It’s no surprise that the long-awaited changes to lease accounting standards have caused quite the ruckus in recent years, particularly as businesses scramble to understand and implement the complex new rules. In addition to understanding the new rule’s impact on an operational level, it’s also important for businesses to prepare for the various tax implications that are likely to ensue.
Background of the New Lease Accounting Standard ASC 842
In a nutshell, the new lease accounting standards (formally referred to as ASC 842) require businesses to record all leases greater than one year on the balance sheet. This will require businesses to collect and analyze their lease agreements to identify leases and ultimately separate non-lease components from lease agreements.
Affecting virtually every industry in the United States, the increase in liabilities on the balance sheet will inherently change how those numbers are perceived and understood. Public companies were required to implement the new standard by December of 2018, while the changes go into effect for private companies beginning December 15, 2019.
Tax Implications of ASC 842
Here are seven of the major areas impacted by the new lease accounting standard:
1. Accounting Methods
There’s no question that the new standards will affect nearly every business’ accounting methods. Businesses may need to revisit certain aspects of their taxes, particularly with respect to characterization of leases, timing of income under IRC 467, treatment of tenant allowances, and treatment of lease acquisition costs.
2. Deferred Taxes
The new rules require operating leases to be recorded as right-of-use (ROU) assets with a corresponding lease liability, consequently grossing the balance sheet. This will result in additional recordkeeping to track book-to-tax items. Book and tax basis items need to be reconciled to ensure that deferred tax liability (DTL) and deferred tax assets (DTA) are recorded correctly. Note that this is a temporary difference that will reverse over the life of the lease term. Furthermore, valuation allowance may also need to be considered.
3. State and Local Taxes
Many states consider a company’s property when determining the amount of income tax to be allocated to the state. Because the new standard requires ROU assets related to operating leases to be recorded on the same line item as underlying assets, property factors (such as plants and equipment) may appear to be increased on a company’s balance sheet.
Ultimately, this will affect state apportionment for companies with activity in states that include property factors when calculating apportionment percentage. In addition, it will also affect state filings where a net worth-based tax is implemented.
4. Transfer Pricing
The new standard will affect companies with related party leasing arrangements, as transfer pricing arrangements may need to be revised to reflect the arm’s length standard. The arm’s length standard relies on financial ratios and profit level indicators, which may change when companies begin to record all leases on their statements of financial position.
5. Foreign Taxes
In addition to its effect on state and local income tax, the new standard will also impact foreign country income tax. The extent of the impact will depend on the particular tax jurisdiction and how income tax is calculated within that country.
6. Property Taxes
Depending on the tax jurisdiction, ROU assets may be considered tangible personal property and must therefore be included in property tax filings.
7. Sales and Use Tax
Going forward, companies must determine whether a state will treat a lease transaction as a taxable purchase.
ASC 842 will have a wide-sweeping impact on virtually every business, and it’s best to prepare for the changes as soon as possible. If you have questions about the new lease accounting standards, or want to learn more about the potential tax implications for your business, please get in touch with us.