ASC 842 expands the failed sale-leaseback concept to include equipment. Under ASC 840, only real estate was subject to this accounting approach. Unless the current tax rules change, a similar issue arises when considering the tax effect of certain sale leasebacks. These factors mostly affect the lessee however lessors should be aware of them when structuring leases. Joe Sebik explains the accounting and tax ramifications and considers how the approaches may have to change to accommodate the new rules.
Background of Sale-Leaseback Accounting
A sale-leaseback occurs when a company sells an asset to a lessor then and leases it back. The leaseback may be for the entire asset or a portion of it (as in real estate) and for its entire remaining useful life or for a shorter period.
Sale-leaseback accounting addresses whether the asset is derecognized (removed) from the seller’s balance sheet, whether any profit or loss is recognized on the sale and how the leaseback is capitalized back on the seller-lessee’s balance sheet.
Under FAS 13 and ASC 840, if the present value of the leaseback was 10% or less of the asset’s fair market value at the time of the sale, any profit resulting from the sale could be recognized completely and the leaseback would remain off the lessee’s balance sheet because the resulting leaseback would be treated as an operating lease.
If the leaseback was greater than 10% and less than 90%, a gain could be recognized to the extent it exceeded the present value of the leaseback, while the leaseback remained off the balance sheet because it was reported as an operating lease. In essence any gain that was less than or equal to the PV of the leaseback was deferred and amortized over the leaseback term. The gain would essentially be recognized as a reduction to offset the future rental expense.
For leasebacks equal to or greater than 90%, the asset would remain on the lessee’s balance sheet, no gain could be reported and any proceeds would be treated as loans to the lessee from the buyer.
Under FAS 13 and ASC 840, sale-leasebacks of real estate and equipment considered integral to real estate included an added caveat. If the leaseback included any form of fixed price purchase option for the seller/lessee, it was not considered a sale-leaseback.
Therefore, even if the sale was a valid sale for legal and tax purposes, the asset remained on the lessee’s balance sheet and the sale was treated as a financing or borrowing against that asset. The FASB’s position was based on what was then known as FAS 66 “Accounting for Sales of Real Estate” which highlighted the numerous unique ways in which real estate sale transactions are structured. Additionally, the FASB noted that many such real estate transactions resulted in the seller/lessee repurchasing the asset, thus supporting their view that the sale-leaseback was merely a form of financing.
Sale-leasebacks Under ASC 842
Accounting for sale-leaseback transactions under ASC 842 aligns the treatment of an asset sale with ASC 606 pertaining to revenue recognition. As such, if a sale is recognized under ASC 606 and ASC 842, the full profit or loss may thus be recorded by the seller-lessee.
ASC 842 is said to actually enable more sale and leaseback transactions of real estate to be considered a sale under the new set of standards, provided the sale and leaseback does not include a fixed price purchase option.
In contrast however some transactions of assets other than real estate or equipment integral to real estate will be considered a FAILED sale and leaseback under ASC 842. As mentioned above, those sales and leasebacks which include a fixed price purchase option will no longer be considered a ‘successful’ sale and leaseback.
A failed sale-leaseback occurs when
leaseback is classified as a finance lease, or
a leaseback includes any repurchase option and the asset is specialized (the FASB has indicated that real estate is almost always considered specialized), or
a leaseback includes a repurchase option that is at other than the asset’s fair value determined “on the date the option is exercised”.
This last item means that any sale and leaseback that includes a fixed price purchase option at the end will remain on the lessee’s balance sheet at its full value and classified as a fixed asset rather than as a Right of Use Asset (ROUA). Even though an asset may have been legally sold, a sale is not reported and the asset is not removed from the lessee’s balance sheet if those conditions exist!
Note also that additional nuances too numerous to address here exist in the sale-leaseback accounting world.
The accounting treatments are explained further below.
IFRS 16 Considerations
IFRS 16 on the other hand has a slightly different set of standards;
if the seller-lessee has a “substantive repurchase option” than no sale has occurred and
any gain recognition is limited to the amount of the gain that relates to the buyer-lessors residual interest in the underlying asset at the end of the leaseback.
In essence, IFRS 16 now also prevents any de-recognition of the asset from the lessee’s balance sheet if any purchase option is provided, other than a purchase option the value of which is determined at the time of the exercise. Ironically IFRS 16 now requires a limitation on the amount of the gain that can be recognized in a similar fashion to what was permitted under ASC 840, namely the gain can only be recognized to the extent it exceeds the present value of the leaseback.
Federal Income Tax Considerations
In December 2017, Congress passed and the President signed what has become known as the Tax Cuts and Jobs Act (TCJA). TCJA provided for a rejuvenation of bonus depreciation for both new and used assets being “used” by the owner for the first time. This meant that when a taxpayer first placed an asset to use, they could claim bonus depreciation, which starts now at 100% for assets which are acquired after September 27, 2017 with certain limitations. Bonus depreciation will start to phase down 20% a year starting in 2023 until it is eliminated and the depreciation schedules revert back to standards MACRS.
Upon the passing of TCJA, a question arose as to whether a lessee could claim bonus depreciation on a leased asset if it acquired the asset by exercising a purchase option.
For instance, assume a lessee is leasing an asset such as a truck or machine tool or MRI. At the end of the lease or if an early buyout option exists, the lessee may exercise that purchase option to acquire the asset. If the lessee can then immediately write-off the value of that asset by claiming 100% bonus depreciation, the after tax cost of that asset is immediately reduced.
Under the current 21% federal corporate tax rate and following 100% bonus depreciation, that means the asset’s after tax cost is reduced to 79% (100% – 21%). If however the asset is NOT eligible for bonus depreciation because it was previously used, or should we say, utilized by the lessee, then the cost of the asset starts at 100% reduced by the present value of the future tax deductions.
This would mean that a leased asset being purchased may result in an inherently greater after-tax cost to a lessee than an asset not leased.
Lessors were concerned if lessees could not claim bonus depreciation the value of their assets would become depressed. The ELFA brought these concerns to the Treasury and the Treasury responded with a Notice of Proposed Rulemaking referenced as REG-104397-18, clarifying that the lessee can claim bonus depreciation, provided they did not previously have a “depreciable interest” in the asset, whether or not depreciation had ever been claimed by the seller/lessee. The IRS asked for comments on this proposed rulemaking and the ELFA is responding, however, the final rules are not in place.
In many leasing transactions, seller/lessees accumulate a number of similar assets over a period of time and then enter into a sale and leaseback. The current tax law permitted the buyer/lessor to treat those assets as new and thus under prior law, qualified for bonus depreciation. The provision followed was commonly known as the “3 month” whereby as long as the sale and leaseback occurred within 3 months of the asset being placed in service, the buy/lessor could also claim bonus depreciation.
With the advent of bonus depreciation for used assets, this rule was not necessary since a buyer/lessor can claim the bonus depreciation regardless of how long the seller/lessee had previously used the asset. Also under tax rules, if an asset is acquired and then resold within the same tax year, the taxpayer is not entitled to claim any tax depreciation on the asset.
The introduction of the depreciable interest concept throws a curve into the analysis. Although a seller/lessee may have owned an asset before entering into a sale-leaseback and did not claim tax depreciation because of the sale-leaseback, they likely had a depreciable interest in the asset. Many syndicated leasing transactions, particularly of motor vehicles, followed this syndication approach; many assets would be accumulated to achieve a critical dollar value to be sold and leased back.
As of this writing, all assets originated under those circumstances would likely be ineligible for bonus depreciation should the lessee exercise a purchase option!
Accounting for a Failed Sale and Leaseback by the lessee
If the transfer of the asset is not considered a sale, then the asset is not derecognized and the proceeds received are treated as a financing. The accounting for a failed sale and leaseback would be different depending on whether the leaseback was determined to be a finance lease or an operating lease under Topic 842.
If the leaseback was determined to be a finance lease by the lessee, the lessee would either (a) not derecognize the existing asset or (b) record the capitalized value of the leaseback, depending on which of those approaches created a greater asset and offsetting lease liability.
If the leaseback was determined to be an operating lease by the lessee, the lessee would derecognize the asset and defer any gain that might have otherwise resulted by the sale, and then capitalize the leaseback in accordance with Topic 842.
Two caveats exist regarding how the financing portion of the failed sale-leaseback must be amortized:
No negative amortization is permitted Essentially the interest expense recognized cannot exceed the portion of the payments attributable to principal on the lease liability over the shorter of the lease term or the financing term.
No built-in loss may result. The carrying value of the underlying asset cannot exceed the financing obligation at the earlier of the end of the lease term or the date on which control of the underlying asset transfers to the lessee as buyer.
These conditions may exist when the failed sale-leaseback was caused for instance by the existence of a fixed price purchase option during the lease, as was illustrated in the standard itself.
In that case the interest rate required to amortize the loan is imputed through a trial and error approach by also considering the carrying value of the asset as discussed above, rather than by calculating it based solely on the factors associated with the liability.
In effect the existence of the purchase option is treated by the lessee as if it will be exercised and the lease liability is amortized to that point. If the condition causing the failed sale-leaseback no longer exists, for instance the purchase option is not exercised, then the carrying amounts of the liability and the underlying asset are adjusted to then apply the sale treatment and any gain or loss would be recognized.
The FASB example is as follows:
842-40-55-31 – An entity (Seller) sells an asset to an unrelated entity (Buyer) for cash of $2 million. Immediately before the transaction, the asset has a carrying amount of $1.8 million and has a remaining useful life of 21 years. At the same time, Seller enters into a contract with Buyer for the right to use the asset for 8 years with annual payments of $200,000 payable at the end of each year and no renewal options. Seller’s incremental borrowing rate at the date of the transaction is 4 percent. The contract includes an option to repurchase the asset at the end of Year 5 for $800,000.”
Authors comment: A simple calculation would conclude that this is not a “market-based transaction” since the seller/lessee could simply pay 5-years of rent for $1,000,000 and then purchase the asset back for $800,000; not a bad deal when they sold it for $2 million. Nonetheless this was the example provided and the leasing industry determined that the rate needed to meet the FASB’s test was determined using the following table and a trial and error approach.
In this example the lessee must use a rate of approximately 4.23% to arrive at the amortization such that the financial liability was never less than the asset net book value up to the purchase option exercise date.
Since the entry to record the failed sale and leaseback involves establishing an amortizing liability, at some time a fixed price purchase option in the agreement (which caused the failed sale and leaseback in the first place) would be
If we assume the purchase option is exercised at the end of the fifth year, at that time the gain on sale of $572,077 would be recognized by eliminating the remaining lease liability of $1,372,077 with the exercise of the purchase option and payment of the $800,000. The previously recorded ROU asset would be reclassified as a fixed asset and continue to be depreciated during its remaining life.
If on the other hand the purchase option is NOT exercised (assuming the transaction was more market based, for example, assume the purchase option was $1.2 million) and essentially expires, then presumably the remaining lease liability would be adjusted to reflect the present value of the remaining rents yet to be paid, discounted at the then incremental borrowing rate of the lessee.
Any difference between the then outstanding lease liability and the newly calculated present value would likely be an adjustment to the remaining ROU asset, and the ROU asset would then be amortized over the remaining life of the lease. Assuming the present value of the 3 remaining payments using a 4% discount rate is then $555,018, the following adjustments must be made to the schedule.
Any failed sale leaseback will require scrutiny and analysis to fully understand the nature of the transaction and how one must follow and track the accounting. This will be a fairly manual effort unless a lessee software package can track when a purchase option expires and creates an automatic adjusting journal entry at that time.
Apparently for this reason, the FASB also provided for adjusted accounting for transactions previously accounted for as failed sale leasebacks. The FASB suggested when adopting the new standard to examine whether a transaction was previously a failed sale leaseback.
Procedural Changes to Avoid a Failed Sale and Leaseback
While we can get engrossed in the minutia of the accounting details for a failed sale-leaseback, recognize the FASB introduced this somewhat cumbersome accounting to derecognize only those assets in which the transaction was clearly a sale. This process existed previously only for real estate transactions. With the advent of ASC 842, the accounting also must be applied for sale-leasebacks of equipment.
If the tax rules or tax interpretations are not clarified or changed, many existing assets under lease would not be eligible for bonus depreciation merely because when the original sale leaseback was executed, the lessees afforded themselves of the existing transaction rules in the tax code.
Going forward, lessors and lessees must develop new methods of administratively executing a so-called sale-leaseback while considering the accounting issues inherent in the new standard and the tax rules discussed previously.
This may require a prospective lessee to arrange for one or many potential lessors to underwrite its new leasing business beforehand to avoid entering into any form of sale-leaseback. Of course, this means much work will need to be done as soon as possible and well ahead of the placement for any equipment orders. Given the asset-focused specialties of many lessors, it is unlikely that one lessor will desire to handle all forms of equipment that a prospective lessee may desire to lease.
The concept of a failed sale leaseback becomes complicated when considering how to account for the transaction. Additionally the resulting potential tax implications may arise many years down the road. Nonetheless, since the accounting standard and tax rules exist as they are, lessees and lessors must either adapt their approaches or conform to the accounting requirements promulgated by ASC 842 and tax rules under TCJA.
In all likelihood, for some standardized transactions the approaches will be adapted. For larger transactions such as real estate sale-leasebacks, creative minds will again examine the repercussions of the accounting and simply consider them in the way they enter these transactions. In any event, it keeps our industry interesting!
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