Part III. Administrative, Procedural, and Miscellaneous
Internal Revenue Bulletin 2005-9 · 2026-10-03 edition · updated 2026-10-04 · United States
Tax-Exempt Leasing Involving Defeasance
Notice 2005–13
The Internal Revenue Service and the Treasury Department are aware of types of transactions, described below, in which a taxpayer enters into a purported sale-leaseback arrangement with a tax-indifferent person in which substantially all of the tax-indifferent person’s payment obligations are economically defeased and the taxpayer’s risk of loss from a decline, and opportunity for profit from an increase, in the value of the leased property are limited. This notice alerts taxpayers and their representatives that these transactions are tax avoidance transactions and identifies these transactions, and substantially similar transactions, as listed transactions for purposes of § 1.6011–4(b)(2) of the Income Tax Regulations and §§ 6111 and 6112 of the Internal Revenue Code. This notice also alerts parties involved with these transactions of certain responsibilities that may arise from their involvement with these transactions.
FACTS
X is a U.S. taxpayer. FP is a tax-indifferent person that owns and uses certain property. 1 BK1, BK2, BK3, and BK4 are banks. None of these parties is related to any other party, unless otherwise indicated.
Situation 1
On the closing date of January 1, 2003 (“Closing Date”), X and FP enter into a purported sale-leaseback transaction under which FP sells the property to X, and X immediately leases the property back to FP under a lease (“Lease”). The purchase and sale agreement and the Lease are nominally separate legal documents. Both agreements, however, are executed pursuant to a comprehensive participation agreement, which provides that the parties’ rights and obligations under any of the
agreements are not enforceable before the execution of all transaction documents.
The Lease requires FP to make rental payments over the term of the Lease (“Lease Term”). As described below, the Lease also provides that under certain conditions, X has the option (“Service Contract Option”) to require FP to identify a party (“Service Recipient”) willing to enter into a contract with X to receive services provided using the leased property (“Service Contract”) that commences immediately after the expiration of the Lease Term. The Service Recipient must meet certain financial qualifications, including credit rating and net capital requirements, and provide defeasance or other credit support to satisfy certain of its obligations under the Service Contract. If FP cannot locate a qualified third party to enter into the Service Contract, FP or an affiliate of FP must enter into the Service Contract. The aggregate of the Lease Term plus the term of the Service Contract (“Service Contract Term”) is less than 80 percent of the assumed remaining useful life of the property.
On the Closing Date, the property has a fair market value of $105x and X makes a single payment of $105x to FP. To fund the $105x payment, X provides $15x in equity and borrows $81x from BK1 and $9x from BK2. Both loans are nonrecourse and provide for payments during the Lease Term. Accrued but unpaid interest is capitalized as additional principal. As of the Closing Date, the documents reflect that the sum of the outstanding principal on the loans at any given time will be less than the projected fair market value of the property at that time. The amount and timing of the debt service payments closely match the amount and timing of the Lease payments due during the Lease Term.
FP intends to utilize only a small portion of the proceeds of the purported saleleaseback for operational expenses or to finance or refinance the acquisition of new assets. Upon receiving the $105x purchase price payment, FP sets aside substantially all of the $105x to satisfy its lease obligations. FP deposits $81x with BK3 and
$9x with BK4. BK3 may be an affiliate of BK1, and BK4 may be an affiliate of BK2. The deposits with BK3 and BK4 earn interest sufficient to fund FP’s rent obligations as described below. BK3 pays annual amounts equal to 90 percent of FP’s annual rent obligation under the Lease (that is, amounts sufficient to satisfy X’s debt service obligation to BK1). Although FP directs BK3 to pay those amounts to BK1, the parties treat these amounts as having been paid from BK3 to FP, then from FP to X as rental payments, and finally from X to BK1 as debt service payments. In addition, FP pledges the deposit with BK3 to X as security for FP’s obligations under the Lease, while X, in turn, pledges its interest in FP’s pledge to BK1 as security for X’s obligations under the loan from BK1. Similarly, BK4 pays annual amounts equal to 10 percent of FP’s rent obligation under the Lease (that is, amounts sufficient to satisfy X’s debt service obligation to BK2). Although FP directs BK4 to pay these amounts to BK2, the parties treat these amounts as having been paid from BK4 to FP, then from FP to X as rental payments, and finally from X to BK2 as debt service payments. Although FP’s deposit with BK4 is not pledged, the parties expect that the amounts deposited with BK4 will remain available to pay the remaining 10 percent of FP’s annual rent obligation under the Lease. FP may incur economic costs, such as an early withdrawal penalty, in accessing the BK4 deposit.
FP is not legally released from its rent obligations. X’s exposure to the risk that FP will not make the rent payments, however, is substantially limited by the arrangements with BK3 and BK4. In the case of the loan from BK1, X’s economic risk is remote due to the deposit arrangement with BK3. In the case of the loan from BK2, X’s economic risk is substantially reduced through the deposit arrangement with BK4. X’s obligation to make debt service payments on the loans from BK1 and BK2 is completely offset by X’s right to receive Lease rentals from FP. As a
1 In some instances, FP meets the definition of a tax-exempt entity under section 168(h)(2). In other instances, FP does not meet that definition but possesses attributes, such as net operating losses, that render FP tax indifferent.
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the Equity Collateral is less than the Termination Value, X may require FP to maintain a letter of credit. During the Service Contract Term, the Service Recipient will be required to provide defeasance or other credit support that would be available to satisfy the Termination Value. As a result, X in almost all events will recover its investment plus a pre-tax rate of return.
For tax purposes, X claims deductions for interest on the loans and for depreciation on the property. X does not include the optional Service Contract Term in the lease term for purposes of calculating the property’s recovery period under §§ 168(g)(3)(A) and 168(i)(3). X includes in gross income the rents received on the Lease. If the Purchase Option is exercised, X also includes the Exercise Price in calculating its gain or loss realized on disposition of the property.
The form of the sale from FP to X may be a head lease for a term in excess of the assumed remaining useful life of the property and an option for X to purchase the property for a nominal amount at the conclusion of the head lease term. In some variations of this transaction, the participation agreement provides that if X refinances the nonrecourse loans, FP has a right to participate in the savings attributable to the reduced financing costs by allowing FP to renegotiate certain terms of the transaction, including the Lease rents and the Purchase Option price.
Situation 2
The facts are the same as in Situation 1 except for the following.
The Lease does not provide a Service Contract Option. In lieu of the Purchase Option described in Situation 1, FP has an option (“Early Termination Option”) to purchase the property from X on the date (“ETO Exercise Date”) that is 30 months before the end of the Lease Term. Exercise of the Early Termination Option allows FP to terminate the Lease and repurchase the property for a fixed exercise price (“ETO Exercise Price”) that on the Closing Date, exceeds the projected fair market value of the property on the ETO
result, neither bank bears a significant risk of nonpayment. 2
FP has an option (“Purchase Option”) to purchase the property from X on the last day of the Lease Term (“Exercise Date”). Exercise of the Purchase Option allows FP to repurchase the property for a fixed exercise price (“Exercise Price”) that, on the Closing Date, exceeds the projected fair market value of the property on the Exercise Date. The Purchase Option price is sufficient to repay X’s entire loan balances and X’s initial equity investment plus provide X with a predetermined after-tax rate of return on its equity investment.
At the inception of the transaction, X requires FP to invest $9x of the $105x payment in highly rated debt securities (“Equity Collateral”), and to pledge the Equity Collateral to X to satisfy a portion of FP’s obligations under the lease. 3 Although the Equity Collateral is pledged to X, it is not among the items of collateral pledged to BK1 or BK2 in support of the nonrecourse loans to X. The Equity Collateral upon maturity, when combined with the balance of the deposits made with BK3 and BK4 and the interest on those deposits, fully funds the amount due if FP exercises the Purchase Option. This arrangement ensures that FP is able to make the payment under the Purchase Option without an independent source of funds. Having economically defeased both its rental obligations under the Lease and its payment obligations under the Purchase Option, FP keeps the remaining $6x, subject to its obligation to pay the Termination Value (described below) upon the happening of certain events specified under the Lease.
If FP does not exercise the Purchase Option, X may elect to (1) take back the property, or (2) exercise the Service Contract Option and compel FP either to (a) identify a qualified Service Recipient, or (b) enter (or compel an affiliate of FP to enter) into the Service Contract as the Service Recipient for the Service Contract Term. If X exercises the Service Contract Option, the Service Recipient must pay X predetermined minimum capacity payments sufficient to provide X with a minimum af
ter-tax rate of return on its equity investment. The Service Recipient also must reimburse X for X’s operating and maintenance costs for providing the services.
As a practical matter, the Purchase Option and the Service Contract Option collar X’s exposure to changes in the value of the property. If the value of the property is at least equal to the Purchase Option Exercise Price, FP likely will exercise the Purchase Option. Likewise, FP likely will exercise the Purchase Option if FP concludes that the costs of the Service Contract Option exceed the costs of the Purchase Option. Moreover, FP may exercise the Purchase Option even if the fair market value of the property is less than the Purchase Option Exercise Price because the Purchase Option is fully funded, and the excess of the Exercise Price over the projected value may not fully reflect the costs to FP of modifying, interrupting, or relocating its operations. If the Purchase Option is exercised, X will recover its equity investment plus a predetermined after-tax rate of return. Conversely, if the Purchase Option is not exercised, X may compel FP to locate a Service Recipient to enter into the Service Contract in return for payments sufficient to provide X with a minimum after-tax rate of return on its equity investment, regardless of the value of the property.
Throughout the Lease Term, X has several remedies in the event of a default by FP, including a right to (1) take possession of the property or (2) cause FP to pay X specified damages (“Termination Value”). Likewise, throughout the Service Contract Term, X has similar remedies in the event of a default by the Service Recipient. On the Closing Date, the amount of the Termination Value is slightly greater than the purchase price of the property. The Termination Value fluctuates over the Lease Term and Service Contract Term, but at all times is sufficient to repay X’s entire loan balances and X’s initial equity investment plus a predetermined after-tax rate of return. The BK3 deposit, the BK4 deposit and the Equity Collateral are available to satisfy the Termination Value during the Lease Term. If the sum of the deposits plus
2 The arrangement by which FP sets aside the funds necessary to meet its obligations under the Lease may take a variety of forms other than a deposit arrangement involving BK3 and BK4. These arrangements include a loan by FP to X, BK1 or BK2; a letter of credit collateralized with cash or cash equivalents; a payment undertaking agreement; prepaid rent (regardless of whether X finances a portion of the purchase price by borrowing from BK1 or BK2); a sinking fund arrangement; a guaranteed investment contract; or financial guaranty insurance.
3 The arrangement by which the return of X’s equity investment plus a predetermined after-tax return on such investment is provided may take a variety of forms other than an investment by FP in highly rated debt securities. For example, FP may be required to obtain a payment undertaking agreement from an entity having a specified minimum credit rating.
February 28, 2005 631 2005–9 I.R.B.
sale-leaseback transaction respected by the Court in Frank Lyon .
First, in Frank Lyon, the sales proceeds were used to construct the lessee’s new headquarters. In contrast, in the transactions described above, substantially all of the $105x sales proceeds are immediately set aside by FP to satisfy its obligations under the Lease and to fund FP’s exercise of the Purchase Option or the Early Termination Option. As a condition to engaging in the transactions, FP economically defeases substantially all of its rent payment obligations and the amounts due under the Purchase Option or the Early Termination Option by establishing and pledging the deposit with BK3 and the Equity Collateral. Moreover, even though FP may not pledge the deposit with BK4, FP fully funds its remaining rent obligations with the BK4 deposit and may have limited rights to access the funds held in that deposit. Consequently, the only capital retained by FP is the remaining $6x portion of the sales proceeds that represents FP’s fee for engaging in the transaction.
Second, in Frank Lyon, the taxpayer bore the risk of the lessee’s nonpayment of rent, which could have forced the taxpayer to default on its recourse debt. The Court concluded that the taxpayer exposed its business well-being to a real and substantial risk of nonpayment and that the long-term debt affected its financial position. Frank Lyon, 435 U.S. at 577. In contrast, in the transactions described above, economic defeasance renders the risk to X of FP’s failure to pay rent remote. Moreover, because of the economic defeasance, X’s right to receive the Equity Collateral upon the exercise of the Purchase Option, and FP’s obligation with respect to the Termination Value, a failure by FP to satisfy its lease obligations does not leave X at risk for repaying the loan balances or forfeiting its equity investment.
Third, in Frank Lyon, the taxpayer’s return was dependent on the property’s value and the taxpayer’s equity investment was at risk if the property declined in value. The economic burden of any decline in the value of the property is integral to the determination of tax ownership. See, e.g., Swift Dodge v. Commissioner, 692 F.2d 651 (9 th Cir. 1982). In the transactions described above, X bears insufficient risk of a decline in the value of the property to be treated as its owner for tax purposes. In
Exercise Date. The Early Termination Option price is sufficient to repay X’s entire loan balances and X’s initial equity investment plus a predetermined after-tax rate of return on its equity investment. The balance of the Equity Collateral combined with the balance of the deposits made with BK3 and BK4 and the interest on those deposits fully fund the amount due under the Early Termination Option.
If FP does not exercise the Early Termination Option, FP is required to obtain residual value insurance for the benefit of X, pay rents for the remaining Lease Term, and return the property to X at the end of the Lease Term (“Return Option”). The residual value insurance must be issued by a third party having a specified minimum credit rating and must provide that if the actual residual value of the property is less than a fixed amount (“Residual Value Insurance Amount”) at the end of the Lease Term, the insurer will pay X the shortfall. On the Closing Date, the Residual Value Insurance Amount is less than the projected fair market value of the property at the end of the Lease Term. If FP does not maintain the residual value insurance coverage for the entire Lease Term remaining after the ETO Exercise Date, FP will default and be obligated to pay X the Termination Value. If FP does not exercise the Early Termination Option, the rents for the remaining Lease Term plus the Residual Value Insurance Amount are sufficient to provide X with a minimum after-tax rate of return on the property, regardless of the value of the property. As a practical matter, the Early Termination Option and the Return Option collar X’s exposure to changes in the value of the property. At the end of the Lease Term, FP also may have the option to purchase the property for the greater of its fair market value or the Residual Value Insurance Amount.
For tax purposes, X claims deductions for interest on the loans and for depreciation on the property. X treats a portion of the property as qualified technological equipment within the meaning of § 168(i)(2). X depreciates that portion of the property over five years under § 168(g)(3)(C). X treats a portion of the property as software. X depreciates that portion of the property over 36 months under § 167(f)(1)(A).
X includes in gross income the rents received on the Lease. If the Early Termina
tion Option is exercised, X also includes the ETO Exercise Price in calculating its gain or loss realized on disposition of the property.
In some variations of this transaction, if the Early Termination Option is not exercised, the Lease rents payable to X may increase for the portion of the Lease Term remaining after the ETO Exercise Date.
ANALYSIS
The substance of a transaction, not its form, governs its tax treatment. Gregory v. Helvering, 293 U.S. 465 (1935). In Frank Lyon Co. v. United States, 435 U.S. 561, 573 (1978), the Supreme Court stated that “[i]n applying the doctrine of substance over form, the Court has looked to the objective economic realities of a transaction rather than to the particular form the parties employed.” The Court evaluated the substance of the particular transaction in Frank Lyon to determine that it should be treated as a sale-leaseback rather than a financing arrangement. The Supreme Court described the transaction in Frank Lyon as “a genuine multiple-party transaction with economic substance which is compelled or encouraged by business or regulatory realities, is imbued with tax-independent considerations, and is not shaped solely by tax-avoidance features that have meaningless labels attached.” Frank Lyon, 435 U.S. at 584. The Court subsequently relied on its approach in Frank Lyon to recharacterize a sale and repurchase of federal securities as a loan, finding that the economic realities of the transaction did not support the form chosen by the taxpayer. Nebraska Dep’t of Revenue v. Loewenstein, 513 U.S. 123 (1994). A sale-leaseback will not be respected unless the owner/lessor acquires and retains “significant and genuine attributes” of a traditional owner, including “the benefits and burdens of ownership.” Coleman v. Commissioner, 16 F.3d 821, 826 (7 th
Cir. 1994) (citing Frank Lyon, 435 U.S. at 582–84). Considering the totality of the facts and circumstances in the transactions described in Situations 1 and 2, X does not acquire the benefits and burdens of ownership and consequently cannot claim tax benefits as the owner of the property. The transactions described above are, in substance, fundamentally different from the
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Situation 1, regardless of a decline in the value of the property, X can recover its entire investment, repay both loans, and obtain a minimum after-tax rate of return on its equity investment by exercising the Service Contract Option. Similarly, in Situation 2, a decline in the value of the property will not prevent X from recovering its entire investment, repaying both loans and obtaining a minimum after-tax rate of return on its equity investment through the rents for the remaining Lease Term plus the Residual Value Insurance Amount under the Return Option. The failure of FP to satisfy its obligations under the Service Contract Option in Situation 1 or the Return Option in Situation 2 results in default and obligates FP to pay X the Termination Value. In both Situation 1 and Situation 2, the BK3 and BK4 deposits and Equity Collateral are available to fund FP’s obligations upon termination of the Lease. Thus, in both situations, X has substantially limited its risk of loss regardless of the value of the property upon termination of the Lease.
Fourth, the combination of FP’s Purchase Option and X’s Service Contract Option in Situation 1, and FP’s Early Termination Option and continued rent and residual value insurance obligations under the Return Option in Situation 2, significantly increase the likelihood that FP will exercise its Purchase Option in Situation 1 and its Early Termination Option in Situation 2 even if the fair market value of the property is less than the Purchase Option Exercise Price or ETO Exercise Price, respectively, because both options are fully funded and the excess of the exercise price over the leased property’s fair market value may not fully reflect the costs to FP of modifying, interrupting, or relocating its operations. See Kwiat v. Com- missioner, T.C. Memo. 1992–433 (ostensible lessor did not possess the benefits and burdens of ownership because reciprocal put and call options limited the risk of economic depreciation and the benefit of possible appreciation); see also Ader- holt Specialty Co. v. Commissioner, T.C. Memo. 1985–491; Rev. Rul. 72–543, 1972–2 C.B. 87. In contrast, in Frank Lyon, the lessee’s decision regarding the exercise of its purchase option was not
constrained by a lessor’s right to exercise a reciprocal option similar to the Service Contract Option or the Return Option described in Situations 1 and 2, respectively. Similarly, X’s opportunity to recognize a return through refinancing the BK1 and BK2 loans is also limited in those cases in which FP has a right to participate in any savings attributable to reduced financing costs, such as through renegotiation of the Lease rents and the Purchase Option price. See Hilton v. Commissioner, 74 T.C. 305 (1980), aff’d, 671 F.2d 316 (9 th
Cir. 1982) (arrangement whereby lessor and lessee shared the savings from any refinancing of lessor’s nonrecourse debt was a factor supporting holding to disregard form of sale-leaseback transaction).
In the transactions described above, X does not have a meaningful interest in the risks and rewards of the property. Thus, X does not acquire the benefits and burdens of ownership of the property and does not become the owner of the property for U.S. federal income tax purposes. In substance, the transactions described above are merely a transfer of tax benefits to X, coupled with X’s investment of the Equity Collateral for a predetermined aftertax rate of return.
Furthermore, in appropriate cases, the Service may challenge the purported tax benefits from these transactions on additional grounds, including (1) that the substance over form doctrine requires recharacterization of the arrangement as a financing arrangement, or (2) that the loans from BK1 and BK2, in substance, do not involve the use or forbearance of money, do not constitute valid indebtedness for tax purposes, and that any interest nominally paid or accrued on the loans is not deductible. Cf . Rev. Rul. 2002–69, 2002–2 C.B. 760 (disregarded offsetting obligations in a LILO arrangement gave the taxpayer, at most, a future interest in the property).
The American Jobs Creation Act of 2004, P.L. 108–357, 118 Stat. 1418 (the “Act”), was enacted on October 22, 2004. Section 847 of the Act amended §§ 167 and 168 to provide that service contracts that follow a lease must be included in the lease term and to modify the recovery period for qualified technological equipment and computer software subject to a
lease with a tax-exempt entity. Section 848 of the Act added new § 470, which suspends losses for certain leases of property to tax-exempt entities. See H.R. Rep. No. 755, 108th Cong., 2d Sess., at 660, 662–663 (2004). These amendments generally are effective for leases entered into after March 12, 2004. 4
Transactions that are the same as, or substantially similar to, the transactions described in this notice are identified as “listed transactions” for purposes of § 1.6011–4(b)(2) and §§ 6111 and 6112 effective February 11, 2005, the date this notice is released to the public. Independent of their classification as “listed transactions,” transactions that are the same as, or substantially similar to, the transactions described in this notice may already be subject to the requirements of § 6011, § 6111, or § 6112, or the regulations thereunder. Persons required to disclose these transactions under § 1.6011–4 who fail to do so may be subject to the penalty under § 6707A. 5 Persons required to disclose or register these transactions under § 6111 who have failed to do so may be subject to the penalty under § 6707(a). Persons required to maintain lists of investors under § 6112 who have failed to do so (or who fail to provide such lists when requested by the Service) may be subject to the penalty under § 6708(a). In addition, the Service may impose penalties on parties involved in these transactions or substantially similar transactions, including accuracy-related penalties under § 6662 or § 6662A.
The Service and the Treasury Department recognize that some taxpayers may have filed tax returns taking the position that they were entitled to the purported tax benefits of the types of transactions described in this notice. These taxpayers should consult with a tax advisor to ensure that their transactions are disclosed properly and to take appropriate corrective action.
DRAFTING INFORMATION
For further information regarding this notice, contact John Aramburu at (202) 622–4960 (not a toll-free call).
4 Leases or purported leases of Qualified Transportation Property described in section 849(b) of the Act are not identified as listed transactions subject to the terms of this notice.
5 Section 6707A applies to returns and statements due after October 22, 2004. See Notice 2005–11, 2005–7 I.R.B. 493.
February 28, 2005 633 2005–9 I.R.B.
Differential Earnings Rate for Mutual Life Insurance Companies
Notice 2005–18
This notice publishes a tentative determination under § 809 of the Internal Revenue Code of the “differential earnings rate” for 2004. This rate is used by mutual life insurance companies to calculate their federal income tax liability for taxable years beginning in 2004.
The Job Creation and Worker Assistance Act of 2002, Pub. L. 107–147, § 611,
amended § 809 by adding new paragraph (j). As amended, § 809(j) provides that the differential earnings rate shall be treated as zero for purposes of computing both the differential earnings amount and the recomputed differential earnings amount for a mutual life insurance company’s taxable years beginning in 2001, 2002, or 2003. See Notice 2002–33, 2002–1 C.B. 989. Because of § 809(j), there is no need to determine a tentative recomputed differential earnings rate for 2003. The final recomputed differential earnings rate for 2003 is already determined to be zero. Subsequently, the Pension Funding Equity Act
Notice 2005–18 Table 1
Tentative Determination of Rates To Be Used For Taxable Years Beginning in 2004
Differential earnings rate for 2004 . . . . . . . . . . . . . . . . . . . . . . . . . 0
Imputed earnings rate for 2004 . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4.449
Base period stock earnings rate . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18.221
Current stock earnings rate for 2004 . . . . . . . . . . . . . . . . . . . . . . . . 4.913 Stock earnings rate for 2001 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.354 Stock earnings rate for 2002 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . -1.876 Stock earnings rate for 2003 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14.261 Average mutual earnings rate for 2002 . . . . . . . . . . . . . . . . . . . . . . 5.570
of 2004, Pub. L. 108–218, § 205, repealed § 809 of the Code for taxable years beginning after December 31, 2004. Therefore, the Internal Revenue Service is required to determine a tentative differential earnings rate for 2004.
The final recomputed differential earnings rate for 2003 is : 0
The tentative determination of the rates is set forth in Table 1.
4-year period ending on the last day before the beginning of the plan year.
Notice 2004–34, 2004–18 I.R.B. 848, provides guidelines for determining the corporate bond weighted average interest rate and the resulting permissible range of interest rates used to calculate current liability. That notice establishes that the corporate bond weighted average is based on the monthly composite corporate bond rate derived from designated corporate bond indices.
The composite corporate bond rate for January 2005 is 5.48 percent. Pursuant to Notice 2004–34, the Service has determined this rate as the average of the monthly yields for the included corporate bond indices for that month.
The following corporate bond weighted average interest rate was determined for plan years beginning in the month shown below.
For additional background concerning the tentative differential earnings rate, see Notice 2002–19, 2002–1 C.B. 619.
DRAFTING INFORMATION
The principal author of this notice is Katherine A. Hossofsky of the Office of the Associate Chief Counsel (Financial Institutions and Products). For further information regarding this notice, contact Ms. Hossofsky at (202) 622–8435 (not a toll-free call).
Weighted Average Interest Rates Update
Notice 2005–19
This notice provides guidance as to the corporate bond weighted average interest rate and the permissible range of interest
rates specified under § 412(b)(5)(B)(ii)(II) of the Internal Revenue Code. In addition, it provides guidance as to the interest rate on 30-year Treasury securities under § 417(e)(3)(A)(ii)(II), and the weighted average interest rate and permissible ranges of interest rates based on the 30-year Treasury securities rate.
CORPORATE BOND WEIGHTED AVERAGE INTEREST RATE
Sections 412(b)(5)(B)(ii) and 412(l) (7)(C)(i), as amended by the Pension Funding Equity Act of 2004, provide that the interest rates used to calculate current liability and to determine the required contribution under § 412(l) for plan years beginning in 2004 or 2005 must be within a permissible range based on the weighted average of the rates of interest on amounts invested conservatively in long term investment grade corporate bonds during the
2005–9 I.R.B. 634 February 28, 2005
Corporate
For Plan Years Bond 90% to 100%
Beginning in: Weighted Permissible Month Year Average Range
February 2005 6.07 5.46 to 6.07
imum amount of the deduction allowed under § 404(a)(1).
The rate of interest on 30-year Treasury securities for January 2005 is 4.73 percent. Pursuant to Notice 2002–26, 2002–1 C.B. 743, the Service has determined this rate as the monthly average of the daily determination of yield on the 30-year Treasury bond maturing in February 2031.
The following 30-year Treasury rates were determined for the plan years beginning in the month shown below.
30-YEAR TREASURY SECURITIES WEIGHTED AVERAGE INTEREST RATE
Section 417(e)(3)(A)(ii)(II) defines the applicable interest rate, which must be used for purposes of determining the minimum present value of a participant’s benefit under § 417(e)(1) and (2), as the annual rate of interest on 30-year Treasury securities for the month before the date of distribution or such other time as the Secretary may by regulations prescribe.
Section 1.417(e)–1(d)(3) of the Income Tax Regulations provides that the applicable interest rate for a month is the annual interest rate on 30-year Treasury securities as specified by the Commissioner for that month in revenue rulings, notices or other guidance published in the Internal Revenue Bulletin.
Section 404(a)(1) of the Code, as amended by the Pension Funding Equity Act of 2004, permits an employer to elect to disregard subclause (II) of § 412(b)(5)(B)(ii) to determine the max
30-Year
For Plan Years Treasury 90% to 105% 90% to 110%
Beginning in: Weighted Permissible Permissible Month Year Average Range Range
February 2005 5.08 4.57 to 5.33 4.57 to 5.59
liability occurs at least 3 years before the beginning of the taxable year, or
(ii) in the case of a liability arising out of a tort, such liability arises out of a series of actions (or failures to act) over an extended period of time a substantial portion of which occurs at least 3 years before the beginning of the taxable year.
For this purpose, a liability is not taken into account unless the taxpayer used an accrual method of accounting throughout the period or periods during which the acts or failures to act giving rise to the liability occurred.
The Sealy Decisions
In Sealy Corp. v. Commissioner, 107 T. C. 177 (1996), aff’d, 171 F.3d 655 (9 th
Cir. 1999), the Tax Court held that the portion of NOLs generated by deductions for the following liabilities did not result in former § 172(f)(1)(B) specified liability losses:
(1) professional fees incurred to comply with current reporting, filing, and disclosure requirements imposed by the Securities and Exchange Act of 1934;
Drafting Information
The principal authors of this notice are Paul Stern and Tony Montanaro of the Employee Plans, Tax Exempt and Government Entities Division. For further information regarding this notice, please contact the Employee Plans’ taxpayer assistance telephone service at 1–877–829–5500 (a toll-free number), between the hours of 8:00 a.m. and 6:30 p.m. Eastern time, Monday through Friday. Mr. Stern may be reached at 1–202–283–9703. Mr. Montanaro may be reached at 1–202–283–9714. The telephone numbers in the preceding sentences are not toll-free.
Specified Liability Losses
Notice 2005–20
PURPOSE
This notice addresses several questions of statutory interpretation arising under § 172(f)(1)(B) of the Internal Revenue Code prior to its amendment by § 3004(a) of the Tax and Trade Relief Extension
Act of 1998 (former § 172(f)(1)(B)). The amendment to former § 172(f)(1)(B) is effective for net operating losses (NOLs) arising in taxable years ending after October 21, 1998.
BACKGROUND
The Statute
Section 172(b)(1)(C) provides that the portion of any NOL that qualifies as a specified liability loss may be carried back to each of the 10 taxable years preceding the taxable year of the loss. For NOLs arising in taxable years ending prior to October 22, 1998, former § 172(f)(1)(B) treats as a specified liability loss the portion of the NOL generated by:
(B) [a]ny amount [other than product liability expenses and certain expenses related thereto] allowable as a deduction under [chapter 1 of the Internal Revenue Code] with respect to a liability which arises under a Federal or State law or out of any tort of the taxpayer if—
(i) in the case of a liability arising out of a Federal or State law, the act (or failure to act) giving rise to such
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a federal law’ means more than just that the liability is incurred with respect to an obligation under a federal law.” 334 F.3d at 1046. Second, “the nature and amount of the liability must be traceable to a specific law and cannot be the result of choices made by the taxpayer or others.” Id . As in Sealy, the statutory provisions did not establish a liability to pay the amounts at issue. Rather, the decisions of the taxpayer and the creditors’ committee, subject to final approval by the bankruptcy judge, as to the means of compliance determined the nature and amount of the costs. The court concluded that the connection between the Bankruptcy Code and the liabilities for the fees was “too attenuated to meet the level of ‘arise under’ necessary to qualify as a specified liability loss.” Id . at 1047.
QUESTIONS AND ANSWERS
The “Arises Under a Federal or State Law” Requirement
Q–1. What tests must a liability satisfy to arise under federal or state law within the meaning of former § 172(f)(1)(B)?
A–1. To arise under federal or state law the liability must be directly imposed by federal or state law and must not be the result of decisions made by the taxpayer or others. See Sealy and Major Paint .
Q–2. May a tort liability satisfy the requirements of former § 172(f)(1)(B)(i)?
A–2. Yes. A tort liability may be directly imposed under either federal or state law. If the act or failure to act giving rise to the tort liability occurs at least 3 years before the beginning of the taxable year of the liability’s deduction, the requirements of former § 172(f)(1)(B)(i) are satisfied.
Multiple Act Torts
Q–3. What is a tort liability that arises out of a series of actions (or failures to act) over an extended period of time?
A–3. A tort liability that arises out of a series of actions (or failures to act) over an extended period of time within the meaning of former § 172(f)(1)(B)(ii) is a liability that arises only from multiple acts or failures to act over an extended period of time. An example is a tort liability for causing someone to develop a disease because of repeated exposures to chemicals or other toxic substances. This liability would be a tort liability within the meaning
(2) professional fees incurred to comply with current ERISA reporting requirements; and
(3) professional fees incurred in connection with an income tax audit by the Service for a prior taxable year.
The Tax Court gave three reasons for its conclusion that these liabilities did not arise under a federal or state law within the meaning of former § 172(f)(1)(B). First, the federal laws cited by the taxpayers did not establish their liability to pay the amounts at issue. Instead, the taxpayers’ liabilities did not arise until the services were contracted for and received and the taxpayers’ choice of the means of compliance, rather than the cited provisions, determined the nature and amount of their costs. Sealy at 184. Second, Congress intended former §172(f)(1)(B) to apply only to liabilities for which a deduction is deferred because of the economic performance requirement of § 461(h). The economic performance requirement did not delay the taxpayers’ accrual of the deductions at issue. Sealy at 185–86. Third, invoking the statutory construction rule of ejusdem generis, the court concluded that Congress intended the 10-year carryback to apply to a relatively narrow class of liabilities similar to other liabilities referred to in former § 172(f). Sealy at 186.
In affirming the Tax Court’s judgment, the Ninth Circuit stated that the acts giving rise to the liabilities at issue in Sealy were contractual acts by which Sealy engaged lawyers or accountants and did not occur at least 3 years before the beginning of the taxable year of the related deductions as required by former § 172(f)(1)(B)(i).
The Host Marriot and Intermet Decisions
In Host Marriott Corp. v. United States, 113 F. Supp. 2d 790 (D. Md. 2000), aff’d, 267 F.3d 363 (4 th Cir. 2001), the district court concluded that interest liabilities on federal tax deficiencies arise under federal law within the meaning of former §172(f)(1)(B). The court pointed out that § 6601(a) imposes interest on due but unpaid federal taxes. The court noted that, in contrast to the situation in Sealy, the interest liabilities were set by federal law, not by the taxpayer’s choice.
In Intermet Corp. v. Commissioner, 117 T.C. 133 (2001), the Tax Court cited Host Marriot and concluded that liabilities
for state tax deficiencies, interest on state tax deficiencies, and interest on a federal income tax deficiency arise under federal or state law within the meaning of former § 172(f)(1)(B). In distinguishing Sealy, the Tax Court only referred to the first reason ( i.e., federal law did not establish the liability to pay the amounts at issue) that it gave in Sealy for concluding that the professional fee liabilities at issue in that case did not arise under federal or state law.
In addition, in both Host Marriot and Intermet, the courts concluded that the filing of an erroneous tax return, resulting in the initial failure to timely pay the entire amount of tax due, constitutes the act giving rise to the entire compound interest liability on unpaid tax.
The Major Paint Decision
In Major Paint Co. v. United States, 334 F.3d 1042 (Fed. Cir. 2003), aff’g Standard Brands Liquidating Creditor Trust v. United States, 53 Fed. Cl. 25 (2002), the Federal Circuit held that liabilities for capitalized legal, accounting, and other professional fees and expenses incurred pursuant to a reorganization bankruptcy under Chapter 11 of Title 11 of the United States Code did not arise under federal law for purposes of former § 172(f)(1)(B). The fees included those incurred by the taxpayer on its own behalf as well as fees incurred on behalf of the unsecured creditors’ committee but required to be paid from the bankruptcy estate. The taxpayer capitalized a portion of the fees incurred as a result of the reorganization bankruptcy and later deducted the capitalized fees upon a subsequent voluntary liquidating bankruptcy.
The Bankruptcy Code requires the appointment of an unsecured creditors’ committee and allows the committee, with court approval, to employ various professionals to perform services for the committee. The Bankruptcy Code also requires the bankruptcy court to approve the employment of the professionals, the terms of their employment, and the amounts paid to them. In Major Paint, a local court rule required the bankrupt taxpayer to employ counsel.
The Federal Circuit analyzed the opinions in Sealy, Host Marriot, and Intermet, from which it concluded two principles could be derived. First, “‘arising out of
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talized into the cost basis of the equipment. If an NOL is incurred for a taxable year and the sales tax liability was incurred at least 3 years before the beginning of that taxable year, some taxpayers have asserted that any portion of the NOL generated by depreciation deductions for the portion of the property’s depreciable basis attributable to the capitalized sales tax constitutes a former § 172(f)(1)(B) specified liability loss irrespective of how the property is used. Likewise, taxpayers may be required to place certain equipment into service to comply with requirements of federal or state law, for example, clean water standards. Some of these taxpayers have asserted that if the equipment was acquired by the taxpayer at least 3 years prior to the beginning of the taxable year, the portion of any NOL generated for the taxable year by depreciation deductions attributable to the equipment qualifies as a former § 172(f)(1)(B) specified liability loss. The Service disagrees with both of these assertions.
Section 167(a) allows a depreciation deduction only for property that is either used in a trade or business or held for the production of income. Whether a depreciation deduction is allowable “with respect to” a liability depends upon the property’s actual use. For example, if a taxpayer uses equipment to satisfy an environmental cleanup liability imposed by federal law, the portion of the equipment’s depreciation allocable to satisfying the environmental cleanup liability is allowable with respect to the environmental cleanup liability. If the environmental cleanup liability arose as a result of a chemical spill that occurred at least 3 years before the beginning of the taxable year and the environmental cleanup liability is otherwise deductible, the depreciation deductions may generate a specified liability loss. However, if a taxpayer uses equipment to satisfy environmental cleanup liabilities that arise during the same taxable year the depreciation deductions are allowable, for example, by preventing the discharge of pollutants resulting from manufacturing activities during the current taxable year, the act giving rise to the taxpayer’s environmental cleanup liability will not satisfy the 3-year act or failure to act requirement of former § 172(f)(1)(B)(i), irrespective of when the taxpayer placed the cleanup equipment in service.
of former § 172(f)(1)(B)(ii) if a substantial portion of the exposures occur at least 3 years before the beginning of the taxable year of the liability’s deduction.
On the other hand, what may appear to be a tort liability involving multiple acts, such as a tort liability arising from a continuing trespass, is actually a number of separate liabilities, each arising from separate acts or failures to act resulting in separate causes of action. The Internal Revenue Service will not treat this type of liability as a multiple act or failure to act liability that satisfies the requirements of former § 172(f)(1)(B)(ii). Instead, to generate a specified liability loss, the separate liabilities must independently satisfy the 3-year act or failure to act requirement of former § 172(f)(1)(B)(i).
The “Act or Failure to Act” Requirement
Q–4. Which act in the chain of causation leading to the creation of a liability constitutes “the act or failure to act” giving rise to that liability within the meaning of former § 172(f)(1)(B)(i)?
A–4. The act or failure to act resulting in the establishment of a legal liability constitutes the act or failure to act within the meaning of former § 172(f)(1)(B)(i). For example, in the case of a trespass, the act of trespassing constitutes the relevant act for purposes of former § 172(f)(1)(B)(i), not the judgment of a court.
In the case of interest on unpaid federal or state taxes, the Service continues to believe that a taxpayer’s use of the government’s money over discrete periods, such as days, months or portions of a month, is an essential element that creates the liability. Therefore, the Service believes that the courts in Host Marriott and Intermet incorrectly concluded that the initial failure to pay the taxes when due constituted the act or failure to act giving rise to any interest that economically accrued during the taxable year such interest was deductible and the 3-year period prior to the beginning of that taxable year. Consequently, the Service will continue to assert that interest that economically accrues on a liability for unpaid taxes in the taxable year such interest is deductible and the 3-year period prior to the beginning of that taxable year does not satisfy the 3-year act or failure to act requirement of former § 172(f)(1)(B)(i).
The “With Respect To” Requirement
Q–5. For purposes of former § 172(f)(1)(B), does a deduction allowable “with respect to” a liability include other items, such as legal and professional fees to contest the liability or court costs incurred to litigate the liability?
A–5. A deduction allowable with respect to a liability includes only a deduction for the liability itself. Therefore, legal fees, court costs, and similar items do not generate a former § 172(f)(1)(B) specified liability loss even if the liabilities are incurred in determining the amount of a liability that does satisfy the requirements of former § 172(f)(1)(B).
In Sealy, the Tax Court and Ninth Circuit held that deductions for accounting and legal fees incurred in connection with a federal income tax audit did not generate a specified liability loss under former § 172(f)(1)(B). Federal law directly imposed only the federal income tax liability and did not impose the taxpayer’s liability for the accounting and legal fees. The taxpayer’s liabilities for the accounting and legal fees arose as a result of decisions made by the taxpayer, and such liabilities were incurred when the services were contracted for and performed. Implicit in the Tax Court’s holding is the conclusion that the deduction for the legal and professional fees was not, within the meaning of § 172(f)(1)(B), allowable “with respect to” the federal tax liability that was the subject of the audit.
Depreciation Deductions
Q–6. For purposes of § 172(f)(1)(B), are depreciation deductions allowable with respect to the liability giving rise to the depreciable basis of a depreciable asset?
A–6. Depreciation deductions are not allowable with respect to the liability giving rise to the depreciable basis of a depreciable asset. Depreciation deductions may be allowable with respect to liabilities satisfied through the use of the depreciable asset.
Liabilities arising under federal or state law may be treated as part of the cost basis of property if the liabilities are properly chargeable to a capital account. For example, § 164(a) requires sales taxes imposed on the purchase of equipment used in a taxpayer’s trade or business to be capi
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case of any portion of a State which is not within a county, section 143(k)(2)(D) provides that the Secretary may designate as a county any area that is the equivalent of a county. Section 6a.103A–1(b)(4)(i) of the Temporary Income Tax Regulations (issued under section 103A of the Internal Revenue Code of 1954, the predecessor of section 143) provides that the term “State” includes a possession of the United States and the District of Columbia.
.07 Section 6a.103A–2(f)(5)(i) provides that an issuer may rely upon the average area purchase price safe harbors published by the Department of the Treasury for the statistical area in which a residence is located. Section 6a.103A–2(f)(5)(i) further provides that an issuer may use an average area purchase price limitation different from the published safe harbor if the issuer has more accurate and comprehensive data for the statistical area.
Qualified Mortgage Credit Certificate Program
.08 Section 25(c) permits a state or political subdivision to establish a qualified mortgage credit certificate program. In general, a qualified mortgage credit certificate program is a program under which the issuing authority elects not to issue an amount of private activity bonds that it may otherwise issue during the calendar year under section 146, and in their place, issues mortgage credit certificates to taxpayers in connection with the acquisition of their principal residences. Section 25(a)(1) provides, in general, that the holder of a mortgage credit certificate may claim a federal income tax credit equal to the product of the credit rate specified in the certificate and the interest paid or accrued during the tax year on the remaining principal of the indebtedness incurred to acquire the residence. Section 25(c)(2)(A)(iii)(III) generally provides that residences acquired in connection with the issuance of mortgage credit certificates must meet the purchase price requirements of section 143(e).
Income Limitations for Qualified Mortgage Bonds and Mortgage Credit Certificates
.09 Section 143(f) imposes limitations on the income of mortgagors for whom
DRAFTING INFORMATION
The principal author of this notice is Forest Boone of the Office of Associate Chief Counsel (Income Tax and Accounting). For further information regarding this notice, contact Mr. Boone at 202–622–4960 (not a toll-free call).
26 CFR 601.201: Rulings and determination letters. (Also: Part I, §§ 25, 103, 143.)
Rev. Proc. 2005–15
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