Rev. Rul. 72-543

Advice has been requested regarding the Federal income tax treatment by unrelated corporations of certain financial arrangements under the circumstances described below.

Corporation X is engaged in the business of shipping ocean freight. It owns a vessel that required extensive overhaul. To finance the cost of reconstructing the vessel, X considered obtaining a loan. However, X found it inadvisable to obtain a loan by means of direct borrowing. Instead, it effected the borrowing in the following manner:

(1) S, a wholly-owned subsidiary of P, a bank, and unrelated to X, acquired title to the vessel at its fair market value. Pursuant to an agreement between X and S the vessel was reconstructed at a certain cost.

(2) S borrowed an amount equal to the cost of such acquisition and reconstruction of the vessel from a group of lenders under an agreement whereby X and S entered into a charterparty (a contract by which S leases the vessel to X to be used by X in transportation) under which all of S's right, title, and interest in and to all monies and claims to money due and to become due under the charterparty were assigned to P as agent for such lenders.

(3) S chartered the vessel to X for a term of 21 years at a rental equal to an amount sufficient to retire the total acquisition and reconstruction costs plus accrued interest over the 21-year charter period. The charter contained an unconditional obligation of X to pay the rental regardless of whether X uses the vessel.

(4) The vessel will throughout the term of the charter be in every respect at the risk of X and X will throughout the same term insure and keep the vessel insured in a manner consistent with the insurance carried on similar vessels owned by X.

(5) Under the charter, X has an option to buy the vessel on the ninth anniversary of the delivery date of the vessel (the date the vessel as reconstructed was placed in the hands of S) at a pre-determined price which will be equal to the unamortized principal amount of the loan on that date. Also, S has the right to put the vessel to X on the same date that X's option is exercisable and at the same price. Furthermore, the lenders have the right to force S to exercise the put on the ninth anniversary of the delivery date of the vessel.

(6) The economically useful life of the vessel is estimated to be less than the 21-year period for which S agrees to charter the vessel to X.

Section 162 of the Internal Revenue Code of 1954 provides, in part, that:

There shall be allowed as a deduction all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business, including * * * (3) rentals or other payments required to be made as a condition to the continued use or possession, for purposes of the trade or business, of property to which the taxpayer has not taken or is not taking title or in which he has no equity.

The substance of a transaction, rather than its legal form, is controlling for Federal income tax purposes, Helvering v. Lazarus and Co., 308 U.S. 252 (1939), Ct. D. 1430, C.B. 1939-2, 208. Calling a transaction a lease does not make it one, if in fact it is something else. Walburg A. Oesterreich v. Commissioner, 226 F.2d 798 (1955). However, a mere option to buy at the expiration of a lease does not turn it into a contract of sale. H. T. Benton v. Commissioner, 197 F.2d 745 (1952).

The substance of the transaction in the instant case, when viewed in its entirety, is a financing arrangement with beneficial ownership being in X and mere legal title being in S who holds such title as a mortgagee. Although the arrangements are considered in the form of a sale and leaseback (or a lease), they really constitute security devices for the protection of the group of lenders who provided financing for the reconstruction of the vessel.

X has all the burdens and benefits of ownership. X is obligated to repay the total acquisition and reconstruction costs of the vessel plus interest in the form of basic rentals. It is also obligated to pay the normal costs of operating the vessel and to keep the vessel insured in a manner consistent with the insurance carried on similar vessels owned by X. Under the charter, X has an option to purchase the vessel on the ninth anniversary of the delivery date of the vessel at a predetermined price which will equal the unamortized principal amount of the loan on that date. Also, S has the right to put the vessel to X on the same date that X's option is exercisable at the same price and the lenders have the right to force S to exercise the put on such date. It is clear that the parties intend legal title to the vessel to pass to X.

Accordingly, X is considered to be the owner of the vessel for Federal income tax purposes. Consequently, the following tax treatment will result to X and S:

(1) The transfer of legal title to S by X will not constitute a sale of the vessel and no gain will be realized by, and no amount will be includible in the income of, X as a result of such transfer;

(2) X will be entitled to the investment credit provided under section 38 of the Code with respect to that portion of the reconstruction which constitutes "section 38 property," subject to the provisions of sections 46, 47 and 48 of the Code and the regulations thereunder;

(3) X will be entitled to deductions pursuant to section 162 of the Code and the regulations thereunder for all ordinary and necessary expenses paid or incurred in the operation of the vessel;

(4) X will be entitled to interest deductions pursuant to section 163 of the Code and the regulations thereunder with respect to that portion of the payments which represents, in effect, the interest payable on the loan;

(5) X will be entitled to deductions pursuant to section 164 of the Code and the regulations thereunder for property taxes;

(6) X will be entitled to depreciation deductions pursuant to section 167 of the Code and the regulations thereunder; (7) X will not be entitled to rental deductions which are provided by section 162(a)(3) of the Code for so-called rental payments under the charterparty;

(8) Under section 1011 of the Code, X's basis in the vessel will be the adjusted basis of the vessel in the hands of X prior to the so-called sale of the vessel to S, increased by the entire amount expended by S in the reconstruction of the vessel and any amounts provided by X for such reconstruction in addition to the amount provided by S;

(9) S will have gross income in the amount of the payments received under the charterparty exclusive of that portion of each payment that constitutes a payment of principal on the loan pursuant to section 61 of the Code and the regulations thereunder;

(10) S will have gross income with respect to any amount received from, or paid on its behalf by, X that represents payment of S's expenses;

(11) S will be entitled to deductions for its expenses in connection with the transaction in the instant case;

(12) S will be entitled to deduction for interest paid to borrow funds for the transaction in the instant case; and

(13) The exercise of the option by X will not result in a gain or loss but will be considered a repayment of a loan.

The holding in the instant case is similar to the holding in Revenue Ruling 68-590, C.B. 1968-2, 66. Revenue Ruling 68-590 relates to the income tax treatment of certain financial arrangements entered into between a political subdivision of a State and a corporation to induce the corporation to locate in the immediate area of the political subdivision. Revenue Ruling 68-590 holds that although the political subdivision financed the construction of an industrial project for use by the corporation on a rental basis, such arrangement is considered merely a financial arrangement and the corporation is considered the owner of the project.