IRS approves tax treatment for TRAC leases in a vehicle refinancing

Plain-English summary

A vehicle leasing business used terminal rental adjustment clauses, or TRACs, in leases of motor vehicles. It planned to transfer beneficial ownership of leased vehicles to a special-purpose entity that would refinance the related receivables. The IRS ruled that the TRAC leases qualified as motor vehicle operating agreements under IRC § 7701(h), and that the leases would be evaluated without regard to the TRAC provisions. The ruling depended on stated conditions, including recourse financing and sufficient lease and disposition proceeds to satisfy lender obligations.

Ruling snapshot

• Question: Do the taxpayer's TRAC leases qualify as qualified motor vehicle operating agreements under IRC § 7701(h)?
• Outcome: Approved.
• Key authorities: IRC § 7701(h); Treas. Reg. § 301.7701-3(b)(1)(ii).

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 201404007 Third Party Communication: None
Release Date: 1/24/2014 Date of Communication: Not Applicable
Index Number: 7701.25-04
Person To Contact:
------------------------------------- -----------------------------, ID No. -------------
----------------------------------- -----------------------------------------------------
------------------------------------------ Telephone Number:
------------------------------------------------------------ ---------------------
------------------------------------------ Refer Reply To:
------------------------------ CC:ITA:B07
PLR-121580-13
Date:
September 19, 2013

LEGEND

Parent = -------------------------------------

Corporation = --------------------------------------------------

Taxpayer = -----------------------------

Name = -----------------------------------

Trust = ----------------------

Company = -----------------------------------

State A = -------------

State B = -------------

Agreement = ----------------------------------

X = ---

Y = ---
PLR-121580-13 2

Dear ----------------:

  This letter responds to your letter dated May 6, 2013, and subsequent

submissions, requesting a private letter ruling under § 7701(h) of the Internal Revenue
Code.

                                       FACTS

   Parent is a State A corporation. Parent is the common parent of an affiliated

group of corporations (the “Affiliated Group”), which files a consolidated federal income
tax return on a calendar year basis.

  Corporation is a State B corporation. Corporation is a direct, wholly owned

subsidiary of Parent and a member of the Affiliated Group.

 Taxpayer, doing business as Name, is a State B corporation. Taxpayer is a

member of the Affiliated Group. Corporation owns 100% of the outstanding shares of
Taxpayer.

   Trust is a State B trust. Taxpayer is the settlor and sole initial beneficiary of

Trust. For federal income tax purposes, the Affiliated Group treats Trust as a
disregarded entity, the assets of which are owned by Taxpayer.

  Company is a State B limited liability company and wholly owned subsidiary of

Taxpayer. For federal income tax purposes, the Affiliated Group treats Company as a
disregarded entity whose assets and activities are held directly by Taxpayer.

     Each entity listed above uses the calendar year accounting period and the

accrual method of accounting for maintaining its accounting books and records and
filing its federal income tax return.

   Taxpayer leases or manages a large number of motor vehicles in the United

States, which are used by Taxpayer’s customers in their sales, services, or delivery
operations. Taxpayer also provides fleet management services to its customers,
including title and registration, fuel management, maintenance management and fleet
administrative services.

    Each approved customer that leases a motor vehicle from Taxpayer executes a

lease agreement (the “Agreement”), which sets forth the general terms and conditions
of the lease. Taxpayer executes the Agreement on its own behalf and as servicing
agent for Trust. In most cases, the customer also executes one or more schedules
PLR-121580-13 3

(“Schedule”), which establish formulas for determining monthly rentals and other terms
for those vehicles subject to the particular Schedule. Neither the Agreement nor the
Schedule identifies the specific vehicles being leased. To lease vehicles, the customer
must issue one or more non-cancelable orders (“Order”) describing the vehicles that the
customer desires to lease under the Agreement and the applicable Schedule. Vehicles
acquired pursuant to an Order are incorporated into the Agreement through a Contract
exhibit (“Exhibit”), which identifies the specific lessor for each vehicle ordered by the
customer. (The Agreement together with its Exhibits, the Schedules, and Orders are
collectively herein referred to as the “Lease Agreement.”)

    When a customer issues an Order to Taxpayer, Taxpayer (acting either on its

own behalf or as agent for Trust) will issue a purchase order to the supplier of the titled
motor vehicle. Subject to satisfaction of the conditions set forth in the purchase order,
Taxpayer (for itself or as agent for Trust) will pay the manufacturer or dealer for the
titled motor vehicle. When acquiring motor vehicles as agent for Trust, Taxpayer makes
the payment directly to the manufacturer or dealer and creates an intercompany
receivable from Trust under loan agreements between Taxpayer and Trust. In its
capacity as servicer under a servicing agreement, Taxpayer applies all applicable
payments received from the customer to pay down the intercompany receivable created
at acquisition of the motor vehicle. Taxpayer finances all purchases of motor vehicles
out of operating capital, capital contributions from Corporation, and the proceeds of fully
recourse loans. Under the terms of the Lease Agreement, at the end of the motor
vehicle lease term, the customer surrenders the motor vehicle and Taxpayer (acting
either on its own behalf or as agent for Trust) solicits wholesale cash bids and sells the
vehicle.

   Most Agreements contain a terminal rental adjustment clause (or “TRAC”), which

provides: (i) if the net proceeds from the sale of the vehicle exceed book value, the
lessor retains an amount equal to the book value and remits the excess to the customer
as a partial refund of rents paid, or (ii) if the net proceeds are less than the book value,
the customer pays the lessor, as additional rent, the difference between the net
proceeds and the book value. In most Lease Agreements, the lessor bears the risk
when net proceeds are less than a guaranteed amount (generally, X percent of book
value or, if the lease is terminated at the end of the minimum lease term, Y percent of
the original cost of the vehicle).

   When executing the Agreement, most customers sign and provide to the lessor a

separate written statement (i) under which the customer certifies, under penalties of
perjury, that it intends that motor vehicles leased under the Lease Agreement will be
used more than 50% in the trade or business of customer and (ii) which states that
customer has been advised that it will not be treated as the owner of the vehicles for
federal income tax purposes (a “Business Use Certification.”) (Each Lease Agreement
PLR-121580-13 4

that includes a TRAC and a Business Use Certification is hereinafter referred to as a
“TRAC Lease.”)

   In some cases, the Agreement includes a TRAC but the lessee does not execute

a Business Use Certification. In those instances, Taxpayer and the lessee treat the
lessee as the owner of the vehicle for federal income tax purposes and treat the
arrangement between Taxpayer (or Trust) and the lessee as a loan for federal income
tax purposes. Lease Agreements that do not include a Business Use Certification are
not TRAC Leases and are not addressed in this ruling request.

Proposed Transaction.

  Taxpayer intends to seek to use the receivables generated in its business to

access cost-effective sources of funding by transferring the full beneficial ownership of
leased motor vehicles to a special purpose entity, which will issue notes or other
evidences of indebtedness secured by the receivables and the future cash flows they
are expected to generate (a “Subsequent Refinancing”).

    Trust will issue a special unit of beneficial interest (“SUBI”) to Taxpayer.

Taxpayer will immediately transfer the SUBI to Company. In return for the SUBI,
representing full beneficial ownership of the included leased motor vehicles, Taxpayer
will receive cash or a combination of cash and equity interests in Company. The
transfer to Company will be made pursuant to a Sale Agreement.

   Company will transfer the SUBI to a wholly owned, special purpose subsidiary

(“Issuer”) pursuant to a purchase and sale agreement.

   Issuer will be organized as a State B limited liability company. Like Company,

Issuer will be a single-member entity that Taxpayer will treat as disregarded for federal
income tax purposes under § 301.7701-3(b)(1)(ii) of the Income Tax Regulations.
Because Issuer will be wholly owned by Company, which in turn is wholly owned by
Taxpayer, for federal income tax purposes Taxpayer will treat the assets of Issuer as
owned directly by Taxpayer. Accordingly, Taxpayer represents that the transfers of the
SUBI by Taxpayer to Company and by Company to Issuer will be disregarded for
federal income tax purposes.

   In return for its transfer of the SUBI to Issuer, Company will receive an equity

interest in Issuer and debt instruments (“Issuer Notes”). Company will transfer Issuer
Notes outside of the Affiliated Group in exchange for cash.

   Alternatively, Issuer may borrow directly from a bank or other third-party lender

by issuing an Issuer Note in exchange for cash, in which case the consideration paid by
Issuer to Company will take the form of an equity interest in Issuer and the cash
proceeds from the loan to Issuer.
PLR-121580-13 5

   Taxpayer represents that in either event the Issuer Notes will constitute debt for

income tax purposes and it will continue to be the tax owner of the underlying leased
motor vehicles included in the SUBI. Thus, the issuance of the Issuer Notes outside of
the Affiliated Group will not alter tax ownership of the motor vehicles.

    Issuer will be a special purpose entity whose activities generally will be limited to:

1) executing and performing its obligations and exercising its rights under the terms of
the Subsequent Refinancing and related transactions; 2) acquiring, transferring,
financing, pledging, and otherwise dealing with the SUBI; 3) dealing with transactions
involving the leased motor vehicles that will be designated to the SUBI; 4) borrowing
money to the extent contemplated by the Subsequent Refinancing; 5) negotiating,
executing, or performing the obligations under any agreement relating to the foregoing
activities; and 6) engaging in any lawful act or activity and to exercise any powers
permitted to limited liability companies organized under State B law that are related or
incidental to and necessary, convenient, or advisable for the accomplishment of the
foregoing purposes.

   Issuer will enter into the Servicing Agreement and Administration Agreement with

Corporation, which in turn will enter into a Subservicing Agreement with Taxpayer. As
subservicer, Taxpayer will invoice the obligors, collect payments, and perform ancillary
functions on behalf of Issuer.

   Company will transfer the SUBI to Issuer. Issuer will use certain payments

received on the leases represented by the SUBI to pay principal and interest on the
Issuer Notes. Thus, as Taxpayer customers pay the underlying obligations to Issuer,
Issuer will repay the Issuer Notes issued in the Subsequent Refinancing. Upon
repayment of all the Issuer Notes, Issuer will distribute any remaining assets to
Company and liquidate.

    Taxpayer’s business will continue to originate TRAC Leases and other assets.

Taxpayer will identify assets originated by its business (including leased motor vehicles
owned through Trust) that are eligible to be acquired by Company for inclusion in a
future Subsequent Refinancing, based on criteria such as customer concentration,
credit ratings, asset type and location, and the term of the lease. Further, Taxpayer, as
the beneficiary of all of Trust’s assets not assigned to a SUBI, may cause Trust to
create new SUBIs. Taxpayer may transfer the new SUBIs to Company, which may use
new Issuers to engage in future Subsequent Refinancings.

   Trust is authorized to acquire cash, the leases and the related motor vehicles, to

receive payments made under the leases, to sell or otherwise dispose of motor vehicles
following the end of the leases, to hold motor vehicles certificates of title, and to own
other rights and proceeds (collectively “Trust Assets”).
PLR-121580-13 6

     When Trust acquires a motor vehicle, it holds legal title and the economic

benefits and burdens of ownership (such as the right to rental income and the risk of
loss). The SUBI represents all of Trust’s ownership rights in the underlying leased
motor vehicles with the exception of bare legal title, which Trust continues to hold for the
benefit of the SUBI holder. The SUBI represents full economic ownership of particular
vehicles assigned to that SUBI, but has no interest in, or exposure to, other assets and
liabilities of Trust. In addition to the SUBI, Trust also has an undivided trust interest
(“UTI”) which represents a beneficial interest in all trust assets not assigned to a SUBI.
Taxpayer is the holder of the UTI.

  The UTI and the SUBI and their related assets constitute separate “Sub-trusts.”

The SUBI will represent beneficial interests in the portion of the Trust Assets that
comprise its Sub-trust. Under State B law, all liabilities of a Sub-trust generally are
enforceable only against the assets designated to the Sub-trust.

   The owner of a SUBI has all of the incidents of ownership of the corresponding

motor vehicles with the exception of bare legal title. As with any other trust, the trustee
of Trust holds legal title as a fiduciary for the beneficial owner (in this case, the owner of
the SUBI). Thus, the issuance of a SUBI permits the transfer of beneficial ownership of
the associated assets without having to re-title the motor vehicles and prevents the
need to qualify Issuer to do business in each jurisdiction in which vehicles are titled.
Taxpayer represents that because the holder of a SUBI possesses the economic
benefits and burdens associated with the underlying motor vehicles, the trustee’s
retention of bare legal title does not prevent tax ownership of the included motor
vehicles from vesting in the holder of the SUBI.

                              RULINGS REQUESTED

    Taxpayer requests rulings that the Lease Agreement of each TRAC Lease is a

qualified motor vehicle operating agreement under § 7701(h)(2); and that qualification of
the Lease Agreement of each TRAC Lease as a lease for federal income tax purposes
will be determined without regard to the TRAC provision of the Agreement.

                               LAW AND ANALYSIS

    Section 7701(h)(1) provides that in the case of a “qualified motor vehicle

operating agreement that contains a terminal rental adjustment clause,” the agreement
is treated as a lease if (but for such “terminal rental adjustment clause”) the agreement
would be treated as a lease for federal income tax purposes, and the lessee is not
treated as the owner of the property subject to the agreement during the period the
agreement is in effect.
PLR-121580-13 7

   Section 7701(h)(2)(A) defines a “qualified motor vehicle operating agreement” as

any agreement with respect to a motor vehicle (including a trailer) that meets three
requirements, which are set forth in subparagraphs (B), (C), and (D) of § 7701(h)(2).

   First, § 7701(h)(2)(B) requires that, under the agreement, the sum of the amount

the lessor is personally liable to repay, and the net fair market value of the lessor’s
interest in any property pledged as security for property subject to the agreement,
equals or exceeds all amounts borrowed to finance the acquisition of property subject to
the agreement. Any property pledged that is property subject to the agreement or
property directly or indirectly financed by indebtedness secured by property subject to
the agreement is not taken into account.

     Second, pursuant to § 7701(h)(2)(C), the agreement must contain a separate

written statement signed by the lessee that the lessee certifies, under penalty of perjury,
that it intends that more than 50 percent of the use of the property subject to the
agreement is to be in a trade or business of the lessee, and that clearly and legibly
states that the lessee has been advised that it would not be treated as the owner of the
property subject to the agreement for federal income tax purposes.

    Finally, § 7701(h)(2)(D) requires that the lessor must not know that the

certification in § 7701(h)(2)(C) is false.

   Taxpayer represents that, if analyzed without regard to the terminal rental

adjustment clause, each TRAC Lease created under a Lease Agreement will qualify as
a lease for federal income tax purposes.

   Further, Taxpayer represents that any amount it borrows to fund the initial

acquisition from the manufacturer or dealer of a motor vehicle that is subject to a TRAC
Lease will be recourse debt that Taxpayer is personally liable to repay, and that it will
fund the entire acquisition price of the motor vehicle using operating capital or the
proceeds of recourse debt. Hence, Taxpayer will be fully at risk on the acquisition price
of the motor vehicles from the time of initial acquisition of the vehicle. In addition,
Taxpayer represents that each TRAC Lease created under a Lease Agreement will
contain a Business Use Certification that satisfies the requirements of § 7701(h)(2)(C)
and will meet the requirements of § 7701(h)(2)(D).

    Based on the facts and representations made by Taxpayer, and provided that:

(1) Issuer borrows funds from lenders on a recourse basis; and (2) amounts received in
lease payments and from the disposition of motor vehicles (using rental defaults
consistent with historical experience) are expected to be sufficient to satisfy all
obligations to lenders, we conclude that the Lease Agreement of each TRAC Lease is a
qualified motor vehicle operating agreement under § 7701(h)(2). In addition,
qualification of the Lease Agreement of each new TRAC Lease as a lease for federal
PLR-121580-13 8

income tax purposes will be determined without regard to the TRAC provision of the
Agreement.

    Except as expressly provided herein, no opinion is expressed or implied

concerning the tax consequences of any aspect of any transaction or item discussed or
referenced in this letter. Specifically, we express or imply no opinion concerning: (1)
whether the Lease Agreement is a true lease for federal income tax purposes; (2) a
situation in which Issuer borrows funds from lenders on a nonrecourse basis; and (3) a
situation in which the amounts received in lease payments and from the disposition of
motor vehicles (using rental default consistent with historical experience) are not
expected to be sufficient to satisfy all obligations to lenders.

  This ruling is directed only to the taxpayer requesting it. Section 6110(k)(3)

provides that it may not be used or cited as precedent.

    Temporary or final regulations pertaining to one or more of the issues addressed

in this ruling have not yet been adopted. Therefore, this ruling will be modified or
revoked by the adoption of temporary or final regulations, to the extent the regulations
are inconsistent with any conclusion in the letter ruling. See section 11.04 of Rev. Proc.
2013-1, 2013-1 I.R.B. 1, 49. However, when the criteria in section 11.06 of Rev. Proc.
2013-1, 2013-1 I.R.B. 1, 50 are satisfied, a ruling is not revoked or modified retroactively
except in rare or unusual circumstances.

     In accordance with the Power of Attorney on file with this office, a copy of this

letter is being sent to your authorized representative.

  The rulings contained in this letter are based upon information and

representations submitted by the taxpayer and accompanied by a penalty of perjury
statement executed by an appropriate party. While this office has not verified any of the
material submitted in support of the request for rulings, it is subject to verification on
examination.

                                   Sincerely,



                                   WILLIE E. ARMSTRONG, JR.
                                   Senior Technician Reviewer, Branch 7
                                   Office of Associate Chief Counsel
                                   (Income Tax & Accounting)

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