Leveraged Leasing and Economic Substance under Proposed I.R.C. §7701(o)

Abstract

In a “true lease,” the lessor reports rental income and deducts related business expenses. The lessee deducts his rental payments. The Commissioner, however, has on numerous occasions challenged purported lease agreements, arguing that a “sales” or “financing” transaction, rather than a “leasing” transaction, has actually occurred. When a lease is recharacterized as a sale, the lessee will be considered the owner of the leased property and, thus, lose the expense deduction for the rental payments, but have depreciation and other related expense deductions. The lessor will be treated as if he sold the leased property in a taxable transaction and recognizes gain and imputed interest income as rental payments are received. And since he is no longer the owner of the leased property, no deduction for depreciation or other related expenses will be allowed. In order for the parties to avail themselves to the implicit tax benefits of a lease, the transaction must generally meet both common law “economic substance” and “business purpose” doctrines. However, due to the lack of a uniformly accepted “bright-line” test defining these doctrines, differing rules currently exist among the federal circuits. This has led to both taxpayer uncertainty and inconsistent tax results. In 2003, Congress began an initiative to solve these problems by proposing to codify the “economic substance” and “business purpose” doctrines. Proposed I.R.C. §7701(o) statutorily defines the economic substance doctrine, to include the business purpose doctrine. It also attempts to define and quantify “profit potential.” This article examines the economics and structure of leveraged leasing, relevant common law tax rules, and the impact proposed I.R.C. §7701(o) will have on those rules, should it become law.