Lease Accounting: Gather your data now and understand tax implications. Tuesday, December 5, 2017

Lease Accounting: Gather your data now and understand tax implications Tuesday, December 5, 2017

Presenters Chris Stephenson Principal, Business Consulting & Technology chris.stephenson@us.gt.com Rebekah Feather Managing Director, Strategic Federal Tax Services rebekah.feather@us.gt.com Grant Thornton LLP. All rights reserved. 2

Learning objectives Identify key challenges and roadblocks for collecting lease data Express the benefits of creating a centralized data repository Analyze the impact of the leasing standard on the tax department Summarize the book and tax differences that require further consideration Discuss the pitfalls of not involving your organization s tax department early in the process Grant Thornton LLP. All rights reserved. 3

Overview of new FASB Standard for leases What is the impact to companies? $1.25 trillion in off balance sheet lease obligations Based on 2005 estimates of SEC registrants Assuming Tax rate of 40% on 2005 SEC numbers Leads to $500 billion in possible deferred tax assets/liabilities Financial statement ratios and taxes paid may see big change Policies, processes, controls, and system capabilities will need to adjust accordingly

Four pillar lease accounting approach Identify Categorize Measure Maintain Collect lease data for identified and unidentified leases Validate data collection Embedded leases Define process for identifying future leases Design policy to support lease collection process Identification of resulting tax differences Determine categories of in scope leases Identify leases vs. services criteria Define policy for in scope leases Provide guidance for future lease negotiation Determine data needed for calculation Draft disclosures and identify relevant data Document assumptions required for calculation Update policy for calculation assumptions Assurance on proper calculations during shift to 842 Assist with software selection for lease management Build a lease repository Modify processes to incorporate lease software Project impact on B/S, ratios, debt covenants Provide lease management service Transformational Ongoing Management Grant Thornton LLP. All rights reserved. 5

Pillar 1: Identifying leases Identifying and centralizing all current and relevant lease information 1 Design a future state process to identify leases at time of contract Design policies and procedures to ensure best effort of lease identification is followed

Capturing Lease Data key themes** LEASE ADMINISTRATION DATA: 1. Lease identifiers and key lease information (dates, terms, etc.) 2. Asset identification, type, description, locations 3. Asset details as applicable including rental details (square footage, other measurement criteria) 4. Master Lease information and related schedules FINANCING INFORMATION: 1. Payment information (e.g., fixed vs. variable) 2. Interest rates as stated in the leasing documentation 3. Any purchase or termination options 4. Residual guarantees 5. Other payments including up front, lease concessions, penalties) CLASSIFICATION DATA: 1.Asset economic life assumptions & related lease terms 2.Asset fair value and present values 3.Answers to criteria to determine financing vs. operating: Transfer of ownership Purchase option Present value of lease terms Life of lease compared to economic life of asset Specialized nature of asset such that there is no alternative use OTHER DATA POINTS: 1. Tax classification data including related party information, tax exempt entity status, sale-leaseback treatment, residual values or contingent rents, options or lender guarantees. 2. Any other fields required by tax organization to determine/calculate any book vs. tax differences **Note: Above data points are meant to describe key data elements that should be gathered from leases for purposes of determining ASC 842 impact. Additional data elements may be required based on individual company circumstances or system requirements. Grant Thornton Proprietary not intended for further distribution

Big impact throughout your organization Primary functions affected Finance Financial planning & analysis Tax IT (identifying technology solutions) Functions that will feel the change IT (for leases initiated through IT) Facilities/real estate Operating entities Procurement Legal (contracts)

New process challenges for managing leases Gathering data from decentralized sources Inconsistent lease accounting processes Lack of common structure in lease documents Catching all leases before they get into payment system (need policy and process) Inadequate systems to do the job Managing lease renegotiations

6 tax issues CFOs should understand Deferred tax considerations finance and operating leases effect on the balance sheet State income tax apportionment property factor rent expense Franchise, net worth and similar taxes adjustments for debt Personal property and real estate taxes right-of-use assets lease agreement terms Sales and use taxes rentals of tangible personal property and real property streamlined sales and use tax agreement Interest expense considerations debt-to-equity ratio violations and limitations

Common book/tax differences for leasing Most aspects of leases have book/tax differences, including: Acquisition costs Tenant improvements Lease classification Lease income/deduction Lease termination payments 2017 Grant Thornton LLP All rights reserved U.S. member firm of Grant Thornton International Ltd 11

Acquisition costs tax treatment Must capitalize costs that facilitate the lease (i.e. legal fees, brokers fees). See Treas. Reg. 1.263(a)-4(d)(6) & (e) Exception for de minimis costs (<$5,000) and employee compensation. Capitalized costs are recovered over the life of the lease. See Treas. Reg. 1.167(a)-3 Must capitalize costs that facilitate the lease (i.e. legal fees, brokers fees). See Treas. Reg. 1.263(a)-4(d)(6) & (e) Exception for de minimis costs ($5,000) and employee compensation Capitalized costs are recovered over the life of the lease. See Treas. Reg. 1.167(a)-3; Rev. Rul. 70-408; Rev. Rul. 73-421 For the tenant For the landlord 2017 Grant Thornton LLP All rights reserved U.S. member firm of Grant Thornton International Ltd 12

Book initial direct costs ASC 842 Incremental costs of a lease that would not have been incurred if the lease had not been obtained Broker commissions Legal costs for structuring transaction 2017 Grant Thornton LLP All rights reserved U.S. member firm of Grant Thornton International Ltd 13

Acquisition cost book vs. tax ASC 842 Cost to negotiate or arrange a lease that would have been incurred regardless of whether the lease was obtained are not initial direct costs allocated to the lease. The costs for legal advice is not capitalized. Do not capitalize $7,000 Tax Treas. Reg. 1.263(a)-4(e) provides that costs that facilitate the acquisition of an intangible (the lease) must be capitalized. See Treas. Reg. 1.263(a)-4(e) and 1.167(a)-3. The cost facilitate the acquisition of the lease is capitalized and amortized over the term of the lease. Capitalize $7,000 2017 Grant Thornton LLP All rights reserved U.S. member firm of Grant Thornton International Ltd 14

Tenant improvement allowances: what's at stake Unless excludable from income, payments received in connection with entering into a lease are taxable as ordinary income upfront. Leasehold improvements must be depreciated over the MACRS recovery period but the tenant may deduct its remaining unrecovered improvement costs in full at the end of the lease. 27.5 years for residential real property or 39 years for nonresidential real property, unless eligible for 15 years (e.g. QLIP, QRP, or QRIP) Consideration paid to induce a tenant to enter into a lease may be amortized over the lease term. See Treas. Reg. 1.263(a)-4(d)(6) and 1.167(a)-3. Consideration paid for construction of improvements owned by the landlord must be depreciated over the MACRS recovery period over 39 years (27.5 for residential real property or 15 for QLIP, QRP, QRIP) Unrecovered costs of leasehold improvements that are "abandoned" when the lease ends may be deducted by the landlord under Section 168(i)(8)(B). For the tenant For the landlord 2017 Grant Thornton LLP All rights reserved U.S. member firm of Grant Thornton International Ltd 15

ASU 842 ASU 842 - "Lease Incentive" Must determine who owns improvements constructed with tenant allowance, but don't necessarily use the same factors as tax Generally, inducement is amortized over the life of the lease and ends up reducing the amount of rent Build to suit arrangements might be subject to sale-leaseback rules 2017 Grant Thornton LLP All rights reserved U.S. member firm of Grant Thornton International Ltd 16

Rents in general Section 162(a)(3) allows a deduction for rentals. See also, Section 212(1), which allows tenant to deduct rent as an expense of producing income. Section 461 accrual-basis taxpayers deduct rental payments as the property is used under economic performance. See Treas. Reg. 1.461-4(d)(3). Section 467 special rules that generally require the deduction to follow the payment schedule, if the agreement is subject to Section 467. For the tenant Section 61 gross income includes rents. Advance rentals are includible when received. Treas. Reg. 1.61-8(b). Section 451 Rental payments constitute gross income in the year received or accrued. See Treas. Reg. 1.451-1(a). Section 467 special rules that generally require the revenue to follow the payment schedule, if the agreement is subject to Section 467. For the landlord 2017 Grant Thornton LLP All rights reserved U.S. member firm of Grant Thornton International Ltd 17

Additional rents GAAP ASC 842 Common area maintenance (ASC 842-10-55-144 & 842-20-40-2) If common area maintenance is covered by a lessee's rental payments, then the lessee is receiving a service from the lessor. The lessee's payment under the lease will be allocated between the lease and the service. Lessee: the non-lease components may be accounted for as executory arrangements by lessees (customers), i.e. under the general rules for expenses under GAAP. Lessor: the service income to the lessor will be analyzed under ASC 606. 2017 Grant Thornton LLP All rights reserved U.S. member firm of Grant Thornton International Ltd 18

Section 467 What is a Section 467 rental agreement? Very common! & Increasing or decreasing rent & Deferred or prepaid rent Not very common! Not what you think! 2017 Grant Thornton LLP All rights reserved U.S. member firm of Grant Thornton International Ltd 19

ASC 842 GAAP Payments made by lessee For most operating leases, a lessee will recognize rental expense in a similar pattern to that prescribed under ASC 840. In other words, rental expense will be recognized on a straight-line basis over the lease term, unless another systematic and rational approach better represents the pattern in which the Lessee expects to derive benefits from its right to use the leased asset. For finance leases, a lessee will recognize rental expense in a similar manner to capital leases under ASC 840. Therefore, a lessee will recognize interest expense based on either the interest rate implicit in the lease, its incremental borrowing rate, or the risk free rate if applicable, and amortize the ROU asset over the shorter of its useful life or the lease term. This generally results in a front-loaded expense recognition pattern. 2017 Grant Thornton LLP All rights reserved U.S. member firm of Grant Thornton International Ltd 20

Book/tax differences Rent payments (both landlord and tenant) It's a red flag if there is no book/tax difference Typically, should be a difference unless payments are made ratably over the term of the contract and book deduction is equal to cash payments. We just learned that book generally does straight-line for an operating lease, so there should be a book/tax difference for a Section 467 lease. 2017 Grant Thornton LLP All rights reserved U.S. member firm of Grant Thornton International Ltd 21

Termination payments lessee Payments made by lessee A lessee of real or tangible property generally is not required to capitalize amounts paid to terminate a lease, unless: the lessee enters into a new agreement with the same landlord, the lessee could not cancel the terminated agreement without the agreement of the landlord, and the landlord would not have consented to the cancellation unless the taxpayer entered into the new agreement. Treas. Reg. 1.263(a)-4(d)(6)(iii). What happens if the lessee purchases the property it is leasing? 2017 Grant Thornton LLP All rights reserved U.S. member firm of Grant Thornton International Ltd 22

Termination payments lessor Payments made by lessor A lessor of real or tangible property must capitalize amounts paid to terminate a lease. Treas. Reg. 1.263(a)-4(d)(7)(i)(A). Example: an owner of an office building must capitalize a payment to a tenant to terminate the tenant's lease. If the lease is terminated to renegotiate the lease with the same lessee, the amounts are capitalized as part of the lease acquisition costs of the new lease. Treas. Reg. 1.263(a)-4(d)(6)(iii). 2017 Grant Thornton LLP All rights reserved U.S. member firm of Grant Thornton International Ltd 23

Termination payments lessor Payments received by lessor "Amounts received by a lessor from a lessee for canceling a lease constitutes gross income for the year in which it is received, since it is essentially a substitute for rental payments. Treas. Reg. 1.61-8(b). 2017 Grant Thornton LLP All rights reserved U.S. member firm of Grant Thornton International Ltd 24

Termination payments lessee ASC 842 ASC 82-20-40-1 General lease termination A termination of a lease before the expiration of the lease term shall be accounted for by the lessee by removing the right-of-use asset and the lease liability, with profit or loss recognized for the difference. The lessor is required to derecognize any deferred rent liability or accrued rent asset and adjust the selling profit or loss accordingly. ASC 82-20-40-2 Purchase of the underlying asset If the lessee purchases the underlying asset, any difference between the purchase price and the carrying amount of the lease liability immediately before the purchase is recorded by the lessee as an adjustment of the carrying amount of the asset (not apply to business combinations). 2017 Grant Thornton LLP All rights reserved U.S. member firm of Grant Thornton International Ltd 25

Learn More: 1 2 Find out how lease data can open new opportunities for your business in New lease accounting: Mitigate risks, tap opportunities Visit An integrated approach to lease accounting for more information about issues and solutions. 3 See Lease accounting changes: Frequently asked questions to read about implications for U.S. leases. 4 For audit-focused tips see, Audit committee spotlight: Getting ready for lease accounting changes Grant Thornton LLP. All rights reserved. 26

Presenters Chris Stephenson Principal, Business Consulting & Technology chris.stephenson@us.gt.com Rebekah Feather Managing Director, Strategic Federal Tax Services rebekah.feather@us.gt.com Grant Thornton LLP. All rights reserved. 27

Disclaimer This Grant Thornton LLP presentation is not a comprehensive analysis of the subject matters covered and may include proposed guidance that is subject to change before it is issued in final form. All relevant facts and circumstances, including the pertinent authoritative literature, need to be considered to arrive at conclusions that comply with matters addressed in this presentation. The views and interpretations expressed in the presentation are those of the presenters and the presentation is not intended to provide accounting or other advice or guidance with respect to the matters covered For additional information on matters covered in this presentation, contact your Grant Thornton LLP adviser

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