Private businesses implemented new lease accounting rules in 2022, resulting in a major shift in how leases are reported for “book” purposes. While the tax rules for leases haven’t changed, the new accounting rules can have notable implications for how the tax rules play out.
New Accounting Rules
The Financial Accounting Standards Board (FASB) issues standards for organizations that apply U.S. Generally Accepted Accounting Principles (GAAP). In 2016, the FASB released the new lease accounting rules, but their implementation was delayed. Accounting Standards Update (ASU) No. 2016-02, Leases (Topic 842), finally went into effect for private companies in 2022.
Under the previous rules, leases were classified as either capital or operating. Lessees reported capital (or finance) leases on their balance sheets as assets and liabilities. Operating leases were recognized on financial statements as rent expense and disclosed in the footnotes.
ASU 2016-02 called for a major shift in how operating leases are reported under GAAP. It requires lessees to recognize right-of-use assets and corresponding lease liabilities for all leases with terms of more than 12 months. The new rules also require additional disclosures about leases. For many organizations, implementing the changes required significant time and effort to review leases and compile the necessary information for the expanded disclosure requirements.
Potential Tax Effects
The new accounting rules don’t affect how leases are treated for federal income tax purposes. Tax law will continue to treat a lease as either:
1. A true tax lease. These arrangements are what would have been considered an operating lease under earlier GAAP. A true tax lease is one where the lessor maintains ownership of the asset and benefits from the associated deductions (for example, for depreciation), and the lessee claims the rent expense for its payments.
2. A nontax lease. These were previously called capital leases under GAAP. With a nontax lease, the lessee assumes the risks and rewards of ownership, including tax deductions, and the lessor recognizes interest income.
ASU 2016-02 nonetheless can affect a lessee’s taxes in several ways, including:
Deferred taxes. With all leases included as assets and liabilities, lessees may have more book-to-tax reconciliation items — or new deferred tax liabilities (DTLs) and deferred tax assets (DTAs).
Under the accounting rules, a lessee doesn’t have any tax basis in the right-to-use asset and lease liability. The excess book basis over tax basis in the right-of-use asset will be a DTL, and the excess book basis over tax basis in the lease liability will be a DTA. The deferred tax balances for nontax leases will be smaller than for true tax leases, as both book and tax will have some basis.
These initial differences are temporary, though, and will reverse over the lease term. The effect of the reversal depends on whether the lease is capital or operating for book purposes.
A capital lease generally will accelerate expense recognition on financial statements because lease liability is based on an effective interest rate calculation. An operating lease, on the other hand, typically will produce a more consistent annual cost because the asset is amortized at a rate intended to allocate the lease cost over the term on a more straight-line basis.
State and local taxes. The new accounting rules mean that businesses with substantial operating leases are seeing significant increases in their reported assets. This could lead to higher tax liability in states with franchise or other taxes based on net worth. In addition, sales and use taxes might be triggered if a state deems leasing to constitute a purchase transaction.
For businesses with tax nexus in multiple states, the rules also could affect apportionment — or the assignment of a portion of the business’s tax base to a state for taxation there — for both franchise and income taxes. Apportionment formulas vary by state, but they often include a factor for “property.” With leases included on the balance sheet, a business will appear to have more property assets than it actually owns, which could result in a higher taxable portion in those states.
The rules could have property tax implications, too. Some tax authorities may treat right-of-use assets as tangible personal property. Leases could be subject to additional property tax in those jurisdictions.
Foreign taxes. Depending on how other countries calculate their income taxes, the balance sheet changes could increase a business’s overseas taxation.
Transfer pricing. The federal tax code requires that transfer pricing on intercompany transactions reflect the pricing that would be involved in an arm’s-length transaction for the same goods, services or intangibles. The inclusion of operating leases as assets on the balance sheet could affect the financial ratios and profit level indicators (for example, return on operating assets) that typically are part of the arm’s-length analysis. In other words, a transfer price that satisfied the arm’s-length standard in the past might not under the new lease accounting rules.
The new lease accounting rules under GAAP create book-tax differences that businesses must be prepared to address. The addition of operating leases to balance sheets also might have repercussions for overall tax liability and compliance with transfer pricing requirements. Contact your financial advisors to help establish and maintain the necessary tracking processes and systems to account for these effects.