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2ELA – 45th Annual Convention – Facing Your Future
IntroductionsMr. David FowlerTax PartnerPricewaterhouseCoopers LLPPh: 614.225.8736E-mail: [email protected]
Mr. William J Bosco, Jr.PresidentLeasing 101Ph:914.522.3233E-mail: [email protected]
Ms. Laurie HumannAsst. Tax DirectorUSBancorpPh: 612.303.4811E-mail: [email protected]
Mr. Jeff NelsonManaging DirectorPricewaterhouseCoopers LLP.Ph: 612.596.4444E-mail: [email protected]
The Future of Lease TaxationTax Incentives & Benefits “TIBs” available to the leasing industry
Dave Fowler
PricewaterhouseCoopers LLP
October 24, 2006
4ELA – 45th Annual Convention – Facing Your Future
Tax Incentives and Benefits (“TIB”)Identifying TIBs available to the leasing industry
Background – Lessees and Lessors have a choice between- Lease- Loan
5ELA – 45th Annual Convention – Facing Your Future
Tax Incentives and Benefits (“TIB”)Identifying TIBs available to the leasing industry
Why lease?- Lessee vs. Lessor tax position- Reduction of lessee costs (Lessor utilizes TIBs)- Improved lessee cash flows (finance full cost of
equipment)- Financial reporting- Lessor tax shelter for other income
6ELA – 45th Annual Convention – Facing Your Future
Tax Incentives and Benefits (“TIB”)Identifying TIBs available to the leasing industry
Impact of - NOLs- AMT- Desired financial reporting- Pricing
7ELA – 45th Annual Convention – Facing Your Future
Tax Incentives and Benefits (“TIB”)Identifying TIBs available to the leasing industry
Lessor/Lessee Treatments- Depreciation- Rental- Principal amortization and Interest
8ELA – 45th Annual Convention – Facing Your Future
Tax Incentives and Benefits (“TIB”)Identifying TIBs available to the leasing industry
Depreciation- Accelerated Depreciation - MACRS- Bonus Depreciation – 30 & 50%- Like Kind Exchange – Deferred recognition of Gain
9ELA – 45th Annual Convention – Facing Your Future
Tax Incentives and Benefits (“TIB”)Identifying TIBs available to the leasing industry
Credits- Clean Fuel Vehicle Deductions (pr law)- Alternative Fuel vehicles (new iteration)
• Hybrid vehicles• Advanced lean-burn technology vehicles• Fuel cell vehicles• Alternative fuel vehicles
10ELA – 45th Annual Convention – Facing Your Future
Tax Incentives and Benefits (“TIB”)Identifying TIBs available to the leasing industry
New IRC Sec. 199 - Special deduction for Qualified Production Income- QPI includes any gross receipts derived from:
• Lease, rental, license, sale, exchange or other disposition of:Tangible personal propertyComputer software and other
• that have been manufactured, produced, grown or extracted by thetaxpayer in whole or significant part within the U.S.
- less cost and deductions allocable to such gross receipts
11ELA – 45th Annual Convention – Facing Your Future
Tax Incentives and Benefits (“TIB”)Current developments and legislative updates
Potential Gulf Opportunity Zone Proposals- Similar to 9/11 proposals- Secretary Snow before the Senate Finance
Committee on October 6:• Affected Zone specific?• Raise cap on Sec. 179 expensing to $200,000 for 2
years• Provide 50% bonus depreciation• Provide tax relief for building new structures
12ELA – 45th Annual Convention – Facing Your Future
Tax Incentives and Benefits (“TIB”)Current developments and legislative updates
Gulf Opportunity Zone Proposal- Special NOL C/Os & C/Bs for affected businesses- Specific industries in affected states or counties?- Impacts proposed governmental spending cuts?- Most likely the next major legislation to be
considered- Potential timing of passage & effective dates?
• House scheduled to consider in early Nov.• Senate to follow closely thereafter
The Future of Lease Taxation____________________________________________
William Bosco
Leasing 101
October 24, 2006
jtn2
14ELA – 45th Annual Convention – Facing Your Future
AgendaTargeting customers for tax lease- NOL & AMT discussion- Reading a tax footnote
GAAP treatment of tax benefits- Operating lease example- Direct finance lease example
Understanding MISF vs. ROA for tax lease pricing
15ELA – 45th Annual Convention – Facing Your Future
Why Do Customers Lease? To Manage Taxes!
Problem
Net operating loss (NOL)
Alternative minimum tax(AMT)
Leasing solution
Manages unfavorable tax positions, while at the same time reduces after-tax cost of borrowing
Leasing companies target customers by their tax position.
16ELA – 45th Annual Convention – Facing Your Future
Net Operating Loss - “NOL”A tax position where a company has negative taxable income.- Can be carried back to generate a refund. - Unused NOL is carried forward but can expire.
Customers with an NOL lease to lower their after-tax cost of financing equipment. - Customer can’t take advantage of tax benefits currently. - The lessor will take the tax benefits currently and charge a lower tax
effected rent rate. Lease vs. buy analysis determines if the trade off of tax benefits for a lower financing rate is beneficial.
17ELA – 45th Annual Convention – Facing Your Future
Alternative Minimum Tax - “AMT”AMT causes companies with significant tax preferences to pay a minimum tax. - AMT tax is calculated by adding back preference items to regular taxable income
and applying a 20% AMT rate to the AMT income. - The higher of AMT tax or regular tax is paid.- AMT credits (excess of AMT over regular tax) carried forward with no expiration.
AMT customers can lower after tax financing cost by leasing as MACRS is a preference item, thus leasing equipment rather than buying equipment helps reduce AMT. - The lessor will take the full MACRS benefit at the higher regular tax rate (35%)
currently and charge a lower tax effected rent rate.-
Lease vs. buy analysis determines if the trade off of tax benefits for a lower financing rate is beneficial.
18ELA – 45th Annual Convention – Facing Your Future
Lease vs. Buy AnalysisAnalysis done by the lessee to determine if a tax lease financing is more cost-effective than borrowing to buy the equipment
The dilemma is that the tax lease rent rate looks better than the loan rate but the lessee is giving up potentially valuable tax benefits
19ELA – 45th Annual Convention – Facing Your Future
Lease vs. Buy AnalysisThe calculation is a discounted cash flow analysis:- Calculates the PV of the after tax cash flows of the lease- Rent to be paid less the tax benefit of deducting the rent- Tax deductions are adjusted for impact of NOL & AMT - Calculates the PV of the after tax cash flows of a loan- Loan payments to be paid less the tax benefit of deducting the interest
on the loan & the depreciation on the asset net of the after tax gain on sale of the asset
- Tax deductions are adjusted for impact of NOL & AMT- Must assume the asset is either sold under the loan or bought under the
lease assumptions to be comparableThe lowest PV of the 2 choices = the lowest after tax cost & therefore it is the best choice
20ELA – 45th Annual Convention – Facing Your Future
How Do We Know the Lessee’s Tax Position?Read the tax footnote in their annual report before we contact the customer- Tax position is a factor in determining the structures we
present to the customer- The text of the footnotes will disclose any negative tax
positions- The current tax provision in the P&L is not a good indicator
We should ask!- Often the leasing decision maker/customer contact doesn’t
know - the customer’s tax department knows best!- Tax considerations are often not focused on in mid/smaller
ticket deals
21ELA – 45th Annual Convention – Facing Your Future
Note 15 — Income Taxes
The effective tax rate varied from the statutory federal corporate income tax rate as follows:
Year Ended December 31,
2003
Three Months Ended December
31, 2002
Year Ended September 30,
2002
June 2 through September 30,
2001
January 1 through June,
2001(successor) (successor) (successor) (successor) (predecessor)
Federal income tax rate 35.0% 35.0% 35.0% 35.0% 35.0%Increase (decrease) due to:
State and local income taxes, net of federal income tax benefit. 3.7 2.6 (0.3) 2.2 2.2
Foreign income taxes 1.0 1.6 (0.4) 2.2 2.2Goodwill impairment — — (36.1) — —Interest expense — TCH — — (4.2) — —Goodwill amortization — — — 6.2 7.8Other (0.7) (0.2) 0.1 0.2 2.6Effective tax rate 39.0% 39.0% -5.9% 45.8% 49.8%
Percentage of Pretax Income
XYZ Inc. and SubsidiariesNotes to consolidated financial statements
22ELA – 45th Annual Convention – Facing Your Future
Note 15 — Income Taxes
The provision for income taxes is comprised of the following ($ in millions):
Year Ended December 31,
2003
Three Months Ended December
31, 2002
Year Ended September 30, 2002
June 2 through September 30,
2001
January 1 through June,
2001(successor) (successor) (successor) (successor) (predecessor)
Current Federal income tax provision $ - $ - $ - $ - $ -Deferred Federal income tax provision 265.1 71.9 276.9 113.6 63.7Total Federal income taxes 265.1 71.9 276.9 113.6 63.7State and local income taxes 53.5 9.4 30.4 11.7 5.7Interest expense — special transaction — — (4.2) — —Foreign income taxes 46.4 10.7 66.7 32.1 15.4
Total provision for income taxes $365.0 $92.0 $374.0 $157.4 $84.8
XYZ Inc. and SubsidiariesNotes to consolidated financial statements
23ELA – 45th Annual Convention – Facing Your Future
The tax effects of temporary differences that give rise to significant portions of the deferred income tax assets and liabilities are presented below ($ in millions).
December 31, 2003 December 31, 2002 September 30, 2002(successor) (successor) (successor)
Assets:Net operating loss carryforwards $834.1 $849.9 $834.4Provision for credit losses 202.4 254.8 282.1Alternative minimum tax credits 142 142 142.0Purchase price adjustments 67.9 176.9 207.7Goodwill 65.6 91.5 98.4Other comprehensive income items 47.6 84.3 86.0Accrued liabilities and reserves 43.8 46.5 59.9Other 14.1 — —
Total deferred tax assets 1,417.5 1,645.9 1,710.5Liabilities:Leasing transactions (1,311.7) (1,189.6) (1,215.6)Securitization transactions (633.0) (614.4) (590.0)Market discount income — (1.4) (1.5)
Total deferred tax liabilities (1,944.7) (185.4) (1,807.1)Net deferred tax (liability) ($527.2) ($159.5) ($96.6)
Percentage of Pretax Income
At December 31, 2003, XYZ had U.S. federal net operating losses of approximately $1,937.7 million, which expire in various years beginning in 2011. In addition, XYZ has various state net operating losses that will expire in various years beginning in 2004. Federal and state operating losses may be subject to annual use limitations under section 382 of the Internal Revenue Code of 1986, as amended, and other limitations under certain state laws. Management believes that XYZ will have sufficient taxable income in future years and can avail itself of tax planning strategies in order to fully utilize these losses. Accordingly, XYZ does not believe a valuation allowance is required with respect to these net operating losses.
XYZ Inc. and SubsidiariesNotes to consolidated financial statements
24ELA – 45th Annual Convention – Facing Your Future
GAAP Treatment of Leasing Tax BenefitsMuni Leases
Tax benefit is the interest income is exempt from Federal Income taxes. The GAAP treatment is a reduction in tax expense.
Tax CreditsTax credit is a direct reduction of income taxes payable.Tax credits like ITC are amortized over the lease term for
direct finance leasesTemporary Differences
Book income vs. tax income for direct finance leases MACRS vs. book depreciation for operating leases.
Temporary differences create deferred tax balances.
25ELA – 45th Annual Convention – Facing Your Future
GAAP Tax Benefits - Operating Lease ExampleAn example comparing book income to taxable income for an operating lease:
1. Assume an operating lease for GAAP purposes and a true lease for income purposes.- Lessor enters into a 60-month FMV lease of material handling equipment, having a cost of $1 million,
monthly rent of $18,500, a residual of $200,000, and an implicit interest rate of 10%. - The first basic rent date is April 1, 1996.- There is no automatic transfer of ownership.- There is no bargain purchase option.- The equipment has an economic life of 10 years, therefore the lease term of 5 years is less than 75%
of the economic life. The PV of the rents at the implicit rate of 10% is $878,000, which is less than 90% of the cost the equipment. Therefore, the lease is an operating lease for financial reporting purposes.
2. Material handling equipment (generally) is five-year class property. MACRS depreciation rates (from the IRS table) are:
Year %1996 20.00 1997 32.00
1998 19.201999 11.522000 11.522001 5.76
26ELA – 45th Annual Convention – Facing Your Future
From the standpoint of the lessor, the lease will have the following earnings pattern:
Year ended December 31Tax Books 1996 1997 1998 1999 2000 2001 TotalRental Income $166,500 $222,000 $222,000 $222,000 $222,000 $55,500 $1,110,000
Sale Proceeds 200,000 200,000
Depreciation Expense 200,000 320,000 192,000 115,200 115,200 57,600 1,000,000
Tax Income (Loss) (33,500) (98,000) 30,000 106,800 106,800 197,900 310,000
Tax Rate 40% (CombinedFederal & State Rate) 40% 40% 40% 40% 40% 40% 40%
Tax Liability (Savings) ($13,400) ($39,200) $12,000 $42,720 $42,720 $79,160 $124,000
GAAP Books
Rental Income $166,500 $222,000 $222,000 $222,000 $222,000 $55,500 $1,110,000
Sale Proceeds 200,000 200,000
Depreciation Expense 120,000 160,000 160,000 160,000 160,000 240,000 1,000,000
Income before Tax 46,500 62,000 62,000 62,000 62,000 15,500 310,000
Tax Expense @ 40% 18,600 24,800 24,800 24,800 24,800 6,200 124,000
Net Income $27,900 $37,200 $37,200 $37,200 $37,200 $9,300 $186,000
Current Tax Liability 13,400 39,200 (12,000) (42,720) (42,720) (79,160) (124,000)
Deferred Tax Balance (32,000) (96,000) (108,000) (90,880) (72,960) 0 0
GAAP Tax Benefits - Operating Lease Example
27ELA – 45th Annual Convention – Facing Your Future
Operating Lease Tax Provision Calculation
1996 1997 1998 1999 2000 2001
Equipment Tax Basis 800,000 480,000 288,000 172,800 57,600 -
Equipment Book Basis 880,000 720,000 560,000 400,000 240,000 -
Taxable Temporary Difference (80,000) (240,000) (272,000) (227,200) (182,400) -
Applicable tax rate 40% 40% 40% 40% 40% 40%
Deferred tax liability (32,000) (96,000) (108,800) (90,880) (72,960) -
Current tax receivable/(payable) 13,400 39,200 (12,000) (42,720) (42,720) (79,160)
Change in the Deferred Tax Liability (32,000) (64,000) (12,800) 17,921 17,920 72,960 (Deferred Tax Expense)Total Income Tax Provision (18,600) (24,800) (24,800) (24,800) (24,800) (6,200)
The deferred tax provision is calculated by identifying the temporary differences and carryforwards.
GAAP Tax Benefits - Operating Lease Example
28ELA – 45th Annual Convention – Facing Your Future
A simple GAAP balance sheet presentation of the lease:
Year ended December 31GAAP Books 1996 1997 1998 1999 2000 2001
Cash $179,900 $441,100 $651,100 $830,380 $1,009,660 $1,186,000
Equipment under lease 1,000,000 1,000,000 1,000,000 1,000,000 1,000,000 0
Accumulated depreciation (120,000) (280,000) (440,000) (600,000) (760,000) 0
Equipment under lease, net 880,000 720,000 560,000 400,000 240,000 0
Total Assets $1,059,900 $1,161,100 $1,211,100 $1,230,380 $1,249,660 $1,186,000
Deferred Taxes 32,000 96,000 108,800 90,880 72,960 0
Stockholder’s Equity 1,027,900 1,065,100 1,102,300 1,139,500 1,176,700 1,186,000
Total Liabilities & Equity $1,059,900 $1,161,100 $1,211,100 $1,230,380 $1,249,660 $1,186,000
GAAP Tax Benefits - Operating Lease Example
29ELA – 45th Annual Convention – Facing Your Future
GAAP Tax Benefits - Direct Finance Lease ExampleAn example comparing book income to taxable income for direct finance lease:
1. Assume an direct finance lease for GAAP purposes and a true lease for income purposes.- Lessor enters into a 60 month FMV lease of material handling equipment, having a cost of $1 million,
monthly rent of $20,087, a residual of $100,000, and an implicit interest rate of 10.25%. The first basic rent date is April 1, 1996.
- There is no automatic transfer of ownership.- There is no bargain purchase option.- The equipment has an economic life of 10 years, therefore the lease term of 5 years is less than 75%
of the economic life. The PV of the rents at the implicit rate of 10% is $939,970, which is more than 90% of the cost of the equipment. Therefore, the lease is a direct finance lease for financial reporting purposes.
2. Material handling equipment (generally) is five-year class property. MACRS depreciation rates (from the IRS table) are:
Year MACRS %1996 20.00%1997 32.00%1998 19.20%1999 11.52%2000 11.52%2001 5.76%
30ELA – 45th Annual Convention – Facing Your Future
From the standpoint of the lessor, the direct finance lease will have the following earnings pattern:Year ended December 31
Tax Books 1996 1997 1998 1999 2000 2001 TotalRental Income $180,786 $241,049 $241,049 $241,049 $241,049 $60,263 $1,205,245
Sale Proceeds 100,000 100,000
Depreciation Expense 200,000 320,000 192,000 115,200 115,200 57,600 1,000,000
Tax Income (Loss) (19,214) (78,951) 49,049 125,849 125,849 102,663 305,245
Tax Rate 40% (CombinedFederal & State Rate) 40% 40% 40% 40% 40% 40% 40%
Tax Liability (Savings) ($7,686) ($31,580) $19,620 $50,340 $50,340 $41,065 $122,098
GAAP Books
Rental Income $73,253 $84,247 $67,398 $48,738 $28,074 $3,534 $305,244
Sale Proceeds
Depreciation Expense 0 0 0 0 0 0 0
Income before Tax 73,253 84,247 67,398 48,738 28,074 3,534 305,244
Tax Expense @ 40% 29,301 33,699 26,959 19,495 11,230 1,414 122,098
Net Income $43,952 $50,548 $40,439 $29,243 $16,844 $2,120 $183,146
Current Tax Receivable (Liabili 7,686 31,580 (19,620) (50,340) (50,340) (41,065) (122,098)
Deferred Tax (liability) balance (36,987) (102,266) (109,065) (78,760) (39,650) 0 0
GAAP Tax Benefits - Direct Finance Lease Example
31ELA – 45th Annual Convention – Facing Your Future
Direct Finance Lease Tax Provision Calculation
1996 1997 1998 1999 2000 2001
Equipment Tax Basis 800,000 480,000 288,000 172,800 57,600 -
Lease Book Basis 892,467 735,665 562,014 369,703 156,728 -
Taxable Temporary Difference (92,467) (255,665) (274,014) (196,903) (99,128) -
Applicable tax rate 40% 40% 40% 40% 40% 40%
Deferred tax liability (36,987) (102,266) (109,605) (78,760) (39,650) -
Current tax receivable/(payable) 7,686 31,580 (19,620) (50,340) (50,340) (41,065)
Change in the Deferred Tax Liability (36,987) (65,279) (7,339) 30,845 39,110 39,650 (Deferred Tax Expense)Total Income Tax Provision (29,301) (33,699) (26,959) (19,495) (11,230) (1,414)
The deferred tax provision is calculated by identifying the temporary differences and carryforwards.
GAAP Tax Benefits - Direct Finance Lease Example
32ELA – 45th Annual Convention – Facing Your Future
A simple GAAP balance sheet presentation of the lease:
Year ended December 31GAAP Books 1996 1997 1998 1999 2000 2001
Cash $196,508 $469,136 $690,566 $881,275 $1,071,984 $1,183,147
Gross Receivable 1,024,457 783,409 542,360 301,311 60,262 0
Unearned Income (231,991) (147,744) (80,346) (31,608) (3,534) 0
Residual 100,000 100,000 100,000 100,000 100,000 0
Net Investment, Leases 892,466 735,664 562,014 369,703 156,728 0
Total Assets $1,088,974 $1,204,801 $1,252,580 $1,250,978 $1,228,712 $1,183,147
Deferred Taxes 45,022 110,301 117,641 86,796 47,686 0
Stockholder’s Equity 1,043,952 1,094,500 1,134,939 1,164,182 1,181,026 1,183,147
Total Liabilities & Equity $1,088,974 $1,204,801 $1,252,580 $1,250,978 $1,228,712 $1,183,147
GAAP Tax Benefits - Direct Finance Lease Example
33ELA – 45th Annual Convention – Facing Your Future
Pricing for True LeasesMany lessors price to an MISF (Multiple Investor Sinking Fund) yield target.The MISF yield is the rate of return of after-tax cash flows on the amount of net cash invested, in periods where it is positive.It’s purpose is to amortize accounting earnings for leveraged leases where the net cash invested can be zero or even negative.It has incorrectly evolved into a measurement of profitability but does not correlate to GAAP returns.
34ELA – 45th Annual Convention – Facing Your Future
Pricing for True Leases: ROAThe solution to the MISF dilemma is to target ROA (Return on Assets).The denominator is Net Asset (or Net GAAP Investment) usually discounted using the ROE return target rate to levelize uneven returns.The numerator is after-tax profits, also discounted at the ROE discount rate.Deferred taxes generate a free source of funds, which reduces interest cost to carry.
35ELA – 45th Annual Convention – Facing Your Future
MISF Profile
• MISF yield is the internal rate of return of the net cash flows versus the net cash invested.
100%
Inception Expiry
Residual
Net Cash Invested (Net Investment – Deferred Taxes)
Net Investment (GAAP)
• Net Cash Invested is reduced by:• Cash received from rents• Cash received from taxes (and then increased by cash paid for
taxes) (in effect the deferred tax balance is deducted from the investment)
36ELA – 45th Annual Convention – Facing Your Future
ROA Profile
• Under the ROA calculation the net risk asset is not reduced by the deferred tax balance as the risk is the unamortized balance of the your investment.
100%
Inception Expiry
Net Risk Asset (= Investment – rent + income)
Residual
Deferred Tax Balance
• The deferred tax balance is utilized under the ROA calculation as a reduction of the amount to be funded (reduction in cost of funds).
37ELA – 45th Annual Convention – Facing Your Future
Pricing for True Leases: ROA vs. MISF
Accounting for Leveraged Leases
Pricing all True Leases incl. Leveraged Leases
Best Suited for
No adjustmentVaries by lease classification
Income Pattern
Net Cash Invested
GAAP AssetDenominator (Asset)
After-tax cashBook IncomeNumerator (Income)
NoYesAligned with GAAP Books/Mgmt Acctg
MISFROA
38ELA – 45th Annual Convention – Facing Your Future
ROA vs. MISF: What is the Impact?The greater the tax benefits and the more back-ended the accounting earnings, the greater the difference.Example parameters:- 5 year term, level rents in arrears- 5 year MACRS, December delivery- 15% residual 40% tax rate, 5% COF rate, 3% PT spread on
MISF basis- Operating lease for lessor
Results = PT ROA < PT MISF Spread by 67bps!
The Future of Lease TaxationLike Kind Exchange Programs for Equipment Leasing
Jeff Nelson
PricewaterhouseCoopers LLP
October 24, 2006
40ELA – 45th Annual Convention – Facing Your Future
Today’s Agenda
• Background – What is Like Kind Exchange (LKE) and why should you consider an LKE Program for your business?
• IRS Safe Harbor Rules for Leasing LKE Programs
• Valuing LKE for your business? • Direct Benefits – cash flow, pricing, profitability and
competitiveness.• Indirect Benefits - proper state/fed reporting, vendor
programs.
• Questions
41ELA – 45th Annual Convention – Facing Your Future
What is Like Kind Exchange (“LKE”)?
• IRC Section 1031 provides:
•No gain or loss shall be recognized on the “exchange”of property held for productive use in a trade or business if such property is exchanged solely for property of like-kind which is also to be held for productive use in a trade or business.
• Bottom line:
•No tax is paid on the disposition of tax leased property where sales proceeds are reinvested in new leases of like kind property.
42ELA – 45th Annual Convention – Facing Your Future
Exchange v. Sale and Repurchase
Taxpayer
$Old Asset
Exchange Sale & Repurchase
Buyer Seller
Taxpayer
Buyer & Seller
Old Asset
New Asset New
Asset
$
43ELA – 45th Annual Convention – Facing Your Future
Exchange v. Sale and RepurchaseQI Safe Harbor – A “Fictional” Exchange
Taxpayer
Qualified Intermediary (QI)
Buyer Seller
Old Asset New Asset
New Asset
$$Old Asset
Exchange of old and new assets
44ELA – 45th Annual Convention – Facing Your Future
Nature of LKE benefit
• Trade-off between current gain recognition and future depreciation deductions
• Single Asset LKE results in a “disappearing net deferral over the replacement assets tax depreciable life, however
• LKE “program” results in a “permanent” deferral to the extent taxpayers• continue their trade or business, and
• maintain the level of their $investment in Like Kind property
45ELA – 45th Annual Convention – Facing Your Future
Nature of LKE benefitsWhere does LKE make sense?
• Significant tax lease portfolio
• High rate of asset turnover - Recurring originations and dispositions
• High residual value relative to tax bases (however, “Bonus Op”)
• High unit volume
• Asset replacements occur as part of a continuous process
• Utilized “bonus” depreciation in 2001 thru 2004
46ELA – 45th Annual Convention – Facing Your Future
Equipment Leasing where LKE makes sense- vehicles (automobiles, trucks, trailers)- construction equipment- industrial machinery- aircraft- motor coaches / buses- railcars- tractors and trailers- barges & ships
Nature of LKE benefitsWhere does LKE make sense?
47ELA – 45th Annual Convention – Facing Your Future
Nature of LKE benefitsWhere does LKE make sense?
Assets subject to 50 & 30% “Bonus”Depreciation”
Commodity intensive industries• Oil and Gas Industry - pipelines, drilling, production
and refining equipment• Electrical Generation and Transmission - cable, poles
and insulators• Rail Transportation - ties, ballast and rail• Telecommunications – cable, switching and
microwave communications equipment
48ELA – 45th Annual Convention – Facing Your Future
Nature of LKE benefitWhy adopt an LKE Program Now?
• IRS and Regulatory Acceptance of LKE Programs – Safe Harbor Guidance under Rev. Proc. 2003-39
• The Impact of expiring “Bonus” depreciation on your decision.• Benefits of “Step in the Shoes” depreciation• Ongoing Improvements in LKE Best Practices & Technology • Direct benefits to lessors• Indirect benefits to vendors and customers
49ELA – 45th Annual Convention – Facing Your Future
Revenue Procedure 2003-39LKE Program Safe Harbors
Applicable only to “LKE Programs”Issued May 7, 2003Applicable to tax leases only
50ELA – 45th Annual Convention – Facing Your Future
Revenue Procedure 2003-39What is an “LKE Program”
Multiple exchanges of 100 or more properties with all the following characteristics.- Regular & routine purchase and sale of personal
property- Qualified Intermediary- Utilizes a “Master Exchange Agreement”- Process for collecting, holding & disbursing funds
ensuring QI control- Process that matches relinquished wt. replacement
property
51ELA – 45th Annual Convention – Facing Your Future
Revenue Procedure 2003-39Receipt of non-LKE property
- TP can process checks or instruments made payable to person other than TP (or disqualified person)
- Joint QI-TP account OK as long as in third party or QI name & QI must OK funds transfer
- Funds netting OK • Amounts owed by TP to buyer against buyer purchase• Amounts owed to TP by seller against TP purchase
52ELA – 45th Annual Convention – Facing Your Future
Revenue Procedure 2003-39Receipt of non-LKE property
- TP can loan purchase funds to Buyer (Conversion of lease to loan)• TP makes similar loans in ordinary course of its
business• Buyer has option to obtain other financing• Loans must be arm’s-length
- Security Deposits can be applied to Purchase Price
Continued
53ELA – 45th Annual Convention – Facing Your Future
The Bonus Depreciation “Bubble”Can Recapture be avoided?
- Bonus Depreciation expired as of 1-1-2005- Tax Lessors can expect a significant increase in taxes
and gains on dispositions of assets acquired under the “Bonus” rules
- What can lessors do to avoid paying tax on Bonus Depreciation recapture?
- Like Kind Exchange Programs under IRC Sec. 1031 and Rev Proc 2003-39.
54ELA – 45th Annual Convention – Facing Your Future
The Bonus Depreciation “Bubble”The future cost of depreciation recapture
Bonus DepreciationTax Bases, Gain and Increased TaxAssuming $1mil Asset Cost
Year Year Year Year Year Year1 2 3 4 5 6
Tax Basis under Reg. MACRS 800,000$ 480,000$ 288,000$ 172,800$ 57,600$ -$
Tax Basis under Bonus MACRS 400,000$ 240,000$ 144,000$ 86,400$ 28,800$ -$
Addt'l Gain due to Bonus Recapture 400,000$ 240,000$ 144,000$ 86,400$ 28,800$ -$
Increased Tax on Sale @ 40% 160,000$ 96,000$ 57,600$ 34,560$ 11,520$ -$
55ELA – 45th Annual Convention – Facing Your Future
Valuing LKE for Your BusinessLKE Opportunities For Leasing Companies
- Direct or Captive Leasing Companies
- Vendor or Dealer Leasing Companies
- Funding Other Leasing Companies
56ELA – 45th Annual Convention – Facing Your Future
Valuing LKE for Your BusinessLKE Opportunities For Leasing Companies
- Direct or Captive Leasing Companies• Source business directly • Can use the LKE benefit to reduce its funding costs,
increasing its profits• Can use the LKE benefit to reduce pricing on
replacement business
57ELA – 45th Annual Convention – Facing Your Future
Valuing LKE for Your BusinessLKE Opportunities For Leasing Companies
- Vendor or Dealer Leasing Companies –• Source business through vendor or dealer
relationships• Can use the LKE benefits to reduce costs or
reduce pricing• Vendor or dealer may want a cut or may force LKE
process on the lessor to offer competitive pricing to vendor/dealer customers
58ELA – 45th Annual Convention – Facing Your Future
Valuing LKE for Your BusinessLKE Opportunities For Leasing Companies
- Funding Other Leasing Companies –• Leasing companies with NOL or AMT problems can’t get the
full LKE benefit on tax lease business they do for their account
• Other leasing companies with big tax base target those leasing companies with sale-leasebacks and ongoing portfolio financings using LKE techniques to make the pricing attractive
• The lessor prices in the LKE on replacement leases so the NOL/AMT lessor gets a lower financing cost and possibly off-balance sheet financing
59ELA – 45th Annual Convention – Facing Your Future
Nature of LKE Program BenefitsSingle asset sale in year 1- Disappearing deferral
Year of SaleYear 1 Year 2 Year 3 Year 4 Total
Without LKEGain recognized on Relinquished Asset 10,000$ 10,000$ Depreciation on Replacement Asset (3,333)$ (4,445)$ (1,481)$ (741)$ (10,000)$
Net effect on taxable income 6,667$ (4,445)$ (1,481)$ (741)$ -$ With LKE
Gain recognized on Relinquished Asset -$ -$ Depreciation on Replacement Asset -$ -$ -$ -$ -$
Net effect on taxable income -$ -$ -$ -$ -$
Net Taxable Income Deferral 6667 -4445 -1481 -741 0
60ELA – 45th Annual Convention – Facing Your Future
Nature of LKE Program Benefits Recurring asset sales yr. 1 & after - “Permanent” deferral
Year of SaleYear 1 Year 2 Year 3 Year 4 Total
Without LKEGain recognized on Relinquished Assets 10,000$ 10,000$ 10,000$ 10,000$ 40,000$ Depreciation on Replacement Assets (3,333)$ (7,778)$ (9,259)$ (10,000)$ (30,370)$
Net effect on taxable income 6,667$ 2,222$ 741$ -$ 9,630$ With LKE
Gain recognized on Relinquished Assets -$ -$ Depreciation on Replacement Assets -$ -$ -$ -$ -$
Net effect on taxable income -$ -$ -$ -$ -$
Net Taxable Income Deferral 6,667$ 2,222$ 741$ -$ 9,630$ Cumulative Deferral 6,667$ 8,889$ 9,630$ 9,630$
61ELA – 45th Annual Convention – Facing Your Future
Nature of LKE benefitCumulative Tax Savings – Equipment LessorEquipment LessorLike Kind ExchangeEstimated Tax SavingsIn 000's Facts & Assumptions:
Tax Rate 38.0%Inflation Rate 3.0% Annual Sales Proceeds $200 millionFleet Growth 2.0% Annual Intial Tax Cost of Sales $300 millionAverage Lease Term 3.00 MACRS Life 3,5 & & years
2006Yr. Yr. Yr. Yr. Yr. Yr.1 2 3 5 7 10 Total
Taxable Income EffectWithout like kind exchange $73,324 -$47,075 -$171,674 -$213,776 -$235,688 -$272,838 -$1,803,105
With like kind exchange -$52,444 -$142,145 -$208,374 -$239,989 -$252,492 -$292,290 -$2,211,609
Tax Inc. Impact -$125,768 -$95,069 -$36,699 -$26,213 -$16,804 -$19,453 -$408,504
Annual Tax Savings $47,792 $36,126 $13,946 $9,961 $6,385 $7,392 $155,231Cumulative Tax Savings $47,792 $83,918 $97,864 $121,628 $134,095 $155,231
62ELA – 45th Annual Convention – Facing Your Future
Nature of LKE benefitSample Benefits – Representative Equip Lease Portfolio
Portfolio SizeIn 000's Net Deferral Tax Deferral Earnings Cash Flow PV
1,241,304$ 351,789$ 133,680$ 43,349$ 177,028$ 35,231$ 500,000$ 141,701$ 53,846$ 17,461$ 71,307$ 14,191$
1,000,000$ 283,402$ 107,693$ 34,922$ 57,445$ 28,382$ 1,500,000$ 425,104$ 161,539$ 52,383$ 69,418$ 42,573$ 2,000,000$ 566,805$ 215,386$ 69,844$ 111,846$ 56,765$ 2,500,000$ 708,506$ 269,232$ 87,304$ 225,259$ 70,956$ 3,000,000$ 850,207$ 323,079$ 104,765$ 544,409$ 85,147$
7 Year
Assumptions:Tax Rate 38.0% Fleet Growth 2.0%Inflation Rate 2.0% Avg Lease Term @ disp 3.61 yrsEarnings Rate 6.5% MACRS Life (3,5, or 7) VariousAnnual Sales $200 mil Annual COS $344 mil
63ELA – 45th Annual Convention – Facing Your Future
Valuing LKE for Your BusinessCase Study Analysis – Basis Point & Rental Rate Benefits
Most business managers want to know both the portfolio benefits of an LKE and the transactional benefits
Assumptions:- Equipment: Construction Equipment- 50% bonus MACRS- Same 5 year lease replaced with a new deal using regular MACRS
Calculation method- Target a yield of 6.50% and solve for rent.- Freeze rent, adjust depreciable basis – solve for new IRR
64ELA – 45th Annual Convention – Facing Your Future
Valuing LKE for Your BusinessCase Study Analysis – IRR and Rental Rate Impact
Effect of LKE process benefits in the replacement lease
Increased Profits and Margins• Case Study - LKE produces an 84 bps after tax increase in IRR
Reduction of customer lease rates • Case Study - Lease rate reduced by 4.1% at the same IRR
65ELA – 45th Annual Convention – Facing Your Future
Valuing LKE for Your BusinessCase Study Analysis – Facts
Example: Cash SavingsUtilizing a Like-Kind Exchange
Current Situation
Like-Kind Exchange Program
Sale of Old EquipmentProceeds 168,500 168,500 Tax Basis - -
Gain 168,500 168,500
Less Federal & State Taxes Due 67,400 - Cash available to acquire new equip 101,100 168,500
Assumptions: Combined tax rate 40%
66ELA – 45th Annual Convention – Facing Your Future
Valuing LKE for Your BusinessCase Study Analysis – Basis Points Benefits
WITHOUT LKECASH FLOW
Pre-taxCash Flow Taxes Paid After-Tax Cash Flow IRR- =
Origination (235,000) - (235,000) 12/30/2006 42,500 (12,560) 55,060 12/30/2007 55,000 (19,800) 74,800 12/30/2008 55,000 8,080 46,920 12/30/2009 27,500 2,280 25,220 Termination 91,000 36,400 54,600
36,000 14,400 21,600 3.22%
67ELA – 45th Annual Convention – Facing Your Future
Valuing LKE for Your BusinessCase Study Analysis – Basis Point Benefits
WITH LKE BENEFIT INCREASING IRRCASH FLOW
Pre-taxCash Flow Taxes Paid After-Tax Cash Flow IRR- =
Origination (235,000) - (167,600) 12/30/2006 42,500 8,400 34,100 12/30/2007 55,000 11,200 43,800 12/30/2008 55,000 18,400 36,600 12/30/2009 27,500 7,400 20,100 Termination 91,000 36,400 54,600
36,000 81,800 21,600 4.06%Without LKE 3.22%IRR BPS Advantage 0.83%
68ELA – 45th Annual Convention – Facing Your Future
Valuing LKE for Your BusinessCase Study Analysis – Rental Rate Benefits
WITH LKE BENEFIT REDUCING RENTAL RATECASH FLOW
Pre-taxCash Flow Taxes Paid After-Tax Cash Flow IRR- =
Origination (235,000) - (167,600) 12/30/2006 40,736 7,620 33,116 12/30/2007 52,718 10,287 42,431 12/30/2008 52,718 17,487 35,231 12/30/2009 26,359 7,018 19,341 Termination 91,000 36,400 54,600
28,530 78,812 17,118 3.22%
69ELA – 45th Annual Convention – Facing Your Future
Valuing LKE for Your BusinessInternal Challenges to Implement LKE Program - Overview
The internal approval and implementation process is challenging• Economics may not work
• Low tax gains on sale• Small ticket assets• Low interest rates
• Business heads and tax staff are usually supportive• Need a project manager/champion to run the implementation• LKE software offers a solution for lack of detailed asset level systems
and record keeping for tax depreciation • Business people may have concerns about customer notifications • Treasury will have to change processes and add new ones• Treasury has to give allocate internal credit for the tax deferral
benefits
The Future of Lease TaxationCommunicating & allocating value to business units
Laurie HumannU.S. Bank
Jeff NelsonPricewaterhouseCoopers LLP
October 24, 2006
71ELA – 45th Annual Convention – Facing Your Future
Topics for DiscussionID the tax incentive or benefit (“TIB”)Quantify the value for the business unitPresent the value to leadershipImplement your planAllocating impacts to business lines
72ELA – 45th Annual Convention – Facing Your Future
Tax Incentives and BenefitsID and quantify the value of the TIB for the business unit
Understand the value of the TIB- Permanent vs. deferral - Income vs. other- Jurisdictional & geographic differences
• Federal• State & Local• International
73ELA – 45th Annual Convention – Facing Your Future
Tax Incentives and BenefitsFor example: Like Kind Exchange
Interest free loan from the IRS- Tax ownership creates a deferred tax liability
• LKE creates an additional deferred tax liability - Free cash flow/ROE/IRR
Strategic advantages- Pricing- Lower funding costs
74ELA – 45th Annual Convention – Facing Your Future
Tax Incentives and BenefitsPresentation of Benefits to Leadership
Quantify the value- Benefits
• Enhanced cash flow• Strategic advantages
- Costs • Implementation and software costs• Ongoing costs such as Qualified Intermediary and processing• Headcount
Tailor message according to time constraints and audience- Pricing advantages- Payback period- Adoption hurdles
75ELA – 45th Annual Convention – Facing Your Future
Tax Incentives and Benefits Implementing Your Plan - Adopting a LKE program
Recommendations for a smooth implementation- Need a point person from business line and tax- Optimal time for any data clean-up- Reconciliation efforts- Operational burdens
Benefits- Improved compliance efforts
76ELA – 45th Annual Convention – Facing Your Future
Tax Incentives and BenefitsMaking it happen in the business
Example: USBEF Like Kind Exchange ProgramSuccess factors and process- Who? Who do you need to get buy-in?- What? What do they need to know?- When? Priorities and resources?- Where? Who benefits? - How? Logistics, scheduling and follow-up?
77ELA – 45th Annual Convention – Facing Your Future
Tax Incentives and BenefitsAllocating Impacts to Biz Lines
Attributing the value of LKE to business line- Improved cash flows- Lower funding costs
• Interest free loan from the IRS
Enhanced understanding of dataIncreased interaction with tax and financeIncreasing market competitiveness- Pricing impacts- Advantages for vendors & customers