[4830-01-u]
DEPARTMENT OF THE TREASURY
Internal Revenue Service
26 CFR Part 1
[TD 8667]
RIN 1545-AT33
Lease Term; Exchanges of Tax-Exempt Use Property
AGENCY: Internal Revenue Service (IRS), Treasury.
ACTION: Final regulations.
SUMMARY: This document contains final regulations relating to
the lease term of tax-exempt use property. The final regulations
also provide guidance regarding certain like-kind exchanges among
related parties involving tax-exempt use property.
DATES: These regulations are effective April 29, 1996.
For dates of applicability see "Effective dates" section
under the "SUPPLEMENTARY INFORMATION" portion of the preamble and
1.168(h)-1(e) and 1.168(i)-2(g).
FOR FURTHER INFORMATION CONTACT: John M. Aramburu of the Office
of Assistant Chief Counsel (Income Tax and Accounting) at (202)
622-4960 (not a toll-free number).
SUPPLEMENTARY INFORMATION:
Background
This document contains final regulations under section 168
of the Internal Revenue Code of 1986 (Code). The regulations
provide guidance relating to certain exchanges of tax-exempt use
property among related parties and the determination of lease term under certain circumstances. Proposed regulations (IA-18-
95) were published in the Federal Register on April 21, 1995 (60
FR 19868). The IRS received a number of comments on the proposed
regulations. A scheduled public hearing was cancelled because
there were no requests to testify. After consideration of all
the comments, the regulations proposed by IA-18-95 are adopted as
revised by this Treasury decision. The revisions are discussed
below.
Overview
Under section 168, property used in a trade or business, or
held for the production of income, generally may be depreciated
under the general depreciation system (GDS) using accelerated
methods over relatively short recovery periods. However, certain
property, including "tax-exempt use property," must be
depreciated under the alternative depreciation system (ADS)
described in section 168(g). Section 168(h)(1)(A) generally
defines tax-exempt use property to include tangible property
(other than nonresidential real property) leased to a tax-exempt
entity. For this purpose, certain foreign entities and persons
are considered tax-exempt entities.
Congress subjected tax-exempt use property to a slower
depreciation system than GDS to prevent tax-exempt entities from
indirectly claiming tax benefits (in the form of reduced rentals)
"from investment incentives for which they [would] not qualify
directly, and effectively gain[ing] the advantage of taking
income tax deductions and credits while having no corresponding
liability to pay any tax on income from the property." S. Rep.
No. 169 (Vol. 1), 98th Cong., 2d Sess. 123 (1984).
In particular, section 168(g)(3)(A) provides that tax-exempt
use property subject to a lease must be depreciated using the
straight-line method over a period equal to the greater of the
property's class life or 125 percent of the lease term. Under
section 168(i)(3), options to renew generally must be taken into
account in determining the lease term and the periods of certain
successive leases must be aggregated with the period of an
original lease.
Lease term
The proposed regulations generally include an additional
period of time during which a lessee may not continue to be the
lessee in the lease term if the lessee (or a related person) has
agreed that one or both of them will or could be obligated to
make a payment of rent, or a payment in the nature of rent, with
respect to such period. The arrangements described in the
proposed regulations are frequently referred to as "replacement
leases." One commentator requested that the portion of the
proposed regulations dealing with replacement leases be
withdrawn. The commentator argued that Congress would not have
intended that the term of the replacement lease be taken into
account in determining lease term. The IRS and Treasury believe
that the proposed regulations are consistent with Congressional
intent, and thus the final regulations retain this portion of the
proposed regulations.
Another commentator indicated that application of the
proposed regulations was unclear where property is subject to
multiple leases, possibly involving multiple parties. The final
regulations clarify that if property is subject to more than one
lease (including any sublease) entered into as part of a single
transaction (or a series of related transactions), the lease term
shall include all periods described in one or more of such
leases. Thus, for example, if one taxable corporation leases
property to another taxable corporation for a 20-year term and,
as part of the same transaction, the lessee subleases the
property to a tax-exempt entity for a 10-year term, then the
lease term of the property is 20 years, and during the period of
tax-exempt use it must be depreciated using the straight line
method over the greater of its class life or 25 years.
Finally, the final regulations provide that lease term also
includes any period during which the lessee (or a related party)
has assumed or retained any risk of loss with respect to the
property (including, for example, by holding a note secured by
the property). The IRS and Treasury believe that such an
arrangement is generally similar to the replacement leases
described in the proposed regulations. As in the case of a
replacement lease, the lessee is assuming risk with respect to
the value of the property at the termination of the initial lease
term. In addition, the term of the debt provides an objective
indication that the useful life of the property exceeds the
original term of the lease, in which case failure to include the
term of the debt in the lease term could allow a tax-exempt
lessee to benefit from depreciation deductions that exceed
economic depreciation, which would be contrary to Congressional
intent.
Like-kind exchanges
The proposed regulations also address certain transactions
between related persons that are designed to circumvent the tax-
exempt use property rules through the use of a like-kind exchange
described in section 1031. The proposed regulations provide
that property (tainted property) transferred directly or
indirectly to the taxpayer by a related person (the related
party) as part of, or in connection with, a transaction described
in section 1031 where the related party receives tax-exempt use
property (related tax-exempt use property) will, if the tainted
property is subject to an allowance for depreciation, be treated
in the same manner as the related tax-exempt use property for
purposes of determining the allowable depreciation deduction
under section 167(a). Under this rule, the tainted property is
depreciated by the taxpayer over the remaining recovery period
of, and using the same depreciation method and convention as that
of, the related tax-exempt use property.
The rule applies only with respect to direct or indirect
transfers of property involving related persons where (1) section
1031 applies to any party, and (2) a principal purpose of the
transfer is to avoid or limit the application of ADS. For
purposes of this rule, a person is related to another person if
they bear a relationship specified in section 267(b) or section
707(b)(1). An exchange between members of a consolidated group
in a taxable year beginning on or after July 12, 1995, will not
be subject to this provision because section 1031 does not apply
to intercompany transactions. See 1.1502-80(f).
No comments were received with respect to the treatment of
like-kind exchanges under the proposed regulations. Accordingly,
these provisions of the proposed regulations are adopted without
modification by this Treasury decision.
Effective dates
The definition of lease term is generally applicable to
leases entered into on or after April 20, 1995. The changes made
by the final regulations apply to leases entered into after April
26, 1996. The treatment of like-kind exchanges is applicable to
transfers made on or after April 20, 1995. No inference is
intended by these effective dates as to the treatment of any
transaction under prior law. The regulations do not preclude the
application of common law doctrines (such as the substance over
form or step transaction doctrines) and other authorities to
transactions described in the regulations (e.g., as to whether a
particular transaction should be characterized as a lease or a
conditional sale for federal income tax purposes).
Special analyses
It has been determined that this Treasury decision is not a
significant regulatory action as defined in EO 12866. Therefore, a regulatory assessment is not required. It has also been
determined that section 553(b) of the Administrative Procedure
Act (5 U.S.C. chapter 5) and the Regulatory Flexibility Act (5
U.S.C. chapter 6) do not apply to these regulations, and
therefore, a Regulatory Flexibility Analysis is not required.
Pursuant to section 7805(f) of the Internal Revenue Code, the
notice of proposed rulemaking preceding these regulations was
submitted to the Small Business Administration for comment on its
impact on small business.
Drafting Information
The principal author of these regulations is John M.
Aramburu of the Office of Assistant Chief Counsel (Income Tax and
Accounting). However, other personnel from the IRS and Treasury
Department participated in their development.
List of Subjects in 26 CFR part 1
Income taxes, Reporting and recordkeeping requirements.
Adoption of Amendments to the Regulations
Accordingly, 26 CFR part 1 is amended as follows:
PART 1--INCOME TAXES
Paragraph 1. The authority citation for part 1 is amended
by adding entries in numerical order to read as follows:
Authority: 26 U.S.C. 7805 * * *
Section 1.168(h)-1 also issued under 26 U.S.C. 168. * * *
Section 1.168(i)-2 also issued under 26 U.S.C. 168. * * *
Par. 2. Sections 1.168(h)-1 and 1.168(i)-2 are added to
read as follows:
1.168(h)-1 Like-kind exchanges involving tax-exempt use
property.
(a) Scope. (1) This section applies with respect to a
direct or indirect transfer of property among related persons,
including transfers made through a qualified intermediary (as
defined in 1.1031(k)-1(g)(4)) or other unrelated person, (a
transfer) if--
(i) Section 1031 applies to any party to the transfer or to
any related transaction; and
(ii) A principal purpose of the transfer or any related
transaction is to avoid or limit the application of the
alternative depreciation system (within the meaning of section
168(g)).
(2) For purposes of this section, a person is related to
another person if they bear a relationship specified in section
267(b) or section 707(b)(1).
(b) Allowable depreciation deduction for property subject to
this section--(1) In general. Property (tainted property)
transferred directly or indirectly to a taxpayer by a related
person (related party) as part of, or in connection with, a
transaction in which the related party receives tax-exempt use
property (related tax-exempt use property) will, if the tainted
property is subject to an allowance for depreciation, be treated
in the same manner as the related tax-exempt use property for
purposes of determining the allowable depreciation deduction
under section 167(a). Under this paragraph (b), the tainted
property is depreciated by the taxpayer over the remaining
recovery period of, and using the same depreciation method and
convention as that of, the related tax-exempt use property.
(2) Limitations--(i) Taxpayer's basis in related tax-exempt
use property. The rules of this paragraph (b) apply only with
respect to so much of the taxpayer's basis in the tainted
property as does not exceed the taxpayer's adjusted basis in the
related tax-exempt use property prior to the transfer. Any
excess of the taxpayer's basis in the tainted property over its
adjusted basis in the related tax-exempt use property prior to
the transfer is treated as property to which this section does
not apply. This paragraph (b)(2)(i) does not apply if the
related tax-exempt use property is not acquired from the taxpayer
(e.g., if the taxpayer acquires the tainted property for cash but
section 1031 nevertheless applies to the related party because
the transfer involves a qualified intermediary).
(ii) Application of section 168(i)(7). This section does
not apply to so much of the taxpayer's basis in the tainted
property as is subject to section 168(i)(7).
(c) Related tax-exempt use property. (1) For purposes of
paragraph (b) of this section, related tax-exempt use property
includes--
(i) Property that is tax-exempt use property (as defined in
section 168(h)) at the time of the transfer; and
(ii) Property that does not become tax-exempt use property
until after the transfer if, at the time of the transfer, it was
intended that the property become tax-exempt use property.
(2) For purposes of determining the remaining recovery
period of the related tax-exempt use property in the
circumstances described in paragraph (c)(1)(ii) of this section,
the related tax-exempt use property will be treated as having,
prior to the transfer, a lease term equal to the term of any
lease that causes such property to become tax-exempt use
property.
(d) Examples. The following examples illustrate the
application of this section. The examples do not address common
law doctrines or other authorities that may apply to
recharacterize or alter the effects of the transactions described
therein. Unless otherwise indicated, parties to the transactions
are not related to one another.
Example 1. (i) X owns all of the stock of two subsidiaries,
B and Z. X, B and Z do not file a consolidated federal income
tax return. On May 5, 1995, B purchases an aircraft (FA) for $1
million and leases it to a foreign airline whose income is not
subject to United States taxation and which is a tax-exempt
entity as defined in section 168(h)(2). On the same date, Z owns
an aircraft (DA) with a fair market value of $1 million, which
has been, and continues to be, leased to an airline that is a
United States taxpayer. Z's adjusted basis in DA is $0. The
next day, at a time when each aircraft is still worth $1 million,
B transfers FA to Z (subject to the lease to the foreign airline)
in exchange for DA (subject to the lease to the airline that is a
United States taxpayer). Z realizes gain of $1 million on the
exchange, but that gain is not recognized pursuant to section
1031(a) because the exchange is of like-kind properties. Assume
that a principal purpose of the transfer of DA to B or of FA to Z
is to avoid the application of the alternative depreciation
system. Following the exchange, Z has a $0 basis in FA pursuant
to section 1031(d). B has a $1 million basis in DA.
(ii) B has acquired property from Z, a related person; Z's
gain is not recognized pursuant to section 1031(a); Z has
received tax-exempt use property as part of the transaction; and
a principal purpose of the transfer of DA to B or of FA to Z is
to avoid the application of the alternative depreciation system.
Accordingly, the transaction is within the scope of this section.
Pursuant to paragraph (b) of this section, B must recover its $1
million basis in DA over the remaining recovery period of, and
using the same depreciation method and convention as that of, FA,
the related tax-exempt use property.
(iii) If FA did not become tax-exempt use property until
after the exchange, it would still be related tax-exempt use
property and paragraph (b) of this section would apply if, at the
time of the exchange, it was intended that FA become tax-exempt
use property.
Example 2. (i) X owns all of the stock of two subsidiaries,
B and Z. X, B and Z do not file a consolidated federal income
tax return. B and Z each own identical aircraft. B's aircraft
(FA) is leased to a tax-exempt entity as defined in section
168(h)(2) and has a fair market value of $1 million and an
adjusted basis of $500,000. Z's aircraft (DA) is leased to a
United States taxpayer and has a fair market value of $1 million
and an adjusted basis of $10,000. On May 1, 1995, B and Z
exchange aircraft, subject to their respective leases. B
realizes gain of $500,000 and Z realizes gain of $990,000, but
neither person recognizes gain because of the operation of
section 1031(a). Moreover, assume that a principal purpose of
the transfer of DA to B or of FA to Z is to avoid the application
of the alternative depreciation system.
(ii) As in Example 1, B has acquired property from Z, a
related person; Z's gain is not recognized pursuant to section
1031(a); Z has received tax-exempt use property as part of the
transaction; and a principal purpose of the transfer of DA to B
or of FA to Z is to avoid the application of the alternative
depreciation system. Thus, the transaction is within the scope
of this section even though B has held tax-exempt use property
for a period of time and, during that time, has used the
alternative depreciation system with respect to such property.
Pursuant to paragraph (b) of this section, B, which has a
substituted basis determined pursuant to section 1031(d) of
$500,000 in DA, must depreciate the aircraft over the remaining
recovery period of FA, using the same depreciation method and
convention. Z holds tax-exempt use property with a basis of
$10,000, which must be depreciated under the alternative
depreciation system.
(iii) Assume the same facts as in paragraph (i) of this
Example 2, except that B and Z are members of an affiliated group
that files a consolidated federal income tax return. Of B's
$500,000 basis in DA, $10,000 is subject to section 168(i)(7) and
therefore not subject to this section. The remaining $490,000 of
basis is subject to this section. But see 1.1502-80(f) making
section 1031 inapplicable to intercompany transactions occurring
in consolidated return years beginning on or after July 12, 1995.
(e) Effective date. This section applies to transfers made
on or after April 20, 1995.
1.168(i)-2 Lease term.
(a) In general. For purposes of section 168, a lease term
is determined under all the facts and circumstances. Paragraph
(b) of this section and 1.168(j)-1T, Q&A 17, describe certain
circumstances that will result in a period of time not included
in the stated duration of an original lease (additional period)
nevertheless being included in the lease term. These rules do
not prevent the inclusion of an additional period in the lease
term in other circumstances.
(b) Lessee retains financial obligation--(1) In general. An
additional period of time during which a lessee may not continue
to be the lessee will nevertheless be included in the lease term
if the lessee (or a related person)--
(i) Has agreed that one or both of them will or could be
obligated to make a payment of rent or a payment in the nature of
rent with respect to such period; or
(ii) Has assumed or retained any risk of loss with respect
to the property for such period (including, for example, by
holding a note secured by the property).
(2) Payments in the nature of rent. For purposes of
paragraph (b)(1)(i) of this section, a payment in the nature of
rent includes a payment intended to substitute for rent or to
fund or supplement the rental payments of another. For example,
a payment in the nature of rent includes a payment of any kind
(whether denominated as supplemental rent, as liquidated damages,
or otherwise) that is required to be made in the event that--
(i) The leased property is not leased for the additional
period;
(ii) The leased property is leased for the additional period
under terms that do not satisfy specified terms and conditions;
(iii) There is a failure to make a payment of rent with
respect to such additional period; or
(iv) Circumstances similar to those described in paragraph
(b)(2)(i), (ii), or (iii) of this section occur.
(3) De minimis rule. For the purposes of this paragraph
(b), obligations to make de minimis payments will be disregarded.
(c) Multiple leases or subleases. If property is subject to
more than one lease (including any sublease) entered into as part
of a single transaction (or a series of related transactions),
the lease term includes all periods described in one or more of
such leases. For example, if one taxable corporation leases
property to another taxable corporation for a 20-year term and,
as part of the same transaction, the lessee subleases the
property to a tax-exempt entity for a 10-year term, then the
lease term of the property for purposes of section 168 is 20
years. During the period of tax-exempt use, the property must be
depreciated under the alternative depreciation system using the
straight line method over the greater of its class life or 25
years (125 percent of the 20-year lease term).
(d) Related person. For purposes of paragraph (b) of this
section, a person is related to the lessee if such person is
described in section 168(h)(4).
(e) Changes in status. Section 168(i)(5) (changes in
status) applies if an additional period is included in a lease
term under this section and the leased property ceases to be tax-
exempt use property for such additional period.
(f) Example. The following example illustrates the
principles of this section. The example does not address common
law doctrines or other authorities that may apply to cause an
additional period to be included in the lease term or to
recharacterize a lease as a conditional sale or otherwise for
federal income tax purposes. Unless otherwise indicated, parties
to the transactions are not related to one another.
Example. Financial obligation with respect to an additional
period--(i) Facts. X, a taxable corporation, and Y, a foreign
airline whose income is not subject to United States taxation,
enter into a lease agreement under which X agrees to lease an
aircraft to Y for a period of 10 years. The lease agreement
provides that, at the end of the lease period, Y is obligated to
find a subsequent lessee (replacement lessee) to enter into a
subsequent lease (replacement lease) of the aircraft from X for
an additional 10-year period. The provisions of the lease
agreement require that any replacement lessee be unrelated to Y
and that it not be a tax-exempt entity as defined in section
168(h)(2). The provisions of the lease agreement also set forth
the basic terms and conditions of the replacement lease,
including its duration and the required rental payments. In the
event Y fails to secure a replacement lease, the lease agreement
requires Y to make a payment to X in an amount determined under
the lease agreement.
(ii) Application of this section. The lease agreement
between X and Y obligates Y to make a payment in the event the
aircraft is not leased for the period commencing after the
initial 10-year lease period and ending on the date the
replacement lease is scheduled to end. Accordingly, pursuant to
paragraph (b) of this section, the term of the lease between X
and Y includes such additional period, and the lease term is 20
years for purposes of section 168.
(iii) Facts modified. Assume the same facts as in paragraph
(i) of this Example, except that Y is required to guarantee the
payment of rentals under the 10-year replacement lease and to
make a payment to X equal to the present value of any excess of
the replacement lease rental payments specified in the lease
agreement between X and Y, over the rental payments actually
agreed to be paid by the replacement lessee. Pursuant to
paragraph (b) of this section, the term of the lease between X
and Y includes the additional period, and the lease term is 20
years for purposes of section 168.
(iv) Changes in status. If, upon the conclusion of the
stated duration of the lease between X and Y, the aircraft either
is returned to X or leased to a replacement lessee that is not a
tax-exempt entity as defined in section 168(h)(2), the subsequent
method of depreciation will be determined pursuant to section
168(i)(5).
(g) Effective date--(1) In general. Except as provided in
paragraph (g)(2) of this section, this section applies to leases
entered into on or after April 20, 1995. (2) Special rules. Paragraphs (b)(1)(ii) and (c) of this
section apply to leases entered into after April 26, 1996.
Margaret Milner Richardson
Commissioner of Internal Revenue
Approved: March 26, 1996
Leslie Samuels
Assistant Secretary of the Treasury
