The revised operating lease accounting standards: what are the implications for transfer pricing?

By Dr. Harold McClure, New York City

Recently revised accounting standards issued by the International Accounting Standards Board and the Financial Accounting Standards Board impact the income statement and balance sheets for entities with leased assets. The changes in the measurement of financial statements impact the financial metrics often used in transfer pricing analysis.

These standards, IFRS 16 and Accounting Standards Update 842, have particular implications for the determination of whether oil rig tax planning structures are consistent with the arm’s length principle. The new accounting standards for leased assets became effective for periods beginning after January 1, 2019.

Reasonable markups

The issues addressed by the revised accounting standards for leased assets particularly impact the evaluation of intercompany pricing for contract manufacturers; namely, how do you determine a reasonable markup over production costs.

The standard approach for contract manufacturers is to estimate an appropriate return to operating assets and then apply this return to the tested party’s operating asset to production cost ratio. The US transfer pricing regulations endorse this approach but note various caveats. Section 1.482-5(b)(4)(i) notes:

Reliability under this profit level indicator depends on the extent to which the composition of the tested party’s assets is similar to that of the uncontrolled comparable. Finally, difficulties in properly valuing operating assets will diminish the reliability of this profit level indicator.

Section 1.482-5(c)(2)(iv) notes:

the assets of an uncontrolled comparable may need to be adjusted to achieve greater comparability between the tested party and the uncontrolled comparable. In such cases, the uncontrolled comparable’s operating income attributable to those assets must also be adjusted before computing a profit level indicator in order to reflect the income and expense attributable to the adjusted assets. In certain cases it may also be appropriate to adjust the operating profit of the tested party and comparable parties. For example, where there are material differences in accounts payable among the comparable parties and the tested party, it will generally be appropriate to adjust the operating profit of each party by increasing it to reflect an imputed interest charge on each party’s accounts payable. 

The issue is a similar issue for leased assets and is addressed by the new accounting standards under both IFRS 16 and Accounting Standards Update 842.

New standards

Aswath Damodaran provided an April 2009 paper noting the reasoning for what became the new accounting standard as well as the mechanics of how to transition from the old accounting standards to the new accounting standards. Under the former accounting standards for leased assets, the assets utilized through an operating lease were not recorded either as an asset or as a liability with the lease payments recorded as an operating expense.

Financial leases, on the other hand, were treated effectively as loans, with the value of the asset utilized being recorded on the balance sheet.

Lease payments are effectively the payment to the formal owner of the leased asset plus the expected rate of economic depreciation.

The impact of the new accounting standards will be to increase the recorded value of operating assets but also to increase reported operating profits by replacing the lease payment with depreciation expenses.

The impact of the new accounting standards will be to increase the recorded value of operating assets but also to increase reported operating profits by replacing the lease payment with depreciation expenses.

Since lease payments represent the sum of depreciation costs and the owner’s expected return to assets, the increase in operating profits represents the owner’s expected return to assets.

Old versus new accounting standards

Our discussion will present a simplified version based on an example that roughly captures the financials for Benchmark Electronics, a publicly-traded electronic manufacturing services company.

Table 1 assumes the sales equal $2.5 billion per year and operating costs equal to $2.43 billion, of which $6 million represents rent payments on leased land.

Operating profits under old accounting standards equal $70 million or 2.8 percent of sales. Electronic manufacturing services entities often have cost structures that consist of component costs representing 90 percent of total costs, with value-added expenses being rather modest.

Even with a significant fixed asset to value-added cost ratio, fixed assets relative to sales is often quite modest. Working capital, including inventory plus receivables net of payables, can be more significant even with modest inventory to component cost ratios.

Our table assumes $500 million in working capital and $200 million in fixed assets, not including the leased land. As such, the measured return to assets under old accounting is 10 percent.

Table 1: Key electronic manufacturing services financials under old versus new accounting standards

Millions	Old accounting	New accounting-a	New accounting-b
Sales	$2500	$2500	$2500
Costs	$2424	$2424	$2424
Rent	$6	$0	$0
Profit	$70	$76	$76
Working capital	$500	$500	$500
Fixed assets	$200	$300	$260
Operating assets	$700	$800	$760
Return on assets	10.0%	9.5%	10.0%

 

Table 1 shows how the conversion to the new accounting standards would alter both measured operating profits and measured operating assets.

Our example assumes that the leased asset is land, so we can abstract from depreciation considerations.

The $6 in rent represents the expected return to the owner of the leased land. The expected return to leased assets can be seen as the risk-free rate plus the premium for bearing ownership or obsolescence risk.

If the risk-free rate is 4 percent, the premium for bearing obsolescence risk is 2 percent, and the owner’s expected return to leased assets is 6 percent.

This expected return is less than the expected return for the operating entity as the latter bears commercial risk with respect to not only the assets it formally owns but also to the leased assets.

The value of the leased assets represents the present value of cash flows over the life of the leased asset.

Since we have assumed no economic depreciation, the value of the leased land equals the rent payments divided by the owner’s expected return to leased assets, which equals $100 million.

The column “new accounting-a” shows fixed assets utilized by our electronic manufacturing services comparable as $300 million, which is the sum of the $200 million of fixed assets owned and the $100 million in leased assets.

Under the new accounting standard, operating profits are restated as $76 million, so the measured return to assets is 9.5 percent.

An analogy to the payables adjustment

The return to operating assets calculated under the new accounting standard is lower than the return calculated under the old accounting standards if the owner’s expected return to leased assets is less than the expected return for the overall operations of electronic manufacturing services.

We earlier noted how the IRS regulations address the role of trade payables, which differs from what is often referred to as the return to net assets approach.

Table 1 was based on the return to net assets as it defined working capital for our electronic manufacturing services as inventories plus trade receivables minus trade payables.

Benchmark’s inventories have been near $450 million, with net receivables being near $50 million.

Table 2 details the latter as $350 million in receivables and $300 million in payables.

Under the return to net assets approach, using old accounting standards, transfer pricing practitioners would typically estimate the return to assets as 10 percent.

The US transfer pricing regulations suggest that the analyst “adjust the operating profit of each party by increasing it to reflect an imputed interest charge on each party’s accounts payable.”

The regulations do not specify what interest rate should be used.

If the interest rate chosen for this adjustment equaled return to net assets, which is 10 percent in our example, the adjusted return to assets would also be 10 percent. If the analyst chose a lower interest rate, such as 6 percent, then the adjusted return to assets would be less than return to net assets.

In our example, this adjusted return to assets is only 10 percent.

Table 2: Alternative approaches for addressing accounts payable

Interest rate	6.0%	10.0%
Sales	$2500	$2500
Costs	$2430	$2430
Profit	$70	$70
Fixed assets	$200	$200
Inventory	$450	$450
Receivables	$350	$350
Payables	$300	$300
Return to net assets	10.0%	10.0%
Adjusted return to net assets	8.8%	10.0%

Table 1 considered the implications of assuming that the expected return to the owner of the leased assets is 10 percent. If the analyst made this assumption, the estimated value of the leased land in our example would be $60 million rather than the $100 million value we used in our above discussion.

In this case, the estimated return to assets under the new accounting standards would be 10 percent, which was the estimated return to assets under the old accounting standards. I raise this consideration as it is a prominent assumption for the representatives of oil drilling rig multinationals.

The economics of leasing, however, notes that the formal owner of leased property receives only the risk-free interest rate plus a modest premium for bearing obsolescence risk while the user of leased property bears the commercial from using property leased by another entity. As such, assuming a 10 percent return for the owner of the leased assets is inconsistent with the economics of leasing. A more reasonable assumption is that this expected return is 6 percent.

One discussion of the transfer pricing implications of these new accounting standards for leased assets featured a picture of an oil drilling rig in Scotland with a caption that claimed: “oil rigs are frequently leased, and those leases are impacted by new accounting standards.” (Valentin Krustev, “Effect of New Lease Accounting Standards on Transfer Pricing Benchmarks”, Bloomberg Tax, July 28, 2020.)

The reality is that oil drilling rig multinationals own their rigs, but they do establish tax planning structures where a tax haven affiliate formally owns the rig and leases it to an operating affiliate.

The new accounting standards should certainly be considered in reviews of whether the transfer pricing for these tax planning structures is consistent with the arm’s length standard.