IRS Examines Effects of LILO Transactions.

• Author: Fiore, Nicholas J.

X is a U.S. corporation. FM is a foreign municipality that has historically owned and used certain property with a remaining useful life of 50 years and a fair market value (FMV) of $100 million. BK1 and BK2 are banks. None of the parties is related.

On Jan. 1, 1997, x and FM entered into a lease-in/lease-out (LILO) transaction under which FM leased the property to X under a "headlease" and X immediately leased the property back to FM under a "sublease." The term of the headlease is 34 years. The "primary" term of the sublease is 20 years. Moreover, the sublease may also have a"put renewal" term of 10 years.

The headlease requires X to make two rental payments to FM during its 34-year term: (1) an $89 million "prepayment" at the beginning of year 1; and (2) a "postpayment" at the end of year 34 that has a discounted present value of $8 million. For Federal income tax purposes, X and FM allocate the prepayment ratably to the first six years of the headlease and the future value of the postpayment ratably to the remaining 28 years of the headlease.

The sublease requires FM to make fixed, annual rental payments over both the primary term and (if exercised) the put renewal term. The fixed, annual payments during the put renewal term are substantially higher than those for the primary term. Nevertheless, the fixed annual payments during the put renewal term are projected (as of Jan. 1, 1997) to equal only 90% of the FMV rental amounts for that term.

At the end of the sublease primary term, FM has a "fixed-payment option" to purchase from X the headlease residual (i.e., the right to use the property beyond the sublease primary term, subject to the obligation to make the rent postpayment) for a fixed amount projected (as of Jan. 1, 1997) to equal the FMV of the headlease residual. If FM exercises the option, the transaction is terminated at that point and X is not required to make any portion of the postpayment due under the headlease. If FM does not exercise the option, X may elect to (1) use the property itself for the headlease's remaining term, (2) lease the property to another person for the headlease's remaining term or (3) compel FM to lease the property for the 10-year put renewal term of the sublease. If FM does not exercise the fixed-payment option and X exercises its put renewal option, X can require FM to purchase a letter of credit guaranteeing the put renewal rents. If FM does not obtain the letter of credit, FM must exercise the fixedpayment option.

To partially fund the $89 million headlease prepayment, X borrows $54 million from BK1 and $6 million from BK2. Both loans are nonrecourse, have fixed interest...