A Rose By Any Other Name
(A Thorny Proposition)
A few years ago, we had an article in this newsletter by this name. We were writing about the growth of the use of EFA's in lieu of leases intended as security. Just for fun, here is the list we included of not-true leases; there must be a million names for them.
Our focus this issue is a bit different: leasing professionals, including lawyers and accountants, misuse the names for various types of leases and it might help to go over a couple of definitions.
First, the list from 2013 (we would love to hear from others what can be added to the list):
$1 Purchase Option Lease
ALIAS (a lease intended as security)
Capital Lease (often incorrect usage - this is an accounting term)
Conditional Sale Lease
Direct Finance Lease (which refers to a number of additional issues, potentially)
FAS 13 Finance Lease
Finance Lease (old usage)
Full-payout Lease (which is misleading as these leases can contain FMD purchase options in which case they may or may not be true leases)
Higher Purchase (Canada British-influenced companies - thanks Jonathan Fleisher)
Installment Sale Lease
Lease Intended as Security (often called "ALIAS")
Mandatory Purchase Lease
Nominal Option Lease
Sales Finance Lease
Synthetic Lease (which opens another can of worms and is largely accounting-driven)
Before we go any further, what is or is not a "lease" is itself much misunderstood: Under state law (which is the law that a bankruptcy court will apply for purposes of determining whether a transaction is a lease or financing), a lease with a "nominal" purchase option is a secured financing and not a lease at all. UCC §1-203 (formerly, 1-102(37)) provides that a lease in which the lessee may acquire the leased property at the end of the term for "nominal" consideration is actually a security interest. Other UCC tests of a true lease include that the lease term (including mandatory renewals) must not exceed the economic life of the equipment and that the lessee must not be obligated to purchase the equipment. A lease that is terminable by the lessee is a lease, not a financing, but case law and logic dictate that this means terminating without paying out the lease in a normal early termination option. How much rent the lessee pays is not a consideration for UCC characterization purposes.
The IRS takes a different view, using a much more subjective test that includes the nature of the equipment and rental payments. Case law and IRS pronouncements make it clear that the IRS can challenge a lease of highly specialized equipment, equipment leased for over 80% of its economic life, or other leases in which the "economic substance" of the transaction is a financing. The most common test of a true lease for federal (and most state) income tax purposes is whether the lease contains a "bargain" purchase option.
In other words, while a lease with a $1.00 purchase option is a financing for state law, bankruptcy and IRS purposes, a lease with a $1,000,000 purchase is likely to be upheld as a lease for state law and bankruptcy purposes, but a financing for IRS purposes if the actual end-of-term value of the leased equipment is certain to be, say, $2-3,000,000. The "economic reality" of the deal is that the lessee would be a fool not to buy the equipment and sell it for a 7-figure profit.
There is an issue here. Is a purchase option in a bargain lease not automatically nominal, no matter how many dollars are involved? That has been argued for years. Someday, we will have sufficient case law to answer the question. We think the majority view is no, and nominal means tiny dollars, but bargain purchase options carry a bit of risk in this regard.
None of this applies to the FAS 13 accounting test, which is even more rigid than the UCC test, but is also more comprehensive in some ways. Until the new rules go into effect, an "operating lease" is a lease in which: (1) the lessee automatically acquires ownership at the end of the lease term OR may acquire ownership under a bargain purchase option (like the IRS test), (2) the lease term is greater than or equal to 75% of the useful life of the equipment, or (3) the discounted present value of the minimum required rental payments is greater than or equal to 90% of the value (purchase price) of the equipment at the beginning of the term, using the lessee's borrowing rate as the discount factor.
So what do we mean when we speak of:
This is an accounting term for any lease that does not qualify as an
lease. A capital lease might or might not be a true lease for UCC purposes (such as a lease with a fmv purchase option where the pv or the rents is more than 90% of the equipment cost). A capital lease might or might not be a true lease for IRS purposes under similar and other tests.
By the same token, an
lease is an accounting term only. A first amendment lease structure in which the lessee can either renew or purchase the equipment might well flunk the true lease test for IRS purposes and vice versa.
Capital Leases and Operating Leases are accounting terms only.
Arrrrgh! (you may quote me). The term finance lease was used for 50 years to mean a financing...a lease with a nominal purchase option....a lease intended as security. For UCC purposes, since the adoption of UCC Article 2A, the meaning is entirely different. A finance lease today means a true lease, not a financing, in which the lessor is not the vendor (supplier) of the equipment and is only acquiring ownership of the equipment to lease it to the lessee. The lessee must have access to the actual purchase agreement including the warranties supplied by the supplier because the lessee automatically has the benefit of those warranties, while the lessor is absolved of liability for them and the equipment's malfunctioning. Automatic hell or high water.
A Finance Lease is a lease, not a financing for UCC purposes. It is a lease in which the lessor is merely providing funds and is not the equipment vendor or a rental company. (There is more to finance leases, for another issue)
This is a financing, not a lease. The misleading thing here is that a $1 purchase option is not the only way to create such a transaction. Any nominal purchase option can be a financing. In some states (Florida), the Revenue Department will look at any purchase option of $101 or less as nominal for sales tax purposes. It is almost certainly nominal for UCC purposes. A lease in which the lessee leases for the entire economic life of the equipment, or automatically takes ownership, or is required to buy the equipment (essentially, a balloon payment) is also a financing.
There are many ways to create a financing as opposed to a lease
This can mean various things. A Payment Upon Termination is a balloon payment, a final rent payment or mandatory purchase payment that the lessee must pay. A lease with this kind of PUT is a financing. A "put" also refers to a right of the lessor to force the lessee to buy the equipment at the end of the lease. This can be more complicated. Why would the lessor want this right? Where a TRAC is not available (where the lessor wants a true lease but the equipment is not a certificated motor vehicle) the lessor could face environmental clean-up liability or other risks if the equipment is returned. What to do?
If the lessor doesn't care whether it has a true lease or a financing, the right to require the lessee to purchase the equipment can be at any price. Where the lessor wants a true lease for IRS purposes, the put right must be at less than anticipated fair market value - a bargain purchase price. This works in the opposite way of a purchase
; a true lease can have a bargain put but not a bargain option. The situation is not entirely clear for tax purposes and much less clear for UCC purposes where there is no statutory law directly on point.
It is safest to require the lessee to buy the equipment under certain circumstances. The lessor can reserve the right to keep the equipment as it comes off lease, but this can create uncertainty as to tas and UCC treatment.