rr-99-14.pdf

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Part I
Section 162.BTrade or Business Expenses
26 CFR 1.162-11: Rentals.
(Also § 163; 1.163-1.)
Rev. Rul. 99-14
ISSUE
May a taxpayer deduct, under §§ 162 and 163 of the Internal
Revenue Code, rent and interest paid or incurred in connection
with a Alease-in/lease-out@ (ALILO@) transaction?
FACTS
X is a U.S. corporation. FM is a foreign municipality that
has historically owned and used certain property having a
remaining useful life of 50 years and a fair market value of $100
million. BK1 and BK2 are banks. None of the parties is related.
On January 1, 1997, X and FM entered into a LILO transaction
under which FM leased the property to X under a AHeadlease,@ and
X immediately leased the property back to FM under a ASublease.@
The term of the Headlease is 34 years. The Aprimary@ term of the
Sublease is 20 years. Moreover, as described below, the Sublease
may also have a Aput renewal@ term of 10 years.
The Headlease requires X to make two rental payments to FM
during its 34-year term: (1) an $89 million Aprepayment@ at the
beginning of year 1; and (2) a Apostpayment@ at the end of year
34 that has a discounted present value of $8 million. For
federal income tax purposes, X and FM allocate the prepayment
ratably to the first 6 years of the Headlease and the future

2
value of the postpayment ratably to the remaining 28 years of the
Headlease.
The Sublease requires FM to make fixed, annual rental
payments over both the primary term and, if exercised, the put
renewal term. The fixed, annual payments during the put renewal
term are substantially higher than those for the primary term.
Nevertheless, the fixed, annual payments during the put renewal
term are projected (as of January 1, 1997) to equal only 90
percent of the fair market value rental amounts for that term.
At the end of the Sublease primary term, FM has a Afixed-
payment option@ to purchase from X the Headlease residual (the
right to use the property beyond the Sublease primary term
subject to the obligation to make the rent postpayment) for a
fixed amount that is projected (as of January 1, 1997) to be
equal to the fair market value of the Headlease residual. If FM
exercises the option, the transaction is terminated at that point
and X is not required to make any portion of the postpayment due
under the Headlease. If FM does not exercise the option, X may
elect to (1) use the property itself for the remaining term of
the Headlease, (2) lease the property to another person for the
remaining term of the Headlease, or (3) compel FM to lease the
property for the 10-year put renewal term of the Sublease. If FM
does not exercise the fixed-payment option and X exercises its
put renewal option, X can require FM to purchase a letter of
credit guaranteeing the put renewal rents. If FM does not obtain
the letter of credit, FM must exercise the fixed-payment option.

3
To partially fund the $89 million Headlease prepayment, X
borrows $54 million from BK1 and $6 million from BK2. Both loans
are nonrecourse, have fixed interest rates, and provide for
annual debt service payments that fully amortize the loans over
the 20-year primary term of the Sublease. The amount and timing
of the debt service payments mirror the amount and timing of the
Sublease payments due during the primary term of the Sublease.
Upon receiving the $89 million Headlease prepayment, FM
deposits $54 million into a deposit account with an affiliate of
BK1 and $6 million into a deposit account with an affiliate of
BK2. The deposits with the affiliates of BK1 and BK2 earn
interest at the same rates as the loans from BK1 and BK2. FM
directs the affiliate of BK1 to pay BK1 annual amounts equal to
90 percent of FM’s annual rent obligation under the Sublease
(that is, amounts sufficient to satisfy X’s debt service
obligation to BK1). The parties treat these amounts as having
been paid from the affiliate to FM, then from FM to X as rental
payments, and finally from X to BK1 as debt service payments. In
addition, FM pledges the deposit account to X as security for
FM’s obligations under the Sublease, while X, in turn, pledges
its interest in FM’s pledge to BK1 as security for X’s
obligations under the loan from BK1. Similarly, FM directs the
affiliate of BK2 to pay BK2 annual amounts equal to 10 percent of
FM’s annual rent obligation under the Sublease (that is, amounts
sufficient to satisfy X’s debt service obligation to BK2). The
parties treat these amounts as having been paid from the

4
affiliate to FM, then from FM to X as rental payments, and
finally from X to BK2 as debt service payments. Although this
deposit account is not pledged, the parties understand that FM
will use the account to pay the remaining 10 percent of FM’s
annual rent obligation under the Sublease.
X requires FM to invest $15 million of the Headlease
prepayment in highly-rated debt securities that will mature in an
amount sufficient to fund the fixed amount due under the fixed-
payment option, and to pledge these debt securities to X. Having
economically defeased both its rental obligations under the
Sublease and its fixed payment under the fixed-payment option, FM
keeps the remaining portion of the Headlease prepayment as its
return on the transaction.
For tax purposes, X claims deductions for interest on the
loans and for the allocated rents on the Headlease. X includes
in gross income the rents received on the Sublease and, if and
when exercised, the payment received on the fixed payment option.
By accounting for each element of the transaction separately, X
purports to generate a stream of substantial net deductions in
the early years of the transaction followed by net income
inclusions on or after the conclusion of the Sublease primary
term. As a result, X anticipates a substantial net after-tax
return from the transaction. X also anticipates a positive pre-
tax economic return from the transaction. However, this pre-tax
return is insignificant in relation to the net after-tax return.

5
LAW AND ANALYSIS
In general, a transaction will be respected for tax purposes
if it has Aeconomic 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 Co.
v. United States, 435 U.S. 561, 583-84 (1978); James v.
Commissioner, 899 F.2d 905, 908-09 (10th Cir. 1990). In
assessing the economic substance of a transaction, a key factor
is whether the transaction has any practical economic effect
other than the creation of tax losses. Courts have refused to
recognize the tax consequences of a transaction that does not
appreciably affect the taxpayer’s beneficial interest except to
reduce tax. The presence of an insignificant pre-tax profit is
not enough to provide a transaction with sufficient economic
substance to be respected for tax purposes. Knetsch v. United
States, 364 U.S. 361, 366 (1960); ACM Partnership v.
Commissioner, 157 F.3d 231, 248 (3d Cir. 1998); Sheldon v.
Commissioner, 94 T.C. 738, 768 (1990).
In determining whether a transaction has sufficient economic
substance to be respected for tax purposes, courts have
recognized that offsetting legal obligations, or circular cash
flows, may effectively eliminate any real economic significance
of the transaction. For example, in Knetsch, the taxpayer
purchased an annuity bond using nonrecourse financing. However,
the taxpayer repeatedly borrowed against increases in the cash

6
value of the bond. Thus, the bond and the taxpayer’s borrowings
constituted offsetting obligations. As a result, the taxpayer
could never derive any significant benefit from the bond. The
Supreme Court found the transaction to be a sham, as it produced
no significant economic effect and had been structured only to
provide the taxpayer with interest deductions.
In Sheldon, the Tax Court denied the taxpayer the purported
tax benefits of a series of Treasury bill sale-repurchase
transactions because they lacked economic substance. In the
transactions, the taxpayer bought Treasury bills that matured
shortly after the end of the tax year and funded the purchase by
borrowing against the Treasury bills. The taxpayer accrued the
majority of its interest deduction on the borrowings in the first
year while deferring the inclusion of its economically offsetting
interest income from the Treasury bills until the second year.
The transactions lacked economic substance because the economic
consequences of holding the Treasury bills were largely offset by
the economic cost of the borrowings. The taxpayer was denied the
tax benefit of the transactions because the real economic impact
of the transactions was Ainfinitesimally nominal and vastly
insignificant when considered in comparison with the claimed
deductions.@ Sheldon at 769.
In ACM Partnership, the taxpayer entered into a near-
simultaneous purchase and sale of debt instruments. Taken
together, the purchase and sale Ahad only nominal, incidental
effects on [the taxpayer’s] net economic position.@ ACM

7
Partnership at 250. The taxpayer claimed that, despite the
minimal net economic effect, the transaction had a large tax
effect resulting from the application of the installment sale
rules to the sale. The court held that transactions that do not
Aappreciably@ affect a taxpayer’s beneficial interest, except to
reduce tax, are devoid of substance and are not respected for tax
purposes. ACM Partnership at 248. The court denied the taxpayer
the purported tax benefits of the transaction because the
transaction lacked any significant economic consequences other
than the creation of tax benefits.
Viewed as a whole, the objective facts of the LILO
transaction indicate that the transaction lacks the potential for
any significant economic consequences other than the creation of
tax benefits. During the 20-year primary term of the Sublease,
X’s obligation to make the property available under the Sublease
is completely offset by X’s right to use the property under the
Headlease. X’s obligation to make debt service payments on the
loans from BK1 and BK2 is completely offset by X’s right to
receive Sublease rentals from FM. Moreover, X’s exposure to the
risk that FM will not make the rent payments is further limited
by the arrangements with the affiliates of BK1 and BK2. In the
case of the loan from BK1, X’s economic risk is completely
eliminated through the defeasance arrangement. In the case of
the smaller loan from BK2, X’s economic risk, although not
completely eliminated, is substantially reduced through the
deposit arrangement. As a result, neither bank requires an

8
independent source of funds to make the loans, or bears
significant risk of nonpayment. In short, during the Sublease
primary term, the offsetting and circular nature of the
obligations eliminate any significant economic consequences of
the transaction.
At the end of the 20-year Sublease primary term, X will have
either the proceeds of the fixed-payment option or a Headlease
residual that has a fair market value approximately equal to the
proceeds of the fixed payment option. If, at the end of the 20-
year Sublease primary term, the Headlease residual is worth more
than the payment required on the fixed-payment option, FM will
capture this excess value by exercising the fixed payment option,
leaving X with only the proceeds of the option. Conversely, if,
at the end of the 20-year Sublease primary term, the Headlease
residual is worth significantly less than the payment required on
the fixed-payment option, X will put the property back to FM
under the put renewal option at rents, that while initially
projected to be at only 90 percent of estimated fair market
value, are (because of the decline in the value of the property)
greater than fair market value. Thus, the fixed payment option
and put renewal option operate to Acollar@ the value of the
Headlease residual during the primary term, limiting much of the
economic consequence of the Headlease residual.
In addition, facts indicate that there is little economic
consequence from X’s nominal exposure to FM’s credit under the
fixed-payment option and, if exercised, the put renewal term. At

9
the inception of the transaction, FM was required to use a
portion of the Headlease prepayment to purchase highly-rated debt
securities that were pledged to X, ensuring FM’s ability to make
the payment under the fixed-payment option. If FM does not
exercise the fixed-payment option and X exercises the put renewal
option, X can require FM to purchase a letter of credit
guaranteeing FM’s obligation to make the put renewal rent
payments. If FM does not obtain the letter of credit, FM must
exercise the fixed-payment option. Thus, as a practical matter,
the transaction is structured so that X is never subject to FM’s
credit.
The conclusion that X is insulated from any significant
economic consequence of the Headlease residual is further
supported by several factors indicating that the parties expect
FM to exercise the fixed-payment option. First, FM has
historically used the property. Second, because the fixed
payment obligation is fully defeased, FM need not draw on other
sources of capital to exercise the option. However, if FM does
not exercise the fixed payment option and X exercises the put
renewal option, FM would be required to draw on other sources of
capital to satisfy its put renewal rental obligations.
In sum, the LILO transaction lacks the potential for
significant economic consequences other than the creation of tax
benefits. During the primary term of the Sublease, X’s
obligations to provide property are completely offset by its
right to use property. X’s obligations to make debt service

10
payments on the loans are completely offset by X’s right to
receive rent on the Sublease. These cash flows are further
assured by the deposit arrangements with the affiliates of BK1
and BK2. Finally, X’s economic exposure to the Headlease
residual is rendered insignificant by the option structure and
the pledge of the securities that defeases FM’s option payment.
Thus, the only real economic consequence of the LILO transaction
during the 20-year primary term of the Sublease is X’s pre-tax
return. This pre-tax return is too insignificant, when compared
to X’s after-tax yield, to support a finding that the transaction
has significant economic consequences other than the creation of
tax benefits.
Some of the features of the LILO transaction discussed above
are present in transactions that the Service will respect for
federal income tax purposes. For example, an arrangement for
Ain-substance defeasance@ of an outstanding debt was respected in
Rev. Rul. 85-42, 1985-1 C.B. 36. By contrast, in the LILO
transaction, the deposit arrangement exists from the inception of
the transaction, eliminating any need by BK1 and BK2 for an
independent source of funds. Similarly, other features of the
LILO transaction, such as nonrecourse financing and fixed-payment
options, are respected in other contexts. However, when these
and other features are viewed as a whole in the context of the
LILO transaction, these features indicate the transaction should
not be respected for tax purposes.
As a result of the transaction lacking economic substance, X

11
may not deduct interest or rent paid or incurred in connection
with the transaction.
The Service will scrutinize LILO transactions for lack of
economic substance and/or, in appropriate cases, recharacterize
transactions for federal income tax purposes based on their
substance. See, e.g., Gregory v. Helvering 293 U.S. 495 (1935),
Bussing v. Commissioner, 88 T.C. 449 (1987), Supplemental
Opinion, 89 T.C. 1050 (1987). Use of terms such as Aloan,@
Alease,@ AHeadlease,@ and ASublease@ in this revenue ruling should
not be interpreted to indicate the Service’s acceptance of X’s
characterization of the LILO transaction described above.
HOLDING
A taxpayer may not deduct, under §§ 162 and 163, rent and
interest paid or incurred in connection with a LILO transaction
that lacks economic substance.
EFFECT ON OTHER DOCUMENTS
Rev. Rul. 85-42 is distinguished.
DRAFTING INFORMATION
The principal author of this revenue ruling is John Aramburu
of the Office of Assistant Chief Counsel (Income Tax and
Accounting). For further information regarding this revenue
ruling contact Mr. Aramburu on (202) 622-4960 (not a toll-free
call).