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Revised exposure draft on leases may have significant tax accounting, state tax, and systems implications

In brief

The Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) issued a revised exposure draft on leases (the Exposure Draft).  The May 16 Exposure Draft attempts to address criticisms of the 2010 exposure draft, yet still meet the key objective of recognizing leased assets and liabilities on the balance sheet.

Although the tax law regarding the treatment of leasing transactions remains unchanged, taxpayers should consider how the Exposure Draft will impact the computation of federal and state taxable income and deferred income tax assets and liabilities associated with their leases.  In addition, taxpayers should consider potential state tax consequences.  As companies assess the impact of the Exposure Draft on their organization, consideration should also be given to tax implications that may require implementation or significant enhancements to systems, processes, and controls in order to comply with the proposed standard.

In detail

Background

Leasing transactions are flexible arrangements that are used as a tool by many organizations to secure the use of an asset with payments typically made over time, to borrow against the full fair value of the property and, sometimes, to unlock the value of appreciated property while continuing to use it. 

The FASB and the IASB recognize the importance of leasing transactions and are working together to develop a new approach to lease accounting that would require lessees to recognize the associated assets and liabilities  on the balance sheet (with the exception of short-term leases).  Accounting by lessors will also be impacted.
The following provides an overview of the proposals outlined in the Exposure Draft from the perspective of both a lessee and a lessor.

Lessee Accounting

The Exposure Draft requires lessees to recognize a right-of-use asset and a lease liability for virtually all leases, initially measured at the present value of lease payments (with the exception of short-term leases).  The income statement will reflect either a front-loaded expense pattern (similar to today's capital leases) or a straight-line expense pattern (similar to current operating leases).  The right-of-use asset represents the lessee's leasehold interest in the underlying property, and the liability represents the lessee's obligation to pay future rents.

Lessor Accounting

Lessors have always been required to reflect an asset. However, proposals in the Exposure Draft would require de-recognition of some or all of the leased asset and recognition of a lease receivable and its interest in the asset's residual value.  A lessor's income statement will reflect either straight-line income (similar to current operating leases) or the financing approach similar to a capital lease today.  In some cases the execution of a lease will permit immediate profit recognition on the portion "sold," profit on the residual is deferred until the underlying asset is re-leased or sold.  This is a change relative to the current accounting standards.  In addition to any upfront profit, interest income on the receivable and residual asset is recognized over the lease term.

To learn more about the financial reporting implications of the Exposure Draft refer to PwC Dataline: Leases – The Great Divide: The new leases landscape (No. 2013-13).

Tax accounting and other implications

While the U.S. tax law would not be directly impacted by the proposals offered in the Exposure Draft, accounting changes may directly impact an organization's computation of deferred income tax assets and liabilities, certain state apportionment factors and franchise taxes, and other non-income based taxes, as well as accounting systems, processes and controls.  We also expect the proposed standard to prompt changes in negotiated terms and conditions relative to today, which may in turn impact the tax treatment of such leases.

Deferred income taxes

Adoption of the Exposure Draft will likely create a number of differences between financial accounting and tax accounting (book/tax differences), such that companies may be required to record new, or adjust existing, deferred income tax assets and liabilities.  For example, the Exposure Draft would require lessees to recognize the following items on its income statement related to financing leases:

For operating leases today lessees generally record a deferred income tax asset for the difference between the cash rent deducted for U.S. federal income tax purposes and the GAAP rent accrued for financial accounting purposes for leases considered true leases for tax purposes.  The Exposure Draft will likely require companies with this fact pattern to:

In other fact patterns (e.g., sale-leaseback arrangements) lessees may be required to adjust existing deferred taxes as part of the cumulative balance sheet adjustments recorded at the transition date.

Similarly, lessors may find that their deferred income tax items will require additional scrutiny following the adoption of the proposed standard.  Under existing accounting standards a lessor records rental income for payments received and accounts for the leased asset as a fixed asset on its balance sheet for an operating lease that is also considered a true lease for tax purposes. Deferred tax assets or liabilities are recorded for certain temporary differences (e.g., depreciation and rent).  For a capital lease that is a true lease for tax purposes, the lessor reverses any book gain or loss recorded at the inception of the lease, reverses financial income and takes into account cash rental income offset by tax depreciation on the corresponding fixed asset. 

Under the proposed standard, the concept of an operating lease no longer exists. As such, a right-of-use asset and liability will be recorded for all leases other than those considered short term.  Leveraged lease accounting is eliminated altogether.  The income statement will also change. Property lessors will likely see little difference in the income statement for leases classified as operating today.  However, lessors leasing non-property are likely to find their income accelerated relative to operating leases under the current standard.  As a result, existing deferred income taxes recorded by a lessor may need to be adjusted to reflect the proposed derecognition approach.

State taxes

State franchise taxes are levied for the privilege of doing business within a particular jurisdiction.  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, debt, reserves, etc.) to arrive at the taxable base. 

Implementation of the proposed standard may impact the computation of a company's franchise tax base due to the requirement to record 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 by the average owned property plus rented property valued at eight times the net annual rental rate.  As a result, to the extent that a state utilizes the book basis in computing the property factor (as opposed to the federal basis, which will not change as a result of the proposed standard), the apportionment factor may be affected by the proposed standard.

Other non-income based taxes
In addition to federal and state deferred income taxes and state apportionment factors and franchise taxes, a company should consider whether the adoption of the proposed standard will impact any other non-income based taxes.  For example, a company should consider whether the computation of its property tax liability (that may be based off of the organization's financial accounting balance sheet) will increase as a result of the proposed standard.

System, processes, and control requirements
Converting a set of financial information from one standard to another and establishing new processes following the conversion requires a transformational change that will have a considerable impact on business processes and information technology systems.  Pre-existing leases will not be grandfathered under the proposed standard and all leases will need to be reassessed.  Accordingly, companies must consider the impact of current and future leasing arrangements.  Implementing systems and processes that will need to be maintained to produce the data necessary to comply with the Exposure Draft will likely be a significant undertaking, particularly for those entities with an extensive portfolio of lease contracts.  Similarly, an assessment of an organization's controls may be required if the proposed standard is adopted.

The takeaway

As companies assess the impact that the proposed standard will have on financial reporting, and gather the information necessary to analyze all existing leases, companies should also consider documenting their processes that surround the tax characterization and treatment of their lease portfolio from a U.S. federal, state, and foreign income tax perspective.  Creating a data repository of an organization's entire lease portfolio, inclusive of renewal options, lease terms, payment schedules, etc. from both a financial accounting and income tax perspective will enable companies to (i) identify differences between the current standard and proposed standard, (ii) assist in the computation of book/tax differences, (iii) inventory all existing leases and deferred income tax items associated with the leases, and (iv) implement a process to properly characterize a lease transaction under the proposed standard on a go forward basis, while at the same time assess the tax treatment of each lease transaction.  

Finally, as the FASB and IASB await comments on the Exposure Draft, companies should consider the following action items in light of the proposed standard:

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Let's talk

For a deeper discussion of how this issue might affect your business from a tax accounting, compliance and process perspective, please contact:

Tax Accounting Services

Ken Kuykendall
Global & US Tax Accounting Services Leader
(312) 298-2546
o.k.kuykendall@us.pwc.com

Douglas Berg
Global & US Tax Accounting Services Managing Director
(313) 394-6217
douglas.e.berg@us.pwc.com

Kristin Dunner
US Tax Accounting Services
Director
(617) 530-4482
kristin.n.dunner@us.pwc.com


Joseph Barnes
Tax
Partner
(203) 539-5614
joseph.barnes@us.pwc.com

Robert Ozmun
State and Local Tax
Partner
(617) 530-4745
robert.c.ozmun@us.pwc.com

Benjamin Luedeke
State and Local Tax
Director
(646) 471-0677
benjamin.luedeke@us.pwc.com


 

 

For a deeper discussion on the treatment of lease transactions from a tax technical standpoint, please contact:

Federal Tax Services

 

 

Annette Smith
Washington National Tax Services
Partner
(202) 414-1048
annette.smith@us.pwc.com

Jennifer Kennedy
Washington National Tax Services
Partner
(202) 414-1543
jennifer.kennedy@us.pwc.com

Scott Thompson
Washington National Tax Services
Director
(202) 346-5131
scott.d.thompson@us.pwc.com