Leasing IT Good for the Government, Too

Leasing IT Good for the Government, Too The commercial world has enjoyed the advantages of leasing information technology equipment for decades. So, why is the government holding back? BY MARK LEE Leasing information technology (IT) recently gained considerable media attention in the government technology and procurement world. Earlier this year, the U.S. General Services Administration (GSA) put a moratorium on leasing IT equipment through Federal Supply Schedule 70. GSA has since lifted the moratorium, with revised terms and conditions that are mutually advantageous to the government and Schedule 70 contract holders. For the government, leasing IT is now a viable and valuable procurement option. What is Leasing? According to Webster s Law Dictionary, leasing is defined as a contract by which an owner of property conveys exclusive possession, control, use, or enjoyment of it for a specified rent and a specified term after which the property reverts to the owner. 1 For practical purpose, leasing can be broken down into two types: a capital lease (lease to ownership) and an operating lease (lease with an option-to-own). In the commercial world, the Financial Accounting Standards Board classifies a lease as a capital lease if it meets one of these four criteria: (1) The lease transfers ownership of the property to the lessee by the end-of-the-lease term. (2) The lease contains an option to purchase the leased property at a bargain price. (3) The lease term is equal to or greater than 75 percent of the estimated life of the leased property. (4) The present value of rental and other minimum lease payments equals or exceeds 90 percent of the fair value of the leased property less any tax credit retained by the lessor. 2 Essentially, if a lease is not classified as a capital lease, then it is an operating 12 Contract Management / November 2002

lease, which is a lease of property and especially equipment for a term which is shorter than the property s useful life and in which the lessor is responsible for certain expenses (such as taxes). 3 From these definitions, one can see that leasing basically only has two classifications. The Commercial Leasing Environment Government contracting professionals and private industry representatives must understand how and why the commercial marketplace leases IT. Saves Money To begin, leasing IT equipment saves commercial companies money. 4 By leasing IT equipment, commercial companies can avoid expending money for the entire cost of the equipment up front. Instead, leasing allows the company to spread out its IT costs over the period of the lease and the equipment s economic life. Thus, leasing frees up cash flow. This additional cash then can be used to satisfy the company s other financial or procurement needs. Provides a Tax Break Leasing IT equipment also provides commercial firms with a federal tax break. Under the Internal Revenue Code, an IT firm that allows its equipment to be leased can take depreciation deductions as an equipment owner under the Modified Accelerated Cost Recovery System. 5 Section 162(a) (3) of the code states that the companies can take tax deductions for ordinary and necessary expenses, rentals or other payments required to be made as a conditions to continued use or possession, for the purposes of the trade or business, of property to which the taxpayer has not taken title or in which he has no equity. 6 This obviously reduces the IT vendor s overall federal tax burden. The tax code also allows a firm leasing IT equipment to expense the lease payment from its tax returns, which also lowers that company s taxable income. Saves Time An organization also can save time when leasing IT equipment. 7 The economic life of IT equipment is short and organizations often have to upgrade their technology to remain competitive in the commercial market. Purchasing new equipment, however, often requires disposing of the old equipment. Selling old IT equipment whose value is typically low eats up valuable organizational resources, and typically does not produce a substantial return on investment. By contrast, an organization that leases IT equipment can ship the equipment back to the leasor at the end of the lease period. Moore s law states that the number of transistors that can be built on the same piece of silicon will double every eighteen months 8 Not surprisingly, significant advances in technology are seen about every year and a half. Leasing IT equipment allows an organization to update its systems quicker and easier, and to keep up with Moore s Law. Relaxes Budget Constraints Leasing IT helps commercial companies avoid internal IT budget restraints. Often, major IT capital purchases in an organization require the approval of top management. However, payments for leased equipment can be treated as operating expenses instead of long-term capital purchases, thereby avoiding budget constraints (and management approval). 9 Leasing s Current Status In the United States, equipment leasing transactions covered by Article 2A of the Uniform Commercial Code (UCC) account for more than $260 billion a year. 10 This growth has spawned many new equipment leasing issues. The most recent development in IT commercial equipment leasing is smart goods, a term used to describe products with software embedded into them. Here are the legal questions that arise from the production of smart goods: (1) Are smart goods subject to Articles 2 and 2A, or is the software content outside the scope of UCC? (2) Can software developers embed software into a product without losing their intellectual property rights? 11 These are issues that the courts must resolve as the future of IT equipment leasing continues to grow. There also is a need for commercial organizations government sales personnel to become better educated about what their own company is buying and selling commercially. For example, employees in the IT Acquisition Center have found vendors listing lower commercial prices on their Web sites than what they offer to the government. Such discrepancies are likely caused by the vendor s lack of knowledge about their own firm s commercial prices. 12 In addition, most vendors that lease equipment to the government are aware of the benefits (e.g., the tax advantages). Government procurement professionals who are knowledgeable of these benefits will have a significant advantage when negotiating a leasing contract. Leasing Today IT leasing today receives mixed reviews as being a viable procurement option. However, in the past, leasing computer equipment was strongly frowned upon by the U.S. General Accounting Office (GAO). Between May 1982 and March 1984, GAO reviewed the government s computer leasing practices. GAO s review About the Author MARK LEE is a contract specialist in the GSA Federal Supply Services IT Acquisition Center in Arlington, Virginia. He is a member of the Washington, D.C., Chapter. This article is the opinion of the author and does not necessarily reflect the opinion of the General Services Administration (GSA). Send comments on this article to cm@ncmahq.org. November 2002 / Contract Management 13

L E A S I N G I T G O O D F O R T H E G O V E R N M E N T, T O O discovered that if alternative methods were employed on existing leasing arrangements, the government could have saved 25 to 70 percent on sampled leases. The report recommended that agencies examine cost-effective alternatives in their leasing arrangements, and incorporate a purchase mechanism into their leases. 13 Essentially, GAO recommended that agencies contract into capital leasing arrangements. IT leasing recently has taken off in the federal IT market. The GSA IT 70 Schedule has been leasing IT goods and services since 1997, and has generated about $351 million in sales since the inception of leasing on that schedule. 14 On April 5, GSA put a moratorium on leasing off the IT 70 Schedule, and eventually revised the terms and condition for its leasing contracts. GSA s revisions were prompted by agencies terminating their leasing arrangement by not exercising the option to fund subsequent years remaining on the lease. The revised terms and conditions include two options for leasing IT. 15 The first option is for the lease to expire at the end of the government fiscal year or planned expiration date, whichever is sooner. The second option contains a cancellation clause that allows agencies to cancel a lease, only if they do not have the funds available to continue the lease. These revised terms and conditions have proven to be mutually advantageous to GSA federal customers and schedule holders, and have helped highlight IT leasing as a viable option. Good for the Government When is leasing a good deal for the government? Basically, the same benefits that make leasing advantageous for the private sector make it beneficial for the government. There are a few considerations, however, due to the government s unique environment. For example, commercial organizations entering into a lease because they can be treated as an operating expense. In government, agencies enter into an operating lease because the source of funds comes from operation and maintenance rather than procurement. Nevertheless, despite leasing advantages, there still may be a bias on the part of government buyers toward purchasing as opposed to leasing. 16 The Rules for Leasing When deciding whether to lease or buy, federal buyers should consider FAR 7.4 (Equipment Lease or Purchase), Office of Management and Budget (OMB) Circular No. A-94 and OMB Circular No. A-11. FAR 7.401 specifically lists the acquisition considerations that federal buyers should consider when deciding between leasing and buying. 17 FAR 7.4 also gives additional guidance by stating, Agencies should not rule out the purchase method of equipment acquisition in favor of leasing merely because of the possibility that future technological advances might make the selected equipment less desirable. 18 Nevertheless, an argument can be made that the leasing IT products because of future technological advances may help the federal government more efficiently and effectively meet the its objectives, such as protecting homeland security and fighting the war on terrorism. The Federal Acquisition Regulation (FAR) also states that leasing with an option to purchase is preferable and long-term leasing should be avoided. 19 Finally, the FAR recommends that agencies request the assistance of GSA when looking to make a lease purchase decision. 20 When an agency is entering into a leasing arrangement with a schedule holder, the federal buyer should go to GSAAdvantage (www.gsaadvantage.gov) to find that schedule holder s contracting officer contact information. A call to the appropriate contracting officer can greatly assist the federal buyer in leasing off a schedule contract. When the value of lease exceeds $1 million, OMB Circular A-94: Guidelines and Discounts Rates for Benefit-Cost Analysis of Federal Programs may help government personnel fulfill the justification requirements for entering a lease. Paragraph 13 of the circular gives special guidance for lease purchase analysis and states three ways in which a federal buyer can justify capital leasing: (1) By conducting a separate leasepurchase analysis; (2) By conducting periodic lease-purchase analyses of recurrent decisions to similar assets used for the same purpose; and/or (3) By adopting a formal policy for smaller leases and submitting that policy to the OMB for approval. 21 Leasing off of a Schedule After conducting thorough market research and satisfying any legal requirements, a federal buyer can enter into a leasing arrangement with a federal supply schedule holder. Currently, there are 69 different vendors that offer leasing under the IT 70 Schedule, 45 have accepted the new leasing terms and conditions, and 24 are still in discussion. Their contracts are for five years, with three additional five-year options. A current list of those vendors that offer leasing can be created by using the database search function at http:/apps.fss.gsa.gov/it/itc. Since the contract periods are for five years and the prices are predetermined to be fair and reasonable, the government must reapportion the contract s interest rate risk. The government assumes the risk of interest rate increases. GSA has already negotiated the rate differential from the U.S. Treasury constant maturities. This narrows that vendor s price risk of rising interest rates when the ordering office places the order. Current U.S. Treasury constant maturities rates can be found at www.bog.frb.fed.us/. When the federal buyer places an order for a lease, the buyer must negotiate an initial price from the vendor schedule pricelist and the residual value of the product. Use the 14 Contract Management / November 2002

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L E A S I N G I T G O O D F O R T H E G O V E R N M E N T, T O O rate differential to compute the monthly payment. The preferable way of computing the monthly payment is to use spreadsheet software that contains a rate function. The federal buyer should receive quotes from at least three schedule holders before placing an order. In addition, in accordance with FAR 8.404 (b) (3), it is advantageous for the federal buyer to seek price reduction for the schedule prices if the order size is near the $500,000 maximum order threshold. 22 To maximize competition, federal buyers should solicit quotes from several vendors and then negotiate down from their schedule prices. In addition, if the lease is an operating lease, buyers must negotiate a residual value for the equipment. The higher the lease s residual value, the lower the lease payment. Therefore, buyers who attempt to negotiate a higher residual value must be able to justify why the product s value should be higher at the end of the lease. To determine prices for residual values, federal buyers should compare the prices of new equipment with the prices of used equipment also listed on the IT 70 Schedule. Currently, 37 vendors sell used equipment on the IT 70 Schedule. Don t Hold Back Since the procurement reforms of the 1990s, government contracting professionals are suppose to emulate the buying practices of the commercial sector. Unfortunately, leasing is a procurement option not often considered by government contracting professionals because of their limited leasing experience. Leasing does, however, provide government buyers opportunities to seize the same advantages available to the commercial sector. Simultaneously, private industry will benefit by entering into leasing arrangements with the government. Although skepticism still surrounds the government leasing IT equipment, it is a viable procurement option. The commercial world is not shy about entering into leasing arrangements when they are financially advantageous. Why, then, should the government hold back? CM Endnotes 1. Webster s Law Dictionary. 2. Financial Accounting Standards Board of the Financial Accounting Foundation, Accounting for Leases A, codification as of October 1, 1998, 11 (1998). 3. Merriam-Webster Dictionary of Law. 4. McWilliams, Gary. To Buy Or Not To Buy? Leasing may save you time, if not money. Business Week, November 13, 1997. 5. Contino, Richard M. Handbook of Equipment Leasing: A Deal Maker s Guide. 3 (2d ed., 1996). 6. 26 USC 163 (a) (3). 7. Ibid, p. 4. 8. Cringely, Robert X. Accidental Empires. Addison-Wesley Publishing Company, Inc. (1992). 9. Ibid, p. 5. 10. The Business Lawyer, Vol. 56, No. 4, 1775 (August 2001). 11. Ibid, p. 10. 12. Interview with Herman Caldwell, director of the mainframe/minicomputer equipment and software division of the IT Acquisition Center. 13. U.S. General Accounting Office, Effective Management of Computer Leases Needed to Reduce Government Costs, Washington, D.C.: GPO, 1985. 14. Dorobek, Christopher J. GSA Freezes IT Leasing: Talks Underway to Adjust Contract Terms. Federal Computer Week, 8 (April 2002) 6. 15. GSA Solicitation FCIS-JB-980001B. 16. Ibid, p.12. 17. FAR 7.401 (Acquisition Considerations): (a) Agencies should consider whether to lease or purchase equipment based on a case-by-case evaluation of comparative costs and other factors. The following factors are the minimum that should be considered: (1) Estimated length of the period the equipment is to be used and the extent of use within that period. (2) Financial and operating advantages of alternative types and makes of equipment. (3) Cumulative rental payments for the estimated period of use. (4) Net purchase price. (5) Transportation and installation costs. (6) Maintenance and other service costs. (7) Potential obsolescence of the equipment because of imminent technological improvements. (b) The following additional factors should be considered, as appropriate, depending on the type, cost, complexity, and estimated period of use of the equipment: (1) Availability of purchase options. (2) Potential for use of the equipment by other agencies after its use by the acquiring agency is ended. (3) Trade-in or salvage value. (4) Imputed interest. (5) Availability of a servicing capability, especially for highly complex equipment; e.g., can the equipment be serviced by the government or other sources if it is purchased? 18. FAR 7.402. 19. Ibid. 20. FAR 7.403. 21. OMB Circular A-94: Guidelines and Discount Rates for Benefit-Cost Analysis of Federal Programs. 22. FAR 8.404. 16 Contract Management / November 2002