Tax Implications of SILOs, QTEs, and Other Leasing Transactions with Tex-Exempt Entities
CRS Report for Congress
Tax Implications of SILOs, QTEs, and Other
Leasing Transactions with Tax-Exempt Entities
Updated November 30, 2004
Analyst in Public Sector Economics
Government and Finance Division
Congressional Research Service ˜ The Library of Congress
Tax Implications of SILOs, QTEs, and Other Leasing
Transactions with Tax-Exempt Entities
Provisions related to certain leasing transactions became an important part of
the American Jobs Creation Act (H.R. 4520) signed into law by President Bush on
October 22, 2004 (P.L. 108-357). The original House and Senate versions of the
foreign sales corporation/extraterritorial income exclusion (FSC/ETI) bill were
different from the enacted version, but in both bills the provisions were major
revenue raisers and as such drew considerable interest.
The purpose of the relevant sections of the law is to put limitations on leasing
transactions involving tax-exempt entities, such as transit authorities or
municipalities. Most commonly these complex arrangements are referred to as
!“lease-in/lease-out” (LILO) — a combination of a lease of an asset
from a tax-exempt entity and a lease back to the same entity;
!“sale-in/lease-out” (SILO) — a combination of a sale of an asset by
a tax-exempt entity and a lease back to the same entity; and
!“qualified technological equipment” (QTE) transactions — a SILO
for certain classes of high-technology equipment.
The Bush Administration’s FY2005 budget proposal sought to modify the rules
applicable to such leases for the stated purposes of preventing their use for tax
avoidance, eliminating significant revenue drain, and ensuring equity of the tax
system. H.R. 4520, and its companion S. 1637, built on the Administration’s
proposals with certain modifications. Similar language was also included into H.R.
It is difficult to put an exact figure on the total value of SILOs and QTEs. The
transactions are designed to mimic other kinds of leases that for the most part have
not encountered objections from the Treasury. Estimates of the total volume
provided by different parties to the debate vary from a low of $15 billion to a high
of $190 billion annually. Hundreds of such transactions were conducted over the last
several years. The underlying asset values are usually in the hundreds of millions of
dollars, and sometimes exceed $1 billion.
The provisions in the Act (i) include service contracts in the lease term and
specify the useful life of tax-exempt use software, and (ii) limit deductions a taxable
entity can claim to the amount of income it receives from the transaction. The Act
has a range of “safe harbor” requirements a transaction must satisfy for the taxpayer
to deduct related losses. The bill’s effective date is March 12, 2004, with exceptions
for some leases. The estimated revenue gain is $26.6 billion over 2005-2014.
Conventional and Leveraged Leases as Financing Tools...................1
General Idea Behind Leasing Transactions with Tax-Exempt Entities.........2
Brief Overview of Tax-Exempt Leasing Legislative and Regulatory History....4
Transaction Volume Estimates.......................................6
Qualified Technological Equipment..................................12
Legislative History of Leasing Provisions in the American Job Creation Act..13
The author wishes to express his appreciation to Erika Lunder, Legislative Attorney,
American Law Division, who provided valuable advice on several key points.
Tax Implications of SILOs, QTEs, and
Other Leasing Transactions with
Provisions related to certain leasing transactions became an important part of
the foreign sales corporation/extraterritorial income exclusion (FSC/ETI) Act signed
into law by President Bush on October 22, 2004 (P.L. 108-357). The original House
and Senate versions of these major corporate tax bills were different from the final
version of the provision, but in both bills the provisions were major revenue raisers
and as such have drawn considerable interest. This report explains the types of
leasing transactions the law targets, briefly discusses the legislative and regulatory
history related to leasing, and compares various versions of the bills in question.
Conventional and Leveraged Leases
as Financing Tools
Leasing is an important financing technique that gives companies technological
and financial flexibility. The leasing industry projects the total volume of1
transactions will reach about $218 billion in 2004. In 2001 leasing represented 31%
of total business investment in equipment in the United States.2 Most segments of
the economy use leasing in one way or another, and in some segments, like airlines,
leasing plays a key role.
Leasing as a form of financing is different from other financing vehicles. A
lessor, unlike a lender, remains the owner of the asset and bears many of the risks
associated with ownership, in particular, a residual value risk. In a conventional
lease, a lessee can acquire use of equipment without tying up its working capital or
assuming equipment ownership and financial risks. These advantages by themselves
may be significant for certain segments of the market, such as start-up businesses.
At the same time, special tax benefits generated by leasing transactions often play an
important role in selection of this financing technique.
In some transactions, called leveraged leases, a lessor leases out debt-financed
property. In these cases the leasing companies serve as intermediaries between other
financial institutions and users of the capital. Many of these transactions have
1 ELA Online, “Industry Research: Overview of the Equipment Leasing & Finance
Industry,” visited on June 14, 2004 at [http://www.elaonline.com/industryData/
2 Vic Lock, “Review of the Leasing and Asset-Finance Industry,” in Leasing and Asset
Finance, The Comprehensive Guide for Practitioners, Fourth Edition, Chris Boobyer, ed.
(London: Euromoney Books, 2003), p. 1.
“economic substance:” the lessors may earn money, for example, by assuming default
risks or offering other services. In addition, leveraged leases typically generate some
tax benefits for the lessor, who may either receive a higher after-tax profit, or
incorporate such benefits into the lower rents charged to its customers. In the past,
Congress and the Treasury have conditionally recognized leveraged leases as a valid
business practice.3 LILOs, SILOs, and QTEs4 are special cases of leveraged leases,
but the Treasury and some legislators view them as having undesirable features that
set them apart from other leveraged leases.
General Idea Behind Leasing Transactions with
How do SILOs, LILOs and QTEs work, and how do the participants benefit
from them? When a for-profit corporation owns a piece of equipment, it may deduct
its cost from taxable income over a certain period of time (depreciate it), thereby
reducing its tax liability. Similarly, if the corporation rents the property instead of
purchasing it, it may be able to deduct the rental payments. Furthermore, if the
corporation takes out a loan to finance the sale or lease, it may be able to deduct the
In contrast, a tax-exempt, or more precisely, a tax-indifferent entity, cannot take
advantage of any of these deductions because it does not owe any taxes in the first
place.5 Thus, the tax deductions are “wasted” without bringing any benefit to the
equipment owner. This situation creates an incentive for the transfer of tax benefits.
Generally, participants of LILOs, SILOs, and QTEs achieve such a transfer when a
taxable participant becomes eligible to claim the tax deductions related to the
equipment, although the details and legal environment are somewhat different for
each kind of transaction.
The benefits to the participants in these transactions come at least in part from
the reduction in the present value of federal taxes paid by the taxable participant.
From an economic standpoint, the deferral of taxes is equivalent to their reduction,
due to the time value of money. The total benefit distributed between all participants
is equal to the present value of the reduction of the tax due to the transaction-related
deductions less the present value of the tax on the corresponding income. The
3 Among other examples, see Rev. Proc. 2001-28, setting forth some guidelines on treatment
of leveraged leases for federal tax purposes.
4 “Lease-in/lease-out” (LILO) — a combination of a lease of an asset from a tax-exempt
entity and a lease back to the same entity; “sale-in/lease-out” (SILO) — a combination of
a sale of an asset by a tax-exempt entity and a lease back to the same entity; and “qualified
technological equipment” (QTE) transactions — a SILO for certain classes of
5 An entity is called tax indifferent if a particular action does not affect its tax position. A
for-profit corporation may be tax-indifferent with respect to acquisition of depreciable
equipment, if it can completely offset its tax liability, for example, by using carryforward
benefit is often measured in percentage terms, as the ratio of the net present value
(NPV) of the tax reduction to the total asset value. Every year the benefit would be
equal to the transaction-generated deductions minus transaction-generated income
multiplied by the corporation’s marginal income tax rate. Accelerating the
transaction-related deductions and delaying recognition of the corresponding
revenues maximizes the payoff.
The total tax savings are shared between the transactions’ various participants.
The reduction in the taxes’ present value is the incentive for the for-profit corporation
to participate in the deal. The tax-exempt party usually receives an implicit
“accommodation fee” for participation, usually between 4%-8% of the transaction’s
total value, although exceptions on both sides of the range abound. Finally, deal
arrangers — legal counsels, trustees, lenders, appraisers — receive fees for their
The arrangers’ fees vary, but they are considerable. “A review of over 30
transactions approved by the Federal Transit Authority indicated that, on average,
fees paid to ... agents advising or assisting tax-exempt entities equaled approximately
24% of the benefits received by the tax-exempt entities.”6 Attachments to the letter
of Secretary of Transportation Norman Y. Mineta provide details on a December
2002 New York Metropolitan Transportation Authority (MTA) transaction.7 Total
associated fees and expenses were about $5.6 million, of which approximately $1.8
million was paid by the lessors and $3.8 million by MTA. According to Asset
Finance International, in that month MTA closed the QTE for automatic fare
collection equipment worth $506 million with a net present value (NPV) benefit of
10%-11%, or about $51 million-$56 million.8 If both sources refer to the same
transaction, the arrangers’ fees would represent over 1% of the deal value and about
10% of the NPV benefit. It is possible that for smaller transactions the percentage
shares are higher.
To see how everything works together, consider an example of a recent sale-in,
lease-out (SILO) contract. The media obtained details of another MTA transaction
under the Freedom of Information Act.9 In 2002 MTA sold to Wachovia Corp. and
Altria Group, Inc. and leased back from them for 30 years subway cars worth $1.18
billion. The transaction generated $104 million for the transit authority. The taxable
participants of the deal would be able to deduct the depreciation of the asset over the
term of the lease, while recognizing the income from the lease payments from MTA.
6 U.S. Congress, Joint Committee on Taxation, Description of Revenue Provisions
Contained in the President’s Fiscal Year 2005 Budget Proposal, Joint Committee Print,thnd
7 N. Y. Mineta, Secretary of Transportation, attachments to the letter to Sen. Grassley, Jan.
8 Asset Finance International Monthly QTE Research, “Closed Deals,” Jan. 2003, p. 1,
visited on July 9, 2004 at [http://www.assetfinance.com/contents/publications/afi/qte/
9 Ryan J. Donmoyer, “Banks and Others May Lose Lucrative Federal Tax Break; Congress
Wants to End Transit Lease Deals That Provide Big Tax Savings,” Charlotte Observer,
March 9, 2004, p. 1D.
It is impossible to determine the monetary value of the transaction for the companies
without knowing (i) timing and amounts of the annual depreciation deductions and
(ii) timing and amounts of MTA’s rental payments by year. (The source article
provides a numeric estimate of the benefit to the companies, but its validity is
uncertain.) The deal arrangers in this case received $23 million in fees, or over 22%
of MTA’s benefit.
The general policy issue these specialized leases present is this: does current tax
treatment of leases provide desirable or necessary support for the leasing industry,
and does it constitute an optimal means of channeling federal aid to state and local
governments and other tax-exempt entities? Do the benefits to tax-exempt and
taxable participants of these transactions outweigh the revenue losses, tax base
erosion, and the overall equity of the tax system? In other words, the question is
where to draw the line separating allowable and abusive transactions.
Brief Overview of Tax-Exempt Leasing Legislative
and Regulatory History
Congress has addressed the issues of leasing for tax-benefit transfer several
times since 1981. Before 1981, such transactions were not allowed, and leasing
transactions had to satisfy a special test designed to weed out the deals whose only
purpose was tax reduction. However, in 1981 Congress changed its stance and
allowed such arrangements as a part of the tax cuts for investments in the Economic
Recovery Tax Act (P.L. 97-34), by adoption of the “safe-harbor leasing” rules. The
intent of the measure was to encourage investments by means of transferring tax
benefits rather than to serve the purpose of determining which person is in substance
the owner of the property.10
The policy on the issue changed again a year later, with the passage of the Tax
Equity and Fiscal Responsibility Act of 1982 (P.L. 97-248), when “Congress
concluded that it was necessary to reduce safe-harbor leasing and ultimately to repeal
it. The principal considerations were the tax avoidance ... , the adverse public
reaction to the sale of tax benefits, the revenue loss,....”11 The 1982 law shut down
such deals with certain exceptions after the end of 1983, and reduced the benefits
available to participants in the meantime.
In 1984, the Deficit Reduction Act (P.L. 98-369) addressed the leasing-related
issues again. Among other changes, it adopted the so-called Pickle rule.12 The rule
provides that the depreciation deduction relating to property leased to a tax-exempt
entity, so-called tax-exempt use property, must be computed on a straight-line basis,
using the longer of the property’s assigned class life or 125% of the lease term. (Of
all the commonly used methods, straight-line depreciation is among the least
10 U.S. Congress, Joint Committee on Taxation, General Explanation of the Revenue
Provisions of the Tax Equity and Fiscal Responsibility Act of 1982, Dec. 31, 1982, p. 45.
11 Ibid, p. 53.
12 IRC § 168(g).
favorable for taxpayers.) In addition, the Pickle rule requires the inclusion of
possible lease renewals, successive leases, and other similar arrangements in the lease
term. The legislation also prescribed certain rules on distinguishing between service
contracts and leases to preclude the use of such contracts for tax benefits transfer.
It also excluded qualified technological equipment leased to tax-exempt entities from
the above general rule.
In 1986, the Tax Reform Act (P.L. 99-514) modified depreciation rules
applicable to foreign and tax-exempt use property. However, it maintained a number
of exceptions, including the rules that “treat qualified technological equipment with
a lease term that exceeds five years as having a recovery period of five years.”13
Among the most recent developments, in 2003, one of the revenue-raising
amendments (S.Amdt. 680) to S. 1054 (108th Congress, 1st session) contained a
provision to include service contracts into the lease term for purposes of the Pickle
rule. However the provision did not emerge from conference.
Two last administrations included language related to leasing transactions in
their budget proposals in various years. The Clinton Administration’s FY2000
budget proposal contained provisions prohibiting the deduction of net losses from
leasing transactions with tax-exempt entities.14 Its FY2001 proposal contained
provisions to increase depreciation life by the service term of tax-exempt use
The FY2005 Bush Administration revenue proposals included two similar
provisions.16 One expanded the Pickle rule to qualified technological equipment and
computer software and included service contracts in the length of a lease term.
Another proposal disallowed net losses related to leases to tax-indifferent parties. It
included five conditions that would exclude the transaction from this limitation. The
major conditions (i) prohibited tax-exempt bond financing, (ii) prohibited defeasance
and similar arrangements exceeding 20% of the leased property cost, (iii) required
substantial investment on the taxpayer’s part, and (iv) required the tax-indifferent
party not to assume more than minimal risk of loss. The proposal would apply to
transactions entered into after December 31, 2003.
Throughout the years the regulations governing lease transactions evolved not
only legislatively, but also through a number of Internal Revenue Service (IRS)
revenue rulings and regulations, as well as through case law. Some of the most
relevant IRS rulings include Rev. Rul. 99-14 and Rev. Rul. 2002-69 (modifying and
13 U.S. Congress, Joint Committee on Taxation, General Explanation of the Tax Reform Act
of 1986, May 4, 1987, p. 106.
14 For further information, see CRS Report RL30160, Foreign Tax Shelter Proposals in the
Administration’s Fiscal Year 2000 Budget, by David L. Brumbaugh, April 30, 1999.
15 Department of the Treasury, General Explanations of the Administration’s Fiscal Year
16 Department of the Treasury, General Explanations of the Administration’s Fiscal Year
superceding Rev. Rul. 99-14). They deal with “lease-in/lease-out” transactions and
are described in more detail below.
Importantly, while the rules that developed limited the use of various leasing
arrangements, they upheld the validity of leveraged leases in general. As mentioned
above, the leveraged leases often do generate substantial tax benefits to the lessor, but
in addition to tax considerations, they can have economic substance, such as the
lessor’s assumption of the lessee’s default or asset ownership risk, and are a widely
used capital funding mechanism.
Transaction Volume Estimates
How widespread are “abusive” leases? It is difficult to determine exactly the
aggregate volume of the transactions that raised recent objections by the Treasury and
some lawmakers because they may differ from the commonly accepted leveraged
leases only in nuances. Lack of well-established definitions and the international
nature of many of these deals complicate the problem even further. For example,
Treasury Assistant Secretary Pamela Olson estimated their volume at $750 billion17
over a four-year period (which translates to approximately $190 billion annually).
The Equipment Leasing Association questioned this figure and put the value at about
10% of the $218 billion-a-year industry, or about $60 billion-$80 billion in four years
($15 billion to $20 billion a year).18 During the Senate Finance Committee testimony
an unidentified witness referred to conservative industry estimates of “a minimum
of $20 billion to $30 billion of foreign infrastructure” leased or sold annually.19
Evidence presented by all sides indicates that the transactions are widespread.
The Wall Street Journal reported that the transactions had been registered as a
possible tax shelter more than 400 times in 2001.20
A somewhat better grasp on the volume of transportation-related projects is
available because the Federal Transit Administration (FTA) reviewed various
municipal transportation-related leases which received federal funding. The FTA’s
2000 guidance “Financing Techniques for Public Transit” listed LILOs as a funding
technique and stated that in 1999 the agency “reviewed over $1 billion in leasehold
17 Statement of the Honorable Pamela F. Olson, Assistant Secretary for Tax Policy, U.S.
Department of the Treasury, accompanied by Gregory F. Jenner, Deputy Assistant Secretary
for Tax Policy, U.S. Department of the Treasury, Testimony Before the House Committee
on Ways and Means, Feb. 11, 2004.
18 U.S. Newswire, “Equipment Leasing Association Responds to Treasury Department
Testimony; Association Disputes $750B Number for ‘SILO’ Transactions,” Feb. 12, 2004.
19 Testimony of “Mr. Janet” — a Witness Pseudonym Regarding Abusive Cross-Border
Leasing and Leasing with U.S. Municipalities Before the United States Senate Committee
on Finance, Oct. 21, 2003.
20 John D. McKinnon and John Harwood, “Tax Shelters Come Under Fire — Democrats
Push Crackdowns, Hope to Cut Bush Approval Ratings,” The Wall Street Journal, June 6,
transactions.”21 The FTA suspended the program in 2003. Between 2000 and early
2003, “U.S. transit authorities have entered into over $7 billion worth of lease
financing transactions, primarily involving rolling stock and facilities.”22 According
to the American Public Transportation Association (APTA), the leaseback program
has guaranteed transit agencies an additional $848 million since 1998. “The
suspension of the program has put on hold about 15 deals that already were in the
works, which would have netted benefits of about $262 million to the transit
agencies,” according to the APTA.23
The data on the transportation-related transactions volume and their benefit to
localities appear to be a bit inconsistent among themselves. Most sources estimate
a typical benefit to a locality at about 4%-8%, and rarely as much as 10% of the
transaction value. The numbers in the previous paragraph imply an average benefit
of 10% or more. This inconsistency opens the possibility that either the volume of
transactions is being underestimated, or the benefit is overestimated, or a
combination of the two, which is entirely possible given the fact that the parties
reporting the numbers (i) could use different sources and (ii) could have opposing
In response to a November, 2003, letter from Senator Grassley, Secretary of
Transportation Mineta provided an updated list of cross-border and domestic
leveraged lease transactions reviewed by FTA since 1988.24 The list has 97 entries,
with the total asset value of $17.1 billion and the transactions’ cumulative net present
value (NPV) of $1.1 billion. It is unclear if this NPV includes benefits to the private
party as well as the public entity. Furthermore, the list appears not to include some
deals. For example, the MTA 2002-D and 2002-E trusts that closed on December 17,
The analysis of leasing transactions reviewed by the FTA since 1988 shows that
four municipalities — Atlanta, Chicago, New York, and Newark — conducted
approximately half of the transactions by value of assets. Four more cities — Los
Angeles, Philadelphia, San Francisco, and Washington, DC — account for another
quarter of the total volume.25
Another federal agency that requires review of lease transactions is the
Department of Energy (DOE). On March 11, 2004, Senators Grassley and Baucus
21 Sen. Grassley, letter to N. Y. Mineta, Secretary of Transportation, Nov. 17, 2003.
22 Structured Finance Review, “Domestic Lease Structures: for U.S. Transit Authorities,
Their Time Has Come,” March 2003, p. 10, also available at
[ h t t p : / / www.at l a si nf or m. com/ pdf / SFR0303.pdf ] .
23 Heather M. Rothman and Katherine M. Stimmel, “House Panel to Examine Issues
Relating to Suspended Transit Leaseback Program,” Daily Tax Report, No. 42, March 4,
24 N. Y. Mineta, Jan. 20, 2004.
25 U.S. Congress, Joint Committee on Taxation, Description of Revenue Provisions
Contained in the President’s Fiscal Year 2005 Budget Proposal, Joint Committee Print,thnd
requested information from the agency on the transactions approved since 1995.26
As of yet there has been no publicly released response from the DOE. The Senators
also reportedly contacted the Federal Aviation Administration and the Environmental
Protection Agency for similar information.27
It is useful to consider the mechanisms of each type of leasing transaction
separately, beginning with the oldest of them (almost extinct by now) — “lease-
in/lease-out.” In this case, a U.S. taxpayer leases a piece of property — e.g., a power
plant, traffic control system, or railcars — from a tax indifferent party, such as a
foreign municipality or tax-exempt organization, under a “headlease,” and
simultaneously leases it back to the same party under a “sublease” or “leaseback.”
In practical terms, the tax-indifferent party continues to use the property as it did
before the transaction. The U.S. taxpayer, meanwhile, is able to defer its tax liability
by deducting its rental payments, amortizing certain transaction costs, and, depending
on its financing arrangement, deducting any interest payments.
The IRS believes that in the late 1990s there were “hundreds of deals with
billions of dollars at stake” conducted by 56 customers, with some taxpayers28
participating in as many as 30 to 60 deals. According to some estimates, during
LILOs’ heyday the volume of U.S. leases to foreign entities increased from $3 billion29
to $20 billion between 1994 and 1998. In 1999 the IRS issued regulations and a
Revenue Ruling (99-14) that effectively stopped the practice of LILOs.30 On the
other hand some transactions closed as recently as August 2002, while structured as
SILOs for federal purposes, were LILOs for state income tax purposes.31
Consider an example. Assume that the U.S. taxpayer is corporation X, and the32
tax-indifferent party is municipality FM. X leases a certain property from FM under
a headlease with a 34 year term. X immediately leases it back to FM under a 20-year
sublease with a buy-back option. The headlease requires X to make just two
26 Sen. Baucus and Sen. Grassley, letter to S. Abraham, Secretary of Energy, March 11,
27 Accounting Today, “Taxing Issues. Tax Practice,” vol. 18, No. 6, April 5, 2004.
28 Lee A. Sheppard, “Challenging LILOs and Their Successors,” Tax Notes, May 26, 2003,
p.1134; Brant Goldwyn, “IRS Appeals Close to Issuing Guidelines on Lease-In/Lease-Out,
Lease Stripping,” Daily Tax Report, No. 184, Sept. 23, 2003, p. G-6.
29 David Nemschoff, “A Growing Substantial Role; Financial Intermediaries and U.S.
Leases to Tax-Exempt Entities,” Equipment Leasing, Jan. 1999, vol. 18, No. 1, p. 5.
30 26 C.F.R. § 1.467-4. Revenue Ruling 99-14 has been modified and superceded by
Revenue Ruling 2002-69.
31 Asset Finance International Monthly QTE Research, Closed Deals, Dec. 2002, p. 2,
visited on July 9, 2004, at [http://www.assetfinance.com/contents/publications/afi/qte/
32 This is a simplified example from the Rev. Rul. 99-14.
payments: $89 million as a prepayment in the beginning of the first year and a
postpayment at the end of the last year of the headlease. FM would deposit most of
the prepayment in a separate account, and pledge it to X as security for the
municipality’s obligations under the sublease. The excess of the prepayment over the
pledge constitutes FM’s fee for participation in this deal.
FM’s obligations under the lease and buy-back option are completely covered
by X’s prepayment. The sublease requires FM to make annual rental payments to X
in equal installments. The payments would come from the pledged part of the $89
million prepayment. At the end of the sublease, FM has an option to purchase from
X the right to use the property for 14 years that would still be remaining under the
headlease at that time. This buy-back option’s cost would be at or slightly above the
fair market value of the headlease residual and also can be paid from the money
received with X’s prepayment. X is relieved of its obligation to make the
postpayment if FM chooses to buy back the headlease residual. In reality FM always
exercises its buy-back option, and the postpayment is never made.
The discrepancy in the timing of the payments between the headlease
prepayment and regular sublease payments would allow X to defer its tax liability
and generate a net gain for X. X would be able to amortize the first $89 million
payment over the first six years of the lease, or about $15 million each year. At the
same time, it would have to recognize revenues from the sublease, but these revenues
would be much smaller than $15 million, thus X’s taxable income becomes lower in
the first six years and it can pay less in taxes. In the later years, X may not be able
to offset the revenues from this deal and therefore may have to pay higher taxes, but
because of the time value of money, the present value of the deductions exceeds the
present value of the rental income.
In reality, the deals are usually more complex and generate additional tax
savings for X. For example, X could finance its $89 million prepayment with a loan
from a bank. In this case, X would deduct its interest expense in addition to the
prepayment. X’s interest payments would be frequently set equal to FM’s sublease
rental payments. X would thus be simply transferring funds from FM to the bank.
In addition, X could get the loan from the same bank that FM would use to deposit
the prepayment. In this case, the actual funds would never even leave the bank for
the duration of the LILO.
Finally, both sides would sign an agreement as part of the contract to ensure that
neither one of them becomes exposed to additional risks throughout the transaction’s
length. In doing so, the parties have to strike a balance between limiting their
exposure to risks on one hand, and making sure the provisions do not disqualify the
transaction as a lease on the other. Under U.S. legal doctrine (the “economic
substance” doctrine) a transaction is respected for federal tax purposes if “there is 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.”33 There are a number of factors to consider, and the
parties’ advisors try to ensure that the legal requirements are satisfied and the deal
will pass regulatory muster.
Nonetheless, in 1999, the IRS significantly undermined LILOs’ value as a tax
shield, when it issued regulations that treat a rent prepayment as a loan.34
Additionally, the IRS has issued rulings concerning LILO-type transactions where the
agency disallows deductions for rent and interest due to the finding of lack of
economic substance.35 As a result, lease-in/lease-out transactions were largely
discontinued and replaced with sale-in/lease-out deals (SILOs), sometimes referred
to as “sale/leasebacks” or “sale/service contracts.” (A note of caution is in order:
there is no set terminology, and these terms do not always designate the type of
transaction described below.)
The parties to a sale-in/lease-out transaction agree to either an outright sale by
a tax-indifferent to a taxable entity of a piece of property or a headlease for a term
exceeding the property’s useful life. Such a lease would be considered a sale for
federal tax purposes. Taking this route helps to avoid the “pure” sale restrictions
often imposed on municipal property. The property is immediately leased back to its,
by now former, tax-indifferent owner (FM) for 12 to 20 years, who continues to
operate it. The transactions are based on the same general idea of the tax benefits
transfer as LILOs, but achieve it in a somewhat different manner. In a SILO, the U.S.
taxpayer (X) can deduct depreciation rather than rental payments. Interest deductions
would also be available to X, just as in a LILO deal.
As long as the sum of the depreciation and interest deductions exceeds rental
income, X receives a net reduction in taxable income and pays lower income taxes.
The present value of the benefit to X is greater the sooner it receives the deductions,
relative to the rental income. In return, FM keeps an accommodation fee of 4%-10%
of the transaction value which may be implicitly included in the original purchase
price or as a rent reduction. The exact fee value is determined by the individual deal
conditions, such as an asset class and value, length, each side’s relative bargaining
powers, as well as the prevailing interest rates. It is common for the transaction value
to exceed the fair market value of the property, making it even more attractive to the
From the financial gain standpoint, it is to X’s benefit to deduct as much of the
depreciation as soon as possible. However, as noted above, the Pickle rule in IRC
§ 168(g) prevents accelerated deductions by requiring straight-line depreciation over
the longer of the property’s assigned class life or 125% of the lease term, including
possible lease renewals and other similar arrangements. It is unclear whether service
33 Frank Lyon Co. v. United States, 435 U.S. 561, 583-84 (1978).
34 26 C.F.R. § 1.467-4.
35 Rev. Rul. 99-14; Rev. Rul. 2002-69 modifying and superceding Rev. Rul. 99-14.
contracts, whose important role in the SILO’s structure is discussed further in this
section, are included in the lease term.36 This ambiguity means that the IRS may
have to make a special determination in every individual case, which is not practical.
The contract includes special defeasance provisions requiring the parties to set
aside cash or bonds sufficient to service their obligations. Typically FM would be
required to pledge enough funds from an initial sale to meet its commitments under
the lease. Usually FM wants to be sure that there is no chance of losing the property
upon the lease termination. For example a transit authority would like to be certain
that it never loses control over its railcars or ticket-dispensing machines. A typical
SILO would include a provision for FM to have an option to buy the property at a
fixed price at the end of the lease. The funds sufficient to exercise it also have to be
set aside at the beginning of the deal.
On the other hand, X is interested in shielding itself from any risks related to the
property ownership after the lease expires. So, the SILO would include service
contract provisions to protect X’s interests at the time of the lease termination.
Usually, the provisions stipulate that FM has to find a service contractor to take over
the management of the property and is required to buy the property if such a
contractor is not found. This arrangement ensures that if for some reason the
property declines in value, FM cannot simply walk away from it, leaving X with all
the “burdens of ownership.”
Presence of the defeasance provisions is one of the controversial features of the
SILOs. The opponents of the practice point to it as one of the indicators of the
circular nature of these deals. In their view the provisions eliminate default risks for
the lessor, one of the determinants of a transaction’s economic substance. To counter
that, the advocates point out that similar arrangements are present in many other
business transactions, for example, when one of the parties has poor credit, and their
mere presence does not automatically rid the transactions of their economic
It might appear more logical to have a simple mandatory buy-back clause at the
lease’s end instead of a combination of the buy-back option and service contract
provisions. However, the mandatory buy-back provision would violate the “genuine”
ownership doctrine and indicate that FM, rather then X, is the true owner of the
property for tax purposes entitled to the deductions. This would make the SILO
pointless. Thus, the service contract arrangement becomes very convenient, as an
alternative to the mandatory buy-back and at the same time as an incentive for FM
to “reacquire” the property without slowing down the depreciation deductions under
the Pickle rule.
In the words of one expert, “U.S. lessors enter into these transactions with the
understanding that, to be entitled to the tax treatment that is an important part of the
investment decision, they must be able to demonstrate that the lessee’s alternative to
36 IRC § 168(i)(3)(A) and 26 C.F.R. § 1.168(i)-2.
37 B. Cary Tolley III, “Leasing to Tax-Exempt Entities: Setting the Record Straight,” Tax
Notes, April 12, 2004, p. 244.
purchase option exercise is a realistic and commercially viable alternative, and that
it would meet the requirements for a service contract. Should they be unable to do
so their transactions will fail.”38
The deal details have to satisfy numerous other requirements. For example, the
lease term should be less than 80% of the property’s remaining useful life to avoid
being treated as a sale for federal tax purposes. The lessee’s financing of the lessor’s
property acquisition may raise a red flag for the IRS. Therefore the structure of the
transaction has to take into account all the potential legal consequences of the SILO’s
Qualified Technological Equipment
Qualified technological equipment leases (QTEs) are essentially SILOs for
special equipment classes defined in the Internal Revenue Code Section 168(i)(2):
computer, high-technology telephone, and medical equipment. This equipment is
explicitly exempt from the Pickle rule and can be depreciated over five years —
much faster than most other types of equipment. The rationale behind this exclusion
was the relatively short useful lives of many types of technological equipment, but
it also made this equipment a prime property for leasing purposes. This is one of the
reasons why the QTEs appear to be the fastest growing segment of the market today.
Another reason for QTE’s growth is technological change which broadens
classes of eligible equipment. As computers become an integral part of what
previously was a low-tech infrastructure, the assets become eligible for the QTEs.
The leasing industry is very enthusiastic about these developments and is constantly39
searching for new QTE-eligible asset classes.
Although the Internal Revenue Code has distinguished qualified technological
equipment since 1984, QTEs were a relatively rare occurrence until recently.40
According to some sources, the first QTEs appeared in 1995. U.S. transit
authorities completed the first domestic QTE leases in 2002 for rail signaling,
control, and communication equipment. According to the early 2003 data,
“approximately $610 million in QTE financings for U.S. transit authorities closed in41
It is possible, though, that these data are incomplete. For example, the above-
mentioned December 2002 MTA automatic fare collection equipment transaction
38 William A. Macan IV, “LILOs and Lease/Service Contract Transactions: A Response,”
Tax Notes, June 30, 2003, p. 1973.
39 Among numerous examples, see Structured Finance Review, “New Opportunities for
QTEs in Gas and Electricity,” Aug. 2003, also available at [http://www.atlasinform.com/
40 Robert Sheridan, “QTEs: Past, Present and Future,” Asset Finance International, Nov.
41 Structured Finance Review, March 2003, p. 10.
alone was worth $506 million. The same issue of Asset Finance International lists
a New Jersey Transit deal worth $150 million that closed in November 2002. It may
be missing from the above totals.42 Adding these two QTEs would almost double the
As the above examples indicate, individual QTEs are usually very large in terms
of underlying asset values. They normally run in hundreds of million dollars, and
some may exceed $1 billion.43 “Financiers say first time entrants to the QTE market
should be looking at deals of $150 million or higher — even though commercial
banks have been known to consider deals as small as $50 million.”44 There are
indications that since publication of the quoted article, small value deals became
more common, possibly because the costs of arranging an individual transaction
decreased as the practice became more popular. Some examples included deals as
small as $2 million, although this is probably an exception.45
The leases normally extend for more than 16 years, and require asset lives of
over 20 years, which is one of the major barriers to their growth.46 For instance, MRI
equipment satisfies the definition of the qualified technological equipment, but the
asset’s five year useful life makes a QTE deal uneconomical.47 On the other hand,
new potential asset classes include electronic toll collection equipment (like “E-
ZPass” systems) or flight simulators, which have lives of up to 40 years.
Legislative History of Leasing Provisions in the
American Job Creation Act
Two pieces of legislation addressing leasing with tax-exempt entities under
consideration by 108th Congress in 2003-2004 were S. 1637 and H.R. 4520. The
Senate passed its version of the bill on May 11, 2004. The provisions in sec. 475 and
sec. 476 of the engrossed version would (i) include service contracts in the lease term
and specify the useful life of tax-exempt use software, and (ii) limit, with exceptions,
deductions a taxable entity can claim to the amount of income it receives from the
transaction.48 Effectively, the first provision extended the Pickle rule to service
42 Asset Finance International Monthly QTE Research, Jan. 2003, p. 2.
43 Milbank, “Project and Asset Finance,” web page visited on June 14, 2004, at
[ h t t p : / / www.mi l b a n k. c o m/ M i l b a n kEur ope / p r a c t i c e _pr oj e c t .ht m] .
44 Trade Finance, “Leasing Finds a New Direction,” Oct. 1, 1999, p. 9.
45 Sheridan, p. 14.
46 Shoomon Perry, “Technology and the Leveraged Lease,” Asset Finance International,
April 2002, Issue 293, p.31.
47 Sheridan, p. 14.
48 Descriptions available in Department of the Treasury, General Explanations of the
Administration’s Fiscal Year 2005 Revenue Proposal, Feb. 2004, pp. 124-128; and U.S.
Congress, Committee on Finance, Jumpstart Our Business Strength (JOBS) Act, report tothnd
accompany S. 1637, 108 Cong., 2 sess., S. Rept.108-192, (Washington: GPO, 2004),
contracts, and the second one applied a mechanism similar to passive loss limitation
to leases with tax-exempt entities.49 Another tangentially related part of the bill was
sec. 401, clarifying the economic substance doctrine.
The Senate bill in many ways matched the Bush Administration proposal
mentioned in an earlier section of this report. The most important exception was the
effective date of sec. 476 limiting the allowable deduction. It specified that the bill
would apply after January 31, 2004, to leases entered into after November 18, 2003
and before that for any transaction with a foreign entity. The Administration
proposal, as well as sec. 475 of the bill dealing with service contracts, would be
effective for leases entered into after December 31, 2003.
The final (engrossed) language of S. 1637 was different from the reported
version’s sec. 472 and sec. 476. The reported version did not apply to QTEs and
transactions with foreign non-governmental entities. On the other hand, it did not
contain the five conditions of the Administration’s proposal that would exempt
certain transactions from the limitations of the bill. There were also differences in
The revenue estimates reflected the evolution of the measure. The
Administration initially estimated the revenue gain of its proposal at $33.4 billion
over FY2005-14, but the Joint Committee on Taxation (JCT) later reduced this
number to $21.3 billion over 2004-14.50 The JCT’s latest estimate of the reported
version of S. 1637 was $8.9 billion over 2004-13.51 The substitute version’s leasing
sections were first (“very preliminary”) estimated by JCT to yield on a stand-alone
basis $24.0 billion in the same period, and over $1.5 billion more if economic
substance doctrine section were enacted.52 The latest estimate substantially increased
the stand-alone impact to $40.6 billion, while keeping the interaction portion at $1.5
pp.192, 193, 197-200.
49 Passive loss limitation rule prevents deducting losses from passive activities, i.e. activities
an investor does not actively participate in, to offset income from other sources, such as
salaries and wages.
50 U.S. Congress, Joint Committee on Taxation, Estimated Budget Effects of the Revenue
Provisions Contained in the President’s Fiscal year 2005 Budget Proposal, JCX-14-04 R,
March 3, 2004.
51 U.S. Congress, Joint Committee on Taxation, Updated Estimated Budget Effects of S.
1637, the “Jumpstart Our Business Strength (“JOBS”) Act,” as Reported by the Committee
on Finance, JCX-15-04, March 3, 2004.
52 U.S. Congress, Joint Committee on Taxation, Estimated Revenue Effects of the Substitute
Amendment for S. 1637, the “Jumpstart Our Business Strength (“JOBS”) Act,” (very
preliminary), March 23, 2004.
53 U.S. Congress, Joint Committee on Taxation, Estimated Revenue Effects of S. 1637,the
“Jumpstart Our Business Strength (‘Jobs’) Act,” JCX-36-04, May 20, 2004.
The relevant provisions in the corresponding House bills, first H.R. 3967 and
then H.R. 4520, also bore similarity to the Administration’s proposal.54 The key
distinctions were: (i) the leasing limitations would be effective for leases entered into
after February 11, 2004, versus the Administration’s December 31, 2003 deadline;
(ii) it would grandfather some of the deals in the pipeline; and (iii) it would reduce
the authority given to the Treasury to close down other types of transactions.55 The
effective date of H.R. 4520 was postponed by a month to March 12, 2004 compared
to H.R. 3967.
The changes introduced into H.R. 4520 before the committee hearing made the
bill less restrictive compared to S. 1637. The Senate bill had a range of requirements
a transaction had to satisfy for the taxpayer to deduct related losses. The House bill
dropped some of the requirements, most importantly a prohibition of tax-exempt
bond or federal fund financing. Additionally, leases with terms of less than five years
were exempt from two more requirements dealing with substantial equity
investments and minimal lessee risk of loss. QTEs could be extended by up to 24
months more than was allowable under then-existing law and still qualify for a short-
term lease exemption. Beyond that, the bill grandfathered transactions under
consideration by FTA, subject to certain time frames.56 The JCT’s June 22 estimate
of the revenue impact of the provision was $19.6 billion over 2004-14.57
The limitations of the House bill attempted to protect the leasing industry from
unintended burdens caused by the new legislation and to minimize the retroactive
effects. The opponents of S. 1637 were concerned with its possible impact on
“legitimate” leasing transactions and the retroactivity of the bill.58 As discussed
above, the leasing transactions in question normally last for years; therefore the bill’s
retroactivity could affect a number of active deals. Other advocates of the practice
asserted that SILOs and QTEs are merely typical representatives of leveraged leases,
and therefore there were no distinct features that would allow one to distinguish
54 There were indications that similar provisions were considered for inclusion in an early
version of the House FSC/ETI bill (H.R. 2896), but eventually dropped, see Alison Bennett,
“Jenner Optimistic for Action on SILOs, Says Shelter Tide Appears to Be Turning,” Daily
Tax Report, No. 60, March 30, 2004, p. G-6.
55 Alison Bennett, “Thomas Marking Up Highway Tax Raisers, But Not SILOs, for Export
Tax Repeal Bill,” Daily Tax Report, No. 50, March 16, 2004, p. GG-1.
56 U.S. Congress, Joint Committee on Taxation, Description Of H.R. 4520, The “American
Jobs Creation Act Of 2004,” Joint Committee Print, 108th Cong., 2nd sess., JCX-41-04
(Washington: GPO, 2004), pp. 199-206.
57 U.S. Congress, Joint Committee on Taxation, Estimated Revenue Effects of H.R. 4520,
The “American Jobs Creation Act Of 2004,” as Passed by the House of Representatives,thnd
Joint Committee Print, 108 Cong., 2 sess., JCX-45-04, (Washington: GPO, 2004), p. 6.
58 Equipment Leasing Association Letter to Senate Finance Chairman Charles Grassley (R-
Iowa) Calling Senate Substitute for S. 1637 “Crisis” for Investors, Daily Tax Report,
Primary Source Material, April 12, 2004.
SILOs and QTEs from other bona fide business transactions. The new limitations in
H.R. 4520 received favorable reaction from the leasing industry.59
On the other hand, supporters of the more restrictive language of the
Administration’s proposal and S. 1637 asserted that “the detailed SILO proposal in
the President’s budget permits legitimate lease transactions to continue.”60 For
example, they argued with respect to inclusion of service contracts in the lease term
“it is difficult to envision a non-tax business reason for a tax-exempt entity
structuring a transaction that converts a 20, 30, or 40-year lease into a service
The House Ways and Means Committee approved H.R. 4520 on June 14. The
bill passed the House on June 17, 2004.
After the conference the final version of the bill retained the “safe harbor”
limitations of the House version (Part 3 of the bill, Sections 847-849), but covered
leases with Indian tribal governments and applied to intangible assets.. The bill’s
effective date is March 12, 2004 with some exceptions for FTA-approved and Indian
government leases. The estimated revenue gain is $26.6 billion over 2005-2014.62
The bill was signed into law by President Bush on October 22, 2004 (P.L. 108-357).
Even though the effective date of the bill is March 12, 2004, IRS still may
question the transactions completed earlier under the rules effective before the
enactment of the bill. There were indications that IRS was planning to continue this
Early reactions from the experts indicated that the bill should succeed in curbing
the leasing transactions with tax-exempt entities in the form they had at the time of
the bill signing.64 At the same time the law may not necessarily achieve the broader
policy goals of tax system equity and revenue drain prevention. Conceptually, the
alleged abusive behavior of taxpayers is the result of the differential treatment of
various entities and activities by the existing Tax Code. It creates the incentives for
tax benefits transfer inducing the otherwise unnecessary transactions. For as long as
59 Letter From Coalition of Power and Local Government Groups to House Ways and Means
Chairman William Thomas (R-Calif.) Praising Changes to SILO Arrangements in New
Export Tax Repeal Bill (H.R. 4520), Daily Tax Report, Primary Source Material, June 14,
60 Statement of the Honorable P. F. Olson, Feb. 11, 2004.
61 U.S. Congress, Joint Committee on Taxation, Description of Revenue Provisions
Contained in the President’s Fiscal Year 2005 Budget Proposal, Joint Committee Print,thnd
62 U.S. Congress, Joint Committee on Taxation, Estimated Budget Effects Of The
Conference Agreement For H.R. 4520, The “American Jobs Creation Act Of 2004,” Jointthnd
Committee Print, 108 Cong., 2 sess., JCX-69-04, October 7, 2004, p. 8.
63 Allen Kenney, “SILO Shutdown: How the New Law Could Cripple the Industry,” Tax
Notes, Nov. 1, 2004, p. 638-639.
this differential treatment exists, the incentives for this type of behavior remain.
SILOs and QTEs may become non-existent, but some other kind of transaction may