Investors’ Dilemma on Purchasing Distressed Obligations

This article discusses the purchaser’s perspective of an investment in distressed obligations that are secured by leases on tangible property. As many banks are looking to unload so-called bad loans from their balance sheets, buyers of these discounted debt instruments need to address the tax treatment of these purchased loans. While much has been written on the tax treatment of distressed debt secured by real estate, there are fewer discussions relating to distressed debt backed by leases. In the recent turmoil of distressed debt, these investments are an emerging trend. This article explores various tax avenues when dealing with this type of debt.

In addition to mortgages, banks provide loans to companies purchasing tangible assets, such as farm equipment, tractors, or trailers. One reason for these loans is to manage a company’s cash flow. Tax benefits are another reason, depending on the deal’s structure. However, the facts and circumstances of a deal can lessen these tax benefits. A typical deal is described in Example 1.

Example 1: M corporation agrees with corporation N to make set payments over a certain period of time in exchange for use of equipment manufactured by N. P bank agrees to pay N a discounted total sum in exchange for N’s right, assignment, title, and interest in the equipment and transfer of all payments due or to become due from M.

In form, it appears M is making lease payments to N, who subsequently assigns its stream of payments to P, while, in substance, the transaction is essentially a conditional “sale” of the equipment rather than a lease. Certain conditions, such as the fact that all rights, interest, and title transfer to P; that it is unreasonable to assume that P intends to go into the business of leasing the equipment; and the total rental payments’ exceeding the equipment’s fair rental value lead to a conclusion that a sale has occurred as opposed to the creation of a true lease. 1

Facts and circumstances determine the substance of a transaction rather than the mere tax-motivated form. 2 From M’s point of view, if the transaction is treated as a lease, M has a rental expense for each payment made for the duration of the lease, which could be two to three years. If the transaction is treated as a sale, M would have to record the equipment as an asset on its books and depreciate it over five years using MACRS depreciation. Absent first-year bonus depreciation or a Sec. 179 deduction, M would get the tax benefit of the payments over a longer period than if it is treated as a lease. The IRS views the above transaction as a sale rather than a lease.

Example 2: Suppose P bank owns several loans like the one in Example 1, and M corporation and other lessees have not been making their payments timely. Investor HF would like to purchase the bank’s pool of loans at a discount. P bank is looking to cut its losses by accepting 60% of the remaining payments discounted to present value rather than potentially receiving nothing.

What is HF ’s tax treatment of these payments? Does HF step into the shoes of P and treat the lease as its own? If HF becomes party to the lease, is HF required to treat the lease as a sale based on the above substance-over-form analysis? Has HF purchased a payment stream to be amortized and offset against HF ’s cost, earning some interest yield? Has HF merely purchased a loan, with each payment consisting of principal and interest? Would interest be calculated using P ’s original loan amortization schedule? Many factors affect how HF treats the obligation for tax purposes, including whether the property reverts back to the lessor after the lease expires; whether the lease term (including renewals) is substantially less than the property’s useful life; and whether the total lease payments are substantially less than the property’s outright purchase price. 3

Example 3: Continuing from Example 2, HF becomes party to the lease, replacing P . P transfers title to the property to HF . M remains solely responsible to repair and maintain the equipment. At the end of the lease term, the lease calls for a bargain purchase option by the lessee for a nominal amount. The lease provides for an internal rate of return based on the lease payments over the lease term.

One option is that the lease could be treated as a sale of the equipment with HF stepping into the shoes of P. Under Rev. Rul. 72-408, 4 HF realizes either a Sec. 1221 capital gain or loss or a Sec. 1231/Sec. 1245 gain or loss on the sale of property using HF’s cost basis and the total amount of payments received that are not interest income or other charges. HF may report the gain, if any, under the installment method of Sec. 453. 5

Alternatively, HF could have purchased a stream of payments that is taxed as ordinary income for amounts in excess of HF ’s return of capital. The Supreme Court ruled that certain oil payment rights were not conversions of capital investments. 6 Since the rights could be ascertained with considerable accuracy, the substance of what was received was the present value of income that would be received in the future. No capital asset was sold.

In one case, the Tax Court 7 determined the sale of a partnership interest formed exclusively to develop “a specific tract of land and selling the houses to be constructed thereon” was the right to receive future “ordinary” income, citing the Supreme Court’s decision in Hort . 8 In Hort , the Supreme Court determined that a lease cancellation payment was “nothing more than relinquishment of the right to future rental payments in return for a present substitute payment and possession of the leased premises” 9 and not a sale of a capital asset. These cases clarify that certain exchanges result in ordinary income, and not sales of capital assets. Thus, HF would accrue ordinary income to the extent amounts exceed HF ’s capital invested for each payment using a constant yield rate of return as determined under the lease contract.

Finally, HF could have merely purchased a debt instrument. Using an amortization schedule that substitutes HF’s cost for P’s loan amount, HF would accrue interest income and reduce principal with every lease payment received, until it fully paid off the original loan. There may be a market discount component within the principal payments. Default on the payments would result in HF repossessing the equipment and recognizing a capital gain or loss measured by the equipment’s value less HF’s adjusted basis.

While no position is free from IRS scrutiny, there are arguments both for and against all of the above positions. Under the first option, HF steps into the shoes of a transaction that the IRS has approved in a ruling and merely continues accounting for the payments as P would have, which would be capital gain or loss under the installment method. This structure of the transaction is probably the least likely to be challenged by the IRS.

Under the second option, while there is a strong argument that H F’s payments are no more than a future ordinary income stream already determined under the lease contract, the bargain purchase option on the equipment inevitably guarantees the lessee will take title to the property at the end of the lease term. This strongly indicates a sale of property. Further, HF bears all the risk of default on payments. This respects the lease as a valid contract, allowing for capital treatment.

Lastly, if HF purchased debt, it is worth noting that, in Frank Lyon Co., 10 a case involving a leveraged lease, the Supreme Court reversed an Eighth Circuit decision and respected the lease in form, rejecting the IRS’s contention that the transaction was truly a financing arrangement (debt instrument) for the lessee. Several factors swayed the decision that the sale-leaseback transaction was valid in substance and form, including, but not limited to, the fact that economic substance was compelled by business or regulatory realities; Lyon (the lessor) was solely liable for the loan to the lender; Lyon was liable for substantial ground rents absent the lease renewals by the lessee; and the call price to the lessee throughout the lease term was fair value. HF’s characterization of the transaction as a debt is weakened, since the binding lease contract with M cannot be ignored, as decided in Frank Lyon.

It would behoove practitioners who encounter clients with similar investments to analyze the facts and details of the collateral issued for each obligation purchased to determine which of the above scenarios may apply. Tax treatment of facts may be litigated with good research, but not the facts themselves. The above analysis is based on just one set of facts. Once the facts are determined for a particular instrument, practitioners should undertake more research. There are many court cases involving leases, which makes it more likely there will be one involving a transaction structured similar to the one at issue.

Footnotes

¹ Rev. Rul. 55-542, 1955-2 C.B. 59.

² See Griffiths v. Helvering, 308 U.S. 355 (1939); Gregory v. Helvering , 293 U.S. 465 (1935); and Frank Lyon Co., 435 U.S. 561 (1978).

³ Rev. Rul. 60-122, 1960-1 C.B. 56.

⁴ Rev. Rul. 72-408, 1972-2 C.B. 86.

⁵ It is worth noting under U.S. GAAP, the lease could be treated as a sales-type lease or direct financing lease for HF . See FASB Statement No. 13, Accounting for Leases (now incorporated in FASB Accounting Standards Codification Topic 840, Leases ).

⁶ P.G. Lake, Inc ., 356 U.S. 260 (1958).

⁷ Hale , T.C. Memo. 1965-274.

⁸ Hort , 313 U.S. 28 (1941).

⁹ Id.

¹⁰ Frank Lyon Co. , n. 2 above.