[Federal Register Volume 60, Number 77 (Friday, April 21, 1995)]
[Proposed Rules]
[Pages 19867-19871]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 95-9946]
=======================================================================
-----------------------------------------------------------------------
[[Page 19868]]
DEPARTMENT OF THE TREASURY
Internal Revenue Service
26 CFR Part 1
[IA-18-95]
RIN 1545-AT33
Lease Term; Exchanges of Tax-Exempt Use Property
AGENCY: Internal Revenue Service (IRS), Treasury.
ACTION: Notice of proposed rulemaking and notice of public hearing.
-----------------------------------------------------------------------
SUMMARY: This document contains proposed regulations relating to the
lease term of tax-exempt use property. The proposed regulations also
provide guidance regarding certain like-kind exchanges among related
parties involving tax-exempt use property. This document also provides
notice of a public hearing on these regulations.
DATES: Written comments must be received by July 20, 1995. Requests to
appear and outlines of topics to be discussed at the public hearing
scheduled for August 2, 1995, must be received by July 12, 1995.
ADDRESSES: Send submissions to: CC:DOM:CORP:T:R (IA-18-95), room 5228,
Internal Revenue Service, POB 7604, Ben Franklin Station, Washington,
DC 20044. In the alternative, submissions may be hand delivered between
the hours of 8 a.m. and 5 p.m. to: CC:DOM:CORP:T:R (IA-18-95),
Courier's Desk, Internal Revenue Service, 1111 Constitution Avenue NW.,
Washington, DC. The public hearing will be held in the IRS Auditorium,
7th Floor, 1111 Constitution Avenue NW., Washington, DC.
FOR FURTHER INFORMATION CONTACT:
Concerning the proposed regulations, John M. Aramburu of the Office of
Assistant Chief Counsel (Income Tax and Accounting) at (202) 622-4960;
concerning submissions and the public hearing, Christian Vasquez, (202)
622-7190 (not toll-free numbers).
SUPPLEMENTARY INFORMATION:
Background
This document contains proposed amendments to the Income Tax
Regulations (26 CFR part 1) relating to the depreciation of tax-exempt
use property under section 168 of the Internal Revenue Code (Code).
Section 168(h) provides rules relating to the definition of tax-exempt
use property. Section 168(i)(3) provides rules for determining a lease
term for purposes of section 168. These proposed regulations provide
guidance relating to certain exchanges of tax-exempt use property among
related parties and the determination of lease term under certain
circumstances.
Explanation of Provisions
Current Law
Under section 168, property used in a trade or business, or held
for the production of income, generally may be depreciated under the
general depreciation system (GDS) using accelerated methods over
relatively short recovery periods. However, certain property must be
depreciated under the alternative depreciation system (ADS) described
in section 168(g). Under ADS, depreciation deductions are determined
using the straight-line method over longer recovery periods.
Under section 168(g)(1)(B), tax-exempt use property is subject to
ADS. Section 168(h)(1) defines tax-exempt use property to include that
portion of any tangible property (other than nonresidential real
property) leased to a tax-exempt entity, as well as nonresidential real
property, under certain conditions. For these purposes, section
168(h)(2)(A)(iii) provides that certain foreign entities and persons
are considered tax-exempt entities. Under ADS, the recovery period of
tax-exempt use property subject to a lease is no less than 125 percent
of the lease term. See section 168(g)(3)(A).
The intent of Congress is subjecting tax-exempt use property to a
slower depreciation system than GDS is expressed in the legislative
history as follows:
The committee believes that reform of the tax law is essential,
insofar as it relates to property used by tax-exempt entities under
a lease, a lease formulated as a service contract, or other similar
arrangements. When tax-exempt entities use property under these
arrangements, they pay reduced rents that reflect a pass-through of
investment tax incentives from the owner of the property. Tax-exempt
entities thereby benefit from investment incentives for which they
do not qualify directly, and effectively gain the advantage of
taking income tax deductions and credits while having no
corresponding liability to pay any tax on income from the property.
S. Rep. No. 169 (Vol. 1), 98th Cong., 2d Sess. 123 (1984).
Thus, Congress subjected tax-exempt use property to a slower
depreciation system in order to prevent tax-exempt entities from
receiving, through reduced rentals, the tax benefits of GDS. Congress
retained the rules for depreciating tax-exempt use property when it
modified the accelerated cost recovery system in 1986. S. Rep. No. 313,
99th Cong., 2d Sess. 103 (1986).
Section 168(i)(5) provides that when property changes status, for
example, ceases to be tax-exempt use property, the depreciation
deduction for the year of change and subsequent taxable years shall be
determined in such manner as the Secretary shall prescribe by
regulation. Proposed Sec. 1.168-2(j)(3) sets forth principles for
depreciating property following a change in its status. Section
1.168(j)-1T, Q&A 2, which relates to tax-exempt use property,
references that provision.
The tax-exempt use property rules contain a number of references to
lease term. As noted above, the recovery period of tax-exempt use
property subject to a lease is no less than 125 percent of the lease
term. In addition, section 168(h)(1)(B)(ii)(III) characterizes as tax-
exempt use property nonresidential real property leased to a tax-exempt
entity for a term in excess of 20 years, section 168(h)(3)(A) excludes
from the definition of tax-exempt use property certain high technology
equipment leased to a tax-exempt entity for a term of no more than five
years, and section 168(h)(1)(C) excludes property subject to certain
short-term leases from the tax-exempt use property rules.
For each of these purposes, the lease term is determined under all
the facts and circumstances. Further, legislative history states that
rules ``similar to those applied under section 46(e)(3) (relating to
investment credits for non-corporate lessors) be applied in determining
lease term. See. e.g., Hokanson v. Commissioner, 730 F.2d 1245, 1248
(9th Cir. 1984) (which applies a reasonable expectations test).'' S.
Rep. No. 169 (Vol. 1), 98th Cong., 2d Sess. 150 (1984). Section
168(i)(3) provides rules for determining a lease term. It indicates
that, in determining a lease term, options to renew generally must be
taken into account and the periods of certain successive leases must be
aggregated with the period of an original lease.
Section 1.168(j)-1T, Q&A 17, provides additional rules for
determining lease term. The regulation sets forth circumstances under
which a lease term will include not only the stated duration of a lease
but also an additional period, including options to renew and
successive leases. It also provides examples of situations in which
aggregation of lease periods is required, and situations in which lease
periods are considered sufficiently independent so that aggregation is
not required.
Lease Term
The proposed regulations generally clarify the rules for
determining a lease [[Page 19869]] term in certain situations. They
require the aggregation of the stated duration of an original lease
with any additional period for which the original, tax-exempt lessee
(or a person related to the lessee) retains financial responsibility.
The proposed regulations are intended to supplement existing
authorities, including Sec. 1.168(j)-1T, Q&A 17.
Specifically, the proposed regulations provide that an additional
period of time during which a lessee may not continue to be the lessee
is nevertheless included in the lease term if the lessee (or a related
person) has agreed that one or both of them will or could be obligated
to make a payment of rent, or a payment in the nature of rent, with
respect to such period. For purposes of this rule, a payment in the
nature of rent includes a payment intended to substitute for rent or to
fund or supplement the rental payments of another. For example, a
payment in the nature of rent includes a payment of any kind that is
required to be made in the event that: (1) The leased property is not
leased for the additional period; (2) the leased property is leased for
the additional period under terms that do not satisfy specified terms
and conditions; (3) there is a failure to make a payment of rent with
respect to such additional period; or (4) similar circumstances occur.
This rule disregards, however, obligations to make de minimis payments.
The proposed regulations also provide that in the event an
additional period is included in the lease term, section 168(i)(5)
(relating to changes in status) applies if the leased property ceases
to be tax-exempt use property for such additional period.
The proposed regulations apply to leases entered into on or after
the date the proposed regulations are filed with the Federal Register.
No inference as to the treatment of additional lease periods under
current law is intended by such effective date. The proposed
regulations do not preclude the application of common law doctrines
(such as the substance over form or step transaction doctrines) and
other authorities to the determination of lease term or to the
determination of whether a transaction is characterized as a lease, a
conditional sale, or otherwise for federal income tax purposes.
Like-Kind Exchanges
The proposed regulations also addresses certain transactions
between related persons that are designed to circumvent the tax-exempt
use property rules. For example, a taxpayer might purchase tax-exempt
use property for $100x and then promptly transfer the property to a
related person in exchange for like-kind property of an equal value
that has a zero basis and is not tax-exempt use property (the taxable
property). If the exchange qualifies for nonrecognition treatment under
section 1031 as to the related person, the related person recognizes
none of its gain with respect to the taxable property and takes the
tax-exempt use property with a zero basis. At the same time, the
taxpayer has a $100x basis in the taxable property. The desired net tax
result of the transaction is that a new investment in property that is
properly subject to the ADS becomes subject to GDS.
To address this situation, the proposed regulations provide that
property (tainted property) transferred directly or indirectly to the
taxpayer by a related person (the related party) as part of, or in
connection with, a transaction described in section 1031 where the
related party receives tax-exempt use property (related tax-exempt use
property) will, if the tainted property is subject to an allowance for
depreciation, be treated in the same manner as the related tax-exempt
use property for purposes of determining the allowable depreciation
deduction under section 167(a). Under this rule, the tainted property
is depreciated by the taxpayer over the remaining recovery period of,
and using the same depreciation method and convention as that of, the
related tax-exempt use property.
This rule is subject to certain limitations. In general, the rule
applies only with respect to so much of the taxpayer's basis in the
tainted property as does not exceed the taxpayer's adjusted basis in
the related tax-exempt use property prior to the transfer. Any excess
of the taxpayer's basis in the tainted property over its adjusted basis
in the related tax-exempt use property prior to the transfer is treated
as property to which the rule does not apply. Moreover, the rule does
not apply to so much of the taxpayer's basis in the tainted property as
is subject to section 168(i)(7).
The proposed regulations provide that related tax-exempt use
property includes property that does not become tax-exempt use property
(as defined in section 168(h)) until after the transfer if, at the time
of the transfer, it was intended that the property become tax-exempt
property. Moreover, in the circumstances described in the preceding
sentence, the related tax-exempt use property will be treated as
having, prior to the transfer, a lease term equal to the term of any
lease that causes such property to become tax-exempt use property.
The proposed regulations only apply with respect to direct or
indirect transfers of property involving related persons where (1)
section 1031 applies to any party, and (2) a principal purpose of the
transfer is to avoid or limit the application of ADS. For purposes of
this rule, a person is related to another person if they bear a
relationship specified in section 267(b) or section 707(b)(1).
The proposed regulations apply to transfers made on or after the
date the proposed regulations are filed with the Federal Register. No
inference is intended as to the treatment of transfers intended to
avoid or limit the application of ADS that are made prior to the
effective date. In addition, the proposed regulations do not preclude
the application of common law doctrines (such as the substance over
form or step transaction doctrines) and other authorities to transfers
intended to avoid or limit the application of ADS, including transfers
occurring prior to the effective date of the proposed regulations.
The IRS and Treasury invite comments on the scope of the proposed
regulations. For example, comments are requested as to whether any
transactions should be excepted from the proposed regulations or
whether other transactions should be included within their scope.
Special Analyses
It has been determined that this notice of proposed rulemaking is
not a significant regulatory action as defined in EO 12866. Therefore,
a regulatory assessment is not required. It also has been determined
that section 553(b) of the Administrative Procedure Act (5 U.S.C.
chapter 5) and the Regulatory Flexibility Act (5 U.S.C. chapter 6) do
not apply to these proposed regulations, and, therefore, a Regulatory
Flexibility Analysis is not required. Pursuant to section 7805(f) of
the Internal Revenue Code, this notice of proposed rulemaking will be
submitted to the Chief Counsel for Advocacy of the Small Business
Administration for comment on its impact on small businesses.
Comments and Public Hearing
Before these proposed regulations are adopted as final regulations,
consideration will be given to any written comments (a signed original
and eight (8) copies) that are submitted timely to the IRS. All
comments will be available for public inspection and copying.
A public hearing has been scheduled for August 2, 1995, at 10 a.m.
in the IRS Auditorium, 7th Floor, 1111 [[Page 19870]] Constitution
Avenue NW., Washington, DC. Because of access restrictions, visitors
will not be admitted beyond the Internal Revenue Building lobby more
than 15 minutes before the hearing starts.
The rules of 26 CFR 601.601(a)(3) apply to the hearing.
Persons that wish to present oral comments at the hearing must
submit written comments by July 20, 1995 and submit an outline of the
topics to be discussed and the time to be devoted to each topic by July
12, 1995.
A period of 10 minutes will be allotted to each person for making
comments.
An agenda showing the scheduling of the speakers will be prepared
after the deadline for receiving outlines has passed. Copies of the
agenda will be available free of charge at the hearing.
Drafting Information.
The principal author of these proposed regulations is John M.
Aramburu of the Office of Assistant Chief Counsel (Income Tax and
Accounting). However, other personnel from the IRS and Treasury
Department participated in their development.
List of Subjects in 26 CFR Part 1
Income taxes, Reporting and recordkeeping requirements.
Proposed Amendments to the Regulations
Accordingly, 26 CFR part 1 is proposed to be amended as follows:
PART 1--INCOME TAXES
Paragraph 1. The authority citation for part 1 is amended by adding
entries in numerical order to read as follows:
Authority: 26 U.S.C. 7805 * * *
Section 1.168(h)-1 also issued under 26 U.S.C. 168.
Section 1.168(i)-2 also issued under 26 U.S.C. 168. * * *
Par. 2. Sections 1.168(h)-1 and 1.168(i)-2 are added to read as
follows:
Sec. 1.168(h)-1 Like-kind exchanges involving tax-exempt use property.
(a) Scope. (1) This section applies with respect to a direct or
indirect transfer of property among related persons, including
transfers made through a qualified intermediary (as defined in
Sec. 1.1031(k)-1(g)(4)) or other unrelated person, (a transfer) if--
(i) Section 1031 applies to any party to the transfer or to any
related transaction; and
(ii) A principal purpose of the transfer or any related transaction
is to avoid or limit the application of the alternative depreciation
system (within the meaning of section 168(g)).
(2) For purposes of this section, a person is related to another
person if they bear a relationship specified in section 267(b) or
section 707(b)(1).
(b) Allowable depreciation deduction for property subject to this
section--(1) In general. Property (tainted property) transferred
directly or indirectly to a taxpayer by a related person (related
party) as part of, or in connection with, a transaction in which the
related party receives tax-exempt use property (related tax-exempt use
property) will, if the tainted property is subject to an allowance for
depreciation, be treated in the same manner as the related tax-exempt
use property for purposes of determining the allowable depreciation
deduction under section 167(a). Under this paragraph (b), the tainted
property is depreciated by the taxpayer over the remaining recovery
period of, and using the same depreciation method and convention as
that of, the related tax-exempt use property.
(2) Limitations--(i) Taxpayer's basis in related tax-exempt use
property. This section applies only with respect to so much of the
taxpayer's basis in the tainted property as does not exceed the
taxpayer's adjusted basis in the related tax-exempt use property prior
to the transfer. Any excess of the taxpayer's basis in the tainted
property over its adjusted basis in the related tax-exempt use property
prior to the transfer is treated as property to which this section does
not apply. This paragraph (b)(2)(i) does not apply if the related tax-
exempt use property is not acquired from the taxpayer (e.g., if the
taxpayer acquires the tainted property for cash but section 1031
nevertheless applies to the related party because the transfer involves
a qualified intermediary).
(ii) Application of section 168(i)(7). This section does not apply
to so much of the taxpayer's basis in the tainted property as is
subject to section 168(i)(7).
(c) Related tax-exempt use property. (1) For purposes of paragraph
(b) of this section, related tax-exempt use property includes--
(i) Property that is tax-exempt use property (as defined in section
168(h)) at the time of the transfer; and
(ii) Property that does not become tax-exempt use property until
after the transfer if, at the time of the transfer, it was intended
that the property become tax-exempt use property.
(2) For purposes of determining the remaining recovery period of
the related tax-exempt use property in the circumstances described in
paragraph (c)(1)(ii) of this section, the related tax-exempt use
property will be treated as having, prior to the transfer, a lease term
equal to the term of any lease that causes such property to become tax-
exempt use property.
(d) Examples. The following examples illustrate the application of
this section. The examples do not address common law doctrines or other
authorities that may apply to recharacterize or alter the effects of
the transactions described therein. Unless otherwise indicated, parties
to the transactions are not related to one another.
Example 1. (i) X owns all of the stock of two subsidiaries, B
and Z. X, B and Z do not file a consolidated federal income tax
return. On May 5, 1995, B purchases an aircraft (FA) for $1 million
and leases it to a foreign airline whose income is not subject to
United States taxation and which is a tax-exempt entity as defined
in section 168(h)(2). On the same date, Z owns an aircraft (DA) with
a fair market value of $1 million, which has been, and continues to
be, leased to an airline that is a United States taxpayer. Z's
adjusted basis in DA is $0. The next day, at a time when each
aircraft is still worth $1 million, B transfers FA to Z (subject to
the lease to the foreign airline) in exchange for DA (subject to the
lease to the airline that is a United States taxpayer). Z realizes
gain of $1 million on the exchange, but that gain is not recognized
pursuant to section 1031(a) because the exchange is of like-kind
properties. Assume that a principal purpose of the transfer of DA to
B or of FA to Z is to avoid the application of the alternative
depreciation system. Following the exchange, Z has a $0 basis in FA
pursuant to section 1031(d). B has a $1 million basis in DA.
(ii) B has acquired property from Z, a related person; Z's gain
is not recognized pursuant to section 1031(a); Z has received tax-
exempt use property as part of the transaction; and a principal
purpose of the transfer of DA to B or of FA to Z is to avoid the
application of the alternative depreciation system. Accordingly, the
transaction is within the scope of this section. Pursuant to
paragraph (b) of this section, B must recover its $1 million basis
in DA over the remaining recovery period of, and using the same
depreciation method and convention as that of, FA, the related tax-
exempt use property.
(iii) If FA did not become tax-exempt use property until after
the exchange, it would still be related tax-exempt use property and
paragraph (b) of this section would apply if, at the time of the
exchange, it was intended that FA become tax-exempt use property.
Example 2. (i) X owns all of the stock of two subsidiaries, B
and Z. X, B and Z do not file a consolidated federal income tax
return. B and Z each own identical aircraft. B's aircraft (FA) is
leased to a tax-exempt entity as defined in section 168(h)(2) and
has a fair market value of $1 million and an adjusted basis of
$500,000. Z's aircraft (DA) is leased to a United States taxpayer
and has a fair market value of $1 million and an adjusted basis of
$10,000. On May 1, 1995, B and Z exchange aircraft, subject to their
respective leases. B realizes gain of $500,000 and Z realizes gain
of $990,000, but neither person recognizes gain because of the
operation of [[Page 19871]] section 1031(a). Moreover, assume that a
principal purpose of the transfer of DA to B or of FA to Z is to
avoid the application of the alternative depreciation system.
(ii) As in example 1, B has acquired property from Z, a related
person; Z's gain is not recognized pursuant to section 1031(a); Z
has received tax-exempt use property as part of the transaction; and
a principal purpose of the transfer of DA to B or of FA to Z is to
avoid the application of the alternative depreciation system. Thus,
the transaction is within the scope of this section even though B
has held tax-exempt use property for a period of time and, during
that time, has used the alternative depreciation system with respect
to such property. Pursuant to paragraph (b) of this section, B,
which has a substituted basis determined pursuant to section 1031(d)
of $500,000 in DA, must depreciate the aircraft over the remaining
recovery period of FA, using the same depreciation method and
convention. Z holds tax-exempt use property with a basis of $10,000,
which must be depreciated under the alternative depreciation system.
(iii) Assume the same facts as in paragraph (i) of this example,
except that B and Z are members of an affiliated group that files a
consolidated federal income tax return. Of B's $500,000 basis in DA,
$10,000 is subject to section 168(i)(7) and therefore not subject to
this section. The remaining $490,000 of basis is subject to this
section.
(e) Effective date. This section applies to transfers made on or
after April 20, 1995.
Sec. 1.168(i)-2 Lease term.
(a) In general. For purposes of section 168, a lease term is
determined under all the facts and circumstances. Paragraph (b) of this
section and Sec. 1.168(j)-1T, Q&A 17, provide rules that apply to
determine whether a period of time not included in the stated duration
of an original lease (additional period) is included in the lease term,
under certain circumstances. These rules do not prevent the inclusion
of an additional period in the lease term in other circumstances.
(b) Lessee retains financial obligation. (1) An additional period
of time during which a lessee may not continue to be the lessee will
nevertheless be included in the lease term if the lessee (or a related
person) has agreed that one or both of them will or could be obligated
to make a payment of rent or a payment in the nature of rent with
respect to such period.
(2) For the purposes of this paragraph (b), a payment in the nature
of rent includes a payment intended to substitute for rent or to fund
or supplement the rental payments of another. For example, a payment in
the nature of rent includes a payment of any kind that is required to
be made in the event that--
(i) The leased property is not leased for the additional period;
(ii) The leased property is leased for the additional period under
terms that do not satisfy specified terms and conditions;
(iii) There is a failure to make a payment of rent with respect to
such additional period; or
(iv) Circumstances similar to those described in paragraph
(b)(2)(i), (ii), or (iii) occur.
(3) For the purposes of this paragraph (b), de minimis payments
will be disregarded.
(c) Related person. For purposes of paragraph (b) of this section,
a person is related to the lessee if such person is described in
section 168(h)(4).
(d) Changes in status. Section 168(i)(5) (changes in status)
applies if an additional period is included in a lease term under this
section and the leased property ceases to be tax-exempt use property
for such additional period.
(e) Example. The following example illustrates the application of
this section. The example does not address common law doctrines or
other authorities that may apply to cause an additional period to be
included in the lease term or to recharacterize a lease as a
conditional sale or otherwise for federal income tax purposes. Unless
otherwise indicated, parties to the transactions are not related to one
another.
Example. Financial obligation with respect to an additional
period.--(i) Facts. X, a taxable corporation, and Y, a foreign
airline whose income is not subject to United States taxation, enter
into a lease agreement under which X agrees to lease an aircraft to
Y for a period of 10 years. The lease agreement provides that, at
the end of the lease period, Y is obligated to find a subsequent
lessee (replacement lessee) to enter into a subsequent lease
(replacement lease) of the aircraft from X for an additional 10-year
period. The provisions of the lease agreement require that any
replacement lessee be unrelated to Y and that it not be a tax-exempt
entity as defined in section 168(h)(2). The provisions of the lease
agreement also set forth the basic terms and conditions of the
replacement lease, including its duration and the required rental
payments. In the event Y fails to secure a replacement lease, the
lease agreement requires Y to make a payment to X in an amount
determined under the lease agreement.
(ii) Application of this section. The lease agreement between X
and Y obligates Y to make a payment in the event the aircraft is not
leased for the period commencing after the initial 10-year lease
period and ending on the date the replacement lease is scheduled to
end. Accordingly, pursuant to paragraph (b) of this section, the
term of the lease between X and Y includes such additional period,
and the lease term is 20 years for purposes of section 168.
(ii) Facts modified. Assume the same facts as in paragraph (i)
of this example, except that Y is required to guarantee the payment
of rentals under the 10-year replacement lease and to make a payment
to X equal to the present value of any excess of the replacement
lease rental payments specified in the lease agreement between X and
Y, over the rental payments actually agreed to be paid by the
replacement lessee. Pursuant to paragraph (b) of this section, the
term of the lease between X and Y includes the additional period,
and the lease term is 20 years for purposes of section 168.
(iv) Changes in status. If, upon the conclusion of the stated
duration of the lease between X and Y, the aircraft either is
returned to X or leased to a replacement lessee that is not a tax-
exempt entity as defined in section 168(h)(2), the subsequent method
of depreciation will be determined pursuant to section 168(i)(5).
(f) Effective date. This section applies to leases entered into on
or after April 20, 1995.
Margaret Milner Richardson,
Commissioner of Internal Revenue.
[FR Doc. 95-9946 Filed 4-20-95; 8:45 am]
BILLING CODE 4830-01-M
