The Effect of Tax Reform: The Good, the Bad and the Unclear

by Joe Sebik March/April 2018

In the second installment of a series, Joe Sebik discusses the potential upsides and pitfalls of the Tax Cuts and Jobs Act.

Joe Sebik,
Director,
Tax Reporting, Siemens Financial Services

This is the second article analyzing the effect the Tax Cuts and Jobs Act (H.R. 1) will have on the equipment financing industry. It will cover a few identified opportunities and challenges that may result from the tax reform changes. The IRS may issue interpretations on applying the law, so some of these items may change over time.

Potential Opportunities

Lessee grandfathered bonus depreciation

When bonus depreciation rates change, questions always exist regarding when an asset will be eligible for the specific bonus depreciation. Add to this the change in tax rates, and opportunities for lessors may arise.

Assets acquired before September 28, 2017 but placed in service after September 27, 2017 are subject to the old bonus depreciation rules. Section 13201 of the House and Senate Conference Report, stated “…the amendments to depreciation shall apply to property which a) is acquired after September 27, 2017, and b) is placed in service after such date … property shall not be treated as acquired after the date on which a written binding contract is entered into for such acquisition.”

The definitions of acquired and written binding contract under the tax code are important. If an asset was delivered to, or assembled or constructed on, a customer site before September 28, 2017 and placed in service and operation in 2018, it may be subject to the prior 50% bonus depreciation rules and depreciated over the remaining MACRS life and at the new 21% statutory rate, diminishing the present value of the after-tax effect of the write-off.

However, a lessor may be able to claim the 100% bonus depreciation when acquiring the same asset from the lessee. Any time a lessee is subject to a different set of tax rules or assumptions, as in this case, an opportunity may exist to provide more cost-efficient financing.

Lessors may want to suggest potential lessees 1) closely examine the new tax rules and their outstanding asset acquisition orders and 2) prepare a lease-versus-own analysis to see how they compare. Leasing an asset versus owning it also eliminates the interest expense that may be subject to limitation, so the advantages start to multiply.

Sale-leasebacks

Taxpayers that previously decided to own rather than lease equipment may take advantage of the federal rate drop to create another unexpected opportunity. For example, taxpayers that acquired new or used assets after September 27, 2017 but before January 1, 2018 can deduct 100% of the asset value at the 35% tax rate. If the taxpayer sells the asset in 2018 to a lessor for the same price paid, the gain will be taxed at only 21%, resulting in a 14% immediate implicit economic gain through the tax differential in the sale-leaseback. This may swing a transaction from ownership to a lease. Although other issues pertain to this action, the immediate benefit may be advantageous because of the tax benefits.

Lessee Early Buyout Options

Depending on an asset’s acquisition and financing history, a lessee exercising an EBO of an asset to which they previously had title may be unable to claim 100% bonus depreciation. The lessor from whom they purchased the asset may also be unable to claim 100% bonus depreciation since the asset has already been depreciating. This may be an opportunity for a new lessor to lease the asset to the lessee and claim 100% bonus depreciation.

Tax-Exempt Lease/Loan vs. True Leases

Smaller tax exempt loans (under $10 million) are generally issued into the bank-qualified tax-exempt marketplace through a financing conduit, such as a state dormitory agency. Normally an investor cannot deduct the interest expense from debt used to finance a tax-exempt loan for taxes. However, an exception in the tax code permits banks to directly hold these bank-qualified loans and still deduct a portion of the interest expense used to fund the transaction. The interest rate to issue such bank-qualified, tax-exempt debt is affected by the tax rate at which the interest expenses used to fund the debt are deducted. At a 35% tax rate, the after-tax interest expense cost is 65% (100% – 35% tax benefit) of the amount paid while at a 21% rate, the after-tax cost increases to 79% (100% – 21% tax benefit). Calculating indicative pricing to estimate how the rate would change suggests interest rates in this marketplace may increase about 0.425% for five-year loans to about 0.600% for 10-year loans. Certain traditional commercial tax leases may become more attractive to these borrowers. The caveat is to take advantage of the 100% bonus depreciation when leasing to a tax-exempt lessee, the lease must be 60 months or less and the asset must be “qualified technological equipment” such as high technology medical equipment, computers and peripheral equipment and communication equipment.

Challenges

Syndication of Used Equipment

The new tax rules may change the way syndications of tax leases must be structured as a result of the inclusion of used equipment. Previously, to claim bonus depreciation, a lessor had to acquire a new asset within three months of the asset originally being placed in service with the end-user. This tax rule was created to facilitate syndicated lease financings.

Under the new tax rules, a lessor can claim 100% bonus depreciation when acquiring a used asset, regardless of the original placed-in-service date with the lessee, so the asset can be new or used if the lessor is acquiring it for the first time. If the lessor desires to further syndicate the lease, the rules are unclear as to whether the second lessor can also claim the 100% bonus depreciation. Opinions regarding the rule’s intention vary — the IRS may clarify this in the future — but as it is written, there appears to be a restriction on syndications.

Specifically, the Internal Revenue Code states:

“…if property is used by a lessor of such property and such use is the lessor’s first use of such property, such property is sold by such lessor or any subsequent purchaser within three months after the date such property was originally place in service and the user of such property after the last sale during such three month period remains the same as when such property was originally placed in service, such property shall be treated as originally placed in service not earlier than the date of such last sale.”1

This indicates that in order to claim 100% bonus depreciation, any syndication must be completed within three months of the date when the end user placed the property in service. Assume ABC recently acquired two used assets and executed a sale-leaseback with Lessor No. 1, which can claim 100% bonus depreciation. Lessor No. 1 desires to syndicate the lease by selling one of the assets subject to the lease. It seems Lessor No. 1 must sell the asset and lease within three months of ABC placing it in service.

When a lessor executes a large sale-leaseback of multiple assets and does not intend to hold the entire portfolio, to maximize the 100% bonus depreciation, it may need to assemble a syndicate beforehand to complete the syndication within the three-month period.

Alternatively, lessors within a syndicate may have to directly acquire the assets to claim the 100% bonus depreciation and avoid the three-month requirement. Assume ABC has 150 used rail cars (previously held more than three months) and desires to execute a sale-leaseback on them. Lessor No. 1 wants to hold only 50 of the cars and locates Lessors No. 2 and No. 3 to own the other cars. For Lessors No. 2 and No. 3 to claim 100% bonus depreciation, the syndicate must be assembled up front. Lessor No. 1 cannot underwrite the 150 rail cars to resell 100 cars because the 100 will lose their 100% bonus depreciation since they were not syndicated within three months of the placed-in-service date by ABC! While this may not seem logical, the rules seem to be written that way. Large underwriting lessors may lose financial muscle because of this rule. This may also be an area where guidance is needed from the IRS.

Lessee Early Buyout Options

An opportunity for one lessor may be a caution for another. Lessees exercising an EBO may direct that asset to another lessor that can claim 100% bonus depreciation while the existing lessor would have no such tax sheltering opportunity. This may result in increased competition for this business by lessors seeking to break into a particular account.

Used Equipment from Related Parties

While 100% bonus depreciation is available for used equipment, it is not available if the used equipment was purchased from a related party filing a separate tax return. This will most often happen when the lessor is a captive of a manufacturing company filing a separate return or when the lessor uses another unconsolidated legal entity or joint venture to refurbish, rebuild or remarket used equipment. The price a captive may be required to charge to lease a used asset may be affected by this limit of bonus depreciation. This, again, may have to be addressed either through a process change or by clarification from the IRS.

Footnotes

  1. §168(k)(2)(E)(iii)(I&II)

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