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
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.
- 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
- 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.
Division's Net Income Basis Safe-Harbor Lease
- 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
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
- 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
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
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
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
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
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
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.
Safe Harbor Lease
Franchise Tax Year
*Effect of safe-harbor lease on federal taxable income
Franchise Tax Paid on Net Income (NI) or Net Worth
NOL reduced because of allocation
$ - 150,000
Total reduction to FTI
$ - 781,000
Total increases to FTI
Net reduction in FTI
$ - 217,000
*Figures taken from the attached numerical example of a
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