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7.3 Changes to a leveraged lease arrangement
Publication date: 31 May 2023
us Leases guide
Once a lessor adopts ASC 842, it may only continue to apply leveraged lease accounting to leases grandfathered at the transition date. A lessor should account for any leveraged lease that is modified on or after the effective date of ASC 842 as a new lease as of the effective date of the modification in accordance with the guidance in ASC 842-10 and ASC 842-30. See LG 3 for information on lease classification.
A leveraged lease arrangement may be changed in one or more ways during the lease term, including through the following events or actions:
- Lessor actions that change the fundamental characteristics of a leveraged lease transaction, for example, refinancing the nonrecourse debt
- An agreement by the lessor and lessee to modify or restructure the provisions of the lease
- Changes in the assumptions regarding the total amount or projected timing of related cash flows
Depending on the type of change in the leveraged lease, the lessor may be required to:
- Reassess the lease classification in accordance with ASC 840-10-35-4 and discontinue accounting for the lease as a leveraged lease if the characteristics required for leveraged lease accounting are no longer present
- Discontinue the use of leveraged lease accounting and account for the modified arrangement as a new lease under ASC 842
- Recalculate the net investment in the leveraged lease and record a gain or loss in the period of the change, without reassessing the classification of the lease
7.3.1 Changes to the fundamental characteristics
As noted in LG 7.2, an arrangement must have certain characteristics to qualify for leveraged lease accounting. A lessor may change aspects of the fundamental structure of an existing lease without necessarily changing the provisions of the agreement with the lessee. If, as a result of such changes, one or more of the defining characteristics of a leveraged lease are no longer present, the lessor may be required to discontinue leveraged lease accounting and reclassify the lease. If a lessor is required to discontinue leveraged lease accounting, it should classify the lease on the date it is changed as either an operating, sales-type, or direct financing lease based on the guidance in ASC 842.
Examples of changes that could cause a lessor to discontinue leverage lease accounting include:
- A lessor repays all of the nonrecourse debt, such that the transaction no longer has a long-term creditor
- A lessor repays a portion of the nonrecourse debt, such that the amount of nonrecourse debt no longer represents “substantial leverage” in the transaction
- A lessor replaces the nonrecourse debt with recourse debt
7.3.1.1 Leveraged lease: requirement for a long-term creditor
In addition to other criteria, a leveraged lease transaction must have a long-term creditor that provides the lessor with substantial leverage in the transaction, as discussed in ASC 840-10-25-43(c). That guidance does not define the required duration that the long-term creditor must remain in the transaction to qualify as a leveraged lease and does not define how much debt would provide “substantial leverage.” Historically, “long-term” was interpreted as nonrecourse financing being present for a majority of the lease term.
When a lessor changes any aspect of the nonrecourse debt payment pattern, it should evaluate whether the repayment causes the lease to fail the requirement to have a long-term creditor necessary to continue to classify the lease as a leveraged lease.
7.3.1.2 Leveraged lease: requirement for substantial leverage
When a lessor repays all or a portion of the nonrecourse debt, it should also consider whether the arrangement, as altered, provides the lessor with substantial leverage. As discussed above, most leveraged leases were originally structured to provide as much as 80% leverage in the transaction. However, historically, a lease that was initially financed with more than 50% debt at lease commencement was generally accepted to have had enough leverage to have qualified for leveraged lease accounting, provided that the debt outstanding remained significant throughout the duration of the nonrecourse debt. When nonrecourse debt amortizes ratably over its term, this requirement is typically met.
As noted above, whenever a lessor changes any aspect of the nonrecourse debt payment pattern, it should evaluate its specific facts and circumstances to determine whether this requirement continues to be met such that the arrangement continues to qualify for leveraged lease accounting.
7.3.1.3 Leveraged lease: requirement for nonrecourse debt
To be considered nonrecourse debt, the lender may only have recourse to the following interests in the lease:
- Unremitted rents
- Variable rents not included in the lease receivable (i.e., contingent rents as defined by ASC 840)
- The underlying asset
- A residual value guarantee from the lessee
If the lessor refinances the nonrecourse debt with debt that has other recourse features, the refinancing would disqualify the lessor from applying leveraged lease accounting. In general, the financing may not have features under which non-rental amounts due to the lessor are subordinate to the financing. Examples of such non-rental amounts include amounts remitted to the lessor to pay for executory costs (e.g., property insurance) or for services the lessor provides to the lessee.
7.3.2 Modifications to a leveraged lease
A lessor and lessee may negotiate changes to a leveraged lease. For example, the lessor may reduce or restructure the rents or enter into a new arrangement to lease the asset to a new lessee. The guidance in ASC 842-10-65-1(z), however, does not allow a lease to be accounted for as a leveraged lease if the terms of the lease are modified on or after the effective date of ASC 842. The lessor should classify any such lease as a new lease as of the modification date, and classify the lease as either an operating, sales-type, or direct financing lease based on the guidance in ASC 842. See LG 3 for information on lease classification.
As noted in LG 7.2, leveraged lease classification applies only to lessors. Accordingly, whenever a leveraged lease is modified, notwithstanding that the lessor should account for the modified agreement as a new lease, the lessee may not have to do so. Rather, the lessee should account for the modification in accordance with the guidance in ASC 842-10-25-8. See LG 5 for information on lease modifications.
7.3.2.1 Leveraged lease: replacing the lessee
When the original lease agreement is replaced by a new agreement with a different lessee, the original leveraged lease is considered terminated. As discussed in LG 7.3, since ASC 842 does not permit new leveraged leases, the lessor should classify the new lease as operating, sales-type, or direct financing based on the guidance in ASC 842. See LG 3 for information on lease classification.
7.3.2.2 Discontinuing the use of leveraged lease accounting
As previously noted, changes to a leveraged lease may require a lessor to account for the lease as a new lease. To apply the guidance in ASC 842, the lessor should separately account for each of the components of its net investment that had been subject to leveraged lease accounting in accordance with the applicable GAAP for that component. Accordingly, the lessor should separately report the property subject to the new lease and the nonrecourse debt (i.e., the lessor will gross-up its balance sheet). While ASC 840-30-40-7 contains specific guidance on how a lessor should measure the leased property upon termination of a lease, that guidance was superseded by ASC 842. See LG 5.8 for guidance on how the lessor should measure the leased property upon termination of a lease.
Due to the unique income recognition pattern for leveraged leases, deferred taxes included in the net investment in the leveraged lease are accounted for in a manner prescribed by ASC 842-50-35-4. When a lessor discontinues use of leveraged lease accounting, it should also adjust any associated deferred tax assets or liabilities to reflect the amount it would have recognized had it accounted for those deferred taxes in accordance with ASC 740. The adjustment should be recognized in income tax expense in the period in which leveraged lease accounting is discontinued.
7.3.3 Leveraged lease: changes in the underlying assumptions
ASC 842-50-35-6 requires a lessor to review the estimated residual value and all other important assumptions used to determine the estimated total net income from the leveraged lease on at least an annual basis. The projected timing of income tax cash flows generated by the lease is an important assumption that should also be reviewed annually, or more frequently if events or circumstances indicate a change in the timing has occurred or might occur.
Changes in important assumptions require a lessor to recognize immediate gains or losses and change its scheduled income recognition, prospectively. However, changes to assumptions alone would not typically require a lessor to reassess lease classification.
Examples of changes in other important assumptions that would likely change the total estimated net income from a leveraged lease include:
- A change in the estimated amount of federal or state income taxes to be paid over the term of the lease
- A change in enacted income tax rates, as well as those that result from a change in state apportionment factors. (As noted in ASC 842-50-35-14, although interest and penalties assessed by the IRS change the estimated total net income from the lease, practice as well as the leveraged lease literature has excluded interest and penalties from the leveraged lease accounting.)
- A change in assumptions regarding the deductibility of certain transaction-related expenses
- Decreases in estimated residual value judged to be other-than-temporary; an upward adjustment of estimated residual value is not allowed
- Other changes in the amount or timing of lease-related cash flows, for example, changes in the amount or timing of rent collections
As required by ASC 842-50-35-6, the rate of return and the allocation of income to positive investment years should be recalculated from the inception of the lease. The change in the net investment as of the date the arrangement is modified should be recognized as a gain or loss in the current period. The collectability of restructured lease payments and realization of the residual value should also be assessed. However, as discussed in ASC 842-50-35-8, the lessor should not record an upward adjustment to the leased property’s residual value even if the amount of the lessee’s residual value guarantee is increased; this would be similar to recognizing a gain contingency, which is prohibited. The pretax gain or loss recognized should be included in income from continuing operations before income taxes in the same line item in which leveraged lease income is recognized. The tax effect of the recognized pretax gain or loss should be included in the income tax line item.
7.3.3.1 Leveraged lease: change in timing of income tax cash flows
ASC 842-50-35-6(c) requires lessors to recalculate the rate of return from a leveraged lease when the projected timing of income tax cash flows changes. As required by ASC 842-50-35-11, only changes in the timing of the tax benefits that are directly related to a leveraged lease require the lessor to recalculate the rate of return in the leveraged lease. Changes in timing that result from an alternative minimum tax (AMT) credit or a net operating loss (NOL) carryforward of the lessor do not require a recalculation, because such changes are not directly related to that lease.
While a change in timing that is not directly related to the leveraged lease transaction would not, by itself, trigger a requirement to recalculate the rate of return in the leveraged lease, the leveraged lease literature requires that, if a recalculation is required for other reasons, the recalculation should include an update of all assumptions used in the leveraged lease. Accordingly, any such recalculation must include the actual or expected changes in timing of all cash flows, including those due to AMT credits and NOL carryforwards, if significant.
Issues related to AMT credits are addressed in ASC 842-50-35-16 through ASC 842-50-35-20. In particular, an entity should include assumptions regarding the effect of the AMT, considering its consolidated tax position in leveraged lease transactions. These assumptions require, at a minimum, annual review, and any change that affects estimated after-tax net income should be accounted for in the manner prescribed.
An enterprise whose tax position frequently varies between AMT and regular tax would not be required to recalculate each year unless there was an indication that the original assumptions regarding total after-tax net income from the lease were no longer valid. In that circumstance, the enterprise would be required to revise the leveraged lease computations in any period in which total net income from the leveraged lease changes due to the effect of the AMT on cash flows for the lease.
As noted in LG 7.2.2, a lessor typically realizes the tax benefits associated with leveraged leases relatively early in the lease term. However, historically, taxing authorities often challenged lessors’ tax positions related to leveraged leases, including both the amounts and the timing of the accelerated tax benefits. As such, there may be some uncertainty about a lessor’s tax positions related to its leveraged leases. See TX 15 for more information about accounting for uncertainty in income taxes.
If, during the lease term, the expected timing of income tax cash flows is revised, the leveraged lease would be recalculated. The recalculation should incorporate:
- actual cash flows up to the date of the recalculation;
- projected cash flows between the date of the recalculation and the date of any projected settlement;
- a projected settlement amount on the date of the projected settlement; and
- projected cash flows following the date of the projected settlement.
ASC 842-50-35-8 through ASC 842-50-35-9 require the lessor to account for changes in the estimated timing of income tax cash flows.
The projected timing of income tax cash flows generated by the leveraged lease is an important assumption and shall be reviewed annually, or more frequently, if events or changes in circumstances indicate that a change in timing has occurred or is projected to occur. The income effect of a change in the income tax rate shall be recognized in the first accounting period ending on or after the date on which the legislation effecting a rate change becomes law.
A revision of the projected timing of the income tax cash flows applies only to changes or projected changes in the timing of income taxes that are directly related to the leveraged lease transaction. For example, a change in timing or projected timing of the tax benefits generated by a leveraged lease as a result of any of the following circumstances would require a recalculation because that change in timing is directly related to that lease:
a. An interpretation of the tax law
b. A change in the lessor’s assessment of the likelihood of prevailing in a challenge by the taxing authority
c. A change in the lessor’s expectations about settlement with the taxing authority.
The changes referred to in ASC 842-50-35-10(b) and ASC 842-50-35-10(c) require a recalculation in two situations involving a change in timing of tax-related cash flows.
The first situation is when there is a change in the amount of an expected settlement with the tax authorities, for example, when the expected settlement changes from a 70/30 settlement (that is, a settlement in which the lessor would retain 70% of the timing benefit that is claimed on the tax return and would concede 30% of that benefit) to a 60/40 settlement. This represents only a change in timing of tax-related cash flows because the lost leveraged lease income will be re-recognized over the remaining lease term. For example, assume that the IRS disallows a portion of a lessor's depreciation deductions, and the lessor enters into a settlement that reflects payment of the related back taxes to the IRS. The tax basis to the lessor of the leased property would be increased accordingly, and the lessor would enjoy the benefit of the additional tax deductions later in the lease term. The total net income from the lease would not change; however, the rate of return inherent in the leveraged lease would be lower. As a result, the lost income would be recycled.
The second situation is when only the timing of the expected settlement changes, for example, when the lessor originally expected a 70/30 settlement to occur in a one period, but then changed the expected settlement date to one year later. Some lessors may be anticipating settling their tax exposures over a period of time. For example, they might expect to settle with the IRS for certain open years prior to settling for other (later) open years. If so, the projected cash flows should reflect the multiple settlements as they are expected to occur.
The recalculation should not incorporate interest and penalties that have been assessed or that are expected to be assessed. Such interest and penalties should be accounted for outside the leveraged lease model, in accordance with ASC 740.
To determine the estimated tax cash flows to be reflected in the recalculation, the lessor should follow the guidance in ASC 740. As described in TX 15.3.1.8, uncertain tax positions that relate only to the timing of when an item is included on a tax return are automatically deemed to have met the recognition threshold for purposes of applying the guidance in ASC 740. Therefore, if it can be established that the only uncertainty is when an item is taken on a tax return, such positions have satisfied the recognition step for purposes of the guidance in ASC 740, and any uncertainty related to timing should be assessed as part of measurement. In these situations, the amounts to be included in the recalculation of the leveraged lease should reflect the largest amount of benefit that is greater than 50% likely of being realized. See TX 15.4 for more information on measuring the tax benefit to be recorded on uncertain tax positions.
Because taxable income for most states is based on federal taxable income, lessors should consider the effects that estimated changes in the timing of federal income tax cash flows will have on the related state income tax cash flows.
Advance payments and deposits made to the taxing authorities should not be considered cash flows of the leveraged lease; rather, they should be included in any recalculation as of the actual settlement date or the expected settlement date.
Example LG 7-1 illustrates how a lessor should consider changes in estimates in timing of income tax cash flows used to remeasure a leveraged lease.
EXAMPLE LG 7-1
Change in the estimated timing of income tax cash flows
Change in the estimated timing of income tax cash flows
A leveraged lessor used its original leveraged lease calculation to recognize income from a leveraged lease. The original calculation reflected income tax-related cash flows consistent with the filing position taken on the lessor’s tax return. At the beginning of year 4, however, the taxing authorities questioned the timing of certain tax deductions in the lessor's filing position. Accordingly, the lessor recalculated the leveraged lease cash flows and recorded an adjustment to the net investment in the leveraged lease.
The original leveraged lease calculation was based on the following amounts:
Year
|
Tax deduction
|
Tax benefit at a 40% rate
|
|---|---|---|
1
|
$142,857
|
$57,143
|
2
|
244,898
|
97,960
|
3
|
187,075
|
74,830
|
4
|
153,061
|
61,224
|
5
|
119,048
|
47,619
|
6
|
53,061
|
21,224
|
7
|
0
|
0
|
8
|
0
|
0
|
9
|
0
|
0
|
10
|
0
|
0
|
Total
|
$900,000
|
$360,000
|
The taxing authorities have asserted that depreciation deductions should be taken as follows:
Year
|
Tax deduction
|
|---|---|
1
|
$50,000
|
2
|
100,000
|
3
|
100,000
|
4
|
100,000
|
5
|
100,000
|
6
|
100,000
|
7
|
100,000
|
8
|
100,000
|
9
|
100,000
|
10
|
50,000
|
$900,000
|
According to the taxing authorities, the entity has taken excess depreciation deductions of $324,830 during the first three years of the lease and underpaid income taxes (excluding interest and penalties) by $129,932 (for the latter, assume an income tax rate of 40%). This example ignores interest and penalties as they are accounted for outside the leveraged lease model.
The entity believes that it will eventually enter into a negotiated settlement with the taxing authorities. The settlement is expected to reflect a compromise, whereby the entity and the taxing authorities will agree that the entity will retain a negotiated portion of the benefits that are reflected in the timing of the deductions; the remaining benefit inherent in the timing of the deductions will be disallowed. As a result of the disallowance, the entity will have to make a payment for the back taxes owed. After the settlement, the entity will be able to take the remaining depreciation, including the amount that was disallowed in connection with the settlement.
How should the lessor evaluate the change in expected income tax cash flows?
Analysis
When the lessor determines that the timing of the income tax cash flows pertaining to the leveraged lease are uncertain (assumed to be at the beginning of the fourth year of the leveraged lease), the lessor must determine whether a recalculation of the leveraged lease is required. Since the previous leveraged lease calculation was based on the assumption that income tax cash flows were consistent with the position taken on the tax return, a recalculation will be required if the income tax cash flows that are determined in accordance with the guidance of ASC 740 now differ from those taken on the tax return.
In the first step of the recognition and measurement process under the guidance of ASC 740, the lessor would conclude that the uncertainty only relates to the timing of the deductions and income for tax purposes. Accordingly, the recognition threshold would be reached and the lessor would proceeds to step 2 to determine the appropriate measurement.
Based on the expected settlement with the IRS, the lessor considers various possible outcomes:
Scenario
|
Portion of timing benefits retained
|
Portion of timing benefits disallowed
|
|---|---|---|
%
|
%
|
|
A
|
100
|
0
|
B
|
90
|
10
|
C
|
80
|
20
|
D
|
70
|
30
|
E
|
60
|
40
|
F
|
40
|
60
|
G
|
20
|
80
|
H
|
0
|
100
|
The entity would assign probabilities to each of the possible outcomes. The individual probabilities and the cumulative probabilities are as follows:
Scenario
|
Probability
|
Cumulative probability
|
|---|---|---|
%
|
%
|
|
A
|
5
|
5
|
B
|
10
|
15
|
C
|
15
|
30
|
D
|
15
|
45
|
E
|
25
|
70
|
F
|
20
|
90
|
G
|
10
|
100
|
H
|
0
|
100
|
Under ASC 740, the accounting is based on the scenario that reflects the most advantageous result that has a cumulative probability of at least 50% (more likely than not.) Scenario E is the first scenario with a cumulative probability that exceeds 50%. Accordingly, the lessor would recalculate the leveraged lease, based on the cash flows implied by scenario E.
The entity projects that at the end of year seven it will make a $60,000 payment to the taxing authorities to settle the tax dispute. The amount is determined as follows: at the end of year 7, the entity will have taken all $900,000 in depreciation deductions, including the $250,000 of deductions that the taxing authorities challenged. Scenario E is based on the assumption that the taxing authorities will allow 60% of the aggressive deductions and disallow 40%. Therefore, the amount of disallowed deductions will be $100,000 [$250,000 x 40%], and the taxes payable will be $40,000, based on an income tax rate of 40%.
The entity projects the following depreciation deductions after the projected settlement:
Year
|
Tax deduction
|
|---|---|
8
|
$40,000
|
9
|
40,000
|
10
|
20,000
|
These amounts coincide with the disallowed deductions. Mechanically, they are equivalent to 60% of the amount in the table relating to the original leveraged lease calculation plus 40% of the amount in the table relating to the deductions originally asserted by the taxing authorities.
Finally, the entity will use the following income tax-related cash flows to recalculate the leveraged lease.
Year
|
Tax deduction
|
Tax benefit at a 40% rate
|
|---|---|---|
1
|
$142,857
|
$57,143
|
2
|
244,898
|
97,960
|
3
|
187,075
|
74,830
|
4
|
153,061
|
61,224
|
5
|
119,048
|
47,619
|
6
|
53,061
|
21,224
|
7
|
(100,000)
|
(40,000)
|
8
|
40,000
|
16,000
|
9
|
40,000
|
16,000
|
10
|
20,000
|
8,000
|
$900,000
|
$360,000
|
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