The Positives of tax changes; Some new accounting and tax rules may prove to be beneficial for equipment rental
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?
Answer: 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 percent expensing of qualified tangible asset purchases and the repeal of 1031 like-kind exchanges already have 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.
However, 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:
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 prompted many lessees to look for sometimes creative ways to characterize leases as operating rather than capital or nance leases. us, 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 o the table by setting a hard threshold of 12 months, aafter 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.
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 Dec. 15, 2018. For all other organizations, it will take effect on Dec. 15, 2019.
Second, as if seeking to affect a one-two-punch, the Internal Revenue Service (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 percent of the taxpayer’s adjusted taxable income — earnings before interest, tax, depreciation and amortization (EBITDA), which scales back to earnings before interest and taxes (EBIT) in 2021.
The remainder of the otherwise deductible interest expense can be carried forward indefinitely. However, for current purposes, this limit will further diminish, materially for some, the appeal of financing equipment purchases and for many the utility of synthetic leases 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 will impact equipment rental operators in at least two ways. 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. On the positive side, it likely will 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 expenses fully in most cases, subject to a new net operating loss carryforward limitation of 80 percent, thereby avoiding the bulk of the interest deduction limitation issues.
One other interesting side-effect of these limitations is the potential impact on the sale-leaseback market, in which owners, such as large contractors, of high-value depreciable assets, sell those assets to bonafide third parties, such as equipment rental companies, and then lease them back for use in their regular business operations.
Doing so might yield a number of benefits. These include enabling sellers to use the sale proceeds to pay o debt that was generating unusable or delayed interest deductions, enabling sellers to fully deduct the resulting rent payments, enabling sellers to eliminate debt from their balance sheets and enabling sellers to 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 percent of their total.
In addition, the purchaser(s) of such equipment, including equipment lessors, can fully expense the purchase in the first year under the new 100 percent expensing rules. The 100 percent expensing is available for both new and used equipment, but it is not available for equipment leased to most governmental entities, nonprofits or foreigners, nor is it available for equipment located outside the United States.
The Tax Cuts and Jobs Act arguably already has 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 gross domestic product (GDP) growth. However, 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 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. A host of other factors — such as interest rates, infrastructure plans, regulatory issues and state and local tax regimes — also may impact the rental market and the U.S. economy at large. Even assuming they do, the aforementioned tax and accounting changes bode well both for existing rental companies and for those preparing to enter the rental industry.