Tax Considerations for Energy Companies When Implementing New Lease Standards Under ASC 842
On February 25, 2016, FASB issued its new lease accounting standard update (ASU) No. 2016-02, Leases, which codified ASC Topic 842 (Topic 842). Topic 842 is effective for calendar year-end public companies on January 1, 2019. For most other entities, required implementation is delayed for a year until 2020.
Topic 842 will primarily affect all companies that lease, or sublease property, plant or equipment; minor changes were made to rules governing lessors. Under Topic 842, a lease with a term more than 12 months will result in a “gross-up” of the balance sheet for a right-of-use (“ROU”) asset and related lease liability.
Topic 842 defines a lease as “a contract, or part of a contract, that conveys the right to control the use of an identified asset for a period of time in exchange for consideration.” When determining whether a contract contains a lease under Topic 842, a company should assess whether (1) performance of the contract depends on the use of the asset and (2) the customer obtains the right to control the use of the identified asset for a particular period.
The scope of Topic 842 does not include leases to explore for or use minerals, oil, natural gas and other non-regenerative resources. However, Topic 842 could change the lease accounting for power purchase agreements, transportation and storage contracts, drilling rig commitments and rights of way ("ROW") and easements.
Topic 842’s effect to most lessees is that for historic “off-balance sheet” operating leases, a new ROU asset is recorded with a corresponding liability for the present value of the unpaid portion of the remaining lease obligation. Finance leases still exist for lessees as well.
ASC 740 Tax Accounting Impact
There is no change in U.S. federal income tax law regarding lease classification. Therefore, an entity will be required to record a deferred tax liability for the tax effect of the book carrying value of the ROU asset and a deferred tax asset for the tax effect of the related lease liability.
The reversal of the deferred tax asset or liability will depend on the timing of income statement recognition of the asset held by the lessee: a ROU asset for operating leases, and the asset itself for finance leases, and the interest expense element of the lease obligation. The tax effect of the difference is a required element of the change in accounting method required for book purposes.
Areas of Income/Franchise Taxation to Evaluate
In addition to the tax accounting impact under ASC 740 described above, companies should evaluate whether Topic 842 could impact the areas of taxation under state law or the laws of foreign jurisdictions.
- Foreign Taxes – Some foreign jurisdictions account for lease transactions for tax purposes in accordance with how such transactions are recorded on the company’s local or statutory books. Therefore, Topic 842, as well as the new lease accounting standard being implemented by the International Accounting Board under IFRS 16, may impact a company’s foreign tax liability.
- Foreign Earnings Repatriation – Certain foreign jurisdictions have minimum capital requirements and/or restrictions on dividend distributions. Additionally, certain jurisdictions impose branch profits taxes on after-tax earnings that are not reinvested. If certain foreign jurisdictions follow book treatment for GAAP or IFRS purposes and the gross-up of the balance sheet becomes relevant, then Topic 842 may impact decisions to repatriate or re-invest foreign earnings.
- Interest Deduction Limitations – With the requirement to record lease liabilities as an obligation on the balance sheet, a company’s debt-to-equity ratio will change, thereby potentially reducing interest expense deductions in certain jurisdictions that follow book treatment of lease liabilities. While the new business interest expense limitation under IRC §163(j) should not be impacted by Topic 842, companies should review interest expense deduction limitations imposed in certain non-US jurisdictions that are based on a percentage of EBITDA.
- Transfer Pricing – Under OECD guidelines, transactions between related parties are to be recorded at arm’s length. Topic 842 applies to related party leases based on enforceable terms and conditions rather than transfer pricing guidelines under IRC §482 or the laws of other foreign jurisdictions. Therefore, there may be a disconnect between the accounting for related party leases under Topic 842 and the transfer pricing methods being used.
- State Apportionment – For states that use property and rent expense factors to compute state apportionment factors, a company’s state tax liability may change upon implementation of Topic 842 if a state uses or chooses to adopt the book standard under Topic 842.
- State Franchise/Net Worth Taxes – Under some state tax jurisdictions certain adjustments are made to debt to compute a franchise/net worth tax. Companies should consider whether lease liabilities under Topic 842 are “debt” for purposes of a debt adjustment. Moreover, Topic 842 may impact a company’s franchise tax liability if such taxes are based on GAAP figures or ROU assets are being used in certain states.
Companies should try to proactively identify and plan around the above income/franchise tax issues that may arise upon implementation of Topic 842. Financial statement auditors and/or tax authorities may request companies to defend their positions on these issues. Companies may also need to locate and track data along with possibly reconfiguring financial systems to implement Topic 842 and file tax returns according to tax laws that are not consistent with Topic 842. While Topic 842 does not change the tax implications under U.S. federal tax law, it may impact state and foreign tax liabilities, depending on each jurisdiction’s use of GAAP/IFRs financial statements or statutory interpretations.
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About the Author
Jeff Borchers is a Managing Director with Opportune’s Tax Advisory practice in Houston. Jeff has over 20 years of tax, treasury, accounting and legal experience serving clients in various segments of the energy sector. He has extensive experience in partnership and corporate tax law, tax accounting and tax compliance. Prior to Opportune, Jeff was with KPMG where he led the firm’s Alternative Investments practice serving private equity firms and portfolio companies in all facets of taxation. Jeff also signed off on large public company tax provisions. Prior to KPMG, he served as Vice President – Tax/Assistant Treasurer at Willbros Group Inc. where he re-domiciled and restructured the company, reducing its overall effective tax rate, promoted tax compliance across all business units in multiple U.S. and international tax jurisdictions, settled U.S. and international tax disputes, participated in buy-side due diligence and managed Willbros’ cash and covenants under its credit facility during challenging times. Jeff holds a Bachelor of Science degree in Accounting from DePaul University and a Juris Doctor (J.D.) degree from the John Marshall Law School.