First let me say “congratulations” to my colleague and Monitor author Bill Bosco on his retirement. It’s been a privilege to know Bill and to work with him for more than 25 years, and I hope that I can fill some of the gaps that his retirement has created in the leasing industry.
The end of 2017 marked the passing of the Tax Cuts and Jobs Act (H.R. 1), which made changes to the tax code that will directly affect the equipment financing industry. This article will summarize some of those changes. A follow up article will identify and predict how some of those changes may affect existing portfolios of investments as well as new business and will also clarify areas where the tax rules may be somewhat ambiguous.
Changes Affecting Equipment Financing
During the deliberations for tax reform, numerous statements were made concerning the planned sun-setting of certain tax provisions and the creation of an incremental federal budget deficit of $1.4 trillion.
For federal budgetary purposes, the budget is scored, or measured, over a 10-year period. That is, the effect of all tax law changes are forecast and incorporated into the projected federal budget. The forecasts assume no change in the underlying level of business that is otherwise taxed (or not taxed). Therefore, by phasing down a particular tax provision over time, such as 100% bonus depreciation, the budget deficit can be temporarily minimized, or as some call it, “kicking the can down the road.” In reality, such timing differences will likely always be deductible; it is just a question of when they will be entered into the budget.
The Major Changes
Federal Corporate Income Tax Rate
For purposes of calendar year corporations, the federal income tax rate drops from its current 35% to 21% effective for tax years beginning after December 31, 2017. Thus, for any calendar year corporate taxpayer, the new federal rate becomes 21%. For any fiscal year taxpayer, the tax rate for the remaining period of their fiscal year will be an annualized pro-rata tax rate consisting of the current 35% and the new 21%. For example, a March, June and September year-end taxpayer would apply tax rates of about 31.55%, 28.06% and 24.53%, respectively. In its next fiscal year, the tax rate will be 21% for all companies.
These rates are important while pricing transactions as a lessor and considering any lease-versus-own analyses for prospective transactions.
For qualifying new assets as well as qualifying used assets, 100% bonus depreciation is available, provided a taxpayer’s original use of the assets began after September 27, 2017. The 100% bonus depreciation will remain in effect for assets placed in service through December 31, 2022 and will phase down 20% each year thereafter until it is gone by 2027. Longer production
period assets, costing more than $1 million and taking one year or more to construct, and certain aircraft may be eligible for 100% bonus depreciation if placed in service by December 31, 2023. Basically, such assets are granted an additional year to be placed in service.
The bonus depreciation rules are retroactive to September 28, 2017, since the initial tax reform proposal came out on that date, and Congress didn’t want to cause any slowdown in acquiring new equipment. For assets acquired between September 28 and December 31, 2017, calendar year taxpayers could have availed themselves of both 100% bonus depreciation as well as the 35% tax rate.
As the amended tax code is written, a lessor would be eligible to claim 100% bonus depreciation when acquiring a used asset under a sale-leaseback transaction, regardless of the time the lessee had previously used the asset. In contrast, a lessee exercising a buyout option of an asset from an existing lease would not be able to claim the 100% bonus depreciation. The lessee, however, could exercise the buyout and then enter into a sale-leaseback with another lessor, who would be able to claim the 100% bonus depreciation when leasing the asset back!
Interest Expense Deduction Limitation
In an effort to limit the frequency of corporate inversions whereby companies move their headquarters to a lower-taxed foreign country and to de-leverage entities in general, a new limitation has been introduced. Net interest expense (interest expense net of interest income) will be currently deductible only to the extent it does not exceed 30% of what is described as adjusted taxable income. Essentially, adjusted taxable income is taxable income adjusted for net interest expense, taxes, depreciation and amortization, or tax EBITDA. Any excess net interest expense above the 30% will not be currently deductible but can be carried forward indefinitely. This means some highly leveraged companies, and those that happen to experience a year with reduced earnings, will not be able to expense the excess interest expense amount in the current year and will be required to carry a balance forward. The form of the limitation changes to be a limit against EBIT after January 1, 2022, forcing a further deleveraging of companies in general.
This new limitation can be beneficial to some lessors by creating more demand for their tax lease products. Potential lessees that may be at risk of having non-deductible interest expenses may seek to lease rather than own more of their assets to avoid this limitation. Some operating lessors that own rental fleets such as trucks, automobiles or construction equipment, however, may be at risk of interest non-deductibility. Operating lessors often borrow large amounts of debt to finance their rental fleets but may now seek other means of financing their fleets. Specifically, these lessors may find that leasing their operating assets may become more palatable than financing them purely with debt. This may be a new experience for some operating lessors.
Retention of Tax-Exempt Private Activity Bonds
The House proposal suggested eliminating the availability of tax-exempt private activity bonds. This tax provision enabled taxexempt entities, such as hospitals and universities, to obtain very low cost tax-exempt financings through the use of a conduit, such as a state dormitory agency. While the retention of this provision was good news, the follow-on article will outline other implications to the tax-exempt market as a result of tax reform.
Changes to Net Operating Loss Provisions
Previously, net operating loss (NOLs) could be carried back two years and carried forward 20 years. H.R. 1 changed this. First, it eliminated the ability of a taxpayer to carry back current year tax losses to obtain an immediate refund for previously paid taxes. Second, it limited the amount of NOLs that can be used to 80% of the taxable income in each future period. This means a taxpayer that has an NOL can no longer monetize it by filing an amended tax return. Now taxpayers must hope to have taxable income in future years which can be used to offset the carried forward loss. A taxpayer may seek to avoid generating a NOL altogether by leasing rather than owning an asset so as to avoid the large 100% bonus depreciation write off.
A taxpayer with existing NOLs (as evidenced by certain deferred tax assets on their balance sheet), may also seek alternative, faster ways of monetizing the NOLs. For instance, such taxpayers may potentially execute a sale-leaseback of existing assets to record an immediate taxable gain (and thus utilize the NOL on a current basis). The existence and management of NOL situations are often based on the facts and circumstances surrounding the situation. That is, every taxpayer has their own specific taxpaying situation and views regarding whether and/or when they will be able to utilize the NOLs. Nonetheless, leasing may provide some form of relief to such taxpayers.
Elimination of Like Kind Exchanges for Personal Property
The availability of Like Kind Exchanges (LKE) for property other than real estate has been eliminated. Previously, the execution of a LKE transaction for personal property enabled a tax gain to be deferred into the tax basis of the replacement property. For instance, the taxable gain from the sale of a rail car previously could be deferred and such gain would adjust the tax basis of the replacement rail car. In this manner, many taxable gains were able to be deferred into the future to be ultimately taxed only when no further deferrals could occur. The gains that will now be recognized can be offset by 100% bonus depreciation from a replacement asset, but only if the taxpayer decides to own a new asset. This provision is still available for real estate assets not otherwise held for sale.
The next article on this topic will examine certain aspects of the new tax law that remain somewhat uncertain and will also address the effect the tax law change may have on existing portfolios, new lease and loan rates and the lease-versus-own analyses that lessees often perform. The article will also summarize other financial reporting implications of the new tax law.