Document 44423

IRS “True Lease” Guidelines
1. Rev. Proc. 2001-28, 2001-19 I.R.B. 1156 (May 7, 2001), 2001-1 CB 1156
2. Rev. Proc. 2001-29, 2001-19 I.R.B. 1160 (May 7, 2001), 2001-1 CB 1160
Sample General Tax Indemnity Provisions
1. Small and Middle Market Leases
A. Example 1
B. Example 2
2. Large Ticket Leveraged Leases
A. Sample General Tax Indemnity Section from a Participation
Sample Income Tax Benefit Indemnity Provisions/Agreements
1. Small and Middle Market Leases
A. Example 1
B. Example 2
Large Ticket Leveraged Leases
A. Sample Tax Indemnification Agreement
Small and Middle Market Leases
Example 1
“Taxes” means all license and registration fees and all taxes, fees, levies, imposts, duties,
assessments, charges and withholdings of any nature whatsoever, however designated
(including, without limitation, any value added, transfer, sales, use, gross receipts,
business, occupation, excise, personal property, real property, stamp or other taxes),
together with any penalties, fines or interest thereon.
Lessor shall report and pay all Taxes now or hereafter imposed or assessed by
governmental body, agency or taxing authority upon the purchase, ownership, delivery,
installation, leasing, rental, use or sale of the Equipment, the Rent or other charges
payable hereunder, or otherwise upon or in connection with any Lease or Financing,
whether assessed on Lessor or Lessee, other than any such Taxes required by law to be
reported and paid by Lessee. Lessee shall promptly reimburse Lessor for all such Taxes
paid by Lessor, together with any penalties or interest in connection therewith attributable
to Lessee's acts or failure to act, excluding (a) Taxes on or measured by the overall gross
or net income or items of tax preference of Lessor, (b) as to any Lease or the related
Equipment, Taxes attributable to the period after the return of such Equipment to Lessor,
and (c) Taxes imposed as a result of a sale or other transfer by Lessor of any portion of its
interest in any Lease or Financing or in any Equipment except for a sale or other transfer
to Lessee or a sale or other transfer occurring after and during the continuance of any
Lessee Default.
Small and Middle Market Leases
Example 2
GENERAL TAX INDEMNITY. (a) To the extent permitted by law, Lessee shall file any
necessary report and return for, shall pay promptly when due, shall otherwise be liable to
reimburse Lessor (on an after-tax basis) for, and agrees to indemnify and hold Lessor
harmless from: (i) all titling, recordation, documentary stamp and other fees; and (ii)
taxes (other than taxes calculated solely on the basis of net income), assessments and all
other charges or withholdings of any nature (together with any penalties, fines or interest
thereon); arising at any time upon or relating to the Equipment or this Lease or the
delivery, acquisition, ownership, use, operation or leasing or other disposition of the
Equipment, or upon the rent, whether the same be assessed to Lessor or Lessee (any of
the foregoing, an “Imposition”).
(b) If any report, return or property listing, or any Imposition is, by law, required to be
filed by, assessed or billed to, or paid by, Lessor, Lessee at its own expense will do all
things required to be done by Lessor (to the extent permitted by law) in connection
therewith and is hereby authorized by Lessor to act on behalf of Lessor in all respects,
including the contest or protest, in good faith and by appropriate proceedings, of the
validity of any Imposition, or the amount thereof. Lessor agrees fully to cooperate with
Lessee in any such contest, and Lessee agrees promptly to indemnify Lessor for all
reasonable expenses incurred by Lessor in the course of such cooperation. An Imposition
or Claim (as hereinafter defined) therefor shall be paid, subject to refund proceedings, if
failure to pay would adversely affect the title or rights of Lessor. If Lessor obtains a
refund of any Imposition which has been paid (by Lessee, or by Lessor and for which
Lessor has been reimbursed by Lessee), Lessor shall promptly pay to Lessee the amount
of such refund to the extent actually received. If a Default of Event of Default has
occurred and is continuing, if Lessor obtains a refund of any Imposition which has been
paid (by Lessee, or by Lessor and for which Lessor has been reimbursed by Lessee),
Lessor shall promptly apply the net amount of such refund to the extent actually received
to Lessee’s obligations under this Lease and, to the extent of any excess, will promptly
pay to Lessee the amount of any excess in accordance with the terms and conditions of
this Lease. Lessee will cause all billings of such charges to Lessor to be made to Lessor
in care of Lessee and will, in preparing any report or return required by law, show the
ownership of the Equipment in Lessor, and shall send a copy of any such report or return
to Lessor. If Lessee fails to pay any such charges when due, except any Imposition being
contested in good faith and by appropriate proceedings as above provided for a
reasonable period of time, Lessor at its option may do so, in which event the amount so
paid (including any penalty or interest incurred as a result of Lessee’s failure), plus
interest thereon at the Late Charge Rate, shall be paid by Lessee to Lessor with the next
periodic payment of rent.
Small and Middle Market Leases
Example 1
TAX BENEFIT INDEMNITY. Each Lease is entered into on the assumption that Lessor
is the owner of the Equipment for tax purposes and is entitled to certain federal, state and
local tax benefits available to an owner of Equipment (collectively, “Tax Benefits”),
including without limitation, accelerated cost recovery system deductions for 5-year
property and deductions for interest incurred by Lessor to finance the purchase of
Equipment available under the Code. Lessee represents, warrants and covenants to
Lessor that (a) Lessee is not a tax-exempt entity (as defined in Section 168(h) of the
Code), (b) all Equipment will be used solely within the United States, and (c) Lessee will
take no position inconsistent with the assumption that Lessor is the owner of the
Equipment for federal, state, and local tax purposes. If, due to any act or omission of
Lessee or any party acting through Lessee, or the breach or inaccuracy of any
representation, warranty or covenant of Lessee contained in any Fundamental Agreement,
Lessor reasonably determines that it cannot claim, is not allowed to claim, loses or must
recapture any or all of the Tax Benefits otherwise available with respect to the Equipment
subject to any Lease (a “Tax Loss”), then Lessee shall, promptly upon demand, pay to
Lessor an amount sufficient to provide Lessor the same after-tax rate of return and
aggregate after-tax cash flow through the end of the Then Applicable Term of such Lease
that Lessor would have realized but for such Tax Loss.
Small and Middle Market Leases
Example 2
TAX INDEMNITY. (1) Lessee represents and warrants that: (a) it believes that it is
reasonable to estimate that the useful life of the Equipment exceeds the lease term
(including any interim and fixed rental renewal periods) of the Equipment Schedule
relating thereto by the greater of one (1) year or twenty (20) percent of such estimated
useful life, and that said Equipment will have a value at the end of the term of such
Equipment Schedule, including any fixed rate renewal period, of at least twenty (20)
percent of the Total Invoice Cost of the Equipment, without including in such value any
increase or decrease for inflation or deflation during the original lease term; and (b) the
Equipment is, and will be used by Lessee so as to remain, property eligible for the
MACRS Deductions (as defined below).
(2) If (a) by reason of (i) any act or failure to act of Lessee (including a breach of any
covenant of Lessee contained in this Lease), or (ii) the misrepresentation of or breach by
Lessee of any of the warranties and representations set forth in this Lease, Lessor in
computing its taxable income or liability for tax, shall lose, or shall not have, or shall lose
the right to claim, or there shall be disallowed or recaptured for Federal and/or state
income tax purposes, in whole or in part, the benefit of MACRS Deductions; or (b)
Lessor shall become liable for additional tax as a result of Lessee having made a
substitution for or replacement of any item of the Equipment, or having added an
attachment or made an alteration to the Equipment, including without limitation, any such
attachment or alteration which would increase the productivity or capability of the
Equipment so as to violate the provisions of Rev. Proc. 2001-28, 2001-19 I.R.B. 1156 (as
it may hereafter be modified or superseded); or (c) as the result of the treatment of any
item of income or deduction attributable to the Lease as being from sources without the
United States, the foreign tax credit which the Lessor may claim against its Federal
income tax liability for any year is less than the credit which the Lessor could have
claimed if all such items of income and deduction had been treated as from sources
within the United States (hereinafter referred to as a “Loss”); then Lessee shall pay
Lessor the Tax Indemnification Payment (as defined below) as additional rent and Lessor
shall revise the Schedule(s) of Stipulated Loss Values to reflect the Loss. As used herein,
“MACRS Deductions” shall mean the deductions under Section 167 of the Internal
Revenue Service Code of 1986, as now or hereafter amended (the “Code”), determined in
accordance with the modified Accelerated Cost Recovery System with respect to the
Total Invoice Cost of any item of the Equipment using the accelerated method set forth in
Section 168(b)(1) or 168(b)(2) of the Code as in effect on the date of this Lease for
property assigned to the class of property specified in the Equipment Schedule pertaining
thereto and taking into account, unless otherwise stated on the Equipment Schedule
pertaining thereto, the special depreciation allowance and basis adjustment under Section
168(k)(1) of the Code; “Lessor” shall be deemed to include the consolidated Federal
taxpayer group of which Lessor is a member; and “Tax Indemnification Payment” shall
mean such amount as, after consideration of (i) all taxes required to be paid by Lessor in
respect of the receipt thereof under the laws of any governmental or taxing authority in
the United States, and (ii) the amount of any interest or penalty which may be payable by
Lessor in connection with the Loss, shall be required to cause Lessor’s after-tax net
return (the “Net Return”) to be equal to, but no greater than, the Net Return computed
consistently with current tax laws (and with the assumption that Lessor is taxed at the
highest marginal Federal and state tax rates) as of the date of this Lease that would have
been available to Lessor had the Loss not occurred.
(3) Lessor shall be responsible for, and shall not be entitled to a Tax Indemnification
Payment by Lessee on account of, any Loss arising solely as a direct result of the
occurrence of any one or more of the following events: (a) the failure of Lessor to timely
and properly claim MACRS Deductions, as applicable, in the tax return of Lessor other
than as a result of changes in the Code or applicable regulations unless in the reasonable
opinion of Lessor’s tax counsel there is no basis for such claim; or (b) the failure of
Lessor to have sufficient taxable income before application of the MACRS Deductions to
offset the full amount of such MACRS Deductions other than as a result of changes in the
Code or applicable regulations; or (c) any event which by the terms of the Lease requires
payment by Lessee of the Stipulated Loss Value if such payment is thereafter actually
made to Lessor, to the extent that such payment reimburses Lessor for amounts otherwise
payable by Lessee pursuant hereto; or (d) a disqualifying disposition due to sale of any
item of the Equipment or the Lease by Lessor prior to a Default, except if in connection
with Lessee’s exercise of any option available under the Lease, or otherwise to or for the
benefit of Lessee in connection with the Lease.
(4) Lessor promptly shall notify Lessee in writing of such Loss and Lessee shall pay to
Lessor the Tax Indemnification Payment within thirty (30) days of such notice. For these
purposes, a Loss shall occur upon the earliest of: (a) the happening of any event (such as
disposition or change in use of any item of the Equipment) which will cause such Loss,
(b) the payment by Lessor to the Internal Revenue Service or state taxing authority of the
tax increase (including an increase in estimated taxes) resulting from such Loss; (c) the
date on which the Loss is realized by Lessor; or (d) the adjustment of the tax return of
Lessor to reflect such Loss.
(5) The obligations of Lessee under this Section, which accrue during the term of an
Equipment Schedule, shall survive the expiration or termination of the Lease and such
Equipment Schedule.
Tax Issues
for Non-Tax Lawyers
New Orleans, Louisiana
May 2-4, 2004
© 2004 Hewlett-Packard Development Company, L.P.and © 2004 Sidley Austin Brown & Wood LLP
The information contained herein is subject to change without notice
G. Daniel McCarthy
Hewlett-Packard Financial Services Company
Louis B. Fontana, Jr.
Hewlett-Packard Financial Services Company
Anne S. Levin-Nussbaum
Sidley Austin Brown & Wood LLP
Important to understand tax issues since treatment as a
“true lease” is essential to realizing the expected
economics of the deal.
“Tax issues” arise throughout the course of the
transaction; frequently changes to the deal raise tax issues
even though, to a non-tax lawyer, they have nothing to do
with taxes.
Dealing with the tax issues adds time and expense to the
transaction, particularly in large ticket leveraged leases
and other highly structured lease transactions, which can
be frustrating to the parties when they don’t understand
the tax analysis.
Purpose/Goals of Presentation
Provide an overview of the basic tax issues that arise in
leasing transactions.
Provide context for some of the typical issues – i.e.,
explain how the tax rules relate to issues that commonly
arise in transactions.
Presentation Structure
Fundamentals - Tax Issue Primer
Documents/Negotiation Issues
Current Issues/Topics
True Lease - Overview
What differentiates a lease from a loan?
− During the lease term (of a net lease), lease financing is very
similar to debt financing.
− Rent is essentially equivalent to interest and, generally, principal
− Lessee has possession of the asset and bears all costs and risks
during the lease term.
Tax analysis will focus on the asset’s residual value at the end
of the lease term; taking into account, based on all the facts and
circumstances, whether the lessor has the “benefits and
burdens” of ownership with respect to the residual.
Tax analysis is similar, but not identical, to the analysis of
whether a transaction is a true lease for commercial law
IRS Guidelines – True Lease
The Guidelines constitute the minimum characteristics that a lease
must satisfy in order for the IRS to issue an advance ruling that the
lease is a “true lease,” and that the lessor is the owner of the property
for tax purposes.
− By their terms, the Guidelines apply only to “leveraged leases.”
− Guidelines are a safe harbor; generally speaking, if all Guidelines are met,
per se qualification as a lease.
− The Guidelines do not purport to define a lease as a matter of law, and are
explicitly not intended to be used for audit purposes.
− Failure to satisfy all of the Guidelines does not mean that a transaction
does not qualify as a true lease.
The Guidelines have become an important resource in tax planning.
In practice, certain Guidelines are routinely satisfied (and certain
Guidelines are not).
The Guidelines – cont’d
Minimum Equity Investment
− Lessor equity investment must equal at least 20% of the cost of
property at the commencement of the lease, and this amount must
remain at risk throughout the lease term.
20% Residual Value
− Asset’s expected fair market value at the end of the term must be
at least 20% of original cost, without regard to inflation or
deflation over the lease term.
20% Remaining Useful Life
− Asset’s remaining economic useful life at end of the lease term
must be expected to be at least 20% of its remaining life as of the
beginning of the lease.
Note: For purposes of the Guidelines, the lease term includes all renewal or
extension periods other than renewals or extensions at the option of the lessee at
then fair rental value.
The Guidelines – cont’d
Purchase and Sale Rights
− Neither lessee nor related parties may have any right to purchase
the asset from the lessor at less than its then fair market value.
− Lessor may not have any “put” rights (including the right to
abandon the asset to any party).
No Lessee Investment
− Lessee cannot have an investment in the leased asset.
− Includes prohibition on lessee not paying for certain non-severable
− At commencement of lease, the property must not need any
improvements to be complete for its intended use.
The Guidelines – cont’d
No Lessee Loans or Guarantees
− Lessee may not lend funds to lessor to acquire the leased property,
or guarantee any indebtedness of the lessor created in connection
with such acquisition.
− An affiliate of the lessee may guarantee the lessee’s obligations
under the lease (this does not constitute a prohibited guarantee of
indebtedness of the lessor).
Profit Requirement
− Lessor must demonstrate that it expects to receive a profit from the
lease apart from, or without regard to, the tax benefits arising from
the transaction.
Asset Not “Limited Use Property”
− At the end of the lease term, the asset must be useable by someone
other than the lessee or someone related to it.
TRAC Leases
A “TRAC” or “terminal rental adjustment clause” is a lease
provision providing that rent may or will be adjusted upward
or downward by reference to the amount actually realized by
lessor upon sale or other disposition of the leased equipment.
A variety of TRAC structures are used in the leasing industry.
Generally, the parties agree at the outset on the residual value
of the equipment at the end of the lease term.
After lease expiration, such agreed value is compared to the
actual proceeds realized by the lessor from the disposition of
the equipment and such difference is the amount of the rental
− actual proceeds less than agreed value, lessee pays shortfall to
− actual proceeds greater than agreed value, lessor rebates excess to
TRAC Leases – cont’d
In its purest form, a TRAC has the effect of transferring to
lessee all upside residual benefit and all downside exposure.
As a result, the lease would generally not be a “true lease” for
tax purposes or for commercial law purposes.
In general, tax law would recharacterize the transaction as a
conditional sale (or secured loan) and treat the lessee as the
owner of the leased equipment, just as commercial law would
generally characterize the transaction as a “lease intended for
Nevertheless, leases containing qualifying TRACs are treated
as “true leases” for tax purposes based on a statutory exception
contained in I.R.C. Section 7701(h).
TRAC Leases – cont’d
Section 7701(h) basically provides that if a “qualified motor
vehicle operating lease agreement” would otherwise constitute
a true lease for tax purposes, it will not be recharacterized as a
conditional sale by reason of the TRAC.
In general, a “qualified motor vehicle operating lease
agreement” is a lease of a motor vehicle (including a trailer)
provided that:
− the lessee certifies that (i) it intends that more than 50% of the use of
the vehicle is to be in a trade or business of the lessee, and (ii) it has
been advised that it will not be treated as the owner of the vehicle for
federal income tax purposes; and
− the lessor does not borrow more than 50% of the purchase price of the
vehicle on a non-recourse basis.
Section 467 - What is it?
Required method of tax accounting for rent under certain leases.
When applicable, lessor and lessee must use accrual method and
follow detailed rules set forth in the Regulations, regardless of
whether taxpayer otherwise uses the cash or accrual method.
Combats structures utilizing mismatched income and deductions
between lessors and lessees by imposing a consistent reporting
regime and using time value of money principles to reduce benefits
of deferral.
Deferred rent is deemed a loan to lessee from lessor, with interest
imputed thereon.
− Benefit to lessor of income deferral reduced by imputed interest.
Prepaid rent is treated as if it were a loan to lessor from lessee, with
lessee having imputed interest income.
− Benefit of lessee’s front-loaded deductions is reduced by imputed interest.
Section 467 - Applicability
Section applicable to rental agreements for tangible property
with aggregate payments (rent or other consideration) of more
than $250,000.
In addition, lease must be considered to have increasing or
decreasing rents or prepaid or deferred rent.
− If lease requires rent to be paid within two years of calendar year
of use, not considered to have prepaid or deferred rent.
− Example: Rent for use of property during 2000 could be required
to be paid as early as January 1, 1998 (within calendar year of year
preceding use) or as late as December 31, 2002 (within calendar
year of year following use) without being considered to have
prepaid or deferred rent.
Frequently not applicable to small/middle ticket market leases.
Almost always applicable to large ticket leveraged leases.
Section 467 - Terminology
Section 467 Rent: the amount treated as rent for tax
accounting purposes (so called “tax rent”).
Allocated Rent: the rent for which lessee is liable on
account of the use of the property during the rental
Rent Payment: the amount and timing of required rent
payments under the agreement.
Section 467 Loan: the loan deemed to arise as a result of
prepaid or deferred rent.
Section 467 Interest: the imputed interest on the deemed
Section 467 - Mechanics
Lessor and lessee have income and deductions for each
tax year equal to the sum of Section 467 Rent and Section
467 Interest, in the amounts determined in accordance
with the Regulations.
Actual calculation methods too detailed and complicated
to review here.
Nonetheless, useful to have basic understanding of how
the provisions operate.
Key concept underlying mechanics is that existence of a
Section 467 Loan is determined by comparing the present
value (PV) of Rents Payable to the PV of Allocated Rent.
Section 467 - Mechanics -cont’d
Where PVs are equal, there is no Section 467 Loan.
− In such case, no Section 467 Interest and 100% of Allocated Rent is
considered Section 467 Rent.
Thus, no Section 467 Loan if the lease has a single
schedule prescribing amount and time for rent payments.
− Where no specific schedule for Allocated Rent, Regulations deem
Allocated Rent to equal Rent Payments.
− PVs of Allocated Rent and Rent Payments would be the same,
regardless of whether rent payments are level, front-loaded or
Where PVs are not equal, the Regulations impute time
value of money principles, similar to the OID rules.
Section 467 - Mechanics - cont’d
Amount of Section 467 Rent for each tax year is
determined by multiplying Allocated Rent by a set
fraction, assuming determined under the Proportional
Rental Amount.
− Methods for computing Section 467 Rent are explained below.
Fraction is the PV of the Rent Payments over the PV of the
Allocated Rents.
At any point in time, the outstanding Section 467 Loan is
the difference between the the cumulative Section 467
Rent accrued and the cumulative Rent Payments.
Section 467 Interest for each period is calculated based on
the outstanding Section 467 Loan, which typically will be
fully amortized by the end of the term.
Section 467 - Mechanics - cont’d
The Regulations provide 3 regimes for calculating Section
467 Rent.
− As described previously, Section 467 Rent is the Allocated Rent
when there is no Section 467 Loan.
− Section 467 Rent is the Proportional Rental Amount (i.e., a set
fraction of Allocated Rent) when there is a Section 467 Loan and
the Constant Rental Amount method does not apply.
− Section 467 Rent is the Constant Rental Amount if the rental
agreement is considered a Disqualified Leaseback or Disqualified
Long-Term Agreement (DLs and DLTAs discussed below).
Section 467 - Mechanics - cont’d
Under the Constant Rental Amount method, Section 467
Rent is a level amount for each rental period (so called
“rent levelization”).
Worst result because removes all ability to optimize lease
In contrast, Proportional Rental Amount is based on lease
schedule for Allocated Rent (with adjustments to take into
account the time value of money).
Section 467 - DLs and DLTAs
Agreement is considered a “leaseback” if the lessee had
an interest in the property at any time during the
preceding 2 years - e.g., any sale/leaseback transaction.
Lease is considered “long-term agreement” if it has a term
longer than 75% of the property’s depreciable class life.
Generally, a leaseback or long-term agreement is
considered a DL or DLTA if the IRS determines that tax
avoidance was a principal purpose of the uneven rent
Nonetheless, leaseback or long-term agreement will not
be considered a DL or DLTA if total rent is less than $2
Section 467 - Tax Avoidance
Regulations provide certain safe harbors, the satisfaction
of which establishes that “tax avoidance” not a principal
purpose for increasing or decreasing rents.
In practice, taxpayers typically seek to fall within a safe
harbor rather than risk being subject to rent levelization
under a subjective standard.
Moreover, if it is reasonable to expect a “significant
difference” in lessee and lessor’s marginal tax rates at any
time during the lease, Taxpayer would have the burden of
proving, with clear and convincing evidence, that tax
avoidance was not “a” principle purpose.
Section 467 - Safe Harbors
Under the “uneven rent test” (also called the 90/110 Safe
Harbor), if Allocated Rent in each calendar year does not
vary by more than 10% of average Allocated Rent, tax
avoidance will not be considered a principal purpose and
there would be no risk of rent levelization.
For property other than real estate, an initial rent holiday
of up to 3 months can be disregarded if inclusion would
cause the Allocated Rents to fall outside the 90/110 band.
Regulations also specify certain types of contingent rent
to disregard in applying the uneven rent test
Existence of contingent rent that is not of a listed type will
preclude reliance on 90/110 Safe Harbor.
Section 467 - Safe Harbors - cont’d
Regulations also provide a Safe Harbor if the increase or
decrease in rent is wholly attributable to certain types of
contingent rent.
• Contingent rent is any payment obligation under the lease
if the amount and timing is not fixed and determinable at
the beginning of the term.
• The types of contingent rent that can be disregarded
include (1) payments for damages and casualties to the
property, (2) third party costs (other than debt service), (3)
late payment charges, (4) certain TRAC provisions (5) tax
indemnity payments and (6) costs related to variable
interest rates.
• Many standard lessee-paid costs not adequately
addressed in Regulations.
Section 467 - Safe Harbors - cont’d
In addition, tax avoidance will not be considered a
principal purpose if the increase or decrease in rent is
wholly attributable to a single rent holiday.
The rent holiday can be either:
up to a 3 month initial holiday, or
up to the lesser of 2 years and 10 percent of the lease term, if
commercially reasonable in the locality.
Accelerated cost recovery deductions is key factor in
achieving tax deferral and can be essential to the
economics of many lease transactions, particularly large
ticket leveraged leases.
The modified accelerated cost recovery system (MACRS)
is the most favorable method.
− accelerated recovery of asset’s cost - e.g., 200% declining balance
method for assets with recovery periods of less than 10 years
− prescribed recovery periods much shorter than actual economic
useful life of asset
Applies to assets leased to U.S. taxpayers and used
predominately within the United States.
Depreciation – cont’d
MACRS generally not available if:
− the asset is used predominately outside the United States
− the lessee is a tax-exempt entity (foreign or domestic), or
− the property is tax-exempt bond financed.
Instead, recovery deductions are calculating under the
alternative depreciation system (ADS).
ADS less desirable because recovery is less accelerated
(straight-line method) and recovery periods are longer
(generally the asset’s “class life”).
Depreciation – cont’d
For lease to tax-exempt lessee, tax deferral is further
reduced by the so called “Pickle Rules.”
The Pickle Rules require the recovery period to be the
longer of the property’s class life and 125% of the lease
This rule eliminated most of the benefits in typical
structured leverage leases.
Over the years, various structures have been devised to
mitigate the impact of the Pickle Rules - namely,
replacement leases, LILOs and now SILOs.
Depreciation – cont’d
Depreciation commences when asset deemed “placed in
service” under the “applicable convention” - i.e., not actual
date of first use.
Half-year convention generally applies to non-real property
and treats property as placed in service at the mid-point of
the year (i.e., get 50% of first year recovery allowance).
However, if more than 40% of aggregate bases of taxpayer’s
property (other than Section 1250 property) is placed in
service in fourth quarter, then mid-quarter convention
generally applies to all property (other than Section 1250
property) placed in service that year.
Under mid-quarter convention, property is deemed placed
in service at mid-point of the relevant quarter.
Depreciation – cont’d
Bonus Depreciation
− further accelerated recovery deductions for “new” property with
recovery periods of 20 years or less
− generally not available if property is subject to ADS
− first use of property must generally commence with TP (subject to
special/leaseback rule)
Bonus deduction is generally equal to:
− 30% of basis for property first acquired after September 10, 2001
and placed in service between September 11, 2001 and May 5, 2003
− 50% of basis for property acquired between May 6, 2003 and
December 31, 2004 and first placed in service before January 1,
Depreciation – cont’d
Permits an addition recovery allowance in the first taxable
year, which applies prior to application of MACRS.
MACRS then applies to adjusted basis (as reduced by
amount of bonus depreciation).
Interest Deductions
Key consideration in large ticket structured leasing
transactions where interest deductions further enhance
economics of tax deferral.
Tax structural concerns relate to whether debt will be
considered “true debt” of lessor.
Deductions generally determined in accordance with
terms of debt instrument, except if OID rules apply and
with respect to Section 467 interest.
Withholding tax issues need to be considered if lender is
foreign or has rights to transfer to a foreign lender.
Interest Deductions – cont’d
Special rules for allocating interest deductions on
qualified non-recourse indebtedness (“QNI”).
If satisfy QNI exception, interest deductions are allocated
directly to the income generated by the asset and source
will match source of rental income for foreign tax
planning purposes.
In general, to be QNI, the lease debt must be nonrecourse, used to finance the purchase of the leased asset,
and not be secured by any collateral other than the leased
Can purposely not qualify as QNI by providing
additional collateral for the loan (so called “break the
General Tax Indemnity (GTI) - Overview
Lessee indemnifies and holds lessor/investor harmless
from any and all taxes arising in connection with the lease
(including interest and penalties) except income taxes.
Other lessor/investor taxes are typically excluded as well,
depending on the market and the specific nature of the
GTI - Small/Middle Market
The GTI appears differently in various form lease
− Sometimes as a separate section entitled “General Tax Indemnity”
or “Taxes” or some other variation thereof.
− Sometimes embedded in another section (usually in the “Rent”
Sometimes not even cast in the form of an indemnification
obligation, but rather as a reimbursement or direct
payment covenant.
Covers all taxes (and related interest and penalties),
except income taxes.
− Other standard and negotiated exceptions are typical.
GTI - Small/Middle Market – cont’d
May or may not include Lessee contest rights.
Primary responsibility for reporting and paying covered
taxes varies.
Most frequently negotiated provisions are:
− lessee contest rights
− exclusions
− lessee direct pay requests
GTI - Large Ticket Market
Typically there is a separate indemnity section for taxes in
the participation agreement (which is the document
governing general matters between all the parties,
including the investor, lessor, lessee, and lender).
Provides tax indemnification to all of the parties for all
non-income taxes (and related interest and penalties),
subject to customary exceptions.
Includes “gross up” protection if any U.S. withholding
taxes are required to be deducted from payments on the
lease debt, subject to negotiated exceptions.
Includes lessee contest rights, tax benefit payback
provisions and provisions governing tax return and
reporting requirements.
GTI - Large Ticket Market – cont’d
Structured as an all-inclusive indemnity for taxes arising out of
the transaction, except taxes that are specifically excluded.
Thus, the most significant provisions (and those which are
negotiated) appear in the exclusions section.
Typical list of exclusions will depend on type of asset and
whether lease is domestic or cross-border - in each market, list
is fairly standard.
− Income taxes, taxes on transfers, taxes in excess of those applicable
to original indemnitee, and taxes resulting from indemnitees bad
acts are always excluded.
Negotiations rarely include significant issues.
− Generally, focus is on expanding or narrowing the scope of the
exclusions and lessee’s contest rights.
Lessor generally negotiates first round with lessee and then
lender negotiates for additional protections.
Income Tax Benefit Indemnity
Provisions/Agreements (TIA) - Overview
Covers federal (and sometimes state and local) income
Protects the lessor/investor from loss of the income tax
benefits that have been priced into the transaction.
Amount payable is based on how the lessor/investor’s
actual tax position differs from the assumptions used in
the pricing – i.e., the lessor/investor’s Net Economic
Return (generally, after tax rate of return and after-tax
cash flow) is preserved.
TIA - Small/Middle Market
Sometimes not even present in small and middle market
Generally appears as a separate section of the lease
agreement entitled “Tax Indemnity,” “Special Tax
Indemnity,” “Income Tax Indemnity,” “Tax Benefit
Indemnity” or some variation thereof.
Generally protects a lessor from a reduction in its return
on the lease transaction due to a loss of anticipated
income tax benefits arising as a result of the lessee’s “acts
or omissions.”
TIA - Small/Middle Market – cont’d
May or may not similarly protect a lessor from
unanticipated income inclusions.
May or may not include lessee contest rights.
Most frequently negotiated issues are:
− lessee contest rights
− scope of lessee “acts or omissions”
− trigger events
− exclusions
− lessee protections and details regarding the calculation of the
amount payable
TIA - Large Ticket Market
Always a separate agreement seen only by investor and lessee.
Indemnity runs only to the equity investor (typically referred
to as the “owner participant”).
Indemnity designed to protect investor’s expected tax
consequences as priced into the transaction.
− amount and timing of federal tax (and state and local tax, to the
extent included in pricing) deductions for depreciation, interest
and transaction expenses (Deduction Loss)
− unexpected additional income with respect to the transaction
Common for everyone except the tax lawyers to take a break
when it’s time to negotiate this agreement.
TIA - Large Ticket Market – cont’d
Structure of TIA:
Tax Assumptions - section describes the tax assumptions
used in calculating the investor’s expected after-tax
− Necessary because the indemnity protection is generally on an
assumed basis and the assumptions function as the model against
which to measure harm.
Tax Representations - generally related to matters within
lessee’s control which, if breached, would adversely
impact investor’s expected return.
− Some overlap with Tax Assumptions, but here function is to
impose liability on lessee for any inaccuracies or breaches.
TIA - Large Ticket Market – cont’d
Structure of TIA - cont’d:
Indemnity Triggers - describes specific acts and omissions that
give rise to indemnification.
− Separate list of triggers for Deduction Losses and Inclusions.
Although, with large amount of overlap.
Exclusions - describes specific tax consequences and events that
are not indemnified.
Contest Provisions - details lessee’s contest rights with respect
to indemnified taxes. Parties generally much more concerned
about limiting/expanding these than in GTI.
Other - includes provisions for payback of tax benefits ,
payment and reporting requirements and other miscellaneous
TIA - Large Ticket Market – cont’d
Illustrative List of Tax Representations:
All information provided to the appraiser was accurate and
complete on the closing date.
Equipment will not require any improvements, modifications
or additions to render it complete for its intended use.
Lessee will not furnish cost of any improvements, except as
permitted by the Guidelines.
Lessee will not take a position that is inconsistent with the tax
Facility will not be used by tax-exempt entity or be tax-exempt
bond financed property during the lease term.
TIA - Large Ticket Market – cont’d
Deduction Loss Triggers - Illustrative List
− breach or inaccuracy of any Tax Representations
− lessee act other than a “Permitted Act”
• Permitted Acts are generally all of the acts and omissions expressly
permitted or required under the operative documents, other than
substitutions and replacements of the property and other negotiated
• Sometimes list is all inclusive, except to the extent expressly excluded
and sometimes (less common) it is a detailed list.
− casualty, loss or damage to the property
− confiscation or condemnation of the property
− improvements, modifications and substitutions
TIA - Large Ticket Market – cont’d
Inclusion Triggers - Illustrative List
− breach or inaccuracy of any Tax Representations
− lessee act other than a “Permitted Act”
− casualty, loss or damage to the property
− confiscation or condemnation of the property
− improvements, modifications and substitutions
− adjustments or modifications to the Allocated Rent or Rent
Payment schedules
− payments other than at times required under the lease
− refinancing of the lease debt
TIA - Large Ticket Market – cont’d
Exclusions: These sometimes override and sometimes
clarify the indemnity triggers.
− voluntary and involuntary transfers by the owner participant
− failure to timely or properly claim tax benefits
− failure to contest tax when properly requested
− lease not a “true lease,”subject to certain exceptions
− failure to get assumed tax basis in property
− change in tax law
− application of Section 467
Exceptions (so called “carve backs”) to the exclusions are
heavily negotiated.
Current Topics/Issues
SILOs - Fate Pending
Pending Legislation - ETI Repeal at Top of Agenda
Synthetic Leases - Revised Structure Using Voting Interest
Tax Shelter Regulations - Rules Continue to Evolve
© 2004 Hewlett-Packard Development Company, L.P.and © 2004 Sidley Austin Brown & Wood LLP
The information contained herein is subject to change without notice