Readers likely agree that synthetic lease structures can be complex financial arrangements with nuances that are not always well understood.
This article promises to clearly define what a synthetic lease is and provide a comprehensive overview of how they work, their key components, on-balance sheet treatment, tax implications, risks, and real-world applications.
You will gain an in-depth understanding of synthetic leases, how they compare to operating leases, their strategic value for companies, and what to consider when evaluating if a synthetic lease is right for your organization.
Introduction to Synthetic Leases
A synthetic lease is a financing structure that allows companies to access asset financing while keeping the asset off the balance sheet. It provides certain accounting and tax advantages compared to a standard operating lease.
Defining a Synthetic Lease
A synthetic lease involves three parties:
- The lessee (tenant) - The company that wants to finance the asset
- The lessor (landlord) - Typically a special purpose entity (SPE) that buys the asset
- The third-party financier - Provides financing to the SPE to buy the asset
The lessee makes rental payments to the lessor to use the asset. At the end of the lease term, the lessee has the option to buy the asset at a discounted price.
Key Components of a Synthetic Lease
The key aspects that make a synthetic lease different from a standard lease include:
- Term - Usually 75% or less of the asset's economic life
- Bargain purchase option - Allows lessee to buy asset at end of lease at a discount
- SPE ownership - Asset is owned by SPE, not the financing company
These allow the synthetic lease payments to be treated as operating expenses rather than debt.
Comparing Synthetic Lease vs Operating Lease
The key differences between a synthetic lease and standard operating lease include:
- Accounting treatment - Synthetic is off-balance sheet, operating is on
- Tax deductions - Both allow tax deductions for lease payments
- Risk - Synthetic has more risk as lessee may need to buy asset to exit lease
So in summary, a synthetic lease provides more flexibility in financing essential assets while gaining tax and accounting benefits. The structure is more complex than a standard lease however.
What is a synthetic lease obligation?
A synthetic lease is a financing structure that allows a company to acquire use of an asset without owning it. Here are some key things to know about synthetic leases:
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A synthetic lease involves three parties - the lessee (the company using the asset), the lessor (the owner of the asset), and a special purpose entity (SPE) that purchases the asset and leases it to the lessee.
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The lessee makes lease payments to the SPE to use the asset. At the end of the lease term, the lessee has the option to purchase the asset from the SPE at a predetermined price.
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For accounting purposes, a synthetic lease is considered an operating lease. This means the asset remains off the lessee's balance sheet. However, for tax purposes, the IRS treats it as debt financing.
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Synthetic leases provide companies with an alternative way to finance assets without increasing debt levels on their balance sheet. This can help preserve debt capacity for other investments.
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Risks include the lessee losing use of the asset if they default on lease payments. There is also risk of lease recharacterization by the IRS if the terms do not meet certain debt/equity thresholds.
In summary, a synthetic lease allows a company to gain use of an asset through a lease structure while keeping the asset off its balance sheet. It involves careful planning to mitigate risks like default or potential IRS recharacterisation.
What are the two types of lease financing?
There are two main types of lease financing: capital leases and operating leases.
Capital Lease
In a capital lease, the lessee (customer) is effectively the owner of the asset for accounting purposes during the lease term. At the end of the lease, the customer may acquire the asset for a nominal amount or the asset is returned to the lessor (financing company).
The key characteristics of a capital lease are:
- The lease transfers ownership of the asset to the lessee by the end of the lease term
- The lease contains a bargain purchase option to buy the asset at less than fair market value
- The lease term is for the major part of the asset's economic life
- The present value of the minimum lease payments equals or exceeds substantially all of the asset's fair value
On the balance sheet, the lessee records a capital lease as both an asset and liability.
Operating Lease
In an operating lease, the lessor retains ownership of the asset and the lessee pays a rental fee for using the asset. Ownership is not transferred to the lessee at the end of the lease.
The key characteristics of an operating lease are:
- The lessor owns the asset
- The lessee pays a rental fee to use the asset
- The lease is for a short period relative to the asset's economic life
- The lease has no bargain purchase option
- The present value of the minimum lease payments is substantially less than the asset's fair value
On the balance sheet, the lessee does not record an asset or liability, only recording the rental payment as an expense.
What is the difference between a finance lease and a capital lease?
A finance lease, formerly known as a capital lease, is a type of lease that transfers substantially all the risks and rewards of ownership to the lessee. The key differences between a finance lease and an operating lease are:
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Ownership Transfer: A finance lease transfers ownership of the asset to the lessee by the end of the lease term, whereas an operating lease does not.
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Lease Term: Finance leases usually cover most or all of the economic life of an asset. Operating leases usually cover only a small portion of the asset's life.
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Payments: Total finance lease payments exceed 90% of the fair value of the leased asset. Operating lease payments are generally much lower in relation to asset value.
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Accounting Treatment: A finance lease is capitalized on the balance sheet, while an operating lease is accounted for as a rental expense on the income statement.
In summary, a finance lease resembles an asset purchase more than a rental agreement. The lessee assumes many of the rewards and risks of ownership, making fixed payments over a lengthy lease term. An operating lease is more flexible and short-term, functioning similarly to renting rather than buying.
How does asset leasing work?
Instead of buying an asset upfront, with a lease the lessee pays a set amount for the right to use the asset, usually in installments over the term of the lease agreement. By the end of the lease, the lessee has paid the lessor either all or part of the asset's market value.
Some key points about how asset leasing works:
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The lessor owns the asset and allows the lessee to use it for a fee over a defined period of time. This avoids the large upfront capital outlay of purchasing the asset outright.
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Lease payments are usually made in regular installments over the lease term. This spreads out the cost over time rather than paying the full value upfront.
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At the end of the lease, the lessee has often paid enough to cover all or most of the asset's value. But the lessor retains legal ownership unless the lessee decides to purchase it.
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There are different types of leases with different payment structures, asset values, and ownership options. Common types include operating leases and finance/capital leases.
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Leasing provides more flexibility since lease terms tend to be shorter than asset lifetimes. Lessees can upgrade equipment or move to new premises more easily.
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There are financial and accounting advantages to leases over purchases, including improved cash flow, balance sheet, and tax treatment in some cases.
In summary, leasing allows the use of assets without needing to buy them. Regular payments cover usage over the lease term rather than paying full value upfront. The lessor retains ownership unless the asset is purchased later. There are various types of leases tailored to different needs.
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Synthetic Lease vs Operating Lease: On-Balance Sheet Implications
Synthetic Lease On-Balance Sheet Treatment
Synthetic leases allow tenants to structure lease agreements so that the leased assets remain off a company's balance sheet. This is accomplished by using a special purpose entity (SPE) that obtains financing and legal ownership of the asset. The SPE then leases the asset to the tenant.
Although the tenant retains operational control of the asset, the SPE, as legal owner, is able to keep the asset off the tenant's balance sheet. This provides financial and operational advantages for the tenant.
Comparative Overview of Operating Lease Accounting
Standard operating leases also allow the tenant to keep the leased asset off their balance sheet. Unlike capital leases, where the tenant assumes substantive ownership and related risks, operating leases are viewed as rental agreements.
As a result, accounting rules allow tenants with operating leases to omit recording the leased asset on their balance sheet. Instead, they record periodic rental payments as expenses on their income statement.
Risks and Recourse in Synthetic Lease Structures
Synthetic leases carry risks, including lease recharacterization and balance sheet recourse if certain conditions are violated:
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Recharacterization risk - If terms like bargain purchase options provide too much tenant ownership, the lease could be reclassified as a capital lease on the tenant's balance sheet.
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Recourse risk - Tenants are obligated to cover SPE debt and repurchase the asset if default provisions are triggered, adding the asset back to their balance sheet.
Thus, while enabling off-balance sheet treatment, synthetic leases have complex risks requiring careful structuring.
Tax Treatment of Synthetic Leases
Synthetic leases can provide some tax advantages compared to standard loans or operating leases. This section will focus on those potential benefits.
Deductibility of Lease Payments for Tax Purposes
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Synthetic lease payments are generally treated as operating expenses from a tax perspective. This allows tenants to deduct regular synthetic lease payments.
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This contrasts with normal loans, where principal payments are not deductible. It can provide a tax advantage for companies using synthetic leases.
Capital Gains Tax Mitigation Strategies
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When the lease term ends, the special purpose entity (SPE) owns the asset. If the asset is sold, capital gains taxes apply to the SPE instead of the tenant.
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This avoids capital gains exposure for the tenant company. It transfers tax liability to the SPE, which has more flexibility in managing gains.
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Strategies like carrying over basis and tax-free mergers may further reduce gains tax owed when divesting assets formerly under a synthetic lease.
In summary, synthetic leases can provide deductions on lease payments and shift capital gains tax exposure relative to standard leases or loans. Companies should consult advisors to fully understand tax implications when considering synthetic leases.
The Anatomy of a Synthetic Lease Structure
Properly structuring a synthetic lease transaction requires multiple specialized parties carrying out specific roles.
Identifying the Participants in Synthetic Lease Arrangements
Key parties in a synthetic lease include:
- Tenant: The company looking to finance equipment or real estate without placing it on their balance sheet
- Landlord: Typically a special purpose entity (SPE) that holds legal title to the asset
- Equity Investor: An investor that contributes equity to the SPE, usually around 3-7% of the asset value
- Lender: Provides financing to the SPE for the remainder of the asset value
Each party plays an important role in the synthetic lease arrangement. The tenant gets use of the asset, the landlord holds legal ownership, the equity investor absorbs residual risk, and the lender provides the bulk of the financing.
Role and Function of the Special-Purpose Entity in Synthetic Leases
The landlord establishes a special purpose entity (SPE) to legally isolate the asset ownership from the tenant company.
Key functions of the SPE include:
- Holding legal title to the leased asset
- Entering into the lease with the tenant
- Securing financing for the asset purchase
The SPE structure ensures the synthetic lease stays off the tenant's balance sheet. The tenant does not own the asset and the SPE has no other purpose than holding the single leased asset.
Crafting Lease Ownership and Terms within Synthetic Lease Agreements
Within a synthetic lease agreement:
- The asset title is under the special purpose entity with the tenant as lessee
- The maximum lease term is typically 75% of the economic life of the leased asset
- The tenant has a bargain purchase option at lease-end to acquire the asset
Structuring agreements this way maintains balance sheet treatment while giving tenants use of the asset. The lease cannot be too long and the tenant must have the option to gain title ownership.
These precise terms and roles within a synthetic lease enable companies to finance assets without additional debt or assets on their financial statements. Properly structuring the lease and participants is key to achieving off-balance sheet reporting.
Real-World Applications of Synthetic Leases
Synthetic leases provide companies with an alternative method to finance major assets while gaining potential tax and accounting benefits. They are commonly used across various industries to access specialized equipment or properties.
Synthetic Lease in Real Estate: A Practical Example
Major retailers like Walmart often utilize synthetic leases to finance new stores, warehouses, and office buildings. The terms allow Walmart to treat the properties as operating leases for accounting purposes while providing the tax benefits of ownership to the lessor. This structure shifts the assets off Walmart's balance sheet while still retaining control and use of the properties.
For example, Walmart may create a special purpose entity (SPE) with a group of investors to legally buy a new supermarket property. The SPE then leases the store back to Walmart through a synthetic lease. Walmart makes regular rental payments but holds an option to buy back the property for a nominal price at lease maturity. This allows Walmart to effectively control the store as an asset while keeping it off the company's financial statements.
Aircraft Financing through Synthetic Leases
Many major airlines use synthetic leases to finance new airplane acquisitions, especially expensive wide-body jets. Under this structure, a group of investors creates an SPE to legally buy new planes which are then leased back to the airline.
The airline makes rental payments over the term of the lease. At the end of the lease, the airline has the option to buy back the planes for a discounted residual value or return them. This structure allows airlines to effectively use and control the aircrafts without having the acquisition costs capitalized on their balance sheets.
Utilizing Synthetic Leases for Manufacturing Equipment
Similarly, industrial and manufacturing companies often take advantage of synthetic leases to finance investments in machinery, equipment, and tooling used in their facilities. An SPE is created to legally buy the assets which are then leased back to the manufacturer.
As in the other examples, this allows the equipment to be treated as operating leases for accounting purposes while providing use and control to the industrial company. The structure shifts the capital expenditure off their balance sheet, preserving debt capacity for other investments.
Understanding Synthetic Leases in the Context of ASC 842
The ASC 842 accounting standard provides guidance on the treatment of synthetic leases. A synthetic lease is a financing structure that is legally considered a lease, but allows the lessee to treat lease payments as operating expenses rather than capital expenses.
Navigating the Criteria of Synthetic Leases Under ASC 842
ASC 842 defines a synthetic lease as having the following characteristics:
- Involves a lessor, lessee, and special purpose entity (SPE) set up by the lessor to purchase, own, and lease assets to the lessee
- Maximum lease term does not exceed 75% of the economic life of the leased asset
- Lessee has an option to purchase the leased asset at lease expiration for a minimal fee
- SPE is expected to derive insignificant revenue from the leased asset other than rental payments from the lessee
A key risk under ASC 842 is recourse - if the lessee bears substantially all the risk related to the leased asset, the lease may be recharacterized as a capital lease.
The Threat of Recharacterisation under ASC 842
If certain criteria are violated, ASC 842 requires synthetic leases to be recharacterized as capital leases:
- If the present value of the rental payments exceeds 90% of the fair value of the leased asset
- If the lease term exceeds 75% of the economic life of the leased asset
- If the lessee guarantees the SPE's debt or has an option to purchase the leased asset for a bargain price
Recharacterisation means the lessee must record the leased asset on its balance sheet along with a related capital lease obligation. This impacts financial ratios and changes how expenses related to the lease are recognized.
To avoid recharacterisation risk, lessees should structure synthetic leases carefully and remain in compliance with ASC 842 guidance. Consultation with accounting advisors is recommended given the complexities involved.
Conclusion: The Strategic Value of Synthetic Leases
In closing, synthetic leases offer companies unique tax deductions and balance sheet classification compared to standard leasing. When structured properly, they provide an alternative form of asset financing aligned to companies' accounting, tax and risk management priorities.
Recapping the Benefits and Strategic Advantages
To summarize, key benefits of synthetic leases include:
- Tax deductibility of lease payments
- Off-balance sheet treatment of leased assets
- Flexibility in acquiring specialized assets
These advantages allow companies to optimize their financial reporting and reduce tax obligations.
The Imperative of Proper Synthetic Lease Structuring
However, to safely realize these benefits, careful structuring of the special purpose entity and lease terms is essential. Companies must work closely with legal and accounting advisors to ensure:
- The special purpose entity meets IRS guidelines for a true lease
- The lease contains no provisions that could trigger recharacterization
- Companies have no recourse against the special purpose entity
Proper structuring ensures companies can utilize synthetic leases as a strategic financial tool aligned with their business objectives.
