Lease termination costs.

Taxpayers frequently enter into leases to guarantee access to a particular asset at a fixed price. Due to market changes, some leases can become financially burdensome. In such cases a taxpayer can either continue the lease or try to terminate it. If the lessor is paid a cancellation fee, the law allows the taxpayer to deduct that fee because it does not create a substantial future benefit. As an alternative, the taxpayer can buy the asset from the lessor. The correct tax treatment of the purchase price recently came before the courts.

Stated simply, Union Carbide Foreign Sales Corp. leased a vessel from a partnership. It then chose to purchase the vessel rather than continue the lease or pay a lease cancellation fee. The company paid approximately $108 million for it although the value, ignoring the lease, was only $14 million. Therefore Union Carbide capitalized $14 million of the purchase price and deducted the remainder. The government wanted it to capitalize the entire purchase price.

Result. For the IRS. The government's main argument was that IRC section 167(c)(2) controls the taxation of the payment. This section says that if a taxpayer acquires property subject to a lease, none of the purchase price may be allocated to the leasehold interest; instead, the entire amount must be capitalized and depreciated.

Union Carbide argued that this applied only if the lease had continued. Since the lease was cancelled when the lessee acquired the property, section 167(c)(2) should not dictate the outcome. Prior case law allowed a deduction for part of the purchase price that was, in fact, a cancellation penalty.

The Tax Court acknowledged that both Parties had complex but reasonable arguments to support their points. Since neither one was clearly right or wrong, the court examined the code section and congressional intent. Unfortunately, the court did not find a specific answer. However, looking at the section in the context of Congress's overall intent when it enacted the provision and IRC section 197, the Tax Court determined that section 167(c)(2) did not require the lease to continue after the acquisition, as the taxpayer had argued.

Reviewing the cases the company cited also did not help its cause. In only one case did the court conclude that part of the price was deductible. And in a similar case, the U.S. Supreme Court later rejected the lower court's reasoning. Therefore the Tax Court denied Union Carbide's deduction. The entire purchase price had to be capitalized and depreciated.

The Tax Court decision follows the wording of the code exactly. It is unlikely other courts will reach a different conclusion. Therefore, a taxpayer that acquires an asset to get out from under a burdensome lease will be required to capitalize the entire payment regardless of the underlying value of the purchased property.

* Union Carbide Foreign Sales Corp., 115 TC no. 32.