Chapter 4 Institutionalizing Customer Engagement at the Urban Bottom of the Pyramid in India: Research Insights – Getting the Best Equipment Lease Deal

CHAPTER 4

Equipment Tax Attributes for Certain Leases

Introduction

A lessor’s ability to write off, depreciate, the cost of the leased equipment can be a key income component in the profitability of an equipment lease transaction. Prior to 1986, another important equipment ownership tax benefit was available, a 10 percent equipment investment tax credit (ITC), eliminated completely by the 1986 Tax Reform Act (TRA), except for certain transition property. In recent years, however, an investment tax credit (ITC) up to 30 percent became available for limited types of equipment, such as wind and solar equipment, as well as fuel cells, often referred to as energy tax credits, which will at the time of this writing generally begin to wind down starting in 2020. The ITC does not merely reduce taxable income, but rather offsets, dollar-for-dollar, the equipment owner’s federal income tax liability. So, a basic understanding of the applicable equipment ownership tax benefits is necessary to properly assess any tax indemnification provisions that your company as a lessee is obligated for under any lease. As a lessee, your company’s equipment lease payments will be a tax-deductible expense for income tax purposes.

In the case of a conditional sale agreement or other equipment loan-type financing contract, the aforementioned equipment ownership tax benefits are available only to your company as the obligor of the financing transaction, because in those situations, your company is deemed, for tax purposes, to, be the equipment owner.

Investment Tax Credit: An Overview

Because an equipment investment tax credit, at the time of this writing, is not a generally available tax benefit except as stated earlier, a detailed discussion of how tax credits work is beyond the scope of this book. However, in the government’s on-again, off-again pursuit of economic stimulus, because it is still possible that some form of general equipment tax credit, beyond the current available energy tax credits, will again reappear, a brief explanation is of use.

Basically, the purpose of tax credits is to encourage investment in new equipment to stimulate economic growth. The tax writers also used them to encourage the growth, development, and stabilization of a business area that the federal government seeks to promote, such as in the energy area.

An investment tax credit permits an equipment owner to offset their federal income tax liability by an amount equal to a specified percentage of the cost (technically, basis) of equipment acquired and placed in service in a tax year. Thus, for example, a taxpayer, including an equipment lessor, buying energy equipment in 2019 that cost one million U.S. dollars for which a 30 percent ITC is available could reduce its federal income tax liability by an amount equal to 300,000 U.S. dollars (30% × $1 million = $300,000) for 2019. It should be kept in mind that a lessor is only entitled to claim the equipment ownership tax benefits, such as the energy-related tax credits and available depreciation, for equipment under lease if the lease qualifies as a true lease for federal income tax purposes, discussed in Chapter 5.

Equipment Depreciation: An Overview

Assets owned, for example, by a leasing and financing company can be depreciated under rules stated in the Modified Accelerated Cost Recovery System (MACRS) in Section 168 of the 1986 TRA. Basically, depreciation allows the equipment owner to recoup their equipment investment over time, the depreciation period, and is an income tax deduction that the equipment owner can use to offset, as an expense, its gross taxable income.

Under MACRS, there are three depreciation methods, six recovery periods, and two averaging conventions that apply to equipment, depending on a variety of factors.

Property Eligible for MACRS

Besides meeting the MACRS requirements, to be depreciable, equipment must qualify under Internal Revenue Code (IRC) Section 167(a). Section 167 establishes the basic rule authorizing an equipment owner to a deduction, in computing federal income tax liability, for the exhaustion, wear and tear of property used in a trade or business or held for the production of income. All depreciation deductions under MACRS must fulfill the stated threshold requirements, that is, the property must be depreciable (subject to wearing out) and must be used in a business or income producing activity.

Generally, property qualifying under Section 167(a) may be depreciated under MACRS. Intangible property, property classified as public utility property (unless the taxpayer uses a normalization method of accounting), certain property that a lessor has elected to apply a depreciation method not expressed in terms of years (such as the unit of production method), motion picture films, video tapes, and sound recordings (such as music tapes), and property covered by MACRS anti-churning or transition rules are not eligible for MACRS depreciation. Additionally, certain other property must be depreciated under an alternative MACRS method, described later in this chapter.

How Are the MACRS Deductions Computed?

Four steps determine the annual MACRS depreciation deduction amount for any equipment. First, the total amount (basis) to be depreciated is determined; next, the applicable MACRS recovery class is selected; third, the appropriate depreciation method is applied; and, fourth, the applicable convention is incorporated.

Total Amount To Be Depreciated

The total amount an equipment owner can write off, and thus the annual deduction amount, depends on the owner’s basis in the equipment. For MACRS purposes, basis is determined under general IRC rules for determining the gain or loss on the sale or other disposition of an asset and includes not only what the equipment owner paid for the equipment, but also the costs incurred in acquiring the equipment. However, an equipment owner must reduce the basis so calculated by any amount expensed under Section 179, discussed in the Expensing section following, by any amount claimed as a first-year bonus depreciation and, if a tax credit is available and claimed, such as an energy tax credit, to account for that credit. There is, however, no reduction for equipment salvage value.

MACRS Recovery Classes

The MACRS recovery class determines the period over which depreciation deductions can be taken. So, the equipment owner must determine if the equipment falls within the IRS stated 3-Year Property Class, 5-Year Property Class, 7-Year Property Class, 10-Year Property Class, 15-Year Property Class or 20-Year Property Class. For example, cars, light and heavy general-purpose trucks, computer and peripheral equipment, trailers and trailer-mounted containers are examples of types of equipment that come within the 5-year property class.

Depreciation Methods

Under MACRS, an equipment owner recovers the equipment’s cost over the number of years in the recovery class plus one; for example, three-year property yields deductions over a four-year period. For equipment in the 3-, 5-, 7-, or 10-year class, a lessor generally uses the 200 percent declining balance method of depreciation, discussed as follows, with a switch to straight-line depreciation at the time that maximizes the deduction, taking into account the half-year or mid-quarter convention, also discussed next. For property in the 15- and 20-year classes, a lessor generally uses the 150 percent declining balance method with a switch to the straight-line method at a time that maximizes the deduction, considering the half-year or mid-quarter convention. Instead of the applicable declining balance method, a straight-line or alternative method of depreciation may be elected, discussed as follows.

Under the declining balance method, the equipment owner calculates the depreciation deduction for any year by multiplying the asset’s basis, reduced by any prior years’ depreciation deductions, by the declining balance rate, and then multiplying it by the percent available each year. Thus, for example, for an asset with a 100 U.S. dollar basis and a five-year recovery period, using the 200 percent declining balance method, the first year’s depreciation is 40 U.S. dollars (ignoring the averaging conventions):


$100 basis × 2 × 20% = $40

For the second year, the MACRS deduction would be 24 U.S. dollars:

$100 basis – $40 first-year deduction = $60

$60 × 2 × 20% = $24


And so on, for three more years.

At the point when the declining balance method yields smaller deductions than straight line, the method switches to straight line. The 200 percent balance method resulted in more accelerated deductions than had been available under earlier depreciation rules. The IRS has calculated and published, in Revenue Procedure 87–57 [IRB 1987–42], the appropriate annual deductions applying the 200 and 150 percent methods for each MACRS recovery class.

As stated earlier, a lessor as the equipment owner can elect to use the straight-line depreciation method instead of the prescribed MACRS accelerated method established for MACRS property classes. Once an election is made, it is irrevocable (unless consented to by the IRS) and applies to all the MACRS-eligible property within the same asset class that is placed in service during the relevant tax year. The assets within the class for which a straight-line method is elected are to be written-off over the recovery period prescribed under the applicable regular recovery period.

MACRS Averaging Conventions

In calculating depreciation deductions, the handling of placements in, and retirements from, service that occur during the year must be addressed. Generally, under MACRS, a lessor recovers equipment costs using the half-year convention. Under that convention, equipment is deemed to have been placed in service at the mid-point of the year in which it was placed in service, regardless of when during the year it was placed in service. Similarly, an asset is deemed to have been disposed of, or retired from service, at the mid-point of the year during which it was disposed of or retired, regardless of when in fact it was disposed of or retired during the year. Thus, a lessor is entitled to one-half a full year’s permitted depreciation in the year they place an eligible asset in service, and one-half a full year’s depreciation in the year they dispose of or retires the asset from service. However, if more that 40 percent of the aggregate basis (essentially, cost) of property placed in service during a taxable year is placed in service during the last three months of that year, the mid-quarter convention applies. Under this convention, the first-year depreciation for all MACRS properties (with a few exceptions, such as for nonresidential real property) placed in service during the tax year is computed based on the number of quarters that the property was in service, with property placed in service anytime during a quarter being treated as having been placed in service at the mid-point of the quarter.

The Alternative MACRS Depreciation Method

An alternative depreciation system (ADS) must be used in certain select cases, discussed as follows, but can be elected in other situations. Under ADS, a taxpayer generally computes their permitted depreciation allowance by applying the straight-line method, without making a basis reduction for salvage value, over a recovery period typically longer than that specified under the other MACRS approaches. The applicable averaging conventions—the half-year or mid-quarter convention—apply in the same situations as under the regular MACRS.

When Must ADS Be Used?

A taxpayer must use ADS to depreciate equipment used predominantly outside the United States, that is, when it is located for more than 50 percent of the time during a tax year outside the United States. ADS must also be used for tax-exempt bond financed property, basically property financed out of the proceeds of tax-exempt bonds, tax-exempt use property, such as equipment leased to a tax-exempt entity, and equipment generally produced or manufactured in a foreign country.

When Can ADS Be Elected?

A taxpayer can elect to use ADS for any MACRS property for any MACRS-eligible tax year, but the election is irrevocable and applies to all properties in the class that the taxpayer has placed in service during the election year.

ADS Recovery Periods

Under ADS, a taxpayer will generally depreciate the equipment over the ADR class life period as stated in Revenue Procedure 87–56. The class life period is five years, for example, for automobiles, light general-purpose trucks, and qualified technological equipment.

Depreciation Recapture

Generally, on the disposition of MACRS equipment, the taxpayer must recapture, as ordinary income, the MACRS deduction, including any Section 179 deduction (discussed next), up to the amount realized on the equipment disposition.

Expensing

Under Section 179, an equipment owner can elect to deduct (expense) currently up to 1,000,000 U.S. dollars of MACRS property (excluding some types of property, such as property used predominately outside of the United States) used in the active conduct of its business in a tax year (the 1,000,000 U.S. dollar limit is the total per taxpayer, not for each equipment item). For tax years starting after 2018, these limitations are subject to adjustment for inflation. Additionally, there are other technical requirements that may come into play, so Section 179 must be reviewed in its entirety before making the election.

Summary

There are two key tax benefits that an equipment owner has available: equipment depreciation and, currently for certain energy property, an energy tax credit for new equipment. Each tax benefit in effect adds to the profitability of a lease investment for a lessor through tax offsets available.