What constitutes a true tax lease? I received a good question the other day on this subject. A lessee is structuring an 84-month, single investor tax lease with a major lessor. The lease is for a long term asset with an early buyout option (EBO) one year prior to the lease expiration with an FMV option at the end of the lease. The lessor, however, is not willing to put a cap of 10% on the FMV option, citing Revenue Ruling 75-21's 20% rule as the reason. I was asked, based on these facts, if I thought this was a copout or a legitimate argument.
First, let’s put this deal in perspective. Based on the description, it appears that the lessee is seeking off balance sheet financing (the EBO) with control over the ultimate cost (the 10% cap). In substance, a long-term purchase that is not on the balance sheet. It is this purchase characteristic of the deal that the lessor is concerned about when defending its position with the IRS. (I know I am mixing tax and accounting motivations here, but that is the nature of structuring an equipment lease – you have to manage multiple moving parts.)
According to the IRS, the tax benefits in a lease belong to the party (lessor or lessee) that bears the risks of ownership, which are based on the terms, conditions, and economic characteristics of the lease. The two sets of guidelines the IRS uses to make this determination are Revenue Ruling 55-540 and Revenue Ruling 01-28 (Revenue Ruling 75-21 has been replaced by Revenue Ruling 2001-28, although the essence of 75-21 has been retained).
Now, here is the crux of the question in this single investor deal. Revenue Ruling 55-540, which was issued for single investor leases, does not have a requirement that the lessor retain a 20% residual value. Revenue Ruling 01-28, on the other hand, does, but 01-28 was issued for leveraged leases. Since the transaction is a single investor lease, why is the lessor referencing the 20% rule?
Shawn, thank you for your views. I enjoy the banter, I hope you do as well. As a follow up, the lessee is not concerned with including the cap in its 90% test as they have a sufficiently high incremental borrowing rate to absorb the cost. Is the lessor then concerned with the cap being construed as a bargain and therefore compelling a buyout which may disqualify them for tax ownership or is it something else? I am focused on this matter because 2 of the 3 lessors do not have issue with the 10% cap at the end of the term.
Posted by: Jay Zeinfeld | February 2, 2006 3:02 PM | Permalink to Comment