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

$1-out Lease

ALIAS (a lease intended as security)

Buck-out Lease

Capital Lease (often incorrect usage - this is an accounting term)

Collateral Lease

Conditional Sale Lease

Direct Finance Lease (which refers to a number of additional issues, potentially)

Dirty Lease

Disguised Lease

FAS 13 Finance Lease

Finance Agreement

Finance Lease (old usage)

Financing Arrangement

Financing Lease

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")

Lease-Purchase

Mandatory Purchase Lease

Money-over-money Lease

Nominal Option Lease

Non-true Lease

Not-true Lease

Put 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:

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?

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.

                                                                

Yikes

No diatribe on the pro's or con's of the current Administration or the political theory behind Mr. Trump's outlined tax reform. Just a word or two to the industry from someone who weathered "ERTA" and "TEFRA" and remembers (sigh) "ITC" and what it stood for, both literally and in terms of policy and effect on our economy and industry.

 

 

Lower taxes for everyone would be very nice.

 

Neither of these has much of anything to do with economic growth, new jobs, bringing business and manufacturing back from overseas or any of the other stated goals. Leaving more money in the hands of America's businesses is always a good idea but it has never been shown to stimulate significant growth.

 

What has been shown to stimulate economic growth, and logically is the one thing certain to work, is engineering the Tax Code to encourage investment by business and spending by consumers. I have to believe that American businesses are ready to buy American-made equipment and technology, if the money is available. There are, of course, limits on what the World Trade Organization would label "government subsidies", but we are already on a course to push that envelope.

 

Once upon a time, business was encouraged to invest in new equipment to ramp up production, increase jobs and make the pricing on American-made goods competitive due to efficiency and state-of-the art production. Once upon a time, American banks and financial institutions were encouraged to provide investment funds to those businesses. The American lenders were also allowed, if not encouraged, to invest overseas. There was plenty of investment dollars to go around; it did not significantly increase interest costs domestically, only improve margins. Friendly foreign governments were even friendlier because American bankers helped build wastewater treatment plants and finance railway systems.

 

Once upon a time, the machine that was American equipment leasing and finance was running like a little top and not wobbling a bit. OK, there were greedy people. There was fraud. There were fools making foolish investments and loans and begging to be burned. The greedy lenders who bought bogus real estate appraisals and made predatory loans that triggered the crash were not OUR people, but we had a few bad actors who contributed to our industry's weakened reputation. The result is a frightening growth in state regulation, but that is a rant for another day.

 

The bottom line (a term coined in the very happy growth days of my youth) to all this is that what politicians and the uneducated call "loopholes" includes sacred cows like the home mortgage interest deduction and deductions for charitable contributions. The term is also loosely applied to deductions that will be significantly less valuable, if not eliminated, but the Administration's proposal. Eliminating these beneficial "loopholes" would be a mistake. It would be nice to have more money to pay dividends and executive salaries, but that doesn't accomplish the goal.

 

Reasonable top and mid-tier corporate tax rates, along with tax credits and deductions designed to stimulate the re-tooling of American business is a much more reliable way to jump-start the economy while keeping the deficit under control. Unfortunately, that is something that doesn't fit into a sound-bite that will excite John Q. Public. It is up to those of us who deal with buyers and sellers of business equipment to speak up or no one else will.

 

And I just did.

 

 

BSM

Suite 100

Birmingham, AL 35202