Equipment Leasing & Leveraged Leasing: an Overview
| Publication year | 1982 |
| Pages | 2111 |
| Citation | Vol. 11 No. 8 Pg. 2111 |
1982, August, Pg. 2111. Equipment Leasing & Leveraged Leasing: An Overview
In the present economic environment, many companies, and particularly smaller companies, may find leasing to be the most available and least expensive method of obtaining needed equipment. The Economic Recovery Tax Act of 1981 ("ERTA"), moreover, has substantially increased the tax benefits of purchasing equipment and has simplified the means of passing such tax benefits through to lessees of equipment. Although the simplified pass-through provisions of ERTA are now under legislative attack, the tax benefits themselves are not. Therefore, if a lease can be negotiated that utilizes fully the tax benefits of the new law, the effective cost to a business of obtaining new equipment will be greatly reduced.
This article considers the financial benefits and legal underpinnings of leasing, with particular focus on those leases taking maximum advantage of the federal tax deductions and credits available under the Internal Revenue Code of 1954, as amended ("Code"). In addition, the relevant provisions of ERTA and the controversy now surrounding their application are considered.
Presently, the Code permits two benefits to a business acquiring new equipment: an investment tax credit of 10 percent of the asset's cost, and accelerated cost recovery system ("ACRS") deductions.(fn1) The present value of these tax benefits will approximate 45 percent of the asset's cost(fn2) and, as a result, full use of these tax benefits is exceedingly important to a company's profits and competitive position.
It is quite common, however, for the tax benefits associated with an acquisition of business equipment to be of little or no value to companies, particularly smaller companies. As with all tax benefits, a potential recipient must have tax liability against which the benefits can be set-off before they become valuable. Thus, a company paying little or no income tax will be unable to use the benefits except on a carry-forward or carry-back basis. Even highly profitable companies may be unable fully to realize such tax benefits where other tax credits, loss carry-forwards, ACRS deductions or depletion allowances have effectively reduced their taxable income. Moreover, due to the progressive nature of corporate tax rates, the ACRS deductions will be worth substantially less to companies with earnings under $100,000 per year.
Leasing may permit a company with reduced or no tax liability to obtain (indirectly) at least some of the tax benefits associated with the acquisition of an item of equipment. That is, if a taxpayer capable of utilizing all of the
Footnotes
* Jerome A. Breed is currently a member of the New York Bar only.
** Jeffrey M. Stoler is currently a member of the Pennsylvania Bar only.
tax benefits can be found to purchase the asset and lease it back to the company, the tax benefits may still accrue to the lessee through a reduced rental rate. In addition, tax benefits accruing to the lessor can be significantly magnified as a percent of the capital invested in the equipment if the parties can locate one or more lenders willing to finance a portion of the equipment's cost. In such a situation, called "leveraged leasing," the commitment of a lender to finance 80 percent of the asset is not uncommon, permitting large interest deductions by the lessor. Moreover, the ratio of the tax benefits to the capital invested by the lessor will be increased by a factor of five, permitting an even greater pass-through of tax benefits to the lessee through reduced rentals.(fn3)Leveraged leasing, therefore, will usually permit a business unable to use the tax benefits of purchasing equipment to acquire the use of such equipment at a cost far below that of alternative methods.
For example, assuming a 15 percent interest rate, a $100,000 item of equipment with a ten-year useful life will cost a company unable to use tax benefits associated with the acquisition approximately $19,100 per year in interest and principal. If that same company were to lease the equipment under a safe harbor lease from another company able to use the tax benefits, it could expect to pay as little as $14,200 per year. Moreover, if that equipment were acquired through a safe harbor leveraged lease, the lessee might pay only $11,400 per annum.(fn4)It should be recognized that transaction costs, which can be substantial in a leveraged lease context, will increase the effective lease rates. The point remains, however, that the full use of tax benefits associated with an acquisition of equipment can significantly reduce its effective cost.(fn5)
The Internal Revenue Service ("Service"), however, has imposed significant constraints on the terms of leases involving the shifting of tax benefits, as discussed in the following section. Except with respect to "safe harbor" leases, the Service will rule that a lessor is entitled to the tax benefits arising from leased equipment only where the lease meets the Service's fairly restrictive standards of what constitutes a "true lease." ERTA established a far less demanding standard under its safe harbor rules for what leases could shift tax benefits. As a result, nearly $20 billion worth of such leases were entered into during 1981, over 60 percent of the leases involving equipment costing less than $100,000.(fn6) The safe harbor lease provisions of ERTA, however, are under challenge in the Congress and, in light of their possible repeal, pre-ERTA law is considered here as well.
As stated above, the tax benefits of owning property are concentrated primarily in the ability of the owner to claim ACRS deductions and an investment tax credit ("ITC") with respect to the investment in the property. The amount which may qualify for ACRS deductions and for ITC is limited to the taxpayer's "basis" in the property, an amount which includes the taxpayer's cash outlay for the property plus any liabilities which the taxpayer incurred in order to purchase it. The inclusion of such liabilities cannot exceed the fair market value of the property.(fn7) The availability of such tax benefits in the context of leasing, however, depends on which party is deemed to own the property.
ACRS deductions and ITC with respect to particular property are available only if the taxpayer owns the property for federal income tax purposes. While in most circumstances ownership of property is clear, in the context of leasing where the benefits and burdens of owning property are distributed between the lessee and lessor, the question of ownership becomes more complex.(fn8) In a "true lease," the lessor retains ownership of the property for federal income tax purposes. In a "financing lease," on the other hand, the lessee is treated as owning the property and the "lease" agreement is deemed to be a security arrangement. With respect to leases not covered by the "safe harbor" rules, the tax benefits of leasing will only be available where the lease can be characterized as a true lease.
In Revenue Procedure 75-21,(fn9) the Service set forth the conditions which must be met before it will rule that a leveraged lease is a "true lease" for federal income tax purposes.(fn10) While the thrust of Revenue Procedure 75-21 does not apply to "safe harbor leases," it continues to apply to the characterization of other lease arrangements as either "true leases" or "financing leases." The conditions focus upon four economic incidents of ownership which, if retained by the lessor, will establish characterization as a "true lease."
1. The first incident of ownership is the "minimum unconditional 'at-risk' investment" to be made by the taxpayer. This incident of ownership requires the taxpayer to maintain an investment throughout the term of the lease equal to at least 20 percent of the cost of the property at the time that property was first placed in service or used by the lessee.(fn11)
While not specifically enunciated in Revenue Procedure 75-21, a component of the "minimum 'at-risk' investment" factor is the retention of the risk of loss with respect to the transaction. Retention of the risk of loss establishes the reality of the taxpayer's investment in the property and is a substantial indication of ownership of the property. The counterpart to the risk of loss is the right to the appreciation. If, under all circumstances, the combination of purchase options and allocation of condemnation or insurance proceeds is such that the lessor cannot make a profit with respect to the sale or other disposition of the property, there is a substantial risk that the lessor would not be the owner of the property for federal tax purposes.
2. The second focal point is the residual value to be returned to the lessor at the end of the lease. To obtain a ruling, the lessor must demonstrate that the fair market value of the property upon termination must equal or exceed 20 percent of its original cost.(fn12) Under pre-ERTA law, for those assets which did not fall within the ADR classifications,(fn13) there was a tension between the depreciable life claimed for the property and the residual value expected at the termination of the lease.(fn14) For instance, a taxpayer could not argue that a 20 percent residual value remained after a ten-year lease term if he had completely depreciated the property over an eight-year...
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