An early buyout option (EBO) is a provision in the lease that allows the lessee to purchase the leased asset at one or more specified times during the lease. An EBO can serve several purposes. Economically, it provides flexibility to the lessee by allowing a purchase at certain points in time if circumstances warrant. The EBO also is a technique for achieving off balance sheet financing under FASB 13, as it shortens the lease term for purposes of the 90% test. The existence of an EBO, however, also triggers some tax concerns related to characterization of the transaction as either a tax or nontax lease.
There are several issues in this regard. The first is one of intent. An EBO after the first 12 months in an 84-month transaction, for instance, begins to smell like a purchase. After all, if the lessee only wants to use the asset (the basic concept behind a tax lease), why would it seek a purchase option so soon after lease inception? In this regard, the combination of an EBO with a fixed price purchase option also raises questions. Again, there are too many indicators of a possible purchase if the lessee has multiple options to purchase the asset at fixed prices.
The number of EBOs, therefore, becomes an issue – the deal begins to look more like a purchase the more options to purchase the asset that are offered. The argument here is that, why should there be any purchase options at all if the lessee only wants to use the asset? Many lessors will not allow more than two EBOs, while some limit the number to one.
Another risk is that the EBO may be construed as a bargain purchase option. In order to avoid the EBO being interpreted as a bargain purchase option, lessors price the EBO such that, after deducting the present value of the cost of complying with the return conditions at lease end, the EBO exceeds the projected fair market value of the asset as of the EBO date. A bargain purchase option is a form of economic compulsion, i.e., economically, it is in the best interests of the lessee to buy the asset, which removes the lessor’s residual risk.
Economic compulsion, therefore, becomes another factor to consider in structuring an EBO. Even if the EBO is not a bargain purchase option, is it sufficiently low, given the alternative of continuing the lease, to compel the lessee to exercise the EBO? If this is, indeed, the case, the lessor no longer has sufficient residual risk to justify true lease treatment. In order to avoid this pitfall, many lessors perform a present value test. As long as the EBO price exceeds the sum of the present value of (1) the future rents, (2) the fair market value of the asset at lease-end, and (3) the present value of the return conditions at lease-end, most lessors are of the opinion that there is no economic compulsion to buy the equipment.
So, there you go – another moving part amongst many when structuring a lease.
Shawn, the transactions that I see on a regular basis with EBO, caps, etc are not always because the lessee has advance plans of acquiring the leased asset and therefore a loan in the disguise of a lease. Many times it is for protection from the lessor who can make it difficult and expensive to comply with return provisions, which forces them to purchase for FMV. FMV of course ends up being higher than the lessee believes the asset is worth and much higher than the residual investment the lessor made at inception plus a healthy return on that investment. That all said, is the IRS or FASB concerned with the minimal residual some lessors make in the asset when they book tax deals?
Posted by: Jay Zeinfeld | February 9, 2006 3:54 PM | Permalink to Comment