In part one of this article, we discussed the changes under the new lease accounting standards, Topic 842, Leases (ASC 842), and began to examine the tax implication of such. In the final article of this two-part series, we cover each specific tax implication.
1. Accounting & Tracking Impacts
ASC 842 was a change in the accounting rules for leases. It was not a change in the Internal Revenue Code made by Congress to the tax rules applicable to leases. While the income tax treatment of the lease remains unchanged by ASC 842, a change in the book accounting for leases forces companies to also analyze what it is doing for tax purposes with leases. In analyzing the guidance with the new lease rules, lessors and lessees may discover that certain existing leases/sales/financing transactions may be misclassified for GAAP purposes and/or for federal income tax purposes. Thus, this may require a change in accounting methods to modify existing leases/sales/financing transactions or a change its tax treatment on a prospective basis.
A company implementing new processes or systems to track leases under ASC 842 will need not only to create processes for the post-implementation tracking of the lease, but will also need to track historical lease information for tax purposes.
The lease accounting structure needs to be revisited in tax accounting terms because of the potential change in:
- Characterization of leases
- Timing of the lease
- Timing of income
- Tenant allowances (general treatment)
- Valuation allowances
- Lease acquisition costs (general treatments and borrowing costs)
2. Deferred Taxes – DTA & DTLs
The tax expense recognized during the first year of an operating lease will likely not change under ASC 842 because (as noted above), the tax rules for leases are not changing with the transition to the new lease accounting standards. However, since operating leases are now required to be recorded as ROU assets and a corresponding lease liability on the company’s balance sheet, this will result in book-to-tax reconciliation items. This will specifically result in new deferred tax liabilities (DTL) and deferred tax assets (DTA). This is a temporary change and will reverse over the life of the lease.
There may also be some uncertainty with leases on partnership tax returns. Generally, a book or GAAP balance sheet is included with a partnership tax return. The liabilities on this balance sheet are then allocated to the various partners of the partnership. These liabilities are reported on the partner’s Schedule K-1 as recourse liabilities, nonrecourse liabilities or qualified nonrecourse financing. Under GAAP, the lease obligations are now reported on the balance sheet; however, since these might not be liabilities for tax purposes, they would not be reported on Schedule K-1 for the partners. This is another item to keep track of with leases for tax purposes.
3. State & Local Taxes
The new standards require lease-related ROU assets to be recorded, which may impact the property factor for apportionment if the ROU assets related to operating leases are to be recorded on the same line item as underlying assets. This may then affect state apportionment for companies that have activity in states that include property factors when calculating apportionment percentages. This will likely also affect state tax filings where a net worth-based tax applies.
4. Transfer Pricing
Companies may need to revise its related party leasing arrangements to reflect the arm’s length standards. The arm’s length standards rely on financial ratios and profit level indicators, which may change when companies begin to record all leases on their balance sheets and statements of financial position.
5. Foreign Taxes
Just as state and local income taxes depend on where company operations take place, the new standards’ requirement for ROU assets being recorded will likely have a similar impact on foreign country income tax filings. This depends on the tax regime of the country where a company, its branch or subsidiary is located (according to IFRS 16).
6. Property Taxes
Another potential impact on leases is the property tax treatment at the state, local and foreign levels that might be levied on leased assets. If ROU assets are considered “tangible personal property,” property taxes could be assessed on the assets.
7. Sales-and-Use Taxes
Depending on whether local, state or foreign tax environments treat the lease transaction as a taxable purchase or not, companies may need to pay sales tax on these leases as well. This will have an impact on a company’s books.
Book vs. Tax Differences for ROU Lease Assets & Liabilities
ROU assets and related liability pertain to the lessee’s right to occupy, operate or hold a leased asset during the lease term. ROU is composed of different components, each with unique tax implications, thus the traditional change-in-balance approach to identifying book-tax differences may no longer apply. ROU assets under the new lease accounting standards are made up of several components, such as initial direct costs and lease incentives, and these are tracked differently for tax purposes. These components are now combined into one ROU asset. The ROU components are as follows:
- The initial amount of the lease liability
- Plus any lease payments made before the lease commencement date
- Plus any initial direct costs (IDC) incremental to the lease execution, such as commissions, payments to existing tenants to incentivize lease terminations, legal fees, etc.
- Less any lease incentives, such as tenant improvement allowances
There are several other issues to address with ASC 842 related to operating leases and finance leases.
Operating Lease Accounting under ASC 842. When accounting for an operating lease, the lessee must:
- Recognize a single lease cost allocated over the lease term, generally on a straight-line basis
- Classify all cash payments within operating activities on the statement of cash flows
Finance Lease Accounting under ASC 842. When accounting for finance leases, lessees must:
- Recognize interest on the lease liability and amortization of the ROU asset on separate line items of the lessee’s income statement
- Classify payments of the principal portion of the lease liability within financing activities and payments of interest on the lease liability within operating activities on the statement of cash flows
ASC 842 presents significant changes regarding leases on a company’s financial statements. While the general tax rules related to leases have not changed, there may still be tax issues to address. Please contact your Sikich advisor for any assistance with leases.