When the new lease accounting standard was released a few years ago, business leaders braced themselves to see their financial statements change. Such a drastic shift in accounting precedent required them to overhaul their policies and procedures surrounding leases. But savvy business leaders are also asking: “How will the standard affect our tax situation?”
It Affects More than Just the Balance Sheet
Under the new lease standard, leases that previously were expensed as incurred now also must be recorded on the balance sheet. Businesses will record right-of-use assets and corresponding lease liabilities for the present value of the lease agreements. These balances will dwindle as the lease gets expensed over the contract’s duration. The balance sheet is where you’ll see the biggest changes, since leases hit the income statement under both accounting standards. But taxes will change, too. The tax return will feel the new standard’s effects in a few different ways.
Unlike with tangible property or real estate, right-of-use assets do not create any tax basis for the entities or the individual taxpayers. Therefore, the right-of-use assets themselves will not affect the tax return. However, they will affect deferred taxes, and here’s why.
When companies first adopt the new standard, they need to record differences between book values and tax values. While book basis of the new lease asset and liability may change, the tax basis will not change, so entities must record the following on their balance sheets: (1) a deferred tax liability for the book/tax difference in the right-of-use asset, and (2) a deferred tax asset for the book/tax difference in the corresponding lease liability. Although this rule will not affect the tax return directly, the calculations will affect the tax team’s workload and their workload’s complexity.
State income taxes will change for entities that operate in more than one state. State apportionment is the method by which we allocate taxable earnings to different jurisdictions. Most states claim a right to entities’ earnings (and their tax dollars) when those entities have sales, payroll, or property in their state. For instance, when an entity attributes $500,000 of its $10 million sales to State A, its “sales factor” to State A is represented as a percentage: 5%. The average of the entity’s sales factor, payroll factor, and property factor is then applied to the entity’s total taxable earnings. The resulting value is the taxable earnings that are taxable by State A.
Entities’ property factors are likely to change under the new lease standard. Both right-of-use assets and lease expenses can affect property factors. Right-of-use assets are recorded alongside other assets like furniture, buildings, and land. When overall asset balances increase, property tax apportionment factors will jump. Similarly, property factors will change when lease expenses change. Lease and rent expenses often contribute to states’ property factors. Companies will need to watch for state changes to property factors for apportionment regarding the inclusion of right-of-use assets. Even if a state ignores right-of-use assets in their property factor, they will be able to capture these leases when they are expensed, causing entities’ property factors to grow. Any increase in a jurisdiction’s property factor will directly contribute to a higher state tax bill.
The lease accounting standard also could affect taxes that are not based on income. For example:
- Property taxes. States will need to release guidance before we know for sure, but some are bound to consider right-of-use assets to be taxable, just as tangible personal property, land, and buildings are taxable. Entities with right-of-use assets in these states will see a jump in their taxes due.
- Sales and use taxes may also change. Some states consider lease transactions taxable for sales tax purposes.
- Some jurisdictions have other statewide taxes that are not based on income. Georgia, for example, has a corporate income tax and a net worth tax. A company’s net worth calculation will increase as leases are added to their asset balances, which may translate to more net worth taxes due.
More to Consider
A company’s tax outlook can change in other ways, too. Transfer pricing is a concern, and foreign taxes have their own considerations. No matter what, companies will need to implement procedural changes in their tax departments, educate department employees about the new accounting principles, and improve data collection. If you have any questions about the new lease accounting standard, reach out to a CRI CPA for help.