The lenders loan funds to the lessor but look to the credit of the lessee and the equipment value in the event of default. In other words, the lending is non-recourse as the lessor is not responsible to repay the loan in the event of default. The lender has some protection in that its claim does precede the lessor's claim in the event of default.
The power of the leverage effect and tax benefits lowers the money-over-money rate to the lessee relative to a typical tax lease or straight loan. Since the lessor is able to depreciate all of the equipment with only a relatively small equity investment, this economic benefit can be shared with the lessee in the form of lower rates. A leveraged lease can also be structured to meet the specific needs of the parties involved. Specialized pricing programs can optimize rent and debt schedules to meet particular criteria, such as lowest present value of rent to the lessee, highest book earnings to the lessor or minimum investment duration for the lenders. Early buyout options are popular features and give the lessee the advantage of a definite purchase price for the equipment at a particular point in the lease term. In order to avoid jeopardizing the lessor's tax treatment, the early buyout option cannot be set at a bargain price. (Brady & Ingram 2006, Leveraged Leasing Basics section ¶ 3-4)
Rules for Leverage Leasing for the lessor to comply with the tax requirements of a leveraged lease, while also qualifying to depreciate the leased equipment, the lessor must also possess the risks and rewards that accompany ownership. Brady and Ingram (2006) explain that: "In a true tax lease, the lessor can depreciate all of the leased equipment, not just that portion financed on an equity basis" (Tax Treatment section ¶1). In addition, as the non-recourse debt is treated as a loan between the lender and the equity participant, the lessor can deduct interest paid to the lender (Brady & Ingram 2006, Tax Treatment section ¶1).
In Revenue Ruling 55-540, the Internal Revenue Service (IRS), proffers some directives to determine if a transaction qualifies for true lease status. For federal income tax purposes, when/if a transaction possesses even one of the following characteristics portrayed in the following figure (1), it may not be considered a true lease (Brady & Ingram 2006, Tax Treatment section ¶ 2):
Even One These Factors Negates Qualification of a True Lease adapted from Brady & Ingram 2006, Tax Treatment section)
In response to the increase in leveraged lease volume during the 1970s, and ensuring requests for advanced rulings to determine whether particular transactions could qualify for true lease status, the IRS issued Revenue Procedure 75-21. This Procedure provides standards to obtain an advance letter ruling from the IRS. Leveraged leases that meet the following standards depicted in the following figure (2) routinely receive a favorable ruling regarding the transaction's true lease classification (Brady & Ingram 2006, Tax Treatment section ¶1):
Figure 2: Standards for Leverages Leases to Receive True Lease Classification adapted from Brady & Ingram 2006, Tax Treatment section)
During 1999, the IRS finalized Code section 467 regulations, which were adopted with (but not exclusively these) the specific allocation of rent, along with section 467 loan structuring techniques routinely used today. The leveraged lease structuring approaches could significantly improve a transaction's economics (Brady & Ingram 2006).
Accounting for Leverage Leasing Financial Accounting Statement (FAS) #13 addresses leveraged lease accounting. The following factors, presented in the following figure (3) must prove true to qualify to use leveraged lease accounting (Brady & Ingram 2006, Accounting Classification section ¶1)
Figure 3: Factors Which Utilization of Leveraged Lease Accounting (Brady & Ingram 2006, Accounting Classification section) leveraged lease possesses a separate accounting classification. FAS #13 notes that the lessor's leveraged lease investment "is recorded on the balance sheet net of the non-recourse debt" (Brady & Ingram 2006, Accounting Classification section ¶ 2).
At some specific points during the lease term, the deferred tax balance may prove to be more than the leveraged lease balance's investment, known as the sinking fund period or disinvestment period. "During the disinvestment period, the lessor has in its possession more cash than it initially invested in the transaction and may then utilize that cash for additional lending or other corporate uses" (Brady & Ingram 2006, Accounting Classification section ¶ 4).
Consequently, the lessor's net investment, its investment less deferred taxes, is utilized for the foundation of income allocation. Leveraged lease earnings, only allocated to times when the lessor's net investment proves to be positive. During the disinvestment period, earnings are not recognized on the income statement, a method of income allocation, deemed as the multiple investment sinking fund (MISF), the method necessary for leveraged leases (Brady & Ingram 2006, Accounting Classification section ¶ 4).
The following figure (4) portrays a summary, reflecting how leveraged lease earnings are derived:
Figure 4: Summary of Ways Leveraged Lease Earnings are Derived
Leveraged lease pricing programs may conduct these calculations prior to the booking of the lease. Brady and Ingram (2006) explain, however, that earnings patterns of book earnings, calculated on an after tax accounting balance, are usually u-shaped; higher at the lease's starting and final years; lower during middle years. "The impact of deferred taxes is to initially lower the after tax accounting balance. Over time, this effect is reversed as taxes are paid and the deferred tax liability is reduced" (Brady & Ingram 2006, Accounting Classification section 5). Due to the utilization of pre-tax accounting balances, single investor leases traditionally reveal a downward-sloping earnings pattern throughout their life span.
Benefits of Leverage Leasing
In leverage leasing, the equipment and its use, as lenders in this industry understand, generates fast and easy approvals ("
Capital equipment: Lease vs." 2007). It preserves the lessors credit lines, while it also offers distinct tax benefit. As a result, a number of accountants attest that leasing may be in their customers' best interests.
The literature (Brady & Ingram 2006; Sharp; 2006) confirms that everaged leasing provides a powerful equipment finance tool. Most lessors are reportedly not well capitalized, and frequently proffer leveraged leases to their customers (lessees). The lessor determines the amount of equity he/she perceives appropriate for a transaction in his/her estimate of the equipment's value at the lease's end. The lessor then invests that amount into the lease. Next, the bank provides the "debt side' of the transaction to the lessor by lending (on a nonrecourse basis) the difference between the equipment cost and the equity, and takes an assignment of the lease payments from the lessee and the underlying equipment as their collateral" (Sharp 2006, How do lessors benefit section ¶ 1). When a lessor wants to purchase equipment that costs $1 million, based on the estimate of the residual value of the equipment at the end of the lease term, he/she then determines the equity amount to invest in the transaction is 10%, he/she will invest $100,000 into that particular transaction. Next, the lessor then petitions the bank to discount the flow of rental payments away from the customer. if/when the bank agrees to do so, it will then supply the balance of the remaining costs; secured not only by the underlying equipment, but also by the assignment of the rental payments from the lessee (Sharp 2006, How does such a partnership section ¶ 1). According to Sharp (2006), legal documents are not that complicated in a lease transaction. Sharp also stresses that leasing equipment, unlike buying, as money is freed from access cash balances may be readily utilized for other purposes, including development and research.
Banks' decisions to provide loans are based primarily on their creditworthiness, Sharp (2006) attests. "Both lessors and lessees must maintain the highest investment-grade credit ratings possible" (Sharp, How important is creditworthiness section ¶ 1). Having a high credit rating would reassure both lessor and lessee, however even companies that may not merit the highest ratings could also qualify for loans. In addition, for unrated companies a number of banks will consider current interim figures, as well as full three-year audited financial statements (Sherp). A number of components make leveraged leasing attractive. One benefit for the lessor, the "non recourse" basis implication, asserts the term lender does not have ny legal recourse against the lessor should the lessor fail to meet debt repayments, other than the security, an assignment of the lease rentals; also a chattel mortgage over the lease. "Another benefit is the fact that: "The lessor contributes 15% - 40% of the purchase price of the asset and claims the tax benefits of ownership of the leased equipment along with any surplus rents (after debts repayments have been met) " (Roy 1990, the Parties Involved section, ¶ 3). The lessor also receives:
resulting tax benefits;
accelerated depreciation deductions;
interest expense for interest paid to the term lender;