With ASC 842 requiring all leases to be placed on balance sheet, will lease structures change to minimize the effect of the balance sheet capitalization?
Implementation of ASC 842 Leases will begin for larger companies in the fiscal years starting after December 15, 2018 and in fiscal years starting after December 15, 2019 for other companies. The impact of this accounting standard is operating leases and certain other agreements which are, or contain, imbedded leases will be required to be capitalized. As a result, many companies are examining arrangements to determine whether they are within the scope of ACS 842 and if so, how to possibly minimize the amount capitalized.
While off-balance sheet treatment was often stated as the principal reason companies lease, leases are used as a form of financing for a large variety of reasons, and I expect leasing will continue to be a robust and viable form of acquiring the use of assets.
The on-balance sheet aspect of leasing may drive some changes in the structure of certain agreements, obviously subject to the economic costs of such structural changes. This article will examine some potential structural changes.
Possible Transaction Structures
While some of the structuring thoughts summarized in this article may appear attractive on the surface, their cost may overwhelm their financial reporting allure.
The reader, and the leasing industry, must discover whether any of these ideas are viable!
While a lessee may simply request a shorter-term lease, these leases require the lessor assume a greater residual value equipment exposure. With the risk of the asset being returned, the lessor will assume a conservative residual value at the end of the first lease. Further, lessors often borrow to finance acquisitions, often relying on the credit of the underlying lessee. With a shorter-term lease the lessor must contribute more equity to the transaction, requiring a greater overall rate of return. Additionally, the lessee may need the asset for a longer period. To meet their usage requirements, the lessee may need to be able to renew the lease.
With all these considerations, a shorter-term lease where the lessor assumes all the risk may be more costly to a lessee, compared to a single lease of the asset for a longer term. Whether lessees will be willing to assume this additional cost is yet to be determined.
Shorter-Term Non-Tax Lease With a Lessee Residual Value Guarantee
The reintroduction of the “synthetic lease structure” is another means of creating a shorter-term lease. Under a traditional synthetic structure, the lessee guarantees the first loss on the value of the stated residual value in the lease.
For example, assume a 60-month lease of a ship costing $10 million, structured with a 50% projected residual value with the lessee guaranteeing the first 35% of any potential loss.
Under ASC 842, lessees will only capitalize the portion of the guarantee that they reasonably expect to pay. Therefore the amount capitalized can be much less than the amount guaranteed. In the previous example, if the lessee projects its risk of loss to be only 5% of the total 35% guarantee, then the lessee would capitalize only the rents plus the 5% it reasonably expects to pay.
The challenge in these leases is whether a lessee is willing to assume the first-loss risk of the residual value. Secondly, the shorter-lease term may again not be sufficient for the lessee’s usage requirements. These leases are non-tax leases because the lessee assumes the full risk of the residual value.
Shorter-Term Tax Lease With Lessee Residual Value Guarantee
Occasionally seen in the past, a tax lease product followed the structural design of the synthetic lease but the lessor assumed a sufficient amount of the residual risk to retain tax ownership of the asset. In the previous example, if the lessee assumes only a risk of the first 20% of the 50% stated residual value, the lessor would continue to assume a 30% risk. This structure may effectively meet the usual tax test of a minimum 20% residual value and is similar to a split-TRAC lease found in the motor vehicle leasing segment. However, since the tax code does not provide a similar exception when leasing non-motor vehicle assets, this structure should be explored with your tax counsel. It may be time for the leasing community to explore this lease structure.
Many lessees may seek a service agreement rather than a lease which is not capitalized. This is much easier said than done. Among the many requirements under ASC 842, the “service recipient” cannot receive the majority of the economic benefits of, operate or control the asset. Further, the service provider must have substantive rights to substitute the asset for its economic benefit. Thus, an agreement providing for a specific asset operated by the service recipient rather than a service provider would likely be characterized as a lease. A power purchase agreement covering the power generated by a solar or wind facility is a good example. Although the service-recipient does not operate the facility, it assumes the majority of the economic benefits from the asset. However, since the payments are fully contingent, the lessee will likely not be required to capitalize any of the payments.
A service agreement structure is acceptable for a solar or wind installation largely because the payments are highly probable and investors are willing to assume the risk that energy will be generated.
The challenge with structuring other transactions as a service agreement are numerous, including the willingness of the service provider to assume the operational risk of the asset and the economic risk of receiving sufficient payments to achieve the targeted return.
Contingent Rent Structures
As in the service agreement, a lease with fully contingent rents is not capitalized. At issue is whether a lessor can structure a business case for leasing an asset on a fully contingent rent basis, such as per usage. This structure has some fundamental business modeling questions. By adding an asset utilization risk, the lessor now has another risk to consider.
Generally speaking, this type of arrangement results in rental rates opposed to lease rates. For instance, when one rents a car, daily rates are much higher for a similar term compared to long-term lease rates. If a lessor and lessee happen to have a specific situation in which the lessor is confident the lessee will pay sufficient contingent rent, then perhaps the contingent rates over the longer term may be closer to a similar termed lease rate.
Another trade-off of a fully contingent per usage model is the lessee potentially forgoes some profit. If the asset produces better than expected revenues, a large portion of the revenue will likely go toward paying the contingent rent, whereas with a fixed rent model, the lessee will keep most of the excess. Perhaps a structure can be negotiated in which the lessee pays a lower per use charge the more it utilizes the asset, providing incentive to utilize the asset further (if able).
The challenge is finding the ideal asset and situation in which both lessee and lessor are comfortable with the risks they are assuming and the rewards from those risks.
Fractional Share or Time-Share Arrangements
Under ASC 842, for an arrangement to be considered a lease, the asset being utilized must be identifiable in nature. In the fractional share aircraft business, a service recipient seeks to obtain the use of an aircraft for only a fraction of the time. It does so by contributing a fractional share of an aircraft to a pool of aircraft managed by an operating company. In exchange for this “contribution,” the service recipient is given a certain number of annual flight hours over a designated period of years from any one of a pool of other aircraft. The service recipient, in fact, may never even use the specific aircraft the fractional share of which it contributed to the arrangement!
The service recipient is paying over time for an opportunity to utilize flight hours on an as needed basis. In this case, I believe the transaction is not capitalized under ASC 842 even if the fractional share itself is leased. Since the asset (a fractional share) is not an identifiable asset it may be outside the scope of ASC 842.
While this structure may be applied to corporate aircraft, consider the other types of potential assets it may be applied to. Similar arrangements are found in the vacation time-share industry.
Perhaps this approach can be applied to other assets such as general office space, warehouse storage space, data centers and even rail freight cars, so a lessee can acquire a time-share usage as needed.
Obviously, until the new leasing rules are implemented and their effect felt, theorizing about potential new products is challenging. For every great idea, we might find that the economic models just don’t make sense for the investors or the lessees. However, we have seen in the past how necessity is the mother of all inventions and perhaps with ASC 842 around the corner, necessity is fast coming upon us.
Therefore, it is up to you, the reader, to further develop these products!
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Ivory Consulting’s CEO Scott Thacker provides advice and counsel to equipment lessors and lenders on ways to improve customer satisfaction, enhance employee engagement and increase shareholder value using modeling and pricing techniques.