Direct cost of gaining lease must be capitalized

Tax Hot Topics newsletter The IRS concluded in a Chief Council Advice memorandum (ILM 202005019) that a financial entity must capitalize certain excess markup and participation payments made to acquire automobile and equipment leases. The memorandum stated that the payments are direct costs of acquiring a lease under Treas. Reg. Sec.1.263(a)-4(c)(1)(vi), which are required to be capitalized to the basis of the intangible acquired.

Per the memorandum’s statement of facts, the taxpayer, through its subsidiaries, enters into master agreements with various automobile dealerships and equipment manufacturers and vendors to acquire certain automobile and equipment leases if they meet certain standards set by the taxpayer. The master agreements state that the transaction, if undertaken, is the purchase of the lease contract, and the dealers may not hold themselves out as agents of the taxpayer. The taxpayer and other financial entities that wish to purchase leases bid on individual leases executed between the dealers and their customers. Per the master agreements between the taxpayer and the automobile dealerships, if a dealer accepts the taxpayer’s bid, it shall constitute a sale and assignment of the dealer’s entire right, title and interest in the lease contract, in the vehicle, and in any guaranty or other document executed in connection with the lease contract. The statement of facts assumes that the master agreements, including the sale and assignment of the entire right, title, and interest, are similar for the equipment leases.

The taxpayer’s payment to the automobile dealership consists of a flat-rate fee, and if applicable a premium fee for leases with excess lease rates (“excess markup payment”). For equipment leases, the payment is a set percentage applied to the cost of equipment (“participation payment”). For book purposes, the taxpayer capitalizes and amortizes the excess markup and participation payments over the life of the lease. For tax purposes, the taxpayer deducts excess markup payments, capitalizes certain participation payments in excess of a certain threshold amount, and deducts the remainder of the participation payments.

Section 263(a) and its interpretation by the U.S. Supreme Court in INDOPCO, Inc. v. Commissioner, 503 U.S. 79 (1992) both conclude that amounts related to the acquisition, creation or enhancement of separate and distinct assets also include ancillary transaction costs incurred in the process of acquisition of the assets. In response to the holdings of INDOPCO, the IRS issued Treas. Reg. Sec. 1.263(a)-4(c), clarifying that taxpayers must capitalize amounts paid to another party to acquire any intangible from that party. A lease is specifically listed under Treas. Reg. Sec.1.263(a)-4(c)(1)(vi) as an intangible subject to this rule.

The taxpayer argued that the dealers are acting as intermediaries that assign leases to the taxpayer, and therefore it is not acquiring an intangible asset for tax purposes. However, the IRS disagreed with the taxpayer’s argument, citing the master agreements that clearly state that there is not an agency relationship between the taxpayer and the dealers. Interestingly, neither the taxpayer nor the IRS addressed Section 167(c)(2), which provides that if property is acquired subject to a lease, no amount paid for the property is assigned to the lease; thus the entire amount is allocated to the depreciable asset.

In the taxpayer’s facts, it appears that the taxpayer acquires the dealer’s entire right, title, and interest in the lease contract, in the vehicle, and in any guaranty or other document executed in connection with the lease contract. The taxpayer therefore appears to have acquired property subject to a lease, to which the rules under Section 167(c)(2) may apply. However, this issue is not addressed, and the IRS concluded that the taxpayer acquired leases, which constitutes the acquisition intangible assets within the meaning of Treas. Reg. Sec. 1.263(a)-4(c), and therefore the excess markup and participation payments are required to be capitalized to the basis of the lease.

Sharon Kay
Washington National Tax Office
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John Suttora
Managing Director
Washington National Tax Office
T +1 202 521 1523

Caleb Cordonnier
Washington National Tax Office
T +1 202 521 1555

Dennis St. Martin
Washington National Tax Office
T +1 202 521 1562

Jason Seo
Senior Associate
Washington National Tax Office
T +1 202 521 1556

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