TAX ISSUES FOR NON-TAX LAWYERS ADDITIONAL MATERIALS I. IRS “True Lease” Guidelines 1. Rev. Proc. 2001-28, 2001-19 I.R.B. 1156 (May 7, 2001), 2001-1 CB 1156 2. Rev. Proc. 2001-29, 2001-19 I.R.B. 1160 (May 7, 2001), 2001-1 CB 1160 II. Sample General Tax Indemnity Provisions 1. Small and Middle Market Leases A. Example 1 B. Example 2 2. Large Ticket Leveraged Leases A. Sample General Tax Indemnity Section from a Participation Agreement III. Sample Income Tax Benefit Indemnity Provisions/Agreements 1. Small and Middle Market Leases A. Example 1 B. Example 2 2. Large Ticket Leveraged Leases A. Sample Tax Indemnification Agreement GENERAL TAX INDEMNITY PROVISIONS Small and Middle Market Leases Example 1 DEFINITIONS: “Taxes” means all license and registration fees and all taxes, fees, levies, imposts, duties, assessments, charges and withholdings of any nature whatsoever, however designated (including, without limitation, any value added, transfer, sales, use, gross receipts, business, occupation, excise, personal property, real property, stamp or other taxes), together with any penalties, fines or interest thereon. TAXES: Lessor shall report and pay all Taxes now or hereafter imposed or assessed by governmental body, agency or taxing authority upon the purchase, ownership, delivery, installation, leasing, rental, use or sale of the Equipment, the Rent or other charges payable hereunder, or otherwise upon or in connection with any Lease or Financing, whether assessed on Lessor or Lessee, other than any such Taxes required by law to be reported and paid by Lessee. Lessee shall promptly reimburse Lessor for all such Taxes paid by Lessor, together with any penalties or interest in connection therewith attributable to Lessee's acts or failure to act, excluding (a) Taxes on or measured by the overall gross or net income or items of tax preference of Lessor, (b) as to any Lease or the related Equipment, Taxes attributable to the period after the return of such Equipment to Lessor, and (c) Taxes imposed as a result of a sale or other transfer by Lessor of any portion of its interest in any Lease or Financing or in any Equipment except for a sale or other transfer to Lessee or a sale or other transfer occurring after and during the continuance of any Lessee Default. GENERAL TAX INDEMNITY PROVISIONS Small and Middle Market Leases Example 2 GENERAL TAX INDEMNITY. (a) To the extent permitted by law, Lessee shall file any necessary report and return for, shall pay promptly when due, shall otherwise be liable to reimburse Lessor (on an after-tax basis) for, and agrees to indemnify and hold Lessor harmless from: (i) all titling, recordation, documentary stamp and other fees; and (ii) taxes (other than taxes calculated solely on the basis of net income), assessments and all other charges or withholdings of any nature (together with any penalties, fines or interest thereon); arising at any time upon or relating to the Equipment or this Lease or the delivery, acquisition, ownership, use, operation or leasing or other disposition of the Equipment, or upon the rent, whether the same be assessed to Lessor or Lessee (any of the foregoing, an “Imposition”). (b) If any report, return or property listing, or any Imposition is, by law, required to be filed by, assessed or billed to, or paid by, Lessor, Lessee at its own expense will do all things required to be done by Lessor (to the extent permitted by law) in connection therewith and is hereby authorized by Lessor to act on behalf of Lessor in all respects, including the contest or protest, in good faith and by appropriate proceedings, of the validity of any Imposition, or the amount thereof. Lessor agrees fully to cooperate with Lessee in any such contest, and Lessee agrees promptly to indemnify Lessor for all reasonable expenses incurred by Lessor in the course of such cooperation. An Imposition or Claim (as hereinafter defined) therefor shall be paid, subject to refund proceedings, if failure to pay would adversely affect the title or rights of Lessor. If Lessor obtains a refund of any Imposition which has been paid (by Lessee, or by Lessor and for which Lessor has been reimbursed by Lessee), Lessor shall promptly pay to Lessee the amount of such refund to the extent actually received. If a Default of Event of Default has occurred and is continuing, if Lessor obtains a refund of any Imposition which has been paid (by Lessee, or by Lessor and for which Lessor has been reimbursed by Lessee), Lessor shall promptly apply the net amount of such refund to the extent actually received to Lessee’s obligations under this Lease and, to the extent of any excess, will promptly pay to Lessee the amount of any excess in accordance with the terms and conditions of this Lease. Lessee will cause all billings of such charges to Lessor to be made to Lessor in care of Lessee and will, in preparing any report or return required by law, show the ownership of the Equipment in Lessor, and shall send a copy of any such report or return to Lessor. If Lessee fails to pay any such charges when due, except any Imposition being contested in good faith and by appropriate proceedings as above provided for a reasonable period of time, Lessor at its option may do so, in which event the amount so paid (including any penalty or interest incurred as a result of Lessee’s failure), plus interest thereon at the Late Charge Rate, shall be paid by Lessee to Lessor with the next periodic payment of rent. INCOME TAX BENEFIT INDEMNITY PROVISIONS Small and Middle Market Leases Example 1 TAX BENEFIT INDEMNITY. Each Lease is entered into on the assumption that Lessor is the owner of the Equipment for tax purposes and is entitled to certain federal, state and local tax benefits available to an owner of Equipment (collectively, “Tax Benefits”), including without limitation, accelerated cost recovery system deductions for 5-year property and deductions for interest incurred by Lessor to finance the purchase of Equipment available under the Code. Lessee represents, warrants and covenants to Lessor that (a) Lessee is not a tax-exempt entity (as defined in Section 168(h) of the Code), (b) all Equipment will be used solely within the United States, and (c) Lessee will take no position inconsistent with the assumption that Lessor is the owner of the Equipment for federal, state, and local tax purposes. If, due to any act or omission of Lessee or any party acting through Lessee, or the breach or inaccuracy of any representation, warranty or covenant of Lessee contained in any Fundamental Agreement, Lessor reasonably determines that it cannot claim, is not allowed to claim, loses or must recapture any or all of the Tax Benefits otherwise available with respect to the Equipment subject to any Lease (a “Tax Loss”), then Lessee shall, promptly upon demand, pay to Lessor an amount sufficient to provide Lessor the same after-tax rate of return and aggregate after-tax cash flow through the end of the Then Applicable Term of such Lease that Lessor would have realized but for such Tax Loss. INCOME TAX BENEFIT INDEMNITY PROVISIONS Small and Middle Market Leases Example 2 TAX INDEMNITY. (1) Lessee represents and warrants that: (a) it believes that it is reasonable to estimate that the useful life of the Equipment exceeds the lease term (including any interim and fixed rental renewal periods) of the Equipment Schedule relating thereto by the greater of one (1) year or twenty (20) percent of such estimated useful life, and that said Equipment will have a value at the end of the term of such Equipment Schedule, including any fixed rate renewal period, of at least twenty (20) percent of the Total Invoice Cost of the Equipment, without including in such value any increase or decrease for inflation or deflation during the original lease term; and (b) the Equipment is, and will be used by Lessee so as to remain, property eligible for the MACRS Deductions (as defined below). (2) If (a) by reason of (i) any act or failure to act of Lessee (including a breach of any covenant of Lessee contained in this Lease), or (ii) the misrepresentation of or breach by Lessee of any of the warranties and representations set forth in this Lease, Lessor in computing its taxable income or liability for tax, shall lose, or shall not have, or shall lose the right to claim, or there shall be disallowed or recaptured for Federal and/or state income tax purposes, in whole or in part, the benefit of MACRS Deductions; or (b) Lessor shall become liable for additional tax as a result of Lessee having made a substitution for or replacement of any item of the Equipment, or having added an attachment or made an alteration to the Equipment, including without limitation, any such attachment or alteration which would increase the productivity or capability of the Equipment so as to violate the provisions of Rev. Proc. 2001-28, 2001-19 I.R.B. 1156 (as it may hereafter be modified or superseded); or (c) as the result of the treatment of any item of income or deduction attributable to the Lease as being from sources without the United States, the foreign tax credit which the Lessor may claim against its Federal income tax liability for any year is less than the credit which the Lessor could have claimed if all such items of income and deduction had been treated as from sources within the United States (hereinafter referred to as a “Loss”); then Lessee shall pay Lessor the Tax Indemnification Payment (as defined below) as additional rent and Lessor shall revise the Schedule(s) of Stipulated Loss Values to reflect the Loss. As used herein, “MACRS Deductions” shall mean the deductions under Section 167 of the Internal Revenue Service Code of 1986, as now or hereafter amended (the “Code”), determined in accordance with the modified Accelerated Cost Recovery System with respect to the Total Invoice Cost of any item of the Equipment using the accelerated method set forth in Section 168(b)(1) or 168(b)(2) of the Code as in effect on the date of this Lease for property assigned to the class of property specified in the Equipment Schedule pertaining thereto and taking into account, unless otherwise stated on the Equipment Schedule pertaining thereto, the special depreciation allowance and basis adjustment under Section 168(k)(1) of the Code; “Lessor” shall be deemed to include the consolidated Federal taxpayer group of which Lessor is a member; and “Tax Indemnification Payment” shall mean such amount as, after consideration of (i) all taxes required to be paid by Lessor in respect of the receipt thereof under the laws of any governmental or taxing authority in the United States, and (ii) the amount of any interest or penalty which may be payable by Lessor in connection with the Loss, shall be required to cause Lessor’s after-tax net return (the “Net Return”) to be equal to, but no greater than, the Net Return computed consistently with current tax laws (and with the assumption that Lessor is taxed at the highest marginal Federal and state tax rates) as of the date of this Lease that would have been available to Lessor had the Loss not occurred. (3) Lessor shall be responsible for, and shall not be entitled to a Tax Indemnification Payment by Lessee on account of, any Loss arising solely as a direct result of the occurrence of any one or more of the following events: (a) the failure of Lessor to timely and properly claim MACRS Deductions, as applicable, in the tax return of Lessor other than as a result of changes in the Code or applicable regulations unless in the reasonable opinion of Lessor’s tax counsel there is no basis for such claim; or (b) the failure of Lessor to have sufficient taxable income before application of the MACRS Deductions to offset the full amount of such MACRS Deductions other than as a result of changes in the Code or applicable regulations; or (c) any event which by the terms of the Lease requires payment by Lessee of the Stipulated Loss Value if such payment is thereafter actually made to Lessor, to the extent that such payment reimburses Lessor for amounts otherwise payable by Lessee pursuant hereto; or (d) a disqualifying disposition due to sale of any item of the Equipment or the Lease by Lessor prior to a Default, except if in connection with Lessee’s exercise of any option available under the Lease, or otherwise to or for the benefit of Lessee in connection with the Lease. (4) Lessor promptly shall notify Lessee in writing of such Loss and Lessee shall pay to Lessor the Tax Indemnification Payment within thirty (30) days of such notice. For these purposes, a Loss shall occur upon the earliest of: (a) the happening of any event (such as disposition or change in use of any item of the Equipment) which will cause such Loss, (b) the payment by Lessor to the Internal Revenue Service or state taxing authority of the tax increase (including an increase in estimated taxes) resulting from such Loss; (c) the date on which the Loss is realized by Lessor; or (d) the adjustment of the tax return of Lessor to reflect such Loss. (5) The obligations of Lessee under this Section, which accrue during the term of an Equipment Schedule, shall survive the expiration or termination of the Lease and such Equipment Schedule. -2- Tax Issues for Non-Tax Lawyers ELA 2004 LEGAL FORUM New Orleans, Louisiana May 2-4, 2004 © 2004 Hewlett-Packard Development Company, L.P.and © 2004 Sidley Austin Brown & Wood LLP The information contained herein is subject to change without notice Moderator G. Daniel McCarthy Hewlett-Packard Financial Services Company Panelists Louis B. Fontana, Jr. Hewlett-Packard Financial Services Company Anne S. Levin-Nussbaum Sidley Austin Brown & Wood LLP Introduction 4 • Important to understand tax issues since treatment as a “true lease” is essential to realizing the expected economics of the deal. • “Tax issues” arise throughout the course of the transaction; frequently changes to the deal raise tax issues even though, to a non-tax lawyer, they have nothing to do with taxes. • Dealing with the tax issues adds time and expense to the transaction, particularly in large ticket leveraged leases and other highly structured lease transactions, which can be frustrating to the parties when they don’t understand the tax analysis. Purpose/Goals of Presentation 5 • Provide an overview of the basic tax issues that arise in leasing transactions. • Provide context for some of the typical issues – i.e., explain how the tax rules relate to issues that commonly arise in transactions. Presentation Structure 6 • Fundamentals - Tax Issue Primer • Documents/Negotiation Issues • Current Issues/Topics True Lease - Overview • What differentiates a lease from a loan? − During the lease term (of a net lease), lease financing is very similar to debt financing. − Rent is essentially equivalent to interest and, generally, principal amortization. − Lessee has possession of the asset and bears all costs and risks during the lease term. 7 • Tax analysis will focus on the asset’s residual value at the end of the lease term; taking into account, based on all the facts and circumstances, whether the lessor has the “benefits and burdens” of ownership with respect to the residual. • Tax analysis is similar, but not identical, to the analysis of whether a transaction is a true lease for commercial law purposes. IRS Guidelines – True Lease Background • The Guidelines constitute the minimum characteristics that a lease must satisfy in order for the IRS to issue an advance ruling that the lease is a “true lease,” and that the lessor is the owner of the property for tax purposes. − By their terms, the Guidelines apply only to “leveraged leases.” − Guidelines are a safe harbor; generally speaking, if all Guidelines are met, per se qualification as a lease. − The Guidelines do not purport to define a lease as a matter of law, and are explicitly not intended to be used for audit purposes. − Failure to satisfy all of the Guidelines does not mean that a transaction does not qualify as a true lease. • • 8 The Guidelines have become an important resource in tax planning. In practice, certain Guidelines are routinely satisfied (and certain Guidelines are not). The Guidelines – cont’d • Minimum Equity Investment − Lessor equity investment must equal at least 20% of the cost of property at the commencement of the lease, and this amount must remain at risk throughout the lease term. • 20% Residual Value − Asset’s expected fair market value at the end of the term must be at least 20% of original cost, without regard to inflation or deflation over the lease term. • 20% Remaining Useful Life − Asset’s remaining economic useful life at end of the lease term must be expected to be at least 20% of its remaining life as of the beginning of the lease. Note: For purposes of the Guidelines, the lease term includes all renewal or extension periods other than renewals or extensions at the option of the lessee at then fair rental value. 9 The Guidelines – cont’d • Purchase and Sale Rights − Neither lessee nor related parties may have any right to purchase the asset from the lessor at less than its then fair market value. − Lessor may not have any “put” rights (including the right to abandon the asset to any party). • No Lessee Investment − Lessee cannot have an investment in the leased asset. − Includes prohibition on lessee not paying for certain non-severable improvements. − At commencement of lease, the property must not need any improvements to be complete for its intended use. 10 The Guidelines – cont’d • No Lessee Loans or Guarantees − Lessee may not lend funds to lessor to acquire the leased property, or guarantee any indebtedness of the lessor created in connection with such acquisition. − An affiliate of the lessee may guarantee the lessee’s obligations under the lease (this does not constitute a prohibited guarantee of indebtedness of the lessor). • Profit Requirement − Lessor must demonstrate that it expects to receive a profit from the lease apart from, or without regard to, the tax benefits arising from the transaction. • Asset Not “Limited Use Property” − At the end of the lease term, the asset must be useable by someone other than the lessee or someone related to it. 11 TRAC Leases • A “TRAC” or “terminal rental adjustment clause” is a lease provision providing that rent may or will be adjusted upward or downward by reference to the amount actually realized by lessor upon sale or other disposition of the leased equipment. • A variety of TRAC structures are used in the leasing industry. • Generally, the parties agree at the outset on the residual value of the equipment at the end of the lease term. • After lease expiration, such agreed value is compared to the actual proceeds realized by the lessor from the disposition of the equipment and such difference is the amount of the rental adjustment. − actual proceeds less than agreed value, lessee pays shortfall to lessor − actual proceeds greater than agreed value, lessor rebates excess to lessee 12 TRAC Leases – cont’d 13 • In its purest form, a TRAC has the effect of transferring to lessee all upside residual benefit and all downside exposure. • As a result, the lease would generally not be a “true lease” for tax purposes or for commercial law purposes. • In general, tax law would recharacterize the transaction as a conditional sale (or secured loan) and treat the lessee as the owner of the leased equipment, just as commercial law would generally characterize the transaction as a “lease intended for security.” • Nevertheless, leases containing qualifying TRACs are treated as “true leases” for tax purposes based on a statutory exception contained in I.R.C. Section 7701(h). TRAC Leases – cont’d • Section 7701(h) basically provides that if a “qualified motor vehicle operating lease agreement” would otherwise constitute a true lease for tax purposes, it will not be recharacterized as a conditional sale by reason of the TRAC. • In general, a “qualified motor vehicle operating lease agreement” is a lease of a motor vehicle (including a trailer) provided that: − the lessee certifies that (i) it intends that more than 50% of the use of the vehicle is to be in a trade or business of the lessee, and (ii) it has been advised that it will not be treated as the owner of the vehicle for federal income tax purposes; and − the lessor does not borrow more than 50% of the purchase price of the vehicle on a non-recourse basis. 14 Section 467 - What is it? • Required method of tax accounting for rent under certain leases. • When applicable, lessor and lessee must use accrual method and follow detailed rules set forth in the Regulations, regardless of whether taxpayer otherwise uses the cash or accrual method. • Combats structures utilizing mismatched income and deductions between lessors and lessees by imposing a consistent reporting regime and using time value of money principles to reduce benefits of deferral. • Deferred rent is deemed a loan to lessee from lessor, with interest imputed thereon. − Benefit to lessor of income deferral reduced by imputed interest. • Prepaid rent is treated as if it were a loan to lessor from lessee, with lessee having imputed interest income. − Benefit of lessee’s front-loaded deductions is reduced by imputed interest. 15 Section 467 - Applicability • Section applicable to rental agreements for tangible property with aggregate payments (rent or other consideration) of more than $250,000. • In addition, lease must be considered to have increasing or decreasing rents or prepaid or deferred rent. − If lease requires rent to be paid within two years of calendar year of use, not considered to have prepaid or deferred rent. − Example: Rent for use of property during 2000 could be required to be paid as early as January 1, 1998 (within calendar year of year preceding use) or as late as December 31, 2002 (within calendar year of year following use) without being considered to have prepaid or deferred rent. 16 • Frequently not applicable to small/middle ticket market leases. • Almost always applicable to large ticket leveraged leases. Section 467 - Terminology 17 • Section 467 Rent: the amount treated as rent for tax accounting purposes (so called “tax rent”). • Allocated Rent: the rent for which lessee is liable on account of the use of the property during the rental period. • Rent Payment: the amount and timing of required rent payments under the agreement. • Section 467 Loan: the loan deemed to arise as a result of prepaid or deferred rent. • Section 467 Interest: the imputed interest on the deemed loan. Section 467 - Mechanics 18 • Lessor and lessee have income and deductions for each tax year equal to the sum of Section 467 Rent and Section 467 Interest, in the amounts determined in accordance with the Regulations. • Actual calculation methods too detailed and complicated to review here. • Nonetheless, useful to have basic understanding of how the provisions operate. • Key concept underlying mechanics is that existence of a Section 467 Loan is determined by comparing the present value (PV) of Rents Payable to the PV of Allocated Rent. Section 467 - Mechanics -cont’d • Where PVs are equal, there is no Section 467 Loan. − In such case, no Section 467 Interest and 100% of Allocated Rent is considered Section 467 Rent. • Thus, no Section 467 Loan if the lease has a single schedule prescribing amount and time for rent payments. − Where no specific schedule for Allocated Rent, Regulations deem Allocated Rent to equal Rent Payments. − PVs of Allocated Rent and Rent Payments would be the same, regardless of whether rent payments are level, front-loaded or back-loaded. • 19 Where PVs are not equal, the Regulations impute time value of money principles, similar to the OID rules. Section 467 - Mechanics - cont’d • Amount of Section 467 Rent for each tax year is determined by multiplying Allocated Rent by a set fraction, assuming determined under the Proportional Rental Amount. − Methods for computing Section 467 Rent are explained below. 20 • Fraction is the PV of the Rent Payments over the PV of the Allocated Rents. • At any point in time, the outstanding Section 467 Loan is the difference between the the cumulative Section 467 Rent accrued and the cumulative Rent Payments. • Section 467 Interest for each period is calculated based on the outstanding Section 467 Loan, which typically will be fully amortized by the end of the term. Section 467 - Mechanics - cont’d • The Regulations provide 3 regimes for calculating Section 467 Rent. − As described previously, Section 467 Rent is the Allocated Rent when there is no Section 467 Loan. − Section 467 Rent is the Proportional Rental Amount (i.e., a set fraction of Allocated Rent) when there is a Section 467 Loan and the Constant Rental Amount method does not apply. − Section 467 Rent is the Constant Rental Amount if the rental agreement is considered a Disqualified Leaseback or Disqualified Long-Term Agreement (DLs and DLTAs discussed below). 21 Section 467 - Mechanics - cont’d 22 • Under the Constant Rental Amount method, Section 467 Rent is a level amount for each rental period (so called “rent levelization”). • Worst result because removes all ability to optimize lease rents. • In contrast, Proportional Rental Amount is based on lease schedule for Allocated Rent (with adjustments to take into account the time value of money). Section 467 - DLs and DLTAs 23 • Agreement is considered a “leaseback” if the lessee had an interest in the property at any time during the preceding 2 years - e.g., any sale/leaseback transaction. • Lease is considered “long-term agreement” if it has a term longer than 75% of the property’s depreciable class life. • Generally, a leaseback or long-term agreement is considered a DL or DLTA if the IRS determines that tax avoidance was a principal purpose of the uneven rent structure. • Nonetheless, leaseback or long-term agreement will not be considered a DL or DLTA if total rent is less than $2 million. Section 467 - Tax Avoidance 24 • Regulations provide certain safe harbors, the satisfaction of which establishes that “tax avoidance” not a principal purpose for increasing or decreasing rents. • In practice, taxpayers typically seek to fall within a safe harbor rather than risk being subject to rent levelization under a subjective standard. • Moreover, if it is reasonable to expect a “significant difference” in lessee and lessor’s marginal tax rates at any time during the lease, Taxpayer would have the burden of proving, with clear and convincing evidence, that tax avoidance was not “a” principle purpose. Section 467 - Safe Harbors 25 • Under the “uneven rent test” (also called the 90/110 Safe Harbor), if Allocated Rent in each calendar year does not vary by more than 10% of average Allocated Rent, tax avoidance will not be considered a principal purpose and there would be no risk of rent levelization. • For property other than real estate, an initial rent holiday of up to 3 months can be disregarded if inclusion would cause the Allocated Rents to fall outside the 90/110 band. • Regulations also specify certain types of contingent rent to disregard in applying the uneven rent test • Existence of contingent rent that is not of a listed type will preclude reliance on 90/110 Safe Harbor. Section 467 - Safe Harbors - cont’d Regulations also provide a Safe Harbor if the increase or decrease in rent is wholly attributable to certain types of contingent rent. • Contingent rent is any payment obligation under the lease if the amount and timing is not fixed and determinable at the beginning of the term. • The types of contingent rent that can be disregarded include (1) payments for damages and casualties to the property, (2) third party costs (other than debt service), (3) late payment charges, (4) certain TRAC provisions (5) tax indemnity payments and (6) costs related to variable interest rates. • Many standard lessee-paid costs not adequately addressed in Regulations. • 26 Section 467 - Safe Harbors - cont’d 27 • In addition, tax avoidance will not be considered a principal purpose if the increase or decrease in rent is wholly attributable to a single rent holiday. • The rent holiday can be either: (1) up to a 3 month initial holiday, or (2) up to the lesser of 2 years and 10 percent of the lease term, if commercially reasonable in the locality. Depreciation • Accelerated cost recovery deductions is key factor in achieving tax deferral and can be essential to the economics of many lease transactions, particularly large ticket leveraged leases. • The modified accelerated cost recovery system (MACRS) is the most favorable method. − accelerated recovery of asset’s cost - e.g., 200% declining balance method for assets with recovery periods of less than 10 years − prescribed recovery periods much shorter than actual economic useful life of asset • 28 Applies to assets leased to U.S. taxpayers and used predominately within the United States. Depreciation – cont’d • MACRS generally not available if: − the asset is used predominately outside the United States − the lessee is a tax-exempt entity (foreign or domestic), or − the property is tax-exempt bond financed. 29 • Instead, recovery deductions are calculating under the alternative depreciation system (ADS). • ADS less desirable because recovery is less accelerated (straight-line method) and recovery periods are longer (generally the asset’s “class life”). Depreciation – cont’d 30 • For lease to tax-exempt lessee, tax deferral is further reduced by the so called “Pickle Rules.” • The Pickle Rules require the recovery period to be the longer of the property’s class life and 125% of the lease term. • This rule eliminated most of the benefits in typical structured leverage leases. • Over the years, various structures have been devised to mitigate the impact of the Pickle Rules - namely, replacement leases, LILOs and now SILOs. Depreciation – cont’d 31 • Depreciation commences when asset deemed “placed in service” under the “applicable convention” - i.e., not actual date of first use. • Half-year convention generally applies to non-real property and treats property as placed in service at the mid-point of the year (i.e., get 50% of first year recovery allowance). • However, if more than 40% of aggregate bases of taxpayer’s property (other than Section 1250 property) is placed in service in fourth quarter, then mid-quarter convention generally applies to all property (other than Section 1250 property) placed in service that year. • Under mid-quarter convention, property is deemed placed in service at mid-point of the relevant quarter. Depreciation – cont’d • Bonus Depreciation − further accelerated recovery deductions for “new” property with recovery periods of 20 years or less − generally not available if property is subject to ADS − first use of property must generally commence with TP (subject to special/leaseback rule) • Bonus deduction is generally equal to: − 30% of basis for property first acquired after September 10, 2001 and placed in service between September 11, 2001 and May 5, 2003 − 50% of basis for property acquired between May 6, 2003 and December 31, 2004 and first placed in service before January 1, 2005 32 Depreciation – cont’d 33 • Permits an addition recovery allowance in the first taxable year, which applies prior to application of MACRS. • MACRS then applies to adjusted basis (as reduced by amount of bonus depreciation). Interest Deductions 34 • Key consideration in large ticket structured leasing transactions where interest deductions further enhance economics of tax deferral. • Tax structural concerns relate to whether debt will be considered “true debt” of lessor. • Deductions generally determined in accordance with terms of debt instrument, except if OID rules apply and with respect to Section 467 interest. • Withholding tax issues need to be considered if lender is foreign or has rights to transfer to a foreign lender. Interest Deductions – cont’d 35 • Special rules for allocating interest deductions on qualified non-recourse indebtedness (“QNI”). • If satisfy QNI exception, interest deductions are allocated directly to the income generated by the asset and source will match source of rental income for foreign tax planning purposes. • In general, to be QNI, the lease debt must be nonrecourse, used to finance the purchase of the leased asset, and not be secured by any collateral other than the leased asset. • Can purposely not qualify as QNI by providing additional collateral for the loan (so called “break the chain”). General Tax Indemnity (GTI) - Overview 36 • Lessee indemnifies and holds lessor/investor harmless from any and all taxes arising in connection with the lease (including interest and penalties) except income taxes. • Other lessor/investor taxes are typically excluded as well, depending on the market and the specific nature of the transaction. GTI - Small/Middle Market • The GTI appears differently in various form lease agreements: − Sometimes as a separate section entitled “General Tax Indemnity” or “Taxes” or some other variation thereof. − Sometimes embedded in another section (usually in the “Rent” section). • Sometimes not even cast in the form of an indemnification obligation, but rather as a reimbursement or direct payment covenant. • Covers all taxes (and related interest and penalties), except income taxes. − Other standard and negotiated exceptions are typical. 37 GTI - Small/Middle Market – cont’d • May or may not include Lessee contest rights. • Primary responsibility for reporting and paying covered taxes varies. • Most frequently negotiated provisions are: − lessee contest rights − exclusions − lessee direct pay requests 38 GTI - Large Ticket Market 39 • Typically there is a separate indemnity section for taxes in the participation agreement (which is the document governing general matters between all the parties, including the investor, lessor, lessee, and lender). • Provides tax indemnification to all of the parties for all non-income taxes (and related interest and penalties), subject to customary exceptions. • Includes “gross up” protection if any U.S. withholding taxes are required to be deducted from payments on the lease debt, subject to negotiated exceptions. • Includes lessee contest rights, tax benefit payback provisions and provisions governing tax return and reporting requirements. GTI - Large Ticket Market – cont’d • • • Structured as an all-inclusive indemnity for taxes arising out of the transaction, except taxes that are specifically excluded. Thus, the most significant provisions (and those which are negotiated) appear in the exclusions section. Typical list of exclusions will depend on type of asset and whether lease is domestic or cross-border - in each market, list is fairly standard. − Income taxes, taxes on transfers, taxes in excess of those applicable to original indemnitee, and taxes resulting from indemnitees bad acts are always excluded. • Negotiations rarely include significant issues. − Generally, focus is on expanding or narrowing the scope of the exclusions and lessee’s contest rights. • 40 Lessor generally negotiates first round with lessee and then lender negotiates for additional protections. Income Tax Benefit Indemnity Provisions/Agreements (TIA) - Overview 41 • Covers federal (and sometimes state and local) income taxes. • Protects the lessor/investor from loss of the income tax benefits that have been priced into the transaction. • Amount payable is based on how the lessor/investor’s actual tax position differs from the assumptions used in the pricing – i.e., the lessor/investor’s Net Economic Return (generally, after tax rate of return and after-tax cash flow) is preserved. TIA - Small/Middle Market 42 • Sometimes not even present in small and middle market leases. • Generally appears as a separate section of the lease agreement entitled “Tax Indemnity,” “Special Tax Indemnity,” “Income Tax Indemnity,” “Tax Benefit Indemnity” or some variation thereof. • Generally protects a lessor from a reduction in its return on the lease transaction due to a loss of anticipated income tax benefits arising as a result of the lessee’s “acts or omissions.” TIA - Small/Middle Market – cont’d • May or may not similarly protect a lessor from unanticipated income inclusions. • May or may not include lessee contest rights. • Most frequently negotiated issues are: − lessee contest rights − scope of lessee “acts or omissions” − trigger events − exclusions − lessee protections and details regarding the calculation of the amount payable 43 TIA - Large Ticket Market • Always a separate agreement seen only by investor and lessee. • Indemnity runs only to the equity investor (typically referred to as the “owner participant”). • Indemnity designed to protect investor’s expected tax consequences as priced into the transaction. − amount and timing of federal tax (and state and local tax, to the extent included in pricing) deductions for depreciation, interest and transaction expenses (Deduction Loss) − unexpected additional income with respect to the transaction (Inclusions) • 44 Common for everyone except the tax lawyers to take a break when it’s time to negotiate this agreement. TIA - Large Ticket Market – cont’d Structure of TIA: • Tax Assumptions - section describes the tax assumptions used in calculating the investor’s expected after-tax return. − Necessary because the indemnity protection is generally on an assumed basis and the assumptions function as the model against which to measure harm. • Tax Representations - generally related to matters within lessee’s control which, if breached, would adversely impact investor’s expected return. − Some overlap with Tax Assumptions, but here function is to impose liability on lessee for any inaccuracies or breaches. 45 TIA - Large Ticket Market – cont’d Structure of TIA - cont’d: • Indemnity Triggers - describes specific acts and omissions that give rise to indemnification. − Separate list of triggers for Deduction Losses and Inclusions. Although, with large amount of overlap. 46 • Exclusions - describes specific tax consequences and events that are not indemnified. • Contest Provisions - details lessee’s contest rights with respect to indemnified taxes. Parties generally much more concerned about limiting/expanding these than in GTI. • Other - includes provisions for payback of tax benefits , payment and reporting requirements and other miscellaneous provisions. TIA - Large Ticket Market – cont’d Illustrative List of Tax Representations: 47 • All information provided to the appraiser was accurate and complete on the closing date. • Equipment will not require any improvements, modifications or additions to render it complete for its intended use. • Lessee will not furnish cost of any improvements, except as permitted by the Guidelines. • Lessee will not take a position that is inconsistent with the tax assumptions. • Facility will not be used by tax-exempt entity or be tax-exempt bond financed property during the lease term. TIA - Large Ticket Market – cont’d • Deduction Loss Triggers - Illustrative List − breach or inaccuracy of any Tax Representations − lessee act other than a “Permitted Act” • Permitted Acts are generally all of the acts and omissions expressly permitted or required under the operative documents, other than substitutions and replacements of the property and other negotiated exceptions. • Sometimes list is all inclusive, except to the extent expressly excluded and sometimes (less common) it is a detailed list. − casualty, loss or damage to the property − confiscation or condemnation of the property − improvements, modifications and substitutions 48 TIA - Large Ticket Market – cont’d • Inclusion Triggers - Illustrative List − breach or inaccuracy of any Tax Representations − lessee act other than a “Permitted Act” − casualty, loss or damage to the property − confiscation or condemnation of the property − improvements, modifications and substitutions − adjustments or modifications to the Allocated Rent or Rent Payment schedules − payments other than at times required under the lease − refinancing of the lease debt 49 TIA - Large Ticket Market – cont’d • Exclusions: These sometimes override and sometimes clarify the indemnity triggers. − voluntary and involuntary transfers by the owner participant − failure to timely or properly claim tax benefits − failure to contest tax when properly requested − lease not a “true lease,”subject to certain exceptions − failure to get assumed tax basis in property − change in tax law − application of Section 467 • 50 Exceptions (so called “carve backs”) to the exclusions are heavily negotiated. Current Topics/Issues 51 • SILOs - Fate Pending • Pending Legislation - ETI Repeal at Top of Agenda • Synthetic Leases - Revised Structure Using Voting Interest Entities • Tax Shelter Regulations - Rules Continue to Evolve Q&A © 2004 Hewlett-Packard Development Company, L.P.and © 2004 Sidley Austin Brown & Wood LLP The information contained herein is subject to change without notice 53
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