PORTFOLIO

Equipment Leasing: Benefits and Burdens (Portfolio 545)

Tax Management Portfolios, Equipment Leasing: Substance and Form, No. 544, and Equipment Leasing: Benefits and Burdens, No. 545, discuss the factors that must be considered in structuring an equipment leasing arrangement so that it will be treated as a lease for U.S. federal income tax purposes. They discuss the effect on such transactions of economic substance and anti-disavowal doctrines, conduit rules, partnership anti-abuse rules, tax-exempt entity leasing rules, etc.

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DESCRIPTION

Tax Management Portfolios, Equipment Leasing: Substance and Form, No. 544, and Equipment Leasing: Benefits and Burdens, No. 545, discuss the factors that must be considered in structuring an equipment leasing arrangement so that it will be treated as a lease for U.S. federal income tax purposes. They discuss the effect on such transactions of economic substance and anti-disavowal doctrines, conduit rules, partnership anti-abuse rules, tax-exempt entity leasing rules, etc.
This portfolio concerns the substantive transactional requirements that govern the characterization of a transaction involving tangible personal property as a lease, loan, partnership, service contract, etc. It begins with an analysis of the benefits and burdens of ownership that a lessor must acquire for a transaction to be treated as a true lease, apart from business purpose and economic substance.
The portfolio discusses when a putative loan secured by property should be recharacterized as a lease of the property because of contingent interest or inadequate collateralization. It compares leases to partnerships and discusses partnership leasing structures. In comparing leases and service contracts, this portfolio addresses transactions in which the service provider owns the property, which are utilized extensively in project financings.


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AUTHORS

TOBY COZART
Toby Cozart, B.A., University of North Carolina (1974); J.D., Duke University (1978); M.S. in Philosophy, University of North Carolina (1979); LL.M. in Taxation, New York University School of Law (1981). Law office, Piedmont, California. Previously: Tax Counsel, GATX Capital Corporation, San Francisco, California; Partner, Lillick, McHose & Charles, San Francisco, California; Associate, Morgan, Lewis & Bockius, New York, New York; Staff Counsel, Subcommittee on Oversight, Committee on Ways and Means, U.S. House of Representatives, Washington, D.C. Member of the Bars of the District of Columbia, New York, California, and the United States Tax Court.

TABLE OF CONTENTS

Detailed Analysis

I. Introduction

A. In General

B. Description of a Lease Transaction

C. Reasons for Leasing

D. Financial Analysis of Lease Transactions

E. Factors Affecting Lease Structures

1. Debt Optimization

2. Limitations on Lessor's Upside

3. Deferred Rent

4. Floating Rate Debt; Refinancings

5. Qualified Nonrecourse Indebtedness

6. Change in Tax Law Risks

7. Alternative Minimum Tax

8. Secondary Market Transactions

9. Cross–Border Leases

F. Sources of Law

1. Tax Shelter Limitations

2. The IRS' Advance Ruling Guidelines

a. Historical Importance

b. Relevance of the Guidelines for Current Transactions

c. Rev. Proc. 2001–28 Guidelines

3. Case Law Directions

a. Simple Precepts Founder: Financing Leases

b. Importance of Form

c. Tax Court's Sham Transaction Doctrine

d. Coleman's Effect on Cross–Border Lease Transactions

4. Treaty Provisions Affecting Cross–Border Leases

5. Legislative Efforts to Define Lease Concept

6. Retroactive Changes in Law

G. Relevance of Financial Accounting Treatment

H. Tax Consequences of Alternative Characterizations

1. Timing Effects Compared

2. Cost Recovery Differences

3. Interest on Third–Party Loans

4. Possible Permanent Losses

5. Shared Ownership

II. Substance and Form

A. Frank Lyon

1. Primacy of Form; Lessor Need Only Possess Significant Attributes of Ownership

2. Digression: Financing Lease versus Estate for Years

3. Sham Transactions

B. Sham Transaction Doctrine

1. Rice's Toyota World

2. Rise of the Unitary Sham Test

3. Implications of Unitary Test

a. Minimal Profit Potential Not Sufficient

b. Reasonable Profit Potential Not Required

4. Sham by Association; Defeasance Transactions

5. Time Value of Money

6. IRS Profit Guidelines

7. Sham Transaction Doctrine Justification

a. Four Competing Justifications

b. Controversial Issues Affecting Leasing

(1) Tax-Motivated Lease Transactions with Minimal Profit and Risk

(2) Lease Stripping Transactions Evidencing Collusion

(3) Integrated Acquisitions of Unprofitable Leased Property

(4) Germaneness of Lease Transactions and Portfolios to Ordinary Business

(5) Reliance Upon Unsettled Interpretations of Substantive Tax Law

C. Holding the Taxpayer to the Form of the Transaction

1. Purposes Behind Doctrine

2. What Is the Form of a Transaction?

3. Strong Proof Rule: Coleman

4. Danielson's Stricter Rule

D. Disregarding Intermediaries

1. Agents and Conduits

2. Separate Entity Doctrine

III. Lease versus Loan

A. Lease Treated as Loan

1. Lease Criteria Summarized

2. Lessor's Investment in the Property

a. Upfront Investment Required?

b. Investment Must be at Risk

(1) Unconditional Investment

(2) Recovery of Investment

(3) Net Lease Obligations

c. Lessee Debt Guarantees

3. Lessor's Residual Expectation

a. Residual Value and Life

(1) Lease Term; Extensions

(2) Components of Residual Value

(3) What is the Relevant Property?

b. Nonlessee Residual Guarantees

c. Nonlessee Residual Rights

(1) Residual Purchase Options

(2) Residual Share

(3) Residual Fees

(4) Residual Nonrecourse Debt Balloon

4. Purchase Options and Puts in Lease

a. Lessee Purchase Options

(1) Residual Purchase Options

(a) Fixed–Price Residual Options

(b) Rent–to–Own Contracts

(2) Compulsion By Extrinsic Advantage

(a) Relevance of Extrinsic Factors

(b) Fair–Market–Value Purchase Options

(c) Extrinsic Commitment to Exercise Option

(3) Early Purchase Options

(a) Lessee's Cost of Funds Relevant to Economic Compulsion

(b) Valuing Property Subject to Early Fair–Market–Value Option

(c) Replacement Lease Structure

(4) Substitution Rights

b. Lessee Residual Guarantees and Lessor Puts

(1) Without Lessee Purchase Option

(2) With Lessee Purchase Option

(3) Motor Vehicle Operating Leases

5. Limited Use Property

B. Loan Treated as Lease

1. Debt Defined Generally

2. Loans With Contingent Interest

3. Sufficiency of Lender's Security

a. Nonrecourse Balloon

(1) Speculative Residuals; Inflation

(2) Off–Balance Sheet Financings

b. Project Financings

IV. Lease versus Partnership

A. Partnership Criteria Summarized

B. Lease Treated as Partnership

1. Lessee and Lessor Pool Resources

2. Lessor and Lessee Share Profits

a. Lessor Shares in Lessee's Profits

b. Lessee Shares in Residual Proceeds

3. Lessor Controls Lessee's Business

4. Lessee Equity Investments

a. Rent

b. Separate Assets and Severable Improvements

c. Lessee Payment of Transaction Expenses

d. Unreimbursed Lessee Cost Contributions

e. Lessee Nonseverable Improvements

f. Lease Collateral

5. Lessee Loans

a. Lease With Genuine Lessee Loan

b. Lessee Loan as Genuine

C. Partnership Treated as Lease

V. Related-Party Leases

Introductory Material

A. Between Separate Taxable Entities

1. Business Purpose Requirement

2. Independence of Lessor; Gift-Leaseback Transactions

3. Lessee Has Reversionary Interest

B. Between Partner and Partnership

1. Section 707(a)(1): Entity Approach

a. Legislative History

b. Case Law

2. Lookthrough: Burde Distinguished

3. Anti-abuse Regulations

4. Partnership Leases to Partner

5. Partner Leases to Partnership

C. Third-Party Investor Treated as Lender

VI. Lease Versus Service Contract

Introductory Material

A. Service Recipient Owns the Property

1. Management Contracts

2. Wrap Leases

3. Digression: Lease-Leaseback Transactions

B. Service Provider Owns Property

1. General Rule of 7701(e)

2. Special Rules for Solid Waste Disposal, Energy and Clean Water Facilities


WORKING PAPERS

Working Papers

Table of Worksheets

Worksheet 1 Model Tax Indemnity Agreement

Worksheet 2 Model General Tax Indemnity.

Worksheet 3 Lease Checklist.

Worksheet 3A Form of Basic Equipment Lease

Worksheet 4 Legislative History of Section 7701(e).

Worksheet 5 Rev. Proc. 2001-28.

Worksheet 6 Rev. Proc. 2001-29.

Worksheet 7 [Reserved]

Worksheet 8 Rev. Rul. 55–540

Worksheet 9 Rev. Rul. 55–541

Bibliography

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Statutes:

Treasury Rulings:

Cases:

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