Is the Service Contract the new Operating Lease?

by Joe Sebik, CPA Jul/Aug 2018

With ASC 842 requiring all leases to be placed on balance sheet, will more lessees seek to structure equipment financing arrangements as service contracts, and is that really possible?

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

With the first implementation of ASC 842 fast approaching and lessees recognizing that the off-balance sheet operating lease will be a thing of the past, the leasing industry is now starting to see inquiries regarding whether financing structures can be changed to achieve similar off-balance sheet results. Some lessees and lessors are investigating whether a financing can be structured and documented as a service contract. This article will explore the new lease accounting rules and the manner in which a contract is characterized as either a lease or a service contract. For purposes of the analysis, we assume that the starting point of this analysis is a legal document and an agreement that is described as something other than a lease.

What is a Service Contract?

In its most basic form a service contract is an agreement for one party (the service provider) to provide “services” to another party (the service recipient). We should point out that also included in the catch-all definition of service contracts are also other forms of contracts, including but not limited to (i) power purchase agreements, (ii) tolling arrangements, (iii) energy performance contracts and (iv) product supply and consumption arrangements.

Key questions to address pertain to the “service” being provided and how that service is provided. The challenges come to play when the service contract also uses an asset as an integral part of delivering that service.

The FASB recognized that more and more contracts are being labeled as service contracts and that many may contain an embedded lease. ASC 842 took efforts to differentiate between a lease and a service contract by providing indicators to differentiate one from the other and to identify a lease embedded within another form of contract, however the answers are not always as clear.

ASC 842 Definition of a Lease

ASC 842 did not redefine what constitutes a lease as a much as it clarified what is and what is not a lease. ASC 842 defined an agreement as a lease if the contract conveys in exchange for consideration for a period of time the right to control the use of an identified asset (property, plant or equipment).

One indicator not discussed in detail is whether the agreement contains a fixed payment element structured to reimburse the provider for the cost of the asset included.
Many service contracts involve significant start-up costs, whether they are costs to acquire assets to deliver the service or to staff and train the service providers. Thus it is not unusual for a contract to include some financial mechanisms to ensure reimbursement for such costs, whether the mechanism is defined as some form of an asset availability payment or simply a minimum service contract term to ensure that the provider receive a specific amount of payments.

If a contract establishes linkage between a payment element and the asset used to deliver the service, the transaction starts to appear more and more like an embedded lease exists.

ASC 842-10-55-1 included a decision tree to assist one in determining in whether an agreement is or contains a lease, however the analysis of transactions may not always flow in such a linear path.

Structuring a Service Contract

ASC 842 did not explicitly provide guidelines on how to structure a service agreement, but was designed as a means of examining an agreement to determine if the agreement might be a lease or might contain a lease. In essence the tests in the standard provide one an approach to an analysis to evaluate the nature of the agreement. Below are some factors to consider how to approach the structuring of a transaction to avoid to the extent possible, it being construed to be or to contain a lease.

A Word on Tax Law

While we are examining the accounting aspects of a lease versus a service contract, it should be pointed out how the accounting standard intersects with the tax regulations pertaining to the same question. That is, the IRS had previously examined what constitutes a service contract and included two sets of guidelines within Section 7701(e) of the Internal Revenue Code (“IRC”).

IRC §7701(e) provides a set of nonexclusive factors pertaining to all service contracts, other than those that are treated as exceptions, for example service contracts such as for alternative energy facilities and water treatment plants, which are addressed through four somewhat looser factors under IRC §7701(e)(3&4). Notice that the tests address the incorporation of an asset within the agreement.

ASC 842 is closely aligned with the first set of IRC §7701(e) indicators essentially articulating what conditions may be indicators that an agreement is not a service contract. Under the Tax Code, if an agreement includes an asset but fails the service contract tests, then likely the agreement either is or contains a lease or alternatively a loan and that portion is treated as such for tax purposes.

The factors under IRC § 7701(e)(1) indicators are summarized below:

  1. The service recipient is in physical possession of the property.
  2. The service recipient controls the property.
  3. The service recipient has significant economic or possessory interest in the property.
  4. The service provider does not bear any risk of substantially diminished receipts or increased expenditures if there is none performance under the contract.
  5. The service provider does not use the property concurrently to provide significant services to entities unrelated to the service recipient.
  6. The total contract price does not substantially exceed the rental value for the property.

IRC § 7701(e)(3) pertains to specified assets such as solid waste treatment facilities, cogeneration plants, alternative energy or water treatment facilities and is somewhat easier to pass, as follows:

  1. The service recipient operates the facility
  2. The service recipient bears any significant financial burden for nonperformance
  3. The service recipient receives significant financial benefit if the costs are less than the standards of performance
  4. The service recipient has an option to purchase or may be required to purchase at a fixed and determinable price that is other than fair market value.

Thus, if the asset included in the contract in question is one of those listed in IRC § 7701(e)(3) and none of the above factors exist, than the agreement should be respected as a service contract for tax purposes. Note that a principal reason for this carve out is that a substantial number of the recipients of the services are tax-exempt entities and these facilities generally provide for favorable tax benefits such as tax credits and accelerated depreciation, which would otherwise not be available under a lease to tax-exempt entities.

Under both set of IRC service contract rules, both physical control and economic benefits are factors used in assessing whether a contract meets the service contract rules.

Documentation

If the agreement is documented as a lease then obviously it will more likely be a lease for accounting purposes and depending on the economics may be considered a loan for legal and tax purposes.

If the agreement is documented as one of the above mentioned agreements, for example, a power purchase agreement, then it should be reviewed for the conditions discussed below to determine its’ accounting characterization.

To the extent that the agreement can actually qualify as a service agreement under IRC § 7701(e)(1) discussed above, then inclusion of a statement to that effect may provide additional support for classifying the agreement as a service agreement for accounting purposes.

Identified Asset

ASC 842-10-15-9 indicated that for a contract to be a lease or to contain a lease, the contract must explicitly or implicitly specify an identified asset. For an agreement to be a service contract, it should to the extent possible, avoid the identification of an asset providing that service.

Lease contracts often explicitly specify exactly what is being leased, for example a model XYX truck with Vehicle Identification Number “123456789” or a railcar with marking number “A- 789456”. Many mobile leased assets even include a physical notice on it that the asset is owned by the leasing company so that should a creditor seek to seize the asset to satisfy other obligations, the notice is physically presented on the asset.

For legal reasons most lawyers would want that the asset being leased is explicitly specified so that the lessor can perfect their security interest in the asset to the extent possible by filing the necessary lien perfection filings. These filings act to register the asset with the appropriate authorities as having a lien on it so that the user cannot inappropriately transfer it to another party in a transaction that can be respected by the courts. That is, if a buyer acquires an asset in good faith from a seller and the buyer has no reason to believe the seller does not own the asset, the transfer may be respected by the courts and the true owner may have little recourse to recover the asset from the buyer.

Hence, if a contract merely describes the asset as a vehicle for instance without, the lessor runs the risk of the asset being transferred out of trust. Nonetheless, many contracts such as service contracts do not specify the asset that is being used to provide the service, ostensibly because the service provider has some confidence that they are controlling the asset sufficiently to protect their rights in the asset (see a theme here?). For instance, the difference between a lease of a truck and the providing of trucking services would be articulated in what is specified; when leasing a truck the vehicle is specified; when receiving trucking services, the capacity, timing and frequency of service is what is specified.

While some lessors may be comfortable without explicitly identifying an asset, for instance because they are comfortable with the integrity and credit of the lessee, the FASB took the identified asset definition further by including the term implicitly in the definition.

An implicit identification of an asset addresses the nuanced way that a lessor may describe an asset; for instance a lessor may describe the model but not the serial number of the asset. This obviously is a sufficient implicit identification. On the other hand, if a lessor attempted to simply describe the asset as for instance, a front-end loader or a bulldozer, it is unlikely a lessee would accept that minimal description for fear that the contract would be unenforceable given the lack of specificity.

Under a service contract, it is often not necessary to identify what asset(s) will be used to accomplish a specified task. That is, if an agreement indicates that the service provider will provide a specified service and how they provide that service is up to the service provider, the agreement looks more like a service agreement. For example, a data processing outsourcing arrangement usually provides the service provider with the flexibility to change the equipment providing that service at will.

This test of a service contract may be achieved for instance if the agreement states that the provider will provide the output but does not specify the asset used to provide that output and has more than one means of producing that output.

For instance assume a developer proposes to provide energy to a company and does not specify the means by which that developer will provide the energy. The developer may be able to provide the energy in multiple ways, for instance, through solar generation, purchased from the grid or other developer and through cogeneration. The developer may even sublease space on the energy off-taker’s property to place their assets for purposes of providing the power. This type of arrangement may appear to be more and more like a service contract than a lease. However the question is whether such an arrangement can be economically viable as well as meet the business requirements of the off-taker.

Imagine however trying to apply this model to something like an MRI or CT scan machine for a hospital. Would a hospital agree to accept any machine the supplier decides to place there or from a business perspective would they insist on more control? And from a business perspective would the supplier assume the risk of investing in the assets without knowing they will generate a defined number of scans? Perhaps the hospital would provide the space to an imaging center which would be run by an independent entity; however does this meet their business needs?

Substantive Substitution Rights

Although an agreement that is purported to be service contract may contain a specified asset, there is nonetheless a possibility that the contract still is a service contract if the service provider has substantive substitution rights throughout the period of use. That is, if the service provider has these rights, then effectively the service recipient may not control the asset and the contract may indeed be a service contract. This section was meant to address those lease agreements which were relabeled as a service contract with the right of substitution included.

The asset substitution rights are established if the following two conditions are met:

  1. At their discretion the supplier has not only the right but also the practical ability to substitute the asset for another asset, and
  2. that the supplier would benefit economically from the exercise of its right to substitute the asset. A supplier benefits economically when the economic benefits of substituting the asset exceed the cost of such substitution.

The economic benefit test is assumed to be met when there is a reasonable benefit; that is, simply stating that the supplier can benefit by a nominal amount would not represent a substantive right of substitution. This right cannot be quantified based on unknown future events, for instance to say that the supplier will benefit because in 2 years a more efficient asset should be available is not a sufficient argument.

On the other hand, having a right to substitute based on the existence of a known, more efficient asset available, which will be substituted provided a higher volume is expected, is a more reasonable argument.

The key to this test is that a supplier/service provider must have the right and ability to substitute the asset for their primary benefit. Conditions which include penalties to the service recipient when a substitution is made are a red flag that the supplier is not the primary beneficiary of the right of substitution. That is, a substitution fee appears to be similar to an early termination or swap out fee in a lease.

Customer Economic Benefit

Assuming the substantive substitution rights do not exist or cannot be proven, ASC 842 asks whether the customer has the right to substantially all of the economic benefits from use of the asset throughout the period of use. Substantially all is defined as 90% or more using ASC 842-10-55-2 as a proxy.

Economic benefit must be viewed in terms of the productive resources and benefits from those resources during the period of the agreement and also identified in terms of connecting the source of the benefit with the recipient of the benefit. For instance, the economic benefit of using a truck to ship goods resides with the party contracting to provide those services and not with the party merely providing the truck to the shipper.

For example, assume an asset is producing some form of benefit that can be economically measured; for instance a rail car is used to move grain and the contracting party pays for the movement of the grain based on loads shipped. The economic benefit of the rail car is represented by revenue generated to move that grain. The party receiving the payment for the shipping is the service provider and they determine the resources to use to move the grain. If the provider is contracting for the use of railcars as part of their function and also assumes the obligation to pay for the rental of the cars, then the agreement between them and the lessor is a lease, even if the lease contains some maintenance elements.

On the other hand, if the service provider is merely an intermediary and the full functional efforts are provided by the rail car owner to the intermediary, including which rail cars and types of rail cars to use (assuming multiple different types may accomplish the same task), then the agreement may be a service contract from the rail company into the service provider.

This brings up a structure of a service contract into the intermediary with a service contract out to the grain shipper similar to a lease-in, lease-out structure.

Right to Direct How and for What Purpose

Assuming the service provider has substantially all of the economic benefits from the asset, the next test to determine if a lease exists is which party has the right to direct how and for what purpose the asset is to be used.

For example, some assets may have multiple general usages; some rail cars for instance can be used to ship other products other than grain and can be used on various different general shipping routes which may be directed by the customer. If the customer dictates which route to take because they are weighing the time to ship versus the cost, then the customer may be controlling the asset and the transaction may contain a lease.

Oftentimes the asset’s purpose is predetermined; an example is a solar installation whose only purpose is to produce energy. For such predetermined assets, then perhaps neither the recipient nor the supplier has the right to direct its use. In this case it is predetermined by the nature of the asset or the operating agreement, in which case the next question to ask is whether the customer can change the operating instructions throughout its use.

In the case of a cogeneration unit, the unit produces multiple forms of energy, including electricity, heat, steam and hot water. The service recipient is responsible for supplying the fuel source input to the unit and as such has the right to determine how much they want to consume. Most cogeneration service agreements include a fixed capital cost recovery pricing element, largely because the service recipient has the right to change the throughput of the facility. This is thus obviously a lese embedded within a service contract.

In the case of a solar energy facility, a typical power purchase agreement calls for the service recipient to acquire all of the energy output produced and the service provider’s goal is to provide as much power as can be generated to maximize their revenue. Usually the service recipient does not have the right NOT to buy the power from the facility.

Economically speaking, if the recipient had this right then the service provider likely would require a fixed payment component as part of the payment structure. Otherwise the service provider would likely not enter into such a transaction since they’d have no assurances of a return, unless of course the service provider had another source to sell the power to.

ASC 842 included a solar power installation as an example and labeled it as a lease, however it was not fully clear if that conclusion was because the lessee had some involvement in the design of the facility (see below) or because it was the sole consumer.

If the service recipient had no involvement in the design and simply provided space for the service provider to place an alternative energy facility on the site, along with the obligation for the recipient to buy all the power generated at a fixed rate, perhaps the conclusion might have been swayed otherwise. If the service provider could also sell power to another service recipient, then that would also enhance the argument that the agreement was not a lease.

Perhaps the goal is to locate two service recipients to purchase all the power, such that neither has the primary economic benefit from the facility.

Another interesting approach is to utilize a virtual power purchase agreement. Under a virtual power purchase agreement, the service provider builds a facility on property owned by the service recipient. The service recipient may not have a need to acquire power in that fashion from the site on which the solar facility is located. Instead, the service provider sells the power to the local utility which then bills the service recipient for that power albeit on a reduced based, based on the solar power purchase agreement. This structure may create require another detailed analysis!

Asset Design

Lastly was the asset designed by the customer? In essence, is the service provider merely an intermediary used to “operate” the asset as a means of treating the agreement as a service contract?

While ASC 842 is more control focused than risk and rewards focused, one cannot remove the economic aspects from the analysis. When analyzing the solar installation, for the most part the installation is usually designed for the particular location and entity in question, so although the customer did not design the facility, it is somewhat limited as to its other functionality. In order to overcome this restriction, it would be helpful if the service provider could actually sell power to another entity. This is often a difficult arrangement to organize.

Conclusion

In order to structure a transaction as a service contract rather than as a lease the fundamental business model would usually have to change. Whether both parties to the arrangement would accept that change depends on not only the rate that would be charged for the arrangement but also the service level that the recipient would expect from the provider.

At the end of the day structuring a transaction as a service contract instead of a lease should be based on the overall economics of the transaction and not merely as a means to achieve off balance sheet reporting for the recipient. It seems that many lessees and lessors will be examining these types of arrangements to determine if they make sense for their needs and again, the off balance sheet treatment should only be one factor in that determination.

Disclaimer – This article represents the views and interpretations of the author and does not reflect any of the positions, views or opinions of the company for which the author works. None of this information should be viewed as providing of tax or business planning advice. In all cases you should consult with your own tax counsel regarding any actions or positions you take.

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