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Dewey Ballantine Recommends Guidance on Nonleveraged Leasing Structures

DEC. 15, 2005

Dewey Ballantine Recommends Guidance on Nonleveraged Leasing Structures

DATED DEC. 15, 2005
DOCUMENT ATTRIBUTES

 

December 15, 2005

 

 

The Honorable Eric Solomon

 

Assistant Secretary of the Treasury for Tax Policy

 

Department of the Treasury

 

1500 Pennsylvania Avenue, N.W.

 

Washington, D.C. 20220

 

 

The Honorable Donald Korb

 

Chief Counsel

 

Internal Revenue Service

 

Room 3026

 

1111 Constitution Avenue, N. W.

 

Washington, D.C. 20224

 

Re: Requests for Guidance Regarding Several Leasing Issues

 

Dear Mssrs. Solomon and Korb:

Dewey Ballantine frequently advises leasing companies on the tax consequences of different "single investor" (i.e., nonleveraged) leasing structures. We have found that certain issues arise frequently where different leasing companies take different tax positions on the same basic transactions. We believe that consistency of treatment would benefit both the administration of the tax system and the leasing industry, which is a significant source of capital investment in the US economy. Accordingly, we have prepared five short memoranda describing five different commonly encountered leasing issues and our views as to the proper tax treatment of each.

In particular, the enclosed memoranda address the following leasing issues: (i) what criteria should be used in determining whether a re-lease of previously leased property constitutes a "true lease" for federal income tax purposes; (ii) the effect of a residual value guarantee on "true lease" characterization; (iii) whether a "true lease" should be re-evaluated if a taxpayer purchases property subject to an existing "true lease;" (iv) under what circumstances an assignment of rents should be treated as a loan versus a sale or "assignment of income;" and (v) the proper characterization of "synthetic leases" for federal income tax purposes.

We would like to work with the Department of the Treasury and the Internal Revenue Service in resolving these important issues with a view toward producing some form of published guidance and would appreciate the opportunity to meet with you at a mutually agreeable time.

We look forward to discussing these matters with you. Please contact me at the number above if you have any questions.

Very truly yours,

 

 

Andrew W. Kentz

 

Dewey Ballantine LLP

 

Washington, D.C.

 

Enclosures

 

 

cc: Michael Desmond (w/enclosures)

 

Tax Legislative Counsel

 

Department of the Treasury

 

 

George Manousos (w/enclosures)

 

Office of Tax Legislative Counsel

 

Department of the Treasury

 

 

Clarissa C. Potter (w/enclosures)

 

Acting Senior Counsel to the Chief Counsel (Legislation)

 

Internal Revenue Service

 

Re-Leases

 

 

Guidance Requested

Published guidance is requested on the proper way to determine whether, for federal income tax purposes, a new lease (the "second lease") entered into by an owner/lessor upon the expiration of an existing "true lease" (the "first lease") constitutes a true lease. We believe that the determination of whether the second lease constitutes a true lease should be based upon the terms and conditions of the second lease and the facts that surround it at the time it is entered into. In particular, the determination should be made with reference to the leased property's then fair market value, its then estimated remaining economic useful life (as compared to its useful life at the inception of the second lease) and its estimated residual value at the end of the second lease term (as compared to the property's fair market value at the inception of the second lease). We understand, however, that some parties have taken the view that the test for determining whether the second lease is a true lease should be based upon the lessor's initial investment and the initially estimated economic useful life determined at the time the first lease was entered into by viewing the second lease term as if it had been part of the first lease term. We believe that published guidance would provide certainty to taxpayers, ensure greater uniformity of treatment, and mitigate the risk of "whipsaw."

Common Facts

Alternative 1: At the termination of a true lease for federal income tax purposes, the lessor enters into a new lease with the same lessee.1 At the time the first lease was entered into, the property had an estimated economic useful life of 25 years; the first lease had a term of 20 years; and at the end of the first lease term the property had an estimated residual value (determined without regard to inflation or deflation) of 20 to 25 percent of the fair market value of the property at the commencement of the first lease term. At the end of the first lease term, the lessee and the lessor negotiate a new lease for a term of 8 years after having determined that the property had a remaining economic useful life of 10 years and an estimated residual value at the end of the second lease term of 20 to 25 percent of the fair market value of the property at the commencement of the second lease term.

Alternative 2: The facts are the same as in alternative 1 except that (i) at the time the first lease was entered into the property had (a) an estimated economic useful life of 40 years, and (b) an estimated residual value at the end of a 30-year lease of 20 to 25 percent of the value of the property in year 30 (determined without regard to inflation or deflation) and (ii) at the time the second lease was entered into the property had a remaining economic useful life of 8 years and an estimated residual value at the end of the second lease term of 1 to 3 percent of the value of the property at the commencement of the second lease term.

Alternative 3: The facts are the same as in alternative 1, except that, during the term of the first lease, the lessor performs a technological upgrade of the property at a cost equal to 10 percent of the property's initial cost to the lessor. At the end of the first lease term, the property (including the technological upgrade) is worth 25 percent of the sum of its original cost and the cost of the upgrade. At the end of the second lease, it is projected that the property will be worth 10 percent of the sum of its original cost to the first lessor and the cost of the upgrade, which is 40 percent of the property's value as of the end of the first lease term. This estimated residual value exceeds 20 percent of the property's value at the time the second lease begins.

In alternative 4, the facts are the same as in alternative 1, except that, at the end of the first lease term, the lessor and the lessee agree to continue the lease for so long as the lessee desires in exchange for the payment of fair market rentals. The fair market rental values will be adjusted from time to time based upon a negotiated appraisal methodology.

Law

Over the years, Treasury and the Internal Revenue Service have provided a fair amount of guidance relevant to whether a lease will be respected as a "true lease." See, e.g., Rev. Proc. 2001-28, 2001-19 I.R.B. 1156 (modifying and superseding Rev. Proc. 75-21, 1975-1 C.B. 715); Rev. Rul. 72-408, 1972-2 C.B. 86; Rev. Rul. 60-122, 1960-1 C.B. 56; Rev. Rul. 55-540, 1955-2 C.B. 39. The guidance clearly indicates certain features that are relevant to whether an arrangement will be characterized as a lease, see, e.g., Rev. Proc. 2001-28, or be viewed as a conditional sale, see, e.g., Rev. Rul. 55-540; Rev. Rul. 55-541, 1955-2 C.B. 19; Rev. Rul. 55-542,1955-2 C.B. 59. For example, for a lease to be respected as such, it must have, among other things, a meaningful residual value and remaining economic useful life (including fixed renewal terms) at the end of the lease. In contrast, if the lease (including fixed renewals) leaves little or no residual value and economic useful life, it will be characterized as a conditional sale. It would seem self-evident that these characteristics are measured at the time of each lease (assuming they are truly independent), without regard to the prior history of the property. As indicated above, however, we have been unable to locate authority that directly supports this view.

Analysis

In alternative 1, based on the law described above, we believe the second lease would constitute a true lease because at the end of the second lease term, there is meaningful residual value and remaining economic useful life when measured against the value and life of the property when the second lease is consummated. So long as there was no prearrangement to enter into the second lease at the time the first lease was entered into, it should be irrelevant that the second lease would not be a true lease if the analysis of remaining economic useful life and residual value were made as of the commencement of the first lease based on a combined lease term.

In contrast, the transaction described in alternative 2 should be viewed as a conditional sale because the second lease provides the lessee with use of the property for its entire remaining economic useful life in exchange for a fixed rent. As in alternative 1, an analysis of useful life and residual value after the combined leases based on the estimates at the commencement of the first lease is not relevant to the true lease determination of the second lease.

In the third alternative, we believe the second lease would be a true lease for the same reasons as in the first alternative -- that is, the property as of the commencement of the second lease is projected to have a meaningful residual value at the end of the second lease in comparison to the property's value as of the commencement of the second lease. The appropriate property to be analyzed is the upgraded property that is the subject of the second lease.

In the fourth alternative, the second lease should be respected as a true lease regardless of the fact that it could run for the full remaining economic useful life of the property because the lessor has retained the principal incidents of ownership -- the residual upside if the property has appreciated in value and the residual downside if it has depreciated in value. Cf. Code Section 470(f)(2) cross referencing Code Section 168(i)(3)(B) (excluding in the case of nonresidential real property options to renew at fair rental value determined at the time of renewal from the definition of lease term); Rev. Proc. 2001-28, 2001-1 C.B. 1338, Section 4.02 (lease term does not include lease renewals at fair rental value at the time of such renewal or extension).

 

FOOTNOTE

 

 

1 A variation on all four alternatives is that at the end of the first lease term the lessee returns the property to the lessor and the lessor negotiates and enters into a new lease with a new lessee. We believe that the analysis set forth below should be equally applicable whether the second lease is with the first lessee or a new lessee.

 

END OF FOOTNOTE

 

 

Residual Value Guarantees

 

 

Guidance Requested

Published guidance is respectfully requested as to the effect of a residual value guarantee ("RVG") on the characterization of a lease as a "true lease" in circumstances in which the guarantor is not the lessee or a party related to the lessee.

Transaction

There are two basic situations in the market place today where RVGs are used. In the more typical case, a lessor purchases property from an equipment manufacturer (e.g., construction equipment) at its fair market value and leases the equipment to an unrelated third party pursuant to a "true lease."

To induce the lessor to purchase the equipment, for no additional consideration the manufacturer provides a RVG at the end of the lease term. Although the terms of the RVG vary from case to case, the following examples are indicative of current practices.

Assume that the original equipment has a cost to the lessor of $200 and that it has an estimated residual value at the end of the lease term of not less than $60. The lessor leases the equipment to a lessee in a "true lease" and the manufacturer agrees that if the equipment is worth less than $60 at the end of the lease term the manufacturer will pay the difference between that value and $60 up to a maximum payment that is typically not more than 10% of the cost of the equipment to the lessor -- in this case $20. Thus, if the equipment is worth at least $60 at the end of the lease term the manufacturer pays nothing; if the equipment is worth $50, the manufacturer pays $10; and if the equipment is worth $25 the manufacturer pays $20. In some instances, the manufacturer also agrees to act as remarketing agent if the lessee does not renew the lease or purchase the equipment at the end of the lease term. In exchange for providing remarketing services, the lessor agrees to pay the manufacturer 50% of the net proceeds realized in excess of the estimated residual value of the property as determined at the commencement of the lease. Thus, in the above example, if the estimated residual value was $60, the manufacturer would receive 50% of the net residual proceeds in excess of $60 if it were called upon to remarket the equipment.

In the alternative situation, an existing lessor sells equipment subject to an existing "true lease" and guarantees a minimum residual value to the purchaser of up to 10% of the sales price of the equipment to the new lessor/purchaser. The RVG generally would provide generally that at the end of the lease, if the equipment is sold (or in cases in which the equipment is not sold, it is appraised) at less that the amount guaranteed under the RVG, the issuer of the RVG (whether the manufacturer or the original lessor) will pay to the new lessor/purchaser the difference between the amount guaranteed under the RVG and the sale price (or appraised value, if applicable) up to 10% of the sales price to the new lessor/purchaser.

Law

The law is clear that for an owner/lessor of property to be respected as such and for a lease of the property be viewed as a "true lease," the owner must possess and bear the economic benefits and burdens of ownership with respect to the property. See Frank Lyon Co. v. United States, 435 U.S. 561 (1978); Helvering v. Lazarus & Co., 308 U.S. 252 (1939). If a lease shifts both the potential upside benefit and downside risk with respect to the residual value of the leased property to the lessee, the lessee is considered the owner of the property. See Swift Dodge v. Commissioner, 692 F.2d 651 (9th Cir. 1982); Leslie Leasing Co. v. Commissioner, 80 T.C. 411 (1983). It has also been the position of the Internal Revenue Service that leases which shift upside potential and downside risk to the lessee should be treated as secured loans. See, e.g., F.S.A. 1990-20-003 (Jan. 12, 1999) (holding that a synthetic lease was a loan financing); Rev. Rul. 72-543, 1972-2 C.B. 87 (finding a loan for tax purposes where seller-lessee retained all benefits of appreciation and bore all risks of loss); Tech. Adv. Mem. 93-13-001 (Apr. 7, 1992) (characterizing an automobile lease as a lease for tax purposes because lessor enjoyed potential gain and bore the risk of loss); Priv. Ltr. Rul. 88-14-006 (Apr. 30, 1985) (treating sale-leaseback of a building as a bona fide sale and lease for tax purposes where partnership-lessor bore the risk of loss and, most likely, would enjoy any appreciation).

The Tax Court noted in Illinois Power that "[a] significant factor to be used in determining ownership of property is the extent to which the taxpayer has potential for profit or loss as a result of holding the property." 87 T.C. at 1437. In order for a taxpayer to have a depreciable interest in a wasting asset, it must be exposed to suffer economic loss if the property loses value. See Lerman v. Commissioner, 939 F.2d 44 (2d Cir. 1991); Northwest Acceptance Corp. v. Commissioner, 500 F.2d 1222 (9th Cir. 1974); Lockhart Leasing Co., 446 F.2d 269; Commissioner v. Moore, 207 F.2d 265 (9th Cir. 1953); Transamerica Corp. v. United States, 15 Cl. Ct. 420 (1988); Rice's Toyota World, Inc. v. Commissioner, 81 T.C. 184 (1983), aff'd in part and rev'd in part, 752 F.2d 89 (4th Cir. 1985); Rev. Rul. 55-89,1955 1 C.B. 284.

In cases in which there is a partial shifting of the upside potential to the lessee, courts and the Service have considered such facts as an infringement on the lessor's ownership interest in the property and, therefore, an adverse factor in the overall true lease analysis. See, e.g., Gilman v. Commissioner, 933 F.2d 143 (2d Cir. 1991) (10% residual share with Lessee); Rice's Toyota World, 81 T.C. at 206 (30% lessee residual share was one of several factors weighing against true lease characterization); Tech. Adv. Mem. 82-19-005 (Jan. 27, 1982) (25% residual share with lessee); Tech. Adv. Mem. 81-18-010 (Jan. 23, 1981) (10% residual share with lessee). Similarly, bearing part of the downside risk also has been considered an adverse factor in true lease analysis. See Tech. Adv. Mem. 84-18-006 (Dec. 9, 1983) (finding that the lessee should be characterized as the owner because it bore 90% of the risk of loss and shared 35% of any potential profit); Tech. Adv. Mem. 82-19-005 (Jan. 27, 1982) (finding that the lease arranger should be treated as the owner because it bore the risk of loss and shared 25% of any potential profit); Tech. Adv. Mem. 81-18-010 (Jan. 23, 1981) (finding that the lessee should be treated as the owner because it bore the risk of loss and shared 10% of any potential profit).

The authority discussed above, for the most part, considers the impact on true lease in situations in which the lessee bears some residual value risk with respect to the leased property. In situations in which the lessor has independently acquired residual value protection, neither the case law nor the Service seems to have been troubled by this fact or considered it to be a basis for recharacterization of the lease. See Gefen v. Commissioner, 87 T.C. 1471 (1986) (availability of residual value insurance for small premium indicated reasonableness of residual value expectation); Tech. Adv. Mem. 98-30-001 (March 3, 1998) (considering appropriate amortization period for premium paid for residual value insurance on leased automobiles); Priv. Ltr. Rul. 95-11-048 (Dec. 23 (1994) (holding that acquisition of residual value insurance did not cause rental income from leasing automobiles as "active rents" under IRC section 954); Tech. Adv. Mem. 93-13-001 (Apr. 7, 1992) (finding that the lessor bore the risk of loss and therefore was the owner in circumstances in which an automobile lessee's only end of term obligation was to return the automobile in good condition and further noting that the lessor's independent acquisition of residual insurance from a third party was not relevant to the ownership analysis as between the lessor and lessee). See also H. Rep. 108-548, Pt. 1, p. 318, N. 387 (2004) ("For purposes of . . . [determining whether a lessee bears more than a minimal risk of loss under section 470(d)((3)(B) of the Code], residual value protection provided to the taxpayer by a manufacturer or dealer of the leased property is not treated as borne by the tax-exempt lessee if the manufacturer or dealer provides such residual value protection to customers in the ordinary course of business.")

Analysis

We believe the above-referenced authority makes it clear that if a lessee bears meaningful risk with respect to the residual value of leased property, it may be appropriate to recharacterize the lease as a secured financing or otherwise. If, on the other hand, a lessor acquires from a prior owner or it is provided by the manufacturer (in both cases from a party unrelated to the lessee) a guarantee of a minimum residual value that leaves a significant part of the residual value risk on the lessor and the lease otherwise satisfies the criteria to be considered a true lease, we believe such insurance or guarantee should not be considered a material factor in determining whether the lease should be recharacterized. Based on this view, the RVG provided to the lessor in the facts described above should not undermine the lease or cause the lessor not to be viewed as the property's owner, particularly in light of the fact that the lessor bears a substantial amount of the residual value risk associated with the property. The key points are that the lease is a "true lease" without regard to the RVG (even if, for example, the lessee had a fixed price purchase option as long as it is set at or above estimated fair market value) and the RVG is provided by a party other than the lessee and is set at a level such that the lesser still bears a significant residual value risk.

 

Lessor Transfers

 

 

Guidance Requested

Published guidance is requested as to whether a transaction that qualifies as a "true lease" when it is entered into must be re-evaluated as a true lease when a new lessor purchases the leased property subject to the lease during the lease term without any modifications to the terms and provisions of the lease.

Transfer of Owner/Lessor's Interest in Leased Property

It is not uncommon for there to be a transfer of property that is subject to a "true lease" between parties in the marketplace during the ongoing term of the lease. It seems clear to us that such a midstream transfer, particularly in cases in which the terms and provisions of the lease are not modified, is not an appropriate occasion to retest whether the transaction continues to qualify as a "true lease."1 Nonetheless, the absence of direct authority has resulted in confusion in the market place, with different parties taking different positions with respect to the issue.

For example, an owner/lessor of property that is subject to a lease that met all of the criteria for a true lease at lease commencement sells the property subject to the lease to a third party and at the time of the sale, due to post-closing economic conditions that were not reasonably anticipated when the lease transaction closed (such as technological obsolescence), the estimated residual value at the end of the lease term is insufficient to support an ab initio true lease determination. The lessee may or may not be aware of the transfer but in any case no changes are made in the terms and provisions of the lease. If the lease, has to be retested at the time of the transfer, it would not qualify as a true lease because of an inadequate estimated residual value.

Law

It is well established that the determination whether a lease should be respected as such for federal income tax purposes occurs at the outset of the lease based upon the intention of the parties as reflected in their actions, including most importantly the terms of the lease. See Western Contracting Corp. v. Commissioner, 271 F.2d 694, 699 (8th Cir. 1959) (concluding that to determine the proper characterization of a lease, "it is necessary to ascertain the intention of the parties as evidenced by the written agreements, read in light of the attending facts and circumstances existing at the time the agreement was executed"); see also Rev. Rul. 55-540, 1955-2 C.B. 39. It is also well established that once a true lease has been entered into, fluctuations in the value of the leased property do not result in a recharacterization of the lease. See Breece Veneer & Panel Co. v. Commissioner, 232 F.2d 319, 322 (7th Cir. 1959) (finding that the lower court had "erroneously considered the contract in retrospect" when concluding that the agreement was not a true lease); Arkansas Bank and Trust Co. v. United States, 224 F.Supp. 171, 177 (W.D. Ark. 1963) (determining that the agreement in question was a true lease because a court must consider the facts as of "the date [the agreement] was entered into," and even though if looked at in retrospect the rental payments might not be considered reasonable, the payments "were reasonable at the date the agreement was entered into"). There is also indirect authority for not retesting a lease in Treasury Regulation section 1.467-1(f)(7)(i), which provides that for purposes of determining whether a lease has to be retested under IRC section 467 "a sale, exchange or other disposition by a lessor of property subject to a rental agreement will not, by itself, be treated as a substantial modification," and no changes are required in the reporting of the rents under IRC section 467, unless the transfer is effected for tax avoidance purposes. See also Treasury Regulation § 1.1001-3, which holds that the sale, exchange or other disposition by the holder of a debt obligation is not a modification of the obligation.

Analysis

We believe that a midstream purchase of property that is subject to a lease that was a true lease when the lease term commenced is not an appropriate occasion for retesting the "true lease" characterization of the transaction as long a no changes are made to the lease in connection with the transfer. Not only would a retesting fly in the face of the well-established principle that fluctuations in the value of property do not affect the characterization of a true lease, but a retesting requirement would create all kinds of practical issues and would expose the Treasury to a serious risk of whipsaw. A published statement that retesting is neither appropriate nor will it be recognized would assist the IRS (by eliminating the risk of whipsaw) and taxpayers (by leveling the playing field). If, contrary to our view of the law, you conclude that re-testing is appropriate upon a lessor transfer, please issue written guidance stating such and explaining the ramifications to the lessee if the transferee/"lessor" determines that the lease is no longer a true lease.

 

Rent Assignment

 

 

Guidance Requested

We request published guidance as to the proper federal income tax treatment of amounts received by a lessor in exchange for an assignment by the lessor of its right to receive rents under the circumstances described below. Based upon the authorities cited below, it is our view that such an the assignment should be treated as a loan for federal income tax purposes provided the assignee receives a security interest in the leased property or other valuable collateral and as an anticipatory assignment of income if the assignee does not. However, we believe there is inconsistency in the treatment of these transactions among the parties that participate in them and that the risk of whipsaw can be mitigated and greater uniformity of treatment can be achieved if there is published guidance on the subject.

Transaction Structure

In alternative 1, an owner of unencumbered property leases it to a lessee in a "true lease" for federal income tax purposes for a fixed term, with rents (and a substitute therefor in the form of a termination payment in the event of an early termination) payable on a "hell or high water" basis over such fixed term. At some point during the lease term, the owner/lessor unconditionally and without personal recourse to the lessor assigns its right to receive all or a stated portion of the rents to an unrelated third party in exchange for a cash payment equal to the "present value" of the rents assigned. The lessor also grants the assignee a security interest in the leased property securing the shortfall, if any, between the amount paid for the right to the rental stream and the "present value" of the assigned rents (including termination payments) actually received by the assignee. At the time of the assignment the leased property has a value in excess of the cash payment received by the owner/lessor. The "present value" is determined by using a discount rate that reflects the lessee's credit-standing and the collateral value of the property. Thus, in the event the assignee does not recover the full present value" of amount paid for the assigned rents, it can requite that the property be sold and proceeds paid to it up to the amount of the shortfall, Otherwise, the lessor continues to bear all responsibilities associated with the property and the lease and the lessee is not provided notice of the assignment. If all of the assigned rents are paid when due, the security interest in the property falls away and the lessor is free to sell or re-lease the property as it sees fit (subject to the terms of the lease).

In alternative 2, the facts are the same as alternative 1 except that the security interest is granted over different property of the lessor.

In alternative 3, the facts are the same as in alternative 1 except that if the assigned rents are not paid when due the assignee's recourse is solely against the lessee.

Law

An unconditional nonrecourse assignment of a rental stream by a lessor that shifts the risks and rewards of ownership of the rental stream to the assignee will constitute an anticipatory assignment of income, and thus will give rise to current income to the lessor to extent of the amounts received. See Stranahan v. Commissioner, 472 F.2d 867 (6th Cir. 1973); J.A. Martin v. Commissioner, 56 T.C. 1255, 1260 (1971), aff'd, 467 F.2d 1406 (5th Cir. 1972). However, if, because of rights against property other than the assigned rents, it is reasonably certain that the assignee will recover its investment and its anticipated return whether or not the rents are paid when due, then the transaction is more appropriately viewed as a loan. See Mapco v. Commissioner, 566 F.2d 1107 (Ct. Cl. 1977); J.A. Martin , 56 T.C. 1255; Hydrometal v. Commissioner, 31 T.C.M. (CCH) 1260 (1971). If the other property belongs to the assignor, then the assignor is really a borrow and the proceeds are that of a loan rather than an anticipatory assignment of income. See id. Thus, if the assignee of rents is granted a security interest in the underlying leased property which it can look to if the rents are not paid and that property is expected to have value sufficient to cover the present value of the unpaid rents, the transaction is properly treated as a loan rather than a sale of the rents. See Watts Copy Systems, Inc. v. Commissioner, 67 T.C.M. (CCH) 2480 (1994); Coulter Electronics, Inc. v. Commissioner, 59 T.C.M. (CCH) 350 (1990), aff'd, 943 F.2d 1318 (11th Cir. 1991); Tech Adv. Mem. 9237004 (Apr. 8, 1992); Tech. Adv. Mem. 8643002 (June 20, 1986); Gen. Coun. Mem. 39567 (June 10, 1986). While we have been unable to find any authority directly on point, it should follow that that the transaction should be viewed as a loan even if the collateral securing payment of the rents is over property of the lessor that is not the subject of the lease.

Analysis

In Alternatives 1 and 2, the assignee of the lease rents has a security interest in property that is reasonably expected to have sufficient value to cover the present value of the rental stream from time to time, thus putting the lessor's property, and hence the lessor, at risk if the rents are not paid when due. This transaction thus has all of the economic characteristics of a nonrecourse secured loan and not an anticipatory assignment of income. Under alternative 3, however, once the assignment is made neither the lessor nor its property are at risk if the lessee fails to pay the rents and this should be treated as an anticipatory assignment of income. While we believe the law supporting the foregoing is relatively clear, we have observed that not all taxpayers have taken positions consistent with the foregoing analysis, thus creating the potential for inconsistent treatment and whipsaw. We believe such guidance should also address the situation when the property securing the payment of the assigned rents does not have a value equal to the present value of the rents but nevertheless has substantial value.

 

FOOTNOTE

 

 

1 Some leases require lessee consent before the lessor can transfer its interest in the property and the lessee may require modifications as a condition to that consent (such as, for example, a parent guarantee to lift lessor liens where the transferee is a weaker credit than the transferor). In other cases, the transferee may request changes in the lease to take into account its special characteristics (such as changes needed to comply with regulatory requirements). Changes of this type should be treated no differently than if they were being made outside the context of a transfer.

 

END OF FOOTNOTE

 

 

Synthetic Lease

 

 

Guidance Requested

We request guidance as to the proper federal income tax treatment of the typical "synthetic lease" transactions described below. Based upon the authorities cited below, it is our view that these "synthetic leases" should be treated as a secured loans for federal income tax purposes. However, because the transactions are cast in the form of a leases, we believe that published guidance would provide certainty to taxpayers, insure greater uniformity of treatment and mitigate the risk of "whipsaw."

Transaction Structure

Synthetic leases, which may involve the financing of new and used personal property as well as real property, are cast in form leases because (i) the financed party seeks to have them characterized as operating leases for financial accounting purposes and (ii) having legal title in the lessor facilitates the assertion of remedies in the event of a default by the lessee. Typically, a financing party will purchase the property, either from the party being financed (in the case of used property) or from a third party designated by the financed party (in the case of new property and real estate), at its fair market value. The financing party funds the purchase from its own resources.1 The financing party leases the property to the financed party under a "hell or high water" "triple net" lease that calls for the unconditional payment of rents over the lease term. The lease term is typically short, five to seven years, and is substantially shorter than the useful life of the property. The rents combined with the purchase option proceeds referenced below are in amounts sufficient to repay the purchase price of the property to the financing party and provide it with a return that is commensurate with a market rate of interest in light of the credit quality of the financed party. The lease will typically characterize the purported rents as interest and, to the extent of any principal amortization, as principal payments, and will provide that at the end of the term, the financed party will have the right to acquire legal title to the property for an amount equal to the unamortized balance of the financing party's original cost of the property plus any accrued but unpaid interest or, alternatively, to renew the lease at stipulated rents that are the economic equivalent of an installment purchase at the interest rate embedded in (and so characterized in) the lease, and at the end of this renewal period to purchase the property for $1.2 The lease term and the principal amortization (if any) are structured so that the purchase option price at the end of the term, and the present value of the renewal rents if that option is exercised, are equal to the property's projected fair market value at the time one or the other of these options are exercised. If the financed party does not exercise the purchase or renewal option, the property is required to be sold to a party unrelated to the financed party. The sales proceeds, up to the amount of the purchase option price plus accrued but unpaid interest, are paid to the financing party and any excess is paid to the financed party. If the sales proceeds are less than the unrecovered principal plus accrued but unpaid interest, the financed party is required to pay the shortfall up to a predetermined amount, which is set to satisfy certain financial accounting rules that are relevant to the financed party obtaining operating lease accounting, can be as low as 25% of the purchase option price. If the sales price falls short of the purchase option price by more than such 25%, the financing party bears the shortfall. The financing party's internal underwriters (or in some cases outside appraisers) determine that a loss due to the fact that the property has insufficient residual value at the end of the lease term is unlikely (i.e., it is unlikely that the property will be worth less than 75% of its projected fair market value).

In some cases the lease provides that the parties intend that the financed party is the owner of the property for federal income tax purposes and that they will report the transaction consistent with that characterization and in other cases they are silent on this point. However, as noted above, the transaction documents will inevitably characterize the rents as consisting of interest and, to the extent applicable, principal payments. From an economic viewpoint, the transaction is identical to a secured loan in which a portion of the loan principal is nonrecourse.

Law

It is black letter law that for federal income tax purposes the substance of a transaction prevails over its form. Frank Lyon Co. v. United States, 435 U.S. 561 (1978); Gregory v. Helvering, 293 U.S. 465 (1935). This principle has been applied frequently when considering whether a transaction cast in the form of a lease should be respected as such, see, e.g., Helvering, v. Lazarus & Co., 308 U.S. 252 (1939); Coleman v. Commissioner, 833 F.2d 303 (3d Cir. 1987); Lockhart Leasing Co. v. Commissioner, 446 F.2d 269 (10th Cir. 1971), and without regard to which party -- the taxpayer or the Government -- is the one asserting the argument, see, e.g., Lazarus, 308 U.S. 252; Hoffman Motors Corp. v. United States, 473 F.2d 254 (2d Cir. 1973); Estate of Weinert v. Commissioner, 294 F.2d 750 (5th Cir. 1961). When it is the taxpayer asserting the argument, however, he is typically held to the higher evidentiary standard of "strong proof." See Ullman v. Commissioner, 264 F.2d 305 (2nd Cir. 1959); Coleman v. Commissioner, 87 T.C. 178 (1986), aff'd, 833 F.2d 303; Illinois Power Co. v. Commissioner, 87 T.C. 1417 (1986), acq., 1990-2 C.B.1; Field Service Advice 2000-04-011 (Jan. 28, 2000); Tech. Adv. Mem. 98-02-0002 (Sept. 18, 1998); 97-48-0005 (Aug. 19, 1997). But see Commissioner v. Danielson, 378 F.2d 771 (3d Cir. 1967), cert. denied., 389 U.S. 858 (1967).

In the context of a lease, the determination of whether the transaction should be respected as such and which party should be viewed as the property's owner turns on the intent of the parties as evidenced by the terms of the contracts. See Oesterreich v. Commissioner, 226 F.2d 798 (9th Cir. 1955). Most critical in this analysis is which party has the benefits (the "upside" value in the property) and the burdens (the "downside" risk in the event the property is worth less than expected) of ownership. See Frank Lyon, 435 U.S. 561; Lazarus, 308 U.S. 252. Case law and Internal Revenue Service guidance is longstanding and clear that when a lease shifts both the potential upside benefit and downside risk with respect to the residual value of property to a nominal lessee, the lessee should be viewed as the owner of the property for income tax purposes, See e.g., Swift Dodge v. Commissioner, 692 F.2d 651 (9th Cir. 1982); Illinois Power Co., 87 T.C. 1417; Rev. Rul. 72-543, 1972-1 C.B. 87. See also Field Service Advice 1999-20-003 (Jan. 12, 1999) (three party "synthetic lease" held to be a financing). But see Richard G. Miller et al, 88 T.C. 84 (1987) (lessor put to lessee viewed as benefit to lessor, not shifting of burden to lessee); Tech. Adv. Mern. 93-13-001 (April 7, 1993) (auto leases held true leases notwithstanding third party residual guarantee). Cf. IRC § 470(d)(3) (permitting some risk of loss to be shifted to lessee without necessarily tripping provision limiting deductions allocable to property used by tax-exempt entities).3

Analysis

Based on the law described above, and the denotation of rents as interest and, where applicable, principal, and the end of lease term provisions and economics (in which the lessee captures upside value by virtue of the purchase option and its right upon the sale of the property to any proceeds realized in excess of the lessor's unrecovered investment, and bears the meaningful downside risk in the property if the purchase option is not exercised and the property is sold for less than the unrecovered investment), we believe it is very clear that the synthetic lease described above should be viewed as a secured loan. Nevertheless, published guidance is being sought because none currently exists for this commonly used financing technique and because it would confirm that taxpayers are properly reporting the transactions as debt financings, would minimize the risk of inconsistent reporting among taxpayers and mitigate the risk of whipsaw.

 

FOOTNOTES

 

 

1 In some transactions the financing party may leverage the purchase by borrowing a portion of the purchase price from a third party lender on a nonrecourse basis and securing that loan with a security interest in the property as well as a collateral assignment of the rents and other payments due under the lease.

2 For financial accounting purposes the renewal option is viewed as an installment purchase and not as a bargain purchase option.

3 We believe the analysis is the same whether the nominal lessee is a taxpayer seeking to retain the right to depreciate the property or a political subdivision of a local government seeking to issue a section 103 eligible debt obligation.

 

END OF FOOTNOTES
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