Changes In U.S. Law And Economy

The U.S. Economy has sustained 3% growth for two consecutive quarters. Prospects for continued growth in 2018 are strong, and there is likely to be an extra boost if tax reform is passed by Congress. Rising household wealth and job gains suggest the Federal Reserve will raise rates in December and several times in 2018. In this environment, growing air and rail transportation investment requires a strong origination team supported by a supply of competitively priced capital. Behind the business and economic analysis are the specifics of tax law, and financial reporting. How should you best prepare to manage the change expected in these areas in 2018?

The country has not rewritten its tax code since 1986. To promote economic, political, and business objectives, Congress is currently considering a major rewrite. The rewrite would achieve objectives in a ‘backhanded’ way, not through direct appropriations, but through a reduction in taxes payable. The recently passed House Bill suggests a reduction in the corporate tax rate from 35% to 20%. Existing tax law allows a deduction for business interest expense, reducing the after tax cost of borrowing. The House Bill would disallow business ‘net interest expense’ in excess of 30% of a firm’s EBITDA. Small business (with receipts less than $25 Million) would be exempted. Excess interest disallowed would be available for carryforward for five years. The House Bill would also allow the immediate expensing of the full cost of most assets with a tax life of less than 20 years. NOL rules would be altered with no carrybacks for 2018 or beyond allowed, while carryforwards would be limited to 90% of a corporation’s taxable income. If the Senate is able to pass a tax bill, the differences between the House and Senate versions would have to be ‘reconciled’ meaning provisions of a final bill remain in a state of flux. With passage, expect business transportation equipment investment to increase and drive economic growth.

Impact on Lease Investment

Financial accounting for lease investment is currently driven by the Financial Accounting Board’s Statement No. 13 (Accounting Standards Codification 840). The FASB’s new standard for Leases (ASC 842), represents the first comprehensive overhaul of lease accounting since FAS 13 was issued in 1976. The new standard was adopted in February 2016 as part of the FASB/IASB ‘Convergence Project’. It has an effective date of 2019 for public companies and 2020 for non-public companies. Since the SEC requires three years of comparative income statements for calendar year public companies and two years comparative balance sheet data, public companies are currently starting to capture 2017 lease data. Private companies should begin in that process 2018.

The new rules require balance sheet disclosure for all ‘lease contracts’ that identify a ‘specific asset’ and ‘transfer control’ of that asset to the lessee. The old FAS 13 ‘bright line’ tests for lease capitalization are officially gone, but technical ‘guidance’ in the new rules continues to allow consideration of the old FAS 13 tests to determine if a lease is to be treated as a ‘financing’. The most significant change is lessees will be required to recognize the ‘rights and obligations’ resulting from operating leases as assets and liabilities on their balance sheets[1]. The updates for financial reporting do not change the treatment of leases for income tax purposes. For book purposes an ‘operating’ lease, that would now be on the balance sheet as an asset and liability, will generate both deferred tax liabilities for the excess GAAP basis in the right of use asset and a deferred tax asset for the excess GAAP basis in the related lease liability. The new standard will generally result in accelerated expense recognition for those leases classified as ‘financing’ leases for book purposes while operating lease annual cost will be similar to the expense pattern under current operating lease accounting.

The tax and financial reporting changes are complex and can be expected to impact investment strategies. Change is the only constant. Managing change requires experienced advisors. Work with experience.

Work with RESIDCO.

[1] There are a few exceptions including leases shorter than 1 year (provided they do not include an option to purchase the underlying asset).