ARTICLE REPRINT JOURNAL OF EQUIPMENT LEASE FINANCING

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1 ARTICLE REPRINT JOURNAL OF EQUIPMENT LEASE FINANCING The Journal of Equipment Lease Financing is published by The Equipment Leasing and Finance Foundation. The Equipment Leasing and Finance Foundation is a non-profit organization affiliated with the Equipment Leasing Association of America. The Foundation s mission is to increase the body of knowledge in the equipment leasing and financing field N. Fairfax Drive, Suite 550, Arlington, VA 22203: Lisa A. Levine, Executive Director Phone: (703) Fax: (703) Website:

2 The Impact of Bonus Depre c i a tion on Leasing Activ i ty By Jeffrey Taylor In the United St a t e s, a corp o rate taxpaye r re c ove r s,t h rough annual depre c i a t i on deduction s, the cost of certain property used in a trade or business.the amount of the depreciation deduction is determined under the modified accelerated cost recovery system (MACRS). Under MACRS,different types of property receive congressionally mandated recovery periods and depreciation methods. In March 2002,Congress passed a new tax law titled the Job Creation and Worker Assistance Act of While the United States struggled through a difficult post-september 11 (2001) economy, Congress created a new concept called bonus depreciation. Retroactive to Sept.11, 2001,bonus depreciation allows an additional 30% first-year tax depreciation (before declaring regular MACRS) to a tax owner of qualified new equipment.the basis of the property and subsequent depreciation benefits are reduced to reflect this bonus. Bonus depre c i a t i o n u n d e r M ACRS re fers to a co n cept cre a ted by Co n g ress that is re t ro a ct i ve to Se p t. 11,2001.Be fo re this new tax prov i s i o n was enacte d, lessors thought bonus depreciation wo u l d help leasing. Now, in a down eco n o m y, it turns out that whether it act u a l ly is a benefit depends on the tax life of the asset. For property to qualify for the additional firstyear depreciation deduction,it must be property to which the general rules of MACRS apply with (1) an applicable recovery period of 20 years or less, (2) water utility pro p e rty, (3) cert a i n computer software, or (4) qualified leasehold improvement property (all as documented in d i f fe rent sections of the tax code), and the pro p e rty must be placed in service on or after Se p t.1 1, Prior to the enactment of this new tax prov i s i on, many lessors thought that bonus depreciation would help leasing. Unfortunately, feedback from the lessor community indicates that this may or may not be true, depending on the tax life of the asset.

3 In general,small-ticket and middle-market players are reporting no or little impact from the bonus depreciation,whereas large-ticket players a re re p o rting some positive impact in their pri c i n g. Ye t, m a ny large-ticket players are also sayi n g that their inability to syndicate the tax benefits hurts them. Figure 1 B O N U S D E P R E C I AT I O N A L LOWA N C E FOR 3-YEAR PRO PE RTY 3- Property Old Rules New Rules Difference % 53.33% 20.00% % 31.11% % % 10.37% -4.44% % 5.19% -2.22% % 20% % 30% % 40% % 20% % 30% % 40% % 20% % 30% % 40% % 20% % 30% % 40% Figure 2 B O N U S D E P R E C I AT I O N A L LOWA N C E FOR 5-YEAR PRO PE RTY 5- Property Old Rules New Rules Difference % 44.00% 24.00% % 22.40% -9.60% % 13.44% -5.76% % 8.06% -3.46% % 8.06% -3.46% % 4.03% -1.73% % 20% % 30% % 40% % 20% % 30% % 40% % 20% % 30% % 40% % 20% % 30% % 40% HOW DEP RE C I ATION CHANGED Before reviewing the results of an survey, let s first review how the depreciation numbers changed. For example, let s say a lessor has a $100,000 computer (5-year property).a corporate tax owner can deduct 30% in the first year before computing regular MACRS.Under the old rules,a tax owner could only declare 20% depreciation in first-year MACRS. Now, the tax owner gets 30%, or $30,000, plus 20% of $70,000 (the remaining basis) or 14%,for a total tax deduction of 44%. Figures 1 through 4 summarize the annual tax allowances for 3-,5-,7-, and 10-year property under the old rules (without bonus depreciation) and under the new rules (with bonus depreciation). Present value com p u t a t i ons have been perf o rm e d on each of the classes using different discount rates and different tax brackets. Let s look at the first line of the 5-year property present value (PV) benefit analysis.given a discount rate of 5%,a 20% tax bracket,and a Jan.1,2002,inception,the net present value (NPV) of the pretax tax savings would rise from cents per dollar to cents per doll a r for a net increase of.0047 cents per dollar. Now let s look at the last line of the 7-year pro p e rty PV benefit analysis.given a discount rate of 20%,a tax bracket of 40%,and a Jan.1,2002, inception,the NPV of the pretax savings would rise from cents per dollar to cents per dollar, for a net increase of cents per dollar. In fact,the pretax savings for a corporate tax owner can rise as high as cents per dollar on 10-year pro p e rty, and we can assume that eve n g reater savings would be generated on 15-ye a r and 20-year property. Granted,the potential savings vary based on the tax life of the asset, discount rates,and tax brackets.however, large- 3 6 J O U R N A L O F E Q U I P M E N T L E A S E F I N A N C I N G F A L L V O L. 2 0 / N O. 2

4 ticket lessors (who tend to finance longer-lived assets) and small-ticket and middle-market lessors (with large portfolios) should be able to reduce their pricing while maintaining yield targets. These results should surprise most lessors because, under normal circumstances,pv should drop as discount rates rise.however, because there is so much additional first-year depreciation,the PV actually rises as the cost of capital incre a s e s.( Note that to be totally accura t e, one should conduct after-tax analysis.) Lessor feedback indicates that while small-portfolio lessors say the law does not help them and encourages lessees to pay cash or borrow from a bank,large-portfolio lessors have been able to lower their prices.unfortunately, creditworthy lessees are demanding that lessors give up all of the newly acquired tax benefits,thus forcing yields to be driven down. On a bright note, many lessors indicated that bonus depreciation should create an explosion in leasing activity when the economy starts to turn around in the fourth quarter of 2002 and corporations actively seek to acquire more equipment in RES U LTS OF ONLINE SURV EY Has bonus depreciation helped, hurt,or done nothing to increase leasing activity? The author conducted an survey of lessors from Aug. 5-7,2002,and received 125 responses to this question. Figure 5 (next page) displays the results to the question. Only 28 of the respondents (22%) said that bonus depreciation helped.they said that the law helps cash purchases and loans/finance leases but discourages tax leasing. To win business, lessors have had to pass the bonus depreciation benefits through to the lessee in the form of lower rents, resulting in lower effective rates. Healthcare, aviation,and agriculture property w e re fre q u e n t ly mentioned as well as other 7-ye a r and 10-year property. Several respondents commented that amending prior year tax returns, Figure 3 B O N U S D E P R E C I AT I O N A L LOWA N C E FOR 7-YEAR PRO PE RTY 7- Property Old Rules New Rules Difference % 40.00% 25.71% % 17.14% -7.35% % 12.24% -5.25% % 8.74% -3.75% % 6.25% -2.68% % 6.24% -2.68% % 6.25% -2.68% % 3.12% -1.34% % 20% % 30% % 40% % 20% % 30% % 40% % 20% % 30% % 40% % 20% % 30% % 40% Figure 4 B O N U S D E P R E C I AT I O N A L LOWA N C E FOR 10-YEAR PRO PE RTY 10- Property Old Rules New Rules Difference % 37.00% 27.00% % 12.60% -5.40% % 10.08% -4.32% % 8.06% -3.46% % 6.45% -2.77% % 5.16% -2.21% % 4.59% -1.97% % 4.59% -1.98% % 4.59% -1.96% % 4.59% -1.97% % 2.30% -0.98% % 20% % 30% % 40% % 20% % 30% % 40% % 20% % 30% % 40% % 20% % 30% % 40% J O U R N A L O F E Q U I P M E N T L E A S E F I N A N C I N G F A L L V O L. 2 0 / N O

5 Many lessors believe that the economy has slowed down equipment financing needs and that surplus equipment and rental companies are competing heavily against new purchases. under the new net operating loss (NOL) ca r ryb a ck ru l e s,p rovided substantial gove rnment re f u n d s. In spite of the new rules favoring longer-lived assets,11 respondents (9%) said that the new law impedes syndication.respondents said that the new law does not provide a means for qualifying used equipment or equipment that had been ordered prior to September 11 and put into production in a later period. Some lessors responding to the online survey said they could not afford to pass all of the benefits to the lessee, while others said that CPAs are getting more involved and are advising lessees to buy or finance. Several also mentioned that T RAC (terminal rental adjustment clause) leasing (lessee wants depreciation) and synthetic leasing (in which the lessee does not want off-balance sheet treatment) were in jeopardy. The majority of the respondents,86 (69%) said that the new law did not do anything to stimu l a t e leasing activity. Many were from small-ticket and middle-market leasing companies financing 3-year and 5-year property. Many lessors believe that the economy has slowed down equipment financing needs and that surplus equipment and rental companies are competing heavily against new purchases. Accounting scandals have scarred off-balance sheet financing, and CFOs are demanding onbalance sheet with no footnote disclosures.in addition,low interest rates from banks and m a n u f a c t u re r - i n c e n t i ve pro g rams favor financing. CO N C LU S I O N Although bonus depreciation was highly anticipated by lessors,it appears to have collided with a bad economy. Early results indicate that 3-year and 5-year property have not generated new business for small-ticket and middle-market lessors.although 7-year and 10-year property have generated new business,large-ticket lessors are frustrated by the lack of a tax syndication market. Lessors should remember that the Job Creation and Worker Assistance Act of 2002 still has two years left to go. Perhaps additional analysis of its e f fect on bonus depre c i a t i on in 2003 and 2004 will lead to different conclusions.unfortunately, leasing companies may have to struggle until then. The author s biog raphy may be found on page 63. Figure 5 R E S U LTS O F B O N U S D E P R E C I AT I O N S U RV EY Hurt 8.8% Helped 22.4% Done Nothing 68.8% How Has Bonus Depreciation Affected Your Leasing Activities? Helped % Hurt % Done Nothing % Total J O U R N A L O F E Q U I P M E N T L E A S E F I N A N C I N G F A L L V O L. 2 0 / N O. 2