Navigating the Tax Implications of ASC 842 for Lease Accounting

Practical Insights for Companies

The introduction of ASC 842 by the Financial Accounting Standards Board (FASB) has fundamentally changed how companies recognize leases on their financial statements. Where leases were previously divided into capital and operating leases—only capital leases appearing on the balance sheet—ASC 842 requires most leases to be recorded as both a right-of-use (ROU) asset and a corresponding liability. This shift has introduced significant tax implications, affecting deferred taxes, taxable income, and financial ratios, which can heavily influence business decisions.

Understanding these tax implications and their potential impact on cash flow, financing, and strategy is essential for companies adapting to ASC 842. Here’s a closer look at key areas affected by ASC 842, examples of these changes, and actionable steps to help mitigate the tax impacts effectively.

Deferred Tax Assets and Liabilities

Under ASC 842, companies record both ROU assets and lease liabilities, which creates new book-tax differences and results in deferred tax assets (DTAs) and deferred tax liabilities (DTLs).

Example

Suppose a retail company with numerous store leases previously recognized these leases as operating expenses on the income statement. Now, under ASC 842, the ROU assets and lease liabilities appear on the balance sheet, creating a temporary difference between the book value and tax basis of these assets and liabilities. This difference requires recalculating deferred tax positions each period.

Business Impact

New DTAs and DTLs can affect financial metrics like debt-to-equity ratio and return on assets (ROA). Higher deferred liabilities may make the company appear more leveraged, potentially impacting credit ratings and investor perception.

Action to Mitigate

To reduce the impact of increased deferred tax liabilities, companies might consider renegotiating lease terms to shorter durations or exploring purchase options for critical assets. This can limit long-term liabilities on the balance sheet and provide a more favorable tax profile.

Changes in Taxable Income Calculations

ASC 842 affects the timing and method of lease expense recognition. For book purposes, leases are recorded on a straight-line basis, which may differ from the cash-based deduction method used for tax purposes, creating discrepancies in taxable income.

Example

A manufacturing company leases equipment with fixed monthly payments. For financial reporting, the lease expense is recorded on a straight-line basis, but for tax purposes, only actual lease payments are deductible. This timing difference can result in temporary income discrepancies.

Business Impact

These differences may push a company into a higher effective tax rate or result in unexpected tax liabilities. Higher book-tax differences can complicate tax planning, especially for companies with significant lease portfolios.

Action to Mitigate

Companies might negotiate for leases with variable payments tied to revenue or production, which can help align lease expenses with cash flow. This strategy can also provide greater flexibility in taxable income management.

Impact on Lease Classification and Tax Treatment

While ASC 842 capitalizes most leases on the balance sheet, it does not affect IRS tax classifications. The resulting dual reporting requirements can increase administrative complexity.

Example

A company leases a fleet of delivery vehicles. For financial reporting, this lease is classified as a finance lease, requiring recognition of both depreciation and interest expense. For tax purposes, however, it might still be treated as a true lease, allowing deductions based on lease payments.

Business Impact

Book and tax treatment differences increase the burden of tracking leases, especially for companies with large portfolios, and may create unexpected tax variances.

Action to Mitigate

To simplify reporting, companies may opt for shorter lease terms or renegotiate lease structures to align more closely with tax rules. This approach can streamline dual reporting requirements and reduce volatility in tax treatment.

Interest Expense Deduction Limitation (Section 163(j))

The IRS limits the deductibility of interest expense under Section 163(j), capping deductions at 30% of adjusted taxable income. This impacts companies with high finance lease obligations.

Example

A tech company with finance leases on costly equipment incurs significant interest expenses, which are subject to the Section 163(j) limitation. This limits their ability to deduct the full interest amount.

Business Impact

Restricted interest deductions may lead to higher taxable income and increased tax liability, reducing the financial appeal of leasing versus purchasing assets outright.

Action to Mitigate

Companies can consider financing alternatives with lower interest components or shorter lease terms, which can help keep interest expenses within deductible limits and minimize tax liability.

State Tax Considerations

State tax rules vary in conformity to federal tax standards, introducing complexity for multi-state operations under ASC 842.

Example

A healthcare organization operates across several states, some of which do not fully conform to federal lease accounting rules. This requires adjustments in lease reporting and tax-deductible expenses in these states.

Business Impact

Higher lease liabilities and ROU assets may alter state tax calculations, potentially increasing state tax burdens for multi-state organizations.

Action to Mitigate

To optimize tax positions, companies may centralize leases in states with favorable tax treatment or adjust lease terms based on state-specific tax requirements. This can help minimize multi-state tax liabilities.

Tax Planning Opportunities and Strategic Adjustments

While ASC 842 introduces challenges, it also opens opportunities for strategic tax planning.

Example

A construction company leasing heavy machinery may benefit from reclassifying long-term leases to shorter terms or variable leases, reducing deferred tax liabilities and gaining greater flexibility.

Business Impact

Restructuring leases can improve cash flow, minimize tax exposure, and allow companies to take advantage of depreciation deductions instead of managing complex tax reporting requirements under ASC 842.

Action to Mitigate

Companies may consider purchasing critical assets to take advantage of depreciation or restructuring leases to optimize tax benefits. This approach can reduce deferred tax obligations and simplify tax reporting.

Considerations for International Operations

Multinational companies face added complexity managing lease accounting across jurisdictions, as each country’s tax laws differ.

Example

A global company with leased properties in multiple countries needs to reconcile ASC 842 with IFRS standards, impacting local tax filings and deferred tax positions.

Business Impact

International operations may face discrepancies in deferred tax treatment across jurisdictions, complicating tax compliance and reporting.

Action to Mitigate

Centralizing international lease management and developing streamlined internal policies can help multinational companies reconcile ASC 842 with varying jurisdictional standards.

Actionable Steps by Organizational Role

Each role within the organization has responsibilities to help manage ASC 842 tax implications:

Role of the CFO

The CFO should collaborate with tax and finance teams to assess ASC 842 impacts on tax and financial metrics. This includes overseeing tax-saving strategies, such as renegotiating lease terms or reclassifying leases.

Role of the Tax Manager

The Tax Manager plays a key role in updating tax provisions, recalculating deferred taxes, and coordinating with the accounting team to align tax reporting with ASC 842.

Role of the Controller

The Controller ensures proper classification and accounting of leases, collaborates with tax professionals, and documents book-tax differences for streamlined reporting.

Role of the IT Department

IT ensures accounting systems reflect ASC 842 requirements and enables data integration for accurate tax reporting.

In Summary

ASC 842 fundamentally changes lease accounting, introducing new tax implications that affect business decisions and strategy. Through careful planning and collaboration, companies can navigate ASC 842 effectively, leveraging tax-saving opportunities while maintaining compliance and optimizing tax benefits.

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