I field a lot of questions about lease accounting. I devote this article to answer a few that may have broad interest.

Question: Can you structure a terminal rental adjustment clause (TRAC) lease that fully amortizes (also known as a Zero TRAC) such that the lease is a true lease and an off balance sheet operating lease? Many fleet managers want a 50-month TRAC lease with 2% per month “amortization,” so they can easily calculate the TRAC value of any vehicle by multiplying 2% times the months elapsed in the term. The typical fully amortizing fleet lease has a 12-month firm term followed by a series of 38 monthly options to renew or terminate with a TRAC adjustment. The maximum lease term is 50 months, at which point the TRAC is fully amortized.

Answer: The short answer is yes, but first I should say check my answer with your tax and accounting advisors to make sure they agree.

In my opinion, to be an operating lease for accounting purposes, and thus off balance sheet, the structure must include the following:

1. There can be no lessee fixed price purchase option. The major accounting issue is to make sure the structure does not include an option to buy the vehicle for the TRAC amount at expiry, as an option to buy for zero is a bargain for accounting purposes. Regarding fixed price purchase options set at the TRAC amount during the term, they are problematic at any point along the term where the option price is less than expected fair market value. That is virtually certain to happen due to the steep amortization pattern compared to the expected fair market value curve of the leased vehicle. Also the periods that precede a bargain purchase option are included in the lease term for accounting purposes, which will impact the structuring of the amount of residual risk the lessor must assume (the longer the lease term, the more risk the lessor must assume).
2. The structure must include a split or modified TRAC, that is, a TRAC with a capped residual guarantee. The residual guarantee is capped at an amount in the TRAC structure that when the guarantee is included as a minimum lease payment in the present value calculation of the remaining minimum lease payments (rents and residual guarantees) in the lease term and any renewal term results in a present value that is less than 90% of the fair value of the vehicle at the beginning of the lease term or renewal term.

In my opinion, for tax purposes the major concern is also regarding purchase options. There can be no bargain purchase option, as that would violate the IRS true lease guidelines. The term “terminal rental adjustment clause” means a provision of an agreement that permits or requires the rental price to be adjusted upward or downward by reference to the TRAC amount realized by the lessor under the agreement upon sale or other disposition of such property (note there is no mention of inclusion of a purchase option in the TRAC definition). IRS Code §7701(h)(1) provides that in the case of a qualified motor vehicle operating agreement that contains a terminal rental adjustment clause (a TRAC lease), the agreement is treated as a lease if (but for such terminal rental adjustment clause) the agreement would be treated as a lease for federal income tax purposes and the lessee is not treated as the owner of the property subject to the agreement during the period the agreement is in effect. What this means is that, but for the TRAC provision, the lease must meet the true lease guidelines, which prohibit bargain purchase options.

In summary, the lease cannot contain a bargain purchase option, and the present value of the minimum lease payments must be less than 90% of the fair value of the vehicle at the beginning of the firm term and any renewal term.

Question: In the accounting for a true lease can one record a 0% residual even though the IRS guidelines require the leased asset have at least a 20% residual value at the end of the lease?

Answer: U.S. GAAP defines the residual value to be booked as “the estimated fair value of the leased property at the end of the lease term.” In practice, lessors book a conservative value rather than the “true” expected fair value of the leased asset at lease expiry to avoid residual write downs or residual losses. In essence, most lessors are interested in maintaining quality of earnings, so they assume conservative residuals. In my experience, I have seen many leases where a low, and at times zero, residual was booked because of the nature of the asset while there was documentation in the tax files to support that in a best case scenario one could expect the asset to have a 20% value at the end of the lease term.

Question: Will the proposed new lease accounting rules cause tax law to change?

Answer: No. The IRS, state income tax, local sales tax and local property tax laws are all based on a risks and rewards analysis of leases to determine whether the lessee or lessor is the “true” owner of the leased asset. Because this analysis is based on economic substance, I see no reason for them to change. The proposed accounting rules break from the traditional alignment (in FAS 13) with the tax view (risks and rewards). This break in tax and accounting views, if enacted, will be most problematic for lessees of equipment. The proposed rules would treat operating leases (most often these are true leases for tax purposes) as though they are capital leases for P&L purposes, meaning instead of rent expense the P&L cost will be front loaded (a combination of straight line amortization of the asset plus imputed interest on the lease liability). This creates a book tax difference resulting the need for deferred tax accounting by lessees. State income taxes also consider true leases to have rent as the deduction. Also in state tax apportionment calculations operating leases/true leases are treated differently than capital leases (capital lease assets are considered the same as owned assets). Sales tax laws tax capital leases like a purchase, so there is a risk of error in taxing a capitalized operating lease. Likewise for property tax purposes, a lessee must pay property tax on capital leases, so capitalized operating leases may be erroneously included in property tax returns.

Bill Bosco is the principal of Leasing 101, a lease consulting company. Bosco has more than 37 years of experience in the leasing industry. His areas of expertise are accounting, tax, financial analysis, structuring, pricing and training. He has been on the EFLA accounting committee since 1988 and was chairman for ten years. He is a frequent author and speaker on leasing topics and has been selected to the FASB/IASB Lease Project working group. He can be reached at [email protected], www.leasing-101.com or 914-522-3233.