Synthetic Leases and Special Purpose Entities

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Synthetic Leases and Special Purpose Entities

• Robert L. Vigeland
• April 2007

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What is a synthetic lease?

• A financing contract that is treated as an
  operating lease for financial reporting purposes
  but as a loan for federal income tax purposes.
• Synthetic leases typically involve at least 3
  parties
• Lessee/end-user of the leased asset
• Lessor (typically a special purpose entity)
• Financial institution providing the financing

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A Simple Synthetic Lease
Rent and residual value guarantee
Loan
Lessee (end-user)
Lessor (SPE)
Financial institution
Principal and interest
Operating lease
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Advantages of a synthetic lease

• Synthetic leases are designed to to keep the
  asset and the related liability off-balance
  sheet.
• Balance sheet is freed from non-producing asset
  and attendant debt
• Income is typically higher
• Debt-to-equity, return on equity, and other
  ratios are improved
• Borrowing capacity may be improved

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Advantages of a synthetic lease

• Lessee retains most of the advantages of
  ownership
• Tax advantage lessee gets to deduct both
  interest and depreciation for tax purposes
• Lessee retains potential benefit from price
  appreciation in the asset value

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Advantages of a synthetic lease

• Advantages of structured financing.
• The asset is separated from the bankruptcy risks
  of the end-user
• This lowers risk to the financial institution
• This results in substantially lower financing
  costs
• 100 financing

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Disadvantages of a synthetic lease

• Complexity and high transaction costs make
  synthetic leases unsuitable for amounts under 10
  million
• Off-balance sheet financing is not viewed
  favorably in the post-Enron world

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Disadvantages of a synthetic lease

• Short-term financing for a long-lived asset
• Synthetic leases typically run for 5-7 years
• Lessee/end-user may have to refinance at much
  higher cost
• Lessee/end-user may be forced to sell the asset
  at depressed prices

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The Special Purpose Entity (SPE)

• Its function is to acquire the asset and lease it
  to the lessee/end-user
• It is designed as a bankruptcy-remote entity,
  i.e., one that is unlikely to file for bankruptcy
  protection or be forced into bankruptcy

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The Special Purpose Entity (SPE)

• Capital structure of the SPE
• Minimal equity capital (typically 3)
• Debt
• All capital is provided by the financial
  institution(s)
• The owner of the SPE (the financial institution)
  or the beneficiaries have no obligation to
  provide additional capital

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Accounting issues

• To qualify as an operating lease, none of the
  following conditions from SAS 13 can be met
• Title transfers to lessee at the end of the lease
  term.
• Lease contains a bargain purchase option.

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Accounting issues

• Lease term is greater than or equal to 75 of
  assets life.
• Present value of the minimum lease payments is
  greater than or equal to 90 of the assets fair
  market value.

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Accounting issues

• FAS 98 applies to sale-leaseback transactions
  involving real estate and, if applied, may result
  in operating lease treatment being not
  applicable.
• To avoid this, the lessee/end-user should not
  have title to the leased asset before entering
  into the synthetic lease.

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Other uses for SPEs

• Originally, SPEs were designed for legitimate
  business purposes
• Facilitate financing transactions
• Isolate assets and perfect liabilities
• Increasingly, SPEs are being used to move assets
  and liabilities off the balance sheet.

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Other uses for SPEs

• Securitization of financial assets, e.g.,
  mortgages and auto loan receivables
• The SPE holds the receivables in trust for the
  benefit of investors who own securities issued by
  the SPE
• Commercial paper conduits
• SPE purchases assets funding those assets by
  issuing commercial paper