By Bob Gillispie

Equity participants in the leveraged-lease market are agonizing over whether they have to rerun earnings from a variety of highly-structured equipment lease transactions that were done in the last decade. These deals have names like replacement lease, LILO or SILO. In a typical deal, a European government agency might have leased railroad cars or an electric distribution system to a US institutional equity investor and then leased it back. “LILO” stands for “lease-in-lease-out.” “SILO” refers to deals where equipment was sold and then leased back. The deals were also done in the United States between US institutional equity investors and tax-exempt entities.

The Internal Revenue Service is moving to disallow tax benefits in the deals. Some companies have negotiated settlements with the IRS. The Financial Accounting Standards Board is debating whether these companies are required to rerun their earnings from the deals based on the actual pattern in which tax benefits end up being taken.

Chadbourne hosted a conference call to report on the debate and the options that companies have if they are forced to rerun numbers. The participants on the call were Roy Meilman, a tax partner in the Chadbourne New York office, William Bosco, chairman of the accounting committee of the Equipment Leasing Association, and Richard Specker, managing director of Global Capital Finance and a
former senior leasing executive with NationsBank and Fleet. The moderator is Bob Gillispie, head
of the leasing group at Chadbourne in New York.

IRS Update

MR. MEILMAN: The Internal Revenue Service issued guidelines last February indicating the terms on which it would be willing settle tax claims against US companies that participated in LILO transactions.
The methodology portion of the guidelines was deleted when they were made publicly available, but in
dealings with the IRS, the core of the agency’s approach has become generally known. To oversimplify, but not very much, one starts by negotiating a constant percentage with the IRS. The percentage starts at 50 or 50ish and goes to 80%. You then take that percentage and apply it to the bottom-line tax loss or the bottom-line taxable income in the LILO transaction on a year-by-year basis. So that, for example, if the negotiated percentage was 60%, you would take 60% of the year one tax loss and move it from year one to the year of the fixed price purchase option under the sublease. You would take the same 60% of the year two tax loss, move it from year two to year last, move 60% of the tax loss for year three from year
three to year last, et cetera, and when the transaction turns tax positive you would, again, take 60% of the
positive bottom-line taxable income from that year, move it to the year in which the purchase option becomes exercisable, et cetera, year by year. That methodology results in an underpayment of taxes for pre-settlement years. Interest would also be owed on the back taxes. 

A number of investors — a limited number — have settled. The terms of those settlements are known only to those investors. A number of other investors are contesting the IRS claims either under the agency’s “fast track” procedure or are in the normal appellate procedure with a view to settling. BB&T has filed suit in the federal district court in Greensboro, North Carolina, seeking a refund on a LILO involving pulp mill equipment in Sweden, and a number of other investors are considering litigation.

More generally, over the last couple of years, the IRS has won a number of cases involving corporate tax
shelters, and the IRS has lost a number of cases involving corporate tax shelters. None of those involved LILOs or SILOs.

There are two things, among many others, that are notable about the settlement methodology the IRS has adopted. The first is that it is completely arbitrary. There are a dozen theories the IRS has asserted in attacking LILO and SILO transactions, but none of them would lead to the pattern of taxable income and tax deductions on which the settlements are based. So, at the end of the day, it is a formula for coming
up with a number of dollars. 

Second, when the IRS issued the settlement guidelines, it was trying to be sensitive to the investors’ financial accounting considerations. And, indeed, the IRS proceeded on the understanding that because the described methodology affects the timing but not the amount of taxable income and deductions, there would not be an impact on the investors’ financial statements. 

Whether that is where the accounting is coming out, Bill Bosco will address, and one of the other things that I think we wanted to start people thinking about is whether there’s a way to give the IRS, in rough justice, the same number of dollars, but package it in a way that does not adversely affect the financial accounting. With that, I will turn it over to Bill. 

Accounting Issues

MR. BOSCO: The accounting issue is whether to rerun or not to rerun - that’s the question. Let me start with some background: what the accounting questions are, talk about some of the accounting literature and comment on that, talk about what the Financial Accounting Standards Board has done so far, give you an update on the status and what FASB’s future plans are to meet on this issue, update you all on the Equipment Leasing Association action plans, and then give my opinion on what’s likely to happen after all is said and done.

In terms of the background, LILOs have already been subject to IRS settlements as far back as 1999, and many lessors have, in fact, not rerun their leveraged lease accounting earnings as a result of IRS  settlements. Now SILOs will be subject to IRS settlements as a result of the new tax factors. Another point of background is that composite income tax rates have changed in the recent past and some lessors have rerun their leveraged lease earnings, while other lessors have not as a result of income tax rate changes.
The “big four” accounting firms have concerns due to the inconsistency of treatment with some companies
rerunning and some not rerunning and the size of potential adjustments. They have met and talked about the issue, but they have also asked the FASB several questions, because the rules regarding when to rerun the leveraged lease earnings are not explicit. 

Now, let’s talk about what the accounting issues are. This may sound a little confusing, but one accounting
question is whether you rerun the leveraged lease earnings if tax deductions are rescheduled, but there is
no change in taxable income and after-tax income.

Another question is whether you rerun the leveraged lease earnings if your composite income tax rate changes, with the result that there is a change in net income. Another question is whether you reschedule tax deductions when you do a rerun of leveraged lease earnings due to a change in the composite income tax rate.

The last question is whether you reconsider the lease classification as to whether or not the transaction is a leveraged lease, as a result of rerunning the earnings. Those are the four questions. FASB was  presented the questions in a slightly different format when it met on November 17.

Let me talk first about the accounting rules that come into play when trying to answer the questions. With regard to rerunning earnings, paragraph 46 of FAS 13 addresses this but it is a little vague. It says that you must rerun your earnings if there has been a change in the estimated total net income from your original 
assumptions. A change in scheduling of deductions does not change estimated total after-tax net income, and although it is not explicit in the rules, the practice has been not to rerun deals just because of  rescheduling of deductions. In other words, the big four accounting firms have decided that even though it is not explicit, you do not rerun earnings after a mere change in timing. The major accounting firms have enforced this and precluded recalculation of earnings when total estimated net income from the lease did not change. 

The next question is what happens if my income tax rate changes? There have been a couple of pieces of
accounting literature that dealt with this. Specifically, there is a FASB technical bulletin, 79-16, that  confirmed that the income tax rate in the leveraged lease is an important assumption and the change in that income tax rate requires a rerun. A lot of people have not rerun because of income tax rate changes, and I think what they are falling back on is an EITF issue 87-8 that dealt with alternative minimum taxes, where a lessor asked a question about what happens if it does in and out of AMT, does that mean that it must keep rerunning its leveraged lease earnings? FASB said that if your tax position changes between AMT and regular tax, you are not required to recompute each year, unless there is reason to believe that the original assumptions are no longer valid, meaning you are not likely to ever come out of AMT. This would change your tax expense and your total net income. I think people have been using that
guidance to say if my income tax rate changes with the possibility of reversing, I should not rerun. Composite income tax rates often change up and down if you book a leveraged lease in a multi-state vehicle as the composite income tax rate will change due merely to apportionment changes that occur every year. The theory is that if I am unsure that my total net income really has changed because the income tax rate will fluctuate in the future, then I do not rerun until I know that there has been a change in my total net income.

That is the guidance on the issues in front of us today. To summarize, if there has been a change in the timing of deductions, the practice has been not to rerun earnings. If there has been a change in the tax rate, the rules say you should rerun, but many people have not rerun, probably because they believed that the tax rate change was not permanent.

The other question — the last question that I mentioned — is the question of lease classification. If I
rerun my lease, should I re-examine my leveraged lease classification tests? The literature currently says that you really should only retest classification if there has been a change in the agreement, not a change in the assumptions. The issue here is that if I do rerun my leveraged lease earnings and the investment does not phase as a result of the rerun, then I do not meet all of the leveraged lease classification tests. I do not think that will be a question that will result in an adverse accounting decision for the industry.

Moreover, in the LILO and SILO examples of reruns that I have seen, the investment still does phase.

FASB View

What does FASB think of this? What actions has it taken and what is the status?

First, I should say that the big four generally agree that leveraged leased earnings should be rerun when
there has been a change to the composite income tax rate that is unlikely to reverse. They also agree that you should use the rescheduled tax deductions if rescheduling has occurred. They have asked FASB for clarification. 

FASB met on this issue on November 17. FASB was asked the questions on whether or not you rerun, and when you rerun, and it was also asked the question whether lease classification should be reconsidered.
It came to two tentative conclusions that the industry does not like.

The first tentative conclusion is that you should rerun when tax deductions are rescheduled. This answer
presumes that you will rerun when the income tax rate changes. Even if the income tax rate has not changed, FASB is saying that you should rerun. The second conclusion is lease classification should be reconsidered. 

In other words, if the investment no longer phases, or does not phase as a result of the recalculations, then you should reclassify the lease. That would be horrendous, because it would mean having to “gross up” the investment on your books and record the leveraged lease debt as a liability.

The important thing to note here is that the conclusions were tentative. FASB instructed the staff to research the issues and recommend threshold limits, which, if met, would force a rerun. FASB will meet again with the idea of making final decision in early February After the FASB meeting, the Equipment Leasing Association made some action plans. ELA scheduled a meeting in early January with the FASB board liaison member. The agenda for the meeting is first to present a comment letter that addresses the FASB tentative conclusions. ELA believes it has support for reversing or modifying the tentative conclusions. If FASB holds to its tentative conclusions, that really amounts to an amendment to Statement 13. FASB would rather not add reopening Statement 13 to the board’s existing workload. ELA is also arguing that it is not appropriate to consider reclassification when leveraged lease assumptions change, and there is support in the literature for that conclusion. ELA plans to give FASB a primer on leveraged leases so that the board understands what a leveraged lease is, what the MISF yield calculations are, and
some of the background on the accounting issues that FASB is considering. ELA plans also to present a hypothetical case of a LILO where tax deductions are rescheduled, and to show the board several different cuts with and without tax rate changes, so that FASB understands the potential magnitude of the adjustments.

Here are my predictions about the ultimate outcome. On the issue of reclassification, I believe FASB will
change its tentative conclusion. The only time that you are supposed to recalculate, or retest a lease, is when an agreement changes. There is no change in the agreement when tax deductions that were assumed fail to be realized. I think the industry should take comfort in the fact that the LILO and SILO examples that we have seen have not resulted, or are still resulting in phasing, so I think that classification will not be an issue. We still plan to fight FASB because we want to make sure that the principle stands.

The bottom line is reclassification is not an issue about which we will have to worry. On the issue of rerunning, we have to worry about that. ELA may be able to convince FASB that reruns should not be done if there have been merely a change in the timing of deductions, because some literature and the
practice supports that conclusion. In other words, if there has been no change in net income, but merely a change in the timing deductions that affects the MISF yield, we may be able to convince FASB that you don’t have to rerun. 

I believe FASB will require reruns when the composite income tax rate changes. I believe FASB will require using any changes in timing of deductions in the assumptions so that, if there has been a composite income tax rate change, you will have to rerun with the new assumptions,. That will be bad news for the industry. I have a suggestion about which Roy Meilman started to talk earlier. The only way to avoid a rerun is to negotiate with the IRS to pay interest on the tax adjustment, rather than actually rescheduling deductions and paying under a new schedule of deductions. The reason is if you do not reschedule your deductions, the big four have generally followed the interpretation that you do not have to rerun. They have also held unanimously in the past that payments of interest and penalties to the IRS should not be included in the leveraged lease earnings recalculation.

In other words, if you pay interest and penalties, rather than reschedule, you do not have to rerun.

Business Considerations

MR. SPECKER: I am going to focus on the business considerations tied to management of opportunities that may present themselves, or compel themselves, as a result of changes in the tax profile of LILO and similar structures.

This should include all transaction types that have been done in the cross-border tax-exempt structured
markets since the early 1990s. I would include O-FSCs, which are a subset of the traditional Pickle  replacement lease structure. This was followed by the Pickle lease with a mini-replacement lease and residual value guarantees. These structures were eliminated in 1996 and gave way to the early leasehold structures, which involved section 178 and the optional prepayment leasehold structure, which then rapidly evolved into the LILO as we came to know it. Then, post Rev. Proc. 99-14, the dominant structure was the lease-to-service contract, which I will begrudgingly refer to as the SILO.

Thus, we have Pickle replacement lease deals, early LILOs, LILOs and SILOs as the transactions in question. When you look at the situation from the standpoint of an equity investor, the question is, “Why should I consider doing anything at all with my existing portfolio?” Bill Bosco obviously pointed out the grand reason, which is the changes to leveraged lease accounting threatened by FASB. But there is almost a perfect storm of other elements converging to cause the investor to consider making changes in the portfolio to address these issues.

The first issue is the prospective accounting changes that may yet occur. It is clear that if they do not occur in the way that would be most damaging — an automatic rerun because of the change in timing — the investor is still going to be faced with a potential rerun, which would incorporate that change no matter what, if there is a change in some other variable like tax rate. Second, there is the tax environment generally, and a variety of connected audit settlement issues. Third, we have a regulatory environment, with Basle 2 coming on, that may cause these transactions to attract more capital; this is more of a balance sheet and capital management issue.

Lastly, in this little perfect storm of negative elements, there is that subjective quality of reputational risk. I think this is probably less of a concern now that the industry is not actively pursuing new transactions and, therefore, these deals will not be in the media, but still it remains something about which most institutions have some lingering concern. When you consider the business aspects of what action to take given these negative developments, there are six primary issues to consider. I have to caveat everything with the observation that every individual transaction is, and needs to be, dealt with on a case-by-case basis. However, there are general principles that apply when looking at the opportunities that could be there.

The first issue is, “What is the book position of the asset in the portfolio?” Is the book termination value
equal to the document termination value? Did the document termination values originally provide for some
padding, so that they protected an amount more than book exposure? Have there been prior reruns for nonsettlement related changes? Bill Bosco mentioned the change in state apportionment where a change in the composite tax rate might actually create a potential book termination value that is less than the original termination value in the deal. If a tax settlement is reached, but there is no rerun, then we have to consider what is the potential liability associated with the composite tax rate change; I would break those into two concepts, the current liability created by a non-settlement rerun, and then the contingent liability that we believe will be hanging out there indeterminately unless the IRS comes up with another settlement option.

The contingent liability arises where you do not have to rerun as a result of a settlement or an audit change or any kind of result that involves a changed tax profile, but you will have to incorporate those changes
when another important assumption changes subsequently. The long tenor of these transactions should
indicate to all that the likelihood of some change occurring down the line is very, very high, so this risk will be hanging over these transactions for a long period of time. The questions are: how do I manage that exposure? How do I quantify it? It can be summed up generally by asking, “Is taking a small loss now better than possibly taking a huge loss later?” Those decisions are individualized, not just in a portfolio sense or an institutional sense, but also from deal to deal.

The second aspect is the value and nature of the equity collateral. In the early days of these deals in the
cross border market, the Pickle replacement lease structures, in particular, were often done with  standalone strong credits. There may have been letters of credit involved, but there typically was some strong standbehind credit such as the Kingdom of Sweden on an SJ rail deal, or Belgium for SNCB, or the Swiss Confederation for a national rail deal in Switzerland. These circumstances might offer less of an opportunity to come to a structured exit from the transaction. It depends, too, in more recent transactions, whether or not the collateral is liquid. Is there a package of treasury securities or highly-rated quasi-government securities, or is it a less liquid payment undertaking agreement or other guaranteed investment contract or deposit type instrument? Of course, the range over the years includes simple bank deposits, time deposits at banks, internal swaps, external swaps, the PUA and basic institutional GIC, and also securities held in a custodial account. This last case typically offers the best opportunity to create some sort of structured settlement. 

It is also very important to consider the interest rate environment when the collateral was put in place. Deals done before 1996 or 1997 are more optimal because the rate environment was quite high. The rate environment we find today has substantially lower prevailing interest rates. This, coupled with a shorter remaining term to maturity, can create a break funding environment where theequity collateral has a greater value than might have been originally anticipated when scheduling it from the inception of the lease. The third aspect involves the individual lessor’s need or interest in boosting current income. I mention this because it can drive a decision. If the company is flush with income — although I don’t think too many lessors are finding themselves in that position these days — if institutionally there is the ability to absorb smaller losses now, it might argue for arranging exit strategies from transactions. On the other hand, if there is a great need for current income (because of the runoff in the business) that cannot be easily replaced, then there are clear opportunities embedded in many of these transactions that allow for book revisions and portfolio engineering techniques to be applied that can create an increase in current income. This is totally absent from any considerations with respect to tax-structured settlements, and they should be considered in light of the risks and rewards that might come from those events happening. 

Looking at the book position and the asset levels on the balance sheet might create a fourth analytical element to consider. A lot of these transactions are going to be coming into periods where the gross investment balance is large, but the transactions are generating little book income. Thus, you have an asset that is attracting capital, and may actually soon be attracting more capital under Basle 2, and that is not providing any meaningful return. This creates no real problem on an individualizeddeal basis, but it does produce a significant drag on portfolio returns on equity; dragging down the overall return on equity of the leasing company. 

The fifth element for an investor to consider is the benefit of the unwind or termination strategy that could
be created in cross-border deals from a foreign source income perspective. Where, by virtue of  engineering a sale or a termination or the variety of other mechanisms by which you can exit these transactions, you create a large current amount of foreign source income. This could free up foreign tax credits that would otherwise go unutilized and could compel economics in another side of the corporation’s books that might justify taking the small loss that might result from terminating a deal. There may be a small loss. There also may be a small gain. Each transaction needs to be examined individually to ascertain the foreign-source impact. 

Last from the standpoint of business considerations, we have to look at the lessees and what their issues are. I think there are three primary ones. Most lessees that entered into these transactions over the years are now finding them a bit of a burden from a variety of different standpoints. First, the deals are often administratively burdensome, although it depends on the individual deal and what the administrative requirements actually are. They produce a hassle factor. Next, the encumbrance on the business ability of the lessee is proving in a number of cases fairly significant and costly. Any lessees that entered into compelled reorganizations, mergers, or other business combinations or who have been interested in making, or have been compelled to make, asset transfers to affiliated entities within the jurisdiction find that the LILO and SILO transactions, that gave them these significant cash benefits up front, now provide a significant impediment to operational flexibility. 

The last element is really a cost-related factor pertaining to the lessee’s issues; have there been credit triggers which have caused either upgrades in collateral or other additional credit support needed to be posted which will have some cost to the lessee over the remaining term of the transaction? With one transaction that we were involved in, by way of example, the lessee did a simple present value analysis and said if it costs me X on a PV basis to provide a LC for the remainder of this term and this is a new trigger event and I can terminate the transaction for something exceeding the value of X plus the collateral then I’ve got a net gain. This is the kind of analysis that goes into the thinking there.

Options?

Which options should be pursued, and how should they be engineered? You can’t really discuss that on a
conceptual basis because each case is different. Solutions that can be employed are not conceptually complicated, but we have found, through a fairly large experience base, that the execution is complex. It can be quite difficult and it requires management of the documentation process, approval issues, expectations of management and then dealing with liquidation of collateral.

The options can be distilled into four basic categories. One is “terminations”; there are several ways they can be effected. Another is an outright sale of your interest in the transaction. Engineered collateral changes, which are more of a book-revenue enhancer or a cash-raising device, have attracted a lot of attention. They are not the only available book management device. There are a variety of simple, in principle, but fairly involved in execution, pure book revision strategies. These are slight modifications to the lease that allow you to accelerate or decelerate income in a way that creates a book benefit in the current period. Again, that is absent any of the gross considerations involved with tax settlements. With the looming threat of an ultimate rebooking, whether in January of 2005 or January of 2007, we believe it is important for lessors to engage in the serious analysis of all the issues and look at the strategies that are available to manage exposure with existing transactions.

Terminating a Transaction

MR. GILLISPIE: Now if Rick Specker was persuasive enough to convince people to terminate one of these
deals, then the issue would become how to document the termination?

The documentation itself is simple. It consists of an assignment of the various collateral agreements to the
respective parties. For example, there would be a debt assignment agreement whereby the lessee would transfer the defeasance to the lessor — again remembering that the collateral is really the lessee’s. Then the lessor would transfer that on to the lenders, thereby terminating the debt side of the transaction. This would entail not only the 90% defeasance but in those cases where there is a 10% defeasance — directly in the documents or outside — you would need basically to roll both of those out. On the equity side, most of the older deals did not have equity collateral. The more recent deals had the strip collateral and, in those cases, the lessee would transfer the strip collateral to the lessor. An alternative to the foregoing, that Roy Meilman and I would strongly recommend, is for the lessee literally to purchase the leasehold interest from the lessor for a lump-sum amount. This is done in order to respect the formality of the transaction that we had entered into initially, and it would be effected by transferring or liquidating the various defeasances and paying a lump-sum amount to the lessor.

The reason for this approach is that one of the arguments the IRS has asserted in its audits is that in the
SILO and LILO transactions, the lessor should be treated really as an owner of the equity collateral, rather than as an owner of the asset. Effectively, the IRS is saying that the lessor is merely buying a stream of principal and interest payments rather than buying an asset. Therefore, that would be our suggestion on the assignment side.

The final documentation would be a termination of the lease agreement whereby all the parties are released from the various operative documents other than any existing indemnities for which the lessee would remain on the hook. The bottom line is that unraveling a lease transaction requires analysis of the underlying operative documents to make sure you turn square corners.

Audience Questions

MR: GILLISPIE: Now to questions for our speakers. The questions are coming in by email from  participants on the call.

The first question is for Rick. How big is the SILO-LILO market? And if FASB merely requires a rerunning of leveraged lease earnings and not the reclassification of the leveraged lease, would you expect most equity participants who have entered into IRS settlements to terminate their transactions?

MR. SPECKER: The answer to the first question is there are no hard facts. If you believe the US Treasury
Department, the market was $750 billion. I think the actual market size, even including precursor  structures, is about $150 billion. That is a significant number, but nowhere near what the government was maintaining. 

Now on reclassification versus rerunning for income purposes, there will not be a material difference in the need to find some exit strategy or some management strategy if rerunning is required but reclassification is not. I think reclassification is the worst of all possible worlds because you balloon up your balance sheet, but the negative economic and book impact of the rerun in almost every single situation that we have examined is so significant that the avoidance of loss motivation is tremendous and the exiting of the transaction is almost compelled.

MR. GILLISPIE: A follow up to that question — someone asked if Bill Bosco could quantify what are we
talking about? If someone had to rerun a transaction, what does it really mean?

MR. BOSCO: It depends on where you are in the life of the deal, whether you are in a sinking-fund phase or not, and the settlement you work out with the IRS. The reversal of earnings in some cases could be very significant. For deals in the sinking-fund phase, the reversal of earnings was as much as half the earnings already taken. Of course, it is a timing thing: you will be able eventually to re-recognize those earnings, but in some deals the wait is as long as 10 years.

MR. GILLISPIE: Roy Meilman, what impact would there be on IRS settlements if the FASB proposals are adopted? 

MR. MEILMAN: The inevitable tax lawyer answer to that is that it depends. I think if the FASB does what it has threatened to do and the IRS is wedded to its settlement methodology, then a lot of people will not settle. On the other hand, if there is a way to give the IRS the same number of dollars in a way that avoids both a current rebooking and a future rebooking on a subsequent event such as a change in tax rate or state apportionment formula, then things will continue as they have to date. 

The following idea comes from the four of us talking before this call, so it is not an idea that anybody has vetted with any of the accounting firms, but Bill Bosco believes it has a lot of promise. The thought is to go through the settlement methodology that I described and reach agreement with the IRS. That gives you two things. It gives you a schedule of taxable income and tax deductions under the settlement, and you  start out with the schedule of taxable income and tax deductions as reported and as one planned to report it. Take the difference between those two things — the settlement line and the reported line — and treat that, in effect, as a loan from the government to the taxpayer, recognizing that it will all zero out by the end of the sublease term, so you are implicitly repaying that principal. Pay interest on the amount, and the cash settlement is the interest on that hypothetical difference.

Bill Bosco and Rick Specker thought, off the top of the head, that this probably creates about the right number of dollars, although no one has run numbers. Bill may want to elaborate.

MR. BOSCO: I have suggested to the Equipment Leasing Association that we try to advance the concept in our lobbying with the IRS. The big four generally have held that interest and penalties are outside of the leveraged lease calculations. I think that if you do not reschedule, but rather pay interest on what you would have had to pay in taxes, you do not have to rerun because you do not have any rescheduling of tax deductions. One downside to that — probably a minor downside when you look at the earnings adjustment that you face — is that the rate that you would have to pay to the IRS is a lot higher than you would have to pay on internally borrowed funds. It preserves your earning pattern, but it costs you a little bit more annually in interest costs.

MR. GILLISPIE: Bill Bosco, someone asked the question — what do you see as the timing of the adoption by FASB of any proposal? 

MR. GILLISPIE: If FASB does not change its conclusions, it will have to amend Statement 13 and it could take a year for it to make the change because it would have to put out an exposure draft and go through the normal due diligence process. If, instead, it says it is just an interpretation, then FASB could act fairly quickly, finalizing this in a few months. 

MR. GILLISPIE: We have another question that came in from an investor. He says he booked a  transaction with only the federal rate and not the state tax rate. Given that the federal tax rate has not changed for several years and his company is not booking any state tax rate, has the composite rate really changed and would the company need to rerun the leveraged lease?

MR. BOSCO: I have seen leveraged leases that were booked in legal vehicles that only paid the federal rate and, if that is the case and over the life of the deal the federal rate has not changed, then you have no change in tax rate. You are safe under the current interpretation of the rules, but as I said earlier, FASB is now saying that regardless of whether the rate changed, if your deductions changed, you would have to rerun. 

MR. GILLISPIE: Another one for Bill Bosco — if the lease rerun is required, has there been any discussion about how to lock in earnings recorded to date and force the impact of the rerun on future years?

MR. BOSCO: The question is whether you can lock in the interest recorded to date and spread the impact over future years. I would like to see that happen, and the bank regulators would probably like to see that happen for bank-owned leasing companies, because of this quirky accounting rule requiring a huge loss and huge impact on capital and then a slow dribbling o the amount back into income. I doubt there is any basis in accounting for that. It would be a nice result, but I don’t think we can get there.

MR. GILLISPIE: Is that not similar to the alternative approach you had suggested, namely having it recharacterized as interest? 

MR. BOSCO: This is a different question. Suppose I have a large negative adjustment. Can I prorate it over future years? I would like that result, but I don’t know if we have any real basis for persuading the Office of the Comptroller of the Currency or the Federal Reserve to agree to it. 

MR. GILLISPIE: Another question — what if I priced my deal without the state tax benefit? 

MR. BOSCO: There might be some confusion about pricing and booking. Many lessors choose to do their pricing using a conservative tax rate. Suppose someone priced using only the federal rate. He figures that the state rate might change, and adding in the benefit of deferral on a state and local basis usually increases the yield. But pricing and accounting are two different things. When you run the deal for accounting purposes, you are supposed to use your composite income tax rate and so even if you did the pricing at a different rate, you are bound by accounting rules to use the right tax rate.

MR. GILLISPIE: The last question involves foreign tax credits. Rick Specker mentioned a foreign source issue. Roy Meilman, would you elaborate on the concept of the foreign tax credits and how they might be beneficial?

MR. MEILMAN: Many investors are unable to use foreign tax credits on a current basis because of the way foreign tax credits are set up technically. And in those cases, the credits get carried forward and then used some day. Generating a slug of foreign source income for those investors could well free up tax credits that can be used on a dollar-for-dollar basis currently, rather than only in the future, and if terminating a transaction has the effect of creating a significant amount of current foreign source income, then the cost of the transaction is cushioned by acceleration in the ability to use those foreign tax credits.