Magazine article Journal of Commercial Lending

Understanding Some Fundamentals of Tax Leasing

Magazine article Journal of Commercial Lending

Understanding Some Fundamentals of Tax Leasing

Article excerpt

One of the creative techniques that is gaining popularity among financial officers these days is the use of tax leasing in place of traditional bank debt. In 1989, the latest year for which data are available, $122 billion of equipment was leased in the United States. That represents a 43% growth rate for the period of 1986 to 1989.

As a result of this, it is more important than ever that loan and credit officers understand what tax leasing is all about and how it can be used to shape a company's balance sheet.

WHAT IS A TAX LEASE?

Simply stated, a tax lease is a contract in which one party (the lessor) gives another party (the lessee) the exclusive right to use and possess its property or equipment for a specific period of time. Under a tax lease, the Internal Revenue Service (IRS) grants to the lessor all the tax benefits and liabilities of equipment ownership, such as depreciation deductions. The lessor is, in fact, the owner of the equipment for accounting and tax purposes.

To claim this status, the IRS has issued a list of four tests that the lease contract must pass for it to be considered a tax lease. Those tests are:

1. Any purchase option in the lease must be for a price of no less than the equipment's fair market value (FMV).

2. The term of the lease must not exceed 80% of the estimated useful life of the equipment.

3. The lessee must not have any investment in the equipment. In other words, there must not be joint ownership of the equipment by the lessee and lessor.

4. The equipment must not have such a specific purpose that the equipment could not be resold at the end of the lease to a third party.

WHY DO COMPANIES

LEASE?

There are many reasons a company will choose to enter into a lease rather than obtain typical bank financing to purchase equipment. All of them provide unique advantages over straight debt. Some of these reasons are discussed below.

* Leasing Improves Cash Flow. Since the lessor will attempt to sell the equipment at the end of the lease term for its FMV, the lessor will typically give credit for this incoming cash flow by treating it in much the same manner as a balloon payment, thus lowering the rentals charged to the customer on a monthly basis. In addition, since the customer is not allowed to have any investment in the equipment, leasing is always 100% financing by virtue of the fact that there is no down payment made.

Further, terms can be longer than usually found in conventional financing because the lease can be for as long as 80% of the useful life of the equipment. This often results in lease terms of 7-10 years. Very often, customers will request payment structures designed to match the revenue generated by a piece of equipment. An example of this would be a construction company requesting skip payments in the winter months when his equipment may be idle.

* Balance Sheet Considerations. Tax leases may be structured in a way that will allow them not to be shown on the balance sheet as debt. This helps companies to keep their leverage ratios within the constraints of their loan covenants, thereby giving them a better negotiating position when seeking additional financing. Of course, not all tax leases qualify for this off-balance-sheet treatment, as I will discuss later. And all lease obligations must be noted in the footnotes of the financial statements.

* Transfer of Tax Benefits. When any "for profit" company (and some nonprofit companies in certain cases) buys equipment, it is entitled to make use of the depreciation benefit that the tax laws allow. However, in many cases the company acquiring the equipment may not be in a position to use the full tax benefits for a number of reasons.

Among them may be the absence of current profits, the accumulation of other tax credits, or the company's alternative minimum tax (AMT) position. …

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