Rev. Rul. 68-590

Advice has been requested regarding the income tax treatment, by a corporation, of certain arrangements entered into between a political subdivision of a State and a corporation to induce the corporation to locate in the immediate area. The arrangements are embodied in the following documents: (1) a letter agreement outlining the proposed transactions, (2) a `Contract of Purchase,' (3) a `Trust Indenture,' and (4) a `Lease Agreement and Option to Purchase.'

The letter agreement provided for the acquisition of land and the construction and equipping of an industrial project thereon according to the corporation's specifications, either by the corporation or by the political subdivision. The letter agreement provided that if the corporation assumed responsibility for acquisition of the project, then the corporation and the political subdivision would simultaneously enter into a `Contract of Purchase,' whereby the corporation would agree to `sell' and the political subdivision would agree to `buy' the project for a price equal to its cost, but not in excess of the net proceeds from the sale of the bonds discussed below. The letter agreement further provided that if the political subdivision assumed responsibility for the acquisition of the project, then the corporation would agree to reimburse the political subdivision for any costs in excess of the net proceeds from the sale of the bonds.

The political subdivision obtained the funds to finance the purchase or construction of the project by issuing `industrial development bonds' within the meaning of section 103(c)(2) of the Code. The bonds were not general obligations of the political subdivision but were secured by and payable solely from proceeds derived from the leasing of the project as explained below. To provide for issuance of the bonds, disbursement of the net proceeds, and to secure payment of the interest on and principal of the bonds, the political subdivision executed a `Trust Indenture' appointing a trustee for the bondholders. The trustee was to receive the net proceeds from the sale of the bonds to the general public and use the funds to pay the purchase price of the project as provided in the `Contract of Purchase' or to pay the costs of the project if the political subdivision was responsible for its acquisition. In either event, if the net proceeds from the sale of the bonds were not sufficient to cover the costs of the project, the corporation agreed to provide the additional funds. If the net proceeds from the sale of the bonds exceeded the costs of the project, then the trustee was to retain such excess for payment of the interest on and principal of the bonds.

The last maturity date of the bonds coincides with the end of the initial lease term provided in the `Lease Agreement and Option to Purchase.'

Under the terms of the `Trust Indenture,' the trustee was given a deed of trust to the project subject to the `Lease Agreement and Option to Purchase.' The political subdivision also assigned the basic rentals, discussed below, to the trustee for payment of the interest on and principal of the bonds.

Simultaneously with the other agreements, the political subdivision and the corporation entered into the `Lease Agreement and Option to Purchase' whereby the political subdivision agreed to `lease' the project to the corporation for an initial lease term of 20 years, which is 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 lease term in an amount sufficient to cover the payment of the interest on and principal of the bonds. The basic rental is payable directly to the trustee. The basic rental is adjustable to take into consideration any excess of the net proceeds from the sale of the bonds over the costs of the project and certain other contingencies. The corporation is given options to renew for renewal terms which, when added to the initial lease term, aggregate 99 years. The basic rent during the renewal periods is nominal. The corporation is also given an option to purchase the project for a nominal amount at the end of the initial lease term (or at any time during the renewal terms), or earlier upon prepayment of the basic rental.

The corporation also agreed to pay, as additional rent, all fees and expenses of the trustee incurred under the `Trust Indenture,' all utility charges, taxes, assessments, casualty and liability insurance premiums, and any other expenses or charges relating to the use, operation, maintenance, occupancy, and upkeep of the project.

The `Lease Agreement and Option to Purchase' and the `Trust Indenture' contain provisions relating to damage to or condemnation of the project or default by the corporation. The substance of the provisions make the corporation entitled to any excess of insurance, condemnation, or foreclosure sale proceeds over the remaining basic rentals and liable for any deficiency.

Section 162(a) of the Code 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 agreements between the corporation and the political subdivision, when viewed in their entirety, is clearly that of a financing arrangement. The letter agreement, the `Contract of Purchase,' the `Lease Agreement and Option to Purchase,' and the `Trust Indenture,' although in the form of a sale and leaseback (or a lease), are security devices for the protection of the bondholders who provided the financing for the project.

The corporation has all the burdens and benefits of ownership. The corporation is obligated to repay the principal cost of the project plus interest in the form of basic rentals. It is also obligated to pay the normal costs of operating the project plus the financing expenses in the form of additional rent. In the event of default, casualty, or condemnation, the corporation has the same substantive rights and obligations as a mortgagor. It is clear that the parties intend legal title to the project to pass to the corporation. The existence of an option to renew does not negate this intent since rental during any renewal periods is nominal and the corporation still retains the right to acquire legal title upon payment of a nominal sum.

The political subdivision assumes no risk of loss regarding the project and has no opportunity of gain.

Accordingly, the corporation is considered to be the owner of the project for Federal income tax purposes. Consequently, the following general tax treatment will result to the corporation:

(1) The corporation will be considered the purchaser and original user of the project and its component parts;

(2) The corporation will be entitled to the invesment credit provided under section 38 of the Code with respect to that portion of the project which constitutes `section 38 property,' subject to the provisions of sections 46, 47, and 48 of the Code and the regulations thereunder, but in this regard, the exceptions provided in section 48(a)(4) and (5) of the Code will not apply;

(3) The corporation will take into account any premium or discount on the bonds pursuant to section 61 of the Code and the regulations thereunder;

(4) The corporation will not be entitled to rental deductions which are allowed by section 162(a)(3) of the Code and the regulations thereunder;

(5) The corporation will be entitled to deductions for all ordinary and necessary expenses paid or incurred in the operation of the project, including but not limited to the annual trustee's fees, pursuant to section 162 of the Code and the regulations thereunder;

(6) The corporation will be entitled to interest deductions with respect to that portion of the basic rentals which represents, in effect, the interest payable on the bonds pursuant to section 163 of the Code and the regulations thereunder;

(7) The corporation will be entitled to deductions for all state and local taxes imposed with respect to the project, pursuant to section 164 of the Code and the regulations thereunder; and

(8) The corporation will be entitled to depreciation deductions with respect to all depreciable property in the project, pursuant to section 167 of the Code and the regulations thereunder.