ON JAN. 20, 2021, Joseph Biden was officially sworn in as President of the United States. While the state of politics dictates when legislation will be passed, one can “read the tea leaves” and come to one’s own conclusions as to what this may mean for the Tax Code. This article is aimed at looking at President Biden’s campaign suggestions with respect to the Tax Code and address what effect some of those suggestions may have on the leasing industry.
To evaluate how this might affect the equipment finance industry we can look to what effect the opposite had when the federal income tax rate decreased. Most lease or loan investments are analyzed to some extent on an After-Tax Return-on-Equity basis (“AT-ROE”). AT-ROE is measured over the life of the contract and is weighted by the after-tax cash flows. Most pricings assume a consistent tax rate.
Taxable Loans – The pretax spread between taxable interest income and interest expense is a consistent rate on the outstanding principal. Assuming a uniform income tax rate over the life of a loan, the AT-ROE yield should be constant. If the tax rate decreases, the AT-ROE will increase as less margin is paid in taxes. Conversely, assuming the tax-rate increases, the AT-ROE will decrease.
Is it time to consider exploring sharing these risks with borrowers?
Tax-exempt Loans – In the narrower tax-exempt lending marketplace, when tax rates decreased the AT-ROE yield on these tax-exempt loans also decreased because interest expense used to fund these loans (when possible) were now worth less. In this market lenders may have had the right to raise the rates based on a formula in the loan agreement. Whether they did or not was likely based on whether they were concerned about the relationship with the borrower or the publicity that may have been generated.
Can offering a rate-reset if tax rates increase be a competitive advantage to win more business?
True (Tax) Leases – When tax rates are known and scheduled, one can incorporate the planned change into the pricing tool and the tool will provide the rents based on the desired AT-ROE target. However, tax rates often change without much warning and lessors are usually dealing with (i) how to price new transactions and (ii) how to address what will happen to their existing true lease portfolio.
For new transactions, perhaps proposals should be priced under two separate scenarios assuming the funding may be some time in the future, perhaps after rates are increased. The first proposal may be assuming tax rates remain the same at closing and the second assuming the rate has increased prior to closing. Some lessors may also seek to price transactions with a rate increase built-in; for instance, assuming the transaction funds at 21% but that rates increase to 28% within a year of funding.
To analyze an existing portfolio, stratify the portfolio into logical groups and have your pricing team test the effect a rate increase will have on the AT-ROE.
Alternative-Tax on Book Income – Candidate Joe Biden suggested a 15% minimum tax on book income on companies earning more than $100 million.
First a refresher on the Alternative Minimum Tax (AMT). Previously companies calculated their tax bill in at least two ways; (i) taxes calculated using the statutory rate (i.e., 35% before TCJA) applied to taxable income and (ii) taxes calculated using the AMT rate (10%) after adding back “tax-preference items” which typically were items such as the acceleration of depreciation over standard MACRS. If the AMT tax was higher than the statutory tax, the AMT tax was paid BUT the excess was carried as a credit to be used when the opposite occurred. In theory the amount of taxes paid over-time was the same, except that the AMT forced taxes to be paid earlier. It is unknown whether book-AMT would provide for a credit carry-forward.
Under this proposal, many companies would be subject to the new “book AMT,” held so many potential lessees may desire to lease rather than own. This is likely to also affect larger lessors; often those that are subsidiaries of banks or manufacturers. Additionally, this would likely affect those lessors that book more finance leases than operating leases, largely because operating leases have a greater tendency to generate early period pre-tax book losses after considering the interest expense used to fund the lease.
Beware the potential affect this may have on your business model; time to start running some financial models and socializing this fact with upper management for some decision-making.
New Investment Tax Credits? Talk on the “Hill” has included exploratory inquiries for tax incentives that can assist those industries that have seen the brunt of difficulty as a result of the pandemic, such as the restaurant, entertainment, shipping and transportation industries. With the administration’s stated objective for a cleaner environment, expect to potentially see new tax credits being considered. Now might be the time to bring those new products and ideas forward, for instance new forms of alternative fuels such as hydrogen not previously mainstream. Expect corporations to move in that direction also, for instance companies with large vehicle fleets seeking to electrify them.
Be on the lookout for new tax incentives!
Disclaimer - Any opinions expressed herein are of the author and not of the company he works for. No observations or suggestions should be taken as either tax advice or accounting advice. Readers should consult with their own accountants or tax-counsel for such opinions.
Be on the lookout for new tax incentives.
Potential Changes to the Tax Code
Corporate Tax Rate – During his campaign, President Biden proposed raising the corporate income tax rate from 21% back up to 28%; current suggestions indicate that the target may be more like 25%.To evaluate how this might affect the equipment finance industry we can look to what effect the opposite had when the federal income tax rate decreased. Most lease or loan investments are analyzed to some extent on an After-Tax Return-on-Equity basis (“AT-ROE”). AT-ROE is measured over the life of the contract and is weighted by the after-tax cash flows. Most pricings assume a consistent tax rate.
Taxable Loans – The pretax spread between taxable interest income and interest expense is a consistent rate on the outstanding principal. Assuming a uniform income tax rate over the life of a loan, the AT-ROE yield should be constant. If the tax rate decreases, the AT-ROE will increase as less margin is paid in taxes. Conversely, assuming the tax-rate increases, the AT-ROE will decrease.
Is it time to consider exploring sharing these risks with borrowers?
Tax-exempt Loans – In the narrower tax-exempt lending marketplace, when tax rates decreased the AT-ROE yield on these tax-exempt loans also decreased because interest expense used to fund these loans (when possible) were now worth less. In this market lenders may have had the right to raise the rates based on a formula in the loan agreement. Whether they did or not was likely based on whether they were concerned about the relationship with the borrower or the publicity that may have been generated.
Can offering a rate-reset if tax rates increase be a competitive advantage to win more business?
True (Tax) Leases – When tax rates are known and scheduled, one can incorporate the planned change into the pricing tool and the tool will provide the rents based on the desired AT-ROE target. However, tax rates often change without much warning and lessors are usually dealing with (i) how to price new transactions and (ii) how to address what will happen to their existing true lease portfolio.
For new transactions, perhaps proposals should be priced under two separate scenarios assuming the funding may be some time in the future, perhaps after rates are increased. The first proposal may be assuming tax rates remain the same at closing and the second assuming the rate has increased prior to closing. Some lessors may also seek to price transactions with a rate increase built-in; for instance, assuming the transaction funds at 21% but that rates increase to 28% within a year of funding.
To analyze an existing portfolio, stratify the portfolio into logical groups and have your pricing team test the effect a rate increase will have on the AT-ROE.
Alternative-Tax on Book Income – Candidate Joe Biden suggested a 15% minimum tax on book income on companies earning more than $100 million.
First a refresher on the Alternative Minimum Tax (AMT). Previously companies calculated their tax bill in at least two ways; (i) taxes calculated using the statutory rate (i.e., 35% before TCJA) applied to taxable income and (ii) taxes calculated using the AMT rate (10%) after adding back “tax-preference items” which typically were items such as the acceleration of depreciation over standard MACRS. If the AMT tax was higher than the statutory tax, the AMT tax was paid BUT the excess was carried as a credit to be used when the opposite occurred. In theory the amount of taxes paid over-time was the same, except that the AMT forced taxes to be paid earlier. It is unknown whether book-AMT would provide for a credit carry-forward.
Under this proposal, many companies would be subject to the new “book AMT,” held so many potential lessees may desire to lease rather than own. This is likely to also affect larger lessors; often those that are subsidiaries of banks or manufacturers. Additionally, this would likely affect those lessors that book more finance leases than operating leases, largely because operating leases have a greater tendency to generate early period pre-tax book losses after considering the interest expense used to fund the lease.
Beware the potential affect this may have on your business model; time to start running some financial models and socializing this fact with upper management for some decision-making.
New Investment Tax Credits? Talk on the “Hill” has included exploratory inquiries for tax incentives that can assist those industries that have seen the brunt of difficulty as a result of the pandemic, such as the restaurant, entertainment, shipping and transportation industries. With the administration’s stated objective for a cleaner environment, expect to potentially see new tax credits being considered. Now might be the time to bring those new products and ideas forward, for instance new forms of alternative fuels such as hydrogen not previously mainstream. Expect corporations to move in that direction also, for instance companies with large vehicle fleets seeking to electrify them.
Be on the lookout for new tax incentives!
Conclusions
Aside from the suggestions mentioned above, lessors should analyze and consider whether they should try to defer some tax deductions when possible or accelerate taxable income when possible – e.g. convince a customer to exercise an end-of-lease purchase option out of a true lease before rates increase. Most importantly, run those financial models!Disclaimer - Any opinions expressed herein are of the author and not of the company he works for. No observations or suggestions should be taken as either tax advice or accounting advice. Readers should consult with their own accountants or tax-counsel for such opinions.
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EL&F magazine article
LEASE ACCOUNTING
Financial Watch
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2021