Price Waterhouse Comments On Rental Agreement Regs.

Leo F. Naughton of Price Waterhouse LLP, New York, has submitted comments on the proposed regulations relating to section 467 rental agreements. Naughton says that the Service should amend the de minimis exception in the regs to eliminate the reference to contingent rent or contingent consideration. He also recommends that the Service substitute the word "payable" for the word "paid" when referring to rent, arguing that Congress intended that all taxpayers be required to accrue rent under section 467. Rent, according to him, accrues not with the passage of time, but when there is a legal obligation for the payment. Naughton also states that leases with optional deferrals should be subject to the proportionality and section 467 loan rules only when the option is elected. And he says that terminal rental adjustment clauses and standard commercial indemnification provisions should be exempted from the definition of contingent rents.

Naughton also discusses the regulations' safe harbor provisions, the application of the regs to foreign subsidiaries, and the effective date of the regulations.

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October 28, 1996

Mr. Forest Boone

Re: Proposed 467 Regulations

Dear Mr. Boone:

[1] This letter is in response to the request for written comments on the Proposed 467 Regulations issued on June 3 of this year. Attached are comments on these Proposed Regulations submitted on behalf of Price Waterhouse LLP. We hope they are informative and helpful to you in your drafting of the final regulations.

[2] We would appreciate an informal meeting with you and the reviewer at your convenience to further discuss issues raised by the issuance of the Proposed Regulations.

[3] My phone number is (212) 596-8218. Thank you very much.

Sincerely,

Leo F. Naughton

cc: Jon Orvik

[4] In response to the request for public comments on the proposed 467 regulations issued on June 3,1996, Price Waterhouse LLP hereby submits the following comments.

1. SCOPE OF SECTION 467

1.1 GENERAL DEFINITION

[5] Section 467 of the Internal Revenue Code of 1986, as amended (the "Code") applies to leases that are "Section 467 rental agreements". In general, the definition of a "Section 467 rental agreement" is a rental agreement that has increasing or decreasing rents, or prepaid or deferred rents. An exception to the general rule is provided for rental agreements involving total payments of $250,000 or less (the "de minimis exception").

1.2 DE MINIMIS RULE

[6] Under the de minimis exception of section 1.467-1(c)(4) of the Proposed Income Tax Regulations (the "Proposed Regulations"), a rental agreement is not a section 467 rental agreement if, taking into account any payments of contingent rent and any other contingent consideration, the sum of the aggregate amount of rental payments under the rental agreement and the aggregate value of other consideration e.g., contingent consideration) is not reasonably expected as of commencement of the lease to exceed $250,000. Exceptions are provided for contingent rent based upon reasonable price indexes and for contingent rent based upon certain third-party costs.

[7] We believe that this provision should be modified to eliminate any reference to contingent rent or contingent consideration for the following reasons:

(a) The statute and legislative history contain no

(b) Many "small ticket" leases contain rent increases based

[8] We believe that the provisions relating to contingent rent and contingent consideration should be deleted. In the event the provisions are refained, we request that the Internal Revenue Service ("IRS") include exceptions for rent increases (and decreases) attributable to usage and to the lessee's receipts (gross or net). See Proposed section 1.467-1(c)(2)(iii)(B)(3).

1.3 DE MINIMIS RULE -- MASTER LEASES

[9] Many lessors (particularly bank lessors) enter into Master Leases with customers whereby the bank agrees to lease after-acquired equipment to the customer. After executing the Master Lease, the bank will purchase items of equipment as required by the customer and will lease the equipment to the customer/lessee under a 1-2 page schedule which sets forth the rent, lease term and description of the equipment. Such schedule then becomes an addendum to the Master Lease between the parties and is therefore subject to the terms and conditions of the Master Lease. The scheduled items of equipment are sometimes identical, while at other times the equipment is comprised of different items. Often the Master Lease will cover all of the equipment acquired by the lessee in a particular year or years.

[10] Legally, each addendum is a separate, enforceable lease. We believe that where the items of equipment are different, the $250,000 benchmark should be applied to each separate lease (to each separate addendum). Where the items are fungible, aggregation would be appropriate. We request guidance on this particular issue.

1.4 CONTINGENT RENT (MISCELLANEOUS POINTS)

[11] In general, a rental agreement has increasing or decreasing rent if it requires or may require the payment of contingent rent, other than contingent rent described in section 1.467-1(c)(2)(iii)(B) of the Proposed Regulations. Contingent rent, as defined in paragraph (h), includes any rent that is not fixed rent. Proposed section 1.467-1(h)(2). Fixed rent generally means "any rent to the extent its amount and the time at which it WILL BE PAID are fixed and determinable under the terms of the section 467 rental agreement as of the lease date." See section 1.467-1(h)(3) of the Proposed Regulations (underscoring supplied).

(a) We believe that the use of the term "will be paid"

[12] When there is a mandatory deferral of rent, the date on which rent will be paid is ascertainable. A mandatory deferral of rent would result in the application of proportional rental accrual and a section 467 loan. However, if the lessee or the lessor has an option to defer rent, then under a literal reading of this phrase the rent becomes contingent rent subject to constant rental accrual if there is deemed to be a tax avoidance purpose. This anomaly should be eliminated in the final regulations because many leases contain such optional deferrals.

[13] We believe that leases with optional deferrals should be subject to the proportionality and section 467 loan rules, but only when such option is elected.

[14] Thus, the definition of fixed rent should be changed to mean rent to the extent its amount and the time at which it is REQUIRED TO BE PAID are fixed and determinable under the section 467 rental agreement. Further, in the event of an optional deferral, the fixed rent would be the rent required to be paid, assuming the option is not exercised. When the option is exercised, fixed rent would be the rent required to be paid pursuant to the deferral option. This will eliminate the necessity of predicting (as of the lease commencement date) the time at which rents will actually be paid.

(b) There is concern in the automobile leasing industry that

(c) Many leases contain contingent rent based upon use of the

(d) Typically, most leveraged leases contain indemnification

(e) The increased costs of refinancing should also be exempted

[15] In general, by defining contingent rent as everything except fixed rent, the burden is placed on the taxpayers and their representatives to identify every potential payment under the lease to determine whether the lease has contingent rents and is therefore potentially subject to constant rental accrual. It would be more helpful to the taxpayer if the IRS would define contingent rent in a manner which would prevent those abuses which are of concern to the IRS (i.e., thinly veiled rent increases) without subjecting standard leveraged leases to potential constant rental accrual. We would be happy to provide suggestions concerning such definition.

1.5 SAFE HARBOR PROVISIONS

(a) CALENDAR YEAR RENTS

[16] For purposes of the new 90/110 safe harbor, the Proposed Regulations state that in determining the average rent allocation, the taxpayer must use the calendar year rather than the lease year, which was traditionally used under Rev. Proc. 75-21, 1975-1 C.B. 715. As such, non-calendar year taxpayers must annualize the rent in partial calendar years by multiplying the rent by the number of partial years in a full calendar year. Under the calculation stated in Proposed section 1.467-3(c)(2)(i), a taxpayer can have a different average calendar rent allocation than one which is calculated on a lease year basis.

[17] For example, in the case of a four year lease which begins on July 1, 1996 and ends on June 30, 2000 and has rents of $90 for the first six months of 1996, $180 for 1997, $180 for 1998, $210 for 1999, and $105 for the first six months of 2000, the determination of the average rent may vary depending on whether it is calculated on a calendar year or lease year basis. Under the IRS' calendar year method, the average annual rent is calculated as follows:

(90(2) + 180 + 180 + 210 + 105(2))/5 = $192

[18] However, the lease year method is calculated by taking the sum of all the rents under a lease and dividing that amount by the total number of years:

(90 + 180 + 180 + 210 + 105)/4 = $191.25

[19] As the calendar year calculation does not parallel the stated economic result, we believe that the determination should be made under the annual lease-year method. Such is the current practice according to Rev. Proc. 75-21, 1975-1 C.B. 716. In Rev. Proc. 75-21, the IRS did not place any calendar year restrictions on this safe- harbor provision. See also Rev. Proc. 75-28, 1975-1 C.B. 752. In addition, no mention of a calendar year restriction was made in the 1984 Conference Report explaining these provisions as passed by Congress. H.R. Rep. No. 861, 98th Cong., 2nd Sess. (1984) (hereinafter the "Conference Report").

(b) ELIMINATION OF THE TWO-THIRDS/ONE-THIRD TEST

[20] The Proposed Regulations do not include as a safe harbor the two-thirds/one-third test which is set forth in Rev. Proc. 75-21. The advance ruling guidelines state that no question as to prepaid or deferred rent will be raised if the annual rent for any year satisfies the two-thirds/one-third test. This test provides that in the case of prepaid or deferred rent, a safe-harbor exists if during at least the first two-thirds of the lease term the rent is not more than 10% above or below the amount calculated by dividing the total rent payable, by the number of years in such initial portion of the lease term, and if the annual rent for any year during the remainder of the lease term is no greater than the highest annual rent for any year during the initial portion of the lease term and no less than one-half of the average annual rent during such initial portion of the lease term.

[21] The two-thirds/one-third test has been standard in the leasing industry for 20 years and there is no indication that Congress found such standard to be abusive. We also note that Rev. Proc. 75-21 is still operative for advance rulings. Since the final regulations should reflect current IRS ruling practice, it is our opinion that in the absence of a legislative change, the two- thirds/one-third test should remain as a safe-harbor provision. Such a test adds flexibility to the 467 rules without allowing any tax avoidance.

(c) RENT HOLIDAY

[22] Rental holidays are granted for a multitude of business reasons. A lessee may (i) have cash flow constraints when putting a new asset into service, (ii) be entering into a new business, or (iii) be in a seasonal business in a resort location, such as in the leasing of pleasure craft in summer. In such situations, the lessor may offer a rental holiday to induce a lessee to sign a lease.

[23] In addition, certain practices have arisen which establish the rent holiday as an important standard in the U.S. leasing industry. Rental holidays of 6 months are prevalent throughout the equipment leasing business. The rental holiday provision described in Proposed Regulations will severely disrupt such accepted practices.

[24] Proposed section 1.467-3(c)(2)(ii)(D) provides that tax avoidance will not be considered to be a principal purpose for providing increasing or decreasing rent if all of the increases and decreases are attributable to a rent holiday provision allowing reduced rent (including no rent) for an interim period at the beginning of the lease term, but only if the rent holiday does not exceed the lesser of 24 months or 10% of the lease term and there is substantial business purpose for the rent holiday. Neither the statute nor the legislative history contains the requirement of a "substantial business purpose", which would act to severely restrict the use of a rent holiday in most cases. Further, the regulations do not give a comprehensive definition of what is "substantial", seemingly defeating the purpose of a safe-harbor. Either the substantial business purpose language should be dropped or relevant examples should be provided for clarification.

[25] Additionally, the inability to combine a rent holiday with a 90/110 rent structure mentioned in Proposed section 1.467- 3(c)(2)(i) is contrary to current industry standards. We believe that the final regulations should more closely reflect these standards by allowing a rent holiday of limited duration to be combined with the 90/110 structure.

(d) REASONABLE PRICE INDEX

[26] The safe harbors do not allow rent increases or decreases based upon changes in the lessor's interest rate on loans used to fund the lease. Leveraged leases often provide for such "floating rentals" tied to the lessor's debt rate. The statute and legislative history both provide that rent fluctuations based upon third-party costs are not motivated by tax avoidance. In the 1984 Conference Report, Congress stated that generally it is the common commercial practice to pass increases based on the CPI or third party costs on to lessees, and "such increases should not generally be considered in determining whether rents are stepped to avoid taxes." H.R. Rep. No. 861, 98th Cong., 2nd Sess. 893 (1984). Congress went on to reserve judgement on whether increases due to fluctuations in the lessor's debt interest rate should be considered in determining whether rents are stepped to avoid taxes by stating that "[t]he conferees intend no inference as to the effect of a lease clause requiring the lessee to assume the burden of any increases in the lessor's debt service on the property . . ." Id. at n.5. Such increases or decreases based on such interest rate changes are clearly outside the control of the lessor and lessee. Accordingly, we believe that such provisions do not lend themselves to tax avoidance and that taxpayers should be able to retain such provisions in leases without being subject to the risk of constant rental accruals.

1.6 APPLICATION OF PROPOSED REGULATIONS TO FOREIGN SUBSIDIARIES

[27] United States manufacturing companies often lease equipment to foreign users. Typically, a foreign sales corporation or other controlled foreign corporation ("CFC") acts as the lessor in such leases. United States banks and other financial institutions have purchased (or started-up) offshore leasing operations usually through CFCs. These companies compete with foreign competitors for the leasing business in such foreign countries. To compete effectively, such CFCs must execute lease agreements that are customary in their respective foreign countries. Many of these leases contain increasing rents which are outside the safe harbors described above. For example, a lease of equipment in the United Kingdom will typically contain a rent escalation clause. Such lease rentals might escalate 2%-5% per year to reflect inflation in the United Kingdom. In fact, escalating rentals are common in U.K., French, German, and other leases.

[28] Many foreign leases contain variation clauses where the rent fluctuates based upon the interest rate fluctuations attributable to the lessor's debt. Deferral of United States federal income tax under Subpart F or under other offshore taxing regimes (e.g., PFIC), is seldom (never in my personal experience) the motivating factor for such rent escalation clauses. Many leases are not subject to Subpart F because they generate active rentals under section 954(c)(2)(A) of the Code.

[29] Further, many companies can offset the potential Subpart F inclusion with foreign tax credits.

[30] Under the Proposed Regulations, a U.S. taxpayer is in a quandary if it enters into the standard U.K. escalating lease. The Commissioner may attempt to level the rents, potentially resulting in Subpart F income or passive income for PFIC purposes. On the other hand, the taxpayer cannot level the rents.

[31] We believe that the section 467 Proposed Regulations should provide that constant rental accrual will not apply to a lease by a CFC where the rent escalations (or decreases) are commercially reasonably in the foreign country where the equipment is located. Any other rule will damage the competitiveness of U.S. leasing companies and will result in further complexities with negligible (if any) revenue gains. However, if the lease is not commercially reasonably in the locality, the IRS can level the rents.

1.7 EFFECTIVE DATE OF REGULATIONS

[32] Proposed section 1.467-8 states that the regulations will be effective for (a) rental agreements entered into after the date the final regulations are published in the Federal Register, and (b) for disqualified leasebacks and long-term agreements entered into after June 3, 1996. In addition, the preamble to the Proposed Regulations provides that in appropriate circumstances, the Service will "apply the provisions of section 467 requiring constant rental accrual to rental agreements entered into on or before June 3, 1996."

(a) DECREASING PAYMENTS

[33] Under section 467(f) of the Code, the Secretary of Treasury is directed to issue regulations with respect to decreasing rents that are comparable to the rules on increasing rents. In the Conference Committee Report, the conferees stated that "Regulations will also deal with the treatment of front-loaded (i.e. prepaid) agreements. The conferees intend that the provisions relating to deferred payment services agreements and front loaded agreements AND THE REGULATIONS THEREUNDER BE APPLIED PROSPECTIVELY FROM THE DATE OF ISSUANCE OF REGULATIONS." See Conference Committee Report on P.L. 98- 369 (underscoring supplied).

[34] The Proposed Regulations are written so that all of the provisions apply equally to rental agreements that contain increasing or decreasing rents. Thus, under the Proposed Regulations the constant rental accrual method (leveling) can, "in appropriate circumstances", be applied to disqualified long-term agreements with DECREASING rents that are entered into on or before June 3, 1996.

[35] Based on the Code and legislative history cited above, we believe the Proposed Regulations should not apply to decreasing payments arising under transactions that are entered into before publication of the final section 467 regulations. It is our view that constant rental accrual for decreasing payments should only apply to decreasing payments made under transactions entered into after publication of such final regulations in the Federal Register.

[36] In addition, in the case of increasing rents, it is our opinion that the retroactive application of the Proposed Regulations to rental agreements in situations deemed appropriate by the Service is tacitly unfair to any taxpayer who has entered into a lease agreement prior to the issuance of the Proposed Regulations without the benefit of unavailable foresight as to their content. Further, the standard of "deemed appropriate by the Service" will result in arbitrary assessments. We doubt the constitutionality of such a standard. We also note that such "discretionary" retroactive application defeats the purpose of stating a date when the regulations become effective.

[37] We therefore believe that the Proposed Regulations should be effective for agreements entered into after the date final regulations are published in the Federal Register.

[38] With respect to the TRAC leases (mentioned above), we note that most lessors in automotive leasing (captive and independent lessors) offer TRAC leases. We respectfully request that the IRS issue a notice under which the IRS could provide that constant rental accrual would not be applicable to TRAC leases in absence of the final regulations and that these Proposed Regulations will not be applied retroactively. Such a notice is necessary due to the fact that car lessors are presently concerned that their TRAC leases (which are congressionally sanctioned) could possibly be subject to constant rental accrual which would make such leases uneconomic to the lessor.

1.8 REAL ESTATE LEASES

[39] We will be glad to provide further comments on real estate lease rental holidays at some future date.

1.9 FINAL COMMENTS

[40] Thank you for considering our comments on the Proposed Regulations. We hope that our comments will be helpful to you.

[41] Please call if you need any further information.

Sincerely,

Leo F. Naughton

cc: Jon Orvik

FOOTNOTE

/1/ Section 467 generally requires a lessee and lessor use the accrual method of accounting when accounting for a leasing transaction, notwithstanding the method of accounting used by the taxpayer to account for other items of income or expense. Deficit Reduction Act of 1984 Bluebook p. 284-6. The general explanation of section 467 states that the primary reason for the implementation of this section was due to the "unwarranted tax benefits" in leasing transactions received by taxpayers. These unwarranted tax benefits were a result of cash basis lessees and accrual basis lessor (and vice versa). This suggests that section 467 operates under a payable (accrual method concept) rather than a paid (cash method concept) approach.

END OF FOOTNOTE