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Final section 467 regulations present problems and opportunities.

The Internal Revenue Service recently promulgated final regulations under section 467,(1)(*) which addresses leases of tangible property where the rental agreement has (1) increasing or decreasing rents, or (2) deferred or prepaid rent. Section 467 generally requires a lessor and lessee of tangible property under a section 467 rental agreement to treat rents consistently and to use the accrual method of accounting (and time value of money principles) regardless of their overall method of accounting. In addition, where certain leases are structured with a tax avoidance purpose, section 467 requires the lessor and lessee of tangible property to account for rent using a constant rental accrual method.(2)

Many companies routinely rent tangible property (both as lessor and lessee), and frequently these rental agreements do not provide for level rent payments. As a result, corporate tax departments must be aware of the situations where section 467 will apply. Indeed, every rental agreement should likely be reviewed in order to determine whether unanticipated tax results will arise under section 467.

In addition, since section 467 triggers recognition of income and deductions at a time unrelated to when rent is paid, the final regulations under section 467 may also provide planning opportunities. For example, payments that previously might have been treated as rent could be recharacterized as loans, producing far different tax consequences to both lessor and lessee. Any regulation that artificially alters the timing of income and deductions raises such tax planning opportunities.

Overview

Application of the section 467 regulations requires a series of determinations. First, each rental agreement must be examined to determine whether or not it is a "section 467 rental agreement." Generally, a section 467 rental agreement is a "rental agreement" that has either "increasing or decreasing rents" or "deferred or prepaid rents."(3) A "rental agreement" is defined as any agreement, whether written or oral, that provides for the use of tangible property and is treated as a lease for federal tax purposes.(4)

If a section 467 rental agreement has increasing or decreasing rents, the amount of rent and interest to be taken into account by the lessor and the lessee must be determined. Specifically, the lessor and lessee must each take into account for any taxable year the sum of (1) the section 467 rent for the taxable year and (2) the section 467 interest for the taxable year.(5) Computations of both amounts are described below.

Special rules apply to section 467 rental agreements that provide for deferred or prepaid rent without adequate stated interest. In addition, the constant rental accrual method must be utilized for certain section 467 rental agreements, specifically a "disqualified" leaseback or a long-term agreement. Other special rules relate to variable rent, contingent payments, and dispositions by a lessor of property subject to a section 467 rental agreement. The regulations also provide complex effective date and transition rules.(6)

There are a limited number of exceptions to the treatment of a lease of tangible property as a section 467 rental agreement. First, a lease is not a section 467 rental agreement if it specifies equal amounts of rent for each month throughout the lease term and all rent payments are due in the calendar year to which the rent relates (or the preceding or succeeding calendar year). Second, a rental agreement that provides for total rents of $250,000 or less is not a section 467 rental agreement. Various other exceptions, including transition rules, are explained below.

Section 467 Rental Agreements

The threshold question that must be addressed with respect to every lease of tangible property is whether the lease constitutes a "section 467 rental agreement." A "section 467 rental agreement" is any lease (except leases that provide for total rent of $250,000 or less) that provides for (1) increasing or decreasing rent or (2) deferred or prepaid rents. If a lease is a section 467 rental agreement, the effect of all of the various rules in the regulations should be reviewed; if it is not, the analysis is over.(7)

A rental agreement qualifies for the less-than-$250,000 de minimis exception if, as of the agreement date,(8) it is reasonably expected that the sum of the aggregate rental payments under the lease and the aggregate value of all other consideration to be received for the use of property (including contingent rent) will not exceed $250,000.(9) For purposes of this rule, all rental agreements that are part of the same transaction or a series of related transactions involving the same lessee (or any related person) and the same lessor (or any related person) are treated as a single rental agreement.(10)

Special rules apply to rental agreements with floating rent, rent based on variable interest rates, or contingent rent. First, if a rental agreement includes a provision increasing or decreasing rent solely as result of an adjustment based on a reasonable price index, the price index is assumed not to change during the lease term.(11) An adjustment is based on a reasonable price index if the adjustment reflects inflation or deflation under a generally recognized index (such as the Consumer Price Index). An otherwise qualifying adjustment can be limited to a fixed percentage (such as a "cap" of five percent per annum) only if the parties reasonably believe that the percentage will actually limit the amount of the rent payable during less than 50 percent of the lease term.(12) In other words, a cap on the adjustments is respected only if the lessor and lessee do not believe that the cap will have effect throughout the lease term.

Second, if the rental agreement includes a variable interest rate provision for computing rent due, the $250,000 de minimis ceiling is computed using fixed-rate substitutes under the original issue discount (OID) regulations.(13) For purposes of this rule, a variable interest rate provision requires the rent payable by the lessee to the lessor to be adjusted by the amount of changes in the amount of interest payable by the lessor on any indebtedness that was incurred to acquire the property, but only to the extent the changes are attributable (1) to changes in a qualified floating rate (within the meaning of Treas. Reg. [sections] 1.1275-5(b)) or (2) to a refinancing at a fixed or qualified floating rate.(14)

Third, certain types of contingent rent(15) are not taken into account in determining whether total expected rent under the rental agreement is less than $250,000, including:(16)

(1) Third Party Costs. This term includes real estate taxes, insurance premiums, maintenance costs, and any other costs (excluding debt service) that relate to the property and are not controlled by the lessor, the lessee, or any related person.(17)

(2) Late Payment Charges. Any amount required to be paid by the lessee to the lessor as additional compensation for the lessee's failure to pay rent when due.(18)

(3) Loss Payment. A provision that requires the lessee to pay the lessor if the property is lost, stolen, damaged, destroyed, or otherwise rendered unsuitable for use.(19)

(4) Qualified TRAC Adjustment. A payment under a terminal rental adjustment clause (as defined in section 7701(h)(3)) contained in a qualified motor vehicle operating agreement under section 7701(h)(2), but only if the adjustment to the rental price is based on a reasonable estimate of the fair market value of the motor vehicle at the end of the lease term.(20)

(5) Residual Condition Payments. A payment by one party to the other based on the difference between the actual condition of the property as of the termination of the lease and its expected condition, but only if the payment represents compensation for use of, or wear and tear on, the property above or below the expected level.(21)

(6) Tax Indemnity. One or more payments to the lessor in the event that the federal, foreign, state, or local income tax consequences actually realized by the lessor from owning the property differ from those reasonably expected by the lessor, but only if the differences result from a misrepresentation, act, or failure to act on the part of the lessee, or any other factor not within the control of the lessor or any related person.(22)

A. Increasing or Decreasing Rents. The first determination that must be made with respect to any rental agreement that does not meet the de minimis exception is whether the lease provides for "increasing or decreasing rent." A rental agreement has increasing or decreasing rent if during the lease term the annualized fixed rent allocated to any rental period exceeds the annualized fixed rent allocated to any other rental period.(23) A rental agreement allocates fixed rent only if the rental agreement unambiguously specifies, for periods of no longer than a year, a fixed amount of rent for which the lessee becomes liable on account of the property during that period, and the total amount of fixed rent specified is equal to the total amount of fixed rent payable under the lease. For example, a five-year, calendar-year lease providing for rent of $100,000 per calendar year and total rent of $500,000 contains a qualifying rent allocation.(24)

It is essential to be aware that a rental agreement that states only when rent is payable does not specifically allocate rent within the meaning of the regulations.(25) If a rental agreement does not provide a specific allocation of fixed rent, the amount of fixed rent allocated to a rental period is the amount of fixed rent payable during that period.(26) The effect of this rule is to place a premium on a rent allocation provision in any lease that provides for unequal payments during the term of the lease. Indeed, in addition to stating when rent is due and payable, every lease should contain a provision (labeled "Rent Allocation for Purposes of Section 467") that states how rent is allocated under the lease.

This provision is especially important because the section 467 regulations permit only limited rent holidays. Specifically, a rental agreement does not have increasing rent if the increase is solely attributable to a rent holiday provision allowing reduced (or no) rent for a period of up to three months at the beginning of the lease term.(27) This exception is extremely narrow and limited. Even where the forgone rent is equivalent to three months' rent, the amount cannot be spread over a longer period of time nor accorded to the lessee after the initial three months of the lease term. When releasing the final regulations, the IRS rejected comments on the proposed regulations recommending that this unduly brief period be lengthened.(28) Hence, many commercially reasonable rent holidays can result in section 467 rental agreements.

Unless one of ten express exceptions apply, a rental agreement with contingent rent payments will be treated as having increasing or decreasing rent.(29) The exceptions are (1) the foregoing list of six contingent rent payments that do not affect the determination of whether the total rent under the rental agreement is less than $250,000, (2) an adjustment based on a reasonable price index or a variable interest rate provision (as described above), (3) a qualified percentage rents provision, or (4) any other provision designated by the IRS. Qualified percentage rent is rent equal to a fixed percentage of the lessee's receipts or sales, but only if the percentage does not vary throughout the lease term.(30)

B. Deferred or Prepaid Rent. A rental agreement will constitute a section 467 rental agreement if it has either deferred or prepaid rent. The final regulations contain a complex formula for making this determination. Briefly summarized, a rental agreement has deferred rent if the cumulative amount of rent allocated as of the close of a calendar year exceeds the cumulative amount of rent payable as of the close of the succeeding calendar year.(31) A rental agreement has prepaid rent if the cumulative amount of rent payable as of the close of a calendar year exceeds the cumulative amount of rent allocated as of the close of the succeeding calendar year.(32)

This test is best explained through an example. Assume that Aaron and Betty enter into a rental agreement that provides for the lease of property from 1/1/2000 to 12/ 31/2003. The rent accrues at the rate of $100,000 per year ($400,000 over the four-year lease), with no rent payable in 2000, $100,000 payable on 12/31/2001 and 12/31/2002, and $200,000 payable on 12/31/2003. There is no deferred rent in this situation because the cumulative rent allocated as of any year does not exceed the cumulative rent payable as of the close of the succeeding year. Specifically, for the year 2000, the allocated rent ($100,000) does not exceed the rent allocated as of the close of 2001 ($100,000); for 2001, the cumulative allocated rent ($200,000) does not exceed the cumulative rent paid as of the close the succeeding calendar year ($200,000); likewise, the cumulative allocated rent through 2003 ($300,000) does not exceed the cumulative rent paid as of the close of 2004 ($400,000).(33)

Contrast the foregoing result with the following. Assume Chris and Dana enter into a 10-year lease beginning 1/1/2000 and ending 12/31/2009. The agreement provides for rent of $120,000 per year, but all of the rent ($1.2 million) is paid on 12/31/2000. In this ease, the cumulative rent paid as of the close of 12/31/2000 ($1.2 million) exceeds the cumulative rent allocated as of the close of the succeeding calendar year ($240,000), so the rental agreement includes prepaid rent.(34) If the same agreement provided for all the rent to be payable on 12/31/2009, the agreement would include deferred rent since the cumulative rent allocated as of 12/31/2000 ($120,000) exceeds the cumulative rent payable as of the close of the succeeding calendar year ($0).

C. Modification of a Rental Agreement. In genera], the final section 467 regulations apply prospectively.(35) Where a substantial modification of a rental agreement occurs after May 18, 1999, the post-modification agreement is treated as a new agreement for purposes of testing whether it is a section 467 rental agreement. Although a substantial modification after June 3, 1996, would be taken into account to determine whether the rental agreement is a disqualified leaseback or a long-term rental agreement.(36)

For these rules to apply, there must be (1) a "modification" of a rental agreement and (2) the modification must be "substantial." A rental agreement is "modified" if there is any alteration, including any deletion or addition, in whole or in part, of a legal right or obligation of the lessor or lessee, whether the alteration is evidenced by an express agreement (oral or written), conduct of the parties, or otherwise.(37) In effect, nearly any change in a rental agreement can result in a "modification." The modification occurs on the earlier of the first date on which there is a binding contract that substantially sets forth the terms of the modification or the date on which agreement to such terms is otherwise evidenced.(38)

In light of the hair-trigger determination whether a modification has occurred, the more important question is whether the modification is "substantial." A modification is substantial if, based on all of the facts and circumstances, the legal rights or obligations that are altered and the degree to which they are altered are economically substantial.(39) A modification is not substantial if the modification occurs solely as a result of one or more of the following:

(1) the refinancing of any indebtedness incurred by the lessor to acquire, and secured by, the property, but only if certain stringent conditions are satisfied;(40)

(2) A change in the lessee's obligation to make any of the contingent payments described above as part of the less-than-$250,000-rent test; or

(3) A change in the amount of fixed rent allocated to a rental period that, when combined with all previous changes in the amount of fixed rent allocated to the rental period, does not exceed one percent of the fixed rent allocated to that rental period prior to the modification.(41)

Finally, for purposes of this rule, substitution of a new lessee or a sale or exchange of the property by the lessor will not, by itself, constitute a substantial modification unless a principal purpose of the modification is the avoidance of federal income tax. The parties to the lease, however, can request that the IRS treat such changes as a substantial modification.(42)

Effect of a Section 467 Rental Agreement

After determining that a lease is a section 467 rental agreement, the tax consequences of the lease depend upon the type of section 467 rental agreement involved (disqualified leaseback or long-term agreement versus other rental agreements) as well as the amount of section 467 rent and section 467 interest provided under the lease.

A. Disqualified Leasebacks and Long-Term Agreements. A section 467 rental agreement is a leaseback if the lessee or a related person had any interest (other than a de minimis interest) in the property at any time during the two-year period ending on the agreement date. For this purpose, interests in property include options and agreements to purchase the property (whether or not the lessee or a related person is considered the owner of the property for federal tax purposes).(43)

A section 467 rental agreement is a long-term agreement if the lease term exceeds 75 percent of the property's statutory recovery period. In the case depreciable property and any other tangible property, the statutory recovery period is determined under section 467(e)(3)(A).(44) For land, the statutory recovery period is 19 years.(45)

Special rules apply if a section 467 rental agreement is a leaseback or a long-term agreement, but only where such agreements are "disqualified." This requirement is met only if (1) a principal purpose for providing increasing or decreasing rent is the avoidance of federal income tax, (2) the IRS determines that, because of the tax avoidance purpose, the agreement should be treated as a disqualified leaseback or long-term agreement,(46) and (3) the amount of rent under the agreement exceeds $2 million.(47) When the final section 467 regulations were released, the IRS proposed regulations that will eliminate the $2 million threshold on a prospective basis.(48)

The determination whether tax avoidance is a principal purpose for increasing or decreasing rent is a facts and circumstances inquiry, but the regulations provide presumptions and safe harbors.(49) Specifically, the regulations include a presumption that, if as of the agreement date, a significant difference between the marginal tax rates of the lessor and lessee can reasonably be expected at some time during the lease term, the agreement will be closely scrutinized and clear and convincing evidence is required to establish that tax avoidance is not a principal purpose for providing increasing or decreasing rent. For purposes of this rule, a marginal tax rate difference is significant if it is more than 10 percentage points.(50)

The regulations also provide two important safe harbors. First, tax avoidance will not be considered a principal purpose for providing increasing or decreasing rent where the increase or decrease is wholly attributable to (1) a contingent rent provision, or (2) a single rent holiday affording reduced (or no) rent for one consecutive period during the lease term, but only where the rent holiday is (a) for a period of three months or less at the beginning of the lease term and for no other period, or (b) is otherwise reasonable, as determined by commercial practice (as of the agreement date) in the locality where the property is in use, and does not exceed the lesser of 24 months or 10 percent of the lease term.(51) Thus, a two-year rent holiday in a 20-year lease will not cause the lease to be "disqualified," but the lease will constitute a section 467 rental agreement.

Under the second safe harbor, tax avoidance will not be considered a principal purpose of a transaction where the "uneven rent test" is met.(52) This test is met if the rent allocated to each calendar year does not vary from the average rent allocated to all calendar years by more than 10 percent (15 percent if 90 percent or more of the property subject to the lease is real estate).(53)

B. Section 467 Rent. Section 467 sets forth rules concerning the timing of the recognition of income from "section 467 rent" in any section 467 rental agreement. For any taxable year, "section 467 rent" is the sum of (1) the fixed rent for any rental period that begins and ends in the taxable year, (2) a ratable portion of the fixed rent for any rental period that begins or ends in the taxable year, and (3) the contingent rent that accrues during the taxable year.(54)

The final regulations set forth three different rules for determining the treatment of the section 467 rent. First, for all section 467 rental agreements that constitute either a disqualified leaseback or a long-term agreement, the fixed rent for a rental period is the constant rental amount (described below). Second, if a section 467 rental agreement includes deferred or prepaid rent, but is not described in the previous sentence and does not provide adequate interest on fixed rents, the fixed rent allocated to any rental period is the "proportional rental amount" (described below). Third, for any section 467 rental agreement that provides adequate interest on fixed rents (or has no deferred or prepaid rent) and is not a disqualified leaseback or a long-term agreement, the fixed rent for a rental period is the amount of fixed rent allocated to that period under the rental agreement.(55)

These three rules are the key to understanding the application of section 467. In the case of disqualified leasebacks and long-term agreements, which are presumed in some respects to be "abusive," rent is accounted for using the constant rental accrual method. For non-abusive section 467 rental agreements, the constant rental method is unnecessary, but if the rental agreement has deferred or prepaid rent and does not provide adequate interest on fixed rents, the proportional method must be utilized. Finally, if a section 467 rental agreement is not abusive, has either no deferred or prepaid rent, or provides for adequate interest on fixed rents, then (and only then) is the allocation under the rental agreement is respected.

C. Section 467 Loans and Section 467 Interest. A section 467 rental agreement includes a section 467 loan if, as of the first day of a rental period, there is a difference between the amount of fixed rent payable and accrued under the rental agreement.(56) The principal balance of a section 467 loan may be either positive or negative. In other words, if the accrued rent is not the same as the paid rent, which is the likely case in nearly every rental agreement containing deferred or prepaid rent, there will be a section 467 loan.(57)

The exception to this general rule is that a section 467 loan does not arise where a rental agreement has no deferred or prepaid rent or if the rental agreement has deferred or prepaid rent, where the agreement also provides for adequate stated interest at a single rate.(58) As an exception to this exception, however, a section 467 loan must be taken into account in the case of any section 467 rental agreement that is subject to the constant rental method (i.e., a disqualified leaseback or long-term agreement).(59) In addition, section 467 loan balances must be computed for certain purposes, including the effect of the disposition of property subject to a section 467 rental agreement.(60)

For any section 467 rental agreement that includes a section 467 loan, the section 467 interest for a taxable year is the sum of (1) the interest on fixed rent for any rental period that begins and ends in the taxable year, (2) a ratable portion of the interest on fixed rent for any rental period that begins or ends in the taxable year, and (3) any interest that accrues on any contingent rent that accrues during the taxable year.(61) In general, the interest on fixed rent for a rental period is equal to the product of (1) the principal balance of the section 467 loan and (2) the yield on the section 467 loan.(62) Contingent payments are not taken into account in calculating either the yield or principal balance of a section 467 loan.(63)

The principal balance of a section 467 loan at the beginning of a rental period equals the fixed rent accrued in preceding rental periods, increased by the sum of the interest on fixed rent includible in the gross income of the lessor for preceding rental periods and any amount payable by the lessor on or before the first day of the rental period as interest on prepaid fixed rent, and decreased by the sum of the interest on prepaid fixed rent includible in gross income of the lessee for preceding rental periods and any amount payable by the lessee on or before the first day of the rental period as fixed rent or interest thereon.(64) If a section 467 rental agreement calls for prepaid fixed rent and provides adequate interest, the principal balance of the section 467 loan at the beginning of the rental period equals the amount determined under the preceding sentence plus the fixed rent accrued for that rental period.(65)

The yield of a section 467 loan is the discount rate at which the sum of the present values of all amounts payable by the lessee as fixed rent and interest on fixed rent, plus the sum of the present values of all amounts payable by the lessor as interest on prepaid fixed rent, equals the sum of the present values of the fixed rent that accrues under the rental agreement.(66) In the case of a section 467 rental agreement that is a disqualified leaseback, a long-term agreement, or a section 467 rental agreement that does not provide adequate interest on fixed rent, the yield of the section 467 loan equals 110 percent of the applicable federal rate (AFR).(67)

Calculation of Proportional Rental Amount

A section 467 rental agreement is subject to proportional rental accrual unless the agreement is (1) a disqualified leaseback or long-term agreement or (2) provides for adequate interest on fixed rent.(68) A section 467 rental agreement provides adequate interest on fixed rent if, disregarding any contingent rent, (1) the rental agreement has no deferred or prepaid rent, (2) if the rental agreement has deferred or prepaid rent, the rental agreement provides interest on such rent at a single fixed rate, not less than 110 percent of the AFR, which rent must be adjusted and paid or compounded at least annually, (3) the rental agreement provides for deferred rent but not prepaid rent, and the present values of all amounts paid as fixed rent are equal to or greater than the sum of the present values of the fixed rent allocated to each rental period (i.e., interest is inherent in the deferred rent), or (4) the rental agreement provides for prepaid rent but not deferred rent, and the sum of the present values of the amounts payable by the lessee as fixed rent, plus the sum of the negative present values of all amounts payable by the lessor as interest, if any, on prepaid fixed rent, is equal to or less than the sum of the present values of the fixed rent allocated to each rent period (which requirement will be satisfied only if the section 467 rental agreement provided for interest to be paid by the lessor to the lessee or if interest is inherent in the calculation of prepaid rent).(69)

These complex exceptions can be illustrated with an example. Assume that Charles leases property from Diana for five years beginning on 1/1/2000 and ending on 12/31/ 2004. The section 467 rental agreement provides that rent of $100,000 accrues in each calendar year and that rent of $500,000 plus interest of $120,000 is payable on 12/31/ 2004. The required 110 percent of AFR for this rental agreement is 10 percent. The rental agreement has deferred rent because the fixed rent allocated to the year 2000 ($100,000) is less than the fixed rent payable as of the close of 2001 ($0). The present value of all payments under the rental agreement (including the interest), however, exceeds the fixed rent plus 110 percent of the AFR, so the proportional rental method does not apply.(70)

If a section 467 rental agreement does not qualify for one of the exceptions, the proportional rental amount must be computed and taken into account by the lessor and lessee. The proportional rental amount is the amount of fixed rent allocated to the rental period multiplied by a fraction the numerator of which is the sum of the present values of the amounts payable under the terms of the section 467 rental agreement as fixed rent and interest thereon and the denominator of which is the sum of the present values of the fixed rent allocated to each rent period under the rental agreement.(71) In other words, the present value difference between the amount of the payable and allocated fixed rent is calculated, and the ratio of this difference is used to determine the proportional rental amount taxable in each rental period.

For purposes of calculating the proportional rental amount, the present value of any amount is determined using a discount rate equal to 110 percent of the AFR for the section 467 rental agreement.(72) The determination of which AFR to use- short-term, mid-term or long-term -- is based upon the term of the rental agreement.(73)

An example illustrates the application of the proportional rental method. Assume that Ernie and Burt enter into a three-year section 467 rental agreement on 1/1/2000, which provides that rent of $800,000 is allocated to the year 2000, $1 million is allocated to 2001, and $1.2 million is allocated to 2002, with $3 million being due and payable on 12/31/2002. Further assume that 110 percent of AFR for this rental agreement is 8.5 percent.

Because this rental agreement fails to provide adequate interest, the fixed rent for each rental period is the proportional rental amount The present value of the amount payable under the lease is the present value of $3 million at 8.5 percent, or $2,348,724.30. The sum of the present values of the amount of fixed rent allocated to each period is determined by discounting at 8.5 percent the $800,000, $1 million, and $1.2 million allocated to 2000, 2001, and 2002, respectively, resulting in total present values of $2,526,272.20. The ratio of these amounts is 0.9297194 ($2,348,724.30/$2,526,272.20), and this ratio is multiplied by the amount of fixed rent allocated to each period in order to determine the proportional rental amount allocable to each period during the term of the lease. Thus, the section 467 rent allocated to 2000, 2001, and 2002 is $743,775.52, $929,719.40, and $1,115,663.28, respectively. Interest on the section 467 loan inherent in this arrangement must be calculated under the rules discussed above.(74)

Treatment of Disqualified Leasebacks and Long-Term Agreements

The constant rental accrual method must be used for any disqualified leaseback or long-term agreement.(75) Taxpayers, however, are not permitted to avail themselves of this anti-abuse rule to determine whether a leaseback or long-term agreement is disqualified; only the IRS may determine that a principal purpose of a leaseback or longterm agreement is tax avoidance. In other words, the constant rental accrual method is a sword wielded solely by the IRS and not a shield for taxpayers.

The constant rental amount is the amount that, if paid at the end of each rental period, will result in a present value equal to the present value of all amounts payable under the disqualified leaseback or long-term agreement as rent and interest. The rules for making this computation are the same as for calculating the proportional rental amount, i.e., a discount rate equal to 110 percent of the AFR for the appropriate term is used. For purposes of making this calculation, all rental periods must be of equal length (other than an initial or final short period of not more than one month).(76) If the disqualified leaseback or long-term agreement has an initial or final short rental period, the constant rental amount for such period is determined using any reasonable method.(77)

The regulations provide a "simplified" three-step method to determine the constant rental amount. First, the present value of amounts payable under the disqualified leaseback or long-term agreement are determined. Second, the taxpayer must determine the present value of $1 to be received at the end of each rental period during the lease term as of the first day of each rental period. Third, the amount determined under the first step is divided by the dollars computed under the second step; the result is divided by the number of dollars determined under the second step.(78)

Section 467 Recapture

Notwithstanding any other provision of the Code and except for certain specified dispositions discussed below, a lessor disposing of property subject to certain section 467 rental agreements must recognize the "recapture amount" as ordinary income. This recapture rule applies to any section 467 rental agreement that is a leaseback or a longterm agreement that is not disqualified but which allocates to any rental period fixed rent that, when annualized, exceeds the annualized fixed rent allocated to any preceding rental period.(79)

The recapture amount that must be recognized by the lessor is the lesser of (1) the prior understated inclusion or (2) the section 467 gain.(80) The prior understated inclusion is the excess, if any, of the aggregate amount of section 467 rent and section 467 interest for the period during which the lessor held the property, determined using the constant rental accrual method, over the aggregate amount of section 467 rent and interest actually accrued by the lessor.(81) The section 467 gain is the excess, if any, of the amount realized from the disposition over the sum of the basis of the property and the amount of any gain from the disposition that is treated as ordinary income (generally, as a result of depreciation recapture).(82) The practical effect of this provision is that the lessor on a non-disqualified leaseback or long-term agreement could suffer ordinary income on a disposition of the property.

Various property transfer transactions are not subject to the recapture rule. First, dispositions by gift and at death do not trigger recapture.(83) Second, in the case of certain tax-free exchanges, the recapture amount is limited to the gain recognized to the transferor, reduced by the amount of gain that otherwise is treated as ordinary income to the transferor.(84) The latter provision generally applies if the basis of the property in the hands of the transferee is determined by reference to its basis in the hands of the transferor by reason of sections 332,351,361, 721 or 731.(85) Recapture also is not required in the case of a disposition of property to a tax-exempt organization except to the extent that the property is used by the exempt organization in an activity that generates unrelated business taxable income.(86)

Section 467 recapture can also affect the transferee of property. If the recapture amount arising from a disposition of property is limited as a result of a disposition by gift or a tax-free exchange, and the transferee subsequently disposes of the property in a transaction that otherwise produces section 467 recapture, the prior understated inclusion for the transferee is computed by taking into account the amounts attributable to the period of the transferor's ownership. In other words, the transferee is effectively responsible for the section 467 recapture of the transferor!(87)

Where property is disposed of in a like-kind exchange under section 1031 or as a result of an involuntary conversion under section 1033, section 467 overrides the general nonrecognition rules and gain is recognized to the extent of the sum of (1) the amount of gain recognized on the disposition of the property plus (2) the fair market value of property acquired that is not subject to the same section 467 rental agreement and does not result in gain recognition.(88) In the case of an installment sale of property, the recapture amount is recognized and treated as income in the year of disposition, and only gain in excess of such amount qualifies for the installment method of reporting.(89)

Special rules also apply following the modification of a section 467 rental agreement.(90) In general, in reporting income and expense attributable to the rental agreement, the lessor and lessee must take "pre-modification items" into account under the method of accounting employed before the modification.(91) In computing section 467 rent, section 467 interest, and the amount of the section 467 loan with respect to "post-modification items," the post-modification items (such as rent, the lease term, and the AFR) are computed without regard to pre-modification items,(92) although various adjustments are required.(93)

If a rental agreement is modified after May 18, 1999, and the modification is not substantial, the amount of the section 467 loan relating to the agreement is computed as of the effective date of the modification. The section 467 rent and section 467 interest for periods before the effective date of the modification are determined, solely for purposes of computing the amount of the section 467 loan, under the terms of the entire agreement as modified. If the amount of the section 467 loan is reduced (i.e., the section 467 loan after the modification is less than before the modification), the excess is taken into account as additional rent.(94) In addition, the IRS is given the right to require adjustments to taxable income to reflect the effect of a modification.(95)

Finally, in applying the modification rules, adjustments must be made to the extent necessary to prevent the omission or duplication of items of income, deduction, gain, or loss. For example, if a transferee lessor acquires property subject to a section 467 rental agreement at other than the beginning or end of a rental period, and the transferee lessor's beginning section 467 loan balance differs from the transferor lessor's section 467 loan balance immediately before the transfer, the rental period that includes the day of the transfer must be bifurcated into two rental periods, one beginning before the transfer and one beginning after.(96)

Effective Dates

The final section 467 regulations apply generally to all rental agreements entered into after May 18, 1999. The regulations apply retroactively, however, to any disqualified leaseback and long-term agreements entered into after June 3, 1996.(97) If a leaseback or long-term agreement entered into after June 3, 1996, (but before May 18, 1999) is not disqualified, then a taxpayer may elect to apply the final regulations retroactively.(98) In addition, taxpayers are granted automatic consent to change their accounting method to apply the new regulations to rental agreements for the first taxable period ending after May 18, 1999.(99)

Conclusion

The final section 467 regulations will have a significant effect on any corporation entering into a lease whether as lessor or lessee. The extent of the effect will depend on whether the lease is a section 467 rental agreement and, if so, the type of section 467 rental agreement.

The most significant effect of section 467 arises for disqualified leasebacks and long-term agreements. These leases are subject to the constant rental accrual method, which will significantly alter the timing of income and deductions from the lease. Since the IRS alone has the authority to determine whether a section 467 rental agreement is "abusive," it will likely invoke the authority of section 467 to apply the constant accrual method only where it will generate additional tax revenue.

In contrast, the parties to any section 467 rental agreement that provides for deferred or prepaid rent are required to utilize the proportional method in order to determine the income and expense allocated to each period. Furthermore, unless the agreement provides for adequate interest on rent (which rarely occurs), a section 467 loan will be imputed, which will produce imputed interest income and deductions to the parties and, hence, may cause significant differences between the parties' expected and actual tax results in respect of the timing, amount, and character of income and deductions.

The most pervasive effect of the section 467 regulations will arise in situations where the rental agreement does not provide for deferred or prepaid rent. In that situation, the final section 467 regulations require that rental income and expense be taken into account in the periods to which such rent is allocated (and not when the rent is paid). This will likely have a significant effect on cash-method taxpayers, which could be the corporation, but more frequently involves an individual lessor. Needless to say, the unanticipated application of section 467 could create problems where corporations lease property from individual lessors.

As the foregoing discussion illustrates, the final section 467 regulations are exceedingly complicated. Every corporation that enters into a lease (whether as lessor or lessee) must consider these regulations and review the terms of its lease.

Notes

(1) All statutory references are to the Internal Revenue Code of 1986, as amended ("Code").

(2) Treas. Reg. [sections] 1.467-1(a)(1).

(3) Treas. Reg. [sections] 1.467-1(c)(1).

(4) Treas. Reg. [sections] 1.467-1(h)(12). The section 467 regulations do not create any inference whether, for federal tax purposes, an arrangement constitutes a lease or any obligation of the lessee under a rental agreement is treated as rent. Treas. Reg. [sections] 1.467-1(a)(4).

(5) Treas. Reg [sections] 1.467-1(b).

(6) Treas. Reg. [sections] 1.467-1(a)(3).

(7) Treas. Reg. [sections] 1.467-1(c)(1).

(8) The agreement date is the earlier of the lease date or the first date on which there is a binding written contract that sets forth the terms of the lease. Treas. Reg. [sections] 1.467-1(h)(1).

(9) Treas. Reg. [sections] 1.467-1(c)(4)(i). Consideration other than cash is taken into account at its fair market value; assumed liabilities are taken into by reference to outstanding principal and accrued interest. Treas. Reg. [sections] 1.467-1(c)(4)(ii)(B). Stated interest on deferred rent is not taken into account (although the IRS reserved the right to recharacterize such interest as additional rent). Treas. Reg. [sections] 1.467-l(c)(4)(ii)(A).

(10) Treas. Reg. [sections] 1.467-1(c)(4)(ii)(C).

(11) Treas. Reg. [sections] 1.467-1(c)(4)(ii)(D).

(12) Treas. Reg. [sections] 1.467-1(h)(10).

(13) Treas. Reg. [sections] 1.467-1(c)(4)(ii)(E). The fixed rate substitute is determined under Treas. Reg. [sections] 1.1275-5(e).

(14) Treas. Reg. [sections] 1.467-1(h)(16).

(15) This exclusion applies only to the contingent rent listed in Treas. Reg. [subsections] 1.467-1(c)(2)(iii)(B)(3)-(8).

(16) Treas. Reg. [sections] 1.467-1(c)(4)(ii)(F).

(17) Treas. Reg. [sections] 1.467-1(h)(15). Thus, variable maintenance costs paid to a service company related to the lessor would not qualify.

(18) Treas. Reg. [sections] 1.467-1(h)(4).

(19) Treas. Reg. [sections] 1.467-1(h)(7).

(20) Treas. Reg. [sections] 1.467-1(h)(9).

(21) Treas. Reg. [sections] 1.467-1(h)(13).

(22) Treas. Reg. [sections] 1.467-1(h)(14). Thus, tax indemnification if the property is not depreciable in the hands of the lessor (unless as a result of acts or misrepresentations by the lessee) would generally not qualify under this provision.

(23) Treas. Reg. [sections] 1.467-1(c)(2)(i)(A).

(24) Treas. Reg. [sections] 1.467-1(c)(2)(ii)(A)(2).

(25) Id.

(26) Treas. Reg. [sections] 1.467-1(c)(2)(ii)(B). Amounts payable before the lease commences are allocated to the first rental period in the lease term. Amounts payable after the lease ends are allocated to the last rental period.

(27) Treas. Reg. [sections] 1.467-1(c)(1)(B).

(28) T.D. 8820, 1999-24 I.R.B. 3.

(29) Treas. Reg. [sections] 1.467-1(c)(2)(iii).

(30) Treas. Reg. [sections] 1.467-1(h)(8). Different percentages can apply to different departments or floors of a retail store; the percentage can also relate to sales in excess of stated amounts.

(31) Treas. Reg. [sections] 1.467-1(c)(3)(i).

(32) Treas. Reg [sections] 1.467-1(c)(3)(ii).

(33) Treas. Reg. [sections] 1.467-1(c)(3)(iv), Example 1.

(34) Treas. Reg. [sections] 1.467-1(c)(3)(iv), Example 2.

(35) Treas. Reg. [sections] 1.467-9(a).

(36) Treas. Reg. [sections] 1.467-1(f)(1).

(37) Treas. Reg. [sections] 1.467-1(f)(5)(i).

(38) Treas. Reg. [sections] 1.467-1(f)(5)(iii).

(39) Treas. Reg. [sections] 1.467-1(f)(5)(ii).

(40) Under a safe harbor, changes arising from a debt refinancing will not produce a substantial modification where (1) neither the amount, nor the time for payment, of the principal on the debt differs by more than a de minimis amount, (2) the rent allocation schedule and the payments of rent are altered only to the extent necessary to take into account the refinancing, (3) the lessor and lessee are not related, and (4) with respect to the indebtedness being refinanced, the lessor was granted the unilateral option to repay the debt without the lender's consent.

(41) Treas. Reg. [sections] 1.467-1(f)(6).

(42) Treas. Reg. [sections] 1.467-1(f)(7).

(43) Treas. Reg. [sections] 1.467-3(b)(2).

(44) Section 467(e)(3)(A) provides recovery periods that are generally the same as under MACRS, except that 20-year property has a recovery period of 15 years and all buildings have a recovery period of 19 years.

(45) Treas. Reg. [sections] 1.467-4(b)(3).

(46) As a result, a taxpayer cannot invoke the rule to claim that a section 467 rental agreement is a disqualified leaseback or long-term agreement. Only the IRS can make this determination.

(47) Treas. Reg. [sections] 1.467-3(b)(1). Thus, there is not a significant difference between the maximum marginal rates for individuals and corporations.

(48) Prop. Reg. [sections] 1.467-3(b)(1).

(49) Treas. Reg. [sections] 1.467-3(c)(1).

(50) Treas. Reg. [sections] 1.467-3(c)(2).

(51) Treas. Reg. [sections] 1.467-3(c)(3)(ii).

(52) Treas. Reg. [sections] 1.467-3(c)(3)(i).

(53) Treas. Reg. [sections] 1.467-3(c)(4).

(54) Treas. Reg. [sections] 1.467-1(d)(1).

(55) Treas. Reg. [sections] 1.467-1(d)(2).

(56) Treas. Reg. [sections] 1.467-4(a)(1).

(57) Special rules are provided for section 467 rental agreements with variable interest; those rules are beyond the scope of this article. See Treas. Reg. [sections] 1.467-5.

(58) Treas. Reg. [sections] 1.467-4(a)(2).

(59) Treas. Reg. [sections] 1.467-4(a)(3).

(60) Treas. Reg. [sections] 1.467-4(a)(4).

(61) Treas. Reg. [sections] 1.467-1(e)(1).

(62) Treas. Reg. [sections] 1.467-1(e)(2).

(63) Treas. Reg. [sections] 1.467-4(d).

(64) Treas. Reg. [sections] 1.467-4(b)(1).

(65) Treas. Reg. [sections] 1.467-4(b)(2).

(66) Treas. Reg. [sections] 1.467-4(c)(1).

(67) Treas. Reg. [sections] 1.467-4(c)(2).

(68) Treas. Reg. [sections] 1.467-2(a).

(69) Treas. Reg. [sections] 1.467-2(b).

(70) Treas. Reg. [sections] 1.467-2(f), Example 1.

(71) Treas. Reg. [sections] 1.467-2(c)(1).

(72) Treas. Reg. [sections] 1.467-2(d).

(73) Treas. Reg. [sections] 1.467-2(e).

(74) Treas. Reg. [sections] 1.467-2(f), Example 3.

(75) Treas. Reg. [sections] 1.467-4(a).

(76) Treas. Reg. [sections] 1.467-3(d)(1).

(77) Treas. Reg. [sections] 1.467-3(d)(2).

(78) Treas. Reg. [sections] 1.467-3(d)(3). Examples in the regulations explain this computation, which is beyond the scope of this article. See Treas. Reg. [sections] 1.467-3(e).

(79) Treas. Reg. [sections] 1.467-7(a).

(80) Treas. Reg. [sections] 1.467-7(b)(1).

(81) Treas. Reg. [sections] 1.467-7(b)(2).

(82) Treas. Reg. [sections] 1.467-7(b)(3).

(83) Treas. Reg. [subsections] 1.467-7(c)(1) and (2).

(84) Treas. Reg. [sections] 1.467-7(c)(3)(i).

(85) Treas. Reg. [sections] 1.467-7(c)(3)(ii)(A).

(86) Treas. Reg. [sections] 1.467-7(c)(3)(ii)(B). If the tax-exempt entity disposes of the assets, the recapture amount must be recognized by the tax-exempt entity.

(87) Treas. Reg. [sections] 1.467-7(c)(4).

(88) Treas. Reg. [sections] 1.467-7(c)(5).

(89) Treas. Reg. [sections] 1.467-7(c)(6).

(90) Treas. Reg. [sections] 1.467-7(g).

(91) Treas. Reg. [sections] 1.467-7(g)(1)(i).

(92) Treas. Reg. [sections] 1.467-7(g)(1)(ii).

(93) Treas. Reg. [subsections] 1.467-7(g)(1)(iii) and (iv) (which applies to modifications resulting from a disposition of the property subject to the section 467 rental agreement).

(94) Treas. Reg. [sections] 1.467-7(g)(2).

(95) Treas. Reg. [sections] 1.467-7(g)(4).

(96) Treas. Reg. [sections] 1.467-7(h).

(97) Treas. Reg. [sections] 1.467-9(a).

(98) Treas. Reg. [sections] 1.467-9(c).

(99) Treas. Reg. [sections] 1.469-9(e)(1).

RICHARD M. LIPTON is a partner in the Chicago law firm of Sonnenschein, Nath & Rosenthal. He is a frequent lecturer on corporate tax issues and has written for numerous tax publications. His article on corporate tax shelter issues appeared in the March-April 1999 issue of The Tax Executive.
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Title Annotation:IRC section 467
Author:Lipton, Richard M.
Publication:Tax Executive
Geographic Code:1USA
Date:Sep 1, 1999
Words:8371
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