Lessees buying assets out from under leases cannot deduct part of the payment immediately as a cost to cancel the lease | Norton Rose Fulbright
Union Carbide had a special tanker built in 1983 for carrying liquid chemicals, and it financed the ship through a 20-year lease with Merrill Lynch as the lessor. The lease proved burdensome. Ten years into the lease, Union Carbide wanted out.
The company had separate options under the lease either to terminate for payment of termination value or to buy the ship. It chose to buy it because the purchase price – at a little over $107 million – was about 20% less than it would have had to pay merely to terminate the lease and give back the ship to the lessor. Both Union Carbide and the IRS agreed that the ship was worth only about $13 million in 1993 when Union Carbide bought it.
Under the tax laws, a payment to cancel a burdensome contract is deductible when paid. Union Carbide deducted the amount above $13 million as its cost of getting out of the lease. The tax court said no. It said Union Carbide had to treat the full $107 million as tax basis in the vessel and recover it over time through depreciation.
The court gave two reasons for this conclusion. First, it said that section 167(c)(2) of the US tax code – enacted in 1993 – compels this result. That section says that anyone buying an asset “subject to a lease” must treat the entire purchase price as tax basis in the asset; no part of it is allocated to the lease. Union Carbide argued that it did not take the asset “subject to a lease” since the lease was effectively cancelled when it acquired the ship. The court said the time to test is immediately before the purchase. Second, the court said it would have reached the same conclusion even if there were no section 167(c)(2). It said the weight of authority is not to allow bifurcation of payments.
The case is Union Carbide Foreign Sales Corp. v. Commissioner, 115 TC 32 (November 8, 2000). The taxpayer is considering whether to appeal.