Synthetic Leases: Benefit or Burden?

The bull market for publicly traded equities has left many companies searching for new and innovative ways to bolster their stock prices in hopes of attracting even more investor dollars. This competitive environment has led many sophisticated corporate real estate users to employ a relatively new technique known as the synthetic lease.

In its simplest form, a synthetic lease is a type of off-balance-sheet financing that provides a number of benefits for the corporate lessee, including enhanced financial ratio performance; as much as 100 percent financing with competitive pricing; realization of future property appreciation through a fixed-price purchase option; and tax benefits, including deductions for both interest expense and depreciation.

In a typical synthetic lease, the lessor, usually a bank, leasing company, or other financial institution (often a special-purpose entity formed by the parties for the sole purpose of holding title to the asset) purchases the asset from a vendor and leases it to the user, or lessee. The lease agreement requires the lessee to pay the lessor periodic lease payments during the lease term.

At the end of the term, the lessee may purchase the asset at a predetermined fixed purchase price. Alternatively, the lessor may sell the asset to a third party, with the lessee providing a first-loss guarantee in the form of a termination payment. The net present value of the lessee’s termination payment plus the lessee’s total lease payments will be less than 90 percent of the present value of the original purchase price.

Structuring to Meet the Standard
A synthetic lease is structured to qualify as an operating lease for financial accounting purposes and to qualify as a financing transaction under existing federal tax law.

Financial Accounting Provisions. Generally speaking, the financial reporting benefits of a synthetic lease cannot be achieved through the sale-leaseback of a facility currently owned by a prospective lessee.

Qualifying as an operating lease, as opposed to a capital lease, ensures the lessee of the desired off-balance-sheet treatment. The lease will not receive this treatment if it meets any of the following four criteria from the Statement of Financial Accounting Standards (SFAS) No. 13:

  • It transfers ownership to the lessee at the end of the lease.
  • It contains an option for the lessor to purchase the real estate at a bargain purchase price.
  • The noncancelable lease term is equal to or greater than 75 percent of the estimated economic life of the real estate.
  • The present value of the rents and other minimum lease payments equal or exceed 90 percent of the fair market value of the leased property.

To avoid meeting these criteria, a typical synthetic lease will include a market-rate, fixed-price purchase option, a relatively short lease term (generally three to seven years), and a lease payment stream with a present value of less than 90 percent of the fair market value of the leased property.

A synthetic lease structure also must avoid the provisions of SFAS No. 98, which will disallow sale treatment for the seller if the seller retains the option to purchase the property, or if the lease contains any guarantee provisions.

Federal Tax Provisions. A properly structured synthetic lease will be treated as a financing transaction for federal income tax purposes, allowing interest expense and depreciation deductions to the lessee (rather than rent expense). While the lessee does not hold actual title to the property in form, the lessee will retain, in substance, the significant benefits and burdens of ownership.

This is accomplished through the use of a fixed-price purchase option (FPO) or a termination payment. An FPO is an agreement between the lessor and the lessee to allow the lessee to buy the property at the end of the lease term for a price equal to the original purchase price (subject to appraisal) less any amortization provided by the lease terms. An FPO gives the lessee the benefits of appreciation on the property and furthers the argument that the lessee substantively owns the property for federal income tax purposes.

On the other hand, if the lessee does not purchase the asset at the end of the lease term, the lessor can sell the property to a third party. The lessee then must pay the lessor a specified amount (the termination fee) usually equal to the shortfall between the sales price and an agreed-upon target price. If the property has depreciated significantly in value over the term of lease, the lessee effectively realizes a loss.

Federal Tax Issues
Two key issues are at the core of receiving financing treatment for federal income tax purposes: disregarding the transaction’s form (a lease) in favor of its economic substance (a financing); and proving that the lessee retains the benefits and burdens of ownership. Ultimately the second factor, which points to the economic realities and substance of a transaction, governs the outcome of each case.

It is not unusual for both the courts and the Internal Revenue Service (IRS) to review the form of a transaction to get at its substance—however, it is more unusual when doing so favors the taxpayer. The structure of a synthetic lease asks the IRS to do just that; overlook the fact that the transaction looks like a sale-leaseback and treat it as financing for federal income tax purposes.

The courts have rendered a number of decisions on both sides of this issue. One case often cited by the IRS in support of the argument that parties must be held to the form of a transaction is Commissioner v. Danielson, in which the taxpayers were denied capital gains treatment on the sale of stock because the original agreement between the parties allocated a portion of the stock to a noncapital asset.

Conversely, several cases and IRS rulings support the argument that substance should govern the tax treatment of a transaction, rather than form, in a context applicable to synthetic leases.

In many cases, the courts had to determine if the petitioners had the benefits and burdens of ownership, including:

  • Who would the property ultimately revert to?
  • Does the lessee have any residual value risk? and
  • Will the lessee receive any profit if the property is sold at the end of the lease term at a value greater than what is due to the lessor at that time?

Weighing the Benefits
Synthetic leases, if properly structured, can be a viable off-balance-sheet financing option for sophisticated real estate users. Their downside is the complexity involved in structuring a transaction that qualifies as a lease for financial reporting purposes, while constituting financing for federal income tax law.

Steven M. Friedman and Samuel H. Hoppe

Steven M. Friedman is a tax partner and Samuel H. Hoppe is a tax professional in the McLean, Va., office of Ernst & Young. Contact them at (703) 747-1000 or steve.friedman@ey.com and samuel.hoppe@ey.com.