Articles & Publications

6/13/2001

Financing Power Projects with Synthetic Leases

by Nancy R. Little

This article originally appeared in Project Finance International, Issue 219 (June 13, 2001). Reprinted with permission.

For a number of years, synthetic leases have been one of the hottest techniques for the acquisition and/or construction of a variety of corporate assets. The concept developed as corporate users sought off-balance sheet financing of their assets to improve the appearance of their balance sheets. Within the last several years, synthetic lease financing has also become popular as a vehicle to finance the construction of power generating facilities.

Simply stated, a synthetic lease is a financing arrangement that is classified as a lease for financial accounting purposes and as a loan for tax purposes. This type of financing arrangement is attractive to a lessee/borrower because the lessee achieves off-balance sheet accounting treatment for its debt but retains the tax benefits associated with the ownership of property. The lessee’s purchase option also permits the lessee to capture any appreciation in the property. From the lessor’s standpoint, the lessee retains the residual risk of any decline in value of the property, contrary to a typical lease arrangement.

The lessee receives off-balance sheet accounting treatment for both the asset and the debt incurred to finance the acquisition and/or construction of the property. The lessee is also treated as the owner of the property for income tax purposes and is entitled to both interest and depreciation deductions. Typically, the lessee is appointed to act as the construction agent for the lessor and controls the design and construction of the facility, though recent accounting rules have affected the structuring of most construction agency arrangements. Under the terms of the lease, the lessee also retains operational control of the property, and the potential appreciation in the facility remains with the lessee because of the lessee’s purchase option described below. The rent in a synthetic lease arrangement is based on the lessee’s credit; therefore, the result is a lower cost of occupancy than in a traditional lease arrangement. The transaction also provides 100% financing for the facility.

At the end of the synthetic lease term, the lessee has several options. The lease may be renewed if agreed to by both the lessor and the lessee. Alternatively, the lessee may elect to purchase the property for a purchase price equal to the amount of the outstanding debt and equity. Under the accounting rules, the lessee cannot be required to purchase the property. However, if the lessee does not elect to purchase the property, the lessee must pay the lessor a "contingent rent payment" or "maximum guaranteed amount" equal to approximately eighty to eighty-five percent of the cost of the facility, which is applied to a pay off a portion of the outstanding debt, and the lease typically requires the lessee to market the property for the lessor. The proceeds of any sale are applied to pay the remaining debt and equity. Any excess sales proceeds are paid to the lessee.

For U.S. federal income tax purposes, a synthetic lease is usually characterized as a loan arrangement. The lessee is entitled to deduct interest expense and depreciation. Most state income tax statutes follow the federal law. Accordingly, if the transaction is treated as a loan for federal income tax purposes, it will be given the same characterization under state law. The lease usually includes a provision stating that the parties intend the transaction to be characterized as a loan for tax purposes. The documents also contain a tax indemnity by the lessee in the event that, notwithstanding the intent of the parties, the tax treatment as a loan is not upheld.

To achieve the benefits of a synthetic lease transaction in the U.S., the transaction must comply with the generally accepted accounting principles ("GAAP") promulgated by the Financial Accounting Standards Board (the "FASB"), including the following:

Statement of Financial Accounting Standards ("SFAS") No. 13 requires that all of the following requirements must be met for the lessee to receive off-balance sheet accounting treatment:

(1) There can be no automatic transfer of title to the lessee at the end of the lease term.

(2) Any option to purchase the property by the lessee cannot be at a "bargain" purchase price.

(3) The term of the lease cannot be seventy-five percent or more of the economic useful life of the leased property.

(4) The present value of the minimum rental payments cannot be ninety percent or more of the fair market value of the property, determined as of the date of the inception of the lease.

Synthetic leases are structured to comply with SFAS No. 13. As noted above, the lessee has an option, but not an obligation, to purchase the facility for a purchase price equal to the outstanding amount of the debt and equity. An appraisal is used to confirm that the purchase price approximates the fair market value of the facility so that the lessee's purchase option is not at a bargain price. The term of most synthetic leases (exclusive of optional renewals) is relatively short, approximately five to seven years, and power plants generally do not present a problem for the purposes of the 75% useful life test noted above. A synthetic lease transaction is also structured so that the present value of the rent paid during the lease term (which is usually in an amount equal to the accrued interest on the principal amount of the financing), plus the present value of the maximum guaranteed amount referred to above and other amounts required to be paid by the lessee is less than 90% of the fair market value of the facility.

In order to obtain the principal benefits of a synthetic lease, the transaction should be structured taking into account SFAS No. 98, which applies to sale-leaseback transactions of real estate and "integral equipment," such as turbines and other equipment integral to the operation of a power plant. Under SFAS No. 98, a lessee that owns the property and sells it to the lessor cannot have any "continuing involvement" after entering into the lease other than in a "normal" leaseback arrangement. SFAS No. 98 cites the following as examples of continuing involvement that would be prohibited:

(1) An option or obligation to purchase the property by the lessee.

(2) A guarantee by the lessee of the lessor's investment or return on investment.

(3) Sharing of appreciation in the property with the lessor.

If SFAS No. 98 applies to the transaction, the lessee would be deprived of some of the significant benefits of a synthetic lease. To avoid the application of SFAS No. 98, the lessee should not acquire title to the property, including the turbines and other equipment that will be incorporated into the facility. Title should be conveyed directly to the lessor by the third party seller, though a synthetic lease can be structured for a new power plant if the company owns the land on which the facility will be constructed if the lessee ground leases the land to the lessor before the commencement of construction.

In recent years, the FASB has promulgated a number of new accounting pronouncements affecting synthetic leases. In particular, the Emerging Issues Task Force of the FASB has reached a consensus on such issues as a minimum equity investment on the part of the lessor, limitations on indemnification by the lessee for environmental risks and restrictions on the construction period risk that can be assumed by the lessee. In addition, the FASB has proposed changes in its consolidation policies and procedures that could result in the consolidation of the lessor and the lessee for financial accounting purposes if the lessor is an entity that is controlled by the lessee. Current accounting advice is critical in any synthetic lease transaction.

Many synthetic leases are financed by commercial banks or other affiliates, who may act as both lessor and lender. Typically, the lessor acquires a site identified by the lessee and leases it to the lessee, who acts as the lessor’s agent to construct the improvements. The term is usually five to seven years, though some synthetic leases are longer and/or may provide for renewal terms. The lessee pays rent equal to the return on the lessor’s equity and the debt service on the loans made by the lenders to the lessor. Often, the pricing is based on a percentage over the London Interbank Offered Rate ("LIBOR"), and there is usually no amortization, which makes the lessee’s up-front occupancy costs significantly lower than most alternatives. Lower rent can be achieved with a synthetic lease that is secured by a cash collateral account, which is included in some synthetic lease structures.

Larger synthetic leases, such as those used to finance power projects, are structured using commercial paper conduits to fund the debt component of the transaction. A syndicate of banks provides the liquidity support and also provides the back-up funding for the debt. Certain lenders also are offering longer term leases, though usually with a lock-out period or prepayment premium. Some bank programs offer initial five year terms with renewal options up to fifteen years. However, the interest rate (or "rent") is usually re-priced at the time of the renewal, and the renewals require the lenders’ approval.

Synthetic leases can be combined with I.R.C. §1031 like-kind exchanges to defer gain on the sale of obsolete facilities, using property subject to a synthetic lease as the replacement property. They have also been structured using taxable or tax-exempt financing. Some lenders are offering "seamless" construction and permanent off-balance sheet lease financing with a "construction phase" synthetic lease and a "permanent phase" leveraged lease. Interim or "bridge" synthetic leases have become relatively common in the market. Interim synthetic leases are particularly useful as a way to keep long lead-time purchases of integral equipment, such as turbines, off-balance sheet.

Synthetic leasing is spreading internationally as well. However, implementation of a synthetic lease outside of the U.S. may require that the transaction comply with U.S. GAAP and applicable local accounting rules. In addition, the lessee must carefully structure around local VAT and other applicable taxes.

Synthetic leasing of power plants can present a number of challenges. Often, the company must arrange for turbine purchases significantly in advance of closing the synthetic lease. In addition, EPC agreements must be entered into by the lessor, not the lessee. Interconnection and other project agreements may call for bonds, letters of credit or other security, which can be problematic under the accounting rules applicable to synthetic leases. Careful structuring of such agreements is required to maintain the lessee’s off-balance sheet accounting treatment. However, on the operational side, synthetic leases often can provide greater flexibility than the typical project financing because a synthetic lease is recourse to the lessee up to the maximum guaranteed amount referred to above.

Although synthetic leases appear to be a complicated web of accounting rules, they can be surprisingly easy and efficient to execute. It remains to be seen the extent to which energy deregulation and other changes in the industry may affect the structuring and implementation of synthetic leases in the power arena. For now, the popularity of synthetic leases undiminished, and they provide an attractive means of providing off-balance sheet financing.

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