Some New Accounting and Tax Rules May Prove a Boon for the Rental Industry

Question:   I heard that some changes to the tax code and/or accounting rules are on the horizon that might be positive for rental operators.  What are they, and how can I take advantage of them?  

James Waite’s Answers:

Yes, as a matter of fact, H.R. 1 (the “Tax Cuts and Jobs Act”) and some changes to the accounting standards that apply to leasing have altered the landscape for rental operators in some important, and likely positive, ways.  Many of the changes, including the reduction in the corporate tax rate, 100% expensing of qualified tangible asset purchases, and the repeal of 1031 (“Like-Kind”) exchanges, have already been discussed at length in a number of training sessions and industry publications, and are, as a consequence, already being factored into the fleet and financial plans of many industry participants.  

But, a few other changes that haven’t garnered the same level of attention may yet profoundly impact the industry.  Here are two that I think will prove particularly important over the next few years:

  1. First, under Accounting Standards Update (“ASU”) 2016-02, which added ASC 842, most lessees of tangible assets will be required to include on their balance sheets rentals and leases with terms of more than 12 months.  Prior to this change, Generally Accepted Accounting Principles (“GAAP”) only required lessees to include on their balance sheets “capital” leases (those that either required, or made it likely that the lessee would complete, a purchase of the asset, such as through “dollar buy-outs”).  Other (“operating” or “true”) leases, regardless of their length, did not require the same disclosure.  

Because “off-balance-sheet” leases tend to make a company’s financial statements appear more attractive, this of course, prompted many lessees to look for, sometimes creative, ways to characterize leases as “operating” rather than “capital” (or “finance”) leases.  Thus, in some cases, transactions that might have been considered capital leases in most people’s minds (including equipment lessors, who still tended to record them as such for their own purposes) were portrayed on lessees’ financial statements as operating leases through various means, including the use of third-party purchase guarantees and variations on assumed “implied” interest rates. The new standards largely take these options off the table by setting a hard threshold of 12 months, after which all leases must appear on lessees’ balance sheets (albeit with some differences in how they are characterized) irrespective of whether lessees would portray them as “capital” or “operating.”

Obviously, this will, to a considerable degree, eliminate an important element of value for equipment lessees who formerly used leasing more or less aggressively as part of an overall effort to improve their financial picture and by doing so, enhance shareholder value.

This change became effective for public companies on December 15, 2018.  For all other organizations, it will take effect on December 15, 2019. 

  1. Secondly, as if seeking to effect a “one-two-punch,” the IRS radically changed the economics of equipment financing, and therefore, equipment purchasing, by establishing a new limit on the amount of interest expense that can be deducted by taxpayers in any given year, starting in 2018.  Subject to exceptions for small businesses (those with average gross receipts of $25 million or less), floor plan financing and certain specified activities, amended Section 163(j) of the Tax Code limits net interest expense to 30% of the taxpayer’s adjusted taxable income (Earnings Before Interest, Tax, Depreciation and Amortization, which scales back to Earnings Before Interest and Taxes in 2021). The remainder of the otherwise deductible interest expense can be carried forward indefinitely, but for current purposes, this limit will further diminish (materially for some) the appeal of financing their equipment purchases, and for many the utility of “synthetic” leases (those utilizing a third-party acting as a lessor in order to facilitate off-balance sheet financing while retaining the tax effects of debt financing), by making it more expensive in terms of lost or delayed tax benefits.

This, of course, will impact equipment rental operators in at least two ways: (i) on the downside, it may tend to make financing their own fleets more expensive by limiting the interest they can deduct each year (though “sale-leasebacks,” an exclusion for some types of floorplan financing and other strategies might be used to curb the effect of this limitation to a degree); and (ii) on the positive side, it will likely yield greater customer demand for short-term (up to 12 months) rentals of their equipment, because their lessees – who will experience similar cost increases with respect to their own equipment financing – will continue to be able to deduct short-term rental expense fully in most cases (subject to a new “Net Operating Loss Carryforward” limitation of 80%), thereby avoiding the bulk of the interest deduction limitation issues.

One other interesting side-effect of these limitations is their potential impact on the “sale-leaseback” market, in which owners (for example, large contractors) of high-value depreciable assets, sell those assets to bona fide third parties (e.g., equipment rental companies), and then lease them back for use in their regular business operations. Doing so might yield a number of benefits, including: (a) enabling sellers to use the sale proceeds to pay off debt that was generating unusable or delayed interest deductions; (b) enabling them to fully deduct the resulting rent payments; (c) enabling them to eliminate debt from their balance sheets; (d) enabling them eliminate assets that were generating accelerated depreciation deductions that added to their partially unusable net operating loss carryforwards (now also limited under the new Tax Act to 80% of their total, as mentioned above); and at the same time (e) permit the purchaser(s) of such equipment (in our case, equipment lessors) to fully expense those assets in the first year under the new 100% expensing rules (Note: 100% expensing is available for both new and used equipment, but it is not available for equipment leased to most governmental entities, non-profits or foreigners, nor is it available for equipment located outside the United States).

Conclusion:

The Tax Cuts and Jobs Act has arguably already had a substantial impact on U.S. businesses and their employees, by among other things, helping to reduce unemployment to historic lows and increasing capital spending and GDP growth.  But its most salutary effects for rental industry participants, when combined with the new accounting rules applicable to leasing, may be yet to come.  As recognition of the additional benefits of renting equipment, particularly versus the cost of financing it, grows, demand for rental assets is likely to expand, perhaps much more than previously anticipated. This, of course, should augment lessors’ pricing power, propel utilization and profits, create incentives for further industry growth, and ultimately, enhance the values of rental companies as both partners and acquisition targets.  Obviously, a host of other factors, including interest rates, infrastructure plans, regulatory issues and state and local tax regimes, may also impact the rental market and the U.S. economy at large. But even assuming they do (and they will), the aforementioned tax and accounting changes bode well both for existing rental companies and for those preparing to enter the rental industry.      

 James R. Waite is a business lawyer with over 20 years in the equipment industry. He authored the American Rental Association’s book on rental contracts, and represents equipment lessors throughout North America on a wide range of issues, including corporate law, contracts, real estate, employment, taxation, litigation, and buying, selling and financing their businesses and their equipment.  He is a veteran of the United States Air Force, has a BBA in Finance from the University of Texas at San Antonio, a Juris Doctor from St. Mary’s University, and an MBA from Northwestern University. He can be reached at (866) 582-2586, or via email at j.waite@wwlegal.net.