It is officially 2018! It is now time to focus on the new leasing standards that are effective for fiscal years after December 15, 2018. Between the new leasing and revenue recognition standards, accounting departments have been very busy. If you’re feeling a little behind on implementation of ASC 842, do not worry! We wrote a blog that outlines the biggest changes with the new standard, and we also compiled a list of resources to help with your implementation! Understanding the new standards is important, and identifying the potential changes in deferred tax accounts should not be overlooked. Let’s take a look at the biggest tax impacts of ASC 842.
Lessee – Operating leases
Under ASC 840 (the old/current leasing guidance), operating leases were not recorded on the balance sheet of the lessee. In revising the standard, one of the goals of the FASB was to make sure these obligations were recorded by entities on the balance sheet in order to more clearly and effectively make these obligations known to users of the financial statements. Therefore, under ASC 842, the new leasing standard requires additional assets and liabilities to be recorded.
According to U.S. GAAP, lessees will need to book a right-of-use (ROU) asset and the related lease liability for all leases, regardless of classification, which is now operating or financing under the new standard.
Meanwhile, for tax purposes, leases are either treated as a true tax lease or a non-tax lease. A true tax lease is simple – the lessor maintains ownership of the asset and the related deductions, while the lessee would deduct rental payments (this is like an operating lease under the old U.S. GAAP guidance). A non-tax lease assumes that the risks and rewards of ownership is with the lessee. Therefore, the tax benefits of ownership such as depreciation deductions and the deduction for the interest portion of the payments are booked by the lessee (This is like a capital lease under the old U.S. GAAP guidance). In this circumstance, the lessor recognizes interest income.
So how are deferred tax assets and liability accounts impacted? Much like existing GAAP (ASC 840), ASC 842 will create book/tax differences. However, because ASC 842 results in additional assets and liabilities being recorded as compared to ASC 840, this creates new, or adjusts existing, deferred tax assets and liabilities. ASC 842 requires a lessee to record an ROU asset and related lease liability for all leases. Under previous GAAP, the lessee did not record leases. As a result, the only temporary difference created was the difference between the rent expense recognized for tax purposes versus that recognized in the financial statements. However, since ASC 842 requires the lessee to record an ROU asset and lease liability that have no tax basis (i.e. they are not recorded on the tax ledger), deferred tax assets and liabilities will need to be recorded to recognize these temporary differences in the financial statements in accordance with ASC 740.
Lessor – Direct financing leases
Under ASC 842, a lessor classifies leases as either operating, direct financing, or sales-type leases in its U.S. GAAP financial statements. For tax purposes, those leases are generally treated as true tax leases or as non-tax leases, which are similar to a sales transaction.
When a lease is categorized as a direct financing lease, any selling profit is deferred under U.S. GAAP. This deferral of profit may create new (or larger) deferred tax assets since those leases will typically be non-tax leases for tax purposes. Under tax law, the entire profit on the lease (sales price – tax basis of the asset) will be recognized for tax purposes at the time of the sale.
When we study the effects of ASC 842, we believe that the balance sheet assets and liabilities will increase accounts evenly for the most part, without impacting the income statement. However, by adding or increasing the amount of deferred tax assets recorded, entities may also need to reconsider whether or not they need a valuation allowance using the “more-likely-than-not” threshold in ASC 740, which provides the guidance on accounting for income taxes. If so, there will be an impact to the P&L.
There are also some important specific issues to think about with the adoption of ASC 842:
- Lease origination, or initial direct costs, are capitalized for both book and tax purposes now unless they are immaterial. But under the stricter capitalization criteria of ASC 842, less costs will end up being capitalized.
- Sale-leaseback transactions may result in new deferred tax amounts. For example, a seller-lessee may be considered to have sold the asset for tax purposes, but the asset and liability are still on the financial statements for book purposes.
- State and local income tax returns often use apportionment formulas based on where assets are located. With leased assets included on the balance sheet, the income attributable to that state may be taxed at a higher or lower rate. Some states also charge a franchise tax, which is typically a flat rate or based on net worth or capital held by the entity.
- Transfer pricing is used by entities to determine the appropriate amount to charge for intercompany transactions. While these types of transactions are eliminated when consolidating for book purposes, they are not eliminated in each taxing jurisdiction for tax purposes.
Keep in mind that the Form 3115 needs to be filed for changes in accounting methods due to the ASC 842! Each lease an entity is involved with needs to be evaluated to predict the changes to the deferred income tax accounts.
The due date for public entities to apply the new leasing standards will be here before we know it! We hope this blog has helped you understand how taxes will be impacted by the new leasing standards.
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