Rent And Interest Not Deductible In Connection With Lease-In, Lease- Out Transaction.

Rev. Rul. 2002-69

ISSUE

[1] May a taxpayer deduct currently, under §§162 and 163 of the Internal Revenue Code, rent and interest paid or incurred in connection with a "lease-in/lease-out" ("LILO") transaction?

FACTS

[2] X is a U.S. corporation. FM is a foreign municipality that has historically owned and used certain property. As of 1997, it is estimated that the property has a remaining useful life of 50 years and a fair market value of $100 million. BK1 and BK2 are banks. None of these four parties is related to any of the others.

[3] On January 1, 1997, X and FM entered into a LILO transaction under which FM leased the property to X under a "Headlease," and X immediately leased the property back to FM under a "Sublease." The term of the Headlease is 40 years. The primary term of the Sublease is 20 years. Moreover, as described below, the Sublease also may be renewed for a term of 10 years ("put renewal term") at the option of X. X's right to possess the property under the Headlease for the first 20 years is substantially the same as FM's right to possession under the Sublease for the primary term.

[4] The Headlease requires X to make two rental payments to FM during its 40-year term: (1) an $89 million prepayment at the beginning of year 1; and (2) a postpayment at the end of year 40 that has a discounted present value of $8 million. For federal income tax purposes, X and FM allocate the prepayment ratably to the first 6 years of the Headlease and the future value of the postpayment ratably to the remaining 34 years of the Headlease.

[5] The Sublease requires FM to make fixed, annual rental payments over both the primary term and, if exercised, the put renewal term. The fixed, annual payments during the put renewal term are equal to 90 percent of the amounts that (as of January 1, 1997) are projected to be the fair market value rental amounts for that term.

[6] To partially fund the $89 million Headlease prepayment, X borrows $54 million from BK1 and $6 million from BK2. Both loans are nonrecourse, have fixed interest rates, and provide for annual debt service payments that fully amortize the loans over the 20-year primary term of the Sublease. The amount and timing of the debt service payments mirror the amount and timing of the Sublease payments due during the primary term of the Sublease. The remaining $29 million of the Headlease prepayment is provided by X.

[7] Upon receiving the $89 million Headlease prepayment, FM deposits $54 million into a deposit account with an affiliate of BK1 and $6 million into a deposit account with an affiliate of BK2. The deposits with the affiliates of BK1 and BK2 earn interest at the same rates as the loans from BK1 and BK2. FM directs the affiliate of BK1 to pay BK1 annual amounts equal to 90 percent of FM's annual rent obligation under the Sublease (that is, amounts sufficient to satisfy X's debt service obligation to BK1). The parties treat these amounts as having been paid from the affiliate to FM, then from FM to X as rental payments, and finally from X to BK1 as debt service payments. In addition, FM pledges the deposit account to X as security for FM's obligations under the Sublease, while X, in turn, pledges its interest in FM's pledge to BK1 as security for X's obligations under the loan from BK1. Similarly, FM directs the affiliate of BK2 to pay BK2 annual amounts equal to 10 percent of FM's annual rent obligation under the Sublease (that is, amounts sufficient to satisfy X's debt service obligation to BK2). The parties treat these amounts as having been paid from the affiliate to FM, then from FM to X as rental payments, and finally from X to BK2 as debt service payments. Although FM's deposit with the BK2 affiliate is not pledged, the parties understand that FM will use the account to pay the remaining 10 percent of FM's annual rent obligation under the Sublease.

[8] As a result of the foregoing arrangement, X's obligation to make the property available under the 20-year primary term of the Sublease is completely offset by X's right to use the property under the Headlease. X's obligation to make debt service payments on the loans from BK1 and BK2 is completely offset by X's right to receive Sublease rentals from FM. Moreover, X's exposure to the risk that FM will not make the rent payments is further limited by the arrangements with the affiliates of BK1 and BK2. In the case of the loan from BK1, X's economic risk is eliminated through the defeasance arrangement. In the case of the $6 million loan from BK2, X's economic risk, although not eliminated, is substantially reduced through the deposit arrangement. As a result, neither bank requires an independent source of funds to make the loans, or bears significant risk of nonpayment. In short, during the primary Sublease term, the transaction is characterized by reciprocal and circular obligations that offset one another.

[9] At the end of the Sublease primary term, FM has a fixed-payment option to purchase from X the Headlease residual (the right to use the property beyond the Sublease primary term subject to the obligation to make the rent postpayment) for a fixed exercise price equal to 105 percent of the amount that (as of January 1, 1997) is projected to be the future fair market value of the Headlease residual. If FM exercises the option, the transaction is terminated at that point, and X receives the exercise price of the option and is not required to make any portion of the postpayment due under the Headlease. If FM does not exercise the option, X may elect to (1) use the property itself for the remaining term of the Headlease, (2) lease the property to another person for the remaining term of the Headlease, or (3) compel FM to lease the property for the 10-year put renewal term of the Sublease. If FM does not exercise the fixed-payment option and X exercises its put renewal option, X will receive rents that are equal to 90 percent of the amounts that are (as of January 1, 1997) projected to be the fair market rents for that term. If the actual fair market rents in 20 years turn out to be less than the amount specified in the put renewal option and FM does not exercise the fixed-payment option, X will be able to compel FM to lease the property for rents that are greater than the then fair market rental value. Thus, as a practical matter, the fixed-payment option and put renewal option operate to "collar" the value of the Headlease residual during the primary term.

[10] In addition, X has nominal exposure to FM's credit under the fixed-payment option and, if exercised, the put renewal term. At the inception of the transaction, X requires FM to invest $15 million of the Headlease prepayment in highly-rated debt securities that will mature in an amount sufficient to fund the fixed amount due under the fixed-payment option, and to pledge these debt securities to X. This arrangement ensures that FM is able to make the payment under the fixed-payment option. Having economically defeased both its rental obligations under the Sublease and its fixed-payment under the fixed-payment option, FM keeps the remaining portion of the Headlease prepayment as its return on the transaction. If FM does not exercise the fixed-payment option and X exercises the put renewal option, X can require FM to purchase a letter of credit guaranteeing the put renewal rents. If FM does not obtain the letter of credit, FM must exercise the fixed-payment option.

[11] For tax purposes, X claims deductions for interest on the loans and for the allocated rents on the Headlease. X includes in gross income the rents received on the Sublease. If the fixed-payment option is exercised, X also includes the option price and recaptures rent deductions taken during the primary Sublease term that are attributable to the postpayment it is no longer required to make.

LAW AND ANALYSIS

[12] X and FM's allocations of the prepayment and the postpayment for federal income tax purposes meet the uneven rent test contained in proposed § 467 regulations (§ 1.467- 3(c)(2)(i)), and under those regulations the Headlease would not be treated as a disqualified leaseback or long-term agreement subject to constant rental accrual. Because this LILO transaction was entered into after June 3, 1996, and on or before May 18, 1999, the provisions of the proposed regulations are available. See § 1.467-9(c). For later years, however, final § 467 regulations effective May 18, 1999, treat the prepayment of rent as resulting in a deemed loan from X to FM and require the imputation of interest income to X. § 1.467-4. Moreover, X's rent deduction would be subject to proportional rent rules that reflect the time value of money concept. See § 1.467- 2(c).

[13] The substance of a transaction, not its form, governs its tax treatment. Gregory v. Helvering, 293 U.S. 465 (1935). In Frank Lyon Co. v. United States, 435 U.S. 561, 573 (1978), the United States Supreme Court stated, "In applying the doctrine of substance over form, the Court has looked to the objective economic realities of a transaction rather than to the particular form the parties employed." The Court evaluated the substance of the transaction in Frank Lyon to determine that it was indeed a sale/leaseback, as it was structured, rather than a financing. The Court subsequently relied on its approach in Frank Lyon to recharacterize a sale and repurchase of federal securities as a loan, finding that the economic realities of the transaction did not support the form chosen by the taxpayer. Nebraska Dep't of Revenue v. Loewenstein, 513 U.S. 123 (1994).

[14] Where parties have in form entered into two separate transactions that result in offsetting obligations, the courts often have collapsed the offsetting obligations and recharacterized the two transactions as a single transaction. In Rogers v. United States, 281 F.3d 1108 (10^th Cir. 2002), the part-owner (Fogelman) of a professional baseball team that was organized as an S corporation borrowed money from the S corporation. The nonrecourse loan was secured by Fogelman's ownership interest in the corporation and his existing option to purchase the rest of the shares from the taxpayer (Kauffman), the other owner of the team. Fogelman also granted the corporation an option to purchase both his shares and his existing option to buy Kauffman's shares. The option price was an amount equal to the outstanding loan balance. The corporation exercised its option immediately but deferred closing until the due date of Fogelman's loan, five months later. On that date, Fogelman transferred his shares in the corporation to the corporation in lieu of its foreclosure on the loan. The corporation claimed that the shares had no value at that time and deducted the loan amount as a bad debt, which was passed through to Kauffman.

[15] The court in Rogers applied the substance over form doctrine to collapse the loan and the option transaction into a redemption of Fogelman's stock in exchange for cash. Fogelman had no incentive to repay the loan because any reduction in the loan balance would reduce the option price. The immediate exercise of the option precluded any attempt by Fogelman to repay the loan and keep the stock. On the basis of those facts, among others, the court held that the substance of the transaction was a sale of Fogelman's stock to the corporation.

[16] In Bussing v. Commissioner, 88 T.C. 449, reconsideration denied, 89 T.C. 1050 (1987), a Swiss subsidiary of a computer leasing company (AG) purchased computer equipment in a sale/leaseback transaction involving a five-year lease. Subsequently, AG purportedly sold the equipment to a domestic corporation (Sutton), which in turn purportedly sold interests in the equipment to the taxpayer (Bussing) and four other individual investors. Bussing acquired his interest in the computer equipment subject to the underlying lease by paying cash, short-term promissory notes, and a long-term promissory note to Sutton. Bussing then leased his interest in the equipment back to AG for nine years. The rents due Bussing from AG equaled Bussing's annual payments on the long- term promissory note to Sutton for the first three years and were supposed to generate nominal annual cash flow thereafter.

[17] The court first disregarded Sutton's participation in the transactions on substance over form grounds. It then held that Bussing's long-term indebtedness also must be disregarded because it was completely offset by AG's rent payments in a "purported sale- leaseback pursuant to which the respective lease and debt obligations flow between only two parties." Id. at 458. The court stated,

[18] Courts have similarly disregarded the parties' obligations in purported installment sales where the taxpayer received an installment note that was offset by some other arrangement between the two parties, indicating that the maker of the note would not be called upon to pay the installment obligation. See Rickey v. Commissioner, 502 F.2d 748 (9^th Cir. 1974), aff'g 54 T.C. 680 (1970). Although taxpayers are entitled to arrange the terms of a sale in order to qualify for the installment method, "the arrangements must have substance and must reflect the true situation rather than being merely the formal documentation of the terms of the sale." Id. at 752-53, quoting 54 T.C. 680 at 694. See also United States v. Ingalls, 399 F.2d 143 (5^th Cir. 1968); Blue Flame Gas Co. v. Commissioner, 54 T.C. 584 (1970); Greenfield v. Commissioner, T.C. Memo. 1982-617; Big "D" Development Corp. v. Commissioner, T.C. Memo. 1971-148, aff'd per curiam, 453 F. 2d 1365 (5^th Cir.1972).

[19] Similarly, the Headlease and Sublease impose offsetting obligations that must be disregarded, regardless of whether other components of the LILO transaction are respected. During the first 20 years of its term, the Headlease confers to X a right to use the property that is immediately reversed by the Sublease grant to FM of substantially the same right to use property. In the LILO transaction, the Sublease interest retained by FM is of the same nature as the Headlease interest conveyed to X. Because the transfer and retransfer of the right to possess the property for the first 20 years are disregarded as offsetting obligations, the transaction that remains is, at best, a transfer of funds from X to FM in exchange for FM's obligation to repay those funds and provide X the right to begin to lease the property in 20 years.

[20] An analogous situation occurs when the conveyance of property is accompanied by the retention of some interest in the same property. If the interest retained is of substantially the same nature as the interest conveyed, only a future interest is conveyed. In McCully Ashlock v. Commissioner, 18 T.C. 405 (1952), acq., 1952-2 C.B. 1, taxpayer had acquired property through a deed dated June 6, 1945. The seller, however, had retained the right to possession and rentals through August 15, 1947. The court found that taxpayer had acquired only a future interest in the property because "the trustees [sellers] not only retained the rents legally but they also retained control and benefits of ownership." Id. at 411. Consequently, rentals from the property were income to the seller.

[21] Similarly, in Kruesel v. United States, 63-2 U.S. Tax Cas. (CCH) & 9714 (D. Minn. 1963), the court concluded that taxpayer had transferred only a future, remainder interest in property and reserved a life estate. The government had unsuccessfully argued that taxpayer had sold its entire interest in the property and the taxpayer's amount realized on the sale included the value of a right to occupancy provided to the taxpayer by the buyer.

[22] In contrast, in Alstores Realty Corp. v. Commissioner, 46 T.C. 363 (1966), acq., 1967-2 C.B.1, the court held that a sale of property accompanied by the reservation of a right of occupancy did not result in the transfer of only a future interest because the seller's right of occupancy was in the nature of a leasehold interest, because the purchaser acquired the benefits and burdens of ownership of the property.

[23] Alstores can be distinguished from McCully Ashlock and Kruesel. McCully Ashlock and Kruesel conclude that where a retained interest is of the same nature as the interest conveyed, only a future interest has been transferred. In Alstores, the interests were not of the same nature.

[24] Similarly, the LILO transaction is distinguishable from the transaction involved in Comdisco, Inc. v. Commissioner, 756 F.2d 569 (7^th Cir. 1985). In that case, equipment was subject to end user leases, and the lessor of that equipment assigned an interest to taxpayer in a transaction designed to give the taxpayer investment tax credits. The taxpayer's entitlement to the credits depended on whether it had the status of lessee/sublessor. In concluding that it did, the court noted a number of factors that supported taxpayer's claim that it had acquired a leasehold interest. The taxpayer was obligated to the lessor in the event of a default by the sublessee. The taxpayer relet certain equipment after one sublease had expired. In connection with another sublease, the taxpayer was responsible for rent to its assignor in excess of amounts paid by the sublessee directly to the assignor. The court also emphasized the regulatory restrictions on direct leases between the assignor and the end users. Id. at 576-77. Unlike Comdisco, in the LILO transaction the headlessor and the sublessee are the same party. Further, in the LILO transaction the headlessee/sublessor is not materially exposed to the risk that the sublessee will fail to make rent payments.

[25] Section 162(a)(3) permits a deduction for rentals and other payments required to be made as a condition to the continued use or possession, for purposes of the trade or business, of property. Because X does not acquire a current leasehold interest in the property, it is not entitled to current deductions for rent. The $29 million "equity" portion of the Headlease prepayment is, effectively, a payment for at most X's right under the Headlease to lease the property 20 years hence for a term of 20 years. (Economically, $29 million is an overpayment for the value of any right that X obtains to lease the property in the future. X was willing to overpay in this manner, however, in order to induce FM to participate in the transaction.). In accordance with § 467, the $29 million "equity" portion of the Headlease prepayment is deductible over the 20-year residual term of the Headlease (the 10-year put renewal term and the 10-year "shirttail' period). Alternatively, in the event FM exercises its fixed-price option at the end of the primary term of the Sublease, X will have gain or loss equal to the difference between the option price and X's cost of acquiring a right to the Headlease residual term. Section 1001.

[26] The remainder of the Headlease prepayment, $60 million, must be disregarded, because the "loans" that purportedly finance this portion of the Headlease prepayment are without substance. In Bridges v. Commissioner, 39 T.C. 1064, aff'd 325 F.2d 180 (4^th Cir. 1963), taxpayer "borrowed" funds from banks and used the funds to purchase Treasury notes, which the banks held as collateral and ultimately sold to satisfy taxpayer's debts. The court's rationale for disallowing taxpayer's deductions of prepaid interest is equally applicable here:

[27] Although this ruling refers to a foreign municipality and its property, the analysis and holding apply as well to LILO transactions that involve or include domestic tax-exempt or tax- indifferent entities.

HOLDING

[28] A taxpayer may not deduct currently, under §§ 162 and 163, rent or interest paid or incurred in connection with a LILO transaction that properly is characterized as conferring only a future interest in property. Where appropriate, the Service will continue to disallow the tax benefits claimed in connection with LILO transactions upon other grounds, including that the substance over form doctrine requires their recharacterization as financing arrangements and that they are to be disregarded for lack of economic substance.

EFFECT ON OTHER DOCUMENTS

[29] Rev. Rul. 99-14, 1999-1 C.B. 835, is modified and superseded.

DRAFTING INFORMATION

[30] The principal author of this revenue ruling is John Aramburu of the Office of Associate Chief Counsel (Income Tax & Accounting). For further information regarding this revenue ruling contact Mr. Aramburu at (202) 622-4960 (not a toll-free call).