Ivory Consulting’s CEO Scott Thacker provides advice and counsel to equipment lessors and lenders on the best ways to improve customer satisfaction and profitability using modeling and pricing techniques, this time focusing on tax benefits from tax vs. non-tax yields. His colleague Ray James contributed to this article.
There are significant differences between an equipment lease transaction that is structured to take into account tax benefits, known as a tax lease, and one that does not take into account tax benefits, known as a non-tax lease. Calculating the yield on a given lease transaction is fairly straightforward for a non-tax lease, but much more complicated for a tax lease. Comparing these two yields as “apples to apples” requires complicated analysis.
Tax Benefits
Tax benefits primarily result from accelerated depreciation, ITC and renewable energy tax credits. The use of accelerated depreciation produces a deferred tax liability — the difference between the book depreciation (typically straight-line depreciation) and the tax depreciation (typically accelerated depreciation). Essentially, deferred taxes are the combined federal and state tax amount owed that has been recognized on the accounting books, but not remitted to the taxing authorities. To properly account for deferred taxes, think of the amount as being “borrowed” from the government at an effective interest rate of 0%.
Tax leases are often funded with both debt and equity. There is a cost of funds associated with the debt component, for example, it could be 6%. If the transaction includes deferred taxes, then the cost of funds for the debt component has two components: the cost of the debt actually borrowed and the deferred taxes which is hypothetically “borrowed” from the government at 0%.
Now, this is clear as mud so an example is needed to illustrate. If the average debt component is 15 parts borrowed money at 6% and one part deferred taxes at 0%, then the funding cost would drop from 6% to 5.63% ((15 x 6%)/16), and conversely, the spread on the tax lease would increase by 0.37%, all from the tax benefits.
Comparison
Since non-tax leases and loans do not generate deferred taxes, a question arises as to how to compare the yield on these two instruments with the yield on a tax lease which generates deferred taxes. In this situation, it is common to measure the tax benefit of a tax lease as a hypothetical improvement of the tax lease yield rather than as a reduction in the cost of funds. In the equipment finance industry, various yields are often used when comparing a tax lease yield to a non-tax lease or loan yield.
To be competitive in the equipment finance industry with tax lease products, it is essential to measure the value of the related tax benefits and also receive the benefit. Not recognizing tax benefits at the time of booking makes it difficult to structure competitive lease bids.
One Reply to “Tax vs. Non-Tax Yields – A Primer”
My former employer’s approach to put the pricing of a true lease on the same basis as a loan was to use a weighted average present valued ROA to evaluate the tax lease. The tax lease balance sheet and P&L (including funding costs assuming the deferred tax balance has a zero cost and including the ITC revenue) is run out using GAAP earnings (either DFL or operating lease). Since there is a timing issue with the earnings pattern compared to a loan (it has a constant return while the tax lease does not), an adjustment is made to time value the lease’s ROA using the lessor’s targeted ROE rate. The PV of the average net earnings divided by the PV of the average assets balance – the result is the PV weighted average ROA. It may be the best reflection of how the tax lease will impact the financials of the lessor over time assuming the shareholders desired return on equity. All this is fine in a vacuum but there is competition out there using the MISF yield to price, so you may have to reduce price to win deals BUT at least you know what your booked returns are if you run the deal thru the weighted avg PV calculation..