Rev. Rul. disallows LILO transaction deductions.

• Author: Kautter, David J.
• Position: Lease-in/lease-out transactions

The IRS issued Rev. Rul. 2002-69, which reaffirmed the conclusion in Rev. Rul. 99-14 that a taxpayer may not deduct rent or interest arising from a lease-in/lease-out (LILO) transaction. However, in the new ruling, the Service did not look (as it had in the past) to a lack of pre-tax profit potential or business purpose to challenge the LILO for lack of economic substance. Instead, it examined the transaction on a limited technical basis, concluding that the arrangements conferred only a future property interest, rather than a current leasehold; thus, the ruling recommended that a U.S. taxpayer defer any deductions until the possessory interest became actual.

Facts

A foreign municipality (F) entered into a 40-year property headlease (H) with a U.S. taxpayer (X). X was required to make two rental payments--an $89 million prepayment ($60 million in loans and $29 million in equity) and a post-payment, due after H expired, with a current $8 million present value. A $54 million portion of the loan was fully defeased, by F making a deposit with an affiliate of the lender and pledging the deposit through X as security for a sublease (S) assigned as loan collateral. The remaining $6 million of the nonrecourse loan was not directly defeased, even though F had made a nonpledged funding deposit with another affiliate of the same lender.

X later subleased the property to F for 20 years. At the end of this term, F had a fixed-purchase option at 105% of the anticipated fair market value (FMV). If F declined to exercise the option, X could accept return of the property or require F to renew the lease at specified rents currently projected at less than FMV through a 10-year put renewal term. The initial lease payments under the initial S term equaled the loan's debt service; thus, the ruling did not mention any free cash-flow to X during the base lease term.

Theory

The IRS determined that F's S interest was of the "same nature" as the H interest conveyed to X; thus, X acquired no property right. Accordingly, because X did not acquire a current leasehold interest, the IRS determined that X could not currently deduct rent or amortize the lease prepayment.

The $29 million "equity" portion of the H prepayment was, effectively, a payment for X's future right under H to lease the property 20 years hence for a 20-year term. Only at that time would a deduction be allowed for the basis in the right, either through amortization or sale of the interest to the...