Robert B. Goldi, Financial Services Practice Group Leader, has co-authored an article on equipment leasing along with Phil Harrison, CPA and president of Harrison Capital Corporation. “Equipment Leasing: Another Arrow for a Community Bank’s Quiver” was published in the June 2016 issue of Great Lakes Banker. The article follows and is one in a series discussing equipment leasing and the issues presented to community banks that are in the equipment market and/or are considering entering this market.
“Equipment Leasing: Another Arrow for a Community Bank’s Quiver”
Equipment leasing has been an investment conduit for many banks since the 1960’s when the Comptroller authorized personal property equipment leasing for national banks. Leasing is a diverse product that helps increase business with existing customers and provides opportunity for new and broader market share. According to the Equipment Leasing and Finance Association, more than $1 trillion of plant and equipment is financed through loans, leases and lines of credit. Banks control the majority of this market. Until recently, however, community banks have not been major participants in this segment.
Why the Leasing Market
1. Access to untapped commercial and industrial lending product. Broadens bank products and services.
2. Historic higher return on assets and lower loss history.
3. Help retain existing banking relationships.
4. Provides introduction to new relationships.
5. Industry and collateral diversification.
6. Asset growth and fee income from syndication/participation opportunities.
7. Complements existing commercial loan activity.
Barriers to Entry
1. Possibly endure start-up costs that may not initially be covered by earnings from new lease business.
2. Prefer to stay in current home footprint and historical core products.
3. Unfamiliarity with the market and competitive environment.
4. Need for well-educated sales force that identifies leasing opportunities.
5. Lack the necessary accounting, tax, lease pricing, bank policies, and administrative/documentation systems and resources.
To evaluate the market, it is necessary to understand the basics of leasing and differences among general categories of equipment leases.
A lease is a contract wherein, over the term of the lease, the lessor (owner) permits the lessee (user) the use of an asset in exchange for promise to pay a series of payments.
After the equipment and terms have been specified, lessee enters into lease agreement with the lessor. The lessee negotiates with the lessor the length of the lease, the payment, insurance, maintenance and other customary considerations. The lessor then pays for the equipment, and the lease commences.
At the end of the lease term, the lessee has the option to renew, buy the equipment, or terminate the agreement and return the equipment. The options available at the end of the lease are significant, as they determine the lease classification for tax and financial accounting purposes.
Types of Equipment Leases
Equipment leases fall into three general categories, each with different types of purchase option.
1. Non-tax-oriented leases, which either have nominal purchase options or automatically pass title to the lessee at the end of the lease.
2. Tax-oriented true leases which have fair market value purchase options.
3. Tax-oriented TRAC leases for licensed over-the-road vehicles, which have terminal rental adjustment clauses that shift the residual risk to the lessee, but may permit the lessee to acquire the equipment at a fixed price at lease end.
Non-Tax-Oriented Lease or Conditional Sale Lease
A conditional sale lease transfers all incidents of ownership of the equipment to the lessee, and gives the lessee a bargain purchase or renewal option not based on fair market value. The lessee treats the property as owned, depreciates the property and deducts the interest portion of rent payments for tax purposes. The lessor treats the transaction as a loan.
Tax-Oriented True Lease
The true lease offers all primary benefits commonly attributed to leasing. Lessor claims depreciation deductions, and lessee deducts the lease payment as an expense. The lessor owns the leased equipment at lease end.
The principal advantage to a lessee in a true lease is the economic benefit that comes from the indirect realization of tax benefits that would otherwise be lost or deferred.
The Deficit Reduction Act of 1984 authorizes a lease for motor vehicles called a “TRAC lease” that combines the benefits of a true lease and a conditional sale. The name “TRAC lease” derives from the fact that a TRAC lease contains a “terminal rental adjustment clause.” A TRAC lease is used to provide a lessee with true tax-oriented lease rates even though the lease contains a terminal rental adjustment clause which is comparable to a fixed price purchase option. TRAC leases finance motor vehicles used in a trade or business.
As a mature industry with a proven track record of historic higher returns and lower loss levels, the equipment finance sector will continue as a product market that will attract the interest of community banks.