14 • May 2006

Theleveragedleaseproducthasbeenusedbymanylargecorporationstofinancecapitalequipmentacquisitions.

Commercialaircraft,vessels,railcarsandmanufacturinglinesareassetscommonlyacquiredusingthisvehicle.Taxbenefitsandanoptimizedstructuremakeleveragedleasinganattractivefinancingoption.

LeveragedLeasingBasicsOneofthecharacteristicsofaleveragedleaseisthatitinvolvesatleastthefollowingthreeparties:alessee,ales-sorandalong-termcreditor.Thelessee,typicallytheenduseroftheequipment,isusuallyanorganizationthathasaninvestmentgradecreditrating.Anon-investmentgrade

FinancialWatch

lesseemaybesupportedbyacreditguaranteefromamorehighlyratedorganization.Typicallesseesincludeairlines,railroads,energyproducers,andmanufacturers.

Thelessor,commonlyreferredtoastheequityinvestor

ALeveragedLeasePrimerUnderstanding the tax and accounting treatments of this powerful equipment finance tool.

Despite its relatively small

investment of 20 – 35 percent, the

lessor is able to depreciate the full

equipment cost for tax purposes.

May 2006 • 1�

FinancialWatch

orowner,investsanamountmuchlessthanthefullcostoftheequipment.Theamountoftheequityinvestmentvariesbytransaction,butmanylessorsinvestaround20percent-35percentofequipmentcost.Despitethisrelativelysmallinvestment,thelessorisabletodepreciatethefullequip-mentcostfortaxpurposes.Lessors,betheybank-ownedleasingcompanies,independentleasingcompaniesorcap-tivefinancingcompanies,usuallyhavelargetaxbasestofullyutilizethesebenefits.

Theremaining65percent-80percentofthecostoftheequip-mentisprovidedbythelong-termcreditor.Thelong-termcredi-tor,oftenreferredtoasthethirdpartyornon-recourselender,istheproviderofthetransaction’sleverage.Banks,insurancecom-panies,pensionfunds,orothersseekinglong-termreturnsonamoney-over-moneybasisprovidetheleverage.Morethanonelendermayparticipateinagiventransac-tion.Thelendersloanfundstothelessorbutlooktothecreditofthelesseeandtheequipmentvalueintheeventofdefault.Inotherwords,thelendingisnon-re-courseasthelessorisnotrespon-sibletorepaytheloanintheeventofdefault.Thelenderhassomeprotectioninthatitsclaimdoesprecedethelessor’sclaimintheeventofdefault.

Thepoweroftheleverageef-fectandtaxbenefitslowersthemoney-over-moneyratetothelesseerelativetoatypicaltaxleaseorstraightloan.Sincethelessorisabletodepreciatealloftheequip-mentwithonlyarelativelysmallequityinvestment,thiseconomicbenefitcanbesharedwiththelesseeintheformoflowerrates.Aleveragedleasecanalsobestruc-turedtomeetthespecificneedsofthepartiesinvolved.Specializedpricingprogramscanoptimizerentanddebtschedulestomeetparticularcriteria,suchaslowestpresentvalueofrenttothelessee,highestbookearningstothelessororminimuminvestmentdurationforthelenders.Earlybuyoutop-

tionsarepopularfeaturesandgivethelesseetheadvantageofadefinitepurchasepricefortheequipmentataparticu-larpointintheleaseterm.Inordertoavoidjeopardizingthelessor’staxtreatment,theearlybuyoutoptioncannotbesetatabargainprice.

TaxTreatmentInordertomeetthetaxrequirementsofaleveragedlease

16 • May 2006

FinancialWatch

andbeentitledtodepreciatetheequipment,thelessormusthavetherisksandrewardsofownership.Inatruetaxlease,thelessorcandepreciatealloftheleasedequipment,notjustthatportionfinancedonanequitybasis.Thelessorcanalsodeducttheinterestpaidtothelender,sincethenon-recoursedebtistreatedasaloanbetweenthelenderandtheequityparticipant.

TheIRS,inRevenueRuling55-540,providedsomeguid-ancefordeterminingwhetheratransactionqualifiedfortrueleasestatus.Ifatransactionhasanyoneofthefollow-ingcharacteristics,itmaynotbeconsideredatrueleaseforfederalincometaxpurposes:n Portionsoftheperiodicpaymentsaremadespecifically

applicabletoanequitytobeacquiredbythelesseen Thelesseewillacquiretitleuponpaymentofastated

amountofrentalsrequiredunderthecontract.n Overarelativelyshortperiodofusage,thelesseeis

requiredtopayalargepercentageofthetotalsumneededtosecuretransferoftitle

n Theagreedrentsmateriallyexceedthecurrentfairrentalvalue.

n Thepropertymaybeacquiredatanominalorbargainpurchaseprice

n Someportionoftheperiodicpaymentsisdesignatedasinterest

Withtheincreaseinleveragedleasevolumeinthe1970s,theIRSreceivedmanyrequestsforadvancedrulingstode-terminewhetherthesetransactionswouldqualifyfortrueleasestatus.TheIRSissuedRevenueProcedure75-21toprovidethestandardsforobtaininganadvanceletterrulingfromtheIRS.Leveragedleasesmeetingthefollowingstan-dardscouldexpecttoreceiveafavorablerulingregardingthetransaction’strueleaseclassification:n Lesseemusthaveaminimumunconditionalatrisk

investmentof20percentwhentheleasebegins,duringtheleasetermandattheendofthelease.Inaddition,thelessormustrepresentthattheequipment’sremainingusefullifeisequaltonolessthanoneyearand20percentoftheoriginalestimatedusefullife.

n Lesseemaynothaveacontractualrighttopurchasethepropertyfromthelessoratapricethatislessthanfairmarketvalue

n Lesseecannotmakeaninvestmentinleasen Lesseecannotlendanyportionofthefundsto,or

guaranteeanyindebtednessof,thelessorinconnectionwiththeacquisitionoftheleasedproperty.

n Thelessormustexpecttoreceiveaprofitapartfromtaxbenefits.Thetransactionmusthavepositivepre-taxcashflow.In1999,thefinalizedIRSCodeSection467regulations

May 2006 • 17

wereadoptedwith,amongotherthings,thespecificalloca-tionofrentandSection467loanstructuringtechniquesthatarecommonlyusedtoday.Thesearepowerfullever-agedleasestructuringapproachesthatcangreatlyimproveatransaction’seconomics.

Aleveragedleasestructuredusingtheallocatedrenttechniquehastwoseparaterentschedules:1)acashrentschedulebetweenthelesseeandlessorand2)ataxrentscheduleonwhichtaxableincomeiscomputed.Therearetwomajorconstraintsontherelationshipbetweenthesetwoschedules.First,theymustsumtothesamefigureattheendofthelease(taxrentequalscashrent.)Second,theannualbalancesofeachschedulemustbenomorethanoneyearoutofsynchwitheachother.Inotherwords,thecashrentbalanceattheendofyearoneofaleasemustbenogreaterthantheallocatedrentbalanceattheendofyeartwo,andviceversa.Thelessorfindsthisstructureadvantageousbecausetheremaybeanop-portunitytodefersometaxableincomefromoneyeartoanother,thushavingfewertaxabledollarsintheearlieryearsoftheleaseandimprovingtheafter-taxcashflows.Lesseesshareinthisadvantagethroughpotentiallylowerleasepayments.

TheSection467loanisthetreatmentappliedtoales-soriftheleveragedleaserentalstructurefallsoutsidetheallocatedrentguidelinesdetailedabove.Aloanisdeemedtohavebeenmadebetweenthelesseeandthelessortorepresentthelessee’sprepaymentofrentsascomparedtotheamountallowedundertheguidelines.Thelessormusttreattheamountoftheprepaymentasaloanfromtheles-seeandimputeinterestagainstthatbalance.Thatimputedinterestisanexpenseandisdeductiblebythelessor.LesseesmaytakeadvantageoflowerIRR’sbyutilizingthestructure;however,theremaybeagreatdetrimenttothelessee’scashposition.

AccountingClassificationLeveragedleaseaccountingisaddressedinFinancialAc-countingStatement(FAS)#13.Thefollowingmustbetrue

toutilizeleveragedleaseaccounting:n Thoughaleveragedleasehasaseparateaccounting

classification,theleasemustmeetthecharacteristicsofadirectfinancinglease.Leasesthatmeetthedefinitionofsalestypeoroperatingleasescannotbeaccountedforasleveragedleases.

n Theleaseinvolvesatleastthreeparties:lessee,lessorandlong-termcreditor.

n Thefinancingprovidedbythelong-termcreditorisnon-recoursetothegeneralcreditofthelessorandprovidessubstantialleverage.Substantialhasgenerallybeeninterpretedtomeanmorethan51percentofthetotalequipmentcost.

n Thenetinvestmentdeclinesintheearlyyearsandrisesinthelateryearsofthelease.Thepatternmayoccurmorethanonceduringtheleaseterm.Althoughthereisnoamountbywhichthenetinvestmentmustincreaseordecrease,someaccountingfirmshavedecreedthat10percentistheminimumacceptableamountofmovement.AccordingtoFAS#13,thelessor’sleveragedlease

investmentisrecordedonthebalancesheetnetofthenon-recoursedebt.Thenetofthebalancesofthefollowingaccountsrepresenttheinitialandcontinuinginvestmentinleveragedleases:

FinancialWatch

The power of the leverage

effect and tax benefits lowers

the money-over-money rate to

the lessee relative to a typical

tax lease or straight loan.

1� • May 2006

n Rentalsreceivablenetofthatportionoftherentalapplicabletoprincipalandinterestonthenon-recoursedebt.Therentreceivableistheamountoffreecashyettobereceivedbythelessor.Freecashequalstheamountofrentreceivedfromthelesseelesstheamountofdebtserviceowedtothelender.

n Areceivablefortheamountoftheinvestmenttaxcredittoberealizedonthetransaction.Theinvestmenttaxcredit,whichwasataxcreditavailabletoencouragecapitalinvestment,waseliminatedin1986.Someagedleveragedleasesmaystillcarryaninvestmenttaxcreditbalance.

n Theestimatedresidualvalueoftheleasedassetn Anyunearnedincomeordeferredincome.Unearned

incomeistheestimatedpre-taxleaseincomeremainingtobeallocatedovertheleaseterm.Unearnedincomeiscalculatedbydeterminingthetotalpre-taxincomeinthetransactionandnettingthetotalinterestexpenseonthedebt.Deferredincomeistheinvestmenttaxcreditremainingtobeallocatedtoincomeovertheleaseterm.FAS#13dictatesthattheinvestmentinleveragedleases

lessdeferredtaxesshallrepresentthelessor’snetinvest-mentinleveragedleasesforthepurposesofcomputingnetincomefromthelease.Thedeferredtaxbalancerepresentsthedifferencebetweenthesumof“normalized”provisionsforincometaxesandthesumofcurrenttaxespayable.The“normalized”provisionisdeterminedbydividingthetotaltaxestobepaidoverthelifeoftheleasebythetotalpre-taxyieldandmultiplyingtheresultingpercentagebyperiodicpre-taxincome.Assumingnotaxratechangehasoccurredsinceleaseinception,thedeferredtaxbalancecomputedunderthedictatedleveragedleasemethodologywillequalthedeferredtaxbalancecomputedunderFAS#109(wheredeferredtaxesrepresentthattaxeffectofthetemporarydifferencebetweentaxescalculatedontheac-countingbooksandtaxespaid.)However,ifaratechangehasoccurred,theeffectofthatratechangewouldbereflectedoverthelifeoftheleveragedlease,whereasunderFAS#109theeffectwouldbereportedimmediately.

Atparticularpointsthroughouttheleaseterm,thedeferredtaxbalancemaybegreaterthantheinvestmentinleveragedleasebalance.Whenthisoccurstheleaseissaid

tobeinthedisinvestmentperiodorsinkingfundperiod.Duringthedisinvestmentperiod,thelessorhasinitspossessionmorecashthanitinitiallyinvestedinthetransactionandmaythenutilizethatcashforadditionallendingorothercorporateuses.

Aspreviouslystated,thelessor’snetinvestment,whichisitsinvest-mentlessdeferredtaxes,isusedasthebasisforincomeallocation.Leveragedleaseearningsareonlyallocatedtotheperiodsduringwhichthelessor’snetinvestmentispositive.Noearningsarerec-ognizedontheincomestatementduringthedisinvestmentperiod.Thismethodofincomealloca-tionisreferredtoasthemultipleinvestmentsinkingfund(MISF),anditistherequiredmethodforleveragedleases.Asummaryofhowleveragedleaseearningsare

FinancialWatch

In order to meet the tax requirements of a leveraged lease

and be entitled to depreciate the equipment, the lessor

must have the risks and rewards of ownership.

20 • May 2006

FinancialWatch

derivedisshownbelow:1. Calculatethetransaction’safter

taxcashflows,whichequatetothetransaction’saftertaxearn-ings

2.ApplythesecashflowstothenetinvestmentconsistentwiththeMISFyieldmethod,sothatearningsareonlyallocatedtoyearswithpositiveinvestment

3.Grossupincometodeterminethepre-taxbookearningsontheleveragedlease

Leveragedleasepricingprogramsareavailabletoperformthesecal-culationsbeforetheleaseisbooked.Sincebookearningsarecalculatedonanaftertaxaccountingbalance,theearningspatternsaregener-allyu-shaped,thatis,higherinthebeginningandendingyearsoftheleaseandlowerinthemiddleyears.Theimpactofdeferredtaxesistoinitiallylowertheaftertaxaccount-ingbalance.Overtimethiseffectisreversedastaxesarepaidandthedeferredtaxliabilityisreduced.Loansandsingleinvestorleasesgenerallyhaveadownward-slopingearningspatternthroughouttheirentirelivesduetotheuseofpre-taxaccountingbalances.

RecentFASBDevelopmentsHistorically,aleveragedleaseshouldberecalculatedifthereisanychangeinan“importantassumption”thatimpactsthetransaction’stotalnetincome,suchasachangeinenactedtaxratesorestimatedresidualvalue.Upontheoccurrenceofachangeaffectingestimatedtotalnetincome,therateofreturnandtheallocation

ofincometopositiveinvestmentyearswouldneedtoberecalculatedfromtheinceptionofthelease.Anexampleofachangeinanimportantassump-tionthatwouldnotimpacttotalnetincomeisachangeinthetimingoftaxcashflows.

InJuly2005,FASBissuedaproposedstaffpositiontitledFSPFAS13-aAccounting for a Change or Proposed Change in the Timing of Cash Flows Relating to Income Taxes Gener-ated by a Leveraged Lease Transaction.FASBconcludedinthisstaffpositionthatamaterialchangeinthetim-ingoftaxcashflows(otherthanasaresultofachangeintheapplicabletaxsystem—regularoralternativeminimumtax)wouldalsoresultinarecalculationofthelessor’seco-nomicswithanadjustmenttoleaseearnings.FASBdecidedthatanentityshouldrecognizethecumula-tiveeffectofinitiallyapplyingthisguidanceasachangeinaccountingprincipleandthereafterasachangeinearnedleaseincome.FASBalsodecidedthatamaterialchangeinstatetaxestobepaidshouldalsoresultinrecalculation.

ThefinalversionofFSPFAS13-aistargetedtobeissuedwhentheUncertainTaxPositionsinterpretationofFAS109isissued.Ascoordinatedpronouncements,FASB’snewinter-pretationwillprovidenewrecogni-tionandmeasurementguidancetobefollowedinschedulingoffuturetaxcashflows.ELAwillcontinuetopro-videupdatesontheprogressofthisFSPasdevelopmentsoccur.

ELT thanks Deborah Brady and Paul Ingram

of Key Equipment Finance for this month’s

column.

FASB’s new interpretation will provide new

recognition and measurement guidance to be

followed in scheduling of future tax cash flows.