IN TRO DUCTION
A synthetic lease is a popular financial instrument in commercial real estate, allowing tenants to borrow based on their financial strength and rental agreements In this arrangement, lenders anticipate that debt repayment will come from the tenant's rental payments rather than the nominal owner's finances The term "synthetic" reflects its dual nature, as tenants classify it as an operating lease for financial accounting while treating it as a mortgage for federal tax purposes This article explores synthetic leases within the framework of asset securitization and structured finance, highlighting the differences in their treatment under financial accounting standards and federal income tax law.
For financial accounting, tenants can often keep debt off their books by structuring leases to avoid capitalization tests set by the Financial Accounting Standards Board (FASB), especially if they do not engage in sale and leaseback transactions In contrast, for federal income tax purposes, tenants can assert that they are the substantive owners of the leased assets through a "benefits and burdens" analysis, allowing them to claim depreciation deductions In 1999, the IRS's Office of the Chief Counsel issued Field Service Advice confirming that this analysis dictates the tax treatment of lessees in synthetic lease transactions, concluding that lessees can be recognized as the "tax owner" of depreciable properties despite disclaiming ownership for financial accounting purposes.
The financial accounting standards set by FASB need reform to address the significant discrepancies in the treatment of synthetic leases compared to traditional lease agreements Rather than altering federal income tax law, FASB should remove the clear distinction between sale-leaseback transactions and those involving a Special Purpose Entity (SPE) acquiring title from a third party Specifically, FASB must mandate balance sheet disclosure when a transaction's key element is an agreement that the tenant, rather than the landlord, will claim substantive ownership of the asset for federal income tax purposes.
* Dean and Professor, Florida State University College of Law B.S., Fordham University, 1966; J.D.,
In 1969 at the University of Texas at Austin, the author expresses gratitude to research assistants Eric Dickey and Peter Fisher, as well as to Martin J McMahon, Jr., for their invaluable insights and support Additionally, the author contributed as an expert in two of the disputes mentioned in the references.
1 FREDERICH W MAITLAND, EQUITY: A COURSE OF LECTURES 189 (Brunyate ed 1969).
4 Internal Revenue Service National Office Field Service Advice, UILC: 61.16.03 (Jan 12, 1999) [hereinafter Advice].
Synthetic Leases and Special Purpose Entities
The term "synthetic lease," much like "creative financing" in the 1980s residential real estate market, is frequently used without clear definition To effectively define a synthetic lease, it is essential to consider both the desired outcomes for property financiers and the common characteristics associated with synthetic lease transactions.
A synthetic lease is a unique financial arrangement that functions as a lease for accounting purposes while allowing the nominal tenant to treat it as a mortgage for federal income tax purposes This concept reflects a historical contrast in how leases are viewed in financial accounting versus mortgage and tax law, reminiscent of innovative financing methods from the 1980s that echoed pre-Depression home financing techniques.
For financial accounting, synthetic leases are structured to qualify as "operating leases" instead of "capital leases." If classified as a capital lease, the tenant's rental obligations are capitalized and recorded as long-term debt on the balance sheet Conversely, operating leases allow rent to be treated as an expense for the period incurred, with the long-term rental obligation only noted in a footnote on the financial statements.
For federal income tax purposes, a synthetic lease allows the tenant to effectively consider themselves the owner of the property, treating rental obligations as debt service This perspective enables the tenant to claim a depreciable interest in the building, including a basis that accounts for costs financed through borrowed funds Consequently, the tenant asserts that they are depreciating their investment in the property However, because the rent is viewed as debt service, only the portion of the payment attributable to interest is deductible, excluding the rest.
6 The definition in the Advice refers only to one part of the blend:
A synthetic lease, also known as synthetic real estate financing, offers off-balance sheet financing for corporations to acquire and develop commercial properties This financing method provides significant credit support for debt issued by investors or financial institutions, allowing companies to manage their assets effectively while optimizing their balance sheets.
Advice, supra note 4, at 2 (citing John C Murray, Off-Balance Sheet Financing: Synthetic Leases, 32 REAL PROP PROB & TR J 193, 195 (1997)).
In the case of Frank Lyon Co v United States, the Supreme Court highlighted that the classification of a transaction can differ between financial accounting and tax purposes, emphasizing that these two perspectives do not have to align This distinction is crucial for understanding how transactions are reported and assessed in different contexts.
2000] traceable to repayment of principal 12 Especially in the early years of the financing arrangement, the combined depreciation and interest deductions typically exceed the rental deduction.
Investing in a synthetic lease transaction is a risky endeavor that prioritizes form over substance The underlying assumption is that financial accounting standards will recognize the lease's structure, while federal income tax law will acknowledge the tenant's investment in a depreciable asset financed through borrowed funds.
A synthetic lease transaction is typically structured using a Special Purpose Entity (SPE), which is created solely for financing transactions and has no other existence The SPE usually holds minimal assets, "purchases" an asset, and "borrows" funds to finance the acquisition through a contemporaneous lease These leases are often short-term, ranging from three to seven years, and are usually "triple-net," meaning the tenant is responsible for all operating costs, including insurance, maintenance, and taxes Rent payments are primarily designed to cover the SPE's debt service, with little excess.
The tenant's obligation to pay rent is crucial for the value of the Special Purpose Entity's (SPE) obligations, often enhanced by credit facilities This obligation is generally absolute and unconditional, remaining intact despite landlord defaults or other unforeseen events Notably, the tenant must continue paying rent even if the SPE suffers a complete failure of title Leases typically grant tenants significant control over long durations, especially when considering lease renewal options, which may allow for rent reductions that still reflect an estimated fair rental value Additionally, tenants may have purchase options at prices tied to market value, although these can be influenced by the terms of lease renewals or other factors.
Synthetic leases feature unique operating provisions that differentiate them from traditional leases They often empower the lessee to act on behalf of the Special Purpose Entity (SPE) in various scenarios, such as negotiating with authorities during a condemnation event Additionally, these leases may incorporate presumptions not typically found in standard agreements, allowing for a range of tenant actions or proposals to be assumed as accepted, even though the SPE retains the right to formally reject them Essentially, these provisions facilitate the tenant's intentions and streamline decision-making processes.
Financial accounting standards are tougher on sale-leasebacks then they are on leases of property the lessor acquires from a third party 16 Stated differently, financial
13 See H Peter Nesvold, What Are You Trying to Hide? Synthetic Leases, Financial Disclosure, and the
Information Mosaic, 4 STAN J L Bus & FIN 83, 89 (1999); see also Murray, supra note 6, at 200.
A lease is considered a capital lease when its duration is excessive or when the rental payments are nearly equivalent to the total value of the asset.
15 For other features in synthetic lease transactions, see Murray, supra note 6, at 211.
Synthetic leases are more likely to be classified as capital leases rather than operating leases when the lessor traces title back to the lessee This creates significant opportunities for blended treatment primarily in new acquisitions instead of sale-leasebacks Typically, synthetic leases refer to transactions that do not involve sale-leasebacks In this arrangement, the user effectively owns and finances the property without holding title before becoming a tenant Instead, the user designates property for a Special Purpose Entity (SPE) to acquire from a third party, which the SPE then leases back to the user The SPE finances this acquisition through debt, secured by a mortgage on the property and an assignment of its right to collect rent from the user, potentially supplemented by a credit facility.
Synthetic leases in commercial real estate are best understood within the framework of asset securitization During the competitive landscape of the 1980s and 1990s, corporations focused on downsizing and restructuring to hone in on their core missions and optimize efficiency They outsourced functions that could be performed more effectively by external providers, leading to a paradigm where every individual and asset was expected to generate profit This shift resulted in a perspective that evaluated success or failure based on the ability to deliver tangible results.
Businesses can enhance their financial standing by organizing assets into groups or profit centers For instance, a borrower with a limited credit rating can secure favorable terms for a specific transaction by granting a lender a first security interest in their most valuable assets This can be achieved by establishing a Special Purpose Entity (SPE) and transferring these assets to it, allowing the SPE to act as a nominal borrower The SPE is considered "bankruptcy remote" for two reasons: first, isolating the assets within the SPE protects them from the bankruptcy risks of the original company; second, the SPE itself has a minimal likelihood of facing bankruptcy.
In 1992, the Securities and Exchange Commission (SEC) introduced Rule 3a-7 to prevent Special Purpose Entities (SPEs) from being classified as "investment companies" under the Investment Company Act of 1940 This rule aimed to eliminate an unintended barrier to the utilization of structured financings across various economic sectors, facilitating greater access to these financial instruments.
1992 SEC LEXIS 3086, at *1 (Nov 19, 1992) (codified at 17 C.F.R pt 270.3a-7).
Improved Balance Sheet and Ratios
Two Ways to Challenge the Transaction
This article focuses on the key financial accounting standards that enable synthetic lease transactions within structured finance and asset securitization Financial accounting standards can impact off-balance sheet real estate financing in two primary ways: first, by assessing lease provisions to determine if a lease should be classified as a long-term liability for the tenant; and second, by evaluating the relationship between a tenant and a Special Purpose Entity (SPE) to ascertain if they must consolidate their financial statements Although the lease itself may not be recharacterized, the outcome is similar, as the SPE's debt will appear on the tenant's consolidated balance sheet.
Challenging the Lease Itself
FA S 13 and FA S 98
The primary Statements of Financial Accounting Standards (FAS) relevant to real estate lease characterization are FAS 133 and FAS 98 Among these, FAS 13 is the more comprehensive standard, as it encompasses all leasing transactions.
FAS 98 specifically pertains to sale-leaseback transactions and imposes stricter requirements compared to FAS 13 Unlike FAS 13, FAS 98 mandates that leases be recorded as debt on the tenant's balance sheet, highlighting the critical differences in accounting treatment between the two standards.
34 See ACCOUNTING FOR LEASES, Statement of Financial Accounting Standards No 13 (Financial Accounting Standards Bd 1976) [hereinafter FAS 13].
35 See ACCOUNTING FOR LEASES: SALE-LEASEBACK TRANSACTIONS INVOLVING REAL ESTATE, SALES- TYPE LEASES OF REAL ESTATE, DEFINITION OF THE LEASE TERM, INITIAL DIRECT COSTS OF DIRECT FINANCING LEASES, Statement of Financial Accounting Standards No 98 (Financial Accounting Standards Bd.
38 FAS 98 focuses on sale-leasebacks of real estate, including sale-leasebacks that include equipment. Most basically, FAS 98 prohibits sale-leaseback accounting unless the transaction qualifies as a true sale, which will be denied if the lessee has any continuing involvement other than a "normal leaseback" in which the seller- lessee intends to actively use the property during the lease FAS 98 further states:
Sale-leaseback accounting is applicable for a seller-lessee when the transaction includes a standard leaseback, payment terms that clearly reflect the buyer-lessor's initial and ongoing investment in the property, and terms that transfer all ownership risks and rewards, ensuring no further involvement from the seller-lessee.
To achieve favorable accounting results, lessees construct synthetic lease transactions to avoid the implications of FAS 98 This involves ensuring that the lessor purchases the asset from a third party rather than the lessee Once the application of FAS 98 is circumvented, the lease agreement is then structured to comply with the requirements of FAS 13.
The Four Tests of FAS 13 and Consequences of a Capital Lease
To achieve off-balance sheet financing under FAS 13, a lease must be classified as an "operating" lease instead of a "capital" lease According to FAS 13, a lease qualifies as a capital lease if it meets any one of four specific criteria If the lease does not meet any of these criteria, it is classified as an operating lease.
A lease is categorized as a capital lease if it satisfies any of the following conditions: it transfers ownership of the property to the lessee at the end of the lease term, includes a bargain purchase option, has a lease term that lasts for seventy-five percent or more of the property's estimated economic life, or if the present value of the minimum lease payments at the start of the lease equals or exceeds ninety percent of the fair value of the property to the lessor at lease inception.
FAS 98 defines continuing involvement as any option to repurchase property without a genuine third-party purchase offer, while FAS 13 considers an option to repurchase detrimental only if offered at a bargain price.
39 FAS 98 only applies to real estate, property improvements, and integral equipment See FAS 98, supra note 35, 6 Property improvements and integral equipment are defined as "any physical structure or equipment attached to the real estate that cannot be removed and used separately without incurring significant cost." Id
6 n.2 Assets that can be moved "[without] incurring significant cost" are not subject to FAS 98 Id
40 See Holmes, supra note 24, at 17, 20.
Generally, SFAS 98 provides that the seller in such a transaction is precluded from recognizing a sale if it retains options to purchase or provides guarantees or other provisions that constitute
"continuing involvement" with the property Since such provisions are integral to the synthetic lease structure, the lessee must avoid obtaining title to the leased property (including the land).
To prevent potential issues, a direct purchase by the lessor or Special Purpose Entity (SPE) is advisable Additionally, the lessee should refrain from providing guarantees or commitments during the construction phase that could effectively position them as the project's owner.
41 The Emerging Issues Task Force has stated that in build-to-suit lease transactions, "[a] lessee who commences construction activities would recognize the asset (construction in progress) on its balance sheet, and any subsequent lease arrangement would be within the scope of [FAS] 98." EITF 96-21: IMPLEMENTATION ISSUES IN ACCOUNTING FOR LEASING TRANSACTIONS INVOLVING SPECIAL-PURPOSE ENTITIES, EITF Abstracts Issue No 96-21 (Financial Accounting Standards Bd., Emerging Issues Task Force 1996) [hereinafter EITF 96- 21].
44 See FAS 98, supra note 35, 22(a) (amending the definition of "lease term" in FAS 13, 5(0).
46 See id 5(g) (defining "estimated economic life of leased property") This criterion is not used to classify the lease if the beginning of the lease term falls within the last 25% of the total estimated economic life of the leased property Id 7(c).
If a lease fails to meet any of the four specified tests, the lessee must categorize it as a capital lease in their financial records Additionally, this classification may impact any associated investment tax credits retained by the lessor.
Treating a lease as a capital lease requires the lessee to record it as both an asset and an obligation, reflecting the present value of minimum payments at the lease's inception If the lease involves both land and buildings, they must be capitalized separately based on their fair values The capitalized building asset must be amortized, and each minimum lease payment is divided into a reduction of the obligation and an interest payment Upon termination of a capital lease, the asset and obligation must be removed from the balance sheet, with any resulting gain or loss recognized Conversely, if the lease lacks the necessary characteristics for capital treatment, it is classified as an operating lease, with the asset recorded on the lessor's balance sheet and the lessee expensing rent as it becomes due.
The Core "Concept" of FAS 13
According to FAS 13, a lease should be capitalized if it transfers nearly all the benefits and risks of ownership to the tenant, regardless of whether it is fundamentally equivalent to a purchase.
A lease that effectively transfers most ownership benefits and risks must be recorded as an asset acquisition and obligation by the lessee, while the lessor should treat it as a sale or financing Conversely, all other leases should be classified as operating leases.
47 Consider, for example, a lease provision that anticipates a sale of the building at the end of the lease If the sales proceeds are insufficient to return the lessor's investment and that of its creditors, the lessee cannot pledge in advance to make up the full amount without running afoul of the 90% test of FAS 13:
If the sales proceeds do not cover the lessor's net investment, the lessee must pay a contingent rental fee equal to the shortfall However, this payment is capped so that the total of the contingent rent and scheduled monthly lease payments does not surpass 89.9% of the asset's original cost.
48 FAS 13 provides special rules that vary the application of the basic tests when a lease involves real estate See FAS 13, supra note 34, 24-28.
49 Id 10 "However, if the amount so determined exceeds the fair value of the leased property at the inception of the lease, the amount recorded as the asset and obligation shall be the fair value." Id
51 Id I Land capitalized under a lease that meets the first two of the four criteria will normally not be amortized FAS 13, supra note 34 26(a)(1).
55 Id 15, at n.30 While FAS 13 does not require property subject to an operating lease to appear as an asset on the balance sheet, it does require disclosure of operating lease obligations by way of a footnote to the balance sheet See FAS 13, supra note 34, 16 For operating leases having non-cancelable lease terms longer than one year from the date of the current balance sheet, the footnote disclosure must include future minimum rental payments in the aggregate and for each of the five succeeding fiscal years See id 16(b)(i).
Synthetic leases are financial agreements that shift most of the ownership benefits and risks, creating an economic impact comparable to an installment purchase However, these transactions should not be classified strictly as "in substance purchases" as defined in earlier authoritative literature.
The drafters of FAS 13 thought that its principal contribution was to extend the
Lessees are now required to analyze and report "substantially all of the benefits and risks" in accordance with the same principles used by lessors Notably, the Board chose not to align these financial accounting standards with federal income tax law.
FAS 13 and Tax Consequences
FAS 13 addressed the interplay between accounting treatment and tax treatment. With respect to sale-leasebacks in particular, the Board noted that most are entered into
"as a means of financing, for tax reasons, or both" and that the terms of the sale and the terms of the lease are usually negotiated as a package.
Due to the interdependence of terms, it is impractical and subjective to separate sale and leaseback transactions Consequently, the Board has determined that the existing requirement to defer and amortize gains and losses from these transactions should remain in place However, an exception occurs when the property's fair value at the transaction time is lower than its undepreciated cost, leading the Board to conclude that a loss should be recognized in that scenario.
The transfer of substantial ownership benefits and risks is a key concept in lessors' accounting, while lessees' accounting has historically followed different guidelines Earlier literature mandated the capitalization of leases that effectively function as installment purchases, defined by their terms creating significant equity in the property This discrepancy in concepts and criteria can lead to a leasing transaction being classified as a sale or financing for the lessor, while being treated as an operating lease for the lessee.
The Board clarified its stance on lease capitalization, stating that not all leases should be treated as "in substance installment purchases." They emphasized that this interpretation would only apply to leases that guarantee ownership transfer, whereas other leases possess unique features, like the reversion of property to the lessor upon lease termination.
Certain Board members advocating for FAS 13 argued that a lease, by granting the right to use property for its duration, results in the lessee acquiring an asset and incurring a corresponding obligation This perspective emphasizes the necessity of reflecting these transactions in the financial statements, regardless of the transfer of substantial benefits and risks of ownership.
2000] recognized up to the amount of the difference between the undepreciated cost and fair value 58
When adopting FAS 13, the Board chose not to consider a lessee's treatment of a lease as a purchase for federal income tax purposes as a criterion They acknowledged that tax and financial accounting often diverge, and the need for conformity between the two is outside the scope of this Statement Given the current prevalence of synthetic lease transactions, it may be an opportune moment for the Board to reevaluate this decision.
In a synthetic lease transaction, the lessee is responsible for reporting depreciation deductions for federal income tax, indicating that the lessee bears most of the benefits and burdens of ownership This arrangement suggests that the lessee should be viewed as the primary owner and debtor, rather than the lessor Consequently, the Board should mandate disclosure of this relationship for transparency in financial reporting.
The Board aims to establish a requirement for financial accounting that is not influenced by frequently changing tax rules Historically, federal income tax analysis has relied on a stable benefits and burdens approach, which is unlikely to change The proposed disclosure should focus on the contractual understanding between the lessee and the Special Purpose Entity (SPE), rather than on uncertain legal outcomes related to federal income tax treatment Consequently, lessees should be mandated to disclose their contractual agreement indicating that they, not the lessor, will claim ownership and debt for federal income tax purposes This disclosure should be included in the financial statements submitted to the SEC, clarifying what the lessee intends to report to the tax authorities.
Requiring Consolidation of Lessee and Special Purpose Entity
Introduction 4 58 2 EITF 90-15 and EITF 96-21
In summary, when a sale-leaseback is not involved and FAS 98 does not apply, businesses seeking off-balance sheet financing can easily structure leases that avoid classification as capital leases under FAS 13 by adjusting the lease term and contingent rental payments However, if the lessor is not an independent entity or seems to act as the lessee's agent for financing, classifying the lease as an operating lease may not guarantee it remains off-balance sheet in certain circumstances.
58 Id 107 Although FAS 28 modified FAS 13 with respect to sale-leasebacks, the major change with respect to sale-leasebacks of real property was announced in FAS 98, which requires capitalization of many more sale-leasebacks See supra Part II.B 1.
62 This is sometimes discussed in terms of the financing corporation serving as a "friendly" lessor.
Board requires consolidation of the financial statements of a lessee and an SPE, bringing both the asset and its encumbrance onto the books of the lessee.
The adoption of FAS 13 by the Board led to a shift in focus, as the criterion of lease characterization concerning the lessor's lack of independent substance was deprioritized.
The Board dismissed the argument that a lessee should account for a leasing transaction based on the economic substance of an unrelated lessor, suggesting that if the lessor lacks independent economic substance, it merely indicates that the lender effectively acts as the lessor However, this situation does not warrant a change in how the lessee accounts for the lease.
Concern over unrelated lessors without independent economic substance finally got moved to a front burner when the Emerging Issues Task Force addressed what it labeled Issue Number 90-15.
EITF 90-1564 responds to concern over the gap in treatment between FAS 13 and FAS 98 The Task Force perceived that SPEs were being used to avoid FAS 98 while achieving "substantive," though not "formal," sale-leasebacks EITF 90-15 established three factors that, if present, require consolidation of the financial statements of lessor and lessee Six years later, as interest in the use of synthetic leases increased, EITF 96-
2165 clarified the application of the three factors.
EITF 90-15 defines circumstances in which an SPE will be consolidated with a lessee for financial statement purposes because of the SPE's "lack of economic substance." 66 A lessee is required to consolidate an SPE lessor when all of the following conditions exist:
1 Substantially all of the activities of the SPE involve assets that are to be leased to a single lessee; 67
2 The expected substantive residual risks and substantially all of the residual rewards of the leased assets and the obligations imposed by the underlying debt of the SPE reside, directly or indirectly, with the lessee 68
64 See EITF 90-15: IMPACT OF NONSUBSTANTIVE LESSORS, RESIDUAL VALUE GUARANTEES, AND OTHER PROVISIONS IN LEASING TRANSACTIONS, EITF Abstracts Issue No 90-15 (Financial Accounting Standards Bd., Emerging Issues Task Force 1990) [hereinafter EITF 90-15].
65 See EITF 96-21: IMPLEMENTATION ISSUES IN ACCOUNTING FOR LEASING TRANSACTIONS INVOLVING SPECIAL-PURPOSE ENTITIES, EITF Abstracts Issue No 96-21 (Financial Accounting Standards Bd., Emerging Issues Task Force 1996) [hereinafter EITF 96-21]
66 See Nesvold, supra note 13, at 105.
3 The owners of record of the SPE have not made an initial substantive residual equity capital investment that is at risk during the entire term of the lease 69
When certain conditions are met, the assets, liabilities, operations, and cash flows of a Special Purpose Entity (SPE) must be consolidated into the lessee's financial statements, necessitating the capitalization of leases by the lessee EITF 90-15 stipulates that consolidation occurs only when all three specified conditions are satisfied The first condition is fulfilled when the majority of the SPE's activities involve assets leased to a single lessee; however, merely leasing to multiple lessees does not guarantee avoidance of this condition EITF 96-21 emphasizes that this requirement is substantive rather than merely formal, indicating that the use of nonrecourse debt without cross-collateral provisions effectively separates cash flows and assets, thereby creating the functional equivalent of two SPEs.
To avoid violating condition 1 of Issue 90-15, the assets of the Special Purpose Entity (SPE) must remain separate In the event of a default, both lenders should have equal rights to the cash flows and assets tied to each lease within the SPE, ensuring that there is no commingling of assets.
68 Id at 106 EITF 90-15 states that the residual risks and substantially all the residual awards of the asset and the obligation of the SPE's debt may reside with the lessee through such means as: a The lease agreement; b A residual value guarantee through, for example, the assumption of first dollar of loss provisions; c A guarantee of the SPE's debt; d An option granting the lessee a right to (1) purchase the leased asset at a fixed price or at a defined price other than fair value determined at the date of exercise or (2) receive any of the lessor's sales proceeds in excess of a stipulated amount.
70 For a recent proposal for reform of the financial accounting treatment of synthetic leases, see Nesvold, supra note 13, 112-13:
To achieve optimal outcomes, the FASB should consider revising EITF 90-15 by potentially increasing the required equity stake for the SPE-owner of record beyond the current three percent threshold This change could enhance the criteria for synthetic leases to qualify for off-balance sheet treatment.
The FASB should contemplate introducing a fourth aspect to EITF 90-15, stipulating that a lessee-corporation must consolidate the lessor-Special Purpose Entity (SPE) in cases where a synthetic lease includes an option to purchase the underlying asset at either its future fair market value or the lessor-SPE's unamortized principal balance for the duration of the lease.
Synthetic lease transactions primarily involve a single lessee who finances based on their credit and pledges select assets, fulfilling the first condition of such agreements The second condition is satisfied when the lessee holds the expected substantive residual risks and rewards of the leased assets, alongside the obligations tied to the underlying debt of the Special Purpose Entity (SPE) This can occur through lease terms, residual value guarantees, debt guarantees, purchase options at predetermined prices, or rights to excess sales proceeds According to EITF 90-15, the SEC evaluates whether a registrant possesses substantive residual risks and rewards by assessing elements of management or control, such as the presence of a non-substantive lessor, the lessee's ability to benefit from asset appreciation while bearing depreciation risks, and the lessee acting as both the construction and selling agent Typically, synthetic leases involve tenants who actively seek to maintain practical control while forgoing formal ownership, thereby meeting both conditions.
The third condition for a synthetic lease is fulfilled when the owners of the Special Purpose Entity (SPE) do not make an initial substantive equity investment at risk throughout the lease term To avoid this condition, modern synthetic lease transactions require the SPE to provide and retain equity The owners must invest capital comparable to what a substantive business would in similar leasing scenarios, with the EITF working group suggesting a minimum investment of three percent However, the SEC staff has indicated that a larger investment may be necessary based on the specific lease circumstances.
77 See James Blythe Hodge, The Synthetic Lease: Off-Balance Sheet Financing of the Acquisition of Real
Property, 433 PLI/REAL 657, 667 (Order No NO-0013) (1998); see also Evelyn Giacco, Synthetic Lease
Transactions and "Off-Balance Sheet 'Financing, 424 PLI/REAL 563, 573 (Order No N4-4608) (1997); Nancy
R Little, Unraveling the Synthetic Lease, PROB & PROP , Jan-Feb 1997, at 22, 24.
78 EITF 90-15, supra note 64, at Response to Question No 3.
Most practitioners emphasize the importance of the initial equity investment in a synthetic lease arrangement, particularly focusing on the third requirement Although there is no definitive guidance, it is generally interpreted that a minimum initial equity investment of 3% is necessary If the owners of record of the Special Purpose Entity (SPE) meet this investment criterion as outlined in EITF 90-15, it safeguards the lessee's off-balance sheet treatment.
2000] made, it must remain at risk for the entire term of the lease to continue to insure criterion three remains unmet 8 1
SPEs and Professional Test Flunkers
STATE MORTGAGE LAW OF SUBSTANCE OVER FORM
The transfer of title for loan repayment has a rich historical background, particularly in Anglo-American mortgage law Initially, under common law, lenders required borrowers to convey property as security for loan repayment.
82 Howard A Zuckerman, Lenders Get Creative with New Capital Structure: Synthetic Real Estate Funding, in CAPITAL SOURCES FOR REAL EST., Dec 1995, at 31 (emphasis added).
83 See Holmes, supra note 24, at 20 (noting in a typical illustration that the only difference in substance from a loan secured by the leased assets is "a partial shift of the residual risk to the synthetic lessor in the event the building retains only a substantially diminished residual value").
84 For an excellent one-volume discussion on the law of mortgages and mortgage substitutes, see GRANT
S NELSON & DALE A WHITMAN, REAL ESTATE FINANCE LAW (3d ed 1994).
Synthetic leases involve a conveyance in fee simple with a defeasance clause, typically structured as a fee simple on condition subsequent This arrangement stipulates that the borrower can reclaim the property from the lender only upon the full and timely repayment of principal and interest However, in cases of borrower default, many sought relief from forfeitures through equity courts.
Defaulting borrowers aim to protect two key interests: the right to pay off their loan and redeem their property, and the right to recover any remaining value after the property is sold to satisfy the lender's claims While the right to pay off the loan is often limited by acceleration clauses that require the entire outstanding amount to be paid upon default, this right holds little value for those who cannot afford to pay Consequently, the recognition of the right to recover residual property value becomes crucial, as the transfer of title is primarily viewed as a means for lenders to achieve their legitimate goal of recouping principal, interest, and additional costs incurred due to default.
The borrower's right to redeem a secured loan by making late payments has evolved into a recognized entitlement rather than a discretionary privilege This right, known as "equity of redemption," is treated as an estate in land, affording it legal protection from being easily revoked Similar to how a fee simple estate cannot be forfeited merely due to inactivity, an equity of redemption remains intact even if the borrower is slow to exercise it Consequently, it is the responsibility of the secured lender to take action to extinguish this equity.
Lenders require a process to finalize secured loans in default, leading to the development of foreclosure A foreclosure decree terminates the borrower's right to redeem the property, compelling them to either pay the overdue amount or lose all claims to it Traditionally, the law has allowed borrowers to receive any remaining value from the property after the lender recoups their principal, interest, and costs through a foreclosure sale If the borrower fails to pay or opts not to, the secured property is sold, and any surplus funds are returned to the borrower Most states mandate that foreclosure sales occur through the court system, while some allow nonjudicial processes.
89 See generally BERNARD RUDDEN & HYWEL MOSELEY, AN OUTLINE OF THE LAW OF MORTGAGES (1967).
90 See NELSON & WHITMAN, supra note 84, at 7.
91 See RUDDEN & MOSELEY, supra note 89, at 8.
92 See generally NELSON & WHITMAN, supra note 84, at 571-73.
2000] foreclosure under a power of sale clause in a deed of trust or in a mortgage is enforceable 94
Lenders cannot require borrowers to waive their equity of redemption when taking out a loan, as such agreements are unenforceable This principle, often referred to as the prohibition against "clogging" the mortgagor's equity of redemption, applies regardless of whether the waiver is explicit or implicit For instance, a fee simple absolute conveyance may be recognized as a mortgage if it is linked to a secured loan Similarly, a purchase money mortgage can be established even if a deed appears to grant unqualified title from a seller to a lender.
For centuries, lenders have tried to avoid the foreclosure process by characterizing a borrower's possession as that of a lessee rather than as that of a mortgagor in possession.
Sale-leasebacks can involve lenders acquiring title directly from third parties, but in both scenarios, the nominal lessee must demonstrate that the conveyance to the lender was meant to secure a repayment promise This promise can manifest in various forms, such as a "put" option allowing the lender to compel the lessee to buy the property, or a favorable purchase option that the lessee feels economically pressured to exercise Courts may also interpret a seemingly absolute conveyance at a significantly low price as an indication of a loan security intent If a lease is determined to function as a mortgage, the lessee retains an equity of redemption, which can only be terminated through proper foreclosure procedures, rather than the expedited remedies typically seen in landlord-tenant disputes.
Equity courts established a doctrine that prevents the obstruction of a mortgagor's equity of redemption, ensuring that even in cases of mortgage default, no agreement associated with the mortgage can eliminate the mortgagor's rights without the mortgagee initiating foreclosure proceedings.
96 See Talbot v Gadia, 267 P.2d 436, 440 (Cal Ct App 1954):
When a conveyance is executed from the vendor to the lender to secure a loan for the purchase, the legal title is held in trust for the borrower, ensuring that the title will ultimately transfer to them The grantee serves a dual role, acting as both a trustee of the legal title and a mortgagee for the funds provided for the purchase.
See also Wilcox v Salomone, 258 P.2d 845, 849 (Cal Ct App 1953):
In this transaction, which involves three parties instead of the typical two, the individual who acquires the property acts as a trustee for the party who provided the purchase funds This trustee also maintains a lien as a mortgagee to secure the repayment of the loan Consequently, the standard rules governing absolute deeds and mortgage cases remain applicable in this scenario.
97 See Golden State Lanes v Fox, 42 Cal Rptr 568 (Ct App 1965).
98 See NELSON & WHITMAN, supra note 84, at 52.
State common law is often enhanced by statutes that classify any instrument functioning as a mortgage as a mortgage, irrespective of its form Historically, any interest "in the shape of a mortgage" is subject to foreclosure in the same manner as a traditional mortgage These statutes typically protect good faith purchasers for value who are unaware of the mortgage's existence Courts strictly enforce these statutes due to a longstanding concern for borrowers and a historical context that aims to limit judicial oversight of foreclosure processes.
The parole evidence rule and the statute of frauds do not prevent the introduction of evidence to demonstrate that an alternative form was intended as a mortgage The essential aim is to establish a promise to repay, secured by a pledge of property Key considerations include efforts to obtain debt financing, the relationship between the transferred consideration and the property's value, the transferor's intention to maintain possession and control, provisions for reconveyance upon lease termination, the presence of a favorable repurchase option, enhancements made to the property beyond typical tenant improvements, and the assumption of ownership benefits and burdens by someone other than the nominal owner.
FEDERAL INCOME TAX LAW OF SUBSTANCE OVER FORM
Federal income tax law, much like state mortgage law, prioritizes the substance of a loan over its form Judicial opinions emphasize that substance prevails, asserting that economically identical transactions should be taxed similarly unless altered by Congress Courts consistently indicate that the IRS has greater flexibility to overlook the transaction's form compared to the taxpayer who made the choice.
99 An example of a more modem statute is FLA STAT ch 697.01 (1999), entitled "Instruments Deemed Mortgages," which states:
All instruments used to convey or sell property for securing payment, whether between debtor and creditor or involving a third party trustee, are classified as mortgages These instruments will adhere to the same foreclosure rules and regulations as traditional mortgages.
See also CAL CIV CODE § 2924 (West 1999) and N.Y REAL PROP § 320 (McKinney 1989).
According to Florida Statute 697.01(2) (1999), a conveyance cannot be considered a mortgage against a bona fide purchaser or mortgagee who is unaware of it and holds rights under the grantee This principle is further supported by the case Moeller v Lien, 30 Cal Rptr 2d 777 (Ct App 1994).
101 See, e.g., Davis v Stewart, 127 P.2d 1014 (Cal Ct App 1942); Thomas v Thomas, 96 So 2d 771 (Fla 1957); In re Nolta's Estate, 56 N.Y.S.2d 818 (Sup Ct 1945).
102 See NELSON & WHITMAN, supra note 84, at 48-50.
In the case of In re Wingspread, 116 BR 915 (Bankr S.D.N.Y 1990), it is emphasized that both the government and taxpayers have gained advantages from the principle that substance should take precedence over form in financial dealings This perspective is further explored in Thomas R Fileti's work on real estate off-balance sheet financing, specifically synthetic leasing, which highlights the implications of this principle in financial practices.
An analysis of significant case law regarding the claim of depreciable interest in real property reveals three main conclusions Firstly, federal income tax case law, similar to FAS 13, employs a "benefits and burdens" approach Secondly, this approach, which favors lessees in synthetic lease transactions, aligns with sound tax policy by preventing taxpayers from exploiting loopholes.
The practice of "stripping" and transferring depreciation deductions among mortgage brokers and others aiming to leverage tax losses raises concerns Additionally, the analysis of benefits and burdens indicates that the Financial Accounting Standards Board (FASB) should mandate capitalization when both lessor and lessee preemptively agree that the lessee, rather than the lessor, will account for a depreciable interest with debt in its basis.
Since the landmark case Helvering v F & R Lazarus & Co., it has been established that a lessee can ignore the lease's form if it effectively functions as a mortgage The Supreme Court in Lazarus affirmed that a lessee engaged in trade or business, who bears the burden of capital depreciation, is entitled to a statutory depreciation deduction This principle has evolved through subsequent rulings, such as the Tax Court's decision in Bolger v Commissioner, which highlighted a taxpayer's successful claim related to depreciation deductions.
104 See, e.g., Highland Farms, Inc v Commissioner, 106 T.C 237 (1996) In ASA Investerings
In the case of Partnership v Commissioner, 76 T.C.M (CCH) 325 (1998), the court determined that the substance of a transaction takes precedence over its form This ruling highlighted that when one party, such as a special purpose entity (SPE) in a synthetic lease arrangement, is merely a compliant and accommodating participant—selected for the venture due to its readiness to act under the direction of another party—the court may disregard the transaction's formal structure.
A benefits and burdens analysis is utilized in state tax law, allowing taxpayers to challenge the classification of certain transactions For instance, in cases involving state taxes on leasing, taxpayers may argue that a lease should be treated as a mortgage based on its substance rather than its form, as demonstrated in Bridgestone/Firestone, Inc v Dep't of Revenue This approach was also evident in Hialeah, Inc v Dade County, highlighting the importance of examining the true nature of financial agreements in tax assessments.
Ct App 1986), the court permitted a county to disregard the form of a sale-leaseback transaction and tax a
In the case of Hialeah, Inc versus the City of Hialeah, the court determined that while the City holds title to the property, the true ownership benefits and responsibilities lie with Hialeah, Inc The lease payments made by Hialeah, Inc are directly aligned with the city's mortgage obligations, as Hialeah, Inc pays the banks without routing payments through the city Furthermore, Hialeah, Inc is fully responsible for all taxes, insurance, and property-related expenses, with an unwavering obligation to continue lease payments regardless of eviction, property destruction, or eminent domain actions The city cannot transfer property title without honoring the lease, and any compensation from condemnation must first settle outstanding debts before benefiting Hialeah, Inc.
A successful recharacterization of a lease can lead to additional tax implications, including the potential for a documentary stamp tax on mortgages Relevant guidance can be found in Florida Department of Revenue Technical Assistance Advisories, specifically 97A-001 issued on January 8, 1996, and 96(M)-002 released on June 21, 1996.
Synthetic leases allow for the allocation of depreciation deductions to a Special Purpose Entity (SPE) controlled by the financing transaction's orchestrator A notable case is Sun Oil Co v Commissioner, where the Third Circuit upheld the IRS's effort to reclassify a lessee as the actual owner of the property Additionally, the Supreme Court's decision in Frank Lyon Co further explores the complexities of lease structures and ownership implications in financing arrangements.
The recent Supreme Court ruling in United States v 110 clarifies the allocation of depreciation deductions between real estate lessors and lessees Additionally, the Tax Court's decision in Hilton v Commissioner rejects the previous Bolger case and applies the Frank Lyon Co precedent, thereby restricting taxpayers' ability to assign depreciation deductions to special purpose entities (SPEs) that possess minimal equity.
1 Bolger's Building: Nobody Said It Was a Mortgage
In the landmark case Bolger v Commissioner, the tax shelter industry celebrated a significant victory when the court upheld David Bolger's transactions as a real estate investor Bolger established a financing corporation with a minimal initial investment of $1,000, which then acquired a property intended for lease by a manufacturing or commercial user In a streamlined process, the property was transferred to the financing corporation, which simultaneously entered into a lease agreement and sold negotiable interest-bearing notes to institutional lenders, securing these notes with a first mortgage and lease assignment The financing corporation covered all lender expenses and subsequently transferred property title to Bolger and selected individuals, who claimed depreciation deductions based on the mortgage notes However, the IRS contested Bolger's depreciation claims, asserting that the depreciable interest remained with the financing corporation, while not disputing the tenant-users' ownership status.
The financing corporation was typical of many SPEs in synthetic lease transactions.
It promised to maintain its existence, and it also promised to refrain from all business activity except that which arose out of the ownership and leasing of the property 120
Payments by the lessee were made directly to the mortgagee or trustee to service the financing corporation's secured notes, with any small excess paid to the financing corporation 12 1
The financing corporation was expected to transfer title to a grantee, who would be subject to the corporation's obligations without assuming them The grantee was responsible for ensuring the financing corporation's continued existence, preventing it from engaging in other business activities, maintaining accessible financial records for the mortgagee's inspection, and prohibiting any merger or consolidation with other entities.
The 1999 Advice and the Continued Importance of Sun Oil and Hilton
In 1999, the IRS addressed synthetic lease transactions by applying a benefits and burdens analysis to support a tenant's depreciation deductions in complex situations Key factors included the tenant's control over acquisitions and construction, the close relationship between the special purpose entity (SPE) and the tenant, lending based solely on the tenant's creditworthiness, and the tenant's structuring of transactions for financial accounting Both the SPE and the tenant consistently reported the tenant as the substantive owner and borrower for federal income tax purposes.
The potential for a significant financial penalty in the future related to a major structure, like a department store, is not typically the type of speculative risk that even habitual gamblers would find appealing.
301 Id at 364 (quoting Estate of Franklin v Commissioner, 544 F.2d 1045, 1049 (9th Cir 1976)).
The Advice's unexpected flexibility highlights the Service's effort to maintain previous successes in restricting taxpayers from prioritizing form over substance This approach underscores the continued relevance of the principles established in the Sun Oil and Hilton cases.
Sun Oil is crucial as it addresses the allocation of rights and responsibilities between landlords and tenants, emphasizing practical implementation It examines scenarios such as a lessor rejecting "rejectable" purchase offers and a lessee opting not to exercise a purchase option, along with the implications of costly appraisals The article highlights provisions that empower tenants to act as owners, including negotiations with governmental authorities and asserting ownership rights It also considers the dynamics of acceptance in offers that may be automatically deemed accepted if not promptly rejected Lastly, it suggests that an analysis of the parties' consistent behaviors can reveal their initial intentions.
The Hilton case is significant as it overturns the unfavorable ruling in Bolger and applies the principles from Frank Lyon Co to a typical consensual leasing transaction It emphasizes that a transaction should be assessed from both the lessee's and the Special Purpose Entity's (SPE) perspectives While there is no universal model of ownership applicable to all commercial leases, an SPE will not qualify as the owner for tax purposes if the tenant retains the majority of ownership benefits and burdens Consequently, an SPE or financing transaction facilitator may be ineligible for depreciation deductions Although the importance of this principle may have diminished following the 1986 enactment of passive loss rules, it remains a crucial consideration in tax assessments related to leasing transactions.
Under current tax law, ownership benefits and burdens cannot be simply transferred to another party, especially at the insistence of the IRS to eliminate perceived advantages of synthetic lease transactions The issue lies not in the benefits and burdens analysis of federal income tax law, but rather in the financial accounting standards that may require reassessment.
305 "Synthetic Lease, "Approved by IRS, Offers Off-Book Financing, 91 J TAx'N 123, 123 (1999).
306 See Sun Oil v Commissioner, 562 F.2d 258 (3d Cir 1977); Hilton v Commissioner, 74 T.C 305
(1980), aff'dper curiam 671 F.2d 316 (9th Cir 1982).
308 Frank Lyon Co v United States, 435 U.S 561 (1978).
The passive loss rules, established under I.R.C § 469 (1986), restrict the ability to deduct passive activity losses solely to income generated from similar passive sources This effectively prevents these losses from being applied against compensation earned from personal services or other types of portfolio income.
Synthetic lease transactions have gained significant popularity among public companies as they enable off-balance sheet financing by allowing firms to report an operating lease instead of a mortgage-encumbered asset This structure permits companies to claim ownership of the asset for federal income tax purposes, thereby qualifying for valuable depreciation deductions In these arrangements, it is typically the tenant, rather than the landlord, who reports the investment in the depreciable asset, maximizing tax benefits while maintaining financial flexibility.
A lessee can validly assert that it has made a depreciable investment in leased real estate, even when financial accounting standards lead to the exclusion of both the asset and the associated debt The existence of differing positions for tax and financial accounting does not imply that there is a fundamental issue requiring resolution.
The federal income tax law remains stable and effective, particularly in commercial real estate finance, where ownership is complex and requires careful analysis Property rights are likened to a bundle of sticks, with the key tax question being whether a claimant has sufficient rights to justify a depreciation deduction In commercial leasing, multiple parties may be viewed as owners, allowing for some flexibility in allocating benefits and burdens to support a claim for depreciation on an asset However, this flexibility is limited, as the depreciation deduction cannot be assigned away from the individual who holds the majority of ownership benefits and responsibilities.
The Service should carefully examine synthetic lease transactions for their economic substance, as taxpayers often attempt to disregard the chosen transactional form by claiming a different economic reality for financial reporting However, the Service must exercise caution in disputing tenants' depreciation deductions to avoid undermining previous rulings that highlight the significance of a benefits and burdens analysis Specifically, it is crucial to uphold the precedent set in Hilton, which states that a financier cannot receive depreciation deductions from a lessee who retains most economic benefits and burdens of ownership To prevent improper income assignments, the Service should maintain a comprehensive scrutiny of the overall relationship between lessor and lessee, in line with Sun Oil's principles.
Synthetic Leases reading of Frank Lyon Company's suggestion that taxpayers may select substance with form.
Financial Accounting Standards
The financial accounting standards, unlike federal income tax law, are in need of significant reform, as they currently allow companies to obscure substantial debt from their balance sheets This enables corporations to present a less leveraged position by reclassifying mortgages as leases, undermining the principle of transparency Although the Financial Accounting Standards Board (FASB) has made gradual improvements to lease accounting, finding a comprehensive solution remains challenging due to the complexities involved The pursuit of clear accounting standards often leads to loopholes, making it difficult to create rules that effectively address all relevant factors.
To effectively reduce the use of synthetic lease transactions and prevent billions in debt from being concealed on corporate balance sheets, two key actions are essential First, the Financial Accounting Standards Board (FASB) should eliminate the significant distinction between sale-leasebacks and other financing transactions, aligning its approach with state mortgage law, which treats them equally FASB has already begun to narrow this distinction by requiring certain tenants to consolidate their reporting with Special Purpose Entities (SPEs), and this process should continue until the distinction is eliminated entirely There is no justification for sale-leasebacks to be subject to stricter standards than third-party acquisitions by SPEs Second, FASB must mandate full disclosure from lessees when they and the lessor agree that the lessee will claim ownership of the asset for federal income tax purposes.
Some accounting professionals may resist the idea of aligning financial accounting treatment with federal income tax classification; however, there are compelling reasons to consider this approach Firstly, the federal income tax classification of leases as mortgages has demonstrated remarkable stability over the past fifty years, primarily through the benefits and burdens analysis, which is unlikely to change Secondly, this proposed adjustment should not be seen as directly linking financial accounting to tax classification Instead, it would simply require tenants to disclose their contractual understanding that they, not the landlord, will report ownership of the encumbered asset to government authorities.