that aspects of the Tax Code include incentives to stimulate investment in capital assets which are part of the industrial heart of this country that every candidate says has been damaged by offshoring.

To recap, the Tax Cuts and Jobs Act (TCJA) reduced corporate income tax rates to 21% and re-introduced 100% bonus depreciation. Bonus depreciation somewhat offset the lower tax rate with regards to the sheltering created through accelerated depreciation, by improving the present value of those benefits.

At this time, both remaining candidates suggest tax rate increases and changes should they become president.

Senator Sanders proposes raising the corporate tax rate back to 35% and using an economic depreciation for all investments, something much slower than current accelerated methods.

Vice President Biden suggests 28% as well as a 15% minimum tax.

Beware the Effect on Existing Investments

Leasing and lending, as well as investing, in any long-term capital asset have one common thread: their economic effect occurs over an extended timeframe. Any assumption about the after-tax return on the investment assumes a future tax rate.

Loan Pricing: When pricing a loan, one assumes a forecasted spread between the interest income and the interest expense from debt used to leverage the investment. Loan pricings usually assume the tax rate used to calculate the after-tax return on the investment will be uniform for the duration of the loan. Typically, the lender usually assumes any risk of a change in tax rates (however see the tax-exempt loan section below).

Tax Lease Pricing: When pricing a tax lease, it is assumed the leased asset will be disposed of at the end of the lease and taxes will be due on the taxable gain from the asset sale. Again, the tax rates in this equation are usually based on tax rates at the inception of the lease unless a published schedule exists for rates to change in the future.

When the corporate income tax rate decreased from 35% to 21% as a result of TCJA, lessors typically benefited. For instance, a truck lease under a terminal rent adjustment clause (TRAC) lease that assumed a $50,000 residual value was assumed to be taxed at 35%. Assuming the truck has a zero tax-basis, the full proceeds of $50,000 would be taxed and the lessor would retain $32,500 ($50,000 x (100%–35%)). When the tax rate dropped to 21%, lessors had a windfall and could expect to receive 79% of the proceeds, or $39,500!

If the corporate income tax rate is increased back to prior levels, outstanding tax lease transactions and taxable loans that were priced assuming a 21% tax rate would be negatively affected. This could have a material effect on the expected yield of the existing investments.

Tax-exempt Loan Pricing: With respect to tax-exempt loan investments, after the federal income tax rate decreased, after-tax yields of existing tax-exempt loans also decreased. In those cases, the original pricing assumed that the revenue was not taxable but that costs were deductible at 35%. When the after-tax value of those deductions decreased because of the tax rate decrease (while the revenue remained tax-exempt), the after-tax yield on those investments also decreased. While many tax-exempt loans had adjustment clauses which compensated for this change, not all lenders enforced them on the borrowers because of “customer satisfaction reasons.”

Therefore, if tax rates increase, the after-tax yields on existing tax-exempt investments would also increase because the after-tax cost of the expenses then decreases. Of course, for those loans in which lenders enforced the indemnification, the borrowers will likely ask for the rate increase back!

Portfolio Balancing: The takeaway here is that since different investments are affected differently from tax rate changes, if possible, lenders and lessors should consider maintaining a balanced portfolio (if possible) so that offsetting effects counter balance each other. Of course, it would also be great if one could simply hedge against the downside risks and retain the upside profits!

Beware ‘Back Door’ Tax Increases

In the TCJA, certain new tax rules were put in place which, although they did not specifically change a prior tax rule, created diminished benefits for a targeted circumstance.

For instance, TCJA introduced a limit on the amount of interest expense that can be deducted. Any excess above the limit is carried forward until such time as the current period interest expense is below the limit.

The interest deduction limitation effectively prevents an entity from deducting all of its’ interest expense currently if the interest expense is greater than 30% of tax EBITDA. In a few years the limitation becomes even stricter as it is based on EBIT. So, while taxpayers may have borrowed in good faith and planned their long-term investments assuming they can deduct the expense when incurred, the interest expense may not be currently deductible. While this may benefit tax-leasing (because rents are not limited), it may affect those lessors that borrow heavily to finance their rental fleets.

An additional “back-door” tax amendment was the Base Erosion Anti-Abuse Tax (BEAT). BEAT mostly targeted U.S. subsidiaries of foreign entities which previously transferred taxable income overseas through intercompany loans and royalties. BEAT created an alternative tax, which is calculated as 10% on an adjusted taxable income after subtracting BEAT payments (the intercompany interest payments, for example) as well as cutting some tax credits by 20%.

For example, a taxpayer that had previously invested in a wind farm and that subsequently became subject to BEAT would find their projected 10-years of tax credits cut by 20% and their tax losses from accelerated depreciation (also key to their after-tax return) would be valued assuming a 10% tax rate instead of a 21% rate.

So while the basic tax rules did not change, the taxpayer was affected by the “back door” tax increase through a set of new rules. While several tax rules have been presumptively fixed for several years, such as the bonus depreciation phase-down schedule, who knows what other future “back door” revisions could be created that affect these existing tax rules. Biden’s minimum tax is just one of those possible examples.

What is a Lessor or Lender to Do?

With the real possibility that more radical tax law changes could occur, what actions can a lessor or lender take to mitigate the possible effects?

1. Review your existing portfolio of investments.

Lessors should measure the effect of potential changes in tax rates and consider the effect on the overall portfolio yield. Consider portfolio balancing, if possible. Lenders and lessors should determine whether and how much tax rate changes could either put them at risk or benefit them.

2. Adjust your business model.

Operating lessors that typically borrow large sums to finance the acquisitions of assets for their rental portfolio may consider leasing them instead to reduce interest expenses. Many lessors commonly use leasing to manage their own tax bills.

Lessors that may become subject to BEAT can reduce their cross-border interest expenses by using leasing to finance some of their asset acquisitions.

Using sale lease-backs are one form of managing a company’s taxable income as well as interest expenses.

3. Start exploring “two-way” tax-indemnification clauses in agreements.

Lessees and borrowers may have felt that lenders and lessors were given a nice gift from Congress after TCJA and may now be reluctant to agree to indemnify them for any increase in tax rates, but it is worth a try. Perhaps when negotiating lease or loan rates borrowers may ask for a lower initial rate in exchange for providing such an indemnity. Lenders and lessors should incorporate some form of probability analysis of a rate adjustment into their pricing models.

4. Be creative and search for a hedge against tax-rate changes. 

We have heard of products that previously provided forms of insurance or hedges for many different types of events — from weather-related events to risk against IRS challenges. Perhaps it is time to ask your investment bankers if hedges exist for tax-rate changes.

Conclusions

Now more than ever, lessors must understand the repercussions of both current tax laws and potential future changes to those laws. The leasing industry can provide a valuable service to companies to help them manage their tax bills, but the industry must understand how they educate their customers on these benefits! Lessors themselves must also incorporate some of these same actions to manage their own business.

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