Sales-Leasebacks: The Devil Remains In The Details

A sale-leaseback happens when a business offers an asset to a lessor then and rents it back. The leaseback might be for the whole property or a part of it (as in realty) and for its whole remaining beneficial life or for a shorter duration.


Sale-leaseback accounting addresses whether the possession is derecognized (eliminated) from the seller's balance sheet, whether any earnings or loss is acknowledged on the sale and how the leaseback is capitalized back on the seller-lessee's balance sheet.


Under FAS 13 and ASC 840, if today value of the leaseback was 10% or less of the asset's reasonable market worth at the time of the sale, any profit arising from the sale might be recognized entirely and the leaseback would stay off the lessee's balance sheet due to the fact that the resulting leaseback would be treated as an operating lease.


If the leaseback was higher than 10% and less than 90%, a gain might be acknowledged to the level it exceeded today worth of the leaseback, while the leaseback remained off the balance sheet since it was reported as an operating lease. In essence any gain that was less than or equal to the PV of the leaseback was postponed and amortized over the leaseback term. The gain would basically be acknowledged as a decrease to offset the future rental expenditure.


For leasebacks equal to or higher than 90%, the asset would stay on the lessee's balance sheet, no gain might be reported and any profits would be dealt with as loans to the lessee from the purchaser.


Under FAS 13 and ASC 840, sale-leasebacks of property and devices considered essential to property included an added caution. If the leaseback consisted of any type of fixed price purchase choice for the seller/lessee, it was ruled out a sale-leaseback.


Therefore, even if the sale was a valid sale for legal and tax functions, the possession stayed on the lessee's balance sheet and the sale was treated as a funding or loaning against that possession. The FASB's position was based on what was then referred to as FAS 66 "Accounting for Sales of Real Estate" which highlighted the various special ways in which realty sale deals are structured. Additionally, the FASB kept in mind that numerous such realty deals led to the seller/lessee buying the asset, therefore supporting their view that the sale-leaseback was simply a form of funding.


Sale-leasebacks Under ASC 842


Accounting for sale-leaseback transactions under ASC 842 lines up the treatment of a property sale with ASC 606 relating to revenue acknowledgment. As such, if a sale is recognized under ASC 606 and ASC 842, the complete revenue or loss might thus be recorded by the seller-lessee.


ASC 842 is said to really make it possible for more sale and leaseback deals of property to be considered a sale under the brand-new set of requirements, supplied the sale and leaseback does not include a fixed rate purchase alternative.


In contrast nevertheless some deals of properties other than realty or to realty will be considered a stopped working sale and leaseback under ASC 842. As pointed out above, those sales and leasebacks which include a fixed rate purchase choice will no longer be considered a 'effective' sale and leaseback.


A stopped working sale-leaseback happens when


1. leaseback is categorized as a finance lease, or
2. a leaseback includes any repurchase alternative and the property is specialized (the FASB has actually indicated that property is generally considered specialized), or
3. a leaseback consists of a repurchase choice that is at aside from the asset's fair worth figured out "on the date the option is exercised".


This last item indicates that any sale and leaseback that includes a set rate purchase alternative at the end will remain on the lessee's balance sheet at its complete value and classified as a set property instead of as a Right of Use Asset (ROUA). Even though a possession might have been lawfully offered, a sale is not reported and the property is not removed from the lessee's balance sheet if those conditions exist!


Note also that additional subtleties too many to attend to here exist in the sale-leaseback accounting world.


The accounting treatments are discussed further below.


IFRS 16 Considerations


IFRS 16 on the other hand has a slightly various set of standards;


1. if the seller-lessee has a "substantive repurchase alternative" than no sale has occurred and
2. any gain acknowledgment is restricted to the amount of the gain that connects to the buyer-lessors recurring interest in the hidden property at the end of the leaseback.


In essence, IFRS 16 now likewise prevents any de-recognition of the possession from the lessee's balance sheet if any purchase alternative is offered, besides a purchase choice the worth of which is identified at the time of the workout. Ironically IFRS 16 now needs a limitation on the quantity of the gain that can be recognized in a similar fashion to what was allowed under ASC 840, particularly the gain can just be acknowledged to the extent it exceeds today value of the leaseback.


Federal Income Tax Considerations


In December 2017, Congress passed and the President signed what has become referred to as the Tax Cuts and Jobs Act (TCJA). TCJA offered a rejuvenation of bonus devaluation for both new and secondhand properties being "utilized" by the owner for the very first time. This suggested that when a taxpayer initially positioned a possession to use, they could declare bonus devaluation, which begins now at 100% for possessions which are obtained after September 27, 2017 with certain restrictions. Bonus devaluation will start to phase down 20% a year starting in 2023 up until it is eliminated and the devaluation schedules revert back to standards MACRS.


Upon the death of TCJA, a concern developed regarding whether a lessee might declare bonus offer depreciation on a rented asset if it acquired the property by exercising a purchase option.


For example, assume a lessee is leasing an asset such as a truck or device tool or MRI. At the end of the lease or if an early buyout choice exists, the lessee might work out that purchase option to obtain the property. If the lessee can then right away write-off the value of that property by declaring 100% perk depreciation, the after tax cost of that possession is immediately lowered.


Under the present 21% federal business tax rate and following 100% bonus devaluation, that indicates the property's after tax cost is reduced to 79% (100% - 21%). If nevertheless the asset is NOT qualified for perk devaluation due to the fact that it was formerly utilized, or ought to we say, used by the lessee, then the expense of the asset begins at 100% decreased by the present value of the future tax deductions.


This would imply that a leased asset being purchased might result in a naturally greater after-tax expense to a lessee than a property not rented.


Lessors were worried if lessees could not claim perk depreciation the worth of their assets would end up being depressed. The ELFA brought these issues to the Treasury and the Treasury reacted with a Notice of Proposed Rulemaking referenced as REG-104397-18, clarifying that the lessee can claim reward depreciation, provided they did not previously have a "depreciable interest" in the possession, whether or not depreciation had actually ever been declared by the seller/lessee. The IRS requested for comments on this proposed rulemaking and the ELFA is responding, however, the final guidelines are not in place.


In lots of leasing transactions, seller/lessees accumulate a variety of comparable assets over an amount of time and then participate in a sale and leaseback. The existing tax law permitted the buyer/lessor to treat those assets as brand-new and therefore under previous law, gotten approved for benefit depreciation. The arrangement followed was typically known as the "3 month" whereby as long as the sale and leaseback occurred within 3 months of the asset being positioned in service, the buy/lessor could likewise claim bonus offer depreciation.


With the advent of benefit depreciation for utilized possessions, this rule was not required since a buyer/lessor can declare the perk devaluation regardless of for how long the seller/lessee had actually previously utilized the possession. Also under tax guidelines, if a possession is gotten and after that resold within the same tax year, the taxpayer is not entitled to declare any tax devaluation on the possession.


The introduction of the depreciable interest idea tosses a curve into the analysis. Although a seller/lessee might have owned a property before participating in a sale-leaseback and did not claim tax depreciation due to the fact that of the sale-leaseback, they likely had a depreciable interest in the property. Many syndicated leasing deals, particularly of motor lorries, followed this syndication technique; numerous possessions would be accumulated to achieve a critical dollar value to be sold and leased back.


As of this writing, all assets come from under those scenarios would likely be disqualified for reward devaluation should the lessee workout a purchase option!


Accounting for a Failed Sale and Leaseback by the lessee


If the transfer of the asset is ruled out a sale, then the property is not derecognized and the profits gotten are dealt with as a financing. The accounting for a failed sale and leaseback would be various depending upon whether the leaseback was determined to be a financing lease or an operating lease under Topic 842.


If the leaseback was determined to be a financing lease by the lessee, the lessee would either (a) not derecognize the existing possession or (b) record the capitalized value of the leaseback, depending on which of those techniques created a higher asset and balancing out lease liability.


If the leaseback was determined to be an operating lease by the lessee, the lessee would derecognize the asset and defer any gain that may have otherwise resulted by the sale, and after that capitalize the leaseback in accordance with Topic 842.


Two cautions exist relating to how the funding part of the failed sale-leaseback needs to be amortized:


No negative amortization is permitted Essentially the interest expense recognized can not go beyond the portion of the payments attributable to principal on the lease liability over the shorter of the lease term or the funding term.
No built-in loss might result. The carrying value of the underlying asset can not surpass the funding obligation at the earlier of the end of the lease term or the date on which control of the hidden asset transfers to the lessee as buyer.


These conditions might exist when the stopped working sale-leaseback was caused for circumstances by the presence of a repaired price purchase option during the lease, as was illustrated in the standard itself.


In that case the rate of interest needed to amortize the loan is imputed through an experimentation method by likewise thinking about the carrying worth of the asset as discussed above, instead of by determining it based solely on the elements related to the liability.


In impact the presence of the purchase alternative is treated by the lessee as if it will be worked out and the lease liability is amortized to that point. If the condition triggering the failed sale-leaseback no longer exists, for circumstances the purchase alternative is not worked out, then the bring quantities of the liability and the underlying property are gotten used to then use the sale treatment and any gain or loss would be acknowledged.


The FASB example is as follows:


842-40-55-31 - An entity (Seller) sells a possession to an unrelated entity (Buyer) for cash of $2 million. Immediately before the transaction, the property has a bring amount of $1.8 million and has a remaining beneficial life of 21 years. At the very same time, Seller participates in an agreement with Buyer for the right to utilize the possession for 8 years with yearly payments of $200,000 payable at the end of each year and no renewal choices. Seller's incremental interest rate at the date of the deal is 4 percent. The contract includes a choice to redeem the asset at the end of Year 5 for $800,000."


Authors remark: A basic calculation would conclude that this is not a "market-based deal" given that the seller/lessee could simply pay 5-years of rent for $1,000,000 and after that acquire the property back for $800,000; not a bad offer when they offered it for $2 million. Nonetheless this was the example offered and the leasing industry identified that the rate needed to satisfy the FASB's test was identified using the following table and an experimentation method.


In this example the lessee should utilize a rate of approximately 4.23% to come to the amortization such that the monetary liability was never less than the possession net book worth up to the purchase choice workout date.


Since the entry to tape-record the failed sale and leaseback involves establishing an amortizing liability, at a long time a fixed cost purchase alternative in the contract (which triggered the failed sale and leaseback in the first place) would be


If we presume the purchase option is worked out at the end of the 5th year, at that time the gain on sale of $572,077 would be acknowledged by getting rid of the staying lease liability of $1,372,077 with the exercise of the purchase option and payment of the $800,000. The formerly recorded ROU property would be reclassified as a fixed property and continue to be diminished during its remaining life.


If on the other hand the purchase option is NOT worked out (presuming the deal was more market based, for instance, assume the purchase alternative was $1.2 million) and basically expires, then presumably the staying lease liability would be adapted to show today worth of the remaining rents yet to be paid, discounted at the then incremental interest rate of the lessee.


Any difference in between the then impressive lease liability and the newly computed present value would likely be a change to the staying ROU possession, and the ROU asset would then be amortized over the remaining life of the lease. Assuming today value of the 3 staying payments utilizing a 4% discount rate is then $555,018, the following adjustments should be made to the schedule.


Any failed sale leaseback will require scrutiny and analysis to completely understand the nature of the transaction and how one need to follow and track the accounting. This will be a fairly manual effort unless a lessee software application bundle can track when a purchase choice ends and develops an automatic adjusting journal entry at that time.


Apparently for this factor, the FASB likewise offered for adjusted accounting for transactions previously represented as stopped working sale leasebacks. The FASB recommended when embracing the new requirement to take a look at whether a transaction was formerly a failed sale leaseback.


Procedural Changes to Avoid a Failed Sale and Leaseback


While we can get fascinated in the triviality of the accounting information for a failed sale-leaseback, recognize the FASB presented this somewhat troublesome accounting to derecognize just those assets in which the deal was plainly a sale. This process existed previously just genuine estate transactions. With the advent of ASC 842, the accounting likewise should be looked for sale-leasebacks of equipment.


If the tax guidelines or tax analyses are not clarified or altered, lots of existing properties under lease would not be eligible for benefit devaluation simply because when the initial sale leaseback was carried out, the lessees afforded themselves of the existing deal guidelines in the tax code.


Moving forward, lessors and lessees should establish new techniques of administratively carrying out a so-called sale-leaseback while considering the accounting problems intrinsic in the new standard and the tax guidelines talked about previously.


This may need a prospective lessee to schedule one or lots of prospective lessors to underwrite its brand-new leasing organization in advance to avoid getting in into any form of sale-leaseback. Naturally, this means much work will require to be done as soon as possible and well ahead of the positioning for any devices orders. Given the asset-focused specialties of many lessors, it is not likely that one lessor will desire to manage all kinds of devices that a prospective lessee may prefer to rent.


The principle of an unsuccessful sale leaseback ends up being complex when thinking about how to represent the transaction. Additionally the resulting possible tax ramifications might emerge numerous years down the roadway. Nonetheless, considering that the accounting standard and tax guidelines exist as they are, lessees and lessors should either adapt their techniques or comply with the accounting requirements promulgated by ASC 842 and tax guidelines under TCJA.


In all likelihood, for some standardized transactions the approaches will be adapted. For larger transactions such as genuine estate sale-leasebacks, imaginative minds will once again analyze the effects of the accounting and just consider them in the way they enter these transactions. In any occasion, it keeps our industry intriguing!