Rev. Rul. 55-542

Advice has been requested whether the contract entered into by corporation M whereby it acquired the use of certain equipment manufactured by corporation N was a lease with option to purchase or whether the contract was a conditional sales contract.

Under the contract, M acquired the use of certain equipment and has agreed to pay 150 x dollars in quarterly payments over a period of 15 years. Of this amount, 60 x dollars is payable in the first five years, 52 x dollars is payable in the second five years, and 38 x dollars is payable in the final five-year period. In addition M is required to pay an amount equal to 3 1/2 percent per annum of the amount of the unpaid quarterly amounts due under the contract. At the end of the 15-year period, title will pass to M upon the payment of the then depreciated value of the equipment.

In addition to the contract between corporation M and corporation N , there is a financing contract between corporation N and corporation P whereby P , an insurance company, agreed to remit to N the sum of 150 x dollars as full payment of the purchase price of the equipment upon delivery to M . In return for such payment, N sells, assigns, transfers, and sets over to P all right, title, and interest of N in and to such equipment; and in and to any and all amounts (except freight and delivery charges) due or to become due or owing to N .

Evidence exists that the equipment could have been acquired by direct or outright purchase under an ordinary deferred payment contract at a cost of 152 x dollars plus interest on such amount over a 15-year period of 40 x dollars, or a total of 192 x dollars. Under the adopted plan the amount to be paid as `rent' over the 15-year period is 150 x dollars plus interest estimated to be 36 x dollars, plus the estimated net depreciated value at the termination of the contract of 40x dollars, or a total cost of 226 x dollars.

It is well established as a matter of fundamental law that contracts of the character here involved must be interpreted on the basis of the intent of the parties in the light of the facts and circumstances as they existed at the time the agreement was executed. Such intent cannot be determined by any single specific test and various factors must be considered in order to ascertain the reality of the contract. In these transactions the factors indicative of an intent to effect a conditional sale rather than a lease are found to be both convincing and numerous. Thus, the amount of payments by M required as `rentals' is approximately 82 percent of the total value of the equipment for a period of use of only 75 percent of the useful life of the equipment. The total `rentals' are substantially higher than the fair rental value for such equipment. Even more significant is the requirement that M pay interest on the `rental' balances, the payments of which had not yet become due. The contracts clearly contemplated disposition by N of all its interest in the equipment through the transfer to P . Furthermore, it seems unreasonable to assume that P intends to go into the business of owning and leasing equipment of this nature. It therefore seems wholly proper to conclude that the intention of the parties to the agreement was that M pay the required amount at the end of the `lease' period and keep the equipment.

Based on the foregoing facts and circumstances, it is held that corporation M has contracted to purchase the equipment under a conditional sales contract, and that the quarterly payments made by it are capital expenditures which can be recovered only through deductions for depreciation to the extent that such payments do not represent interest or other charges.

See Rev. Rul. 55-540, page 39, this Bulletin