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International taxation of cross-border leasing income
Mehta, A.S.
Publication date
2004
Document Version
Final published version
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Citation for published version (APA):
Mehta, A. S. (2004). International taxation of cross-border leasing income.
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International l
Taxationn of
Cross-Border r
Internationall Taxation of
Cross-Borderr Leasing Income
Internationall Taxation of
Cross-Borderr Leasing Income
ACADEMISCHH PROEFSCHRIFT
terr verkrijging van de graad van doctor aann de Universiteit van Amsterdam opp gezag van de Rector Magnificus
prof.. mr. P J\ van der Heijden
tenn overstaan van een door het college voor promoties ingestelde commissie,, in het openbaar te verdedigen in de Aula der Universiteit
opp dinsdag 30 november 2004, te 10:00 uur doorr Amar Sureshbhai Mehta
FOREWORD D
AA few years ago at an international tax conference, when I briefly heard aboutt double-dip leasing as an international tax planning technique, I was astonished.. I found it a classic example of how more than one jurisdiction's nationall tax laws, tax treaties as well as anti-avoidance principles could be appliedd together in a single transaction. It also provoked my curiosity about variouss practical aspects concerning cross-border leasing, particularly, transactionn characterization, tax depreciation, income recognition, and ap-plicabilityy of anti-avoidance principles under various national tax laws, as welll as tax treaty issues.
Inn 2001, I got an opportunity to examine the above-mentioned aspects whilee working on a major leasing assignment at the International Bureau of Fiscall Documentation (IBFD) in Amsterdam. Later that year, I began work-ingg on this Ph.D. thesis, when Prof. Dr Jaap Zwemmer of the University of Amsterdamm agreed to be my promoter. I am grateful to Prof. Dr Zwemmer andd my co-promoter Prof. Dr Stef van Weeghel for providing invaluable guidancee at many crucial junctures in the project.
II would also like to thank the members of the promotion committee for ap-provingg the manuscript. In addition to my promoter and co-promoter, the committeee consisted of Prof. Dr Rob Cornelisse (University of Amster-dam),, Prof. Dr Irene Burgers (University of Groningen) and Prof. Wim Wijnenn (LUISS University, Rome).
Manyy of my colleagues at IBFD provided invaluable help. First and fore-most,, I would like to express my gratitude to Prof. Wim Wijnen for self-lesslyy helping me throughout the project. For instance, he introduced me to Prof.. Dr Zwemmer, and also accompanied me to the meeting in which Prof. Drr Zwemmer agreed to act as my promoter. I would also like to express my gratitudee to all my fellow researchers and to the librarians at the IBFD for alwayss helping me smilingly. In particular, I am thankful to Prof. Jan de Goede,, Dr René Offermanns, Bart Kosters, Sebastian Loser, Alessandro Vignaa and Jane Kerr.
II am grateful to Mr Dilip K. Sheth, Chartered Accountant, for being my mentorr ever since I started working on my first dissertation in India in the mid-1990s.. He taught me to see the bigger picture. I am also obliged to him forr going through the manuscript and providing invaluable suggestions for improvements. .
II would like to thank my parents for inculcating in me the passion for higher learning.. And, last but not the least, I am thankful to my wife Namita and twoo wonderful children Jash and Eesha for tolerating me when I worked on thiss project during many weekends and vacation days instead of spending timee with them; but for their sacrifice, I could have never concluded this project. .
Amarr Mehta
Utrecht,, the Netherlands 122 September 2004
TABLEE OF CONTENTS
2.1. . 2.2. . 2.2.1. . 2.2.2. . 2.2.2.1 1 Forewordd v Chapterr 1: Introduction 1Chapterr 2: Transaction/lease characterization aspects 7
Introductionn 7 Leasee characterization in the United States 7
Truee lease: prerequisite for obtaining the tax
advantagee 7 Thee IRS view 8 Revenuee Ruling 55-540: IRS view on what
constitutess a "true lease" 8 2.2.2.2.. Revenue Procedure 75-21: Detailed Guidelines for
grantingg advance rulings 9 2.2.2.3.. Revenue Procedure 2001-28 12 2.2.3.. Judicial developments 13
2.23A.2.23A. Case law developments vis-a-vis the Guidelines
requirements:: a comparison 13 2.2.3.2.. Court decisions on transaction characterization:
leasee v. sale 14 2.3.. Lease characterization in the United Kingdom 16
2.3.1.. Definition of finance lease 17 2.3.1.1.. Relevance of Generally Accepted Accounting
Principless 17 2.3.1.2.. Definition of "finance lease" under SSAP 21 17
2.3.2.. Court decision on characterization of lease
transactionn 18 2.4.. Lease characterization in Germany 18
2.4.1.. Significance of economic ownership 18 2.4.2.. Definition of economic ownership 18 2.4.3.. German Supreme Fiscal Court decision on
transferr of economic ownership 19 2.4.4.. Tax circulars on attribution of economic ownership 19
2.5.. Lease characterization in the Netherlands 20 2.5.1.. Significance of economic ownership 20 2.5.2.. Hoge Raad decision on economic ownership 20
2.5.3.. Lease arrangement 21 2.6.. Lease characterization in Japan 23
2.6.1.. Lease v. sale 23 2.6.2.. Finance lease 25
Chapterr 3: Depreciation/capital allowances aspects 27 3.1. . 3.2. . 3.2.1. . 3.2.1.1. . 3.2.1.2. . 3.2.1.3. . 3.2.2. . 3.2.2.1. . 3.2.2.2. . 3.2.3. . 3.2.4. . 3.2.5. . 3.3. . 3.3.1. . 3.3.2. . 3.3.3. . 3.3.3.1. . 3.3.3.2. . 3.3.3.2.1. . 3.3.3.2.2. . 3.3.3.3. . 3.3.4. . 3.3.5. . 3.4. . 3.4.1. . 3.4.2. . 3.4.2.1. . 3.4.2.2. . 3.4.2.3. . 3.4.3. . 3.4.4. . 3.4.5. . Introduction n
Generall scheme of depreciation allowance Unitedd States
Generallyy applicable method of depreciation Applicablee recovery period
Applicablee convention Unitedd Kingdom General l
Capitall allowances for cars Germany y
Netherlands s Japan n
Eligibilityy for depreciation allowance (ownership criterion) )
Unitedd States Unitedd Kingdom Germany y
Economicc ownership
Circularss issued by the Federal Ministry of Finance Fulll pay-out v. non-full pay-out leasing
Attributionn of the economic ownership in the casee of full pay-out leasing
Attributionn of the economic ownership in the case of non-fulll pay-out leasing
Netherlands s Japan n
Acceleratedd depreciation/capital allowances Unitedd States
Unitedd Kingdom First-yearr allowances Capitall allowances for ships
Rolloverr relief in respect of disposal of ships Germany y Netherlands s Japan n 27 7 28 8 28 8 29 9 29 9 29 9 30 0 30 0 31 1 32 2 32 2 33 3 33 3 34 4 34 4 35 5 35 5 36 6 36 6 37 7 37 7 39 9 40 0 40 0 40 0 40 0 40 0 41 1 42 2 43 3 44 4 44 4
Tablee of contents 3.5. . 3.5.1. . 3.5.1.1. . 3.5.1.2. . 3.5.1.2.1. . 3.5.1.2.2. . 3.5.2. . 3.5.2.1. . 3.5.2.2. . 3.5.2.3. . 3.5.2.4. . 3.5.2.5. . 3.5.2.6. . 3.5.2.7. . 3.5.3. . 3.5.4. .
Restrictionss on depreciation/capital allowances inn case of leasing
Unitedd States
Alternativee Depreciation System (ADS) Exceptions s
Qualifiedd technological equipment (QTE) Otherr exceptions
Unitedd Kingdom
DenialDenial of the first-year allowance Restrictionn in the case of a purchase option Restrictionn on capital allowances in the year of acquisition n
Restrictionss in the case of overseas/export leasing Restrictionn in respect of free depreciation on thee ships used for overseas leasing
Restrictionss in the case of sale and finance leaseback arrangements s
Restrictionss in the case of sale and finance leasebackk on defeased terms
Germanyy and the Netherlands Japan n 45 5 45 5 45 5 46 6 46 6 48 8 48 8 48 8 49 9 49 9 50 0 51 1 52 2 52 2 53 3 53 3
Chapterr 4: Income recognition aspects 55 4.1. . 4.2. . 4.2.1. . 4.2.2. . 4.2.3. . 4.2.3.1. . 4.2.3.1.1. . 4.2.3.1.2. . 4.2.3.2. . 4.2.3.2.1. . Introduction n
Relevantt income recognition rules in the USA (IRCC Sec. 467 and Final Sec. 467 Regulations) Applicabilityy of IRC Sec. 467
Consequencess of applicability of Sec. 467: income taxationn on an accrual basis
Rentt accruals under Sec. 467
Rentt accrual in the case of agreements not perceivedd as "tax avoidance transactions" Relevantt provision in IRC Sec. 461(b)(1) Rentt computation formulae prescribed under thee Regulations
Rentt accrual in the case of perceived "tax avoidance transactions" "
Taxx treatment of rents under the perceived "tax avoidancee transactions" 55 5 56 6 56 6 57 7 57 7 57 7 57 7 58 8 59 9 59 9
4.2.3.2.2. . 4.2.4. . 4.2.5. . 4.3. . 4.3.1. . 4.3.2. . 4.3.2.1. . 4.3.2.2. . 4.3.2.3. . 4.4. . 4.5. . 4.6. .
Meaningg of the perceived "tax avoidance transactions" "
Sec.. 467 interest Safe-harbourr provisions
Relevantt income recognition rules in the Unitedd Kingdom
Taxationn of operating lease rental income Taxationn of finance lease rental income Background d
Returnn of investment in capital form Negativee depreciation
Relevantt income recognition rules in Germany Relevantt income recognition rules in the Netherlands s
Relevantt income recognition rules in Japan
60 0 61 1 61 1 62 2 62 2 62 2 62 2 62 2 64 4 65 5 66 6 66 6
Chapterr 5: Limits of tax-driven cross-border leasing transactions 69 5.1. . 5.2. . 5.2.1. . 5.2.1.1. . 5.2.1.2. . 5.2.1.3. . 5.2.1.4. . 5.2.1.5. . 5.2.1.6. . 5.2.1.7. . 5.2.2. . 5.2.2.1. . 5.2.2.2. . 5.2.2.3. . Introduction n
Relevantt anti-avoidance rules in select jurisdictions: aa brief overview
Unitedd States
Thee sham transaction doctrine Thee step transaction doctrine Thee business purpose Doctrine Thee substance-over-form doctrine
Thee economic substance or the economic sham transactionn doctrine
Thee US Supreme Court decision in the Frank
LyonLyon case
Applicationn of "two-fold test" by the lower courtss in the United States
Unitedd Kingdom
Thee Ramsay principle (W.T. Ramsay v. IRC) Thee step-transaction doctrine (Furniss v.
DawsonDawson and Craven v. White)
Tradingg transactions v. transactions with the sole objectivee of obtaining tax advantage (Overseas
ContainersContainers (Finance) Ltd, v. Stoker (Inspector) and LuptonLupton v. FA. &AB. Ltd.)
69 9 70 0 70 0 71 1 71 1 72 2 73 3 73 3 75 5 76 6 77 7 77 7 78 8 78 8
Tablee of contents 5.2.2.4. . 5.2.3. . 5.3. . 5.4. . 5.4.1. . 5.4.1.1. . 5.4.1.2. . 5.4.1.3. . 5.4.1.3.1. . 5.4.1.3.2. . 5.4.1.4. . 5.4.2. . 5.4.2.1. . 5.4.2.2. . 5.4.2.2.1. . 5.4.2.2.2. . 5.4.2.2.3. . 5.4.2.2.4. . 5.4.2.2.5. . 5.4.3. . 5.4.3.1. . 5.4.3.2. . 5.4.3.3. . 5.43.4. . 5.4.4. . 5.4.4.1. . 5.4.4.2. . 5.4.4.3. . 5.4.5. . 5.4.5.1. .
Thee limits of the Ramsay principle (MacNiven
(Inspector(Inspector of Taxes) v. Westmoreland InvestmentsInvestments Ltd)
Germanyy and the Netherlands
Legall system: impact on tax-driven cross-border leasingg transactions
Tax-drivenn leasing transaction structures Salee and leaseback
Naturee of the transaction
Thee US: Court of Appeals decision in Sun Oil Co. v.
CommissionerCommissioner of Internal Revenue
Unitedd Kingdom
Restrictivee provision under the Capital Allowancess Act 2001
UKK Court of Appeals decision in BMBF case Netherlands:: "technolease" cases
Chain-leasee structure Naturee of the transaction
BMBFBMBF (No 24) v. Inland Revenue Commissioners
Relevantt facts
Relevantt statutory provisions
Relevantt issues before the High Court
Decisionn by the High Court on applicability of Sec.. 42(3) to headlease or sublease
Criticall remarks on the High Court decision Double-dipp leasing
Naturee of transaction
Typicall double-dip lease structure
Howw does double-dip leasing provide a tax advantage? ?
Cann double-dip lease, per se, be regarded as abusive? ?
Two-tierr double-dip structures Naturee of transaction
Usee of two-tier double-dip structures in Japan Cann two-tier double-dip leasing, per se, be regardedd as abusive? Leveragedd leasing Naturee of transaction 79 9 81 1 82 2 85 5 85 5 85 5 86 6 86 6 86 6 88 8 88 8 89 9 89 9 89 9 89 9 91 1 92 2 92 2 95 5 95 5 95 5 96 6 97 7 98 8 99 9 99 9 99 9 100 0 102 2 102 2
5.4.5.2.. Comparative analysis of anti-deferral provisions (too counter rear-loaded leases) under the US and
thee UK tax laws 103 5.4.5.3.. Use of non-recourse debt funding in leveraged
leases:: position in the United States and the
Unitedd Kingdom 105 5.4.5.3.1.. United States: "at risk" provisions of Sec. 465 of
thee IRC 105 5.4.5.3.2.. United Kingdom: House of Lords decision in
EnsignEnsign Tankers case 106
5.4.5.3.3.. United Kingdom: implications of Ensign Tankers decisionn on leveraged leases involving
non-recoursee debt financing 111 5.4.5.4.. German leveraged leases 114 5.4.5.5.. Modified German leveraged leases (modified
subsequentt to Sec. 2b introduction) 115
5.4.5.6.. Japanese leveraged leases 117 5.4.6.. Replacement leases 118 5.4.7.. Like-kind exchange structure 119
5.4.8.. Lease-in-lease-out (LJLO) 120 5.4.9.. Tax sparing credit (TSC) structures 121
5.4.10.. Japanese safe-harbour structures (agreement betweenn Japanese tax authorities and Japan
Leasingg Association) 122 5.4.11.. Tokumei Kumiai arrangements 123
5.4.12.. Japanese operating leasing 124 5.4.13.. Defeasance structures 126 5.4.13.1.. Nature of transaction 126 5.4.13.2.. United Kingdom Court of Appeals decision in
BarclaysBarclays Mercantile Business Finance Ltd.
v.. Maw son (Inspector of Taxes) 127
5.4.13.2.1.. Relevant facts 127 5.4.13.2.2.. Position taken by the tax authorities 129
5.4.13.2.3.. Decision by Special Commissioners 129
5.4.13.2.4.. High Court decision 130 5.4.13.2.5.. Court of Appeals decision 131
Tablee of contents
Chapterr 6: Tax treaty implications of lease income
characterizationn 133 6.1.. Introduction 133 6.2.. Tax treaty definition of "royalties" vis-a-vis
leasee rentals for ICS equipment 133
6.2.1.. The OECD position 133 6.2.2.. Definition of "royalties" in tax treaties 134
6.3.. The characterization issue: effect on treaty
distributivee rules 135 6.3.1.. Complexity of the issue 135 6.3.2.. Characterization: from which state's perspective? 135
6.4.. Characterization of the finance lease income 137 6.4.1.. Finance lease rentals vis-a-vis "royalties" in
treatyy context 137 6.4.2.. Finance lease rentals and "interest" in treaty
contextt 138 6.4.2.1.. The characterization issue 138
6.4.2.2.. OECD position 139 6.4.2.3.. Definition of interest in tax treaties 139
6.4.2.4.. Scope of definition of interest (version a): incomee from debt claims (similar to OECD
definition)) 140 6.4.2.5.. Scope of definition of interest (version b): income
assimilatedd to income from money lent 142
6.4.2.5.1.. Position in the United States 142 6.4.2.5.2.. Position in the United Kingdom 143 6.4.2.5.3.. Position in Germany and the Netherlands 146
6.5.. Characterization of operating lease income 147
Chapterr 7: Tax treaty aspects of taxation of cross-border leasing
incomee in the source state 149
7.1.. Introduction 149 7.2.. Differing provisions in bilateral tax treaties 149
7.2.1.. Differing provisions concerning royalties 149 7.2.1.1.. Right to tax royalty income and treaty definition of
"royalties"" 149 7.2.1.2.. Withholding tax: rate differences 150
7.2.2. . 7.2.2.1. . 7.2.2.2. . 7.2.3. . 7.2.4. . 7.3. . 7.3.1. . 7.3.2. . 7.3.2.1. . 7.3.2.1.1. . 7.3.2.1.2. . 7.3.2.1.3. . 7.3.2.2. . 7.3.2.3. . 7.3.2.3.1. . 7.3.2.3.2. . 7.3.2.3.3. . 7.3.2.4. . 7.4. . 7.4.1. . 7.4.1.1. . 7.4.1.2. . 7.4.1.3. . 7.4.1.4. . 7.4.1.5. . 7.4.1.6. . 7.4.1.7. . 7.4.1.8. . 7.4.2. .
Differingg provisions concerning "interest" income Taxingg right and rate differences
"Beneficiall ownership" requirement
Differingg provisions concerning taxation of capital gains s
Implicationss of differing provisions in bilateral tax treaties s
Entitlementt to treaty benefits in case of improper usee of tax treaties (by third-country residents) Relevancee of the issue in cross-border leasing transactions s
Entitlementt in case of improper use of tax treaties: contemporaryy position
Thee OECD view
Thee 1977 and 1992 OECD MC Commentaries Thee OECD Conduit Companies Report
Thee 2003 version of the OECD MC Commentary ViewsViews expressed by commentators
Courtt decisions on treaty entitlement of interposed entities s
Courtt decisions in the United States Courtt decisions in the Netherlands Courtt decisions in Germany Conclusion n
Anti-abusee tax treaty provisions relevant for cross-borderr leasing transactions
Beneficiall ownership
Thee "beneficial owner" requirement
Purposee of the "beneficial owner" requirement Definitionn of the term "beneficial owner" OECDD Commentary on the term "beneficial owner" "
Internationall tax language meaning of "beneficiall owner"
Beneficiall ownership of income rather than the income-producingg asset
Implicationss of absence of "beneficial ownership" requirementt in a tax treaty
Thee two sublease case studies vis-a-vis the "beneficiall ownership" requirement "Limitationn on benefits" article
150 0 150 0 151 1 151 1 151 1 153 3 153 3 154 4 154 4 154 4 154 4 155 5 157 7 158 8 158 8 160 0 161 1 162 2 163 3 163 3 163 3 163 3 164 4 165 5 166 6 167 7 167 7 171 1 172 2
Tablee of contents 8.1. . 8.2. . 8.2.1. . 8.2.2. . 8.2.3. . 8.2.3.1. . 8.2.3.2. . 8.2.3.2.1. . 8.2.3.2.2. . 8.2.3.2.3. .
Chapterr 8: Relevance of the EC Treaty (cross-border leasing
betweenn the EC Member States) 175
Scopee of the chapter 175 UKK capital allowance restrictions in the case
off outbound leases 176 Thee restrictive provision 176 Conflictt with a Treaty freedom 177 Potentiall justifications for the restrictive
nationall tax law provision 178 Needd to prevent loss of revenue 178
Fiscall cohesion 180 "Fiscall cohesion" argument: seldom accepted
byy the EC J 180
BackmanBackman and Commission v. Belgium 180
Thee two prerequisites for acceptance of the "fiscal
cohesion"" argument 181 8.2.3.2.4.. The UK restriction of capital allowance on
outboundd leases: the two conditions for the
"fiscall cohesion" argument not satisfied 184
8.2.3.3.. The abuse argument 185 8.2.3.3.1.. Argument not yet accepted by the ECJ in tax cases 185
8.2.3.3.2.. Can the Treaty be relied upon to shield abusive
transactions?? 188 8.2.3.3.3.. The abuse argument vis-a-vis the UK restriction
off capital allowances in the case of outbound leases 191
8.2.3.4.. Fiscal supervision 191 8.2.3.5.. Territoriality argument 193 8.2.4.. Main conclusion on the issue 193 8.3.. Denial of group relief in respect of losses suffered
byy subsidiaries resident in other Member States 193
8.3.1.. The issue 193 8.3.2.. The Marks & Spencer case 194
8.3.3.. Conflict with a Treaty freedom (freedom of
establishment)) 198 8.3.4.. Potential justifications for the restrictive national
taxx law provision 199 8.3.4.1.. The argument relating to the need to prevent loss of
revenuee 200 8.3.4.2.. The "fiscal cohesion" argument 200
8.3.4.4.. "Fiscal supervision" argument 204 8.3.4.5.. Territoriality argument 205 8.3.5.. Main conclusion on the issue 206
8.4.. Final conclusions 206
Chapterr 9: Summary, conclusions and recommendations 207 9.1. . 9.2. . 9.2.1. . 9.2.1.1. . 9.2.1.2. . 9.2.1.3. . 9.2.2. . 9.2.2.1. . 9.2.2.2. . 9.2.2.3. . 9.2.2.4. . 9.2.3. . 9.2.3.1. . 9.2.3.2. . 9.2.4. . 9.2.4.1. . 9.2.4.2. . 9.2.4.3. . 9.2.4.4. . 9.2.4.4.1. . 9.2.4.4.2. . 9.2.4.4.3. . 9.2.4.4.4. . 9.2.4.4.5. . Background d
Summaryy and conclusions Incomee recognition aspects
Thee tax deferral advantage of rear-loaded lease rentals s
Relevantt anti-avoidance provisions in select jurisdictions s
Effectivenesss of anti-avoidance provisions in thee United States vis-a-vis the United Kingdom Depreciationn aspects
Significancee of depreciation allowance in tax-drivenn leasing transactions
Generall scheme of depreciation allowances in thee select jurisdictions
Eligibilityy criteria for depreciation allowance (legall v. economic ownership)
Incentivess and restrictions
Transactionn characterization aspects Significancee of transaction characterization Transactionn characterization in select jurisdictions Legall systems, anti-avoidance principles and aggressivelyy tax-driven transaction structures Tendenciess of taxpayers towards aggressively tax-drivenn transactions
Scopee of general anti-avoidance rules
Impactt of legal systems on tax-driven cross-border leasingg transactions
Tax-drivenn transaction structures Salee and leaseback transactions Chain-leasee transaction structure Double-dipp leasing
Two-tierr double-dip leasing Leveragedd leasing 207 7 207 7 207 7 207 7 207 7 208 8 208 8 208 8 209 9 210 0 212 2 212 2 212 2 213 3 215 5 215 5 216 6 217 7 219 9 219 9 219 9 220 0 220 0 220 0
Tablee of contents 9.2.4.4.5.1. . 9.2.4.4.5.2. . 9.2.4.4.5.3. . 9.2.4.4.6. . 9.2.5. . 9.2.5.1. . 9.2.5.2. . 9.2.5.3. . 9.2.5.3.1. . 9.2.5.3.2. . 9.2.6. . 9.2.6.1. . 9.2.6.2. . 9.2.6.3. . 9.2.6.4. . 9.2.7. . 9.2.7.1. . 9.2.7.2. . 9.2.7.3. . 9.3. . 9.3.1. . 9.3.2. . 9.3.3. .
Leveragedd leases with uneven rents Leveragedd leases involving non-recourse financing financing
Germann leveraged and modified leveraged leases Defeasancee structures
Taxx treaty implications of transaction characterization n
Taxx treaty definition of "royalties"
Taxx treaty characterization in the case of operating lease e
Taxx treaty characterization in the case of finance lease e
Thee issue of tax treaty characterization as "royalties" "
Thee issue of tax treaty characterization as "interest" "
Differingg provisions in tax treaties and improper usee of tax treaties
Differingg provisions in tax treaties
Improperr use of tax treaties and entitlement to treaty application n
Implicationss of absence of "beneficial ownership" requirementt in tax treaties
Effectt of typical "Limitation on benefits" article on leasingg entities
Relevancee of EC Treaty in the context of cross-borderr leasing
ECC freedom to provide services: leasing constitutess a service
Overseass leasing: capital allowance restrictions Compatibilityy of group relief regimes with the ECC Treaty
Recommendations s
Amendmentss to UK tax law for taxation of financee lease rentals on an accrual basis UKK safe-harbour rules for leasing transactions Amendmentss to the Capital Allowances Act 2001 (UK)) in respect of cross-border leases with lesseess resident in the other EC Member States
220 0 220 0 221 1 221 1 221 1 221 1 221 1 222 222 222 2 222 2 223 3 223 3 224 4 225 5 225 5 226 6 226 6 226 6 226 6 227 7 227 7 228 8 229 9
9.3.4.. Amendments to group relief regimes under the taxx laws of the United Kingdom, Germany and
thee Netherlands 229 9.3.5.. Strengthening specific anti-avoidance regime
underr the UK tax law 230 9.3.6.. United Kingdom: specific restrictive provision
concerningg interest on non-recourse finance 232 9.3.7.. Inclusion of clarifications in tax treaties:
aspectss relating to characterization of
financee lease income 232
Appendices s 235 5
Appendixx 1 US case law on lease v. conditional sale Appendixx 2 Special and accelerated depreciation in Japan Appendixx 3 List of treaties examined
Appendixx 4 ECJ cases examined for ascertaining argumentss advanced by the Member States too justify restrictive provisions under the nationall direct tax laws
235 5 249 9 253 3
255 5
Bibliography y Tablee of case law Dutchh summary
257 7 263 3 269 9
CHAPTERR 1
INTRODUCTION N
Background d
Businessess seem to have recognized that they derive value by using assets, andd ownership of assets may be incidental. For instance, on 1 February y 20044 the International Tax Review journal reported that BT Group, a Brit-ishh telecom company, recently carried out a GBP 1.3 billion (USD 2.37 bil-lion)) sale-and-leaseback transaction that could cut the company's tax liabilitiess by as much as GBP 300 million (USD 546 million) over a number off years.1
Itt is not surprising that, globally, the volumes of leasing transactions have grownn steadily over the last few decades. For instance, in 2003, the aggre-gatee value of leasing transactions in the United States amounted to USD 2088 billion, representing 31% of the total value of all productive assets ac-quiredd by US businesses;2 that figure is estimated to be USD 218 billion for 2004.. As per the Equipment Leasing Association (US), 80% of the US companiess lease all or some of their equipment. In Japan, in 2002, the ag-gregatee value of the leasing transactions amounted to over JPY 7,374 bil-lionn (approximately USD 67 billion), representing 9.25% of the total privatee investment.3 In Europe, in 2003, the aggregate value of leasing transactionss in 26 countries amounted to about EUR 194 billion, including EURR 44 billion in Germany (representing 18.08% of the total investment in neww assets), EUR 32.15 billion in Italy (13.61%), EUR 32.82 billion in the Unitedd Kingdom (13.75%) and EUR 26.03 billion in France (19.62%).4
Importancee of tax aspects in leasing transactions
AA preliminary investigation revealed that the tax advantage of leasing con-stitutess one of the key reasons for businesses often preferring leasing to
1.. The UK ami of the Société Générale Bank bought the equipment from BT Group, andd agreed to lease it back for five years.
2.. Source: Equipment Leasing Association (US). The value of total productive assets acquiredd by the American businesses in 2001 amounted to USD 697 billion.
3.. Source: Japan Leasing Association. 4.. Source: Leaseurope.
conventionall loan for financing asset acquisition. For instance, among key reasonss for companies' preference for leasing, the Equipment Leasing As-sociationn (US) states as follows:
Companiess are incented to invest in new equipment by the federal and state tax codes.. But often the companies cannot use these incentives. Through the use of leasing,, however, the benefit of the incentive can be passed on through a com-panyy in low rental payments because as the owner of the equipment, the leasing companyy utilized the depreciation or credit incentive.3
Itt is discernible that, in harmony with the above-quoted statement, a survey conductedd by the Japan Leasing Association in 2000 revealed that leased equipmentt costs less than borrowing money to purchase it.6
Leasing:: the cross-border dimension
Whenn I began working on a leasing research assignment at the International Bureauu of Fiscal Documentation in year 2001, the relevant material re-vealedd that the diversity among tax laws of various countries may amplify thee tax advantages of leasing in a cross-border situation, as compared to the taxx advantages of a leasing transaction within a country (domestic leasing). Forr instance, in a cross-border leasing ("double-dip") transaction, both the lessorr as well as the lessee may be entitled to depreciation allowance due to peculiarr features of the tax law in their respective jurisdictions. Also, par-tiess to a cross-border lease may attempt to exploit the beneficial provisions off tax laws of the lessor's country, although the underlying legislative in-tentt of the said provisions may have been only to grant a benefit in the case off a domestic lease.
Researchh objective and structure of the thesis
Generally,, a taxpayer may be able to obtain a tax advantage by resorting to onee or more of the following techniques:
-- minimizing the gross amount of taxable income (vis-a-vis the amount off gross revenue);
-- maximizing the aggregate amount of tax deductions; 5.. Source: web site of the Equipment Leasing Association. 6.. Source: web site of the Japan Leasing Association.
Researchh objective and structure of the thesis
-- deferring the taxability of income; and
-- in the case of cross-border transactions, minimizing source country taxationn (besides the residence country taxation).
Thiss study seeks to investigate, specifically, how the parties to a cross-bor-derr leasing transaction may be able to obtain tax advantages under the rel-evantt tax laws7 and tax treaties of Germany, Japan, the Netherlands, the Unitedd Kingdom and the United States (hereafter referred as "the select ju-risdictions").. The study also aims to investigate whether, and how, the var-iouss anti-avoidance provisions under the relevant tax laws may prevent partiess to cross-border leasing transactions from obtaining undue tax ad-vantages.. For these purposes, the study is divided in the following seven areas: :
(i)) Lease characterization aspects
Ass tax consequences of a lease substantially depend upon characterization off the transaction (as sale, finance lease, or operating lease). As the starting pointt of the study, the lease characterization aspects under the relevant na-tionall tax laws of the select jurisdictions are examined in chapter 2. (ii)) Tax depreciation on leased assets
Generally,, tax depreciation on the leased asset constitutes one of the most substantiall items of deduction in computing a lessor's taxable income in the residencee state. Often, in the early years of the lease term, the excess of al-lowablee tax depreciation over the gross lease rental income results in a tax losss for the lessor, which enables the lessor to postpone his tax liability on thee lease rentals, and to set off the said loss against other taxable income. Usually,, the said advantage derived by the lessor is effectively passed on to thee lessee by way of reduced lease rentals. Accordingly, the lessors' (and in somee cases the lessees') entitlement to depreciation allowance forms the centrall element in many lease transactions. Aspects relating depreciation entitlementt under the relevant national tax laws of the select jurisdictions aree dealt with in chapter 3.
(iii)) Income recognition/deferral aspects
AA lessor may be able to defer tax liability in respect of leasing income by
rear-loadingrear-loading99 the lease rentals. However, the tax laws of many countries
7.. National/federal tax laws.
mayy contain specific anti-avoidance provisions designed to prevent tax de-ferrall by lessors. These aspects are examined in chapter 4
(iv)) Transaction structures and the effect of anti-avoidance rules in
nationalnational tax legislation
Too neutralize aggressive leasing transactions, tax laws of many jurisdic-tionss include specific restrictive or anti-avoidance provisions. However, thee players in the leasing arena are often successful in innovating transac-tionss that are well beyond the said restrictive or anti-avoidance provisions. Suchh innovations are often followed by consequential amendments in the nationall tax laws to plug "newly discovered" loopholes. This seemingly un-endingg "legislative amendment - transaction innovation sequence" leads to continuouss evolution of new transaction structures. Chapter 5 deals with as-pectss relating to various tax-driven leasing transaction structures, such as salee and leaseback, double-dip leasing, leveraged leases, etc., designed to maximizee tax advantages from leasing, as well as the relevant general and specificc anti-avoidance rules (including court decisions, if any) under the relevantt domestic tax laws.
(v)) Income characterization issues under tax treaties
Chapterr 6 begins with an overview of the OECD position on definition of thee term "royalty" vis-a-vis lease rental income in respect with industrial, commerciall and scientific equipment (ICS equipment) and the divergent positionn concerning taxation of royalty income in various tax treaties. Thereafter,, the chapter focuses on the characterization issue: whether and howw characterization of income from a lease transaction may influence ap-plicabilityy (or non-applicability) of the tax treaty distributive rules, par-ticularlyy the articles concerning royalties, interest and business profits. (vi)) Tax treaty aspects of source-state taxation of cross-border leasing
income income
Chapterr 7 analyses the following issues:
-- How various tax treaties differ in provisions concerning taxation of royalties,, interest income and capital gains that may provide tax arbi-tragee opportunities in respect of cross-border leasing transactions. -- Whether an interposed leasing entity carrying on substantive leasing
Researchh objective and structure of the thesis
residencee state. For this purpose, it is important to note that, since the issuee of applicability of a tax treaty in case of "improper" use by resi-dentss of a third country ("treaty shopping") could be a subject matter off another doctoral research project by itself, the same is not investi-gatedd in detail for the purposes of the present research. However, in vieww of the fact that, often, investors resident in third countries may ownn equity capital of a lessor, the contemporary position on the issue iss taken into account.
-- What is the function of the "beneficial ownership" requirement ob-servedd in contemporary tax treaties?
-- What would be the implication of absence of "beneficial ownership" requirementss in a tax treaty? For instance, Germany's tax treaties with Australiaa and Japan do not contain a "beneficial ownership" require-ment.. For this purpose, it is important to note that the present study fo-cusess on the consequences of absence (compared to presence) of a "beneficiall ownership" condition in a tax treaty; detailed analysis of thee meaning of the term "beneficial owner" is beyond the scope of this study.9 9
(vii)) Relevance of EC Treaty freedoms
Thee penultimate chapter (chapter 8) takes into account how the framework off EC Treaty freedoms may be relevant for cross-border leasing trans-actionss within EC Member States.
9.. For a detailed analysis of the meaning of the term "beneficial owner", see doctoral thesiss by Du Toit, Chart, Beneficial Ownership of Royalties in Bilateral Tax Treaties (In-ternationall Bureau of Fiscal Documentation).
CHAPTERR 2
TRANSACTION/LEASEE CHARACTERIZATION
ASPECTS S
2.1.. Introduction
Ass the tax treatment (for the lessor and the lessee) in respect of depreciation allowancee as well as gross taxable income10 is dependent upon transaction characterizationn (as lease v. sale), the characterization issue could be viewedd as the central issue concerning taxation of leasing income.
Sectionss 2.2. to 2.6. deal with the aspects relating to characterization of leasee agreements in the United States, the United Kingdom, Germany, the Netherlandss and Japan.
22.22. Lease characterization in the United States
2.2.1.. True lease: prerequisite for obtaining the tax advantage
Inn the United States, for the lessor to secure the tax benefits associated with thee ownership of the leased asset (mainly the depreciation deduction), the leasee must qualify as a "true lease".11 If the lease transaction is viewed as a conditionall sale or a secured loan, the lessee would be considered as the ownerr of the lease equipment and hence would be entitled to the tax bene-fitss associated with the ownership of the leased equipment. This may nul-lifyy the tax advantages of a leasing transaction.
Forr a transaction to qualify as a true lease, generally, the following two con-ditionss must be satisfied:12
10.. I.e. taxability of the entire amount of the gross lease rentals vis-a-vis taxability of onlyy the finance income part out of the gross lease rentals.
11.. See Rosen, Burt, and others, "United States Invokes Substance Over Form",
Inter-nationalnational Tax Review February 1992. See also Stewart, Mike, and others, "Comparing
Canadiann and U.S. Asset-based Leasing Taxation", Journal of International Taxation Februaryy 2002; and O'Connor, Walter F., and Wiesner, Philip J., 'Taxation of Cross-borderr Leasing" (Chapter for the United States), Cahiers de droit fiscal international, Volumee LXXVa, IFA Congress 1990 (Stockholm).
12.. See Rosen, Burt and others, "United States Invokes Substance over Form",
-- the lessor must sufficiently retain the benefits and burdens typically as-sociatedd with the ownership of the leased asset (facts-and-circumstan-cess analysis);13 and
-- the lessor must have a non-tax profit motive for entering into the trans-actionn (pre-tax profit motive)
2.2.2.. T h e I R S view
2.2.2.1.. Revenue Ruling 55-540: IRS view on what constitutes a "truee lease"
Inn 1955, the Internal Revenue Service (IRS) issued Revenue Ruling 55-540 clarifyingg its position as to when it would regard a lease transaction as a "truee lease", and when it would regard a transaction as purchase and sale of property. .
Ass per the said Revenue Ruling, whether, in substance, a transaction is a leasee or a conditional sales contract depends upon the intent of the parties ass evidenced by the provisions of the contract, viewed in light of the facts andd circumstances existing at the time the transaction was executed.14 Thee Revenue ruling states that in absence of compelling persuasive factors off contrary implication, a transaction would be regarded as a transaction of purchasee and sale (and not lease), if one or more of the following conditions aree present:
-- portions of the periodic payments are made specifically applicable to ann equity to be acquired by the lessee;
-- the lessee will acquire title (in the leased property) upon the payment off a stated amount of "rentals";
-- for a relatively short period of use, the lessee is required to pay an in-ordinatelyy large proportion (out of the total amount required to be paid
13.. On this aspect, also see Orticelli, David J., "Structuring Techniques For Generating Activee Foreign Leasing Income", Journal of International Taxation September 1998. 14.. See, also, O'Connor, Walter F., and Wiesner, Philip J., "Taxation of Cross-border Leasing"" (Chapter for the United States), Cahiers de droit fiscal international, Volume LXXVa,, IFA Congress 1990 (Stockholm); Park, William W., "Tax Characterisation of Internationall Leases: The Contours of Ownership", Cornell Law Review November 1981;; and Rosen, Burt, and others, "United States Invokes Substance over Form",
Leasee characterization in the United States
underr the contract), which could be considered a payment for securing thee transfer of the title;
-- the agreed "rental" payments materially exceed current fair market rentall value, which may indicate that the payments include an element otherr than compensation for the use of the asset;
-- the lessee is entitled to acquire the leased asset under a purchase option att a price which is (i) nominal in relation to the value of the property at thee time when the option may be exercised, as determined at the time off entering into the original agreement, or (ii) a relatively small amount ass compared to the total amount payable by the lessee;
-- a part of the periodic payments is specifically designated as interest or iss otherwise readily recognizable as the equivalent of interest. Thee Ruling also states that the fact that the agreement makes no provision forr the transfer of title or specifically precludes the transfer of title does not, byy itself, prevent the contract from being regarded as sale of an equitable interestt in the property.
Onn the other hand, the Ruling states that transactions would usually be in thee nature of lease (rather than purchase and sale of property) if the rental paymentss are at an hourly, daily, or weekly rate, or are based on production, use,, mileage, or a similar measure and are not directly related to the normal purchasee price, provided, if there is an option to purchase, that the price at whichh the property may be purchased reasonably approximates the antici-patedd fair market value on the option date.
Itt is interesting to note that the Ruling does not state that a transaction wouldd be regarded as a sale (instead of lease), if the lease term approxi-matess the estimated useful life of the asset.
2.2.2.2.. Revenue Procedure 75-21: Detailed Guidelines for granting advancee rulings
Forr facilitating issuance of advance rulings on whether a purported lease transactionn should be treated as lease for federal income tax purposes, the IRSS promulgated general guidelines through Revenue Procedure 75-21,
1975-11 C.B. 715 (hereinafterreferred to as the "old Guidelines"),15 recently supersededd by Revenue Procedure 2001-28. The old Guidelines set forth in Revenuee Procedure 75-21 were supplemented and modified through Reve-nuee Procedure 75-28,1975-1 C.B. 752; Revenue Procedure 76-30,1976-2 C.B.. 647; and Revenue Procedure 1979-2 C.B. 529.
Ass such, the old Guidelines applied only to "leveraged" leases and did not define,, as a matter of law, as to when a transaction constituted a lease for federall income tax purposes. However, the IRS indicated that a transaction thatt complies with the old Guidelines should be treated as "lease" in course off audit.16
Ass per the old Guidelines, for a transaction to be respected as lease, the fol-lowingg conditions must be satisfied:
(a)) Minimum 20% equity investment requirement
Thee lessor must make an initial equity investment in the leased asset equal too at least 20% of the cost of the asset and maintain a 20% equity investment throughoutt the lease term.17 The initial equity investment may be either in thee form of consideration paid or personal liability incurred by the lessor. Inn the case of the personal liability of the lessor, the lessor must have suffi-cientt net worth to satisfy the liability.
Thee equity investment must be unconditional, and therefore the lessor must nott be entitled to the return of any portion of the said minimum investment, afterr the leased property is first placed in service, through any direct or in-directt arrangement with the lessee or any member of the lessee group. How-ever,, the old Guidelines did not prohibit an arrangement between the lessor andd a third party (other than a member of the lessee group) for return of the lessor'ss minimum equity investment, if the leased property did not satisfy thee written specifications for the supply, manufacture or construction of the property. .
15.. See, also, O'Connor, Walter F., and Wiesner, Philip J., "Taxation of Cross-border Leasing"" (Chapter for the United States), Cahiers de droit fiscal international, Volume LXXVa,, IFA Congress 1990 (Stockholm); Park, William W., "Tax Characterisation of Internationall Leases: The Contours of Ownership", Cornell Law Review November 1981;; Rosen, Burt, and others, "United States Invokes Substance over Form",
Interna-tionaltional Tax Review Supplement February 1992; and LeDuc, John Andre, Tax Law and Es-tatetate Planning Course Handbook Series, Practising Law Institute October-November
2000. .
16.. Tech. Adv. Mem. 83-32-005,25 February 1983. 17.. Rev.Proc.75-21,Sec.4(l)(A).
Leasee characterization In the United States
(b)) Minimum 20% residual value and remaining useful life
Thee old Guidelines required that at the end of the lease term, as a reasonable estimate,, the fair market value of the leased property must be at least 20% off its original cost. Further, at the end of the lease term, the leased property mustt still have at least 20% of its total estimated useful life. For this pur-pose,, the term "lease term" included all renewal periods except renewals at thee option of the lessee at fair rental value determined at the time of renew-al. .
(c)) Fixed-price purchase/sale option
Thee old Guidelines required that the lessee should not have an option to purchasee the leased property for a price less than the fair market value of thee property at the time of exercise of the option. Similarly, the lessor shouldd not have a right to cause any party to purchase the leased property (evenn at the fair market value) or to abandon the property to any party. (d)) Lessee not to finance any part of the cost of the property
Ass per the old Guidelines, no part of the cost of the leased property must be fundedd by the lessee or any member of the lessee group.
Also,, the property must not require either a severable or non-severable im-provementt to the leased property by the lessee at the inception of the lease (exceptt the ancillary items that are customarily furnished by the lessee or thee purchaser of the property). Also, any severable improvements made by thee lessee must not be subject to a purchase contract or option between the lesseee and the lessor at a price other than the fair market value at the time off implementation of such contract or exercise of such option. Also, as per thee Guidelines, the lessee may not make non-severable improvements that exceedd certain specified threshold or type, and the lessee may not obtain an equityy interest in any allowable non-severable improvement made by it. (e)) Lessee not to provide any loan or guarantee
Nonee of the members of the lessee group must lend to the lessor any part of thee funds needed to acquire the leased property, or provide a guarantee in respectt of any indebtedness incurred by the lessor to purchase the leased property.. However, recognition of the transaction as "lease" would not be jeopardizedd by a guarantee by a member of the lessee group in respect of thee lessee's rent obligations, maintenance, insurance or other similar obli-gationss of the lessee in case of a net lease.
(f)) Profits and cashflow
Ass per the Guidelines, the lessor must be able to demonstrate that he ex-pectss a pre-tax profit from the transaction. This requirement is satisfied if thee lessor can demonstrate that the sum of the payments to be made by the lesseee and the expected residual value of the leased property at the end of thee lease term exceeds the sum of the aggregate disbursements required to bee paid by/for the lessor and the lessor's equity investment in the equipment includingg any direct costs to finance this equity investment.
Thee Guidelines also require that the lessor's aggregate cash flow from the transactionn must be positive.
2.2.2.3.. Revenue Procedure 2001-28
Onn 7 May 2001, the IRS issued Revenue Procedure 2001-28 ("new Guide-lines"),, superseding the old Guidelines, for advance ruling purposes.18 In essence,, the relevant features of the new Guidelines are similar to the fea-turess of the old Guidelines discussed at 2.2.2.2. However, interestingly, the neww Guidelines deviate from the old Guidelines by stating that the new Guideliness are not intended to be used for audit purposes. Accordingly, the neww Guidelines may be viewed as having a limited function of facilitating thee process of advance rulings, rather than expressing the IRS view on char-acterizationn of transactions as lease or sale. Probably, this deviation (as comparedd to the old Guidelines) is due to the fact that, except the pre-tax profitt requirement, the conditions of the old and the new Guidelines are not judiciallyy enforceable, as the courts have disregarded the said conditions (seee discussion at 2.2.3.). As the said conditions are not enforceable, the IRSS could only refuse to issue an advance ruling in the case of a transaction nott satisfying the conditions of the new Guidelines, though such a transac-tionn may be eventually characterized as lease in accordance with the prin-cipless emerging from the various court decisions discussed in this chapter.
18.. See, also, Stewart, Mike, and others, "Comparing Canadian and U.S. Asset-based Leasingg Taxation", Journal of International Taxation February 2002.
Leasee characterization In the United States
2.2.3.. Judicial developments
2.2.3.1.. Case law developments vis-a-vis the Guidelines requirements:: a comparison
Transactionss that deviated from all aspects of the old Guidelines have been regardedd by courts as lease, except the pre-tax profit requirement,19 as can bee observed from the discussion hereafter.20 As the features of the new Guideliness are comparable to the old Guidelines, the said court decisions aree equally relevant in context of the new Guidelines.
(a)) Minimum 20% equity investment requirement
Comparedd to the Guideline's requirement for the minimum 20% equity in-vestmentt by the lessor, the courts have regarded as lease even the transac-tionss that involved equity investments by the lessors ranging from mere 6% too 17%.21
(b)) Minimum 20% residual value and remaining useful life
Comparedd to the Guideline's requirement for the residual value at the end off the lease term of at least 20% of the original cost of the asset, the tax courtt regarded as lease even a transaction with inflated residual value of 2%.222 Also, in the same case, the tax court accepted the transaction as lease althoughh the estimated useful life of the property at the end of the lease term didd not exceed 16.67%.
(c)) Fixed-price purchase/sale option
Itt appears that the courts recognize transactions with a fixed price purchase optionn (contrary to the Guideline) as lease, if the purchase price either rep-resentss a reasonable estimate of the fair market value of the leased property ass of the option exercise date, or if the purchase price is not nominal in
re-19.. See LeDuc, John Andre, Tax Law and Estate Planning Course Handbook Series, Practisingg Law Institute, October-November 2000.
20.. See, also, Knight, Ray A. and Knight, Lee G., 'True Leases versus Disguised In-stallmentt Sale/Purchases: Factors the Courts Use to Distinguish", The Tax Adviser Marchh 1987.
21.. 6% in Emershaw v. Commissioner, 59 T.CM. (CCH) 621 (1990), affd, 917 F.2d 10400 (8th Or. 1990); 9% in L.W. Hardy Co. v. Commissioner, 52 T.CM. (CCH) 1540 (1987);; 9% in Lansburgh v. Commissioner, 53 T.CM. (CCH) 454 (1987); and 17% in
GreenbaumGreenbaum v. Commissioner, 53 T.CM. (CCH) 708 (1987).
lationn to such value.23 In one case,24 the tax court accepted as lease a trans-actionn that included a put option for the lessor.
(d)) Lessee not to finance any part of the cost of the property
Thee courts have recognized as lease transactions that involved investments byy lessees (contrary to the Guideline).25
(e)) Lessee not to provide any loan or guarantee
Thee court recognized a transaction as lease where the lessee had guaranteed thee lessor's debt in connection with financing of the leased asset.26 (f)) Cashflow
Inn certain cases, courts have upheld as lease transactions in spite of the ab-sencee of net positive pre-tax cash flow, since it was found that the antici-patedd residual value of the leased property was adequate to lead to a net gainn for the lessor.27
Thus,, the courts have upheld the lease transactions satisfying none of the criteriaa stated in the Guidelines, except the pre-tax profit motive aspect.
2.2.3.2.. Court decisions on transaction characterization: lease v. sale Inn the United States, although the IRC does not specify the conditions for characterizationn of a lease transaction, there is an extensive development of casee law on the issue as to whether a "lease transaction" amounts to lease orr conditional sale. Depending upon the particular facts and circumstances
23.. Transamerica Corp. v. United States, 88-2 U.S.T.C. (CCH); Lockhart Leasing Co.
v.v. Commissioner, 446 F. 2d 269 (10th Cir.. 1971); LTV Corp. v. Commissioner, 63 T.C.
39,, 50 (1974); Northwest Acceptance Corp. v. Commissioner, 58 T.C. 836, 847-48 (1972). .
24.. Cooper v. Commissioner, 88 T.C. 84 (1987).
25.. 79% of the cost of the leased asset in Lansburgh v. Commissioner, 53 T.C.M. (CCH)) 454 (1987); 85% in Mukerji v. Commissioner, 87 T.C. 926 (1986); 100% in
JohnsonJohnson v. United States, 86-2 U.S.T.C. (CCH).
26.. Greenbaum v. Commissioner, 53 T.C.M. (CCH) 708 (1987).
27.. Emershaw v. Commissioner, 59 T.C.M. (CCH) 621 (1990), affd, 917 F.2d 1040 (8thh Cir. 1990); L.W. Hardy Co. v. Commissioner, 52 T.C.M. (CCH) 1540 (1987);
Lans-burghburgh v. Commissioner, 53 T.C.M. (CCH) 454 (1987); Greenbaum v. Commissioner, 53
T.CJVI.. (CCH) 708 (1987); Torres v. Commissioner, 88 T.C. 702 (1987); Cooper v.
Leasee characterization in the United States
inn various cases, the courts have reached divergent conclusions. A review off the key court decisions28 reveals that the courts consider economic sub-stancee rather than the legal form of a transaction to characterize a transac-tionn as a lease or a sale transaction.
Thee courts generally tend to respect a transaction as "lease":
-- if in the case of existence of a purchase option in favour of the lessee, thee amount of lease rental payable during the lease term is reasonable (whenn considered strictly as rental), and the price at which the lessee is entitledd to purchase the leased asset in future is not unreasonably low ass on the date of signing the lease agreement;29
-- if a lease agreement does not confer a purchase option in favour of the lessee,, and if the lessee eventually acquires the leased asset from the lessor,, since such acquisition does not necessarily provide an inference thatt the lessee had a legal right as such to acquire the said equipment priorr to its actual acquisition;30
-- if a purchase option in favour of the lessee, the predetermined purchase pricee (to be paid -by the lessee to the lessor) is based on the expected value311 of the leased asset; in such a case mere presence of a purchase optionn in favour of the lessee is not in itself determinative factor and thee rentals at standard rates do not necessarily represent recovery of the purchasee price of the lease asset plus interest;32 or
-- if the lease agreement does not confer a purchase option in favour of thee lessee, and if the lessee is obliged to return the leased asset to the lessorr after expiry of the primary lease term (or extended lease term in casee of a renewal option available to the lessee), the lessee is precluded fromm disposing of the leased asset, the lessor realizes significant in-comee from scrapping of the returned equipment and follows elaborate proceduress for locating/identifying the leased equipment.33
28.. Summarized in Appendix 1.
29.. Benton v. Commissioner of Internal Revenue, 197 F. 2d 745 (US Court of Appeals Fifthh Circuit); The LTV Corporation v. Commissioner of Internal Revenue, 63 T.C. 39 (USS Tax Court).
30.. Western Contracting Corporation v. Commissioner of Internal Revenue, 271 F.2d 6944 (US Court of Appeals Eighth Circuit).
31.. Expected value of the leased asset as on the date of exercise of the purchase option, ass expected at the time of entering into the agreement.
32.. Lockhart Leasing company v. United States of America, 446 F.2d 269 (US Court of Appealss Tenth Circuit); The LTV Corporation v. Commissioner of Internal Revenue, 63 T.C.. 39 (US Tax Court).
33.. The Kansas City Southern Railway Co. v. Commissioner of Internal Revenue, 76 T.C.T.C. 1067 (US Tax Court).
Thee courts generally tend to recharacterize a transaction, styled in form of "lease",, as a "conditional sale transaction":
-- if the lease agreement confers a purchase option to the lessee as a result off which the lessee can acquire the leased asset at the end of the lease termm at a price substantially lower than the expected fair market value off the leased asset;34
-- if the lease agreement does not provide for a purchase option or even-tuall transfer of title in the leased asset to the lessee, the lessor is (the-oretically)) entitled to remove/repossess the leased asset from the premisess of the lessee, but the leased asset is tailor-made for the specif-icc property of the lessee so that such repossession/removal would pro-videe negligible salvage value to the lessor;35
-- if the lease agreement obliges the lessee to bear the entire risk of loss off or damage to the leased asset, the total rental equates with the cost off the equipment plus interest element, and the useful economic life of thee equipment approximates the primary lease term;36
-- if the lease confers upon the lessee a purchase option, the lease rentals payablee under the lease exceed the fair rental value of the asset, the leasee rentals paid by the lessees are taken into account for (or have the effectt of reducing) the amount of purchase option price, and the pur-chasee option price for the leased asset is significantly below the con-templatedd fair market value of the leased asset at the time when the purchasee option is exercisable.37
23.. Lease characterization in the United Kingdom
Inn the United Kingdom, characterization of a lease transaction is based on itss legal form rather than the economic substance, except where a lease in-volvess a purchase option, in which case the transaction is deemed to be a contractt for hire-purchase. Accordingly, in the case of a lease not confer-ringring a purchase option to the lessee, the characterization issue (i.e. lease v. sale)) does not arise. However, since the Capital Allowances Act 2001 pro-videss for restrictions in respect of the finance leases involving certain
spe-34.. Walburga Oesterreich v. Commissioner of Internal Revenue, 226 F.2d 798 (US Courtt of Appeals Ninth Circuit).
35.. Estate of Delano T. Starr v. Commissioner of Internal Revenue, 21A F.2d 294 (US Courtt of Appeals Ninth Circuit).
36.. Mt. Mansfield Television Inc. v. United States of America, 239 F. Supp. 539 (US districtt court for the district of Vermont).
Leasee characterization in the United Kingdom
cificc features (discussed at 3.5.2.6. and 3.5.2.7.), it is important to distinguishh between the finance lease and the operating lease.
2.3.1.. Definition of finance lease
2.3.1.1.. Relevance of the Generally Accepted Accounting Principles
Ass per Sec. 219 of the Capital Allowances Act 2001, "finance lease" means ann arrangement:
(a)) which provides for plant or machinery to be leased or otherwise made
availableavailable by a person ("the lessor") to another person ("the lessee"); and d
(b)) which, under normal accountancy practice:
(i)) falls (or would fall) to be related, in the accounts of the lessor or a personn connected with the lessor, as a finance lease or a loan, or (ii)) is comprised in an arrangement which falls (or would fall) to be so
treated. .
Accordingly,, for tax purposes, the definition of "finance lease" is linked to thee relevant Generally Accepted Accounting Principles. In the United Kingdom,, lease accounting is governed by the Statement of Standard countingg Practice 21 (SSAP 21) issued by the Institute of Chartered Ac-countantss of England and Wales.
2.3.1.2.. Definition of "finance lease" under SSAP 21
Ass per SSAP 21, where the substance of a lease transaction is to transfer substantiallyy all the risks and rewards of ownership in the leased asset fromm the lessor to the lessee, the lease transaction is regarded as a "finance lease".388 For this purpose, substantially all risks and rewards are regarded ass transferred if at the inception of a lease the present value of the mini-mumm lease payments, including any initial payment, amounts to a sub-stantiall part (at least 90 per cent or more) of the fair value of the leased asset.. In a finance lease, the lessor is required to treat the transaction as "sale"" or "financing transaction", and record the lease payments due from thee lessee as "debtor" (i.e. lease receivables).
2.3.2.. Court decision on characterization of lease transaction
Inn the United Kingdom, up to now, there is only one reported court decision onn the issue.39 The case,dating back to 1913, involved the hire purchase of aa railway wagon. The hirer was bound to pay a stipulated hire charge during thee term of the agreement, and was not entitled to return the wagon before thee end of the term under the agreement. At the end of the said term, the hirerr had the option to purchase the wagon for an amount of mere one shil-ling.. The Court of Sessions recharacterized the hire-purchase agreement as twoo concurrent contracts: one for the hire of the wagon and another for the salee and purchase of the wagon at a future date.40
2.4.. Lease characterization in Germany
2.4.1.. Significance of economic ownership
Inn Germany, for tax purposes, characterization of a lease agreement de-pendss upon the fact as to who is the economic owner of the leased asset. If thee lessor is regarded as the economic owner of the leased asset, then the transactionn is characterized as lease. However, if the lessee is the economic ownerr of the leased asset, then the transaction is recharacterized as sale of assett by the lessor to the lessee.41
2.4.2.. Definition of economic ownership
"Economicc ownership" is defined in paragraph 39, subsection 2, No. 1
Ab-gabenordnunggabenordnung (AO) (German Tax Code), according to which a person
otherr than the holder of the legal title under civil law may be treated as the economicc owner of an asset when the said person has the exclusive use of thee asset for its normal useful life in a way such that the holder of the legal titlee is excluded from using the asset.42
39.. Darngavil Coal Company Limited v. Francis (Surveyor ofTaxes) (1913) 7 T.C. 1. 40.. Accordingly, the Court held that the total payment under the contract had to be ap-portionedd between the hire price and the sale price for the wagon.
41.. See PricewaterhouseCoopers, International Leasing (2nd Edition) (Tolley Lexis-Nexis),, pp. 98-102.
Leasee characterization in Germany
2.4.3.. German Supreme Fiscal Court decision on transfer of
economicc ownership
Inn a landmark decision43 involving finance lease of movable assets, the Ger-mann Supreme Fiscal Court held that, for tax purposes, lease arrangements mustt be qualified in accordance with the economic effects of the arrange-ment,, i.e. on the basis of the economic ownership. The Court held that the economicc ownership is transferred from the lessor to the lessee when: -- the usual economic useful life of the leased asset and the primary lease
termm are approximately equal; or
-- the usual economic useful life of the leased asset is longer than the pri-maryy lease term, and the lessee has, at the end of the primary lease term,, an option to either purchase the leased asset or to renew the lease, andd the purchase price or the lease rental during the renewed lease term iss considerably lower than the fair market value; or
-- the leased asset is specially adapted according to special requirements off the lessee, and at the end of the lease term, practically it can be used onlyy by the lessee.
2.4.4.. Tax circulars on attribution of economic ownership
Ass discussed at 333.2., based on the above-mentioned decision of the Ger-mann Supreme Fiscal Court, the German tax authorities issued a circular in 1971,, binding on the tax authorities but not on the taxpayers and tax courts, concerningg attribution of economic ownership in case of full pay-out leases.444 As per the said circular, the lessee is regarded the economic owner iff the minimum lease term is either less than 40% or greater than 90% (with
43.. Dated 26 January 1970. See, also, Park, William W., 'Tax Characterisation of In-ternationall Leases: The Contours of Ownership", Cornell Law Review November 1981. 44.. See, also, Park, William W., "Tax Characterisation of International Leases: The Contourss of Ownership", Cornell Law Review November 1981; and Haarmann, Wil-helm,, "German Cross-border Leasing Goes Global", International Tax Review April 1997. .
orr without a renewal option) of the ordinary useful life of the leased asset,45 orr the lessee has the option to acquire the leased asset either below the fair markett value or below the book value (in the lessor's books). In 1975, the taxx authorities issued a circular concerning the attribution of economic ownershipp in case of non-pay-out lease of movable properties.46
2.5.. Lease characterization in the Netherlands
2.5.1.. Significance of economic ownership
Inn the Netherlands, as in Germany, characterization of a lease agreement dependss on the fact as to who is the economic owner of the leased asset.47
Iff the lessor is the economic owner of the leased asset, then the transaction iss regarded as lease. However, if the lessee is regarded as the economic owner,, the transaction is regarded as sale.48
2.5.2.. Hoge Raad decision on economic ownership
Ass regards the issue of economic ownership, it has been held by the Hoge
RaadRaad4949 that the legal owner (lessor) must also be regarded as the economic
45.. For an explanation on the rationale behind the 90% and 40% limits, see Park, Wil-liamm W., "Tax Characterisation of International Leases: The Contours of Ownership",
CornellCornell Law Review November 1981, where the author states as follows: "The logic of
thee 90% upper limit on the lease term is obvious; relinquishment of dominion over equip-mentt for more than nine-tenths of its life effectively eliminates the lessor's interest in its residuall value. The rationale of the 40% lower limit is perhaps less evident.... A reason-ablee lessee will be unwilling to cover all costs plus interest in exchange for use of equip-mentt for a period less than 40% of the asset's life. According to the German view of humann nature, the lessee will conclude such a deal only if it expects to acquire the prop-ertyy at the end of the lease term pursuant to a tacit understanding with the lessor." 46.. For a detailed reference to the said circular, see 3.3.3.3. In essence, the said circular attributess economic ownership to the party that has a right to obtain the majority of even-tuall capital gain in case of sale of the leased asset.
47.. See Van der Laan, Robert, International Leasing, PricewaterhouseCoopers (2nd Edition),, Chapter on the Netherlands, paragraph 5.3.2.
48.. See International Bureau of Fiscal Documentation, Leasing Taxation (1989), p. 147. .
Leasee characterization in the Netherlands
owner,, unless all (and not some) economic interests/risks in the leased asset aree shifted to the lessee.50 As per Marcel Coenen,51 the interests/risks could bee distinguished as follows:
-- the risk of the leased asset not functioning well;
-- the risk of reduction in value of the leased asset in the course of time duee to technical and/or economic wastage;
-- the risk of loss due to external factors (such as fire, theft or destruction); -- the residual value risk.
2.5.3.. Lease arrangement
Thoughh there are no specific anti-avoidance provisions concerning leasing transactions,, it is important to note the safe-harbour rules issued by the Dutchh tax authorities by way of a "lease arrangement".
Thee said lease arrangement was entered into as a result of discussions be-tweenn the Dutch Ministry of Finance and the Dutch Leasing Association, andd is applicable with effect from 1 January 2000. This arrangement re-placedd the previous arrangement effective as of 1 February 1993 (which wass applicable with retrospective effect from 1 March 1988).52 The terms off the lease arrangement are binding on the Dutch tax authorities. The lease arrangementt derives legal force by virtue of a decree issued by the State Secretaryy of Finance on 15 November 1999, confirming the said lease ar-rangement. .
Ass per the lease arrangement, a leasing transaction is considered as "oper-atingg lease" if all of the following requirements are met:53
50.. Also see, on economic ownership, Altepost, George P., "The Netherlands Provides Favorablee Climate For Aircraft Leasing", Journal of International Taxation November/ Decemberr 1992.
51.. See International Bureau of Fiscal Documentation, Fiscal versus commercial profit
accountingaccounting in the Netherlands, France and Germany (1996), p.61.
52.. It is also relevant to note that prior to the lease arrangement of 1 February 1993, theree were two earlier arrangements with effective dates of 1 December 1984 and 1 Marchh 1987.
53.. See, also, De Gunst, Erik, "Dutch Finance Ministry Clarifies New Leasing Guide-line",, Tax Notes International 6 August 2001.
