by Mr. Terry Winders, CLP
In addition to the new differences between accounting for leases and the income tax rules (IRS), there also will be differences between a lease for the Uniform Commercial Code (NYSEARCA:UCC) and the new accounting rules under proposed FASB changes. Leasing contracts will have to amend several of its “paragraphs.” The announcement of the changes perhaps will come as early as Tuesday effecting an estimated $1.2 trillion in leased assets.
In addition to accounting changes, it will also center around the legal requirements of what the lease contract must say to be considered a legal lease (Article 2A) versus a “disguised conditional sales contract” or “a lease for security purposes” (Article 9).
This is column is a synopsis. It is best to consult your attorney and accountant who have experience in equipment leasing and finance to discuss how the new changes will affect your leasing contract once they are expected to be announced this week as “adopted.”
It may be that “operating leases” or “true leases” will be for shorter time periods and/or more transactions will be “capital leases.” It certainly will result in major changes on the balance sheet and in sales presentations as well as tax consequences.
To find what the UCC defines as a legal lease (true lease) you must go to Article 1 General Definitions and go to Par.1-201 (37) to find the definition of a “security interest” and there you will find that a lease is an exception to a security interest. It begins:
"Whether a transaction creates a lease or security interest is determined by the facts of each case; however, a transaction creates a security interest if the consideration the lessee is to pay to the lessor for the right to possession and use of the goods is an obligation for the term of the lease not subject to termination by the lessee…”
This paragraph is interpreted as the requirement that a true lease must be non-cancelable for the lease term. This requirement is not found in income tax requirements or accounting rules. It is very important to understand this not only in the contract, but for the salesperson making the presentation to understand what he is actually presenting.
The additional requirements must be read in the “negative” because these are what make the lease a lease intended as a security and it will become an article 9 conditional sales contract:
The original term of the lease is equal to or greater than the remaining economic life of the goods (it is prudent to limit your lease term to 80% of the economic life to avoid this rule)
The lessee is bound to renew the lease for the remaining economic life of the goods or is bound to become the owner of the goods.
The lease has an option to become the owner of the goods for no additional consideration or nominal additional consideration upon compliance with the lease agreement, or
The lessee has an option to become the owner of the goods for no additional consideration or nominal additional consideration upon compliance with the lease agreement.
A transaction does not create a security interest merely because it provides that:
The present value of the consideration the lessee is obligated to pay the lessor for the right to possession and use of the goods is substantially equal to or is greater than the fair market value of the goods at the time the lease is entered into.
The lessee assumes risk of loss of the goods, or agrees to pay taxes, insurance, filing, recording, or registration fees, or service or maintenance costs with respect to the goods.
The lessee has an option to renew the lease or to become the owner of the goods.
The lessee has an option to renew the lease for a fixed rent that is equal to or greater than the reasonably predictable fair market rent for the use of the goods for the term of the renewal at the time the option is to be performed, or
The lessee has an option to become the owner of the goods for a fixed price that is equal to or greater than the reasonably predictable fair market value of the goods at the time the option is to be performed.
For purposes of this subsection (37):
(x) Additional consideration is not nominal if (i) when the option to renew the lease is granted to the lessee the rent is stated to be the fair market rent for the use of the goods for the term of the renewal determined at the time the option is to be performed, or (ii) when the option to become the owner of the goods is granted to the lessee the price stated to be the fair market value of the goods determined at the time the option is to be performed. Additional consideration is nominal if it is less than the lessee’s reasonably predictable cost of performing under the lease agreement if the option is not exercised.
(y) “Reasonably predictable” and “remaining economic life of the goods” are to be determined with reference to the facts and circumstances at the time the transaction is entered into; and
(z) “Present value” means the amount as of a date certain of one or more sums payable in the future, discounted to the date certain. The discount is determined by the interest rate specified by the parties if the rate is not manifestly unreasonable at the time the transaction is entered into: otherwise, the discount id determined by a commercially reasonable rate that takes into account the facts and circumstances of each case at the time the transaction was entered into.
In addition Article 2A creates two types of leases; two party leases and three party (finance leases):
A two party lease is a lease between the supplier of the goods and the user of the goods. In this type of lease the supplier becomes the lessor and is “responsible” for the equipments performance.
A three party lease called a finance lease has an equipment supplier (vendor), a lessor, and an equipment user (lessee).
In order for the lessor to eliminate the risk of equipment performance, the lessor must pass the warrantees and guarantees called the “supply contract” from the vendor to the lessee (after informing the vendor to this in a purchase order). In addition the lease must carry a quite enjoyment clause.
Failure of any or all of these rules places the lease under Article 9 and is considered a conditional sales contract requiring the filing of a UCC 1 lien statement to protect the lessor. In certain states, usury may be addressed, as well as the party(ies) involved are not licensed by the state where the lessee is located.
The legal rules are very different from tax or accounting and need to be followed and understood to prevail in a court of law!
Mr. Terry Winders, CLP, has been a teacher, consultant, expert witness for the leasing industry for thirty years and can be reached at email@example.com or 502-327-8666.
He invites your questions and queries.
Disclosure: no postion