The enduring importance of determining tax ownership

Editor: Christine M. Turgeon, CPA

Taxpayers, historically and to this day, have a keen interest in the determination of ownership of tangible property for U.S. federal income tax purposes (“tax ownership”), as evidenced by the large body of case law addressing this issue. At its core, tax ownership entitles a taxpayer to both the income generated by and the deductions related to an asset throughout its useful life.

Potential consequences of tax ownership

The body of law for determining tax ownership of tangible property remains relevant as taxpayers enter into transactions involving transfers of tangible property. For example, the determination of tax ownership of tangible property affects whether a transaction is a sale or a lease; whether a lessee has income (and basis) related to lessor–funded improvements; whether a taxpayer is a manufacturer, reseller, or commissionaire of inventory; and whether a taxpayer can claim accelerated depreciation and tax credits for clean–energy property.

In general, when transacting to transfer tangible property, the substance, rather than the form, of the underlying agreement is paramount. Should the transferor retain the benefits and burdens of ownership of the property after the transaction, the transferee’s ability to recognize future income generated by, or to claim cost of goods sold (COGS), depreciation deductions, or tax credits related to, the assets may be negatively affected (see, e.g., Torres, 88 T.C. 702 (1987)).

Sale or lease: The determination of whether a transfer of tangible property is a sale or a lease has significant implications for both parties. If the transaction constitutes a sale, the purported lessor must recognize income (generally equal to the total discounted consideration less basis or COGS) and may be eligible for the installment method under Sec. 453 (assuming the transaction does not relate to the sale of inventory or other disqualified transactions). Notably, the purported lessor in this scenario also may be subject to the inventory rules under Secs. 471 and 263A. The purported lessee in a transaction that constitutes a sale, however, treats the total consideration once incurred under Sec. 461 as its basis in the property, which generally is subject to an allowance for depreciation to the extent otherwise allowed under Sec. 167.

Alternatively, if the transaction constitutes a lease, then the lessor generally recognizes rental income over the lease term under Sec. 61 or 467, as applicable, and the lessee generally recognizes rental expense over the lease term under Sec. 461 or 467, as applicable. See, for example, Grodt & McKay Realty, Inc., 77 T.C. 1221 (1981), andTorres.

Lessor–funded improvements: In the case of a lessor who provides a lessee a tenant improvement allowance, whether the lessee is the tax owner of the property funded by the tenant improvement allowance determines the treatment of the allowance. If the lessee is the tax owner, the allowance represents an accession to wealth that results in income under Sec. 61 and basis in depreciable property for the lessee. If it is not the tax owner, the lessee is merely a conduit for the construction of property owned by the lessor and does not have income or basis (see, e.g., In re Elder–Beerman Stores Corp., 207 B.R. 548 (Bankr. S.D. Ohio 1997), and the safe harbor provided in Sec. 110 for certain tenant allowances).

Manufacturer, reseller, or commissionaire of inventory: As it relates to inventory, tax ownership is critical to the determination of whether and when a taxpayer is required to recognize income or is entitled to a deduction (e.g., COGS or loss disposal) related to that inventory (see, e.g., Hallmark Cards, Inc., 90 T.C. 26 (1988), and Paccar, Inc., 85 T.C. 754 (1985),aff’d,849 F.2d 393 (9th Cir. 1988)). In addition, the determination of which party is the tax owner of inventory during the manufacturing process is necessary to determine whether the taxpayer is a manufacturer (because they own inventory during production, as in Suzy’s Zoo, 114 T.C. 1 (2000)); a reseller (because they own the inventory after production until sold, as in Liggett Group, Inc., T.C. Memo. 1990–18); or a contract manufacturer or commissionaire earning a fee for a service (because they never own the inventory, similar to ADVO, Inc., 141 T.C. 298 (2013)).

These determinations could affect whether the taxpayer must apply inventory rules under Secs. 471 and 263A; applies the Sec. 263A rules applicable to producers or resellers; or recognizes income and COGS (as a producer or reseller) or a fee for a service (as a contract manufacturer or commissionaire). They also could affect whether the transaction gives rise to foreign–source income or a base–erosion tax benefit (or is eligible for the COGS exception). These general principles are confirmed by Regs. Sec. 1.263A–2(a)(1)(ii)(A), which generally provides that “a taxpayer is not considered to be producing property unless the taxpayer is considered an owner of the property produced under federal income tax principles.” (Taxpayers should be aware that corporate decisions, often made outside the tax function, such as the negotiation of inventory terms, warehousing and pricing decisions, internal accounting and reporting, and contracts with related and third parties, can all affect the tax ownership of inventory.)

Depreciation and tax credits: As taxpayers consider avenues to monetize certain tax benefits associated with tangible property, such as accelerated depreciation and nontransferable tax credits, tax ownership considerations remain critical. Sec. 6418 allows for the transfer of certain tax credits. Taxpayers whose investments in tangible energy property generate nontransferrable federal income tax credits and accelerated depreciation deductions often evaluate alternative ways to monetize these tax benefits (e.g., through the formation of tax equity partnerships). Notably, tax ownership of the underlying asset is critical for a taxpayer (or tax equity partnership) to claim depreciation and tax credits, such as the clean–electricity investment tax credit under Sec. 48E (see Regs. Sec. 1.48E–2(c)) and the credit for qualified commercial clean vehicles under Sec. 45W (see Regs. Sec. 1.45W–3(b)). As such, taxpayers setting up these structures should ensure tax ownership rests with the intended entity.

Determining tax ownership of tangible property

Tax ownership of tangible property hinges upon a multifactor analysis of the benefits and burdens of ownership of the underlying asset, with no one factor being determinative. While legal title is important, control over the property as well as which party is the beneficiary of economic gain and the bearer of risks related to the property generally are stronger indicia of tax ownership of tangible property. The foundation of this technical analysis is the well–established principle that the substance of a transaction, rather than its form, should control its taxation. In Corliss v. Bowers, 281 U.S. 376 (1930), for example, the Supreme Court held, “taxation is not so much concerned with the refinements of title as it is with actual command over the property taxed — the actual benefit for which the tax is paid.”

The Tax Court’s findings in Grodt & McKay Realty, Inc., are frequently cited by taxpayers in the determination of tax ownership. At issue in the case was a transaction in which an investor purportedly purchased cattle for a significantly higher price than the fair market value (FMV), which it paid partially in cash and primarily in the form of nonrecourse promissory notes. The buyer/investor subsequently claimed an investment tax credit based on the purchase price, even though the seller continued to care for and manage the cattle. In holding that the purported sale was a sham and that the buyer/investor in fact did not have tax ownership of the cattle, the Tax Court considered the following eight factors:

• Whether legal title passed;
• How the parties treated the transaction;
• Whether an equity interest was acquired in the property;
• Whether the contract created a present obligation on the seller to execute and deliver a deed and a present obligation on the purchaser to make payments;
• Which party had the right of possession of the property;
• Which party paid the property taxes;
• Which party bore the risk of loss or damage to the property; and
• Which party received the profits from the operation and sale of the property (Grodt & McKay Realty, Inc., at 1237, 1238).

The lack of a bright–line test to determine tax ownership is likely due, at least in part, to some factors being more applicable than others, depending on the underlying transaction and the type of tangible property at issue. For example, while acknowledging the factors enumerated in Grodt & McKay Realty, Inc., the Tax Court in Torres contemplated several additional relevant factors to identify which party to a sale–leaseback transaction held sufficient benefits and burdens of tax ownership. In particular, the Tax Court considered the following factors to determine whether a sale or a lease had occurred (based on the determination of which party held tax ownership of the underlying property):

• The existence of a useful life of the property in excess of the leaseback (or lease) term;
• The existence of a purchase option at less than FMV (i.e., bargain purchase option);
• The existence of renewal rentals at the end of the leaseback (or lease) term at fair market rent; and
• The reasonable possibility that the purported owner of the property can recoup their investment in the property from the income-producing potential and residual value of the property (Torres, at 721).

In addition to these judicial principles, the IRS has offered guidance establishing factors that are potentially determinative of tax ownership in the sale vs. lease context (see, e.g., Rev. Rul. 55–540, Rev. Rul. 83–59, and Rev. Proc. 2001–28).

With respect to inventory, the Sec. 471 regulations appear to stress the importance of legal title (see Regs. Sec. 1.471–1(a)). However, the courts and the IRS have consistently viewed the transfer of title alone as not being determinative of a sale of merchandise. Rather, the courts and the IRS have generally found that a taxpayer has tax ownership of inventory only if it has the benefits and burdens of ownership of that inventory (see, e.g., Paccar, Inc., and Liggett Group, Inc.).

This conclusion is confirmed in Regs. Sec. 1.263A–2(a)(1)(ii)(A), which provides, “The determination as to whether a taxpayer is an owner [of property produced] is based on all of the facts and circumstances, including the various benefits and burdens of ownership vested with the taxpayer. A taxpayer may be considered an owner of property produced, even though the taxpayer does not have legal title to the property.” However, Sec. 263A(g)(2) and Regs. Sec. 1.263A–2 also provide that Sec. 263A applies to property produced for a taxpayer under a contract with another party, regardless of whether the taxpayer is the tax owner of the property during production. Notably, other factors also may be relevant when assessing tax ownership in the context of inventory, where the courts may consider the taxpayer’s degree of control over the inventory (see, e.g., Suzy’s Zoo, 273 F.3d 875 (9th Cir. 2001); Paccar, Inc.; and Clark Equipment Co., T.C. Memo. 1988–111), as well as how the parties account for the transaction (compare, e.g., Simon, 176 F.2d 230 (2d Cir. 1949), with Epic Metals Corp., T.C. Memo. 1984–322).

Observations

Though nearing a century old, the sentiment put forth in Corliss holds true today. Despite endless variables that may apply, the determination of tax ownership remains one based on the substance of the transaction and the identification of the party that holds the benefits and burdens of ownership of the tangible property.

Editor

Christine M. Turgeon, CPA, is a partner with PwC US Tax LLP, Washington National Tax Services, in New York City.

For additional information about these items, contact Turgeon at christine.turgeon@pwc.com.

Contributors are members of or associated with PwC US Tax LLP.