Final section 467 regulations present problems and opportunities.

• Author: Lipton, Richard M.
• Position: IRC section 467

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

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

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

Overview

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

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

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

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

Section 467 Rental Agreements

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

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

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

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

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

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

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

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

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

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

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

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

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