department of the treasury_department of the treasury internal_revenue_service internal_revenue_service washington d c washington d c office of office_of_chief_counsel chief_counsel date number release date cc psi b01 postf-149350-01 uilc memorandum for associate area_counsel cc lm ctm la2 from associate chief_counsel passthroughs special industries subject leasing transaction this chief_counsel_advice responds to your memorandum dated date in accordance with sec_6110 of the internal_revenue_code this chief_counsel_advice should not be cited as precedent legend a b c trust equipment lender foundation appraiser currency a country c d e f g h postf-149350-01 i j z x w v u t date date date date date date date dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure equipment cost amount issues with respect to the transactions described below whether the transactions lack economic_substance alternatively whether the transactions should be recharacterized as a financing rather than a sale-leaseback whether a received original_issue_discount income as a result of the transactions whether a is liable for negligence penalties pursuant to sec_6662 for entering into the transactions conclusion sec_1 the facts set forth below suggest that the transactions lack economic_substance and should not be respected alternatively the transactions described below should be recharacterized as a financing rather than a sale-leaseback postf-149350-01 if the transaction can be described as a sale-leaseback a received original_issue_discount income as a result of the transactions a is liable for negligence penalties pursuant to sec_6662 for entering into the transactions facts pursuant to a participation_agreement dated date a b lender and trust1 entered into a purported sale-leaseback transaction a is a u s_corporation b’s core business is c and is wholly-owned by the government of country c on date b sold the equipment to trust and simultaneously leased the equipment back pursuant to the lease and lease agreement the initial term of the lease comprises an interim term of z months followed by a base term the base term commences on date and ends on date the replacement term of the lease commences on date and extends for x years thereafter a invested in the transaction by providing dollar_figure equity contribution which was j percent of the cost of the equipment to trust and by paying the expenses in connection with the transaction trust borrowed from lender the balance of the purchase_price dollar_figure which was d percent of the cost of the equipment also on date the parties entered into a loan agreement lease agreement lease supplement swap agreement custodial agreement and additional agreement sec_2 to effectuate the participation_agreement to finance the purported purchase of the equipment a entered into a loan agreement with lender and trust the loan and security_agreement is dated date under the loan and security_agreement trust issued loan certificates to lender and pledged the loan estate3 as security for the loan certificates the proceeds of the loan certificates were to be used by trust to pay for a portion of the cost of the equipment pursuant to the loan agreement lender agreed to lend to trust d percent of the cost of the equipment subject_to the lease which was equal to dollar_figure payments on the loan certificates were to be made solely from the loan estate a entered into a_trust agreement with trust on date authorizing trust to execute all documents and rights and perform all of a’s duties with respect to this transaction 2these agreements will be collectively referred to as the documents 3the loan estate consists of the following trust's rights and interests in the equipment the documents involved in the sale-leaseback transaction all amounts of rent due under the lease any moneys arising out of the documents that are required to be deposited on trust's account and any other_property or rights of trust arising out of the documents involved in the sale-leaseback transaction postf-149350-01 b sold the equipment to trust pursuant to a deed of conveyance trust pledged the equipment and the lease to lender as collateral for trust's loan from lender trust agreed to pay all of the transaction costs trust and lender agreed that they would not take any_action that would increase the interest rate in the loan agreement which would in turn affect b’s rent obligation under the lease the parties further agreed that they could not exit from the agreement and could not transfer any of the property and or leases and or loans involved in the agreement unless the transferee agreed to undertake the transferor's obligations under the participation_agreement the lease sets forth a formula for calculating the rent due each month nonetheless the lease agreement provides that the amount of rent due will at a minimum be sufficient to pay the principal installment and accrued principal due on all the loan certificates outstanding under the loan agreement no lease payments were due during the interim term generally lease payments were due biannually from date to date additionally no lease payment was due on date the lease is a net_lease and b is liable for all costs and expenses in connection with the equipment for construction delivery ownership use possession registration control subleasing operation maintenance repair insurance improvement and return of the equipment according to the appraisal the equipment has a useful_life of approximately w years which exceeds the base term by v years even if the term of a new lease is aggregated with the lease to b the combined lease_term is u years which is t years less than the equipment's useful_life in accordance with the lease b will cause each piece of equipment to be serviced repaired maintained overhauled and tested during the term of the lease which should allow the equipment to reach or exceed the estimated_useful_life according to the loan agreement the lease specifies that b pay directly to lender b’s rent obligations to trust at the address specified by lender pursuant to the loan agreement trust agreed that when trust received money that was part of the loan estate_trust would transfer such funds to lender lender and b entered into a currency swap transaction swap purportedly to protect b from the currency exchange risk involved in making its lease obligation payments in u s dollars rather than currency a pursuant to the swap agreement fixed interest payment obligations were swapped for floating rate payment obligations b gave lender an amount equivalent to dollar_figure additionally lender was obligated to pay b a stream of payments in u s dollars the termination_date for the stream of payments for the swap agreement is date the swap agreement payments from lender to b were due biannually each year from date through date on date the amount due under the swap agreement would be dollar_figure postf-149350-01 as a result of all of the above the stream of payments due on the loan agreement lease agreement and swap agreement are equivalent in amount and are due and payable on the same dates except that on the first payment_date the lease payment exceeds the loan and swap payments b and a entered into a tax indemnity agreement on date pursuant to the tax indemnity agreement b and a agreed to the following a will be treated as the owner of the trust estate and will be required to take into account in computing its taxable_income all items of income gain loss and deduction flowing from the trust estate the lease will be treated as a true lease by trust as owner and lessor to b and the obligations on the loan will constitute indebtedness of the lessor and a as the beneficial_owner of the equipment will be treated as the purchaser owner and lessor of each piece of equipment and will be entitled to depreciation_deductions for the equipment interest deductions on the loan and amortization of transaction expenses related to the lease significantly at the end of the base term the lease agreement requires b to exercise one of the three following options to purchase the equipment pursuant to a purchase option to cause a new lessee to enter into a new lease pursuant to a new lease option or to return the equipment to trust pursuant to the return option the purchase option assuming all rents due were paid and the loans were not defaulted on date b could purchase the equipment from trust for a price equal to e percent of the cost of the equipment or dollar_figure additionally b would pay all the unpaid rent due and payable as of date when b paid these amounts rent would stop accruing the term of the lease would terminate and title to the equipment would be conveyed to b additionally trust would request that upon payment of all amounts due under the loan agreement and upon termination of the loan agreement lender would release trust from its liabilities under the loan agreement and related pledge agreements at b's expense trust would execute and deliver to b the appropriate documents conveying trust's right title and interest in and to the equipment to b or b's designee b entered into an agreement with foundation purportedly to protect itself from currency fluctuation risk by providing a source of u s dollars to pay the purchase postf-149350-01 option_price if b chooses to exercise the purchase option on date b transferred funds from the equity contribution to the foundation foundation used the funds to purchase two treasury strips the first strip matured in an amount equal to the net rent amount due on date the net rent equals the amount by which a lease payment exceeds a loan payment the second strip matured on date in an amount equal to the net purchase option_price the net purchase option_price is the extent to which the purchase option_price would exceed the principal and interest scheduled to be paid on the loan certificates on date on date the purchase option_price will exceed the principal and interest scheduled to be paid on the loan certificates in an amount equal to the amount that the second treasury strip will mature to the new lease option to exercise the new lease option b would have to find a new replacement lessee new lessee who would use the equipment in its business lease the equipment to another business sublease the equipment to another entity or enter into subleases for terms of less than three years with sublessees that are tax exempt entities the new lease would begin on date and would extend for a period of x years or less b could compensate the new lessee to induce it to enter into the new lease the rental payments on the new lease must preserve trust's net economic return so that trust's net economic return is the same as it was under the original lease the equipment must be delivered in country c at the commencement of the new lease if days prior to the expiration date of the base term of the lease trust and the new lessee have not entered into a new lease then no later than days before the expiration date of the base term of the lease b will give irrevocable notice to trust of its election to exercise the return option or the purchase option if either b gives notice that it is electing the new lease option or trust and new lessee have not agreed to a new lease at least days prior to the expiration date of the base term of the lease trust may unilaterally make a preemptive election to require the return of the equipment on the expiration date of the base term of the lease in its notice of making a preemptive election b must agree to pay lender all amounts due and payable on date under the loan agreement if trust exercises this preemptive election b will have to return the equipment the return option if b exercises the return option then b must return the equipment to trust on date on date b will have to pay trust all the rent due and payable on that date and a lump sum payment trust would use commercially reasonable efforts to sell and 4the lump sum payment is equal to the appraisal’s projected fair_market_value of the equipment over f percent of the equipment cost where the equipment cost equals equipment cost the appraisal projects that the fair_market_value of the equipment on date will be i percent of postf-149350-01 dispose_of the equipment to the highest bidder at auction if the loan certificates have been repaid in full then the proceeds of the sale in excess of f percent of the equipment’s cost will be paid to b up to the amount of the lump sum payment however if at trust's option trust retained the equipment and the entire principal_amount and accrued interest of the loan certificates has been paid or the interest rate has been reset or the loan certificates have been purchased at par plus accrued interest through date then trust will pay b an amount equal to the fair_market_value of the equipment in excess of f percent of the equipment’s cost up to the amount of the lump sum payment according to the appraisal of the equipment obtained by a from appraiser b will not be under any economic compulsion to exercise any particular option thus it was not possible for the appraisal to conclude which option a would be most likely to exercise at the end of the lease_term law and analysis i whether the sale-leaseback transaction lacks economic_substance in order to be respected a transaction must have economic_substance separate and distinct from the economic benefit achieved solely by tax reduction if a taxpayer seeks to claim tax benefits which were not intended by congress by means of transactions that serve no economic purpose other than tax savings the doctrine_of economic_substance is applicable 31_f3d_117 3d cir 861_f2d_494 7th cir aff’g 87_tc_1087 364_f2d_734 2d cir aff’g 44_tc_284 acm partnership v commissioner tcmemo_1997_115 aff’d in part and rev’d in part 157_f3d_231 3d cir whether a transaction has economic_substance is a factual determination 338_us_451 this determination turns on whether the transaction is rationally related to a useful nontax purpose that is plausible in light of the taxpayer’s conduct and useful in light of the taxpayer’s economic situation and intentions the utility of the stated purpose and the rationality of the means chosen to effectuate it must be evaluated in accordance with commercial practices in the relevant industry 89_tc_986 acm partnership supra a rational relationship between purpose and means ordinarily will not be found unless there was a reasonable expectation that the nontax benefits would be at least commensurate with the transaction costs yosha supra acm partnership supra equipment cost i percent of the equipment cost equals dollar_figure the lump sum payment is equal to h percent of equipment cost which equals dollar_figure postf-149350-01 in determining if a transaction has economic_substance both the objective economic_substance of the transaction and the subjective business motivation of the taxpayer must be determined acm partnership f 3d pincite 968_f2d_1229 d c cir 909_f2d_1360 9th cir the two inquiries are not separate prongs but are interrelated factors used to analyze whether the transaction had sufficient substance apart from its tax consequences to be respected for tax purposes acm partnership f 3d pincite casebeer f 2d pincite consequently in considering whether a sale-leaseback case has economic_substance the tax_court in 91_tc_838 found the following factors to be particularly significant the presence or absence of arm’s-length price negotiations 87_tc_983 affd 860_f2d_1075 3d cir see also 73_tc_1163 affd 673_f2d_1062 9th cir the relationship between the sales_price and fair_market_value 87_tc_970 helba v commissioner supra pincite7 the structure of the financing helba v commissioner supra pincite1 the degree of adherence to contractual terms helba v commissioner supra pincite and the reasonableness of the income and residual_value projections 81_tc_184 accordingly an equipment sale-leaseback will be considered a sham if it was not motivated by any economic purpose outside of tax considerations and was without any real potential for profit see 752_f2d_89 4th cir courts recognize that offsetting legal obligations or circular cash flows may effectively eliminate any real economic significance of the transaction for instance in 364_us_361 the taxpayer repeatedly borrowed against increases in the cash_value of a bond since the bond and the taxpayer’s borrowings constituted offsetting obligations the taxpayer could never derive any significant benefit from the bond the supreme court found the transaction to be a sham because it would produce no significant economic_effect and had been structured only to provide the taxpayer with interest deductions subsequently the court_of_appeals for the second circuit applied an economic_substance analysis in 364_f2d_734 2d cir affg 44_tc_284 in that case the taxpayer won the irish sweepstakes in an attempt to shelter her winnings from tax she borrowed from two banks and invested the loan proceeds in treasury notes the loans required her to pay interest pincite percent while some treasury notes yielded one-half percent and others yielded postf-149350-01 percent her financial advisers estimated that these transactions would produce a pretax loss of dollar_figure but a substantial after-tax gain the court disallowed the interest deductions because it found that the taxpayer’s purpose in entering into the loan transactions ’was not to derive economic gain or to improve here sic beneficial_interest but was solely an attempt to obtain an interest_deduction as an offset to her sweepstakes winnings id pincite the court stated further that the loan arrangements did not have purpose substance or utility apart from their anticipated tax consequences and that the transactions had no realistic expectation of economic profit id pincite goldstein is significant because unlike many purported tax_shelters the tax-motivated transactions in that case were not fictitious goldstein v commissioner supra pincite- they were real and conducted at arm’s length the taxpayer’s indebtedness was enforceable with full recourse and her investments were exposed to market risk yet the strategy was not consistent with rational economic behavior in the absence of the expected tax benefits other courts have applied the teaching of goldstein in varied settings for example in 94_tc_738 the tax_court denied the taxpayer the tax benefits of a series of treasury bill sale-repurchase transactions because they lacked economic_substance in the transactions the taxpayer bought treasury bills that matured shortly after the end of the tax_year and funded the purchase by borrowing against the treasury bills the taxpayer accrued the majority of its interest_deduction on the borrowings in the first year while deferring the inclusion of its economically offsetting interest_income from the treasury bills until the second year the transactions lacked economic_substance because the economic consequence of holding the treasury bills was largely offset by the economic cost of the borrowings the taxpayer was denied the tax_benefit of the transactions because the real economic impact of the transactions was infinitesimally nominal and vastly insignificant when considered in comparison with the claimed deductions sheldon t c pincite even in cases in which a circular flow of funds was not the predominant feature courts have indicated that a minimal profit should not be conclusive in finding economic_substance or practical economic effects minimal or no profit has been held to be acceptable in highly risky circumstances where a chance for large profits also existed see 928_f2d_745 6th cir 915_f2d_832 2d cir conversely a minimal profit should be less acceptable when a ceiling on profits from a transaction is all but certain thus if tax considerations predominate the courts will find that an equipment_leasing transaction is a sham even if it holds out the promise of minimal profit see 912_f2d_736 4th cir prager v commissioner tcmemo_1993_452 the fact that the taxpayer is willing to accept minimal returns in a postf-149350-01 transaction with little additional profit potential is evidence that the transaction was tax motivated in 157_f3d_231 3d cir the taxpayer entered into a near-simultaneous purchase and sale of debt instruments taken together the purchase and sale had only nominal incidental effects on the taxpayer’s net economic position acm partnership f 3d pincite the taxpayer claimed that despite the minimal net economic_effect the transaction had economic_substance the third circuit_court of appeals held that transactions that do not appreciably affect a taxpayer’s beneficial_interest except to reduce tax are devoid of substance and are not respected for tax purposes acm partnership f 3d pincite the court denied the taxpayer the purported tax benefits of the transaction because the transaction lacked any significant economic consequences other than the creation of tax benefits in addition the court specifically affirmed the tax court’s adjustment of future income to net present_value to determine the profit potential of a transaction under the judicially created economic_substance_doctrine the court rejected the argument that there is no statutory basis for using present values and cited several cases sustaining the use of present_value computations to determine the true profit potential of a transaction in 254_f3d_1014 11th cir the eleventh circuit recently reversed the tax_court on the issue of economic_substance finding that ups' restructuring of its excess-value business had both real economic effects and a business_purpose the court reasoned that setting up a transaction that otherwise has economic_substance with tax planning in mind is permissible as long as it figures in a bona_fide profit-seeking business_purpose we do not believe that this opinion will have a negative effect on the instant case because for the reasons articulated below we do not believe that the transactions had a bona_fide profit-seeking business_purpose also unlike ups a is not in c in business moreover the eleventh circuit recently affirmed the tax court's determination that a transaction entered into by the taxpayer was a substantive sham 254_f3d_1313 11th cir in 277_f3d_778 5th cir the fifth circuit found that compaq made a pretax profit and had a non-tax business_purpose on royal dutch adr transactions see also ies indus v united_states 253_f3d_350 8th cir while these cases have not changed our analysis in the instant case we recommend that you carefully scrutinize any claim of pretax return and determine if it is insubstantial when compared to the post-tax returns a the circular flows of funds involved in the sale-leaseback transaction entered into by a_trust b and lender illustrates that a had no postf-149350-01 subjective profit_motive and the transactions had no objective economic_substance on the funding date the sale leaseback loan and swap transactions all commenced creating two complete circular flows of funds yielding a net_cash_flow of zero according to the documents the following three transfers of dollar_figure took place on the funding date lender lent dollar_figure to trust trust contributed the dollar_figure together with the equity contribution from a to b for the purchase of the equipment and b transferred dollar_figure to lender pursuant to the swap agreement accordingly dollar_figure ended where it started with lender additionally according to the documents the following three streams of payments were agreed to and initiated as of the funding date pursuant to the lease agreement b would pay lease payments to trust for use of the equipment pursuant to the loan agreement trust would make loan payments to lender for principal and interest owed on the purported dollar_figure loan from lender to trust and the loan agreement also provided that b would pay the lease payments it owed trust directly to lender and lender would make payments to b pursuant to the swap agreement the amounts of all of the payments were equivalent and the payments were all due on the same date however the lease payment made on date exceeded the amount of the loan payments and swap payments due on date except for the payment made on date the three streams of payments yielded a net_cash_flow of zero thus a does not appear to have an expectation of profit from the rental payments independent of tax benefits the custodial agreement entered into by b and the foundation completed the circular flow of funds b transferred funds from the equity contribution to the foundation the foundation used the funds from the equity contribution to purchase two treasury strips one strip matured to the net rent due on the first lease payment the second strip matured to the net purchase option_price in the amount of dollar_figure the remaining portion of the purchase option_price dollar_figure is part of another circular flow of funds on date the amount due from a to lender outstanding on the loan certificates is dollar_figure and the amount due from lender to b on the swap agreement also equals dollar_figure on date the dollar_figure makes a complete circle between the three parties to the transaction with no net outflow of cash from any of the parties accordingly the amount of the matured treasury strip provided b with sufficient cash to exercise the purchase option_price without any further outlay of cash by b thus a has no risk that b would have insufficient funds to exercise the purchase option on date additionally b has business motives to reacquire the equipment the acquisition of the equipment was part of b’s modernization program furthermore b is in the business of c in country c and is the likely party to wish to operate the equipment postf-149350-01 since a had no opportunity to earn a profit on the deal during the lease_term the only opportunity for a to earn a profit was on date however the following analysis of the three options shows that a would not earn a profit on date either the purchase option the purchase option is the most economically preferable option by drawing on the funds held by foundation by date b would have the funds necessary to exercise the purchase option without any additional costs if the equipment appreciated to a fair_market_value greater than the purchase option_price b acting rationally would exercise the purchase option to take advantage of the bargain price if the equipment depreciated to a fair_market_value lower than the purchase option_price b acting rationally would still exercise the purchase option because as will be illustrated in the following discussion the purchase option is still the most economically advantageous option additionally b has a business motive to exercise the purchase option and retain the equipment if b exercises the purchase option on date a receives a very small profit on its equity contribution the purchase option_price is dollar_figure however a will owe lender dollar_figure leaving a a net return of dollar_figure which is the net purchase option_price on date lender will owe b dollar_figure pursuant to the swap agreement accordingly the dollar_figure goes in a complete circle and ends where it started with b b can take the funds from the treasury strip that matures on date to dollar_figure to pay the net purchase option_price accordingly b has no additional outlay of costs to exercise the purchase option the new lease option it also appears that exercising the new lease option would put b in a worse position economically than exercising the purchase option under the new lease option the lease payments were predetermined as of the funding date thus if b were to find a new lessee the parties would not be able to renegotiate the new lease payments so that they would be in accord with the then fair_market_value if b wished to find a new lessee and the equipment appreciated in value so that the new lease payments were less than fair_market_value b acting rationally would exercise the purchase option and then lease the equipment itself to take advantage of the appreciation in value if the equipment depreciated in value so that the new lease payments would be a higher price than the market would otherwise bear b would have to pay an inducement to the new lessee in this circumstance b would have to pay the inducement and not have the equipment acting rationally we believe that b would exercise the purchase option and then lease the equipment itself in doing so b would be able to find another entity to lease and operate the equipment but would not have any further costs with respect to the sale-leaseback transaction with trust postf-149350-01 however there are significant litigation hazards unless it can demonstrate that the new lease option is purely illusory the new lease option could be viewed as a negotiated protection inserted into the lease agreement for the trust and lender the new lease option offers the protection of a long term fixed rate of return based on a lease_term of as many as x years for the equipment in the event b does not exercise its purchase option for b the new lease option offers protection against being forced to either buy the equipment or walk away with a large expenditure and no equipment nonetheless we believe that the rational choice is the purchase option the return option exercising the return option would put b in a worse position economically than exercising the purchase option if b exercises the return option then b will be required to pay a the lump sum payment equal to h percent of the original equipment cost which is dollar_figure and a will sell the equipment at auction a will pay b proceeds from a’s sale of the equipment greater than f percent of the equipment cost and up to the amount of the lump sum payment if b exercised the return option b would have funds available in the foundation to pay the lump sum however b would not have any equipment pursuant to the terms of the return option b would get some of a’s equipment sale proceeds however b would not be able to receive the first dollar_figure of a’s equipment sales proceeds and would not be able to receive more than the lump sum amount b would not be able to recoup a sufficient amount to purchase the same or alternative equipment thus b would be in a worse economic position if it exercised the return option than if it exercised the purchase option since it is the economically rational choice to select the purchase option regardless of whether the property appreciates or depreciates in value a has no opportunity to profit from appreciation in the property nor to suffer a loss from depreciation in the property a's only net return on the transaction is the net rent paid on date and the net purchase option_price paid on date those amounts are very small compared to the tax benefits that a enjoys during the lease_term a minimal profit should not be conclusive in finding economic_substance or practical economic effects minimal or no profit has been held to be acceptable in highly risky circumstances where a chance for large profits also existed see 928_f2d_745 6th cir 915_f2d_832 2d cir however a minimal profit should conversely be less acceptable when a ceiling on profits from a transaction is all but certain a's willingness to accept minimal returns in a transaction with a limitation on profit potential demonstrates that the transaction was tax motivated thus a minimal profit in an equipment_leasing transaction will not prevent the finding f percent of the equipment cost is dollar_figure postf-149350-01 of a sham if tax considerations predominate see 912_f2d_736 4th cir prager v commissioner tcmemo_1993_452 arguably the only motivation for this transaction was a's desire to purchase tax benefits this transaction could reasonably be viewed as a sale of tax benefits by an entity which cannot use them to a taxable entity which can in exchange for its equity_investment a received a substantially greater amount of tax benefits by claiming depreciation amortization and interest_expenses each year over the life of the transaction because it appears likely that trust will exercise the purchase option and all amounts have been pre-funded this transaction shares many factual similarities with other cases decided under economic_substance principles see knetsch supra offsetting legal obligations in form this transaction was a sale leaseback between a and b financed by a loan from lender with an embedded currency swap with the purported purpose of protecting b from currency exchange risk in the instant case a currency swap was used to complete a circular flow of funds a currency swap agreement is two offsetting loans in two different currencies by substituting a currency swap between lender and b for a loan from b to lender the transaction embeds what is in substance a loan from lender to b in what would otherwise be a sham_transaction involving a circular flow of funds all the cash flows were circular and yielded net_proceeds of zero thus a had no economic risk in undertaking the transaction and a has a cap on the possibility of earning a profit from this transaction or bearing any significant costs either during or at the expiration of the lease_term this series of transactions lacked the potential for any significant economic consequences and therefore lacked economic_substance and had no business_purpose see eg rice's toyota world nicole rose levy for this reason we believe economic_substance principles may be applied in this case accordingly a is not entitled to deduct the depreciation_deductions claimed for the equipment purportedly purchased by a pursuant to the transaction further the interest deductions at issue in the instant case stem directly from the loan taken by a through trust the loan cannot be separated from the purported sale transaction whose sole purpose was for a to obtain tax benefits as such the loan was an integral part of the transaction and a deduction for the interest on the loan is not allowable under sec_163 ii whether the transaction should be treated as a financing rather than as a sale-leaseback alternatively the transaction should be treated as a financing whether a sale- leaseback is respected for federal_income_tax purposes is not determined by the labels postf-149350-01 of the parties in 308_us_252 the supreme court stated that taxation is concerned with substance and realities and formal written documents are not rigidly binding u s pincite in lazarus the taxpayer conveyed property to a bank and then leased the property back for a term of ninety-nine years the court concluded that the transaction though structured in the form of a sale-leaseback was in substance a loan secured_by the property it held that the taxpayer was the party who bears the burden of exhaustion of capital_investment in the property and thus is entitled to deduct depreciation regardless of the fact that the taxpayer had by agreement designated another party as the legal owner lazarus stands for the proposition that in the sale-leaseback area the substance of the transaction rather than its form is controlling for federal tax purposes in 435_us_561 the supreme court set forth standards for determining when a sale-leaseback may not be ignored as a sham holding that so long as the lessor retains significant and genuine attributes of the traditional lessor status the form of the transaction adopted by the parties governs for tax purposes id pincite in frank lyon the frank lyon company’s company majority shareholder and board chairman also served on the board_of worthen bank bank the company invested dollar_figure of its own funds to acquire a new office building from the bank and lease it back to the bank for an initial term of years the company financed the remainder of the building with a full recourse loan of dollar_figure obtained from an unrelated insurance_company the rent for the first years equaled the principal and interest payments that would amortize this loan the company also leased the land under the building from the bank for years the bank had the right to renew its lease of the building for eight additional 5-year intervals at a fixed rent making its total potential leasehold years long the bank had the option to purchase the building pincite years and at other points in the lease for the company’s investment with compound interest pincite percent plus repayment of the loan balance the bank also had the option to purchase the building at fair_market_value under certain conditions involving a transfer of the company’s interest under applicable federal and state law the bank was precluded from financing an office building of that magnitude for its own use however the state and federal regulators approved the sale_and_leaseback so long as the bank had an option to purchase the property after years at a fixed price where another party owned the building the government argued that the sale leaseback should be disregarded as a sham because the company was only acting as a conduit to forward rent payments to pay the mortgage and was doing so for a guaranteed return in rejecting the sham argument the court distinguished lazarus because it involved two rather than three parties the third party the lender was necessary to the transaction in frank lyon because of the restrictions on borrowing imposed on the bank the court found it significant that the bank could not legally own and finance its own building the court emphasized that the company had assumed recourse_liability in the debt and thus it postf-149350-01 had exposure to real and substantial risk moreover the court rejected the contention that the purchase options allowed the bank to accumulate equity in the property over time because the bank was free to walk away without further obligation without exercising any lease extension and alternatively the option prices represented fair estimates of market_value on applicable dates the court also noted that the company would be free to do with the building as it chose if the lease were not extended but would remain liable for the ground rent the court concluded pincite- that where there is a genuine multi-party transaction with economic_substance which is compelled or encouraged by business or regulatory realities is imbued with tax-independent considerations and is not shaped solely by tax-avoidance features that have meaningless labels attached the government should honor the allocation of rights and duties effectuated by the parties expressed another way so long as the lessor retains significant and genuine attributes of the traditional lessor status the form of the transaction adopted by the parties governs for tax purposes what those attributes are in any particular case will necessarily depend upon its facts the decision in frank lyon rested strongly upon the risks incurred by the company including the recourse_debt the ground rent and the possibility the lease would not be extended significantly without any compensation to the company and the rewards of the use of the property if the bank did not extend the lease such risks gave the company the significant attributes of a lessor no similar risks were incurred in the present case here the loan is subject_to satisfaction and the risks as well as the potential gains from the transaction have been carefully collared to limit both potential loss and profit by a while it is true that frank lyon suggests rental payments in a lease may match up to the amount of principal and interest necessary to amortize a loan that case involved the construction of a building that implicitly at least could be used by any lessee that the payments match up therefore is not significant unless it reinforces the view that the lessor’s risks and rewards indicate the lessor is not the owner of the property significantly therefore the below analysis will show that the risks and the potential gains from the transaction to a have been carefully collared to limit both potential loss and profit to a moreover in frank lyon the bank was precluded by federal and state regulations from financing and constructing the building itself no such restrictions are present in this case because b owned the equipment prior to the effective date of the transaction here accordingly although the legal principles of frank lyon that is focusing on the substance of the transaction are appropriate to an analysis of this transaction that case is factually distinguishable from the present case postf-149350-01 despite the government’s inability to demonstrate on the facts in frank lyon that the company was simply financing the bank’s building purchase many courts have addressed whether a sale-leaseback was in substance a financing that is whether the purported owner lessor simply lent money to the purported seller lessee a particularly instructive example is pacific gamble robinson and affiliated companies v commissioner t c memo there petitioner per sold its yakima apple facility to third birkenhead properties inc for dollar_figure dollar_figure of which was financed with a nonrecourse note payable to minnesota mutual_life_insurance_company at the same time the facility was leased back to per for a 25-year primary term and six 5-year renewal terms during the primary lease_term the rental payments equaled the payments due from third birkenhead to minnesota mutual on the note third birkenhead had the right to require per to buy the facility at the end of the basic lease_term under a predetermined price schedule for a stated purchase_price nearly equal to the then outstanding balance owed on the note this lease provision was amended to require per to offer to buy the facility at the end of the primary term for the greater of its then fair_market_value or the outstanding balance owed on the note it was unlikely that the fair_market_value of the facility would exceed the outstanding balance on the note new notes were later issued that provided that the lenders would look solely to the facility and to the sums due from per under the lease for repayment on the notes under the new notes per agreed to pay the installments when they became due the tax_court disregarded the form of the transaction as a sale-leaseback as inconsistent with its economic_substance it held that per was in substance the owner of the facility for federal tax purposes the court cited several factors to support its holding as a matter of economic reality per the lessee not the lessor was principally liable on the debt per not the lessor retained the primary benefits_and_burdens_of_ownership associated with the facility and the lessor had no reasonable opportunity for economic profit from the transaction absent tax benefits similarly in situations involving the characterization of sale-leaseback transactions the service consistently has held that the substance of a transaction is controlling for federal tax purposes for instance revrul_72_543 1972_2_cb_87 concluded that a transaction in the form of a sale-leaseback is in fact a financing where under the terms of the leaseback the taxpayer-lessee never actually parted with the benefits_and_burdens_of_ownership to the property for federal_income_tax purposes in that ruling the taxpayer a shipping company financed reconstruction of a vessel by selling title to the vessel to the subsidiary of a bank for the vessel's then fair_market_value the subsidiary borrowed the cost of the acquisition and reconstruction from a group of lenders under a charter party an agreement whereby the subsidiary leases the vessel to the taxpayer for use in its transportation business at the same time the subsidiary assigned all of its rights title and interest to the monies due under the charter party to the lenders under the agreement the subsidiary chartered the vessel postf-149350-01 to the taxpayer for a 21-year term at a rental rate sufficient to pay the total costs of acquiring and reconstructing the vessel plus interest over the 21-year period the year term exceeded the vessel's useful_life the taxpayer was at risk for the vessel at all times during this term and had to maintain insurance the charter gave the taxpayer the right to buy the vessel on the 9th anniversary of delivery for a predetermined price equal to the unamortized principal_amount of the loan on that date revrul_72_543 concluded that the taxpayer held the benefits_and_burdens_of_ownership to the vessel since i it was obliged to repay the costs of acquisition and reconstruction plus interest in the form of rentals ii it had to pay the vessel's operating and insurance costs iii it had an option to purchase the vessel for the unamortized principal_amount of the loan at a specific anniversary date and iv the parties intended for legal_title to pass to taxpayer although cast in the form of a sale- leaseback the ruling held that the transaction when viewed in its entirety was a financing_arrangement with ownership of the vessel in the taxpayer thus whether a transaction is a sale a lease or a financing_arrangement is a question of fact which must be ascertained from the intent of the parties as evidenced by the written agreements read in light of the attending facts and circumstances 24_tc_1124 aff’d 241_f2d_288 9th cir the judicial test for determining if a transaction is a sale as opposed to a lease or a financing_arrangement is whether the benefits_and_burdens_of_ownership have passed to the purported purchaser 89_tc_1229 for this purpose the refinements of title are not dispositive 281_us_376 in fact even if the vesting of title in someone other than taxpayer created a prima facie case that the taxpayer was not the owner of certain equipment for depreciation purposes the tax_court in 87_tc_178 n aff'd 833_f2d_303 3d cir acknowledged that the location of title did not mean that it was holding that taxpayer was not the owner instead the location of title meant only that the taxpayer had the burden of producing strong_proof that the other_benefits and burdens of ownership were held by the taxpayer t c pincite the court's opinion in coleman analyzed the benefits_and_burdens_of_ownership of the equipment and concluded that the taxpayers failed to demonstrate that it held the incidents_of_ownership to the equipment the tax_court analyzes the following factors to determine if the benefits_and_burdens_of_ownership pass in a transaction whether legal_title passed whether the parties treated the transaction as a sale whether the purchaser acquired an equity_interest in the property whether the sale contract obligated the seller to execute and deliver a deed and obligated the purchaser to make payments whether the purchaser is vested with the right of possession whether the purchaser pays postf-149350-01 property taxes after the transaction whether the purchaser bears the risk of economic loss or physical damage to the property and whether the purchaser receives the profit from the property's operation retention and sale 77_tc_1221 although the potential for gain and amount of risk have been deemed the pivotal factors the overall concentration should lie on the economic_substance of the transaction 556_f2d_1107 ct_cl the tax_court has also considered the following factors as being relevant to determining whether a sale has occurred that is whether to respect a sale-leaseback the existence of a useful_life of the property in excess of the leaseback term the existence of a purchase option at fair_market_value renewal rental at the end of the leaseback term set at fair market rent and the reasonable possibility that the purported owner of the property can recoup his investment in the property from the income producing potential and residual_value of the property 88_tc_702 citing 84_tc_412 87_tc_926 the tax_court in torres has found the taxpayer’s equity_interest as a percent of the purchase_price to be significant and it further noted that a sale-leaseback involving a net_lease has certain specific characteristics t c pincite b ecause net leases are common in commercial settings it is less relevant that petitioner was not responsible for the payment of property taxes or that petitioner bears less of a risk of loss or damage to the property because the lessee is required to maintain insurance on the property similarly a lessor is normally not vested with the right to possession during the term of the lease and therefore the relevant consideration in this regard is whether the useful_life of the property extends beyond the term of the lease so as to give the purchaser a meaningful possessory right to the property also in a leaseback_transaction it is normal for the lessee to receive profits from the operation of the property while the lessor's receipt of payments is less dependent upon the operation of the property since no one factor is dispositive of the issue of whether a sale has occurred the facts and circumstances determine the importance of each factor for example whether the buyer has acquired an equity_interest in the property may be considered substantive evidence of a sale see 544_f2d_1045 9th cir however a taxpayer who acquires no equity_interest in the property has no depreciable_interest in the property but instead will be viewed as having attempted to acquire mere tax benefits 79_tc_570 in this context equity consists of a positive differential between the fair_market_value of the property and the balance of any loans owed on the property postf-149350-01 equity may also be viewed as the amount of the purchaser's funds at risk in the property thus a true owner has potential for gain_or_loss from increase or decrease in the market_value of the property in contrast a mortgagee's economic return consisting of interest payments and return of principal is generally fixed at the time of the initial transaction irrespective of fluctuations in market_value of the property given these overlapping lists of factors we proceed first to examine the factors set out in grodt mckay and then analyze the factors set out in torres to determine if the benefits_and_burdens_of_ownership pass in a transaction and whether a sale has occurred this analysis will then determine whether a is entitled to the depreciation_deductions a claimed for the equipment purportedly purchased pursuant to the sale- leaseback_transaction postf-149350-01 a grodt mckay factor sec_1 whether legal_title passed pursuant to the participation_agreement and deed of conveyance b sold assigned and transferred to trust all of b's right title and interest in the equipment the participation_agreement further provided that if b elects to exercise the purchase option on date trust shall execute and deliver to b appropriate instruments conveying trust’s right title and interest in and to the equipment to b or its designee even though title passed from b to trust at the outset of the transaction the facts also suggest the likelihood that b will exercise the purchase option to regain all right title and interest to the equipment on date additionally the purchase of the equipment is part of b’s modernization program giving b a business incentive to retain the equipment if b exercises the purchase option on date this feature indicates that title is only held temporarily by trust in a form more akin to holding it as security as such the sale-leaseback transaction looks more like a secured financing than a sale see revrul_72_543 whether the parties treated the transaction as a sale of equipment the documents were prepared in the form of a sale moreover a reported this transaction for federal_income_tax purposes as a sale and claimed united_states tax_ownership of the equipment a is deducting depreciation expenses for the base term and a treated the transaction on its books as an asset purchase pursuant to the tax indemnity agreement b agreed not to claim ownership of the equipment for united_states tax purposes which is consistent with treating the transaction as a sale this factor appears to favor sale-leaseback treatment whether a acquired an equity_interest in the equipment the documents are drafted to indicate that a made a j percent equity contribution to the purchase of the equipment if equity is defined as the difference between the equipment’s fair_market_value and the amount of the loan and assuming the sale price represents fair_market_value then a has an equity_interest equal to j percent of the equipment an owner's equity_interest in property is distinguished from a mortgagee's security_interest in property by the potential for appreciation or depreciation in the value of the property the potential to profit from use of the property at the expiration of the lease_term and the nature of its risk of loss 6331_us_1 postf-149350-01 here a’s funds are more in the nature of principal on a secured financing than an equity_interest in the equipment since as a result of the nature of the three options held by b at the end of the base term it appears that a has capped its right to potential appreciation in the equipment at the difference between the purchase option_price and the amount necessary to repay lender if the value of the equipment at the end of the base term exceeds this differential b acting rationally in its economic_interest will exercise the purchase option and reacquired title to the equipment as discussed above the purchase option is the most economically advantageous option for b to exercise acting rationally b would exercise the purchase option regardless of whether the equipment had appreciated or depreciated in value compared to the projected fair_market_value set forth in the appraisal given b's exercise of the purchase option a is prevented from obtaining a profit from potential appreciation in the fair_market_value and a is protected from suffering a loss due to depreciation in fair_market_value accordingly a’s position is more in the nature of a secured mortgagee rather than as an equity owner see lazarus whether the sale contract obligated b to execute and deliver a deed and obligated a to make payments b transferred to trust all of b's right title and interest in the equipment additionally according to the documents a must make semiannual payments to lender on the loan however pursuant to the loan agreement those payments were to be paid to lender by b in the form of b depositing its lease payments to trust directly to lender moreover since the most economically realistic option for b to exercise on date is the purchase option which will return title to the equipment to b it appears that the documents created a circular delivery of the deed that is it appears that a only has a loan of the deed or bill of sale during the base term after which the title to the equipment returns to b such circular delivery or loan of the deed is more consistent with treating a as holding a security_interest in the equipment see lazarus this view is supported by the flow of funds concerning a which is with the exception of the first lease payment offset by the remaining loan payments with rental income it receives from b this point is further illustrated by the fact that pursuant to the loan agreement b was to deposit its lease payments directly to lender in each instance the amount of the rental income equals the amount of the loan payment and the rent and loan payments are due and payable on the same date if b exercises the purchase option b is essentially lending title of the equipment to trust for a for the base term in substance the deed transfer may only be temporary since it is more than reasonable to contemplate the return of the equipment to b whether the purchaser is vested with the right of possession the right of possession factor favors a financing since there is no indication that the parties ever manifested an intent for trust or a to actually possess the equipment postf-149350-01 generally a sale-leaseback contemplates that the buyer-lessor wants possession of the property at the end of the lease_term in a financing however the mortgagee typically does not want use or possession of the property when a acquired the equipment pursuant to the documents a through trust had no right to sell the equipment to anyone other than b or even hold it out for lease to the highest bidder prior to its leaseback to b in fact b already had possession of the equipment at the time the transaction was entered into all of trust’s activities thus were circumscribed so as to keep the equipment under the possession and control of b at all times b also controls whether a will possess the equipment on date by unilaterally determining which option it will exercise arguably such limitations on possession are inconsistent with the benefits_and_burdens_of_ownership a does not have control to determine if it will ever obtain possession of the equipment in addition the lease prevents trust acting for a from taking possession of the equipment unless necessary to protect its rights as in the event of default these conditions are essentially the same as the conditions in which a secured creditor would take possession of the secured_property see revrul_72_543 however while the documents appear to make possession by a a possibility this possibility is unlikely since b is most likely to exercise the purchase option on date consequently when this transaction is taken as a whole a has not shown any intent to possess the equipment this factor favors financing treatment whether the purchaser pays property taxes after the transaction b is responsible for all property taxes under the participation_agreement b is responsible for all applicable customs duties and stamp taxes and all other taxes in respect of the equipment however this factor is neutral since this is common to net leases see torres t c pincite whether the purchaser bears the risk of economic loss or physical damage as discussed above if the equipment declines in value such that its fair_market_value on date is lower or higher than the fair_market_value projected in the appraisal then b acting rationally will still exercise the purchase option this factor insulates a from suffering a loss due to depreciation in the market place rather the loss would be suffered by b since b would reacquire its equipment at a lesser value thus b is the party that ultimately is affected by market decline the lease requires b to maintain insurance on the equipment and to replace or repair the equipment in the event of damage or destruction these requirements are typical in a net_lease situation nonetheless they do insulate a from obligations in the event of physical loss of the property as noted above regarding the risk of loss of value of the equipment the purchase option_price amount and the rental stream for any new lease apparently were determined by reference to the amount necessary to repay the postf-149350-01 loan and guarantee that a would receive a certain rate of return on the transaction these provisions essentially insulate a from any risk of physical loss of the property further these conditions essentially shift the risks to b b's risk of loss is more like that of an owner mortgagor while a's fixed return and entitlement to payment without regard to damage to the collateral are consistent with the risks of a mortgagee see eg helvering v f_r lazarus co whether the purchaser receives the profit from the property's operation courts have consistently found that the potential for profit or loss on the sale or release of the property is a crucial benefit or burden of owning property 87_tc_1471 at all times after the transaction is initiated b operates the equipment and receives the profit if any therefrom this is consistent with a lessee's right to operate property under a valid lease in this case however as previously discussed the amount b must pay under the purchase option the return option or the new lease option results in either a ceiling on a's potential for profit or a floor under its potential for loss for example if the equipment appreciates to a fair market greater than that projected by the appraisal b will exercise the purchase option as such a's potential profit from the sale-leaseback transaction is capped at the difference between the purchase option_price and the amount owed by trust to lender on date since the purchase option_price is preset as of the funding date a is not able to profit from appreciation in fair_market_value rather b having exercised the purchase option will be able to benefit from appreciation in the fair_market_value this factor indicates that the transaction has the character of a financial arrangement b torres factor sec_1 the existence of a useful_life of property in excess of the leaseback term according to the appraisal the equipment has a useful_life of approximately w years which exceeds the base term by v years even if the term of a new lease is aggregated with the lease to b the combined lease_term is u years which is t years less than the equipment's useful_life in accordance with the lease b will cause each piece of equipment to be serviced repaired maintained overhauled and tested during the term of the lease which should allow the equipment to reach or exceed the estimated_useful_life however since b is expected to exercise the purchase option at the end of the base term the additional useful_life may not benefit a because control of whether to exercise the purchase option rests with b and because the purchase option is the most likely to be exercised by b this factor does not strongly support sale-leaseback treatment the existence of a purchase option at fair_market_value postf-149350-01 the appraisal provides that the fair_market_value at the end of the base term is estimated to be i percent of the cost of the equipment under the lease the purchase option_price is set at e percent of the cost of the equipment thus the purchase option_price exceeds fair_market_value by a small amount nevertheless because the appreciation potential of the equipment is capped by this amount this factor arguably favors treatment as a financing_arrangement renewal rental at the end of the leaseback term set at fair_market_value the rental schedules appear to have been determined by reference to the amount required to repay the loan and equity contribution and to guarantee a’s return on investment this coupled with the fact that b may have to pay an inducement in order to acquire a new lessee indicates that the renewal rent is not set at fair_market_value moreover assuming rental rates increase under the documents trust has the right to reject the new lessee chosen by b and recover the equipment this feature would seem to indicate that trust has some appreciation potential in that it can find its own lessee to rent the equipment at a higher rental rate however if the equipment appreciates in value b could simply exercise the purchase option recover title to the equipment and either use it or release it at the higher rental rate reflected by the equipment's then fair_market_value this factor actually indicates that the risks of a decline or the rewards of an increase in the then fair market rental value of the equipment have shifted to b this shift is inconsistent with the risks and rewards to a lessor associated with the requirement that any renewal or release of property be set at fair_market_value therefore this factor supports treatment of the transaction as a financing_arrangement the reasonable possibility that the purported owner of the property can recoup its investment in the property based on its income-generating potential and residual_value of the property under the structure of the transaction a actually received very little net_income stream during the base term since except for the first lease payment all lease payments made by b equal all loan payments made by trust for principal and interest consequently since the rental stream essentially equals the debt service there is very little income-generating potential to a during the base term accordingly a can only look to either the payment received upon exercise of the purchase option or the return option or to payments under an extension of the lease under the new lease option for the recoupment of and a return on its investment in the event the purchase option is exercised a would only recover its investment out of the purchase option payment and thus its profit is capped at the difference between postf-149350-01 the purchase option_price and the amount owed to lender on date if the new lease option were exercised a would see a positive cash_flow during the new lease_term superficially this factor favors the treatment of the transaction as a sale- leaseback since a would receive a profit on the new lease however as the above analysis indicates the terms of the transaction have shifted the risks and rewards of ownership essentially to b from trust and a only if the transaction continues through the end of the new lease_term and the equipment then returns to trust would a have an uncollared risk of loss and opportunity for appreciation this will likely never occur because it is economically more advantageous for b to exercise the purchase option therefore although a will recoup its investment the specified rate of return and collared risk and reward indicate that it is in the position of a mortgagee not a bona_fide owner since the above factors indicate that a stands more in the position of a mortgagee than a bona_fide owner the benefits_and_burdens_of_ownership did not pass to a as a result of this transaction accordingly the transaction should be treated as a financing rather than as a sale-leaseback as such a is not treated as the owner of the equipment and therefore is not entitled to the depreciation_deductions a claimed on the equipment iii whether a received original_issue_discount income as a result of this purported sale-leaseback transaction if the sale-leaseback transaction lacks economic_substance and the purchase_price option will be exercised a may be required to accrue income on a deemed loan from a to lender sec_1273 a provides t he term ‘original issue discount’ means the excess if any of a the stated_redemption_price_at_maturity over b the issue_price to impute oid income in a sale-leaseback transaction there must be an unconditional obligation to return the principal sum a substantial likelihood is not enough to characterize the purchase option as an unconditional obligation_original_issue_discount oid is imputed on a constant yield basis see sec_1_1272-1 indebtedness is defined for federal_income_tax purposes as an unconditional obligation to pay a sum certain at a fixed maturity_date 248_f2d_399 2nd cir if we successfully argue that the purchase_price will always be exercised a’s equity payment might be appropriately viewed as a loan with the unconditional obligation to repay a principal sum being both the net rent payment due on date and the net purchase option payment due on date it is represented that the net rent payment and the net purchase option payment constitute the return on a’s equity_investment the amount by which the net rent payment and the net purchase option payment exceed the equity payment could be asserted to be oid includable in a’s income if we are unable to prove that a will receive a fixed amount of cash at the end of the transaction we will not be able to deem a loan between a and lender postf-149350-01 thus we should also be able to argue that a’s equity payment is a loan if we demonstrate that either the purchase option or the return option will be exercised whether the purchase option or the return option is exercised a will be receiving an amount that exceeds its equity payment the oid calculation is slightly more complicated if we deem the equity payment a loan with repayment being either the amount of the purchase option and net rent payment or the return option and net rent payment as a loan with alternative payment schedules the rules of sec_1_1272-1 of the income_tax regulations would apply to determine the amount of oid includable in a’s income a accrues interest based on the ownership of the treasury strips only if it can be shown that a has control_over and derives readily realizable economic value from the treasury strips see 366_us_213 the issue_price of the strips is the amount at which the treasury strips were issued as owner of the treasury strips a would include in income the oid on the treasury strips if the sale-leaseback transaction is viewed as a financing between a and lender we believe that a should properly include oid income from the deemed financing the amount of oid income from the deemed financing would be calculated in the same manner as described above under the economic_substance argument iv whether a is liable for penalties pursuant to sec_6662 as a result of this transaction sec_6662 imposes an accuracy-related_penalty equal to twenty percent of the portion of the underpayment attributable to among other things negligence or disregard of rules or regulations and any substantial_understatement_of_income_tax sec_1_6662-2 provides that there is no stacking of the accuracy-related_penalty components and thus the maximum accuracy-related_penalty imposed on any portion of an underpayment is twenty percent the accuracy-related_penalty does not apply to any portion of an underpayment with respect to which it is shown that there was reasonable_cause and that a acted in good_faith sec_6664 a negligence pursuant to sec_6662 and sec_1_6662-3 of the income_tax regulations negligence includes any failure to make a reasonable attempt to comply with the provisions of the internal_revenue_code or to exercise ordinary and reasonable care in the preparation of the tax_return negligence has been defined as the failure to do what a reasonable and ordinary prudent person would do under the circumstances marcello v commissioner 380_f2d_499 5th cir 85_tc_934 sec_1_6662-3 provides that negligence is strongly indicated where a taxpayer fails to make a reasonable attempt to ascertain the correctness of a deduction credit or exclusion on a return that would seem to a reasonable person to be too good to be true under the circumstances where the postf-149350-01 taxpayer is sophisticated the court may still find liable even though highly paid professionals were involved in nicole rose v commissioner t c no tnt the tax_court found the taxpayer was liable for an accuracy related penalty pursuant to sec_6662 for entering into a series of transactions lacking in business_purpose and economic_substance and stating that t he participation of highly paid professionals provides petitioner no protection excuse justification or immunity from the penalties in issue petitioner participated in a clear and obvious scheme to reap the benefits of claimed ordinary business_expense deductions that had no business_purpose and no economic_substance the facts and circumstance of this case reflect no reasonable_cause and no good_faith for petitioner's participation in the transactions before us the tax_court likewise sustained the application of the negligence_penalty in 94_tc_738 stating that the taxpayer intentionally entered into loss-producing repurchase agreements to generate and claim tax benefits b substantial_understatement pursuant to sec_6662 a substantial_understatement_of_income_tax exists for a taxable_year if the amount of the understatement exceeds the greater of ten percent of the tax required to be shown on the return or dollar_figure dollar_figure in the case of corporations other than s_corporations or personal_holding_companies sec_6662 provides that understatements are generally reduced by the portion of the understatement attributable to the tax treatment of items for which there was substantial_authority for such treatment and any item if the relevant facts affecting the item's tax treatment were adequately disclosed in the return or a statement attached to the return and there is a reasonable basis for the taxpayer's tax treatment of the item these exceptions however do not apply to tax_shelter items of corporate taxpayers sec_6662 thus if a corporate taxpayer has a substantial_understatement attributable to a tax_shelter_item the accuracy-related_penalty applies to the understatement unless the reasonable_cause exception applies sec_1_6664-4 discussed below contains special rules relating to the definition of reasonable_cause in the case of a tax_shelter_item of a corporation however sec_6662 which is applicable to the years at issue defines a tax_shelter among other things as a plan or arrangement the principal purpose of which is tax_avoidance_or_evasion c reasonable_cause sec_1_6664-4 provides that the determination of whether a taxpayer acted with reasonable_cause and in good_faith is made on a case-by-case basis generally taking into account all pertinent facts and circumstances the most important factor is generally the extent of the taxpayer's effort to assess its proper tax_liability reliance on professional advice may constitute reasonable_cause and good_faith if under all the circumstances such reliance was reasonable see 469_us_241 the advice must also be based upon all pertinent facts and circumstances and the law relating to those facts and circumstances for example the advice must take into account the taxpayer's purpose and the relative weight of such purpose for entering into a transaction and for structuring a transaction in a particular manner with respect to reasonable_cause for the substantial_understatement_penalty attributable to a corporation's tax_shelter items a corporation is deemed to have acted with reasonable_cause and in good_faith if the corporation had substantial_authority as that term is defined in sec_1_6662-4 for its treatment of the tax_shelter_item and if at the time of filing the return the corporation reasonably believed such treatment was more_likely_than_not the proper treatment sec_1 e i the more_likely_than_not standard can be met by the corporation's good_faith and reasonable reliance upon the opinion of a tax advisor if the opinion is based on the advisor's analysis of the pertinent facts and authorities in the manner described in sec_1_6662-4 and the opinion unambiguously states the advisor's conclusion that there is a greater than fifty percent likelihood the tax treatment of the item will withstand a challenge by the service sec_1_6664-4 a cannot hide behind an appraisal for a transaction lacking in economic_substance and claim that it had reasonable_cause for entering into the transaction nicole rose the circular cash flows and the lack of a valid business_purpose evidence that a's involvement in the sale-leaseback transaction was solely due or primarily motivated by the tax benefits and thus is totally devoid of economic_substance moreover if the transaction lacked economic_substance and or a did not truly acquire the benefits_and_burdens_of_ownership of the equipment then a cannot in good_faith claim depreciation and interest deductions flowing from the transaction therefore based on the facts presented assertion of the sec_6662 accuracy-related_penalty is appropriate in this case case developments hazards and other considerations in our view there are several aspects of this case which must be further developed first to support the view that b is compelled to exercise its purchase option to acquire the equipment upon termination of the basic lease_term the field must develop firm evidence that b has effected either a legal or economic defeasance of its obligations although it is possible to hypothesize that b purchased stripped bonds in order to meet any of the three options provided for at the end of the lease the term defeasance is used as if it were a fact in a true defeasance situation the lessee is either required by the documents or informal agreement by the parties to deposit into an escrow account an amount in absolute terms or net present_value terms economic defeasance or it gives legal notice at the initiation of the lease or shortly thereafter postf-149350-01 of its intent to exercise its purchase option at the end of the lease_term and reacquire the property legal defeasance we did not find either in the facts provided accordingly to make this argument the field needs to develop facts that demonstrate a true defeasance in light of the hazards with the new lease option we recommend that you develop additional facts to show that the new lease option is truly illusory such facts would include those that demonstrate that the equipment is limited_use_property see revproc_2001_28 i r b date that is if the facts developed show that the equipment has little value to operators other than those in country c the ownership rights claimed by trust become easier to challenge because its ability to release the equipment to any lessee or operator other than b or to operate the equipment itself would be severely limited development of such facts may require outside engineers and other experts if such facts demonstrate that no one but b may have any commercially reasonable use for the equipment then exercise of the new lease option would be impracticable in addition the field should verify that if country c privatizes the b’s business and restricts b’s ability to own or acquire the equipment the only viable option for b may be the new lease option also helpful facts include those that would demonstrate that it is highly unlikely that country c will decide to acquire even more modern equipment at the end of the base term examination of any presentations to the trust concerning this transaction may provide insight into whether its participation is primarily tax motivated it is also recommended that the field investigate any prearrangement aspects of the transaction persuasive evidence of prearrangement includes any additional evidence that the parties understood that b would exercise the purchase option moreover we note that this transaction is dissimilar to the lease-in_lease-out_transaction described in revrul_99_14 1999_1_cb_835 in that revenue_ruling the taxpayer retained the power to require the lessee to continue with the lease of the property for an additional period of time by virtue of a put renewal option in the agreements in this case however the facts as presently developed indicate that b not a has the sole power to determine which option will be exercised at the end of the base term thus this feature of the transaction makes it important to develop facts which will demonstrate that the new lease is not a viable option for b and therefore the the base term consequently such facts will indicate if the return of the equipment to b at that time is a foregone conclusion little probability of continuing beyond transaction has we recommend that you carefully scrutinize the pretax return and determine if it is insubstantial when compared to the post-tax returns this analysis should be made using both constant dollars and relevant present_value assumptions the field should compare its facts to those in other economic_substance cases or in revrul_99_14 in which the taxpayer’s profit pretax in constant dollars was insignificant compared to the amount invested in furtherance of this strategy case development should include the employment of independent appraisers economists and financial consultants whose analyses could affect the results of these calculations postf-149350-01 with respect to the oid issue a substantial likelihood is not enough to characterize the net purchase option as an unconditional obligation and thus is a high hazard in this case if upon further development the facts do not indicate that the transactions lack economic_substance or constitute a financing_arrangement we recommend you contact cc ita to develop whether a’s depreciation_deductions are based on a lease_term that includes the period of the new lease in that case the tax-exempt_use_property rules could apply to limit the availability of the deductions sec_168 and sec_1 i -2 we encourage you to raise this argument as early as possible in order to preserve it in case the transaction is determined to neither lack economic_substance nor constitute a financing this writing may contain privileged information any unauthorized disclosure of this writing may have an adverse effect on privileges such as the attorney client privilege if disclosure becomes necessary please contact this office for our views please call if you have any further questions by william p o’shea acting associate chief_counsel passthroughs and special industries _____________________________ carolyn h gray senior legal counsel branch office of passthroughs and special industries the associate chief_counsel 7the enactment of the extended lease period in sec_168 was not designed to supplant the traditional arguments challenging sale-leaseback transactions the conference committee report of the deficit_reduction_act_of_1984 provides the primary objective of the conferees is that there be no relaxation of administrative rules and practices that would result in lease treatment for financing transactions in which the purported lessor does not have a significant_ownership_interest in the property h_r rep no 98th congress 2nd sess pincite


internal_revenue_service department of the treasury number release date index number washington dc person to contact telephone number refer reply to cc corp b3-plr-163762-01 date date re distributing controlled agreement a agreement b shareholder c shareholder d llc llc state x date business m business n e f g h percent plr-163762-01 i percent dollar_figurej asset group debt dollar_figurek m n v w percent x percent y dear we respond to your letter dated date requesting rulings on the federal_income_tax consequences of a proposed transaction the information submitted in that request and in the subsequent correspondence of february and date is substantially as set forth below distributing is a state x corporation that made a subchapter_s_election on date and that uses the accrual_method of accounting distributing has two classes of common_stock issued and outstanding class a voting common_stock class a common and class b nonvoting common_stock class b common shareholder d an individual owns e shares of class a common which constitutes all of the class a common and f shares of class b common shareholder c and individual owns the remaining g shares of the class b common there are two classes of preferred_stock authorized none of which is issued or outstanding plr-163762-01 distributing is a holding_company that owns interests in wholly-owned subchapter_c corporations qualified subchapter_s subsidiaries and limited_liability companies distributing is engaged in two distinct businesses business m and business n business m is conducted through a wholly owned limited_liability_company llc and business n is conducted through a wholly owned limited_liability_company llc we have received financial information indicating that business m and business n each have had gross_receipts and operating_expenses representative of the active_conduct_of_a_trade_or_business for each of the past five years controlled will be formed under the laws of state x to effectuate the proposed transaction described below after the transaction controlled will elect to be treated as a subchapter_s_corporation and will use the accrual_method of accounting distributing intends to incorporate controlled and will transfer llc cash of amount dollar_figurej asset group and debt of amount dollar_figurek in exchange for all of the outstanding_stock of controlled controlled will have one class of common_stock distributing desires to separate the different businesses to permit management of each business to focus on the significantly different business plans of business m and business n distributing also desires to provide a mechanism for key employees of business m and business n to obtain meaningful equity interests in the respective businesses in order to retain and motivate existing employees distributing also desires to provide controlled with acquisition currency that does not involve llc 1’s business m thus distributing proposes the following transaction i ii distributing will amend and restate its certificate of incorporation to change its authorized stock to one class of common_stock new common_stock all other classes of stock will be cancelled each shareholder will receive v shares of new common_stock for each share of his class a or class b common_stock distributing will cancel all existing shares of distributing stock held as treasury_stock thus after the recapitalization shareholder c will own m shares of new common_stock and shareholder d will own n shares of new common_stock distributing will transfer the following assets to newly formed controlled in exchange for all of the outstanding controlled stock and the assumption by controlled of the liabilities associates with the transferred assets percent ownership_interest in llc asset group dollar_figurej in cash and debt in the principal_amount of dollar_figurek iii distributing will distribute the shares of controlled common_stock pro_rata to the shareholders of distributing shareholder c and shareholder d and iv key employees of distributing and controlled will be granted restricted_stock awards within one month of the distribution these rewards will require each plr-163762-01 recipient to remain with the granting corporation with x percent of the restricted_stock grant vesting each year until completion of the y-year vesting period at the end of the vesting period key employees of distributing collectively will own h percent of the outstanding vote and value of the stock of distributing and key employees of controlled collectively will own i percent of the outstanding vote and value of the stock of controlled in addition additional_amounts of stock will be made available to key employees through incentive_stock_option awards the taxpayer has made the following representations a b no part of the consideration to be distributed by distributing will be received by a shareholder as a creditor employee or in any capacity other than that of a shareholder of the corporation the five years of financial information submitted on behalf of distributing is representative of the corporation’s present operation and with regard to such corporation there have been no substantial operational changes since the date of the last financial statements submitted c following the transaction distributing and controlled each will continue the d e f active_conduct of its business independently and with its separate employees the distribution of the stock of controlled is being carried out for the corporate business_purpose of providing a substantial equity_interest in distributing and controlled to their respective key employees the distribution of the stock of controlled is motivated in whole or substantial part by this corporate business_purpose distributing is an s_corporation within the meaning of sec_1361 of the internal_revenue_code controlled will elect to be an s_corporation pursuant to sec_1362 of the code on the first available date after the distribution and there is no plan or intent to revoke or otherwise terminate the s_corporation_election of either distributing or controlled there is no plan or intention by the shareholders or security holders of distributing to sell exchange transfer by gift or otherwise dispose_of any of their stock in or securities of either distributing or controlled after the transaction except that shareholder c and shareholder d may make gifts of some of their shares to their children not to exceed w percent of the stock of either distributing or controlled g there is no plan or intention by either distributing or controlled directly or through any subsidiary_corporation to purchase any of its outstanding_stock plr-163762-01 after the transaction except pursuant to agreement b which provides for repurchases of stock from shareholders in certain circumstances in line with currently existing policies and to maintain ownership of distributing and controlled in a closely-held group there is no plan or intention to liquidate either distributing or controlled to merge either corporation with any other corporation or to sell or otherwise dispose_of the assets of either corporation after the transaction except in the ordinary course of business the total adjusted_basis and the fair_market_value of the assets transferred to controlled by distributing each equals or exceeds the sum of the liabilities assumed as determined under sec_357 by controlled the liabilities assumed as determined under sec_357 in the transaction were incurred in the ordinary course of business and are associated with the assets being transferred no intercorporate debt will exist between distributing and controlled at the time of or subsequent to the distribution of controlled stock other than amounts owing from distributing to controlled under agreement a which provides for transitional management services payments made in connection with all continuing transactions if any between distributing and controlled will be for fair_market_value based on terms and conditions arrived at by the parties bargaining at arm’s length no two parties to the transaction are investment companies as defined in sec_368 and iv of the code the distribution is not part of a plan or series of related transactions within the meaning of sec_355 pursuant to which one or more persons will acquire directly or indirectly stock possessing percent or more of the total value of all classes of stock of either distributing or controlled h i j k l m based solely on the information submitted and on the representations set forth above we hold as follows the transfer by distributing to controlled of the assets described above in exchange for all of the stock of controlled and the assumption by controlled of the liabilities associated with those assets followed by the distribution of all the controlled stock pro_rata to the shareholders of distributing will qualify as a reorganization within the meaning of sec_368 distributing and controlled each will be a_party_to_a_reorganization within the meaning of sec_368 no gain_or_loss will be recognized by distributing upon the transfer of assets plr-163762-01 to controlled solely in exchange for controlled stock and the assumption by controlled of certain liabilities of distributing sec_361 and sec_357 no gain_or_loss will be recognized by controlled on the receipt of the assets in exchange for controlled stock sec_1032 the basis of the assets received by controlled will be equal to the basis of such assets in the hands of distributing immediately before the transfer sec_362 the holding_period of the assets received by controlled will include the period during which such assets were held by distributing sec_1223 no gain_or_loss will be recognized by distributing upon the distribution of all of the controlled stock sec_361 no gain_or_loss will be recognized to and no amount will be included in the income of the shareholders of distributing upon receipt of all of the stock of controlled from distributing sec_355 the basis of the stock of distributing and controlled in the hands of distributing shareholders after the distribution will be the same as the basis of the distributing stock held immediately before the distribution allocated in proportion to the fair_market_value of each in accordance with sec_1_358-2 of the income_tax regulations sec_358 the holding_period of the controlled stock received by the shareholders will include the holding_period of the distributing stock with respect to which the distribution will be made provided that such stock is held as a capital_asset on the date of the distribution sec_1223 as provided in sec_312 proper allocation of earnings_and_profits between distributing and controlled will be made under sec_1_312-10 except as expressly provided herein we express no opinion concerning the federal_income_tax consequences of any aspect of the proposed transaction or under any other provisions of the code or regulations or about the tax treatment of any conditions existing at the time of or effects resulting from the transaction that are not specifically covered by the above rulings and specifically no opinion is expressed regarding the allocation of the accumulated_adjustments_account between distributing and controlled this ruling is directed only to the taxpayer s requesting it sec_6110 of the code provides that it may not be used or cited as precedent a copy of this letter should be attached to the federal_income_tax returns of the taxpayers involved for the taxable_year in which the transaction covered by this ruling letter plr-163762-01 is consummated in accordance with the power_of_attorney on file with this office a copy of this letter is being sent to your authorized representative sincerely filiz a serbes chief branch office of the associate chief_counsel corporate cc