Rev. Rul. 57-371

Advice has been requested whether a contract for the installation of an automatic fire protection sprinkler system in a building is a lease or a contract of sale for Federal income tax purposes.

A taxpayer, who owns a concrete warehouse and office building, contracted for the installation of a wet pipe system of fire extinguishing apparatus. The estimated useful life of the system is 40 years. The contract, designated a lease, provides for the installation of the system for a period of five years for an aggregate `rental' of 10 x dollars, representing the total cost of the system and its installation, payable 2 x dollars annually. The contract further provides that the lessor shall retain title to the system, together with the right to assign the lease, the rental installments, and the title to the system. The lessee shall keep the system fully insured at all times in an amount at least equal to the sum of the total rentals, and bear the risk of loss from any cause whatsoever. The liability of lessor in the event of the failure of the system or any defect therein, or for maintenance services called for in the contract, shall be limited to 0.05 x dollars. At the termination of the lease, the lessee has the privilege of renewal for an additional five-year period at a nominal `rental' of 0.1 x dollars per year. If the lessee does not elect to renew the lease, the lessor is granted a period of six months in which to remove the system from the building.

Revenue Ruling 55-540, C.B. 1955-2, 39, sets forth the various criteria whereby the Internal Revenue Service distinguishes for Federal income tax purposes between a lease and a contract of sale with respect to industrial equipment used in a taxpayer's trade or business. Section 4.06 of that Revenue Ruling states that agreements involving such equipment which specify `rentals' over a relatively short part of the expected useful life of the equipment, approximating the price at which it could have been purchased, and where the lessee may continue to use the equipment for an additional period or periods for relatively nominal or token payments, will be held to be sales contracts for Federal income tax purposes, even though a passage of title is not expressly provided in the agreement. In such case, the amounts paid under such agreements are considered to be payments for the sales price of the equipment to the extent that the amounts do not represent interest or other charges.

Accordingly, it is held that an agreement whereby an automatic fire protection sprinkler system is installed in a warehouse and office building for a five-year period, during which the aggregate amount of annual `rental' payments equals the cost of the system and its installation, with the privilege of a five-year renewal at a nominal `rental' of 0.1 x dollars per year, constitutes a conditional sale for Federal income tax purposes rather than a lease. The amounts paid as `rental,' except to the extent representing interest or currently deductible charges, are therefore capital expenditures within the meaning of section 263(a) of the Internal Revenue Code of 1954, recoverable through annual deductions for depreciation over the estimated life of the sprinkler system.