SYNTHETIC LEASES IN AIRCRAFT SALES/PURCHASES

Ownership

AvBuyer | 1st November 2003

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SYNTHETIC LEASES IN AIRCRAFT SALES/PURCHASES

Are they viable in the post-Enron environment?

The recent accounting rule changes in the wake of Enron’s demise- and the financial techniques that obscured the true story from investors have cast synthetic leases in a dim light. In the wake of Enron- the U.S. Securities and Exchange Commission ('SEC') and the Financial Accounting Standards Board ('FASB') have issued new guidelines designed to proper financial disclosure of special purpose entities and synthetic leases.

After Enron and until early 2003 (when the SEC and FASB issued their guidelines)- the propriety of these financial structures was in doubt – and the 2003 pronouncements by the SEC and FASB only eliminate a portion of that doubt. What is the future for synthetic leases- and how might they be used to finance corporate aircraft?

1. What is a Synthetic Lease?
A synthetic lease is a leasing structure that gives the synthetic lessee a favorable mixture of the tax and accounting attributes of both purchase-with-financing and a true lease. The structure is useful in dealing with any costly- depreciable assets with relatively stable market values. Most synthetic leases have been used with commercial properties (offices and factories)- but corporate aircraft fit very well in the structure. To understand a synthetic lease- though- you need to know how it compares to purchase transactions and lease transactions.

a. Purchase-With-Financing: To purchase an aircraft the acquiring company must part with cash- and/or incur corporate debt to pay for the aircraft. The aircraft and the related debt appear on financial statements as an asset and liability- respectively. As owner- the company may be able to enjoy the benefits of depreciation (or suffer the ravages of depreciation- depending on your viewpoint). If the purchase is financed- the borrower will generally be entitled to expense the interest portion of the payments- and the bank will take the interest payments as income. The bank will invariably have a mortgage on the aircraft- and possibly additional collateral support from the borrower.

So- purchasing and financing aircraft is disfavored if you are trying to show strong earnings in relation to asset size (because corporate aircraft are huge- non-earning assets)- or if you are trying to boost paper profits (because aircraft depreciation will consume a lot of income- even though there is no cash effect). Purchasing (with or without financing) is favored if you are looking to shelter income from taxation with depreciation.

b. True Leases (vs. Finance Leases): If the company chooses to acquire the aircraft with a true lease (also known as an operating lease)- then the acquiring company has a lease expense- and the owner of the aircraft retains the tax attributes of ownership (depreciation).

A true lease is favored when a company wishes to keep the aircraft asset off its financial statements (except as a regular lease expense)- and if the company does not want to bear the burden of owning the leased asset for the long haul. When leased- the owner of the aircraft (lessor) has the potential to use the tax attributes of ownership. At the end of a true lease- the asset is generally returned to the lessor – which is to say that the lessor has the benefit or burden of the residual value at the end of the lease.

In contrast- a so-called 'finance lease' or 'capital lease' is a loan transaction wearing a lease label. Extremely simplified- a finance lease generally gives the lessee a highly favorable option to buy the leased asset at the end of the lease (free or bargain purchase). To allow this- the 'rents' paid will allow the lessor to recover a rate of return plus the cost of the leased asset. It looks- sounds and smells like a financing – and for federal income tax purposes- it is treated as a sale/financing. It also is generally treated as a sale/financing for financial reporting purposes. A finance lease is a lease that is really not a lease for tax or accounting purposes.

c. The Synthetic Lease: Synthetic leases use a bit of accounting and tax alchemy- exploiting the fact that the IRS and FASB are independent entities with differing missions. For financial reporting purposes- the lessee in a synthetic lease gets to keep the leased asset off its financial statements (it is not an asset- and there is no associated financing liability). For tax purposes- the same lessee gets to claim depreciation deductions for the leased asset and gets to deduct a portion of the lease payments as if they were interest expense payments. The IRS sees it (and taxes it) as a sale/financing and the FASB sees it as a lease and allows the company to report the transaction as a lease on its financial statements.

A synthetic lease document looks largely like a true lease- except that the lessee retains some obligation to dispose of the property at lease-end. This can be done either by extending the lease- finding a third party purchaser- or by purchasing the property; and when a purchase is involved (by the third party or by the lessee) the purchase price is generally a price established at the time the lease was signed. The purchase terms of a synthetic lease are often called a residual value guaranty to the lessor- which permits the lessor to offer lower payments to the lessee.

Statement of Financial Accounting Standards ('SFAS') No. 13 requires that all of the following requirements must be met for the lessee to receive off-balance sheet accounting treatment:

• There can be no automatic transfer of title to the lessee at the end of the lease term.

• Any option to purchase the property by the lessee cannot be at a 'bargain' purchase price.

• The term of the lease cannot be 75 per cent more of the economic useful life of the leased property.

• The present value of the minimum rental payments cannot be 90 per cent or more of the fair market value of the property- determined as of the date of the inception of the lease.

Synthetic leases became very popular in the late 1990s as a way for a company (often a profit-seeking tech company) to add corporate headquarters and factories without showing a massive capital investment. The property would be ‘off-balance-sheet’- and therefore would not dilute the earning power of the company’s assets (pumping up financial ratios)- and would thus not cause income-sapping depreciation.

d. So What Went Wrong? Enron and others ran into difficulty in how they structured and then disclosed these arrangements on their financial statements. It is generally agreed that Enron (and others) were not complying the FASB guidance that was then in place. The accountants characterized the properties as being 'off-balance-sheet' because the asset was acquired by a 'special purpose entity' (SPE) that financed the purchase of the asset and leased the asset to the company. The SPE was marginally capitalized (roughly 3% of the asset value) by persons who were nominally unrelated to the company – but in fact were often related to- and controlled by- the company. There was generally a financial tie between the company and the SPE that created a liability for the company.

The SEC and FASB now agree that this liability should have been accounted for by the lessee. Not surprisingly- this financial tie was often what made the synthetic lease financially viable. The financial tie could be in the form of a guaranty by the lessee- or some high residual value guaranty. The accounting technique obscured a significant liability- and this liability- for example- made Enron financially responsible for some or all of the SPE’s obligations to third party banks. Once the accounting was corrected- Enron’s financial picture grew dim.

2. Post-Enron – Changes but Less Clarity
Although many agree that the Enron (and similar) structures were improper under the then-existing accounting rules- the SEC and FASB have attempted close down structures that may result in misleading financial statements.

a. FASB Interpretation No. 46 (FIN 46):
FIN 46 (effective January 31- 2003 for new structures- and effective fourth quarter 2003 for structures in place before February 1- 2003) provides guidance for the preparation of financial statements. It states that for a SPE/synthetic lease structure to achieve its intended accounting purpose; (i) the SPE must have sufficient equity capitalization- and (ii) the holders of that equity must have true voting control of the SPE. They must be truly at risk of absorbing losses of the SPE- and they must have the right to receive any residual returns. The pre-existing rule- and common practice- set 3% equity as the baseline. FIN 46 indicates that sufficient capitalization must be significantly higher.

If the structure does not qualify- then the financial statements of the SPE-lessor are consolidated with the financial statements of the company-lessee- meaning that the SPE is no longer accounted for as a separate entity. As a result- the intended synthetic lessee does not accomplish its intended accounting objectives.

b. SEC Rules: Spurred by the Sarbanes-Oxley Act of 2002- the SEC adopted rules in parallel with FASB FIN 46 requiring disclosure by public companies (or companies going public) of off-balance-sheet arrangements that are 'reasonably likely to have an effect' on the reporting company’s financial condition. In short- the company is obligated to disclose the types of financial ties between the reporting company and an SPE (guarantees or an obligation to purchase assets) that are described above. The SEC rules do not proscribe or prohibit any transactions; rather the rules force disclosure. The SEC rules only apply to companies that have a class of stock or debt that is registered for public sale or trading.

3. What is the Future of Synthetic Leases?
Well- the party is over… sort of. Enron/FASB/SEC have vastly changed the marketplace by ruling out structures that hide financial risk. There remains- however- a legitimate framework and purpose for synthetic leases. The question is whether the FASB has left enough room for financing firms to structure viable deals. FIN 46 states several general principles to apply to a SPE/synthetic lease deal- but FASB provides no safe harbors or clear interpretation of SFAS 13. As a result- parties putting together a synthetic lease deal today are feeling their way through the fog; and the risk is substantial. If the structure does not clear an audit- the company runs the risk of having financial statements revised retroactively.

In all likelihood- a synthetic lease that satisfies FASB FIN 46 would not be nearly as financially attractive as those used in the past. It is possible to structure a true ‘arm’s length’ transaction- where the asset is owned by an independent- well-capitalized SPE or other entity- and leased to the company- subject to the company’s obligation to purchase or dispose of the asset at lease-end (at a price determined at the beginning of the lease – and not a bargain price). The 'catch' is that the independent SPE must put real equity (independent of the lessee) at risk – significantly more equity than was formerly put at risk in the pre-Enron era.

Presumably- the party taking the increased risk will want to offset it with a counter-balancing reward. That means higher 'rents' paid by the lessee. Whether these rents are low enough to justify a synthetic lease versus an operating lease- or versus a financing- will depend on the risk tolerance and tax position of the parties. The prior synthetic lease financiers are hoping for clarification from FASB; and in time- it is hoped that deals will come through the gauntlet and establish new roadmaps for future synthetic lease deals.

If synthetic leases make a comeback- it will probably start with smaller- closely-held private companies as the lessee. Public companies would be deterred by the SEC rules (and the public stigma)- and larger companies with multiple shareholders may be deterred by the business risk of having financial statements revised.

Greg Cirillo is a Partner with the law firm Wiley Rein & Fielding- LLP- practicing in their McLean- Virginia office. Greg provides legal counsel to buyers- sellers and financiers of business and commercial aircraft. Greg thanks his partner- Matt Egger- who heads the WRF tax practice- for his assistance in researching and writing this article.

This article is intended as general information- and should not be relied on as legal advice. The statements herein are believed to be accurate and current; but they may be or become inaccurate due to changes in law and interpretations. Please consult your legal and tax advisor(s) before undertaking any transaction of the type discussed.