n-05-13.pdf

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Part III – Administrative, Procedural, and Miscellaneous

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

2
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

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.

3
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 sale-
leaseback 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

4
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 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

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.

5
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

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.

6
minimum capacity payments sufficient to provide X with a minimum after-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

7
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 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

8
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 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

9
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
Termination 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

10
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 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

11
$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

12
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 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

13
leased property’s fair market value may not fully reflect the costs to FP of modifying,
interrupting, or relocating its operations. See
Kwiat v. Commissioner, 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
Aderholt 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 after-tax rate of return.
Furthermore, in appropriate cases, the Service may challenge the purported tax

14
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

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.

15
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 on (202)
622-4960 (not a toll-free call).

5
Section 6707A applies to returns and statements due after October 22, 2004. See
Notice 2005-11, 2005-7 I.R.B. 493.