A Closer Look at Tax Consequences for Leasing for Portfolio Companies
The FASB released changes to accounting for leases to provide more visibility into leasing-related liabilities. Updates to ASC Topic 842, Leases (Topic 842) require lessees to record all leases, except for short-term leases, on the balance sheet and recognize a right-of-use (ROU) asset and lease liability arising from the lease. For lessors, the changes eliminate the concept of leveraged leases and requires that lessors recognize nonlease and lease components separately.
Private equity firms and their portfolio companies should be working through the updates to leasing arrangements now. Public companies adopt these financial reporting changes in fiscal years beginning after Dec. 15, 2018 (calendar year 2019), and private entities adopt for fiscal years beginning after Dec. 15, 2019. Leases must be transitioned using the modified retrospective approach, which will require the new guidance be applied to all leases presented in the financial statements in the adoption year. Leases from 2017 and 2018 will likely need to be adjusted to the new standard, so portfolio companies should be transitioning lease accounting practices now in preparation for the new standard.
As portfolio companies work through the adoption of the new leasing standard, they should also keep in mind potential income tax consequences. The changes affect certain elements of tax reporting, including deferred taxes, state and local taxes, interest expense deductions, transfer pricing, and foreign income taxes.
The new standard changes the way entities account for operating leases on a statement of financial position, which may create differences in methods of accounting for financial reporting and income tax purposes. Current financial accounting standards require lessees to record operating leases as rent expense on the statement of comprehensive income with related footnote disclosures to denote future minimum rent payments. Under the new leasing standard, entities record an ROU asset and a lease liability, effectively grossing up their balance sheets. The federal tax accounting method for leases has not changed, and companies will not have any tax basis in the ROU asset and related lease liability.
These differences between financial reporting and tax bases in the ROU asset and related lease liability will reverse over the course of the lease, and therefore, are temporary in nature. Accordingly, upon adoption of the new standard, companies will recognize a deferred tax liability for the book-tax basis difference in the ROU asset and a deferred tax asset for the book-tax basis difference of the lease liability. These differences will have to be tracked over of the lease term, adding complexity to the income tax provision process. Additional deferred taxes may also arise if the lessee and the lessor decide to change lease terms and conditions as a result of the new standard.
The new leasing standard may also impact other areas of income tax accounting, such as a company’s assessment of the need for a valuation allowance on its deferred tax assets. Companies may also decide to change contemplated tax planning strategies for certain arrangements, such as sale-leaseback transactions, to use as a source of future taxable income.
Portfolio companies will need to evaluate their current income tax provision systems, processes, and controls to determine the appropriate course of action to identify and implement the deferred tax effect of the new leasing standard.
State & Local Taxes
The new leasing standard can impact a portfolio company’s state and local tax profile in multiple ways.
Some states include a property factor in the determination of how much income tax a company should allocate to the state. Property, plant, and equipment amounts may appear to increase on a company’s balance sheet because the new standard requires ROU assets related to operating leases to be presented in the same line item as underlying assets, which essentially means the leased item is being presented as if it is owned by the lessee. States that include a property factor in their apportionment calculation also use a multiple of rent expense incurred in the property factor. Rent expense may change from the previous standard to the extent a lease no longer qualifies as an operating lease and instead has to be treated as a financing lease. In those circumstances, the company would no longer record rent expense and instead would present the income statement impact of the lease as interest expense and amortization.
There are a number of jurisdictions that impose a net worth-based tax, or franchise tax, on companies doing business in their state. Because all leases will be recorded on the balance sheet, any tax computed using a lessee’s balance sheet may be affected by the new standard, because the ROU asset and related lease liability often won’t reverse in equal amounts during each financial statement period.
Further, a company’s property taxes may change if the taxing jurisdiction considers the ROU asset recorded on the balance sheet as tangible personal property eligible for the property tax.
Interest Expense Deductions
Companies occasionally raise new capital by issuing hybrid instruments and intercompany arrangements that involve both debt and equity. It is often difficult to determine whether to treat these arrangements as debt or equity for tax purposes. One important factor in making that determination is the company’s debt-to-equity ratio. The new leasing standard could result in a larger debt-to-equity ratio and lead to more of these instruments being classified as equity rather than debt, thereby denying the company an interest deduction.
Changes to Topic 842 also require that the income statement impact of finance leases be recorded as interest expense and amortization. Under the new tax law, the interest expense limitation is calculated using a tax basis equivalent of EBITDA. As noted above, for tax purposes, a company will not record an ROU asset and related lease liability, and therefore will not incur an interest and amortization expense on such items. Instead, the company will deduct the rent expense, because the tax treatment is unaffected by changes to Topic 842. A company’s EBITDA, for financial reporting purposes, benefits from changes to Topic 842 to the extent rent expense – an item included in and reducing EBITDA – now takes the form of interest and amortization expense – items excluded from and not reducing EBITDA. The financial statement benefit to EBITDA is not relevant for the tax interest expense limitation, however, because the tax basis EBITDA controls for that purpose.
On the other hand, deductions for interest expense may be also be affected in jurisdictions where interest deductions are based on a percentage of EBITDA that is calculated on the book basis of accounting. The income statement impact of finance leases is recorded as interest and amortization expense and thus would increase the amount of EBITDA, whereas the income statement effect of operating leases continues to be recorded as rent expense, reducing EBITDA.
Income tax rules require that transactions between related parties meet the arm’s-length standard, which relies on financial ratios and profit level indicators. These ratios and profit level indicators could change if a company’s total assets are expected to increase as a result of having to record all leases on their statement of financial position. Specifically, companies with related party leasing arrangements for tangible assets will need to consider a potential mismatch in the timing of the income recognition of one party compared to the expense recognition by the other party to the transaction. Portfolio companies with several operating leases or that expect a significant financial statement impact may have to adjust their transfer pricing arrangements to ensure they continue to meet the arm’s length standard.
Foreign Income Taxes and Other Considerations
Just as the changes to accounting for operating leases may affect state and local income tax, so, too, might the changes affect foreign country income tax, especially considering that the IASB also updated its final lease standard. Portfolio companies with leases that span different international jurisdictions should verify how various foreign income taxes are calculated. Some countries, for example, require that income tax calculations follow the book basis of accounting. Others may calculate income tax based off of statutory accounting income.
Portfolio companies should also consider the impact of the new leasing standard on the amounts of the distributable reserves in jurisdictions that impose such limits on distributions to a foreign subsidiary’s parent. Other jurisdictions may impose a branch-level tax on the after-tax earnings of a foreign branch that are not reinvested in the local country.
Time to Call Your Tax Provider
Lessees will likely have a lot to consider when assessing the tax impact of the new leasing standard. A tax provider experienced with the financial statement ramifications of Topic 842 can assist with an evaluation of the proper tax reporting requirements before the effective date arrives. For more information about how the leasing standard affects your taxes, please contact us.
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