By Shawn Halladay

Capitol Hill

Captive and vendor lessors are facing their share of non-market challenges these days, what with the new revenue recognition and embedded lease requirements.  Now we can add the specter of tax reform to that list, as several of the proposals impact vendor leasing programs in ways unique to that space.

Whereas, applying the new accounting standards on revenue recognition (ASC 606) and leases (ASC 842) represent operational challenges, the impact of tax reform is primarily economic, in that it affects vendor ROEs and eliminates a current competitive advantage.  This post will provide insights into how the unique tax benefits that captive and vendor lessors utilize may be affected by tax reform.

Gross profit tax deferral

The gross profit tax deferral, or GPTD, is a tax benefit that is available to manufacturers and vendors that use tax leasing to help sell their products.  Under current IRS rules, the GPTD allows such an entity to defer the taxes it normally would pay on an equipment sale if it leases that equipment to the buyer under a tax lease structure.  As an added bonus, even though the sales profit is deferred for tax purposes, the profit may be recognized immediately for book purposes in some cases.

When a manufacturer sells equipment to a third party, it pays taxes on the gross profit from the sale.  These taxes are paid at the time of the sale (effectively, on day one).  If, however, the manufacturer sells equipment to its captive, and the captive writes a tax lease on the equipment, the taxes on the sale are deferred over the MACRS life of the leased equipment in the same proportion as the MACRS deductions.

The same result occurs if a vendor writes a tax lease and discounts the stream to a funding partner.  The present value of the timing differences of when taxes are paid represents either additional lessor profit or a reduction in the lease payment.  In today’s market, the GPTD is worth roughly five basis points for each point of gross margin (each expressed as a percentage of equipment fair value).

GPTD and tax reform

As can be inferred from the previous paragraphs, the value of the GPTD is a function of both the tax rate and the MACRS life.  As such, this captive tax benefit will be affected by the following elements of the latest proposal:

  • Lower the corporate tax rate from the current rate of 35% to a flat rate of 15%
  • Allow businesses to write off 100% of the cost of investments in equipment on day one

Unfortunately, these two provisions work at cross-purposes to each other when it comes to the GPTD.  For instance, the longer the MACRS life, the greater the value of the GPTD becomes.  The same concept applies to the tax rate component – the higher the tax rate the greater the value of the GPTD.  The proposed provision to write off 100% of the cost of investments in leased equipment on day one severely limits the GPTD benefit.  The reduced tax rate, on the other hand, means that the total amount of taxes paid on the sale will be reduced, which is a benefit that goes beyond any timing difference benefits.

The interplay between these two elements of the GPTD can be seen in the following tables, which assume (1) a 25% gross margin (as a percent of equipment cost) and (2) a lease of 5-year MACRS property that is held for its full life.  The first table illustrates the value of the GPTD under current law.

Value of the GPTD – current law

(present value of taxes paid, as a percentage of equipment FMV)

Without GPTD With GPTD Benefit
8.75% 7.46% 1.29%

The second table shows the changes in the present value of taxes paid under the tax reform proposals, along with a quantification of the attributes that caused the change.

GPTD Comparison

(present value of taxes paid, as a percentage of equipment FMV)

Current Proposed Total change Tax rate impact 100% write-off impact
7.46% 3.54% 3.92% 4.72% (.79%)

The good news in this analysis is that taxes paid have gone down in total.  This result is misleading, however, as the reduced taxes apply across the board for all lessors.  A true comparison between the status quo and the proposed tax changes requires us to parse the change into its relevant elements.  By ignoring the benefit of the reduced tax rate (a rising tide lifts all boats) it is clear that the proposal to write off 100% of the cost of equipment on day one is unfavorable vis a vis the GPTD benefit.

Again, as with net interest deductibility, it can be seen that the current tax reform proposals will create competitive imbalances between lessor business models.  This time it is at the expense of captives and vendor programs.  Who’s up next?

Shawn Halladay is managing director of The Alta Group’s Professional Development Practice. His email is shalladay@thealtagroup.com.