Qualified Lessee Construction Allowances for Short-Term Leases

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[REG-106010-98]

RIN 1545-AW16

Qualified Lessee Construction Allowances for Short-Term Leases

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 concerning an

exclusion from gross income for qualified lessee construction

allowances provided by a lessor to a lessee for the purpose of

constructing long-lived property to be used by the lessee pursuant to a

short-term lease. The proposed regulations affect a lessor and a lessee

paying and receiving, respectively, qualified lessee construction

allowances that are depreciated by a lessor as nonresidential real

property and excluded from the lessee's gross income. The proposed

regulations provide guidance on the exclusion, the information required

to be furnished by the lessor and the lessee, and the time and manner

for providing that information to the IRS. This document also provides

notice of a public hearing on these proposed regulations.

DATES: Written and electronic comments must be received by December 20,

1999. Outlines of topics to be discussed at the public hearing

scheduled for January 19, 2000, must be received by December 29, 1999.

ADDRESSES: Send submissions to: CC:DOM:CORP:R (REG-106010-98), room

5226, Internal Revenue Service, POB 7604, Ben Franklin Station,

Washington, DC 20044. Submissions may be hand delivered Monday through

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Friday between the hours of 8 a.m. and 5 p.m. to: CC:DOM:CORP:R (REG-

106010-98), Courier's Desk, Internal Revenue Service, 1111 Constitution

Avenue, NW., Washington, DC. Alternatively, taxpayers may submit

comments electronically via the Internet by selecting the ``Tax Regs''

option on the IRS Home Page, or by submitting comments directly to the

IRS Internet site at http://www.irs.ustreas.gov/tax__regs/

regslist.html. The public hearing will be held in room 2615, Internal

Revenue Building, 1111 Constitution Avenue, NW., Washington, DC.

FOR FURTHER INFORMATION CONTACT: Concerning the regulations, Paul

Handleman, (202) 622-3040; concerning submissions, the hearing, and/or

to be placed on the building access list to attend the hearing, Michael

Slaughter, (202) 622-7180 (not toll-free numbers).

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

The collection of information contained in this notice of proposed

rulemaking has been submitted to the Office of Management and Budget

for review in accordance with the Paperwork Reduction Act of 1995 (44

U.S.C. 3507(d)). Comments on the collection of information should be

sent to the Office of Management and Budget, Attn: Desk Officer for the

Department of the Treasury, Office of Information and Regulatory

Affairs, Washington, DC 20503, with copies to the Internal Revenue

Service, Attn: IRS Reports Clearance Officer, OP:FS:FP, Washington, DC

20224. Comments on the collection of information should be received by

November 19, 1999.

Comments are specifically requested concerning:

Whether the proposed collection of information is necessary for the

proper performance of the functions of the IRS, including whether the

information will have practical utility;

The accuracy of the estimated burden associated with the proposed

collection of information (see below);

How the quality, utility, and clarity of the information to be

collected may be enhanced;

How the burden of complying with the proposed collection of

information may be minimized, including through the application of

automated collection techniques or other forms of information

technology; and

Estimates of capital or start-up costs and costs of operation,

maintenance, and purchase of services to provide information.

The requirement for the collection of information in this notice of

proposed rulemaking is in Sec. 1.110-1(c). The information is required

so that a taxpayer receiving a construction allowance as lessee from

the lessor may establish the amount qualifying for the safe harbor

under section 110(a). The collection of information is mandatory. The

likely respondents are businesses and other for-profit organizations.

Estimated total annual reporting burden: 10,000 hours.

The estimated annual burden per respondent varies from .5 hours to

1.5 hours, depending on individual circumstances, with an estimated

average of 1 hour.

Estimated number of respondents: 10,000.

Estimated annual frequency of responses: once.

An agency may not conduct or sponsor, and a person is not required

to respond to, a collection of information unless the collection of

information displays a valid control number assigned by the Office of

Management and Budget.

Books or records relating to a collection of information must be

retained as long as their contents may become material in the

administration of any internal revenue law. Generally, tax returns and

tax return information are confidential, as required by 26 U.S.C. 6103.

Background

This document contains proposed amendments to the Income Tax

Regulations (26 CFR part 1) to provide regulations under section 110 of

the Internal Revenue Code of 1986. Section 110 was added to the Code by

section 1213(a) of the Taxpayer Relief Act of 1997, Public Law 105-34

(Act). Under section 1213(e) of the Act, the amendment made by section

1213(a) applies to leases entered into after August 5, 1997.

Explanation of Provisions

Tax Treatment of Lessee Construction Allowances

Section 61(a) provides that gross income means ``all income from

whatever source derived'' except as otherwise provided in subtitle A of

the Internal Revenue Code. Generally, the receipt of a construction

allowance by a lessee from a lessor for property to be constructed and

used by the lessee pursuant to a lease represents an accession to

wealth includible in gross income in the year of receipt. However,

amounts received by a lessee that are expended by the lessee on assets

owned by the lessor are not includible in the lessee's gross income

because there is no accession to wealth. Thus, the proper tax treatment

of construction allowances turns on whether the lessee or the lessor

owns the property constructed with the allowance.

Ownership for tax purposes generally is determined by applying a

``benefits and burdens of ownership'' test to the facts and

circumstances surrounding the transaction. The benefits and burdens of

ownership test was developed by the Tax Court to determine whether a

purported lease should be treated as a sale for Federal income tax

purposes. The court set forth the following factors to determine

whether the taxpayer had the benefits and burdens of ownership of the

leased property: (1) whether legal title passes; (2) how the parties

treat the transaction; (3) whether an equity interest was acquired in

the property; (4) whether the contract creates a present obligation on

the seller to execute and deliver a deed and a present obligation on

the purchaser to make payments; (5) whether the right of possession is

vested in the purchaser; (6) which party pays the property taxes; (7)

which party bears the risk of loss or damage to the property; and (8)

which party receives the profits from the operation and sale of the

property. See Grodt & McKay Realty, Inc. v. Commissioner, 77 T.C. 1221

(1981), and Coleman v. Commissioner, T.C. Memo. 1987-195, aff'd, 16

F.3d 821 (7th Cir. 1994).

In a coordinated issue paper dated October 7, 1996, the IRS

enumerated certain specific factors that help establish whether the

benefits and burdens of ownership of the leasehold improvements are

with the lessee or the lessor; i.e., who carries personal property and

liability insurance on the leasehold improvements; who is the

beneficiary under those policies; who is responsible for replacing the

leasehold improvements if they wear out prior to the end of the lease

term; and, if the usefulness of the leasehold improvements extends

beyond the lease term, who has the remainder interest in the

improvements.

To the extent the lessee holds the benefits and burdens of

ownership of the leasehold improvements constructed with the

construction allowance, the lessee has an accession to wealth and

income under section 61(a). However, to the extent the lessor holds the

benefits and burdens of ownership, the lessee is acting merely as an

agent of the lessor and the construction allowance is not includible in

the gross income of the lessee.

Congress was concerned that the traditional factors used by the IRS

in making the determination of who is the

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tax owner of property may be applied differently by the lessor and the

lessee and may lead to controversies between the IRS and taxpayers.

H.R. Rep. No. 148, 105th Cong., 1st Sess. 423 (1997) (House

Report); S. Rep. No. 33, 105th Cong., 1st Sess. 232-33 (1997) (Senate

Report). Consequently, the Act provides a safe harbor whereby it is

assumed that a construction allowance is used to construct or improve

lessor property (and is properly excludable by the lessee) when long-

lived property is constructed or improved and used pursuant to a short-

term lease. The Act also provides a reporting requirement to ensure

that both the lessee and the lessor consistently treat the property

subject to the construction allowance as nonresidential real property

owned by the lessor. House Report at page 424; Senate Report at page

233.

Safe Harbor Under Section 110

Section 110(a) provides, in general, that gross income of a lessee

does not include any amount received in cash (or treated as a rent

reduction) by a lessee from a lessor under a short-term lease of retail

space, for the purpose of such lessee's constructing or improving

qualified long-term real property for use in such lessee's trade or

business at such retail space, but only to the extent that such amount

does not exceed the amount expended by the lessee for such construction

or improvement.

Section 110(c)(1) defines the term ``qualified long-term real

property'' as nonresidential real property which is part of, or

otherwise present at, the retail space referred to in section 110(a)

and which reverts to the lessor at the termination of the lease.

Section 110(c)(2) defines the term ``short-term lease'' as a lease (or

other agreement for occupancy or use) of retail space for 15 years or

less (as determined under the rules of section 168(i)(3)). Section

110(c)(3) defines the term ``retail space'' as real property leased,

occupied, or otherwise used by a lessee in its trade or business of

selling tangible personal property or services to the general public.

Consistent with section 110(c)(1), the proposed regulations define

the term ``qualified long-term real property'' as nonresidential real

property under section 168(e)(2)(B), which is section 1250 property

other than residential rental property and property with a class life

of less than 27.5 years. The proposed regulations do not require a

direct tracing of the construction allowance, but assume that the

construction allowance is used to construct or improve the lessor's

property if qualified long-term real property is constructed by the

lessee at the leased retail space. The IRS and the Department of

Treasury specifically request comments on whether the definition of

``retail space'' needs to be clarified.

The proposed regulations recognize that a lessee may not be able to

construct the qualified long-term real property in the same taxable

year as it receives the construction allowance from the lessor. Thus,

the proposed regulations give the lessee additional time to satisfy the

safe harbor by allowing the construction allowance to be expended for

qualified long-term real property until 8\1/2\ months after the close

of the taxable year in which the construction allowance was received by

the lessee.

The legislative history of the Act states that no inference is

intended as to the treatment of amounts that are not subject to the

safe harbor provision. In such cases, the provisions of IRS coordinated

issue paper and present law (including case law) will continue to apply

where applicable. H.R. Conf. Rep. No. 220, 105th Cong., 1st Sess. 658-

59 (1997). Thus, a construction allowance failing to qualify under the

safe harbor provision is not includible in the lessee's gross income if

the lessor has the benefits and burdens of ownership of the property

constructed with the construction allowance. Ownership of the property

is determined under general principles of Federal tax law based on all

the facts and circumstances.

Consistency Between Lessee and Lessor and Reporting Requirements

Section 110(b) provides that qualified long-term real property

constructed or improved in connection with any amount excluded from a

lessee's income by reason of section 110(a) shall be treated as

nonresidential real property of the lessor (including for purposes of

section 168(i)(8)(B)).

Section 110(d) provides that, under regulations, the lessee and

lessor described in section 110(a) must, at such times and in such

manner as may be provided in such regulations, furnish to the Secretary

information concerning the amounts received (or treated as a rent

reduction) and expended as described in section 110(a), and any other

information which the Secretary deems necessary to carry out the

provisions of section 110.

The Act provides that the lessor will treat any qualified long-term

real property constructed or improved with a construction allowance

excluded from the lessee's gross income under section 110(a) as

nonresidential real property owned by the lessor. However, the lessee's

exclusion is not dependent upon the lessor's treatment of the property

as nonresidential real property. House Report at page 424; Senate

Report at page 233.

The proposed regulations prescribe the information required to be

furnished by the lessor and the lessee and the time and manner for

providing that information to the IRS. A lessor or a lessee that fails

to furnish the required information may be subject to a penalty under

section 6721.

Proposed Effective Date

The regulations are proposed to be applicable to leases entered

into on or after the date final regulations are published in the

Federal Register.

Special Analyses

It has been determined that this notice of proposed rulemaking is

not a significant regulatory action as defined in Executive Order

12866. Therefore, a regulatory assessment is not required. It is hereby

certified that the collection of information in these regulations will

not have a significant economic impact on a substantial number of small

entities. This certification is based upon the fact that any burden on

taxpayers is minimal. Accordingly, a Regulatory Flexibility Analysis

under the Regulatory Flexibility Act (5 U.S.C. chapter 6) 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 business.

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) or electronic comments that are submitted timely

to the IRS. The IRS and Treasury Department specifically request

comments on the clarity of the proposed rule and how it may be made

easier to understand. All comments will be available for public

inspection and copying.

A public hearing has been scheduled for Wednesday, January 19,

2000, at 10 a.m. in room 2615, Internal Revenue Building, 1111

Constitution Avenue, NW., Washington, DC. Due to building security

procedures, visitors must enter at the 10th Street entrance, located

between Constitution and Pennsylvania Avenues, NW. In addition, all

visitors must present photo identification to enter the building.

Because of access

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restrictions, visitors will not be admitted beyond the immediate

entrance area more than 15 minutes before the hearing starts. For

information about having your name placed on the building access list

to attend the hearing, see the FOR FURTHER INFORMATION CONTACT section

of this preamble.

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

Persons who wish to present oral comments at the hearing must

submit an outline of the topics to be discussed and the time to be

devoted to each topic (signed original and eight (8) copies) by

December 29, 1999.

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 regulations is

Paul F. Handleman, Office of the Assistant Chief Counsel (Passthroughs

and Special Industries), IRS. 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

an entry in numerical order to read in part as follows:

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

Section 1.110-1 also issued under 26 U.S.C. 110(d); * * *

Par. 2. Section 1.110-1 is added to read as follows:

Sec. 1.110-1 Qualified lessee construction allowances.

(a) Overview. Amounts provided to a lessee by a lessor for property

to be constructed and used by the lessee pursuant to a lease are not

includible in the lessee's gross income if the amount is a qualified

lessee construction allowance under paragraph (b) of this section.

(b) Qualified lessee construction allowance--(1) In general. A

qualified lessee construction allowance means any amount received in

cash (or treated as a rent reduction) by a lessee from a lessor--

(i) Under a short-term lease of retail space;

(ii) For the purpose of constructing or improving qualified long-

term real property for use in the lessee's trade or business at that

retail space; and

(iii) To the extent the amount is expended by the lessee in the

taxable year received on the construction or improvement of qualified

long-term real property for use in the lessee's trade or business at

that retail space.

(2) Definitions--(i) Qualified long-term real property is

nonresidential real property under section 168(e)(2)(B) that is part

of, or otherwise present at, the retail space referred to in paragraph

(b)(1)(i) of this section and which reverts to the lessor at the

termination of the lease. Thus, qualified long-term real property does

not include property qualifying as section 1245 property under section

1245(a)(3).

(ii) Short-term lease is a lease (or other agreement for occupancy

or use) of retail space for 15 years or less (as determined pursuant to

section 168(i)(3)).

(iii) Retail space is nonresidential real property under section

168(e)(2)(B) that is leased, occupied, or otherwise used by the lessee

in its trade or business of selling tangible personal property or

services to the general public.

(3) Purpose requirement. An amount will meet the requirement in

paragraph (b)(1)(ii) of this section only to the extent that the lease

agreement for the retail space expressly provides that the construction

allowance is for the purpose of constructing or improving qualified

long-term real property for use in the lessee's trade or business at

that retail space.

(4) Expenditure requirement--(i) In general. Expenditures referred

to in paragraph (b)(1)(iii) of this section will be treated as being

made first from the lessee's construction allowance. Tracing of the

construction allowance to the actual lessee expenditures for the

construction or improvement of qualified long-term real property is not

required. However, the lessee should maintain accurate records of the

amount of the qualified lessee construction allowance received and the

expenditures made for qualified long-term real property.

(ii) Time when expenditures deemed made. For purposes of paragraph

(b)(1)(iii) of this section, an amount is deemed to have been expended

by a lessee in the taxable year in which the construction allowance was

received by the lessee if the amount is expended within 8\1/2\ months

after the close of that taxable year.

(5) Consistent treatment by lessor. Qualified long-term real

property constructed or improved with any amount excluded from a

lessee's gross income by reason of paragraph (a) of this section must

be treated as nonresidential real property owned by the lessor (for

purposes of depreciation under 168(e)(2)(B) and determining gain or

loss under section 168(i)(8)(B)). For purposes of the preceding

sentence, the lessor must treat the construction allowance as fully

expended in the manner required by paragraph (b)(1)(iii) of this

section unless the lessor is notified by the lessee in writing to the

contrary. General tax principles apply for purposes of determining when

the lessor may begin depreciation of its nonresidential real property.

The lessee's exclusion from gross income under paragraph (a) of this

section, however, is not dependent upon the lessor's treatment of the

property as nonresidential real property.

(c) Information required to be furnished--(1) In general. The

lessor and the lessee described in paragraph (b) of this section who

are paying and receiving a qualified lessee construction allowance,

respectively, must furnish the information described in paragraph

(c)(3) of this section in the time and manner prescribed in paragraph

(c)(2) of this section.

(2) Time and manner for furnishing information. The requirement to

furnish information under paragraph (c)(1) of this section is met by

attaching a statement with the information described in paragraph

(c)(3) of this section to the lessor's or the lessee's, as applicable,

timely filed (including extensions) Federal income tax return for the

taxable year in which the construction allowance was paid by the lessor

or received by the lessee (either in cash or treated as a rent

reduction), as applicable. A lessor or a lessee may report the required

information for several qualified lessee construction allowances on a

combined statement. However, a lessor's or a lessee's failure to

provide information with respect to each lease will be treated as a

separate failure to provide information for purposes of paragraph

(c)(4) of this section.

(3) Information required--(i) Lessor. The statement provided by the

lessor must contain the lessor's name (and, in the case of a

consolidated group, the parent's name), employer identification number,

taxable year and the following information for each lease:

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(A) The lessee's name (in the case of a consolidated group, the

parent's name).

(B) The address of the lessee.

(C) The employer identification number of the lessee.

(D) The location of the retail space (including mall or strip

center name, if applicable, and store name).

(E) The amount of the construction allowance.

(F) The amount of the construction allowance treated by the lessor

as nonresidential real property owned by the lessor.

(ii) Lessee. The statement provided by the lessee must contain the

lessee's name (and, in the case of a consolidated group, the parent's

name), employer identification number, taxable year and the following

information for each lease:

(A) The lessor's name (in the case of a consolidated group, the

parent's name).

(B) The address of the lessor.

(C) The employer identification number of the lessor.

(D) The location of the retail space (including mall or strip

center name, if applicable, and store name).

(E) The amount of the construction allowance.

(F) The amount of the construction allowance that is a qualified

lessee construction allowance under paragraph (b) of this section.

(4) Failure to furnish information. A lessor or a lessee that fails

to furnish the information required in this paragraph (c) may be

subject to a penalty under section 6721.

(d) Effective date. This section is applicable to leases entered

into on or after the date final regulations are published in the

Federal Register.

Robert E. Wenzel,

Deputy Commissioner of Internal Revenue.

[FR Doc. 99-24321 Filed 9-17-99; 8:45 am]

BILLING CODE 4830-01-U