Termination of burdensome lease.

• Author: Zarzar, Robert

The Tax Court addressed application of Sec. 167(c)(2) to an acquisition of leased property that resulted in termination of a burdensome lease agreement (Union Carbide Foreign Sales Corp., 115 TC 423 (2000)). The case involved a long-term lease of a specialized seagoing vessel that the taxpayer had operated as lessee for approximately 10 years. However, the lease terms became extremely burdensome to the taxpayer.

Under the agreement, the taxpayer could terminate the lease by making a significant termination payment or by purchasing the leased vessel. The taxpayer determined that the cost of exercising the purchase option was about 20% less than the termination payment and would have the effect of terminating the lease. Therefore, the taxpayer exercised its $107,748,925 purchase option. At exercise, the taxpayer determined the vessel's fair market value to be $13,865,000. Accordingly, the taxpayer deducted the remaining $93,883,925 as a payment for termination of a burdensome lease. The IRS disallowed the taxpayer's deduction on the basis that Sec. 167(c)(2) prohibits such an allocation.

Tax Court Decision

Under Sec. 167(c)(2)(A),"[i]f any property is acquired subject to a lease--no portion of the adjusted basis shall be allocated to the leasehold interest...." Accordingly, the primary issue centered on the definition of property "subject to a lease." The Tax Court found "no direct assistance" from the legislative history of Sec. 167(c)(2), which was enacted for the purpose of clarifying the application of Sec. 197. Nonetheless, the court concluded that under the statute's plain language, the vessel was acquired "subject to a lease" and, therefore, Sec. 167(c)(2) prohibited allocation of any amount as a deductible contract termination payment. The court also rejected the taxpayer's alternative argument that the acquisition should be characterized as two separate transactions, one attributable to acquisition of the vessel and the other attributable to cancellation of the burdensome lease.

Although the Union Carbide decision is troubling, there are a number of issues in the court's analysis that may limit the case's application outside of its specific facts and holding. For example, in rejecting the taxpayer's alternative argument, the court relied on an interpretation of the Supreme Court's analysis in Millinery Center Building Corp., 350 US 456 (1956), that conflicts with a recent Service interpretation of this seminal case.

In Letter Ruling...