This article discusses how to perform lease-versus-own analyses for your customers when navigating the Tax Cuts and Jobs Act (H.R. 1). It will illustrate some of the previously identified opportunities, which may result from the tax reform. I would like to thank David Holmgren of Ivory Consulting for his assistance in preparing the analyses used in this article.
Identifying Tax Leasing Opportunities
There are accounting footnotes within GAAP financial statements which disclose information for specific reporting areas. Reading the Tax Footnotes section of these financial statements helps identify companies that either already lease or perhaps should be leasing.
Income tax expense is reported based on what is commonly described as “the matching principle”, whereby book expenses associated with the generation of book income should be reported in the same period as the income to which it is related. As such anytime income before taxes is reported, a tax provision (expense or benefit) is accrued based on the statutory tax rates then in effect, without giving effect to when those taxes must be paid.
For book purposes, assets are depreciated generally using a straight line approach which is essentially a convention to methodically report the wear and tear of the asset. However for tax purposes that same asset is depreciated using an accelerated approach, the most common of which is called the Modified Accelerated Cost Recovery System or MACRS. At this time the current Tax Code also allows corporate taxpayers to claim 100% bonus depreciation, generally allowing a taxpayer to expense 100% of the acquisition cost of a newly acquired asset.
The tax provision (expense or benefit) is recorded in the financial statements based on the book income or loss. For illustration purposes assume a taxpayer buys a $1 million asset. The asset will be depreciated for book purposes over 10-years at $100,000 per year. Assume that the only item the taxpayer is reporting in its income statement is the depreciation expense from this asset. Thus while the accounting books may report a net pre-tax loss before taxes of $100,000, using the prior federal tax rate of 35%, they would record a tax benefit (a negative expense) of $35,000.
If however the tax law allows the taxpayer to depreciate or write-off that asset immediately as mentioned above, the taxpayer will report a tax loss of $1 million. This $1 million tax loss would be reported as a net operating loss (NOL) that is carried forward to be used in the future periods when the taxpayer expects to report taxable income.
The IRS will not refund taxes not paid, so the future deferred refund due is reported as a Deferred Tax Asset (DTA). The reporting of the tax benefit and the DTA is reflected in the very basic journal entry reported below.
The balancing entry represents deferred taxes payable since overall the book income and tax income will usually be the same, however the timing of when they are reported may be different.
|Tax Provision (benefit)||35,000|
|Deferred Tax Asset||350,000|
|Deferred Taxes Payable||315,000|
As mentioned above, aA deferred tax asset (DTA) represents a n income tax refund receivable that a taxpayer a company cannot use in the current period.
The Tax Cuts and Jobs Act (TCJA) now provides for 100% bonus depreciation for both used and new assets. Therefore taxpayers that acquire a large amount of depreciable assets may be more likely to enter into an NOL position. A tax net operating loss (NOL) carryforward is often one cause of the DTA. If the entity has too many tax deductions, such as 100% bonus depreciation, to utilize on a current basis, it could become a large component of a NOL.
Often these NOLs may not be used by the a taxpayer for many years because the cause of the NOL loss is ongoing, that is the taxpayer may be continuingly acquiring more assetscontinues. AdditionallyFurther, the Tax Cuts and Jobs Act (TCJA) passed in December 2017, llimited the use of new NOL carryforwards to offset only 80% of the future periods’ taxable incomeand established a limit for deducting interest expenses. Obviously if a DTA cannot be utilized for several years, the taxpayer will be reporting a non-performing asset on its balance sheet for quite some time.
Tax leasing es can often help lessees manage these aspects of the tax situation. by avoiding the 100% bonus depreciation but obtaining its benefit in a lower rental rate.
By identifying DTAs that are caused by NOLs within a taxpayer’s financial statements, one can possibly identify a situation where the taxpayer should be leasing rather than owning an asset.
It is even possible for the taxpayer to “monetize” these NOLs by entering into a sale-leaseback. In the example above, the taxpayer could sell the fully tax depreciated asset to a lessor and lease it back, thus reporting a taxable gain to offset the NOL carryforward. This would enable the taxpayer to effectively monetize the previously unavailable tax refund receivable. The ‘refund’ comes from the proceeds the taxpayer receives when they sell the asset because they can retain 100% of the proceeds from the sale, even though it otherwise would have been taxable.
Measuring the Opportunities
To determine whether it is economically better to lease or to borrow, we perform a lease-versus-own analysis, which normalizes both scenarios into a comparable value — the after-tax net present value (AT-NPV).
To perform the analysis, first make assumptions about the acquiring entity including 1) the time a company may be in an NOL position, 2) the tax depreciation they may otherwise claim, 3) their borrowing rate, 4) whether interest expense deductions may be limited and 5) the value a lessee could receive when remarketing the asset. These assumptions are summarized further below.
To make a valid comparison, the lease should qualify as a tax lease since tax depreciation often is the major element monetized under a tax lease.
The analysis normalizes the after-tax cash flows of financing an asset acquisition using either a lease or a loan by comparing the AT-NPV of the cash flows of each. The scenario with the lowest AT-NPV is essentially the less costly financing approach. The differences represent the advantage of either scenario over the other.
While the lease-versus-own calculation is usually not the sole reason a lessee would lease an asset, it has become more relevant because of current unique nuances in the tax code and the specific tax circumstances and differences that may exist between a prospective lessee and a lessor.
If the lessee already has an existing NOL, it will not be able to utilize new tax deductions such as bonus depreciation on a current basis. Further, the new interest expense limitation may also force some lessees to defer expensing a portion of their interest expense to future periods. Often these deferrals may exist for several years since the circumstances are continuous.
We ran several different lease-versus-own analyses to measure how much the AT-NPV comparisons change as a result of changes in the underlying tax assumptions. Bear in mind the purpose of this analysis is to demonstrate how the lease-versus-own analysis changes by altering the tax fact pattern only. See the summary below fFor a detailed listing of the assumptions we used in this analysis, please . refer to the online expanded version of this article.
A lessor starts with the basic set of assumptions to calculate a base lease rate as well as a base lending rate. Using the base case assumptions of a $1 million asset leased over five years, we calculated a lease rental charge of $15,752.92 per month.
Next the AT-NPV cost of the lease is calculated and compared to the AT-NPV cost of a loan for the lessee. Whichever AT-NPV is less will point to the less costly approach to financing for the lessee/borrower. Usually when no unusual tax differences exist between a lessee and a lessor, such as when the lessee is not in a NOL position, financing via a loan will often produce a lower AT-NPV compared to a lease. Any unexpected results are clues to differences in assumptions.
We start with base case assumptions and then change the lessee tax assumptions to analyze the change in the AT-NPVs.
Basic Assumptions Needed
As stated above, in order to commence calculating a lease-versus-own analysis, assumptions must be made about the following data elements.
1. Commencement Date
Commencement date is important because in the first year of a lease, the closer the lease commences to the end of the year the less taxable revenue is recorded, while the same amount of tax depreciation would be recorded.
2. Term of use
In order to run a comparative analysis, it is necessary to normalize the different options by establishing a consistent term of use. While a lessee may have intentions of using an asset or a similar asset for a much longer period, it is necessary to establish a termination date for financial modeling purposes. The term of use should often be the lease term requested. If the lessee requests a lease term that goes beyond the term that would be needed to qualify the lease as a tax lease, the comparison then has less opportunities for a lessor to monetize inefficiencies; that is, the lessee would only be able to compare financing the transaction using internal debt versus external debt and the lessor would not be able to claim any tax benefits or pass them through to the lessee via a lower financing rate.
3. Lessee tax parameters
This is often the most difficult information to obtain because it generally is a very sensitive and confidential area guarded by lessees. Often a lessor can examine several years of tax footnotes to determine how frequent the lessee may be in an NOL position. A lessor salesperson can start with a blanket assumption and let the lessee guide them in the modeling.
4. Lessee debt leverage
The debt leverage percentage is used to determine what portion of the financing of the asset will be funded using debt by the lessee. Often-times entities assume the transaction is financed with 100% debt although that produces the lowest cost to finance compared to when it is financed with debt and equity. Some companies may assume that any new asset is financed with a combination of debt and equity consistent with their existing debt-to-equity ratio, especially when the acquiring company is an industrial company which may only finance the asset with 50% debt and the balance with equity.
5. Lessor debt to equity ratio
Lessors typically finance leases using a debt-to-equity ratio akin to that found in banks.
6. Debt & equity rates
The rate that the lessee can borrow at for debt of a similar term that. If the transaction is also financed with some equity, the rate of equity required to be earned on any equity investment. If the lessee indicates they would finance assets using their standard debt-to-equity ratio, it may be advisable to utilize the lessee’s weighted average cost of capital (WACC), which weights their cost of debt and their cost of equity. To determine their cost of equity, one must either make industry assumptions or review the company’s financial statements and footnotes for a clue as to the rate to use.
7. Lessor targeted return
The after-tax return-on-equity (ROE) rate at which the lessor requires to provide the lease financing.
8. Ending residual value(s)
The value that the entity expects they may be able to dispose of the asset should they finance it with debt. Often the lessee assumes a lower assumption than the lessor because the lessee is likely able to resell the asset as efficiently as the lessor, since the lessor is usually more experienced in remarketing the assets.
With these parameters one can either build a very complicated and sophisticated Excel model or simply use one of the various lease pricing tools available, such as Supertrump by Ivory Consulting. In the analysis performed for this article, SuperTrump was used to model the lease-versus-own scenarios.
The following specific parameters were incorporated into a SuperTrump pricing tool to calculate first the lease rate and then the various lease-versus-own analyses summarized below.
Basic Assumptions Incorporated
|Lessor residual value assumption||15%|
|Lessee residual value assumption||10%|
|Lease start date||12/31/18|
|Lease term||60 months|
|End of term assumptions||Lessee returns leased asset or sells owned asset|
|Standard MACRS||5 years|
|Bonus Depreciation Option||50% or 100% as the case may be discussed below|
|Lessee borrowing rate||5%|
|Lessee financing of ownership||100%|
|Lessor borrowing rate||3%|
|Lessor debt to equity||90% debt / 10% equity|
|Lessor targeted after tax ROE||12%|
|Tax rates||21% federal/ 6% state effective 1/1/18|
|Monthly calculated lease rate||$15,752.92|
With the base financial model built, we then start considering various different scenarios that may exist for the lessee in order to calculate the lease-versus-own analyses indicated below.
No limitations on lessee; lessee and lessor have similar tax situations.
Calculating the AT-NPV of the owning-versus-leasing produced the following result.
Ownership has a lower AT-NPV cost than leasing by $97,277 and is therefore 17.3% better than leasing. This is expected since there were no differences in the tax assumptions between the lessee and the lessor.
Lessee is in a NOL until 2029. In modeling this lease-versus-own analysis we effectively accumulate the tax deductions and then use them all when the lessee is assumed to no longer be in a NOL position.
If a lessee is in such a position, the lessor can make the point that a lease does not add to the NOL position as quickly as owning does and a lease can also help manage any limitation on the deductibility of net interest expenses.
Notice while the overall AT-NPV is higher than all of the other scenarios, the advantage to own compared to lease has been narrowed down when compared to the base case. In this case, the lessee is spreading the lease tax deductions slowly because of the NOL, so the difference between the two is very close, within 7%.
Lessee signed a binding written contract to acquire a new asset before September 27, 2017 and is eligible for only 50% bonus depreciation rather than 100%.
The cost of ownership has increased compared to the Base Case because of the slower depreciation the lessee can claim. The lease AT-NPV remains the same. The AT-NPV of the lease will often remain the same when only the lessee’s tax depreciation methods or timing changes.
Lessee signed a binding written contract to acquire a used asset before September 27, 2017 and is not eligible to claim any bonus depreciation; however, the lessor is not subject to this limitation and can claim 100% bonus depreciation.
The advantage has shifted to leasing because the lessee is not entitled to claim any bonus depreciation because it was acquiring a used asset via a binding written commitment signed prior to September 27, 2017; however, the lessor is not subject to those rules because it acquired the asset after September 27, 2017.
This brings to light the somewhat illogical nature of the tax rules as they have been passed. Whether or not these will be adjusted by the IRS is yet to be determined, but we have not seen this item on any tax-writer’s agenda at this time.
Lessee acquired a new asset on December 31, 2017 and was able to claim both 100% bonus depreciation and deduct the depreciation at a 35% federal tax rate. In this case the lessee can either continue to own the asset or consider a sale-leaseback. This analysis is a little more challenging, and I hope you agree with the approach.
If the lessee sells the asset in 2018, the taxable gain would be taxed at only 21%, resulting in a 14% benefit compared to the expensing of the asset in 2017.
We measured the difference by comparing the AT-NPV cost of doing nothing compared with the AT-NPV cost of executing the sale-leaseback. The sale-leaseback analysis will need to include the net benefit of the additional step of selling the asset and eliminating the AT-NPV cost of doing nothing. We assumed the AT-NPV of selling the asset is the net cash reinjected into the company.
|Benefit of AT-NPV from sale less eliminating existing
AT-NPV of ownership (790,000 – 562,611)
|Adjusted AT-NPV of sale-leaseback||432,499|
If you agree with this analysis, taking this type of action can create a substantially improved AT-NPV cost of leasing. The AT-NPV under this scenario produces the lowest cost of all of the scenarios, including all the other AT-NPVs calculated for owning or leasing. Be cautious of other costs, such as sales taxes incurred that may affect the overall analysis.
These examples demonstrate how the differences in tax circumstances between the lessee and the lessor present many opportunities to market the tax lease product and to illustrate the importance of being proficient in calculating a lease-versus-own analysis. The only way to demonstrate these advantages to prospective lessees is to quantify the values through lease-versus-own financial modeling. Applying this sort of consultative selling will help you gain favor and confidence from your prospective lessees.
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.