Franchise and independent dealers alike are feeling the pinch from the “perfect storm” of negative market factors that are substantially squeezing their profits. In a changed automotive environment, continuing to do the same things is not likely to produce acceptable results. Therefore, many dealers are investigating the opportunity to start buy-here, pay-here (BHPH), lease-here, pay-here (LHPH) or rent-to-own (RTO) programs.
The power of these options is that the dealer no longer has to rely on third-party lenders to consummate the transaction because the paper is maintained in-house. This dramatically increases the credit spectrum of customers that the dealer can serve and the profit opportunities for each transaction.
Definitions and distinctions
You’ve seen the terms “BHPH,” “LHPH” and “RTO” before, but rarely are they accompanied by clear definitions. The products offered under each label sometimes further blur the legal differences.
LHPH programs start with a “true lease.” This distinction applies to the IRS definition for tax purposes and the Federal Reserve Board definition for regulatory purposes. (Meeting the federal tax and regulatory purposes also will generally keep the transaction safely outside the state definition of “conditional sales,” which can be found in your state’s motor vehicle retail installment sale acts). While there are a number of technical requirements and some gray areas, a “true lease” tends to have two main characteristics:
• A market-value residual value. This means the residual value can’t be so low that it creates “equity” in the lease or gives the lessee a “bargain purchase option” that is far below the projected fair market value of the vehicle.
• A term of at least four months. If a transaction (denoted as a lease) violates the first requirement, it could be treated as a conditional sale (Regulation Z and the state motor vehicle retail installment sale act then apply). If it doesn’t have at least a four-month term, it is a rental, not a lease, and therefore subject to any state requirements for rental transactions.
A “true rental” in an RTO program has no minimum term. The lessee can terminate the agreement after any payment period without further obligation. Thus, if an RTO transaction has a minimum term of four months or longer, it is no longer a “rental” and becomes either a “lease” for federal regulatory purposes (Regulation M applies) or, worse, a conditional sale (Regulation Z applies).
Why are LHPH programs preferable?
There are a number of tax, accounting and regulatory differences between conditional sales and leasing that make LHPH programs more attractive and potentially much more profitable than BHPH programs. Compared with RTO programs, LHPH programs are much safer from a compliance standpoint because there are “safe harbor” federal requirements that are relatively easy to follow.
RTO programs have no federal safe harbor, so the states have created a messy array of rules. Worse, state attorneys general often view RTO programs as “predatory,” and create retroactive restrictions and penalties in response to consumer complaints.
Five primary benefits of LHPH programs
The main advantages of LHPH programs over BHPH are the huge increase in upfront cash flow from federal and state income and sales tax differences. Because of the high default rates, the key to a successful BHPH or LHPH program is getting upfront cash to cover the transaction costs and initial depreciation of the vehicle.
BHPH programs have two big cash-flow problems: Most of the customer’s upfront cash payment goes to state sales tax, and the markup on the vehicle creates a significant federal/state income tax liability for the dealer. This follows the deal even after sale of the transaction to a related finance company (RFC) at a discount.
Thus, after paying the upfront sales tax and income tax, the dealer starts most BHPH sales in a negative cash position even if $1,000 was collected from the customer. LHPH programs solve that problem, particularly in the majority of states in which sales tax is collected only on the periodic payments, not upfront.
1. Deferred federal and state income tax liability. In a BHPH conditional sale, there is a significant “gain on sale” when the vehicle is sold, even after the retail installment sale contract (RISC) is sold to an RFC at a discount. Combined federal and state income taxes usually account for at least 40 percent of this “paper profit.”
In LHPH transactions, there is no “gain on sale” when the vehicle is leased because there is no sale! Therefore, there is no initial income tax and no need to sell the lease to an RFC in order to book a separate “loss on sale of the lease.” Additionally, because the leased vehicle can be depreciated on an accelerated basis, the transaction starts with a tax loss from the accelerated depreciation. This creates, in effect, a tax shelter for the dealership rather than a big income tax liability.
2. Elimination of initial sales tax. In most states, the elimination of the upfront sales tax creates an even more dramatic advantage for LHPH. The majority of state codes do not consider an LHPH transaction to be subject to the initial sales tax due on the sale of the vehicle in a BHPH RISC transaction. The customer’s initial cash payment can be retained as a nontaxable security deposit rather than paid to the state as a nonrefundable sales tax.
3. Acceleration of accounting income. Though an LHPH transaction creates a deferral of federal and state tax liability, it actually accelerates the dealer’s accounting income. Virtually all leases of at least 24 months will qualify as “sales-type” leases. The markup profit then is recognized at lease inception rather than being earned month by month over the lease. That profit will substantially improve the financial statement and balance sheet, which may support an expansion of the dealer’s credit lines or other borrowing capacity.
4. Collection of tax-free security deposits. Leasing traditionally includes collection of a refundable security deposit at lease inception rather than the down payment. Compared with a downpayment, security deposits are: 1) Nontaxable, 2) retained throughout the transaction as an offset against default liability and 3) collectible at any point in the lease.
5. Avoidance of a related finance company (RFC). Most BHPH dealers create an RFC to reduce the RISC income tax. This requires a second set of administrative and financial recordkeeping and related expenses. Because there is no initial income tax liability for an LHPH transaction, there is no need for an RFC. This also eliminates the need for a second dealer license in the RFC to repossess and sell vehicles. Secondary benefits of LHPH include:
• Reduced federal regulatory requirements
• Reduced state regulatory requirements
• Reduced consumer disclosures
• Bankruptcy protection
Five risks inherent to LHPH
Like any other program, LHPH naturally carries certain elements of risks for dealers.
1. Vicarious liability exposure. In some states, lessors have been held responsible “vicariously” (that is, with no finding of lessor negligence or fault) for injuries caused by negligent lessees simply because the lessor owned the leased vehicle. However, this risk is covered by “contingent” and “excess” liability insurance coverage.
2. Separate lease accounting system. LHPH programs cannot be accounted for and managed properly on BHPH accounting and data processing systems. A specialized system is required.
3. Avoidance-of-sale terminology and potential “true lease” compliance. Dealers must understand that leasing has its own terminology, legal requirements and customer rights and duties. All staff members must be trained to not use BHPH sales and/or finance terminology because of the potential for confusing customers or violating federal and state disclosure or advertising rules and regulations for leasing.
4. Unfamiliarity among staff and customers. Because most dealership employees are not leasing experts, some technical assistance must be sought out to train the staff, provide ongoing supervision and develop accurate answers to frequently asked questions.
5. Third-party sale/funding limitations. Some BHPH dealers sell their loans and portfolios to third-party finance companies. Others operate on lines of credit with lenders who are familiar and comfortable with BHPH. A change to LHPH may limit the salability of the assets or require increased due diligence from the purchaser or lender, especially due to the residual value risk.
Despite the risks, the benefits of a successful lease-here, pay-here program have paid off for many dealers. Next month, we’ll take a look at the steps and issues involved in implementing a successful LHPH program.
Randall McCathren is an attorney and consultant with more than 25 years’ experience in consumer vehicle leasing. He represented industry members in the formulation of the 1998 Regulation M and has consulted with the Federal Reserve Board on leasing regulatory issues. He is the co-author of two books on vehicle leasing: The Automobile Lending and Leasing Manual and Essentials of Consumer Vehicle Leasing. E-mail him at [email protected].