Rev. Rul. Disallows LILO Transaction Deductions

The IRS issued Rev. Rul. 2002-69, which reaffirmed the conclusion in Rev. Rul. 99-14 that a taxpayer may not deduct rent or interest arising from a lease-in/lease-out (LILO) transaction. However, in the new ruling, the Service did not look (as it had in the past) to a lack of pre-tax profit potential or business purpose to challenge the LILO for lack of economic substance. Instead, it examined the transaction on a limited technical basis, concluding that the arrangements conferred only a future property interest, rather than a current leasehold; thus, the ruling recommended that a U.S. taxpayer defer any deductions until the possessory interest became actual.

Facts

A foreign municipality (F) entered into a 40-year property headlease (H) with a U.S. taxpayer (X). X was required to make two rental payments—an $89 million prepayment ($60 million in loans and $29 million in equity) and a post-payment, due after H expired, with a current $8 million present value. A $54 million portion of the loan was fully defeased, by F making a deposit with an affiliate of the lender and pledging the deposit through X as security for a sublease (S) assigned as loan collateral. The remaining $6 million of the nonrecourse loan was not directly defeased, even though F had made a nonpledged funding deposit with another affiliate of the same lender.

X later subleased the property to F for 20 years. At the end of this term, F had a fixed-purchase option at 105% of the anticipated fair market value (FMV). If F declined to exercise the option, X could accept return of the property or require F to renew the lease at specified rents currently projected at less than FMV through a 10-year put renewal term. The initial lease payments under the initial S term equaled the loan’s debt service; thus, the ruling did not mention any free cashflow to X during the base lease term.

Theory

The IRS determined that F’s S interest was of the "same nature" as the H interest conveyed to X; thus, X acquired no property right. Accordingly, because X did not acquire a current leasehold interest, the IRS determined that X could not currently deduct rent or amortize the lease prepayment.

The $29 million "equity" portion of the H prepayment was, effectively, a payment for X’s future right under H to lease the property 20 years hence for a 20-year term. Only at that time would a deduction be allowed for the basis in the right, either through amortization or sale of the interest to the sublessee. The IRS relied on several cases in which parties have, in form, entered into two separate transactions that resulted in offsetting obligations, but in which the courts collapsed the obligations and recharacterized the two transactions, in substance, as a single transaction (Rogers, 281 F3d 1108 (10th Cir. 2002); Bussing, 88 TC 449 (1987), reconsideration den., 89 TC 1050 (1987), but disting’g the contrary authority of Comdisco, Inc., 756 F2d 569 (7th Cir. 1985)). The Service disregarded both the defeased and nondefeased loans as not being obligations of either X or F and, thus, having no significance to the transaction.

Ruling

The $29 million equity portion of the H prepayment will be deductible under Sec. 467 over H’s 20-year residual term (the 10-year put renewal term and the 10-year shirttail period). Alternatively, if F were to exercise its fixed-price option at the end of the S primary term, X will have gain or loss equal to the difference between the option price and X’s cost of acquiring a right to the H residual term. While not explicitly addressed, this theory also implies that any transaction expenses incurred in acquiring the future interest would also be capitalized and recovered at resolution of the interest.

In addition, the IRS determined that the interest payments under both of the $60 million loans had to be disregarded, because the loans are either without economic significance or will have already been repaid (using rents from an S that itself lacks substance), before X obtains the future property interest. Additionally, neither X nor F obtained the benefit of using the borrowed funds, because the funds were fully defeased; thus, they are not real obligations.

Even though this ruling refers to a foreign municipality and its property, the IRS stated that the analysis and holding also apply to LILO transactions that involve or include domestic tax-exempt or tax-indifferent entities. It does not discuss whether this approach might apply in a traditional sale/leaseback situation with offsetting obligations during the basic term.

Implications

The ruling indicates that the IRS is redirecting its challenge of LILOs beyond a mere finding of lack of economic substance, to focus on a more technical approach. Specifically, it is contending that a taxpayer’s leasehold interest in a LILO transaction differs from a lessor’s ownership interest in a sale/leaseback transaction and, thus, fails to meet the required ownership benefits (and burdens) needed to create a current property interest.

This reasoning could be seen as taxpayer-favorable, depending on a transaction’s specific facts. The Service’s failure to address free cashflow received by the taxpayer during the base lease term is significant and may comfort some taxpayers that their transactions may be respected by a court.

From a risk-assessment standpoint, the ruling maintains the IRS’s position that "these transactions do not work" (per IR 2002-108, accompanying the ruling’s publication). However, the future-interest approach at least indicates that the Service would acknowledge that a real transaction exists and suggests that a taxpayer should have a full recovery of its investment and taxation on the arrangement’s real return. Thus, no permanent disallowance of items on a net basis from the LILO is implied.

From Jay H. Zuckerman, New York, NY