The IRS released a “field service advice” in mid-November to an agent handling an audit of a US company that participated in LILOs. The national office told the agent to deny the company the tax benefits it claimed from the transactions.

“LILO” stands for lease-in-lease-out. In the transaction under audit, a foreign government leased equipment that it had owned for a number of years to a US company. The US company then subleased the equipment back to the foreign government. The sublease was scheduled to end before the head lease so that the US company would have a period, in theory, when it had use of the equipment. However, the foreign government had a purchase option – in its capacity as sublessee – to buy out this residual leasehold interest for a fixed price.

The US company paid the first year rent at closing and borrowed an amount on a nonrecourse basis equivalent to the remaining rents under the lease. It paid the borrowed money over to the foreign government as a “security deposit.” The deposit turned the next year into a prepayment of the remaining head lease rents. The foreign government used most of the security deposit to defease the rents it had to pay under the sublease. It also defeased the fixed-price purchase option. In other words, it put money aside in a bank with instructions to pay the amounts when due. It was not legally released from the obligation to pay the sublease rents. At the end of the day, the money circled back to the original bank that loaned it.

The IRS agent characterized the transaction as a payment of the first year rent plus advisory fees for tax benefits.

In a LILO, the head lease rents are allocated to different periods under the lease in a pattern that decreases over time. The sublease rents have a reverse pattern that starts low and goes high. The lease is supposed to give the US lessee net deductions for rent that are equivalent to a depreciation allowance on the equipment, except that the deductions are more accelerated. Since the US lessee borrows most of the amount needed to prepay the head lease rent, it also has deductions for interest.

The agent said any pre-tax economic return in the transaction was, at best, insignificant. The IRS national office told the agent to disallow the rent and interest deductions on grounds that the transaction was so circular as to lack economic substance.

The IRS staked out its position on LILOs in a May 1999 revenue ruling. The transaction described in the field service advice looks like the first generation structures that were in use before June 1996 when the IRS issued proposed regulations under section 467 of the US tax code limiting the degree to which rents can fluctuate in leases.