AN OVERVIEW OF THE SYNTHETIC LEASE STRUCTURE

Synthetic leases, if properly structured, can be a viable off-balance-sheet financing option for sophisticated real estate users. Their downside is the complexity involved in structuring a transaction that qualifies as a lease for financial reporting purposes, while constituting financing for federal income tax law.

In its simplest form, a synthetic lease is a type of off-balance sheet financing that provides a number of benefits for the corporate lessee. There benefits include: enhanced financial ratio performance; as much as 100% financing with competitive pricing; realization of future property appreciation through a fixed-purchase option; and tax benefits, including deductions for both interest expense and depreciation.

In a typical synthetic lease, the lessor, usually a bank, leasing company, or other financial institution, (often a special-purpose entity formed by the parties for the sole purpose of holding title to the asset), purchases the asset from a vendor and leases it to the user, or lessee. The lease agreement requires the lessee to pay the lessor periodic lease payments during the lease term.

At the end of the term, the lessee may purchase the asset at a predetermined fixed purchase price. Alternatively, the lessor may sell the asset to a third party, with the lessee providing a first-loss guarantee in the form of a termination payment. The net present value of the lessee's termination payment plus the lessee's total lease payments will be less than 90% percent of the present value of the original purchase price.

A synthetic lease is structured to qualify as an operating lease for financial accounting purposes and to qualify as a financing transaction under current federal tax law. Qualifying as an operating lease, as opposed to a capital lease, ensures the lessee the desired off-balance sheet treatment. The lease will not receive this treatment if it meets any of the following four criteria from the Statement of Financial Accounting Standards (FASB No.13):

1. It transfers ownership to the lessee at the end of the lease.
2. It contains an option for the lessee to purchase the real estate 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 real estate.
4. The present value of the rents and other minimum lease payments equal or exceed 90 percent of the fair market value of the lease property.

To avoid meeting these criteria, a typical synthetic lease will include a market-rate, fixed-price purchase option, a relatively short lease term (generally two to seven years), and a lease payment stream with a present value less than 90 percent of the fair market value of the lease property. A synthetic lease structure must also avoid the provisions of FASB No. 98, which will disallow sale treatment for the seller who retains the option to purchase the property, or if the lease contains any guarantee provisions.

A properly structured synthetic lease will be treated as a financing transaction for federal income tax purposes, allowing interest expense and depreciation deductions to the lessee (rather than rental expense). While the lessee does not hold actual title to the property in form, the lessee will retain, in substance, the significant benefits and burdens of ownership.

This is accomplished through the use of a fixed-price purchase option (FPO) or a termination payment. An FPO is an agreement between the lessor and the lessee to allow the lessee to buy the property at the end of the lease term for a price equal to the original purchase price (subject to appraisal) less any amortization provided by the lease terms. An FPO gives the lessee the benefits of appreciation on the property and furthers the argument that the lessee substantively owns the property for federal income tax purposes.

On the other hand, if the lessee does not purchase the asset at the end of the lease term, the lessor can sell the property to a third party. The lessee then must pay the lessor a specified amount (the termination fee) usually equal to the shortfall between the sales price and an agreed-upon target price. If the property has depreciated significantly in value over the term of the lease, the lessee effectively realizes a loss.

FEDERAL TAX ISSUES:

Two key issues at the core of receiving financing treatment for federal income tax purposes disregarding the transaction's form (a lease) in favor of its economic substance (a financing); and proving that the lessee retains the benefits and burdens of ownership. Ultimately the second factor, which points to the economic realities and substance of a transaction, governs the outcome of each case.

The downside of synthetic leases is that the IRS is closing the loopholes and structuring the transaction is very costly. Additionally, it is not unusual for both the courts and the Internal Revenue Service (IRS) to review the form of a transaction to get at its substance-however, it is more unusual when doing so favors the taxpayer. The structure of a synthetic lease asks the IRS to do just that; overlook the fact that the transaction looks like a sale-leaseback and treat it as financing for federal income tax purposes. The courts have rendered a number of decisions on both sides of the issue granting off-balance sheet lease status for synthetic lease structures.

The net cost advantages (credit-driven interest rates and ownership tax benefits) should be understood, as transaction costs are typically high compared to more conventional off-balance sheet lease alternatives. Because of this, synthetic leases tend to be more beneficial in larger transactions, where front-end documentation costs are a smaller portion of the project's overall cost.

Synthetic leases carry unique risk in that they are the subject of ongoing reviews by FASB, EITF, and the SEC. Questions continue to be raised about whether an operating lease classification is appropriate for synthetic lease structures. At some future time these groups may conclude it is not appropriate, and deny operating lease treatment to synthetic lease structures.