Projects on Indian reservations may find it less attractive to use lease financing after two private letter rulings.

The United States encourages investment on Indian reservations by offering special tax breaks. One is a tax credit tied to the wage and health insurance costs to employ members of the Indian tribe in connection with a project. The other is the ability to depreciate the cost of assets used in a trade or business on the reservation more quickly. For example, a wind farm on a reservation can be depreciated in three years rather than the five years that must be used elsewhere. The cost of a coal-fired power plant can be written off over 12 years rather than 20 years.

The deadline has passed for making investments that qualify for these tax breaks — it was December 2005 — but the Senate voted in February to extend the deadline another two years through December 2007. The issue is now in the hands of a group of Senate and House negotiators.

The IRS said in two private letter rulings that the lessor of a project on an Indian reservation can only claim the more rapid depreciation on the part of the project that is “real property” — for example, a building — and not the part that is equipment. Usually no more than 5% of a large power plant is considered real property. The rest is treated as equipment.

The rulings involved two factories that a developer wanted to finance using lease financing.

The problem is the special depreciation can only be claimed on property that is used in a trade or business of the taxpayer on the reservation. In a lease, the lessor is the taxpayer. The standard triple net lease of a project — where the lessee treats the project essentially as its own during the lease term — does not put the lessor in an active trade or business on the reservation.

A special rule in section 168(j)(5) of the US tax code makes an exception for leases of real property. A lessor of real property is viewed as engaged in an active trade or business on the reservation.

The lessor argued that it should be able to look to Oklahoma law, where the factories are located, for direction on how much of each factory is real property. However, the IRS said that it would determine what is real property by looking instead at the rules for investment tax credits. These rules treat projects like factories and power plants largely as equipment. The rulings are Private Letter Rulings 200601019 and 200601020. The IRS made them public in January.

In related news, an Indian tribe is potentially in hot water for issuing tax-exempt bonds to finance a hotel and convention facility on a reservation.

Tribes have the power — like state and local governments — to issue tax-exempt bonds to finance public facilities. However, the power given tribes is more limited. The bonds must be used for an “essential governmental function.” The IRS told the tribe on audit that it had questions about the tax exemption for the bonds the tribe issued. The issue went to the IRS national office in Washington for resolution.

The national office confirmed in a “technical advice memorandum” — or ruling to settle a dispute between a taxpayer and an IRS agent in the field — that the tribe may only use tax-exempt bonds to finance essential governmental functions that are customarily performed by state and local governments. The ruling is Technical Advice Memorandum 200603028.

By Keith Martin