3.2 Definition of a Lease
ASC 842-10
15-3 A contract is or contains a lease if the contract conveys the right to control the use of identified property,
plant, or equipment (an identified asset) for a period of time in exchange for consideration. A period of time
may be described in terms of the amount of use of an identified asset (for example, the number of production
units that an item of equipment will be used to produce).
Pending Content (Transition
Guidance: ASC 842-10-65-7)
15-3A As a practical
expedient, an entity that is not a public business
entity; a not-for-profit entity that has issued or
is a conduit bond obligor for securities that are
traded, listed, or quoted on an exchange or an
over-the-counter market; or an employee benefit
plan that files or furnishes financial statements
with or to the U.S. Securities and Exchange
Commission may use the written terms and
conditions of a related party arrangement between
entities under common control to determine whether
that arrangement is or contains a lease. For
purposes of determining whether a lease exists
under this practical expedient, an entity shall
determine whether written terms and conditions
convey the practical (as opposed to enforceable)
right to control the use of an identified asset
for a period of time in exchange for
consideration. If an entity determines that a
lease exists, the entity shall classify and
account for that lease on the basis of those
written terms and conditions. An entity may elect
the practical expedient on an
arrangement-by-arrangement basis.
15-3B If no written terms or
conditions exist, an entity shall not apply the
practical expedient in paragraph 842-10-15-3A.
Rather, the entity shall determine whether the
related party arrangement between entities under
common control is or contains a lease in
accordance with paragraph 842-10-15-3 and, if so,
classify and account for that lease on the basis
of its legally enforceable terms and conditions in
accordance with paragraph 842-10-55-12.
15-3C If after an entity has
applied the practical expedient in paragraph
842-10-15-3A an arrangement is no longer between
entities under common control, the entity shall
determine whether a lease exists in accordance
with paragraph 842-10-15-3.
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If the arrangement was previously determined to be a lease and continues to be a lease, the entity shall classify and account for the lease on the basis of the enforceable terms and conditions. If the enforceable terms and conditions differ from the written terms and conditions previously used to apply paragraph 842-10-15-3A, the entity shall apply the modification requirements in paragraphs 842-10-25-9 through 25-17 using the enforceable terms and conditions. If the enforceable terms and conditions are the same as the written terms and conditions previously used to apply paragraph 842-10-15-3A, the modification requirements in those paragraphs are not applicable.
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If the arrangement was previously not determined to be a lease and is determined to be a lease, the entity shall account for the arrangement as a new lease.
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If the arrangement was previously determined to be a lease and the lease ceases to exist:
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A lessee shall apply the derecognition requirements for fully terminated leases in paragraph 842-20-40-1.
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A lessor with a lease previously classified as a sales-type lease or a direct financing lease shall apply the derecognition requirements for terminated leases in paragraph 842-30-40-2.
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A lessor with a lease previously classified as an operating lease shall derecognize any amounts that would not exist if the arrangement was not accounted for as a lease and account for the arrangement in accordance with other generally accepted accounting principles (GAAP).
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15-4 To determine whether a contract conveys the right to control the use of an identified asset (see
paragraphs 842-10-15-17 through 15-26) for a period of time, an entity shall assess whether, throughout the
period of use, the customer has both of the following:
- The right to obtain substantially all of the economic benefits from use of the identified asset (see paragraphs 842-10-15-17 through 15-19)
- The right to direct the use of the identified asset (see paragraphs 842-10-15-20 through 15-26). . . .
15-5 If the customer has the right to control the use of an identified asset for only a portion of the term of the
contract, the contract contains a lease for that portion of the term.
ASC 842-10-15-3 indicates that a lease is a contract — or part of a contract —
in which a supplier conveys to a customer “the right to control the use of
identified [PP&E] for a period of time in exchange for consideration.” The
graphic below illustrates this relationship.
Although the definition of a lease in ASC 842-10-15-3 includes the phrase “in exchange for
consideration,” the identification of a lease does not depend on whether the contract contains stated
or cash consideration. See Chapter 6 for a detailed discussion of lease payments and what constitutes
consideration.
3.2.1 Process for Identifying a Lease
To help entities determine whether a
contract is or contains a lease in accordance with ASC
842-10-15-3 and 15-4, the FASB included a flowchart in
its implementation guidance. Each piece of this
flowchart will be further discussed throughout the
remainder of this chapter.
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ASC 842-10
15-8 Paragraph 842-10-55-1 includes a flowchart that depicts the decision process for evaluating whether a
contract is or contains a lease.
Identifying a Lease
55-1 The following flowchart depicts the decision process to follow in identifying whether a contract is or contains a lease. The flowchart does not include all of the guidance on identifying a lease in this Subtopic and is not intended as a substitute for the guidance on identifying a lease in this Subtopic.
Connecting the Dots
Not a Step-by-Step
Process
The FASB’s flowchart in ASC 842-10-55-1 appears to suggest that the lease identification
assessment comprises a series of steps. For example, the flowchart seems to imply that, in
determining whether it has the right to control the use of an asset, an entity must determine
whether there is an identified asset in the contract before it can move on to assessing the right
to control the use in the following sequential manner:
- Whether there is an identified asset.
- Whether the customer has the right to obtain substantially all of the economic benefits from use of the identified asset.
- Whether the customer has the right to direct the use of the identified asset.
However, Example 10, Case A, in ASC 842-10-55-124 through 55-126 (reproduced in Section
3.7.10) states that when the customer in a contract does not have the right to control the use
of PP&E, an entity does not need to assess whether the PP&E is an identified asset. Accordingly,
we do not think that it is necessary for lease identification to be performed on a step-by-step
basis. (However, a step-by-step assessment is required for the specific evaluation of whether the
customer has the right to direct the use of the asset — see Section 3.4.2 for further discussion.)
One way to think about identifying a lease is that the definition of a lease
sits on a three-legged stool. Each leg represents one of the three
requirements in ASC 842-10-15-4: (1) the contract depends on an
identified asset, (2) the customer has the right to obtain substantially
all of the economic benefits from use of the PP&E, and (3) the
customer has the right to direct the use of the PP&E. If you were to
kick out any one of the three legs (i.e., if you were to determine that
a contract does not meet any one of the requirements), the stool falls
over and the definition of a lease is not met.
The flowchart below illustrates an entity’s determination of whether a contract
is or contains a lease and ties into the discussion in the remainder of this
chapter.
Connecting the Dots
It’s All About
Control
The notion of control is critical in ASC 842. The concept is used to identify a lease as well as to classify one when it is identified (see Chapters 8 and 9 for a discussion of the lessee’s and lessor’s classification, respectively). Accordingly, there is effectively a two-step process related to the control concepts behind the FASB’s ROU model in ASC 842:
- Step 1 — Determine whether the customer has the right to control the use of an identified asset. If so, the contract is or contains a lease. If not, the supplier has the right to control the use of the asset.
- Step 2 — Determine the extent of the customer’s control over the use of the asset. There is a range of outcomes from this step. However, if enough control of the use rests with the customer, the customer effectively obtains control of the entire asset. The extent to which the customer has control of the use of the asset governs the classification of the lease and its accounting.
In paragraphs BC124 and BC125 of ASU 2016-02, the FASB notes that the control concept in the
definition of a lease (i.e., step 1 as described above) should be compatible with the same concept
articulated in the revenue standard (i.e., ASC 606) and the consolidation guidance (i.e., ASC 810). Further,
paragraph BC134 of ASU 2016-02 indicates that, in the determination of whether a customer has the
right to control the use of an asset under ASC 842, the concept of control should have “power” and
“benefits” (or “economics”) elements, just as ASC 606 or ASC 810 do for control of a good (or service) or
another entity, respectively.
The table below compares the control principles from the leasing, revenue, and
consolidation standards.
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Consolidation
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Revenue
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Leasing
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---|---|---|---|
ASC Reference
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810-10-25-38A
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606-10-25-25
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842-10-15-4
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Control principle (power and economics
elements)
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“A reporting entity shall be deemed to
have a controlling financial interest in a VIE if it has
both of the following characteristics:
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“Goods and services are assets, even if
only momentarily, when they are received and used (as in
the case of many services). Control of an asset refers
to the ability to direct the use of [power element], and
obtain substantially all of the remaining benefits from,
the asset [economics element].”
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“To determine whether a contract conveys
the right to control the use of an identified asset . .
. for a period of time, an entity shall assess whether,
throughout the period of use, the customer has both of
the following:
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3.2.2 Embedded Leases
Section
3.1 clarifies the balance sheet impact of properly
differentiating between a lease and a service under ASC 842. Further, certain
contracts may not be wholly a lease or wholly a service; in fact, it is not
uncommon for some service arrangements to contain a right to control the use of
an asset. An entity may enter into a service arrangement that involves PP&E
necessary to deliver the contract’s promised services. The importance of the
PP&E to the overall delivery of the service may vary depending on the type
of arrangement. For example, a customer contracting for transportation services
to ship a package from Munich to Milwaukee may care little about the PP&E
used to perform the services. In contrast, a customer contracting a vessel and
crew for a specified period to transport its goods where and when it chooses is
likely to be more concerned with the PP&E used in the arrangement. Both
arrangements, however, involve a significant service component provided by the
supplier to operate the PP&E used to fulfill its transportation
obligations.
In accordance with ASC 842-10-15-2, entities must evaluate
service arrangements that involve the use of PP&E to determine whether the
arrangements contain a lease at contract inception. Often, the assessment of
whether a contract is or contains a lease will be straightforward. However, the
evaluation will be more complicated when a service arrangement involves a
specified physical asset or when both the customer and the supplier make
decisions about the use of the underlying asset. Examples of these more
ambiguous and complex arrangements include those that involve cloud computing
services (i.e., if there is a lease of the supporting equipment, such as
mainframes and servers) and cable television services (i.e., if the cable box
provided to the customer is a leased asset).
Further, not all leases will be labeled as such, and leases may
be embedded in larger arrangements. For example, supply agreements, power
purchase agreements (PPAs), and oil and gas drilling contracts may contain
leases (i.e., there may be an embedded lease of a manufacturing facility,
generating asset, or drill rig, respectively). If an entity identifies PP&E
in an arrangement (either explicitly or implicitly), the customer and supplier
must both determine whether the customer controls the use of the PP&E
throughout the period of use.
3.2.2.1 Embedded Leases and Service Providers
In a manner consistent with the discussion in Section
3.2.2, it is important to review contracts (particularly
service contracts) to determine whether they are or contain a lease. When
the service provider also conveys control of PP&E to a customer, an
embedded lease (to the customer) is likely to exist. On the other hand, when
the customer conveys control of PP&E to the service provider to
facilitate the delivery of the service, it is less likely that there is an
embedded lease in the arrangement.
In certain industry sectors, it is common for a customer to
provide a vendor with the use of an asset (e.g., a piece of customer-owned
equipment) so that the vendor can provide goods or services to the customer
(i.e., the “vendor’s revenue contract”). The vendor’s use of the equipment
is typically limited to activities defined in the contract that by their
nature only benefit the customer. Further, the vendor would not have the
right to opt out of using the customer-owned equipment (i.e., the vendor
could not choose to bring vendor-owned or vendor-leased equipment). In
summary, the vendor typically must use the customer-furnished asset and the
asset’s use is contractually limited to fulfilling the terms of the vendor’s
revenue contract with the customer (i.e., the asset cannot be used to
satisfy the terms of other contracts of the vendor and may not be assigned
to third parties).
Arrangements in which customer-furnished assets are used
exclusively to fulfill the vendor’s contract with the customer typically
include either of the following:
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One or more embedded leases that should be accounted for separately (i.e., a lease from the customer to the vendor and then a corresponding lease back from the vendor to the customer); some may describe such accounting as accounting for the arrangement on a gross basis.
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No leases (such accounting is sometimes described as accounting on a net basis, suggesting an equal and offsetting exchange of rights because the substance of the transaction is that no leases exist).
We believe that, in accounting for such arrangements, an
entity should carefully evaluate the facts and circumstances to determine
whether control of an asset is transferred through the rights to use the
asset as conveyed in the arrangement. In some cases, it will be appropriate
to recognize a lease; however, we believe that when the three criteria
outlined below are met, control of the asset is not conveyed to one party
(vendor) and then transferred back to the owner (customer).
When the three criteria are met, the substance of the
transaction is that there are no leases (i.e., neither inbound nor outbound)
and the accounting should therefore be on a net basis (i.e., there are no
separate accounting effects related to the customer-furnished assets).
However, if these criteria are not met or are only met for a portion of the
term of the use of the customer-furnished asset, the vendor and customer
should further evaluate whether the customer has leased its asset to the
vendor.
The vendor (potential lessee/sublessor) and customer
(potential lessor/sublessee) should not treat customer-furnished assets as
embedded leases (and recognize the gross effects of such leases) only if all
of the following three criteria are met:
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Linked contracts — The right to use the asset is directly linked to the revenue arrangement. That is, the arrangement is executed as part of one contract or each part of two or more contracts is deemed to be combined and accounted for as a single transaction since the contracts are interdependent.
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Coterminous period — Some or all of the period of use of the asset is coterminous with the revenue arrangement. As discussed further below, if the period of use for the asset begins before or ends after the revenue arrangement, this condition would only be satisfied (and therefore net treatment would only be appropriate) for the overlapping period.
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Restricted use — During the coterminous period identified in criterion 2, the vendor’s use of the asset is either restricted contractually or limited practically to solely transferring the goods or services promised in the revenue arrangement, including restricting the vendor from assigning or transferring the rights of the asset without the customer’s consent.
Accordingly, when all of the above criteria are met, there
are no leases of the asset and there would be no gross-up of revenue and
related expense (i.e., both the customer and the vendor would account for
the arrangement as a typical service contract) for the period in which the
vendor’s use of the identified asset coincides with the related revenue
contract (including renewal/extension options). If the vendor can use the
identified asset for a period longer than the related revenue contract,
there may be a lease for the excess period (i.e., use of the asset before or
after the related revenue contract begins or ends, respectively, provided
that control is conveyed to the vendor before or after the revenue contract
begins or ends, respectively). Therefore, the counterparties would need to
determine whether a lease commences when the related revenue contract
expires (or before it starts) because the output from the use of the
identified asset is no longer limited to satisfying the related revenue
contract.
The examples below illustrate situations in which the three
criteria are met and the arrangements would be accounted for on a net
basis.
Example 3-1
Customer-Furnished Equipment
Contractor C enters into a
three-year arrangement with Governmental Agency G,
the customer. Under the arrangement, C provides G
with military base operations related to mail and
food services while G owns and will provide C with
exclusive use of its mail sorting and delivery
equipment and food service equipment over the
three-year term to execute the services. That is, G
owns and will provide the use of all equipment that
C would need to deliver its services to G. The terms
of the contract explicitly limit C’s use of the
equipment to activities defined in the contract as
“contract activities,” and such contract activities
directly benefit G through the services provided by
C under the arrangement. Further, C cannot assign or
transfer its rights under the contract or further
sublease the equipment.
In this example, the three criteria
are met as follows:
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Linked contracts — The right to use the equipment is directly linked to the revenue arrangement. That is, the military base operations arrangement is executed as a single contract that includes C’s use of G’s equipment to execute the contract activities that directly benefit G.
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Coterminous period — The period of use of the equipment is coterminous with the three-year arrangement for military base mail and food services.
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Restricted use — The right to use the equipment is contractually restricted to solely transferring the services promised in the military base operations arrangement. That is, C cannot use the equipment to derive other economic benefits (through offering services to other customers or for C’s internal use). In addition, the contract explicitly restricts C from assigning or transferring its rights under the contract or further subleasing the equipment.
Accordingly, there is no lease of
the mail sorting and delivery equipment or the food
service equipment. Therefore, G will not recognize
lease income as a lessor for C’s right to use its
assets and a separate lease expense associated with
the embedded lease in the services it receives from
C. Similarly, C will not recognize lease expense as
a lessee for its right to use G’s assets and
separate lease income for its provision of an
embedded lease within its service revenue
agreement.
Example 3-2
Customer-Furnished Property
Vendor V enters into a five-year
arrangement with a customer, Freight Carrier F, to
provide the maintenance services on F’s railcars.
The maintenance facility that V will use to execute
its services is owned by F. That is, F owns and will
provide exclusive use of its maintenance facility to
V to perform all the maintenance work over the
five-year term. The terms of the contract explicitly
limit V’s use of the maintenance facility to
activities defined in the contract as “contract
activities.” Accordingly, V cannot use the
maintenance facility (1) to service any customer
other than F or (2) for its internal use. Vendor V
cannot assign or transfer its rights under the
contract or further sublease the maintenance
facility.
In this example, the three criteria
are met as follows:
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Linked contracts — The right to use the maintenance facility is directly linked to the revenue arrangement. That is, the maintenance services arrangement is executed as a single contract that includes V’s use of F’s maintenance facility to execute the contract activities that directly benefit F.
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Coterminous period — The period of use of the maintenance facility is coterminous with the five-year arrangement for maintenance services.
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Restricted use — The right to use the maintenance facility is contractually restricted to solely transferring the services promised in the maintenance services arrangement. That is, V cannot use the maintenance facility to derive other economic benefits (through offering services to other customers or for V’s internal use). In addition, the contract explicitly restricts V from assigning or transferring its rights under the contract or further subleasing the maintenance facility.
Accordingly, there is no lease of
the maintenance facility.1 Therefore, F will not recognize lease income
as a lessor for V’s right to use its maintenance
facility and a separate lease expense associated
with the embedded lease in the maintenance services
it receives from V. Similarly, V will not recognize
lease expense as a lessee for its right to use F’s
maintenance facility and separate lease income for
its provision of an embedded lease within its
service revenue agreement.
3.2.3 Joint Operations or Joint Arrangements
ASC 842-10
15-4 . . . If the customer in the contract is a joint operation or a joint arrangement, an entity shall consider whether the joint operation or joint arrangement has the right to control the use of an identified asset throughout the period of use.
Companies in a number of industries enter into joint arrangements to achieve a common commercial objective. These arrangements may include the use of specified PP&E for a stated time frame. Accordingly, under ASC 842-10-15-4, entities should evaluate such arrangements to determine whether they have the right to control the use of an asset.
Bridging the GAAP
No Joint Definitions
The terms “joint arrangement” and “joint operation” are defined in IFRS
Accounting Standards but not in U.S. GAAP. Under IFRS 11, a joint
arrangement is “an arrangement of which two or more parties have joint
control” and a joint operation is a type of joint arrangement
“whereby the parties that have joint control of the arrangement have
rights to the assets, and obligations for the liabilities, relating to
the arrangement.”
Although ASC 842 does not define these two terms, their use in U.S. GAAP is
aligned with that in IFRS Accounting Standards. The terms appear in ASC
842-10-15-4 for two reasons:
-
The FASB and IASB decided that the definition of a lease in ASC 842 would be converged with that in IFRS 16.
-
The FASB wanted to close a structuring opportunity so that entities cannot come together in a joint arrangement or joint operation structure to avoid identifying a lease and recognizing lease assets and lease liabilities.
Connecting the Dots
Joint Operating Agreements in the
Oil and Gas Industry
Entities in the oil and gas industry often enter into joint operating agreements (JOAs) in which
two or more parties (i.e., operators and nonoperators), without setting up a separate or new
legal entity, collaboratively explore for and develop oil or natural gas properties by using the
experience and resources of each party. These agreements often require the use of leased
equipment. Questions have arisen regarding ASC 842’s lease assessment requirements for
parties to JOAs. While we expect that the analysis of JOAs will be largely based on facts and
circumstances, the example and analysis below should be helpful to companies as they consider
these arrangements.
Example 3-3
Three companies — A, B, and C — form a JOA to execute an offshore drilling program. For the companies
to fulfill the JOA’s objective, a specific asset (e.g., a drill rig) will be necessary. Company A will act as the
counterparty to major contracts of the JOA, including a five-year contract to lease a specific drill rig from its
owner (Lessor X).
Question 1: Which Party, if Any, Is Leasing the Rig?
Given A’s role as primary obligor in the drill rig lease (the rig’s owner may
not be aware of the JOA and the parties that constitute
it), A will generally be deemed the lessee in the
arrangement. Accordingly, A will record the entire lease
on its balance sheet. Even though other parties will
receive economic benefits from the rig, those benefits
arise from the JOA and do not affect the
economic-benefits analysis of the contract between A and
the rig’s owner, X.
Question 2: What Is the Effect of the JOA?
The JOA’s terms may represent a sublease of the rig from A to the JOA. That is, ASC 842 requires the parties
to the JOA to consider the terms and determine whether the JOA is, or includes, a “virtual” lessee of the rig.
Although the JOA is typically not a legal entity that prepares financial statements, a conclusion that the JOA is a
lessee of the rig would have the following implications:
- Company A, as sublessor, would separately account for its sublease to the JOA (apart from its head lease with X, the rig’s owner).
- Each party to the JOA would need to consider other GAAP (e.g., proportionate consolidation guidance) that may require it to record its pro rata portion of lease assets and lease liabilities.
Note that the “other GAAP” mentioned in Question 2 of the example above may vary by industry (e.g.,
proportionate consolidation guidance is not applicable in many industries). Also note that the analysis
should be performed at the appropriate level, which may not always be the JOA. The “joint operation” or
“joint arrangement” mentioned in ASC 842-10-15-4 could be a subset of a JOA to the extent that multiple
parties have agreed to jointly use an identified asset for a defined time frame. For example, in a five-year
JOA involving five parties, if three of the parties agree to jointly develop a property by using a specified
drill rig for the first two years, it may be necessary to evaluate that two-year agreement to determine
whether it contains a lease.
The above example is not meant to suggest that most JOAs will contain leases but to highlight and explain the analysis that ASC 842-10-15-4 requires for joint arrangements involving the use of specified PP&E. We encourage entities affected by this issue to check with their auditors and accounting advisers for input on the accounting for specific arrangements.
Footnotes
1
While this example focuses on
the maintenance facility itself, a similar
analysis would apply to the land on which the
maintenance facility resides. Furthermore, we
believe that there are scenarios involving
vendor-owned assets attached to customer-owned
land (e.g., vendor-owned solar panels attached to
customer-owned land) whereby the land use rights
would be subject to the interpretive guidance in
this section.