This article was originally published in the November/December edition of ELT by ELFA.
The Feds offer—count ‘em—five definitions for “lease term.”
The U.S. Congress and Treasury Department have provided the leasing industry with five definitions of “lease term” for seven different federal income tax purposes. The resulting confusion rivals that associated with the five definitions of “child” prior to the uniform definition codified in the Working Families Tax Relief Act of 2004. The five definitions of lease term make it challenging to understand the tax consequences of common leasing transactions. The chart below is intended to serve as a convenient reference as to when five different types of renewal provisions are “tacked” to the initial term for purposes of determining the “lease term” with respect to these seven purposes. The notes associated with the chart elaborate on the relevance of the definitions.
|Type of Renewal Term1
Different Income Tax Treatments
|Then Fair Market Rental Value (“FMRV”) for Potentially More than Two-Years||Then FMRV Limited to Two Years||Then FMRV with a Cap (e.g., FMRV not to Exceed $5,000 a Month)||Fixed Rent Renewal (e.g., $5,000 a Month)||A Lessor Put Renewal (Regardless of if FMRV or Fixed Rent)|
|True Lease as Provided for in Rev.Proc. 2001-28, § 4.022||Not Tacked||Not Tacked||Tacked||Tacked||Tacked|
|“90-110” Test as defined in Treas. Reg. § 1,467-I(h)(6)3||Only Tacked if Exercise is Expected (Unlikely to be the case)||Only Tacked if Exercise is Expected (Unlikely to be the case)||Tacked if Expected to be Exercised||Tacked if Expected to be Exercised||Tacked|
|§ 168(i)(3)(A) “Pickle Rule” -Equipment||Tacked||Tacked||Tacked||Tacked||Tacked|
|§ 168(i)(3)(B) “Pickle Rule” - Real Estate4||Not Tacked||Not Tacked||Tacked||Tacked||Tacked|
|Qualified Technologic Equipment (QTE) 5-Yr. Term Exception to the “Pickle Rule”6||Tacked||Not Tacked||Tacked||Tacked||Tacked|
|Exception to § 470’s Residual Standard Equipment7||Tacked – Follows Pickle Equipment Rule||Tacked – Follows Pickle Equipment Rule||Tacked – Follows Pickle Equipment Rule||Tacked – Follows Pickle Equipment Rule||Tacked – Follows Pickle Equipment Rule|
|Exception to § 470’s Residual Standard Real Estate 8||Not Tacked – Follows Pickle Real Estate Rule||Not Tacked – Follows Pickle Real Estate Rule||Tacked – Follows Pickle Real Estate Rule||Tacked – Follows Pickle Real Estate Rule||Tacked – Follows Pickle Real Estate Rule|
The last five rows are only relevant if the lessee is tax-exempt (e.g., a government, non-profit, or a foreign individual or entity) and are, therefore, italicized.
1.“Renewal term” is intended to refer to renewal options provided for in the original lease. The chart is not intended to address renewal arrangements negotiated during the term or at the end of term without being provided for in the original lease; such negotiations effectively result in a new transaction.
2. Revenue Procedure 2001-28, 2001-19 C.B. 1156 (the “Revenue Procedure”) (which superceded, without material changes, Revenue Procedure 75-21, 1975-1 C.B. 715) requires a twenty-percent end of lease term residual value (without regard to inflation or deflation) and twenty-percent remaining useful life for purposes of obtaining a private letter ruling from the Internal Revenue Service (IRS) that a leveraged lease is a “true lease” for federal income tax purposes. Therefore, the definition of lease term determines as of which year to apply the projected residual value and useful life tests. For instance, if a transaction includes a ten-year base term with a two-year fixed rent renewal, the tests are applied to the projections as of the end of year twelve. If the same transaction has only a two-year then FMRV renewal, the tests are applied to the projections as of the end of year ten.
In practice, application of this principle can be varied. For instance, some small ticket lessors that take a casual view of technical matters have been known to structure leases with “evergreen” fixed rent renewals with the hope that the lessee out of habit will continue to pay the fixed rent indefinitely. A technical application of this rule to such a lease would result in lease term equal to the useful life of the equipment implying that the transaction is not a true lease; although, the lessor does bear residual risk if the lessee elects to return the equipment at the end of the base term.
One way to provide the lessee with some flexibility at the end of the base term but mitigate the true lease issues associated with a renewal term is to structure the renewal as a “wintergreen” option: condition the exercise of the renewal upon the lessee delivering to the lessor an appraisal prior to the commencement of the renewal that the property at the end of the proposed renewal term will still have twenty-percent remaining useful life and residual value, without regard to inflation or deflation, measured from the original commencement of the lease. The wintergreen approach is effective for true lease purposes; it is effective for Code Section 467 purposes, provided the renewal is not expected to be exercised; however, it is not effective for Pickle Rule, QTE or Code Section 470 structuring purposes all of which are discussed below.
3. The issue with respect to Code Section 467 is what is the “lease term” for purposes of applying the 90-110 test (or the 85-115 test in the case of real estate). The regulations provide that a renewal term that is expected to be exercised as of the closing date is included in the 90-110 test. Treas. Reg. § 1.467-1 (h)(6). The preamble to an amendment to the regulations notes that generally a renewal term at then fair market rental value is not expected to be exercised, absent unusual circumstances. However, it cautions that factors, other than merely the amount of the renewal rent, will be considered. T.D. 8917 (Jan. 5, 2001).
One way to mitigate the application of Code Section 467 to a renewal term that is expected to be exercised is to make the annualized renewal rents equal to the annualized average “base” term rents. Then tacking the renewal for purposes of the 90-110 test would have no effect: all of the rents would still be within the 90-110 band.
4. The Pickle Rule is codified in Code Section 168(g)(3)(A). (It is called the “Pickle Rule" because Representative Pickle was the chair of the Ways & Means Committee when it was enacted.) The Pickle Rule requires “tax-exempt use property” to be depreciated straight-line over the greater of the property’s “class life” and 125-percent of the “lease term”. Class lives are provided for in Revenue Procedure 87-56, 1987-2 C.B. 674. “Tax-exempt use property” includes property leased to a tax-exempt entity (such as a government, non-profit or foreign individual or entity), unless the lease meets either the “short-term” lease exception or the QTE exception. Code § 168(h)(1)(C). The short-term lease exception requires the lease term to be the shorter of thirty-percent of the class life and three years. Code § 168(h)(1)(C). The QTE exception is discussed below. The Pickle Rule in the case of an equipment lease includes any renewal, whether at fixed or then FMRV, in the definition of “lease term”,
5. In the case of real estate, the Pickle Rule does not include a then FMRV renewal. Code § 168 (i)(3) (B).
6. The QTE exception to the Pickle Rule is codified in Code Section 168 (h)(3). If an equipment lease meets the exception, it is eligible for 200-percent declining balance deprecation over five years, despite the property being leased to a tax-exempt entity. To achieve such treatment, the lease must satisfy each of the following criteria:
A. The equipment must be “qualified technological equipment” (e.g., a magnetic resonance imaging machine). See Code § 168(i)(2)(B).
B. The lease must commence within three months of the equipment being placed in service.
C. The lessee may not be the federal government.
D. The lessor may not finance the equipment with tax-exempt bonds.
E. The lease term may not exceed five-years, but for a then FMRV renewal at the lessee’s option that is twenty-four months or less. The next note contains a discussion of the practical limitation on the utility of this twenty-four month then FMRV renewal rule.
7. Code Section 470 was enacted in 2004 to further curtail leasing to tax-exempt entities by limited deductions to rental income unless four criteria are satisfied. See Raleigh Klein & David Burton, Are You Properly Pricing your Medical Equipment Leases (or Other Property Leased to Tax-Exempt Entities) Given the American Jobs Creation Act of 2004?, Equipment Leasing Today, February 2005, at 8. One of the Code Section 470 criteria requires at the end of the “lease term” for the property to be projected to have at least a twenty-percent remaining residual value, without regard to inflation or deflation. Lease term is defined by reference to the Pickle Rule. Therefore, it includes (i) FMRV renewals in the case of equipment (including QTE) and (ii) fixed rent renewals in all cases. Therefore, the two-year FMRV renewal rule that applies for purposes of the QTE depreciation rule is effectively only a benefit to the lessor if at the end of such renewal the equipment is projected to have a twenty-percent residual value without regard to inflation or deflation.
Code Section 470 follows the Pickle Rule’s advantageous treatment of then FMRV renewals in the case of real estate.