Tax Implications of the New Lease Accounting Standards: Part One

The Financial Accounting Standards Board (FASB) recently codified new lease accounting standards in Accounting Standards Codification Topic 842, Leases (ASC 842), representing a material change in the way lessees account for leases, particularly operating leases. The implementation of the new standards for non-public businesses in 2022 will result in all leases being reported on the balance sheet, including “embedded” leases, which may not have been previously identified as leases.

The rules around lease accounting for books are set to change; however, the changes do not directly impact the rules governing lease accounting for income tax purposes. It is still crucial to review the impact of the new lease accounting rules from a tax perspective. It’s also important to note that under the new lease accounting reporting guidance, data needed to meet tax requirements may not be as readily accessible. Keep reading to learn how this change can affect your business, and check out part two of this article.

Summary of Changes

FASB ASC 842 retains the distinction between a “finance lease” (previously classified as a “capital lease”) and an “operating lease” from the prior lease standards, ASC 840. The primary changes now require businesses to record lease right-of-use (ROU) assets and liabilities on the balance sheet for all leases and to disclose new information about leasing arrangements.

ASC 842 consists of four sub-topics, as outlined below:

1. Lessee accounting changed for operating leases by recognizing ROU assets and lease payment liabilities arising from the leases. Accounting for finance leases remains similar to prior accounting for capital leases under ASC 840.
2. Lessor accounting remains mostly unchanged:
   • The leased asset will continue to be recognized as a fixed asset on the lessor’s books for operating leases. Income is recognized on the income statement as rental income is received.
   • The lessor does not recognize the leased asset for either sales-type or direct financing leases, but instead records a net investment in the lease on the balance sheet. When cash is received from sales-type and direct financing leases, a portion of the receipt is applied as a reduction to the net investment in the lease, and a portion is recognized as interest income.
3. Sale-leaseback transactions (meeting the “Topic 606” requirements):
   • A Buyer-Lessor must provide the disclosures for lessors.
   • A Seller-Lessee must disclose the main terms and conditions of the sale and leaseback transaction as well as any gains or losses arising from the transaction separately from gains or losses on disposal of other assets.
     *ASC Topic 606 is the new revenue recognition standard for accounting for revenue from customer contracts. The core principle of the new standard is that an entity should recognize revenue that depicts the transfer of goods or services to customers in an amount that reflects the amount an entity expects to receive in exchange for those goods or services. ASC Topic 842 aligns lessee and lessor accounting in several key respects with the provisions of revenue recognition guidance in Topic 606. It does not differentiate between leases of real estate and leases of other assets.

Seller-lessees can account for the transfer of assets as a sale if the following two conditions exist (according to ASC 842-40-25-1):

• A contract exists (ASC 606-10-25-1 through 25-8)
• The seller-lessee satisfies its performance obligation by transferring control of assets to the buyer-lessor (ASC 606-10-25-30)

A buyer-lessor obtains control of an asset when a contract exists (according to ASC 606-10-25-1 through 25-8) and the seller-lessee has performed its obligations by transferring control of the assets to the buyer-lessor. ASC Topic 606 identifies the following five indicators that a customer (in this case a buyer-lessor) has obtained control of an asset:

• Customer has legal title
• Customer has physical possession
• Customer has the significant risks and rewards of ownership
• Customer has accepted the asset
• Seller has a present right to payment

4. Leveraged lease arrangements not retained for leases that commence after the effective date of ASC 842.

Tax Implications of ASC 842 Changes

For tax purposes, leases are either treated as a true tax lease or a non-tax lease. A true tax lease is simple – the lessor maintains ownership of the asset and the related deductions, while the lessee would deduct rental payments (this is like an operating lease under the prior U.S. GAAP guidance). A non-tax lease assumes that the risks and rewards of ownership are with the lessee, thus the tax benefits of ownership, such as depreciation deductions and the deduction for the interest portion of the payments, are booked by the lessee (this is like a capital lease under the previous U.S. GAAP guidance). In this circumstance, the lessor recognizes interest income.

The new lease accounting standards do not impact the U.S. federal tax treatment like the previous standards, ASC 840, did. However, the increase in assets and liabilities added to the balance sheet could change several areas of the tax function. The tax implications listed in part two of this article could apply with ASC 842. In that article, we provide a synopsis of these specific tax implications.

References: The ASC 842 Standards, Lease Query