United States: Requirements For A "Trust Lease" For Exclusion From Treatment As A Capital Expenditure

As a general rule, any capital expenditure which is properly chargeable to the capital account of any person and which is made with respect to the financed facility must be included for purposes of the $10,000,000 capital expenditure limitation under I.R.C. § 144(a)(4). Treasury regulations provide, however, that certain capital expenditures may be excluded from the computation. One such excluded expenditure is an expenditure made by a person, other than the bond user, a related person, or a State or local governmental unit, if the expenditure is made with respect to tangible personal property, or intangible personal property, leased to the bond user (or a related person) of the facility.

In accordance with Treasury Regulation § 1.103-10(b)(2)(iv)(b), the following requirements must be met for lease payments to be excluded as capital expenditures under I.R.C. § 144(a)(4):

(a) The property must be either tangible personal property or intangible personal property. In other words, the leased property cannot be real estate, buildings, or real estate improvements.

(b) The property must be leased to the user of the facility or a related person.

(c) The lessor of the property must not be a user or a related person to the user or a State or local governmental unit.

(d) The lessor must be either the manufacturer of the property, or a person in the trade or business of leasing property the same as the property being leased.

(e) The property being leased must be such type that it is ordinarily leased pursuant to general business practices.

(f) The "lease" must be a "true lease" and respected as such for Federal income tax purposes.

In addition, a leasing arrangement must be entered into before the bond user purchases, acquires, or takes delivery of the equipment. Compare Rev. Rul. 80-162 (purchase order cancelled and down payment returned prior to delivery) with Rev. Rul. 79-248 (equipment purchased and immediately sold to leasing company and leased back).

This memorandum sets forth the basic guidelines utilized by the Internal Revenue Service ("IRS") to determine whether a lease is to be considered a "true" lease and respected as such for Federal income tax purposes. It, however, is not exhaustive and does not cover many judicial decisions in which courts have found "true" leases in particular fact situations. See, e.g., Frank Lyon Company v. United States, 435 U.S. 561, 98 S. Ct. 1291 (1978) (sale and leaseback of building under construction for bank's long-term use was not a sham transaction); The LTV Corporation v. Commissioner, 63 T.C. 39 (1974) (computer lease was in substance, as well as in form, a lease so that lessee was entitled to rental deductions).

The leading IRS pronouncement on what constitutes a "true" lease in the equipment leasing context is Rev. Rul. 55 540, 1955-2 C.B. 39, which, although issued in 1955, still represents the position of the IRS. In this ruling, the IRS states that whether an agreement, which in form is a lease, is in substance a conditional sales contract depends upon the intent of the parties as evidenced by the provisions of the agreement, read in light of the facts and circumstances existing at the time the agreement was executed. In ascertaining such intent no single test, or any special combination of texts, is absolutely determinative.

Section 3.02 of the ruling provides that in making the determination of the intent of the parties under the facts and circumstances "it is necessary to determine whether by virtue of the agreement, the lessee has acquired, or will acquire, title to any equity in the property."

Section 4.01 lists a number of conditions that tend to show the existence of a sale rather than lease. The ruling states that a lease will be treated as a conditional sale for Federal income tax purposes if one or more of the following conditions are present:

(i) Portions of the periodic payments are made specifically applicable to an equity to be acquired by the lessee. See Truman Bowen v. Commissioner, 12 T.C. 466, acquiescence, C.B. 1951-2, 1.

(ii) The lessee will acquire title upon the payment of a stated amount of "rentals" which under the contract he is required to make. See Hervey v. Rhode Island Locomotive Works, 93 U.S. 644 (1876); Robert A. Taft v. Commissioner, 27 B.T.A. 808; Truman Bowen v. Commissioner, supra.

(iii) The total amount which the lessee is required to pay for a relatively short period of use constitutes an inordinately large proportion of the total sum required to be paid to secure the transfer of the title. See Truman Bowen v. Commissioner, supra.

(iv) The agreed "rental" payments materially exceed the current fair rental value. This may be indicative that the payment includes an element other than compensation for the use of property. See William A. McWaters, et al. v. Commissioner, Tax Court Memorandum Opinion, entered June 15, 1950; Truman Bowen v. Commissioner, supra.

(v) The property may be acquired under a purchase option at a price which is nominal in relation to the value of the property at the time when the option may be exercised, as determined at the time of entering into the original agreement, or which is a relatively small amount when compared with the total payments which are required to be made. See Burroughs Adding Machine Co. v. Bogdon, 9 F.2d 54; Holeproof Hosiery Co. v. Commissioner, 11 B.T.A. 547.

(vi) Some portion of the periodic payments is specifically designated as interest or is otherwise readily recognizable as the equivalent of interest. See Judson Mills v. Commissioner, 11 T.C. 25, acquiescence, C.B. 1949-1, 2.

Rev. Rul. 55-541, 1955-2 C.B. 19, a companion ruling to Rev. Rul. 55-540, discusses a situation where an asset was leased for substantially its entire useful life. The ruling states that the absence of an agreement to pass title is not indicative that the agreement was a lease and, in that situation, equitable ownership had passed. Therefore, it is essential that the lease is for a period which is not substantially the entire useful life of the asset. Accord, Rev. Rul. 60 122, 1960 1 C.B. 56.

In Rev. Rul. 68-590, 1968-2 C.B. 66, the IRS set forth the terms of a financing lease between a political subdivision and a user for a project constructed through the issuance of industrial development bonds. Under this lease, the political subdivision agreed to "lease" the project to the corporation for an initial term of twenty years, which was substantially shorter than the useful life of the project. The corporation assumed an unconditional obligation to make periodic payments, called "basic rental", during the initial term in amounts sufficient to cover the payment of the interest on and principal of the bonds. The basic rental was adjustable to take into consideration any excess of net proceeds from the sale of the bonds over the cost of the project and certain other contingencies. The corporation was given options to renew for terms which, when added to the initial term, aggregated ninety-nine years. The basic rent during the renewal periods was nominal. The corporation was also given an option to purchase the project for a nominal amount at the end of the lease term, or earlier upon prepayment of basic rental. The corporation also agreed to pay, as additional rent, all fees and expenses of a trustee incurred under a "Trust Indenture" all utility charges, taxes, assessments, casualty and liability insurance premiums, and any other expenses or charges related to the use, operation, maintenance, occupancy and upkeep of the project. The IRS held that the corporation had all the burdens and benefits of ownership under this arrangement and, in effect, the corporation was treated as the owner of the project for Federal income tax purposes.

In Rev. Procs. 75-21, 1975-1 C.B. 715, 75-28, 1975-1 C.B. 752, 76-30, 1976-2 C.B. 647 and 79-48, 1979-2 C.B. 529, the IRS has published guidelines which must be satisfied in order to receive an advanced private ruling on the determination of whether a "leveraged lease" is a "true lease" for Federal income tax purposes. Generally, a leveraged lease occurs where the lessor-owner has borrowed the funds to purchase the equipment. Presumably, if the contemplated leasing company will not be borrowing the funds in order to purchase the property it will lease, these requirements need not be met. Nevertheless, if such requirements can be met, strong evidence would exist that the "lease" is a "true lease." The revenue procedures above require the lessor to have, incur and maintain a minimum investment of 20% of the cost of the property. In addition, the revenue procedures provide for a further requirement that at least 20% of the original price of the property be equal to the fair market value of the property at the end of the lease term. In effect, the revenue procedures quantify, in an analogous situation, the requirement of the minimum residual value at the end of the lease term that is required in Rev. Rul. 55-540.

Also, these revenue procedures require (i) that any renewal options should be at fair rental value and that any purchase options should be at fair market value; (ii) that the equipment be capable of removal from the lessee's premises, and (iii) that any maintenance and repairs performed by the lessee not be such that they constitute an improvement or addition to the property. Furthermore, no part of the cost of the property should be furnished by the lessee. If the lessor-leasing company borrows the funds to acquire the property, the lessee may not guarantee any such indebtedness. Also, the lessor should be able to demonstrate, through a formula set forth in the revenue procedures, that it expects to receive a profit, apart from the value of the tax benefits obtained from the transaction.

In summary, Rev. Rul 55-540 contains the IRS's most complete statement on whether a lease of equipment will be treated as a "true" lease or conditional sales agreement. In the ruling it was stated that the IRS will look at the intent of the parties at the time the agreement was executed to determine the proper characterization of the transaction. Generally, an intent to enter into a conditional sale agreement will be found to be present if (a) portions of the rental payments are made specifically applicable to an equity acquired by the lessee, (b) the lessee will acquire a title automatically after certain payments have been made, (c) the rental payments are a disproportionately large amount in relation to the sum necessary to complete the sale, (d) the rental payments are above fair rental value, (e) title can be acquired at a nominal option price, or (f) some portion of the rental payments are identifiable as interest. See also Rev. Rul. 60 122, 1960 1 C.B. 56; Rev. Rul. 72-543, 1972-2 C.B. 87.

In addition to Rev. Rul. 55-540, the IRS has announced, in a series of revenue procedures starting with Rev. Proc. 75-21, more specific guidelines under which it would answer ruling requests in an analogous context, leverage leasing transactions. In general "[u]nless other facts and circumstances indicate a contrary intent," the IRS will not rule that a lessor in a leveraged lease transaction is to be treated as the owner of the property in question unless (a) the lessor has incurred and maintains a minimal investment equal to 20% of the cost of the property, (b) the lessee has no right to purchase except at fair market value, (c) no part of the cost of the property is furnished by the lessee, (d) the lessee has not lent to the lessor or guaranteed any indebtedness of the lessor, and (e) the lessor must demonstrate that it expects to receive a profit on the transaction other than the benefits received solely from the tax treatment.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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