The 90 percent test considers the present value of the future minimum lease payments as compared with the fair value of the plant at lease inception.
Minimum lease payments. The present value at the beginning of the lease term of the minimum lease payments, excluding that portion of the payments representing executory costs such as insurance, maintenance, and taxes to be paid by the lessor, including any profit thereon, equals or exceeds 90 percent of the excess of the fair value of the leased property to the lessor at lease inception over any related investment tax credit retained by the lessor and expected to be realized by the lessor. If the beginning of the lease term falls within the last 25 percent of the total estimated economic life of the leased property, including earlier years of use, this criterion shall not be used for purposes of classifying the lease.
Key considerations in performing the 90 percent test when evaluating leases of power plants include the impact (1) of contingent rentals on minimum lease payments and (2) on the fair value of the property at inception of the lease of any power plant-related government incentives received. These concepts are discussed in this section. See ARM 4650.1242
for further information in general in performing the 90 percent test.
How do default provisions included in a power purchase agreement impact the calculation of minimum lease payments?
It depends. Lease arrangements may include default covenants that are unrelated to the lessee’s use of the property (for example, the plant off-taker may be required to maintain certain financial ratios as a condition of the arrangement). The lessee may be required to pay default penalties in the event of noncompliance with these provisions. As a result, a question arises as to whether potential amounts to be paid in the event of noncompliance should be included in the minimum lease payments for purposes of determining lease classification.
The guidance on default covenants is included in ASC 840-10-25-14
, which indicates that lease classification is not affected if all of the following conditions exist:
• The default covenant provision is customary
• The occurrence of the event of default is objectively determinable
• There are predefined criteria related only to the lessee to be used to determine whether there is an event of default
• It is reasonable to assume that default will not occur based on facts and circumstances existing at lease inception
However, if any of these conditions are not met, then the minimum lease payments used for purposes of lease classification should include the maximum amount that the lessee could be required to pay. The evaluation of these conditions requires judgment; see ARM 4650.1242
for further information.
Minimum lease payments—contingent rent
Minimum lease payments represent amounts that the lessee will pay, or could be required to pay, in connection with the leased asset. However, certain payments that are contingent on future use of the asset are not included in minimum lease payments, as described in ASC 840-10-25-4
Excerpt from ASC 840-10-25-4
Lease payments that depend on a factor directly related to the future use of the leased property, such as machine hours of use or sales volume during the lease term, are contingent rentals and, accordingly, are excluded from minimum lease payments in their entirety.
Contingent rentals are future lease payments that are based on factors, trigger events, or specified targets (e.g., production, sales, or some other variable including changes in the consumer price index) that are outside the control of the lessor. The concept of contingent rentals contemplates that the lessor does not have the ability to effectively control the amount of rentals that it can require the lessee to pay in the future, and, as such, contingent rentals do not represent a present obligation for the lessee to make payments in connection with the leased property. Contingent rentals are defined in ASC 840
Definition from ASC 840-10-20
Contingent Rentals: The increases or decreases in lease payments that result from changes occurring after lease inception in the factors (other than the passage of time) on which lease payments are based, excluding any escalation of minimum lease payments relating to increases in construction or acquisition cost of the leased property or for increases in some measure of cost or value during the construction or pre-construction period. The term contingent rentals contemplates an uncertainty about future changes in the factors on which lease payments are based.
In some cases, a power purchase agreement is structured such that the off-taker is responsible for dispatch; it will pay a fixed capacity charge and a separate charge for any energy delivered. In those circumstances, unless the contract specifies a minimum amount, all of the payments based on energy would be contingent because the lessor cannot require the off-taker to take any amounts.
The evaluation of contingent rentals becomes more complex in assessing must-take arrangements where the lessee is required to take any power produced from the facility as discussed in Questions 2-24 and 2-25.
Power purchase agreements that contain a lease, but include only contingent payments, generally result in operating lease classification because there are no minimum lease payments required (assuming the other criteria for capital lease classification are not met). When accounting for a power purchase agreement as an operating lease, contingent rental expense should be measured and recognized at the time the payments become probable, as required by ASC 840-10-25-35
. If an arrangement meets the criteria for capital lease classification (e.g., because the lease term is greater than 75 percent of the asset’s economic useful life), but all lease payments are contingent, there would be no obligation or related asset to recognize as there are no minimum lease payments. In these circumstances, it may be appropriate to classify the payments made by the lessee as an operating expense. Recording the payments as interest expense may not be appropriate because of a lack of a financing obligation recorded on the balance sheet. Presentation as an operating expense would only be appropriate for capital lease arrangements that have no minimum lease payments. See ARM 4650.1242
for further information on contingent rents.
Does a minimum performance guarantee in a must-take power arrangement that contains a lease result in some level of minimum lease payments?
It depends. In general, if an arrangement requires the off-taker to take all of the output, and provides penalties for failure by the lessor to achieve a certain minimum production level, there is likely some level of minimum lease payments
discusses the definition of minimum lease payments from the perspective of the lessee.
Excerpt from ASC 840-10-25-5
For a lessee, minimum lease payments comprise the payments that the lessee is obligated to make or can be required to make in connection with the leased property, excluding both of the following:
a. Contingent rentals
b. Any guarantee by the lessee of the lessor’s debt and the lessee’s obligation to pay (apart from the rental payments) executory costs such as insurance, maintenance, and taxes in connection with the leased property.
Contingent rentals include amounts that are outside the control of both parties to a contract (e.g., future inflation rates) or that are solely in the lessee’s control (e.g., lessee has the ability to dispatch a facility). Because of the associated uncertainty, these amounts do not represent amounts that a lessee “is obligated to make or can be required to make.” In contrast, if the operations and dispatch of a facility are controlled by the lessor and the contract requires the lessee to take all of the power produced, and the fuel source is also within the control of the lessor (e.g., a natural gas plant or a coal plant), the lessor effectively controls whether the lessee will be required to make certain payments. Although the payments are based on future production from the facility, the level of production is in the control of the lessor and, thus, these amounts are not consistent with the definition of contingent rentals. Therefore, we generally expect that the amounts up to the guaranteed level of production should be used in the determination of minimum lease payments, except as discussed below with respect to certain renewable facilities.
Some renewable facilities are subject to production variability associated with a fuel source that is outside the control of the parties to the agreement (e.g., wind, solar). As a result, the output levels are inherently uncertain because production is dependent on weather or geological conditions. In such cases, the lessor cannot ultimately control whether the lessee will be required to make certain payments (as the facility’s operation depends on outside factors). Recognizing this inherent uncertainty, we believe that all production-based payments should be treated as contingent if the fuel source is outside the control of the parties to the arrangement. This would apply even if the lessor has provided a minimum production or performance guarantee.
In applying this view, reporting entities should assess the level of assurance and control associated with the fuel source. For example, wind, solar, and hydro facilities are dependent on a fuel that is wholly outside the control of the parties to the contract. In contrast, methane or geothermal facilities may be more similar to fossil fuel plants. Reporting entities should consider their specific facts and circumstances in determining the appropriate accounting. Furthermore, the interpretation of minimum lease payments should be disclosed, if material, and should be applied on a consistent basis (to instances of reasonably similar facts and circumstances).
In a must-take power purchase agreement, is there always at least some expected amount of output that is “virtually assured” that should be considered a minimum lease payment?
It depends. Arguably, if the facility relies on a fuel source that is within the control of one of the parties to the arrangement, there is likely to be some portion of production that is virtually assured. As discussed in our response to Question 2-24, we believe amounts up to any guaranteed level of production should be used in the determination of minimum lease payments. However, in assessing arrangements without minimum performance guarantees, there are different views on whether there is a level of production that is not contingent. Some believe that all amounts are contingent because they are dependent on the future operation of a power facility, even though production is within the control of one of the parties to the arrangement. Even if there are engineering and other studies to support a specified level of production, and if the facility has reliably produced at a certain level in the past, there could be variations in the amount or timing of production (e.g., time of year or time of day).
Others hold a view that the facility would not have been constructed without sufficient support for a minimum level of production. The off-taker would not have entered into the agreement without some expectation that output would be produced. Furthermore, parties involved in financing the entity would not have provided support without an expectation of future cash flows. Therefore, supporters of this view believe that there is always a level of production that is virtually assured; they acknowledge that determining the appropriate level requires judgment.
In assessing arrangements involving facilities dependent on a fuel source within the control of one of the parties to the arrangement, we believe that both views have merit when assessing amounts in excess of the guaranteed minimum. Thus, a reporting entity may conclude in such cases that rents related to production above a contractually guaranteed minimum are either all contingent or that there are minimum lease payments. Minimum lease payments based on production above a contractually guaranteed minimum level should be supported with appropriate evidence. For example, payments under a power purchase agreement for a fossil fuel plant may be contingent on future production. Nonetheless, facts and circumstances may suggest that at least a certain amount of power will be produced based on the usage of the plant (e.g., it is a base load plant), historical experience, and the stability of the technology such that it would be reasonable to estimate a corresponding level of minimum lease payments.
However, in evaluating renewable facilities where the fuel source is outside the control of the parties to the arrangement, there is inherent uncertainty about future production. Therefore, in such cases, we believe that all rentals dependent on production from such plants are contingent. See Question 2-24 for further information.
In a tolling or other arrangement where the lessee has volumetric optionality and there are no minimum performance penalties, can output that is virtually assured be considered a minimum lease payment?
No. As discussed in the excerpt from ASC 840-10-25-5
above, minimum lease payments represent the amount that the lessee is required to pay or could be required to pay in connection with the leased asset. In contrast, contingent rentals include amounts that are outside the effective control of both parties to a contract or that are solely in the lessee’s control. In an arrangement where the lessee determines the level of production, all amounts are contingent as the lessee could choose not to dispatch at any point (assuming that there is no minimum guarantee of off-take). This is consistent with the example in ASC 840-10-55-38
, which discusses rentals based on future sales from a retail store.
Note that this conclusion differs from the accounting for a must-take arrangement (discussed in the response to Question 2-25) because of the difference in which party has control of the amount of output from the facility. In a must-take arrangement, the lessor can force the lessee to take all of the output produced and thus payments based on production could be considered minimum lease payments under one of the two views described. In a tolling or option contract, the lessor has no control of the amount dispatched and thus all amounts are contingent.
Impact of government incentives on the fair value of the leased asset at inception
The owners of renewable energy plants often obtain government incentives that may include Section 1603 grants, investment tax credits (ITC), or production tax credits (PTC). Section 1603 grants provide grantees with the choice of applying for and receiving a government grant in lieu of investment tax credits. See UP 16
for further information about Section 1603 grants.
Investment tax credits have an impact on the calculation of the fair value of the lease asset for purposes of the 90 percent test, as discussed in ASC 840-10-25-1
Excerpt from ASC 840-10-25-1(d)
The present value at the beginning of the lease term of the minimum lease payments,
. . .equals or exceeds 90 percent of the excess of the fair value of the leased property to the lessor at lease inception over any related investment tax credit retained by the lessor and expected to be realized by the lessor.
Therefore, when evaluating lease classification, ASC 840
requires that the fair value of the leased property used as the denominator in calculating the 90 percent test be reduced by investment tax credits retained by the lessor. However, a question arises as to how to consider other forms of tax incentives, in particular Section 1603 government grants, which are similar to ITC.
Should Section 1603 grants received by the lessor for the plant that is subject to the lease be deducted from the fair value of the plant in performing the 90 percent test?
Yes. Section 1603 grants are provided as an alternative to investment tax credits and qualifying parties may elect to receive Section 1603 grants in lieu of ITC on qualifying properties. In such cases, a reporting entity should follow a grant accounting model for either the Section 1603 grant or ITC, unless there is an economic disincentive for taking the grant instead of ITC (see UP 16.3
for further information). Given this conclusion, and the fact that the Section 1603 grant results in an immediate cash payment from the government once approved, we believe that the Section 1603 grant should also be deducted from the fair value of the leased property when performing the 90 percent test, provided the control with respect to the risk of recapture of the grant is retained by the lessor, and the lessor expects to realize the grant.
This guidance is specific to the Section 1603 grants and should not be analogized to for other grants or tax credits, including the production tax credit.