Synthetic Lease

Ideally, a company should be able to find a financial instrument that would give it the tax benefits of ownership without the accounting burdens of ownership. Synthetic leases serve this purpose.

Accounting Component

Synthetic leases are designed under current accounting rules to achieve off-balance sheet treatment. When structured properly, neither the asset nor the liability appear on the lessee’s balance sheet and lease payments are classified as operating expenses. Return on assets (ROA), return on equity (ROE), interest-coverage ratios and leveraging ratios (debt to equity) are improved relative to the on-balance sheet alternative.

Synthetic transactions qualify for operating lease (off-balance sheet) status if they fail the following four accounting criteria:

1. The lease transfers ownership of the property at the end of the lease term.
2. The lease contains an option to purchase at a bargain price.
3. The non-cancelable lease term is equal to or greater than 75 percent of the estimated economic life of the property.
4. The present value of rents and other minimum lease payments equal or exceed 90 percent of the fair market value of the property.

Generally, the ownership transfer and bargain purchase criteria are structured to provide a fixed, market-rate purchase price at the end of the lease term. The non-cancelable lease term is structured so that the non-cancelable portion of the lease term is short-term.

Tax Component

Under a synthetic lease, the lessee retains the tax advantages of ownership. Because the transaction places significant benefits, burdens and control of ownership with the corporate user, the user is regarded as the tax owner of the property and is eligible for the accelerated depreciation and interest deductions contained in the lease payments.

Asset Appreciation

There are several factors to look at when deciding if synthetic leases would be right for your company, If you answer yes to any of these questions, a synthetic lease may be the solution.

• Does the value of the equipment appreciate?
• Is the cash that is tied up in the equipment preventing other departments from achieving their marketing goals and objectives?
• Will 100% financing allow you to grow your company faster and more cost-effectively?

Enhancing Cash Flow

Transaction economics are advantageous. In most cases, 100% financing is available, thus creating a structure with "all in" cost that may be substantially lower than traditional financing programs.

What Type of Assets Are Financed Using Synthetics?

The use of synthetic leases has become increasingly popular for equipment integrated into industrial buildings, corporate headquarters, hospitals, single-tenant offices, movie theaters, hotels, retail branches, call centers, and data centers.

Under a synthetic transaction, a capital source provides funding for the construction or acquisition of equipment to be utilized by and leased to a corporate user. If the equipment is purchased by the user upon the expiration of the lease, a predetermined purchase price is paid to the lessor.

Funding Options

There is more flexibility in financing using synthetic leases than traditional conventional methods. There are a number of funding sources available, including commercial paper on a floating-rate or fixed-rate basis through interest-rate swaps, private placement, bank debt or other funding sources.

Leases can be structured such that funds are provided on a drawn basis (usually with spreads over Bankers’ Acceptances), or an undrawn basis (where funds are raised in the commercial paper market by a major funding source using a funding conduit).

End of Term Options

In a typical synthetic transaction, the borrower would have two options at the expiration of the lease term: One is to purchase the property from the lessor (or owner) for the balance due. Because this amount cannot be a bargain purchase, an appraisal is required at the lease inception stating that the amount is not a bargain price. The other option is to sell the property on the last day of the lease term to a buyer unaffiliated with the borrower and guarantee the lessor any deficiency in the sale proceeds up to a specified amount (with any excess payable to the lessee).

Through a fixed price purchase option available at any time, clients may benefit from any appreciation in the underlying value of the leased asset(s) even though such assets are not owned for GAAP accounting purposes.

Alternately, clients have the right to "return" such leased assets at the lease maturity upon making a residual payment, assuming there is no event of default and certain return provisions have been satisfied.

Conclusions

Implementing synthetic leases has led to unique and bleeding-edge structures, which are highly influenced by accounting and tax rules.

Please consult a local professional accounting and tax advisor for guidance on these issues and others, including the structuring of special purpose entities and bankruptcy remote structures which may be challenged in a court of law.