Synthetic Leases: Lessee Involvement in Asset Construction and the Effect of EITF 97-10

Darlene R. Davis
410-347-7306
drdavis@ober.com

In a typical build-to-suit lease transaction (whether the lease is a true lease or a synthetic lease), a lessee is involved in the construction of a facility to be leased to the lessee upon completion. An important factor in the accounting analysis of such a transaction is whether or not the lessee is considered the owner of the facility during the construction period. That issue determines not only whether the lessee records debt during the construction phase, but also how the lessee and lessor account for the lease after commencement. Under Financial Accounting Standards Board Statement No. 98 (FASB 98), a sale-leaseback of real estate will not qualify for either sales recognition or operating lease recognition if a seller/lessee has any continuing involvement other than that typical of a "normal" leaseback. Examples of prohibited types of involvement include: (1) retaining an obligation or option to purchase the property (excluding a right of first refusal); (2) providing guarantees of the buyer/lessor's investment or other credit enhancements; (3) being required to pay the buyer/lessor at the end of the lease term for a decline in the value of the property; or (4) sharing in the appreciation of the property value with the buyer/lessor.

The "continuing involvement" restriction in FASB 98 has a significant impact on any landowner who wants to recognize a sale prior to entering into a build-to-suit lease. The restriction also has a great impact on the accounting treatment afforded to synthetic leases (secured financings structured as operating leases for accounting purposes and as loans for tax purposes). Because a typical synthetic lease involves the very type of lessee involvement described in FASB 98, it is almost impossible to get synthetic lease treatment for sale-leasebacks of real property. Therefore, to avoid the pitfalls of FASB 98, parties to synthetic lease transactions typically arrange for the lessor to take title directly from a third party, and, where the transaction involves construction, the lessor will typically purchase the land and appoint the lessee as construction agent to complete the project. Until recently, many leasing insiders considered the fact that the lessee is not in the chain of title to be dispositive of the sale-leaseback issue.

The sales-leaseback analysis changed drastically in 1997, when the Emerging Issues Task Force (EITF) of the Financial Accounting Standards Board published a consensus report (EITF 97-10) regarding "The Effect of Lessee Involvement in Asset Construction." In short, EITF 97-10 (which is effective for transactions entered into after May 21, 1998) specifies two circumstances in which a lessee will be considered the owner of property during a construction period (regardless of whether the lessee has actual title to the property). First, the lessee will be considered the owner if the construction documents require, under any circumstance, that the lessee pay more than 90% of the total project costs (exclusive of land acquisition costs, certain environmental remediation costs, and the costs of "normal tenant improvements") at any point during the construction period. The lessee's maximum payment (or "maximum guarantee") would be calculated based upon worst case assumptions and would include:

lease payments that must be made regardless of when or if the project is completed;

any guaranty of construction financing made by the lessee or a related party;

primary or secondary obligations to pay project costs under construction contracts;

obligations that could arise out of being developer or general contractor;

an obligation to purchase the real estate under any circumstances;

an obligation to fund construction cost overruns;

rent paid to the lessor or other fees or transaction costs to be paid by the lessee during the construction period; and

payments that might be made with respect to indemnities.

In addition, the working group concluded that, even if the present value of the lessee's maximum guarantee does not violate the 90% test, the lessee is to be considered the owner if any of the following conditions occur:

the lessee makes loans or advances (other than those subject to periodic reimbursement) to the owner lessor or a related party, or makes an equity investment in the owner-lessor or a related party;

the lessee is responsible for paying any costs other than (a) those made pursuant to a contractual right of timely reimbursement, (b) specified environmental costs, or (c) normal tenant improvements;

the lessee indemnifies the lessor for pre-existing environmental risks that are more than remote;

the lessee provides indemnities to parties other than the owner/ lessor, or provides the owner/lessor indemnities against third-party claims (other than claims caused by the lessee's actions or failure to act);

the lessee takes title to the real estate at any time during construction or provides materials other than those purchased after lease inception for which the lessee is entitled to reimbursement; or

the lessee owns or leases the land and does not lease or sublease it to the owner/lessor prior to commencement of construction (although the improvements could be outside the scope of FASB 98 even if the land itself is covered).

EITF 97-10 has proved to be quite troublesome, particularly for parties to synthetic lease transactions. Until May of 1998, construction agency agreements were widely used by parties in build-to-suit synthetic leases. From the lessor's perspective, the agency agreement created a relatively safe way to avoid problems under FASB 98. The lessor could take legal title (or lease the real property from the lessee or a third party), but the lessee, ostensibly acting as agent for the lessor, would construct the facility, and bear the all of the risks during the construction period. After EITF 97-10, construction agency agreements will probably be used more sparingly, for a number of reasons. First, there is no clear consensus among the large accounting firms as to exactly how EITF 97-10 should be interpreted and applied. Secondly, and perhaps more importantly, many lessors may be reluctant to permit the construction of improvements in their names and on their behalf without full indemnification for environmental risks (whether or not remote), as well as full indemnification for liability to the contractors, subcontractors and other third parties, which indemnification would violate EITF 97-10. Some financing sources may be willing to take the increased risks involved in using agency agreements after EITF 97-10, but these increased risks will almost certainly not be without increased costs.

Although the leasing industry has historically shown a strong ability to adjust and vary lease structures as accounting rules change, it is likely that EITF 97-10 will result in at least a slight decline in the use of synthetic lease structures for construction projects. It remains to be seen, however, whether EITF-97-10 signals a trend toward the overall tightening of lease accounting rules.