Synthetic Lease

A synthetic lease is a form of sale and leaseback arrangement. A company sells an asset to another company and leases it back immediately. Thus, it retains control of the asset and reduces the tax liability.

A synthetic lease can result at different participation levels of the lessee. Both parties need to follow some specific guidelines to retain the synthetic lease for accounting purposes.

Let us see how a synthetic lease works and what is the accounting treatment for it.

What is a Synthetic Lease?

A synthetic lease is an arrangement where a company sells an asset to a special purpose entity and immediately leases it back. Put another way, a special purpose entity buys an asset from its parent company and leases it back to the parent company.

A synthetic lease in an off-balance sheet arrangement. Companies use this arrangement in financial distress and to reduce tax liabilities. The leased asset is shown on the balance sheet of the special entity (the lessor) and as an expense on the income statement of the parent company (the lessee) in this arrangement.

How Does a Synthetic Lease Work?

Synthetic lease arrangements are common in the real estate industry. The parent company sells a property or part of it to a newly created entity and leases it back immediately. Thus, it retains the control of the asset indirectly.

A synthetic lease is an arrangement where a company leases an asset to itself. A special-purpose entity is used for synthetic lease arrangement. First, the asset such as property, building, or equipment is purchased by the special purpose entity.

The special purpose entity (the lessor) shows the asset on its balance sheet. It then immediately leases the asset back to the parent company (the lessee). The lessee, in this case, does not show the asset on its balance as it does not own it outright. Rather, the lessee only shows the lease expense on its income statement.

A synthetic lease arrangement involves two events:

1. A sale of an asset such as a property to a special purpose entity.
2. A lease agreement in which the seller becomes the lessee and the buyer becomes the lessor.

Synthetic Lease vs Traditional Operating Lease

In traditional lease arrangements, the lessor retains the ownership and control of an asset leased to the second party. All sorts of benefits and expenses including tax liability are associated with the lessor.

In a synthetic lease, the lessee practically controls the asset., as the asset is sold to an entity created as a special purpose entity. The parent company retains the control of an asset indirectly. Thus, even if it does not show the asset on its balance sheet, it still controls the assets.

Accounting for Synthetic Lease

The accounting treatment of a synthetic lease will depend on the retention rights of the leased asset.

The rights to use the property can be classified into three categories:

1. Minor 0%-10%
2. Minor but less than substantially all 11%-90%
3. Substantially all Rights 91%-100%

The percentage is determined by comparing the net present value of the lease against the asset’s fair value. If the lease amount is above 90% of the asset’s fair value, it will be considered substantially all rights to use the asset to the seller (lessee).

If the lessee substantially retains all rights to use the asset as defined above, the synthetic lease can be termed either a financial lease or an operating lease. The accounting treatment for the lease will be adjusted accordingly as the lease terms for either the financial lease or operating lease.

If the lessee holds minor rights, the lease will be recorded separately. Any gains or losses due to the lease are adjusted in the books. Similarly, if the lessee holds more than minor but less than substantial rights, the excessive profit is adjusted for in its account books.

The use of synthetic leases in real estate requires special considerations. There are three broader sets of guidelines to follow in a synthetic lease arrangement in the real estate industry.

1. The lease arrangement should be a normal lease agreement. It means the lessee must prove active participation in the use of the leased property.
2. The lessor (the buyer of the property) must demonstrate adequate initial and continuing investments in the property through the terms and conditions of the lease agreement.
3. Payments terms and provisions must result in the transfer of ownership of the property to the lessor. It should be demonstrated through a lack of continuing involvement by the lessee.

The lessor’s initial investment will be adequate if the agreement demonstrates the commitment of the lessee to pay for the property. The continuing investment will be considered adequate if the buyer (lessor) demonstrates a capability to pay for the property for its principal and interest over the length of no more than twenty years.

The continuing involvement of the lessee can result in the disqualification of the lease as a sale and leaseback arrangement.

Some common cases of the continuing involvement of the lessee other than the normal leaseback can include:

• The lessee has an option or obligation to buy the property.
• The lessee guarantees return on investment to the lessor, repayment of debt, or investment.
• The lessee becomes liable for the debt related to the leased property.
• The lessee offers collateral for debt financing to the lessor other than the leased property.
• The lessor is obliged to share any appreciation or gains on the property with the lessee over the course of the lease agreement.