Economic Substance of Computer Leasing Deal Considered

2. Whether sections 465 and 469 are potentially applicable to the transaction.

3. Provided the contribution of assets by * * * , and * * * to * * * qualifies as a section 351 transfer, whether the * * * group should recognize gain under section 357.

2. As a closely held corporation, * * * is subject to the section 465 at risk limitations. The section 469 passive activity loss limitations are also applicable because, as discussed more fully below, the consolidated group is treated as a closely held corporation.

2. Section 357 does not apply to the exchange between * * * and * * * because * * * did not assume any liabilities of * * * Therefore, the * * * group should recognize no gain on the section 351 exchange.

[5] In connection with the formation of * * * ("Partnership"), contributed a package of rights and obligations it held with respect to certain computer equipment solely in exchange for * * * % of the outstanding stock of * * * The package was divided into two sets. The first set of rights and obligations represented Partnership's rights as owner (and subsequent lessor) of various pieces of computer equipment ("Equipment rights"). The equipment had been purchased with funds obtained from third party lenders. All of the equipment was leased to third parties. Partnership, as lessor, received lease payments on the equipment. As transferee, * * * received the right to receive lease payments on the equipment. * * * also assumed $* * * of liabilities associated with the original purchase of the equipment. As part of the transaction, * * * assumed $* * * of the $* * * debt.

[6] It appears that the second set of rights and obligations represented Partnership's rights as seller (and subsequent lessee/sublessor) of various pieces of computer equipment ("Leasehold interests"). The equipment had apparently been sold to a group of purchasers for installment notes totalling $* * * and leased back to Partnership. Partnership then subleased the same equipment to other entities. As transferee, * * * stepped into the shoes of Partnership with respect to the second set of rights. Thus, in its capacity as "seller" of the equipment, * * * received the installment notes. In its capacity as "lessee" on the same equipment, * * * assumed the liability of accrued rent payable to the group of purchasers. Finally, in its capacity as "sublessor" of the equipment, * * * obtained the right to receive the accrued rent receivable on the equipment subleased to other entities. ¹ Partnership contends the net basis of the second set of rights and obligations contributed to * * * was $* * * (the difference between the above-described assets and liabilities contributed in the transaction).

[7] The contributions by * * * and Partnership were intended to qualify as tax-free exchanges under section 351 of the Code.

[8] The engineers' report cited in your request for advice indicates that the taxpayer's valuation of the rights transferred under the master leases at $* * * is reasonable, although the engineer's valuation is approximately $* * * lower. The report also indicates that the residual value of the equipment is approximately $* * *

ISSUE 1

[10] The first issue raised is the extent to which the structure of the transaction can be attacked on traditional tax shelter grounds. We note at the outset that significant factual development is necessary before the merits of such an argument can be fully evaluated. Therefore, our discussion focuses on the factors to be considered, as well as the relative weight to be given each factor. We recommend that Litigation Guideline Memorandum TL-30, "Equipment Leasing Litigation", (January 22, 1988), be consulted for a more detailed analysis of this issue.

[11] Over the years transactions involving the leasing of computer equipment have been structured to provide a vehicle for maximizing the tax benefits of the enterprise. While some of these transactions are economically valid and thus not subject to attack, other transactions are in substance nothing more than elaborate financing mechanisms designed to pass tax attributes to the purported lessor.

[12] In selecting sale-leaseback arrangements for litigation the presence of the following factors should be considered:

[14] In this instance, the information provided and discussions with * * * the revenue agent assigned the case, indicate that little is known about the actual terms of the first part of the transaction, the sale and lease-back. The exact nature and parties to the leases in question have yet to be determined. The taxpayer's valuation of the equipment as determined in the engineer's report is within a reasonable range. The taxpayer's projection of residual value is lower than the engineer's projections, and their cash flow is negative. Based on this information alone we cannot determine whether this sale leaseback should be respected for federal tax purposes. However, we recommend that a final decision regarding the merits of a shelter argument be deferred until factual development is completed.

[15] We note that to the extent Examination chooses to pursue the partnership's role in the arrangement with a view toward adjusting the partnership's or partners' treatment of the transaction a TEFRA proceeding is required. Section 6221 of the Code requires that all partnership items be adjusted in a partnership proceeding subject to certain exceptions not relevant in this case. Should you require any assistance regarding the proper procedure to be followed please contact our office for further guidance.

ISSUE 2

[16] We note that you have also asked whether the transaction is subject to sections 465 and 469. The at risk limitations are applicable to individuals, and entities treated as such, as well as closely held corporations where five or fewer individuals directly or indirectly own 50% or more of the outstanding stock. I.R.C. sections 465(a)(3), 542(a)(2). In this instance * * * satisfies the definition of a closely held corporation. Because section 465(c)(1)(C) includes within the definition of covered activities equipment leasing, * * * appears to be subject to section 465. However, please note that if the taxpayer is "actively engaged in equipment leasing" as defined in section 465(c)(4), the section 465(a) limitations are inapplicable. If 465(a) is applicable, the following must be determined prior to reaching any conclusions with respect to the proper at risk limitation for * * * (1) the amount of cash invested; (2) the existence and amount of recourse debt; (3) the extent to which * * * is entitled to include within its at risk amount the Partnership's at risk amount prior to the section 351 exchange pursuant to Prop. Treas. Reg. section 1.465-68. Should you require additional assistance once these amounts are determined, we recommend that supplemental field service advice be requested.

[17] With respect to section 469, the passive activity loss limitation rules are generally applicable to closely held corporations. I.R.C. section 469(j)(1). In the case of a consolidated group as defined in section 1502, closely-held status is determined on a group wide basis. I.R.C. 469(j)(11). Treas. Reg. 1.469- 1(h)(4)(ii). Under section 1.469-1(h)(4)(ii) of the regulations, a consolidated group is treated as a closely held corporation and each group member a closely held corporation if the group's common parent satisfies the stock ownership test. (i.e. at any time during the last half of the taxable year more than 50 percent in value of the corporation's outstanding stock is owned, directly or indirectly, by or for not more than five individuals.) I.R.C. section 542(a)(2).

[18] In this instance, the opinion letter provided by * * * indicates that * * * is a closely held corporation. Opinion letter at page 23. Provided further factual development does not refute this representation, the entire group is thus properly subject to section 469. As a result, section 469 activities of the group as well as the extent to which the material participation tests are satisfied are determined on a group wide basis. Treas. Reg. sections 1.469-4T(m)(1) and 1.469-1(h)(4)(i)(B). Based on the facts as developed thus far we believe that section 469 may provide a mechanism for limiting the tax benefits of the transaction.

ISSUE 3

[19] The second issue to be considered is the validity of the second part of the transaction, the assumption of a series of rental payments and installment note receivables. For the reasons discussed more fully below, further information is required prior to attacking the validity of the transaction.

[20] In the instant case, * * * and * * * appear to have transferred property ² in exchange for stock of a corporation controlled by them within the meaning of section 368(c). Accordingly, the transaction should qualify as a tax-free exchange under section 351. ³ Apparently, the agent does not question whether the transaction qualifies as a section 351 exchange. Instead, he questions whether section 357 applies to the transaction to cause one of the parties to the transaction to recognize gain.

[21] Section 357(a) provides the general rule that a transferor in a section 351 exchange is not treated as receiving boot where the acquiring corporation assumes a liability of the transferor. Sections 357(b) and 357(c) provide exceptions to the general rule of section 357(a).

Section 357(b)

[22] Section 357(b) provides that if in connection with the transfer of property to a controlled corporation, the transferor's principal purpose for having the controlled corporation assume a liability of the transferor or take the property subject to a liability: (1) is to avoid federal income tax on the exchange or (2) is not a bona fide business purpose, then the total amount of liability assumed will be treated as money received by the taxpayer on the exchange. ⁴ Thus, the amount of liability assumed is treated as boot under section 351(b). Under section 351(b), if the transferor has realized gain on the section 351 exchange, the transferor will recognize that gain to the extent of the boot deemed received under section 357(b).

Section 357(c)

[23] Section 357(c) provides that if total liabilities assumed together with the total liabilities to which the property transferred is subject exceed the adjusted basis of all the property transferred, the excess is considered gain from the sale or exchange of the property transferred. Unlike section 357(b), section 357(c) does not treat the assumption of excess liabilities as money received by the transferor. Instead it provides that the excess must be considered as gain. If there is more than one transferor of property to a controlled corporation, the rule requiring recognition of gain to the extent liabilities exceed basis is applied separately to each transferor. That is, the liabilities of each assumed by the corporation is compared with the basis of property transferred by each. See Rev. Rul. 66-142, 1966-1 C.B. 66. This is similar to the transferor by transferor application of the proscribed purpose rules of section 357(b).

Gain to * * * under section 357

[24] * * * contributed cash of $* * * to * * * and assumed a $* * * liability of * * * associated with the Equipment rights contributed by Partnership. * * * assumption of the liability is equivalent to a contribution to the capital of * * * equal to the amount of the liability assumed. See Rev. Rul. 78-330, 1978-2 C.B. 147 (parent's cancellation of its subsidiary's debt, immediately before merging the subsidiary into another subsidiary, in order to prevent the application of section 351(c), is a contribution to the capital of the subsidiary). * * * did not assume any liabilities of * * * Therefore, section 357 does not apply to the exchange between * * * and * * * should recognize no gain on the section 351 exchange.

Gain to Partnership

[25] It is our understanding that Partnership is not currently under examination. Therefore, whether Partnership recognizes gain under section 357 in the instant case is not relevant for purposes of the examination of the * * * group.

[26] However, as discussed above, should Examination choose to pursue this issue we recommend that a partnership proceeding be opened. If the Partnership is audited, additional information will be necessary in order to determine whether Partnership must recognize gain under section 357. Specifically, the Partnership's adjusted basis in the Equipment rights has not been established. Further, although the taxpayer has asserted that the Partnership's adjusted basis in the Leasehold interests is $* * * the agent appears to question the validity of this assertion. The Partnership's adjusted bases in both the Equipment rights and the Leasehold interests is necessary in order to determine whether there is gain to Partnership under section 357(c).

[27] Additionally, assuming there are facts indicating that Partnership transferred a liability to * * * with a principal purpose of tax avoidance, (or a purpose which is not a bona fide business purpose), the total amount of liabilities transferred will be treated as boot to Partnership under section 357(b). In that case, Partnership would be required to recognize gain on the exchange to the extent of the boot. In order to determine Partnership's gain on the exchange the value and adjusted basis of the Equipment rights and Leasehold interests must be established. ⁵

[28] This document may include confidential information subject to the attorney-client and deliberative process privileges, and may also have been prepared in anticipation of litigation. This document should not be disclosed to anyone outside the IRS, including the taxpayer(s) involved, and its use within the IRS should be limited to those with a need to review the document in relation to the subject matter or case discussed herein. This document also is tax information of the instant taxpayer which is subject to section 6103.

[29] Should you have any additional questions regarding this matter please contact Eileeh Shatz (202) 622-7830.

² See section 1.351-1(a)(2); Rev. Rul. 64-56, 1964-1 C.B. 133 (the Service has recognized that "property" includes rights to intangible property); H.B. Zachry Co. v. Commissioner, 49 T.C. 73 (1967) (the right to receive payment on an oil royalty is property).

³ * * * remains in control of * * * for purposes of section 351 after the contribution of all the * * * stock to * * * See section 1.1502-34 of the regulations.

⁴ As the language of the statute indicates, the rule is applied on a transferor by transferor basis.

⁵ The facts appear to indicate that the adjusted bases of the Equipment rights and Leasehold interests will likely exceed their fair market value, in which case Partnership would recognize no gain under section 357(b).