Information Release

CF 1992-04 - Safe-Harbor Leases: Franchise Tax Policy Change - November 10, 1992

This Information Release discusses the Income Tax Audit Division's policy with regard to safe-harbor leases. Franchise Tax Information Releases are not "Opinions of the Tax Commissioner" within the meaning of ORC section 5703.53. Accordingly, the Tax Commissioner is not bound by this release. Nevertheless, the discussion below does reflect the Income Tax Audit Division's interpretation of the law.

The Ohio Supreme Court has held in Goodyear Tire and Rubber Co. v. Limbach (1991), 61 Ohio St. 3d 381 and General Mills, Inc. v. Limbach (1992), 63 Ohio St. 3d 273, that a lessor's net income or loss from IRC section 168(f)(8) safe-harbor lease agreements is not allocable rental income or loss from tangible personal property. The Court noted that in substance the taxpayer-lessor did not purchase the property subject to lease; rather, the taxpayer purchased the intangible tax benefits attributable to the property. Accordingly, the Court held that a lessor's income or loss from a safe-harbor lease is apportionable.

As a result of these decisions the Income Tax Audit Division has changed its policy with regard to safe-harbor lease transactions.1  Set forth on the following pages are: (i) an illustration of a safe-harbor lease, (ii) the Division's new net income basis safe-harbor lease policy, and (iii) an example of a safe-harbor lease.

Illustration

  • Seller-lessee purchases from a supplier new equipment eligible for both ACRS depreciation and the federal investment tax credit (ITC). Seller-lessee does not earn sufficient federal taxable income to take full advantage of the ITC and the ACRS deprecation.
      
  • Purchaser-lessor nominally purchases the property from sellerlessee for the same price that seller-lessee purchased the equipment. Purchaser-lessor pays seller a cash down payment and gives an interest bearing note for the balance of the purchase price.
      
  • Seller-lessee retains legal title, risk of loss, and possession of the property.
      
  • Purchaser-lessor leases the property back to the seller-lessee.
     
  • The transaction is structured so that the deemed rent payable by the lessee exactly offsets the deemed principal and interest on the note payable by the lessor. No money changes hands other than the cash down-payment.
      
  • Purchaser-lessor claims ACRS depreciation and federal ITC on property subject to lease.
        
  • At the end of the lease term, the property is repurchased by the seller-lessee for a nominal amount.
      
  • In substance the purchaser-lessor purchased the tax benefits attributable to the property.

Audit Division's Net Income Basis Safe-Harbor Lease Policy

  • Neither the lessee nor the lessor should adjust its federal taxable income -to reverse the effects of a safe-harbor lease because there is no statutory basis for doing so. Furthermore, the lessor should not reduce its federal taxable income by the cash paid to the lessee for the tax benefits, and the lessee is not to increase its federal taxable income by the cash received from the lessor.
      
  • The lessor must make the ACRS adjustment as provided in ORC section 5733.041 because it is depreciating the property for federal income tax purposes. Despite the fact that the lease is a fiction, for federal income tax purposes the lessor is claiming depreciation which exceeds that allowable for franchise tax purposes. The intent of ORC section 5733.041 is to delay the effects of federal accelerated depreciation. The lessee should not make an ORC 5733.041 ACRS adjustment for the property because it is not depreciating the property for federal income tax purposes.
      
  • A lessor's income and losses from safe-harbor lease agreements are apportionable. A lessor's net income or net loss from a safe-harbor lease is not allocable rental income from tangible personal property. See Goodyear Tire and Rubber and General Mills. However, under certain conditions the Division will permit a taxpayer to allocate its net income from safe-harbor leases (see page 4).
      
  • The lessee should include the property subject to the safe-harbor lease in its property factor as owned property and value it at original cost. The lessee should not reduce the cost of the property by the cash down payment it received from the lessor from the sale of the tax benefits related to the property. The lessee should not include in its property factor its deemed rental expense times eight because it is to include the property as owned property.
      
  • The lessor should not include the property subject to,the lease in its property factor because it neither owns the property nor uses the property in its trade or business. In substance it did not purchase the property; in substance it purchased the tax benefits related to the property.
       
  • The lessor should not include in its sales factor the deemed rental receipts. In substance there is no lease, and, thus, there are no rental receipts. Furthermore, if in substance there were a lease, the rental receipts would not be included in the sales factor because rental income is specifically allocable and is not income from a sale.
       
  • The lessee should not include in its sales factor the deemed selling price of the property subject to the lease for the following reasons: M in substance the lessee did not sell the property; rather, it sold the tax benefits related to the property, and (ii) even if the lessee had in substance sold the property, receipts from the sale of IRC section 1231 assets are not includable in the sales factor (ORC section 5733.05(B)(2)(c)).
  • The lessee should not include in its sales factor the interest deemed received on the note given by the lessor. In substance no note was received, and no interest earned. Furthermore, even if the interest was in fact earned or received on the note, the interest income is not includable in the sales factor, because interest is not a receipt from a sale (see Incom International, Inc v. Limbach, BTA Case No. 84-D-1149, January 11, 1988).
       
  • The lessee should not include in its sales factor the cash payment it received from the sale of its tax benefits to the lessor (the cash down payment received from the "sale" of the property subject to the safe-harbor lease). Receipts from the lessee's sale of its tax benefits are not included in the lessee's federal taxable income; so consistency requires that the recipts be excluded from the lessee's sales factor.  Ohio franchise tax law does not require the seller of the tax benefits to increase its Ohio taxable income by the income from the sale of the tax benefits.Fairness requires that the proceeds from the sale of those benefits be excluded from the sales factor. Furthermore, if the sale of benefits is viewed as a partial sale of the 1231 asset whose tax benefits were sold, then the proceeds are not includable because proceeds from the sale of 1231 assets are not includable in the sales factor (ORC section 5733.05(B)(2)(c).
         
  • Fairness requires that under certain conditions the Department permit a taxpayer to allocate its net income from safe-harbor leases contrary to the Goodyear and General Mills decisions. Taxpayer-lessors who prior to these decisions followed the Department's safe-harbor lease position (that is, taxpayers who allocated their net "rental" losses and income from safe-harbor lease transactions based upon the physical location of the property subject to the lease) may have paid more franchise tax in the early years of the lease as a result of having,followed the Department's position than they otherwise would have paid had they apportioned their net income and losses from safe-harbor leases.

These taxpayers must not be penalized for having followed the Department's position. They must not again be required to pay more franchise tax in the later years of the lease as a result of the Court's recent holding that apportionment of such income is proper.

Typically, a safe-harbor lease reduces a lessor's federal taxable income in the early years of the lease and increases a lessor's federal taxable income in the later years of the lease. This result occurs because (i) all depreciation expense on the property subject to the lease is taken in the early years of the lease, (ii) the deemed interest expense on the note decreases over the life of the lease, and (iii) the gross rental income remains constant over the life of the lease. See the attached numerical example of a safe-harbor lease.

If a taxpayer-lessor's safe-harbor lease "property" was located entirely outside Ohio and if the taxpayer in the early years of a safe-harbor lease allocated outside Ohio its net rental losses based upon the physical location of the property subject to the lease, the taxpayer would generally have computed more franchise tax on the net income basis than it otherwise would have computed had it apportioned its losses from the transaction. The three year refund statute of limitations most probably has expired for all franchise tax years in which the taxpayer allocated its losses from safe-harbor leases. It would be unfair to now assess a taxpayer for the later years of the lease (the years during which the lease generates positive net income which the taxpayer allocated outside Ohio) on the basis that Goodyear now requires apportionment of such income.

A taxpayer who followed the Department's interpretation of the statute with regard to a transaction affecting several tax years and who has now overpaid its franchise tax as a result of the Court's finding that the Department's interpretation was incorrect must be permitted to continue accounting for the transaction under the Department's prior interpretation if by continuing to follow such prior interpretation it could recoup some or all of the taxes previously overpaid and for which the refund statute of limitations has expired.

A taxpayer-lessor must be permitted to allocate outside Ohio positive net rental income from safe-harbor lease property located outside Ohio to the extent that it previously allocated outside Ohio its net rental losses from the safe-harbor lease property. However, the total safe-harbor lease positive net income allocated outside Ohio must not exceed the sum of the safe-harbor lease net rental losses previously allocated outside Ohio during those tax years for which the taxpayers either paid the tax on the net income basis or the taxpayer's Ohio net operating loss was reduced because it allocated the loss. A taxpayer should receive no greater benefit from allocating the income outside Ohio in the later years of the lease than it would have received in the early years of the lease had it apportioned the losses from the lease.

Tax agents are not expected to audit the franchise tax effects of a safe-harbor lease over the entire lease term. But an agent will favorably consider this argument if the taxpayer provides the information necessary to support its claim.

Example

ABC, Inc. participated in a single safe-harbor lease as a lessor and purchaser of tax benefits. The lease was for a term of ten years and began in 1981. The property subject to the lease was physically located outside Ohio. Other pertinent facts are as follows:

  • For franchise tax years 1982 through 1991 (the entire term of the lease), ABC Inc. followed the Department's pre-Goodyear position and allocated outside Ohio its net "rental" losses and income from the lease (that is, ABC, Inc. allocated the amounts in Column 3, below).

  • ABC Inc. paid its 1985 franchise tax on the net worth basis and for all other tax years related to the lease it paid the tax on the net income basis.

  • In franchise tax year 1985 ABC, Inc. incurred an Ohio NOL which NOL would have been greater had ABC Inc. apportioned its safe-harbor lease loss. ABC Inc. carried forward its 1985 Ohio NOL to 1986 and used the loss in its entirety in that tax year.

  • The safe-harbor lease reduced ABC's federal taxable income for franchise tax years 1982 through 1986 by a total of $781,000. The safe-harbor lease increased ABC's federal taxable income for franchise tax years 1987 through 1991 by a total of $564,000. The lease resulted in a net reduction of $217,000 ($781,000 - $564,000) in federal taxable income over its ten year term.

Illustration
ABC Inc.
Safe Harbor Lease

(1)
Federal Year
(2)
Franchise Tax Year
(3)
*Effect of safe-harbor lease on federal taxable income (FTI)
(4)
Franchise Tax Paid on Net Income (NI) or Net Worth (NW)
(5)
NOL reduced because of allocation
========================================================
1981
1982
1983
1984
1985
1982
1983
1984
1985
1986

$ - 150,000
- 177,000
- 160,000
- 152,000
- 142,000

NI
NI
NI
NW
NI



Yes
Total reduction to FTI

$ - 781,000
=========

1986
1987
1988
1989
1990
1987
1988
1989
1990
1991

$   80,000
  94,000
110,000
129,000
151,000

NI
NI
NI
NI
NI

Total increases to FTI

$  564,000
=========

Net reduction in FTI

$ - 217,000
=========

*Figures taken from the attached numerical example of a safe-harbor lease.

A franchise tax agent is about to begin an audit of ABC's 1989, 1990, and 1991 franchise tax reports. Fairness requires that the agent not apportion ABC's safe-harbor lease income for these tax years.

ABC paid more franchise tax in tax years 1982, 1983, 1984, and 1986 than it otherwise would have paid had it apportioned the effects of the safe-harbor lease for these tax years. Furthermore, ABC also paid more franchise tax in 1986 because its NOL carryforward from 1985 was less than it otherwise would have been had ABC apportioned the effects of the safe-harbor lease for 1985. ABC's additional franchise tax paid as a result of allocating the loss outside Ohio for tax years 1982 through 1986 exceeds ABC's tax savings from allocation of the gain outside Ohio for tax years 1987 through 1991. The refund statute of limitation has now expired for the earlier tax years for which the taxpayer allocated the loss outside Ohio. The Ohio Department of Taxation will not require apportionment of the ABC's safe-harbor lease income for tax years 1989, 1990, and 1991 because it would be unfair to do so. The Department will allow ABC to account for the lease under its pre-Goodyear interpretation so that ABC may recoup some of the taxes previously overpaid and for which the refund statute of limitations has expired.

_________________________________________

1 Federal income tax law repealed the safe-harbor lease provisions for leases entered into after 1983. However, safe-harbor leases entered into in 1982 and 1983 may affect Ohio franchise tax reports for much of the 1990's because the original law continues to apply for the duration of those leases.