As companies begin to go live with the newly-implemented ASC 842 lease accounting standards, it’s a good time to reflect on some of the lessons learned and prepare to scale for private company adoptions. Let’s consider a few assumptions to evaluate the tax implications –
- Most companies have evaluated and will select a lease accounting software to assist with maintaining details of each lease and automate lease accounting journal entries (right-of-use asset, interest expense, rent expense, lease liability, etc.)
- Basic functionality for Day 1 reporting has been enabled in the software, however, suites of additional features and functionality are built-in that can be enabled for Day 2+ reporting
- Tax law regarding classification and treatment of leases has not changed, as ASC 842 is a financial statement accounting standard.
So, what can we take away to prioritize in an ASC 842 adoption for privately-held middle market companies?
Recordkeeping and tracking
The primary impact will be additional recordkeeping to track newly-created book-to-tax items generated by the creation of right-of-use assets and lease liabilities related to operating-type leases. For corporations, the data extraction process will be essential as the new GAAP entries will need to be identified and incorporated into the quarterly and annual tax provision process. For pass-through entities, a similar tracking needs to take place, but purely for tax estimate, extension, and annual tax filing requirements. The utilization of lease accounting software should not matter, so long as the new GAAP entries are identified and tracked. However, if the software is implemented, some of the Day 2 reporting implementation could involve activating features to export and automate these entries directly into a tax provision or tax preparation software.
A common pain point in tracking the new book-to-tax differences may result from tax and GAAP differing on the classification of a lease. Generally, entities account for finance-type (i.e. “capital”) leases in a fixed asset ledger, while the capitalization of operating leases under 842 is tracked in lease accounting software or a lease tracking schedule. If tax takes an alternative treatment, the underlying reconciliation of book-to-tax basis and expense could be burdensome. This is where value is derived from utilizing technology as a tool – many lease accounting software solutions have the functionality to track the same item under different methods. Therefore, companies can essentially create a duplicate asset or entry to show a differing tax treatment within their software solution set, thereby automating the reconciliation from book to tax.
Tracking of the new GAAP entries is also essential for taxpayers that may be impacted or limited by the new interest expense limitations in section 163(j). Generally, interest expense on a new right-of-use asset will not be considered indebtedness for purposes of section 163(j) and can generally be excluded from the limitation calculation.
Businesses that rely on book classification of leases to determine items such as sale & use tax, value-added tax, or personal property tax must consider the downstream implications of changes in lease classification for GAAP, including the identification of embedded lease components. This could result in changes to whether sales & use tax is assessed/withheld and how much to withhold. Also, since GAAP and tax lease classification may (or need) to differ, taxpayers can review lease classification on rent-to-own agreements, sale, or financing transactions to minimize personal property taxes due – potentially creating permanent tax savings.
Further, for state income tax apportionment where property factors or rent factors are utilized, taxpayers must consider how the movement from a finance-type lease to an operating-type lease (or vice versa) impacts allocable income between states as apportionment factors may change.
While tax standards regarding leasing are not changing, the review of a company’s leasing policies is relevant for tax throughout an ASC 842 adoption. At a minimum, processes will need to be created to track new book-tax differences, historical tax compliance considerations could arise, and downstream areas of indirect taxation could be impacted. Taxpayers should consider minimum compliance and value‑add consulting to navigate these regulatory changes, coupled with potential tax accounting methods and technology tools to effectuate change.