Lease Term; Exchanges of Tax-Exempt Use Property

[[Page 19868]]

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[IA-18-95]

RIN 1545-AT33

Lease Term; Exchanges of Tax-Exempt Use Property

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking and notice of public hearing.

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SUMMARY: This document contains proposed regulations relating to the

lease term of tax-exempt use property. The proposed regulations also

provide guidance regarding certain like-kind exchanges among related

parties involving tax-exempt use property. This document also provides

notice of a public hearing on these regulations.

DATES: Written comments must be received by July 20, 1995. Requests to

appear and outlines of topics to be discussed at the public hearing

scheduled for August 2, 1995, must be received by July 12, 1995.

ADDRESSES: Send submissions to: CC:DOM:CORP:T:R (IA-18-95), room 5228,

Internal Revenue Service, POB 7604, Ben Franklin Station, Washington,

DC 20044. In the alternative, submissions may be hand delivered between

the hours of 8 a.m. and 5 p.m. to: CC:DOM:CORP:T:R (IA-18-95),

Courier's Desk, Internal Revenue Service, 1111 Constitution Avenue NW.,

Washington, DC. The public hearing will be held in the IRS Auditorium,

7th Floor, 1111 Constitution Avenue NW., Washington, DC.

FOR FURTHER INFORMATION CONTACT:

Concerning the proposed regulations, John M. Aramburu of the Office of

Assistant Chief Counsel (Income Tax and Accounting) at (202) 622-4960;

concerning submissions and the public hearing, Christian Vasquez, (202)

622-7190 (not toll-free numbers).

SUPPLEMENTARY INFORMATION:

Background

This document contains proposed amendments to the Income Tax

Regulations (26 CFR part 1) relating to the depreciation of tax-exempt

use property under section 168 of the Internal Revenue Code (Code).

Section 168(h) provides rules relating to the definition of tax-exempt

use property. Section 168(i)(3) provides rules for determining a lease

term for purposes of section 168. These proposed regulations provide

guidance relating to certain exchanges of tax-exempt use property among

related parties and the determination of lease term under certain

circumstances.

Explanation of Provisions

Current Law

Under section 168, property used in a trade or business, or held

for the production of income, generally may be depreciated under the

general depreciation system (GDS) using accelerated methods over

relatively short recovery periods. However, certain property must be

depreciated under the alternative depreciation system (ADS) described

in section 168(g). Under ADS, depreciation deductions are determined

using the straight-line method over longer recovery periods.

Under section 168(g)(1)(B), tax-exempt use property is subject to

ADS. Section 168(h)(1) defines tax-exempt use property to include that

portion of any tangible property (other than nonresidential real

property) leased to a tax-exempt entity, as well as nonresidential real

property, under certain conditions. For these purposes, section

168(h)(2)(A)(iii) provides that certain foreign entities and persons

are considered tax-exempt entities. Under ADS, the recovery period of

tax-exempt use property subject to a lease is no less than 125 percent

of the lease term. See section 168(g)(3)(A).

The intent of Congress is subjecting tax-exempt use property to a

slower depreciation system than GDS is expressed in the legislative

history as follows:

The committee believes that reform of the tax law is essential,

insofar as it relates to property used by tax-exempt entities under

a lease, a lease formulated as a service contract, or other similar

arrangements. When tax-exempt entities use property under these

arrangements, they pay reduced rents that reflect a pass-through of

investment tax incentives from the owner of the property. Tax-exempt

entities thereby benefit from investment incentives for which they

do not qualify directly, and effectively gain the advantage of

taking income tax deductions and credits while having no

corresponding liability to pay any tax on income from the property.

S. Rep. No. 169 (Vol. 1), 98th Cong., 2d Sess. 123 (1984).

Thus, Congress subjected tax-exempt use property to a slower

depreciation system in order to prevent tax-exempt entities from

receiving, through reduced rentals, the tax benefits of GDS. Congress

retained the rules for depreciating tax-exempt use property when it

modified the accelerated cost recovery system in 1986. S. Rep. No. 313,

99th Cong., 2d Sess. 103 (1986).

Section 168(i)(5) provides that when property changes status, for

example, ceases to be tax-exempt use property, the depreciation

deduction for the year of change and subsequent taxable years shall be

determined in such manner as the Secretary shall prescribe by

regulation. Proposed Sec. 1.168-2(j)(3) sets forth principles for

depreciating property following a change in its status. Section

1.168(j)-1T, Q&A 2, which relates to tax-exempt use property,

references that provision.

The tax-exempt use property rules contain a number of references to

lease term. As noted above, the recovery period of tax-exempt use

property subject to a lease is no less than 125 percent of the lease

term. In addition, section 168(h)(1)(B)(ii)(III) characterizes as tax-

exempt use property nonresidential real property leased to a tax-exempt

entity for a term in excess of 20 years, section 168(h)(3)(A) excludes

from the definition of tax-exempt use property certain high technology

equipment leased to a tax-exempt entity for a term of no more than five

years, and section 168(h)(1)(C) excludes property subject to certain

short-term leases from the tax-exempt use property rules.

For each of these purposes, the lease term is determined under all

the facts and circumstances. Further, legislative history states that

rules ``similar to those applied under section 46(e)(3) (relating to

investment credits for non-corporate lessors) be applied in determining

lease term. See. e.g., Hokanson v. Commissioner, 730 F.2d 1245, 1248

(9th Cir. 1984) (which applies a reasonable expectations test).'' S.

Rep. No. 169 (Vol. 1), 98th Cong., 2d Sess. 150 (1984). Section

168(i)(3) provides rules for determining a lease term. It indicates

that, in determining a lease term, options to renew generally must be

taken into account and the periods of certain successive leases must be

aggregated with the period of an original lease.

Section 1.168(j)-1T, Q&A 17, provides additional rules for

determining lease term. The regulation sets forth circumstances under

which a lease term will include not only the stated duration of a lease

but also an additional period, including options to renew and

successive leases. It also provides examples of situations in which

aggregation of lease periods is required, and situations in which lease

periods are considered sufficiently independent so that aggregation is

not required.

Lease Term

The proposed regulations generally clarify the rules for

determining a lease [[Page 19869]] term in certain situations. They

require the aggregation of the stated duration of an original lease

with any additional period for which the original, tax-exempt lessee

(or a person related to the lessee) retains financial responsibility.

The proposed regulations are intended to supplement existing

authorities, including Sec. 1.168(j)-1T, Q&A 17.

Specifically, the proposed regulations provide that an additional

period of time during which a lessee may not continue to be the lessee

is nevertheless included in the lease term if the lessee (or a related

person) has agreed that one or both of them will or could be obligated

to make a payment of rent, or a payment in the nature of rent, with

respect to such period. For purposes of this rule, a payment in the

nature of rent includes a payment intended to substitute for rent or to

fund or supplement the rental payments of another. For example, a

payment in the nature of rent includes a payment of any kind that is

required to be made in the event that: (1) The leased property is not

leased for the additional period; (2) the leased property is leased for

the additional period under terms that do not satisfy specified terms

and conditions; (3) there is a failure to make a payment of rent with

respect to such additional period; or (4) similar circumstances occur.

This rule disregards, however, obligations to make de minimis payments.

The proposed regulations also provide that in the event an

additional period is included in the lease term, section 168(i)(5)

(relating to changes in status) applies if the leased property ceases

to be tax-exempt use property for such additional period.

The proposed regulations apply to leases entered into on or after

the date the proposed regulations are filed with the Federal Register.

No inference as to the treatment of additional lease periods under

current law is intended by such effective date. The proposed

regulations do not preclude the application of common law doctrines

(such as the substance over form or step transaction doctrines) and

other authorities to the determination of lease term or to the

determination of whether a transaction is characterized as a lease, a

conditional sale, or otherwise for federal income tax purposes.

Like-Kind Exchanges

The proposed regulations also addresses certain transactions

between related persons that are designed to circumvent the tax-exempt

use property rules. For example, a taxpayer might purchase tax-exempt

use property for $100x and then promptly transfer the property to a

related person in exchange for like-kind property of an equal value

that has a zero basis and is not tax-exempt use property (the taxable

property). If the exchange qualifies for nonrecognition treatment under

section 1031 as to the related person, the related person recognizes

none of its gain with respect to the taxable property and takes the

tax-exempt use property with a zero basis. At the same time, the

taxpayer has a $100x basis in the taxable property. The desired net tax

result of the transaction is that a new investment in property that is

properly subject to the ADS becomes subject to GDS.

To address this situation, the proposed regulations provide that

property (tainted property) transferred directly or indirectly to the

taxpayer by a related person (the related party) as part of, or in

connection with, a transaction described in section 1031 where the

related party receives tax-exempt use property (related tax-exempt use

property) will, if the tainted property is subject to an allowance for

depreciation, be treated in the same manner as the related tax-exempt

use property for purposes of determining the allowable depreciation

deduction under section 167(a). Under this rule, the tainted property

is depreciated by the taxpayer over the remaining recovery period of,

and using the same depreciation method and convention as that of, the

related tax-exempt use property.

This rule is subject to certain limitations. In general, the rule

applies only with respect to so much of the taxpayer's basis in the

tainted property as does not exceed the taxpayer's adjusted basis in

the related tax-exempt use property prior to the transfer. Any excess

of the taxpayer's basis in the tainted property over its adjusted basis

in the related tax-exempt use property prior to the transfer is treated

as property to which the rule does not apply. Moreover, the rule does

not apply to so much of the taxpayer's basis in the tainted property as

is subject to section 168(i)(7).

The proposed regulations provide that related tax-exempt use

property includes property that does not become tax-exempt use property

(as defined in section 168(h)) until after the transfer if, at the time

of the transfer, it was intended that the property become tax-exempt

property. Moreover, in the circumstances described in the preceding

sentence, the related tax-exempt use property will be treated as

having, prior to the transfer, a lease term equal to the term of any

lease that causes such property to become tax-exempt use property.

The proposed regulations only apply with respect to direct or

indirect transfers of property involving related persons where (1)

section 1031 applies to any party, and (2) a principal purpose of the

transfer is to avoid or limit the application of ADS. For purposes of

this rule, a person is related to another person if they bear a

relationship specified in section 267(b) or section 707(b)(1).

The proposed regulations apply to transfers made on or after the

date the proposed regulations are filed with the Federal Register. No

inference is intended as to the treatment of transfers intended to

avoid or limit the application of ADS that are made prior to the

effective date. In addition, the proposed regulations do not preclude

the application of common law doctrines (such as the substance over

form or step transaction doctrines) and other authorities to transfers

intended to avoid or limit the application of ADS, including transfers

occurring prior to the effective date of the proposed regulations.

The IRS and Treasury invite comments on the scope of the proposed

regulations. For example, comments are requested as to whether any

transactions should be excepted from the proposed regulations or

whether other transactions should be included within their scope.

Special Analyses

It has been determined that this notice of proposed rulemaking is

not a significant regulatory action as defined in EO 12866. Therefore,

a regulatory assessment is not required. It also has been determined

that section 553(b) of the Administrative Procedure Act (5 U.S.C.

chapter 5) and the Regulatory Flexibility Act (5 U.S.C. chapter 6) do

not apply to these proposed regulations, and, therefore, a Regulatory

Flexibility Analysis is not required. Pursuant to section 7805(f) of

the Internal Revenue Code, this notice of proposed rulemaking will be

submitted to the Chief Counsel for Advocacy of the Small Business

Administration for comment on its impact on small businesses.

Comments and Public Hearing

Before these proposed regulations are adopted as final regulations,

consideration will be given to any written comments (a signed original

and eight (8) copies) that are submitted timely to the IRS. All

comments will be available for public inspection and copying.

A public hearing has been scheduled for August 2, 1995, at 10 a.m.

in the IRS Auditorium, 7th Floor, 1111 [[Page 19870]] Constitution

Avenue NW., Washington, DC. Because of access restrictions, visitors

will not be admitted beyond the Internal Revenue Building lobby more

than 15 minutes before the hearing starts.

The rules of 26 CFR 601.601(a)(3) apply to the hearing.

Persons that wish to present oral comments at the hearing must

submit written comments by July 20, 1995 and submit an outline of the

topics to be discussed and the time to be devoted to each topic by July

12, 1995.

A period of 10 minutes will be allotted to each person for making

comments.

An agenda showing the scheduling of the speakers will be prepared

after the deadline for receiving outlines has passed. Copies of the

agenda will be available free of charge at the hearing.

Drafting Information.

The principal author of these proposed regulations is John M.

Aramburu of the Office of Assistant Chief Counsel (Income Tax and

Accounting). However, other personnel from the IRS and Treasury

Department participated in their development.

List of Subjects in 26 CFR Part 1

Income taxes, Reporting and recordkeeping requirements.

Proposed Amendments to the Regulations

Accordingly, 26 CFR part 1 is proposed to be amended as follows:

PART 1--INCOME TAXES

Paragraph 1. The authority citation for part 1 is amended by adding

entries in numerical order to read as follows:

Authority: 26 U.S.C. 7805 * * *

Section 1.168(h)-1 also issued under 26 U.S.C. 168.

Section 1.168(i)-2 also issued under 26 U.S.C. 168. * * *

Par. 2. Sections 1.168(h)-1 and 1.168(i)-2 are added to read as

follows:

Sec. 1.168(h)-1 Like-kind exchanges involving tax-exempt use property.

(a) Scope. (1) This section applies with respect to a direct or

indirect transfer of property among related persons, including

transfers made through a qualified intermediary (as defined in

Sec. 1.1031(k)-1(g)(4)) or other unrelated person, (a transfer) if--

(i) Section 1031 applies to any party to the transfer or to any

related transaction; and

(ii) A principal purpose of the transfer or any related transaction

is to avoid or limit the application of the alternative depreciation

system (within the meaning of section 168(g)).

(2) For purposes of this section, a person is related to another

person if they bear a relationship specified in section 267(b) or

section 707(b)(1).

(b) Allowable depreciation deduction for property subject to this

section--(1) In general. Property (tainted property) transferred

directly or indirectly to a taxpayer by a related person (related

party) as part of, or in connection with, a transaction in which the

related party receives tax-exempt use property (related tax-exempt use

property) will, if the tainted property is subject to an allowance for

depreciation, be treated in the same manner as the related tax-exempt

use property for purposes of determining the allowable depreciation

deduction under section 167(a). Under this paragraph (b), the tainted

property is depreciated by the taxpayer over the remaining recovery

period of, and using the same depreciation method and convention as

that of, the related tax-exempt use property.

(2) Limitations--(i) Taxpayer's basis in related tax-exempt use

property. This section applies only with respect to so much of the

taxpayer's basis in the tainted property as does not exceed the

taxpayer's adjusted basis in the related tax-exempt use property prior

to the transfer. Any excess of the taxpayer's basis in the tainted

property over its adjusted basis in the related tax-exempt use property

prior to the transfer is treated as property to which this section does

not apply. This paragraph (b)(2)(i) does not apply if the related tax-

exempt use property is not acquired from the taxpayer (e.g., if the

taxpayer acquires the tainted property for cash but section 1031

nevertheless applies to the related party because the transfer involves

a qualified intermediary).

(ii) Application of section 168(i)(7). This section does not apply

to so much of the taxpayer's basis in the tainted property as is

subject to section 168(i)(7).

(c) Related tax-exempt use property. (1) For purposes of paragraph

(b) of this section, related tax-exempt use property includes--

(i) Property that is tax-exempt use property (as defined in section

168(h)) at the time of the transfer; and

(ii) Property that does not become tax-exempt use property until

after the transfer if, at the time of the transfer, it was intended

that the property become tax-exempt use property.

(2) For purposes of determining the remaining recovery period of

the related tax-exempt use property in the circumstances described in

paragraph (c)(1)(ii) of this section, the related tax-exempt use

property will be treated as having, prior to the transfer, a lease term

equal to the term of any lease that causes such property to become tax-

exempt use property.

(d) Examples. The following examples illustrate the application of

this section. The examples do not address common law doctrines or other

authorities that may apply to recharacterize or alter the effects of

the transactions described therein. Unless otherwise indicated, parties

to the transactions are not related to one another.

Example 1. (i) X owns all of the stock of two subsidiaries, B

and Z. X, B and Z do not file a consolidated federal income tax

return. On May 5, 1995, B purchases an aircraft (FA) for $1 million

and leases it to a foreign airline whose income is not subject to

United States taxation and which is a tax-exempt entity as defined

in section 168(h)(2). On the same date, Z owns an aircraft (DA) with

a fair market value of $1 million, which has been, and continues to

be, leased to an airline that is a United States taxpayer. Z's

adjusted basis in DA is $0. The next day, at a time when each

aircraft is still worth $1 million, B transfers FA to Z (subject to

the lease to the foreign airline) in exchange for DA (subject to the

lease to the airline that is a United States taxpayer). Z realizes

gain of $1 million on the exchange, but that gain is not recognized

pursuant to section 1031(a) because the exchange is of like-kind

properties. Assume that a principal purpose of the transfer of DA to

B or of FA to Z is to avoid the application of the alternative

depreciation system. Following the exchange, Z has a $0 basis in FA

pursuant to section 1031(d). B has a $1 million basis in DA.

(ii) B has acquired property from Z, a related person; Z's gain

is not recognized pursuant to section 1031(a); Z has received tax-

exempt use property as part of the transaction; and a principal

purpose of the transfer of DA to B or of FA to Z is to avoid the

application of the alternative depreciation system. Accordingly, the

transaction is within the scope of this section. Pursuant to

paragraph (b) of this section, B must recover its $1 million basis

in DA over the remaining recovery period of, and using the same

depreciation method and convention as that of, FA, the related tax-

exempt use property.

(iii) If FA did not become tax-exempt use property until after

the exchange, it would still be related tax-exempt use property and

paragraph (b) of this section would apply if, at the time of the

exchange, it was intended that FA become tax-exempt use property.

Example 2. (i) X owns all of the stock of two subsidiaries, B

and Z. X, B and Z do not file a consolidated federal income tax

return. B and Z each own identical aircraft. B's aircraft (FA) is

leased to a tax-exempt entity as defined in section 168(h)(2) and

has a fair market value of $1 million and an adjusted basis of

$500,000. Z's aircraft (DA) is leased to a United States taxpayer

and has a fair market value of $1 million and an adjusted basis of

$10,000. On May 1, 1995, B and Z exchange aircraft, subject to their

respective leases. B realizes gain of $500,000 and Z realizes gain

of $990,000, but neither person recognizes gain because of the

operation of [[Page 19871]] section 1031(a). Moreover, assume that a

principal purpose of the transfer of DA to B or of FA to Z is to

avoid the application of the alternative depreciation system.

(ii) As in example 1, B has acquired property from Z, a related

person; Z's gain is not recognized pursuant to section 1031(a); Z

has received tax-exempt use property as part of the transaction; and

a principal purpose of the transfer of DA to B or of FA to Z is to

avoid the application of the alternative depreciation system. Thus,

the transaction is within the scope of this section even though B

has held tax-exempt use property for a period of time and, during

that time, has used the alternative depreciation system with respect

to such property. Pursuant to paragraph (b) of this section, B,

which has a substituted basis determined pursuant to section 1031(d)

of $500,000 in DA, must depreciate the aircraft over the remaining

recovery period of FA, using the same depreciation method and

convention. Z holds tax-exempt use property with a basis of $10,000,

which must be depreciated under the alternative depreciation system.

(iii) Assume the same facts as in paragraph (i) of this example,

except that B and Z are members of an affiliated group that files a

consolidated federal income tax return. Of B's $500,000 basis in DA,

$10,000 is subject to section 168(i)(7) and therefore not subject to

this section. The remaining $490,000 of basis is subject to this

section.

(e) Effective date. This section applies to transfers made on or

after April 20, 1995.

Sec. 1.168(i)-2 Lease term.

(a) In general. For purposes of section 168, a lease term is

determined under all the facts and circumstances. Paragraph (b) of this

section and Sec. 1.168(j)-1T, Q&A 17, provide rules that apply to

determine whether a period of time not included in the stated duration

of an original lease (additional period) is included in the lease term,

under certain circumstances. These rules do not prevent the inclusion

of an additional period in the lease term in other circumstances.

(b) Lessee retains financial obligation. (1) An additional period

of time during which a lessee may not continue to be the lessee will

nevertheless be included in the lease term if the lessee (or a related

person) has agreed that one or both of them will or could be obligated

to make a payment of rent or a payment in the nature of rent with

respect to such period.

(2) For the purposes of this paragraph (b), a payment in the nature

of rent includes a payment intended to substitute for rent or to fund

or supplement the rental payments of another. For example, a payment in

the nature of rent includes a payment of any kind that is required to

be made in the event that--

(i) The leased property is not leased for the additional period;

(ii) The leased property is leased for the additional period under

terms that do not satisfy specified terms and conditions;

(iii) There is a failure to make a payment of rent with respect to

such additional period; or

(iv) Circumstances similar to those described in paragraph

(b)(2)(i), (ii), or (iii) occur.

(3) For the purposes of this paragraph (b), de minimis payments

will be disregarded.

(c) Related person. For purposes of paragraph (b) of this section,

a person is related to the lessee if such person is described in

section 168(h)(4).

(d) Changes in status. Section 168(i)(5) (changes in status)

applies if an additional period is included in a lease term under this

section and the leased property ceases to be tax-exempt use property

for such additional period.

(e) Example. The following example illustrates the application of

this section. The example does not address common law doctrines or

other authorities that may apply to cause an additional period to be

included in the lease term or to recharacterize a lease as a

conditional sale or otherwise for federal income tax purposes. Unless

otherwise indicated, parties to the transactions are not related to one

another.

Example. Financial obligation with respect to an additional

period.--(i) Facts. X, a taxable corporation, and Y, a foreign

airline whose income is not subject to United States taxation, enter

into a lease agreement under which X agrees to lease an aircraft to

Y for a period of 10 years. The lease agreement provides that, at

the end of the lease period, Y is obligated to find a subsequent

lessee (replacement lessee) to enter into a subsequent lease

(replacement lease) of the aircraft from X for an additional 10-year

period. The provisions of the lease agreement require that any

replacement lessee be unrelated to Y and that it not be a tax-exempt

entity as defined in section 168(h)(2). The provisions of the lease

agreement also set forth the basic terms and conditions of the

replacement lease, including its duration and the required rental

payments. In the event Y fails to secure a replacement lease, the

lease agreement requires Y to make a payment to X in an amount

determined under the lease agreement.

(ii) Application of this section. The lease agreement between X

and Y obligates Y to make a payment in the event the aircraft is not

leased for the period commencing after the initial 10-year lease

period and ending on the date the replacement lease is scheduled to

end. Accordingly, pursuant to paragraph (b) of this section, the

term of the lease between X and Y includes such additional period,

and the lease term is 20 years for purposes of section 168.

(ii) Facts modified. Assume the same facts as in paragraph (i)

of this example, except that Y is required to guarantee the payment

of rentals under the 10-year replacement lease and to make a payment

to X equal to the present value of any excess of the replacement

lease rental payments specified in the lease agreement between X and

Y, over the rental payments actually agreed to be paid by the

replacement lessee. Pursuant to paragraph (b) of this section, the

term of the lease between X and Y includes the additional period,

and the lease term is 20 years for purposes of section 168.

(iv) Changes in status. If, upon the conclusion of the stated

duration of the lease between X and Y, the aircraft either is

returned to X or leased to a replacement lessee that is not a tax-

exempt entity as defined in section 168(h)(2), the subsequent method

of depreciation will be determined pursuant to section 168(i)(5).

(f) Effective date. This section applies to leases entered into on

or after April 20, 1995.

Margaret Milner Richardson,

Commissioner of Internal Revenue.

[FR Doc. 95-9946 Filed 4-20-95; 8:45 am]

BILLING CODE 4830-01-M