ON MARCH 27, 2023, the FASB issued Accounting Standards Update (ASU) 2023-01 “Leases (Topic 842) Common Control Arrangements,” focused on leases between related parties of non-public entities under common control.
In contrast, many private companies under common control (but not necessarily consolidated) may lease to one another often for the benefit of one group of owners. Lease arrangements between related parties may have terms that have not been negotiated, may not have been determined at arms-length, or may have been entered into for tax-structuring purposes or for other purposes. For example, assume ABC Leasing and DEF Construction Company (lessee) are under common control. ABC may lease construction vehicles and office space to DEF. The terms and conditions of the leases may be documented or may merely be oral and amended almost at will. By the way, this scenario is not at all uncommon; in fact, some leasing companies had their beginnings as a family-owned lessor that leased assets to another family-controlled entity. This arrangement was often a sort of estate planning mechanism; when the long-term leases ended the owners received their “estate distributions.”
The challenge herein is how to apply ASC 842, largely with respect to the lessee. For example, assume that in the above relationship, ABC leases construction equipment and real estate space to DEF Construction, but the lease terms and conditions are 12 months. Would DEF be able to acquire use of the assets essentially off-balance sheet under the short-term lease exception?
Previously under ASC 842, only legally enforceable terms of the lease (per ASC 842-10-55-12) were to be considered and were addressed in the same manner as leases between unrelated parties. This created challenges largely due to the frequent lack of documentation and the cost and effort required for determining legal enforceability.
For purposes of determining whether a lease exists under this practical expedient, an entity would determine whether written terms and conditions convey the practical (as opposed to legally enforceable) right to control the use of an identified asset for a period in exchange for consideration.
This practical expedient, however, would not be available to common control arrangements that do not have written terms and conditions. If no written terms and conditions exist, an entity would continue to use the legally enforceable terms of the arrangement when applying Topic 842 (i.e., apply the standard consistent with how it would be applied for arrangements between related parties not under common control).
LEASEHOLD IMPROVEMENT PRACTICAL EXPEDIENT - Stakeholders questioned the FASB regarding how to account for leasehold improvements associated with related-party leases; specifically, those related-party leases when the term of the lease differs significantly from the estimated period of benefit of the leasehold improvement. This issue may arise when the term of the lease of the real estate is for a very short-term period, for instance 1–6 months. The specific issue pertains to the term of the amortization of the leasehold improvement, or whether the leasehold improvement should be accounted for as a transfer of the asset at the end of the short-term lease.
The ASU concluded that leasehold improvements associated with leases between entities under common control should be either:
1. Amortized by the lessee over the useful life of the leasehold improvements (regardless of the lease term). The lessee controls the use of the leased asset through a lease. However, if the lessor obtained the right to control the underlying asset through a lease with another entity not within the same common control group, the amortization period may not exceed the lease term associated with the lessor’s lease with the other entity, or
2. Accounted for as a transfer between entities under common control through an adjustment to equity (or net assets for not-for-profit entities) if, and when, the lessee no longer controls the use of the underlying asset.
Disclaimer - The views expressed here are that of the authors and not of the organizations or entities that the authors work with or for. The authors are not providing tax, accounting, legal or business advice herein. Any discussion of U.S. tax matters is not intended or written to be used by any taxpayer for the purpose of avoiding U.S. tax-related penalties. Each taxpayer should seek advice from their own independent tax, accounting or business adviser.
Background
Many larger companies subject to public reporting standards may have extensive intercompany or related-party leasing arrangements, for instance leases of real estate space and equipment. When any specific entity within the larger group of companies was required to provide stand-alone financial statements in accordance with GAAP, for instance for borrowing purposes, the intercompany leasing was subject to the standards articulated in ASC 842.In contrast, many private companies under common control (but not necessarily consolidated) may lease to one another often for the benefit of one group of owners. Lease arrangements between related parties may have terms that have not been negotiated, may not have been determined at arms-length, or may have been entered into for tax-structuring purposes or for other purposes. For example, assume ABC Leasing and DEF Construction Company (lessee) are under common control. ABC may lease construction vehicles and office space to DEF. The terms and conditions of the leases may be documented or may merely be oral and amended almost at will. By the way, this scenario is not at all uncommon; in fact, some leasing companies had their beginnings as a family-owned lessor that leased assets to another family-controlled entity. This arrangement was often a sort of estate planning mechanism; when the long-term leases ended the owners received their “estate distributions.”
The challenge herein is how to apply ASC 842, largely with respect to the lessee. For example, assume that in the above relationship, ABC leases construction equipment and real estate space to DEF Construction, but the lease terms and conditions are 12 months. Would DEF be able to acquire use of the assets essentially off-balance sheet under the short-term lease exception?
“Lease arrangements between related parties may have terms that have not been negotiated. It may be a best practice to establish a legally enforceable agreement.”
ASU 2023-01 Practical Expedients
ASU 2023-01 provides some relief by providing practical expedients discussed herein:
TERMS & CONDITIONS PRACTICAL EXPEDIENT - ASC 2023-01 allows eligible entities to elect to use the written terms and conditions of a related-party arrangement between entities under common control to determine whether that arrangement is or contains a lease, without having to determine if those terms and conditions are legally enforceable.For purposes of determining whether a lease exists under this practical expedient, an entity would determine whether written terms and conditions convey the practical (as opposed to legally enforceable) right to control the use of an identified asset for a period in exchange for consideration.
This practical expedient, however, would not be available to common control arrangements that do not have written terms and conditions. If no written terms and conditions exist, an entity would continue to use the legally enforceable terms of the arrangement when applying Topic 842 (i.e., apply the standard consistent with how it would be applied for arrangements between related parties not under common control).
LEASEHOLD IMPROVEMENT PRACTICAL EXPEDIENT - Stakeholders questioned the FASB regarding how to account for leasehold improvements associated with related-party leases; specifically, those related-party leases when the term of the lease differs significantly from the estimated period of benefit of the leasehold improvement. This issue may arise when the term of the lease of the real estate is for a very short-term period, for instance 1–6 months. The specific issue pertains to the term of the amortization of the leasehold improvement, or whether the leasehold improvement should be accounted for as a transfer of the asset at the end of the short-term lease.
The ASU concluded that leasehold improvements associated with leases between entities under common control should be either:
1. Amortized by the lessee over the useful life of the leasehold improvements (regardless of the lease term). The lessee controls the use of the leased asset through a lease. However, if the lessor obtained the right to control the underlying asset through a lease with another entity not within the same common control group, the amortization period may not exceed the lease term associated with the lessor’s lease with the other entity, or
2. Accounted for as a transfer between entities under common control through an adjustment to equity (or net assets for not-for-profit entities) if, and when, the lessee no longer controls the use of the underlying asset.
Summary Observations
While related-party leases are often entered into because of specific objectives of the related parties, it is also important to consider that at the end of the day, these arrangements may be examined by some outside party, whether they be lenders, taxing authorities, potential customers, potential buyers or even accountants. These outside parties will likely have to think long and hard about how that related-party lease may affect what they are being asked to do, so it may be a best practice to do what many larger companies do: establish a legally enforceable agreement that can stand on its own when the time comes.Disclaimer - The views expressed here are that of the authors and not of the organizations or entities that the authors work with or for. The authors are not providing tax, accounting, legal or business advice herein. Any discussion of U.S. tax matters is not intended or written to be used by any taxpayer for the purpose of avoiding U.S. tax-related penalties. Each taxpayer should seek advice from their own independent tax, accounting or business adviser.
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2023