Tax Impacts of the New Lease Accounting Standard ASC 842
By Daniel Smith, Director, Tax & Business Services
The Financial Accounting Standards Board (FASB) recently proposed a delay in the implementation of Accounting Standards Update on Topic 842, Leases, originally enacted on February 25, 2016. Although the delay will give most private companies until fiscal years beginning after December 15, 2020, to comply, it is important for companies to be proactive in considering the tax as well as the GAAP impact of ASC 842.
The changes in the accounting guidance will not impact how leases are treated for federal income tax purposes, as there were no direct changes in tax law with respect to the treatment of leases. However, as companies transition to the new leasing standard, the new GAAP accounting standards may impact several areas within the tax function.
Prior Lessee Accounting Model
Leasing guidance before the issuance of ASC 842 required lessees to classify leases as either capital or operating leases. Capital leases required lessees to recognize an asset and a corresponding liability equal to the present value of the future lease payments. Expenses associated with capital leases were recognized by amortizing the leased asset and recognizing interest expense on the lease obligation. Many lease arrangements were classified as operating leases. Lessees would not recognize lease assets or liabilities on their balance sheets, but would recognize lease payments as rent expense on a straight line basis over the lease term.
Leasing guidance prior to the issuance of ASC 842 was often criticized for not providing users of financial statements the information necessary to understand a reporting entity’s leasing activities, primarily because it did not provide a comprehensive understanding of the costs of property essential to a reporting entity’s operations and how those costs were funded. Most leasing activity was reported as off balance sheet items in the footnotes to the financial statements.
New Lessee Accounting Model
Under the new accounting model under ASC 842, virtually all leases that were previously expensed only on the income statement now must be recorded on the balance sheet. Lessees will now need to recognize a right-of-use asset and a lease liability upon the inception of a lease. The liability will be equal to the present value of the future lease payments, discounted using the rate implicit in the lease. The right-of-use asset will be based on the amount of the initial measurement of the lease liability plus any lease payments made to the lessor at or before the commencement date of the lease, minus any lease incentives received and any initial direct costs incurred by the lessee.
For income statement purposes, ASC 842 retains a dual model requiring leases to be classified as either operating or finance. Operating leases will result in straight-line rental expense similar to current operating leases. Finance leases will result in interest expense determined under the effective interest method. Amortization expense is recorded on the right-of-use asset, usually on a straight line basis.
Under ASC 842 lessors will classify leases as sales-type — direct financing or operating. The distinction between a sales-type and direct financing lease is that in a sales-type lease, the lessee obtains control of the underlying asset, and the lessor recognizes selling profit and sales revenue upon lease commencement. No sales transaction is recognized for tax purposes at the time of lease commencement. For sales-type and direct financing leases, the underlying asset is derecognized, and the net investment in the lease (the sum of the present value of the future lease payments and unguaranteed residual value) is recorded. The net investment is increased by interest income and decreased by payments collected. For operating leases, the underlying asset remains on the balance sheet, net of depreciation expense over its useful life. The lessor will depreciate the property on a straight line basis for GAAP and over the applicable recovery period for tax.
ASC 842 does not impact how leases are treated for federal income tax purposes. Leases will either be treated as a true tax lease or a non-tax lease. Under a true tax lease, the lessor maintains ownership of the asset and the related deductions such as depreciation, while the lessee would deduct rental payments. A non-tax lease assumes that the risks and rewards of ownership are with the lessee. Tax deductions such as depreciation and interest expense are booked by the lessee, while the lessor recognizes interest income.
Deferred Tax Accounting
Since ASC 842 does not change the treatment of leases for income tax purposes, companies will have to consider the deferred tax implications in the implementation of the new standard. A lessee that is otherwise not required to capitalize the lease for income tax purposes will not have any tax basis in the right-of-use asset and related lease liability recorded for GAAP purposes. Since the differences between the GAAP and tax basis of the right-of-use asset and related lease liability will result in taxable income or deductions upon their reversal, such differences are temporary in nature. Accordingly, a company must recognize a deferred tax liability for the excess GAAP basis in the right-of-use asset and a deferred tax asset for the excess GAAP basis in the related lease liability. Whether the lease is classified as a finance or operating lease under the new guidance, the right=of=use asset and related lease liability are initially measured in the same manner. Accordingly, the initial measurement of the temporary differences will generally be the same, regardless of the classification of the lease.
The manner in which the initial temporary differences reverse, however, is dependent on whether the lease is classified as a finance or operating lease under the new standard. Even though the income statement effect of leases under ASC 842 is largely unchanged from previous guidance, the difference in the reversal pattern between a finance and operating lease will affect the subsequent adjustments to the original deferred tax asset and liability. For finance leases, the new lease standard will generally result in an accelerated expense recognition for financial statement purposes. This outcome is due to the subsequent accretion in the lease liability being based on an effective interest rate calculation, similar to a mortgage with higher interest expense being incurred in the earlier years and less interest expense incurred in later years, as the mortgage liability is reduced by payments made.
For operating leases, the new lease standard will generally result in a constant annual cost similar to the expense pattern under current operating lease accounting. While the subsequent accretion in the lease liability is also based on an effective interest rate calculation, the right-of-use asset is amortized at a rate to ensure that the cost of the lease is allocated over the lease term on a generally straight line basis.
Also, if any impairment is created for a right-of-use asset for book purposes, it will need to be reversed for tax purposes.
Certain states levy franchise taxes for companies doing business within particular jurisdictions. Franchise taxes are generally based upon the net worth (stockholder’s equity) of a corporation; however, various adjustments may be required (e.g., treasury stock, liabilities, reserves, etc.) to arrive at the taxable base. Implementation of the new leasing standard may impact the computation of a company’s franchise tax base, due to the requirement to record essentially all leasing transactions on the balance sheet for financial accounting purposes. Moreover, the property factor utilized in the computation of many state apportionment factors (for both income and franchise tax purposes) is determined through the use of an average owned property (generally, valued at its original cost) and eight times the net annual rent. After the adoption of ASC 842, companies may need to change the process used to gather information for property factor computations, particularly if the right-of-use asset is recorded in the same balance sheet account or line item as other owned property.
Other Tax considerations
Companies should consider whether the adoption of the new lease accounting standard will impact any other non-income based taxes. For example, a company should consider whether its property tax liability (if based on its financial accounting balance sheet) will change as a result of the proposed standard. Companies should also consider if there will be any sales and use tax impact resulting from the adoption of the new lease accounting standard. For example, companies should assess whether a state would consider a lease transaction as a purchase, since companies will have lease transactions on the balance sheet after adopting the new standard. Companies with off shore leases may also need to evaluate the effect that ASC 842 may have in each foreign jurisdiction in which they operate. ASC 842 could also impact transfer pricing arrangements.
As companies prepare to adopt the new lease accounting standard, tax implications and opportunities should be considered at each step of the implementation process.