Payments to acquire vehicle and equipment leases must be capitalized

Plain-English summary

A financial business purchased automobile leases from dealers and equipment leases from manufacturers or vendors. It paid dealers an excess-markup premium tied to a lease's expected profit and paid equipment sellers a participation amount based on equipment cost. The taxpayer currently deducted some of these payments for tax purposes even though it capitalized them for financial reporting. Chief Counsel concluded that both types of payments were direct purchase-price costs of acquiring lease intangibles and therefore had to be capitalized under Treasury Regulation § 1.263(a)-4(c)(1)(vi). The documents described purchases rather than agency or service arrangements, and even treating the transactions as creating intangibles would still require capitalization.

Ruling snapshot

• Question: May a purchaser currently deduct excess-markup and participation payments made to acquire automobile and equipment leases?
• Outcome: advice given, the payments must be capitalized as direct costs of acquiring lease intangibles
• Key authorities: IRC §§ 161, 162, and 263; Treas. Reg. § 1.263(a)-4(c)(1)(vi) and (d)(6); INDOPCO, Lincoln Savings, Woodward, and Winmill

Full text (IRS public release)

       Office of Chief Counsel
       Internal Revenue Service
       Memorandum
       Number: 202005019
       Release Date: 1/31/2020
       CC:ITA:B2:                                            Third Party Communication: None
       POSTU-108243-19                                       Date of Communication: Not Applicable

UILC: 162.00-00, 263.00-00

date: October 24, 2019

 to:   ------------------
       -----------------------------------------
       (Large Business & International)

from: David Silber
Senior Technician Reviewer, Branch 2
Office of Associate Chief Counsel
(Income Tax & Accounting)

subject: --------------------------------------------------------

       This Chief Counsel Advice responds to your request for assistance. This advice may
       not be used or cited as precedent.


       LEGEND

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

       ISSUES

              Is Taxpayer required to capitalize excess markup payments paid to purchase
       auto leases from automobile dealers?

             Is Taxpayer required to capitalize participation payments paid to purchase
       equipment leases from equipment manufacturers?

       CONCLUSIONS

             Taxpayer is required to capitalize excess markup payments under section
       1.263(a)-4(c)(1)(vi) of the Income Tax Regulations paid to purchase auto leases from
       automobile dealers.

POSTU-108243-19
2

   Taxpayer is required to capitalize participation payments under section 1.263(a)-

4(c)(1)(vi) of the regulations paid to purchase equipment leases from equipment
manufacturers.

FACTS

     Taxpayer is a ----------------------------------------------------------- that -----------------------

------------------------------------------------------------------------------------. Taxpayer engages in

----------------------------------------------------------------------------------------------------------- .
Through its subsidiaries, Taxpayer purchases automobile and equipment leases from
third party dealers in the ordinary course of business.

Automobile Leases

   Taxpayer and various dealerships enter into master agreements that provide

Taxpayer the opportunity to purchase vehicle lease contracts originated by the
dealership if they meet Taxpayer’s standards. The dealership enters into master
agreements with other financial institutions as well. When a dealership enters into an
auto lease with a customer, the dealer collects information about the customer’s credit
and financial situation and enters it into a third party software program. The software
system electronically forwards the information to all banks or financial entities with
whom the dealer has entered into master agreements. Taxpayer and other entities bid
on the leases on an individual basis; there are no batched bids. The bid does not
obligate Taxpayer to purchase the lease, and likewise the dealer is not obligated to
choose Taxpayer’s bid. The dealer ultimately decides to which bank it will sell the
lease.

   Taxpayer’s master agreement provides that once Taxpayer’s offer is accepted by

the dealer, delivery of the executed documents to Taxpayer shall constitute a sale and
assignment of the entire dealer’s right, title, and interest in the lease contract, in the
vehicle, and in any guaranty or other document executed in connection with the lease
contract. Further, the master agreements acknowledge that the transaction is the
purchase of a lease contract and that the dealerships shall not represent that they are
an agent of the taxpayer.

   There are two components to the fee Taxpayer offers to pay the dealerships to

acquire the leases: (1) a lease acquisition flat-fee, and (2) a premium on leases with an
excess lease rate. The lease acquisition flat-fee applies to every lease Taxpayer
purchases.1 The premium applies only to leases with excess lease rates. The amount
of the premium is based on a formula using variables that the taxpayer distributes to the
dealers periodically on a so-called “rate sheet.”

1
The lease acquisition flat-fee is not at issue in this request.

POSTU-108243-19
3

   For example, assume Taxpayer has a master agreement with Dealer. Assume

Dealer held legal title to the automobile (prior to leasing it in the instant example).
Assume Dealer then executes a --------------automobile lease with Individual Lessee.
After going through the electronic bidding process described above, assume Dealer
decides to transfer legal title to the automobile (and, more to the point, the lessor’s
position in the negotiated lease with Individual Lessee) to Taxpayer.

    More specifically, assume Taxpayer acquires a Tier 1 (based on Individual

Lessee’s customer’s good credit rating) automobile lease from Dealer. Assume the
lease has a loan-to-value ratio less than ---- percent of the Manufacturer’s Suggested
Retail Price (MSRP). Assume, based on the rate sheet in effect at the time,2 that
Taxpayer has agreed to pay a premium if the lease rate the dealer negotiates with the
lessee-customer is higher than ------------.3 Assume that the dealer negotiated a lease
rate of ------------(and, therefore, Taxpayer owes Dealer a premium associated with
Taxpayer’s acquisition of the instant lease from Dealer). Suppose the lease offered for
sale contained the following terms:

                 Adjusted Residual Value4                               ----------------
                                                                                                          ----------------
                 Adjusted Capitalized Cost5                             ----------------

    Assume, as the result of the lease that Individual Lessee signed, that Individual

Lessee will pay a total monthly payment of ------------each month for ---- months. This
figure represents the sum of two components. The first component is a monthly
depreciation charge to account for the decrease in the FMV of the vehicle during the
lease period. The second component is a base monthly lease charge representing the
lessor’s profit on the lease.

    Based on the terms of this lease, the base monthly lease charge is --------- (i.e.,

the ------------------------------) and over ---- months, the customer would pay a total base
charge of --------------. The built-in profit of -------------- would be split between the dealer
and the taxpayer as follows:

      Negotiated lease factor                                --------------------------
      LTV Pricing Opportunity factor                         ------------ -------------
      Excess markup                                          ------------                         -------------

2

------------------------------------------------------------------------------- .
3
In the example, the lease rate of ------------ is the taxpayer’s estimate to cover the time value of money
and costs, including lease servicing costs.
4
The “Residual Value” represents expected book value of the vehicle at the end of the ---------------lease.
At the end of the lease, the customer has the option to purchase the vehicle for an agreed-upon amount.
5
The “Adjusted Capitalized Cost” represents the agreed upon value of the automobile of -------------plus
Sales Tax of ---------- plus a lease acquisition fee of -------.

POSTU-108243-19
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Taxpayer will keep the minimum of -------------- on the lease. The excess markup is then
shared between the dealership and taxpayer based on a multi-step formula, as follows:

  Step 1:       Calculate the dealer reserve percentage by dividing the excess
                markup rate with a pre-determined base factor.

                       ------------- = ----- dealer reserve
                       ------------

  Step 2:       Calculate the dealer’s and taxpayer’s portions of the excess
                reserve.

                Adjusted capitalized cost                     ----------------
                Dealer reserve percentage                            ---------
                Dealer’s portion of excess markup               --------------

                Taxpayer’s portion of excess markup                ------------
                Total excess markup                             --------------

  Taxpayer pays the dealer reserve up-front to the dealer when the taxpayer

purchases the lease agreement. For book purposes, Taxpayer capitalizes and
amortizes the ---------------excess markup owed to the dealership. For tax purposes,
Taxpayer deducts this amount under its current method of accounting. This amount
must be capitalized for tax purposes as a direct cost of acquiring the lease.

Equipment Leases

   In addition to vehicle leases, Taxpayer also acquires leases from equipment

manufacturers and vendors. The acquisition process is similar to the process for
vehicle leases in that: (1) Taxpayer enters into a master agreement with the
manufacturers or vendors, (2) the manufacturers or vendors enter into lease
agreements with customers, (3) the manufacturers or vendors decide to sell the lease,
(4) Taxpayer identifies leases it wishes to purchase from the manufacturer or vendor,
and (5) the parties agree to the sale/purchase. Upon the purchase, Taxpayer receives
all payments due or that will become due to the vendor under the lease agreement,
including any security deposits paid to the vendor.

    The pricing structure for the equipment leases is simpler than for the vehicle

leases. For equipment leases, Taxpayer offers the vendors a set percentage applied to
the equipment cost (“participation payment”). For example, suppose a piece of
equipment cost ------------------and Taxpayer agreed to pay the manufacturer or vendor a
participation amount of ------ percent of the cost of the equipment. Taxpayer would then
owe the vendor -------------- for the cost of acquiring the lease.

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    For book purposes, Taxpayer capitalizes the participation payments and

amortizes them over the term of the lease agreement. For tax purposes, Taxpayer
capitalizes and amortizes any participation payments exceeding $ --------, and deducts
any participation payments below $-------- under its current method of accounting.6 The
participation payments must be capitalized by Taxpayer for tax purposes as a direct
cost of acquiring the leases.

LAW AND ANALYSIS

   Section 162(a) of the Internal Revenue Code provides a deduction for all the

ordinary and necessary expenses paid or incurred during the taxable year in carrying on
any trade or business. Section 161 of the Code provides that the deductions under
section 162 are subject to the exceptions provided in part IX (section 261 and following,
relating to items not deductible).

  Section 263 of the Code provides generally that no deduction shall be allowed for

any amount paid out for new buildings or for permanent improvements or betterments
made to increase the value of any property or estate.

   In INDOPCO, Inc. v. Commissioner, 503 U.S. 79 (1992), the U.S. Supreme Court

held that section 263(a) of the Code requires taxpayers to capitalize expenditures to
acquire, create, or enhance separate and distinct assets and certain significant future
benefits. See also, Commissioner v. Lincoln Savings and Loan Association, 403 U.S.
345 (1971). The Court also held that capitalization is required not only for costs of the
asset itself, but also for ancillary transaction costs incurred in the process of acquisition.
See, Woodward v. Commissioner, 397 U.S. 572 (1970); Helvering v. Winmill, 305 U.S.
79 (1938).

   Following the decision in INDOPCO, taxpayer and the IRS often disputed

whether particular costs were sufficiently related to the acquisition, creation, or
enhancement of an intangible asset or benefit as to require capitalization. In 2003, to
resolve these disputes, the IRS issued regulations under sections 1.263(a)-4 and
1.263(a)-5.

   Section 1.263(a)-4 deals specifically with amounts paid to acquire or create an

intangible. Section 1.263(a)-4(c) deals with acquired intangibles. Section 1.263(a)-
4(c)(1) provides that a taxpayer must capitalize amounts paid to another party to
acquire any intangible from that party in a purchase or similar transaction. Section
1.263(a)-4(c) then lists various examples of intangibles within the scope of this rule.
Section 1.263(a)-4(c)(1)(vi) specifically lists “a lease.”

  Here, the excess markup payments made by Taxpayer for the automobile leases

and the participation payments made by Taxpayer for the equipment leases fit squarely

6
The application of a $-------- threshold reveals that the taxpayer may be treating the participation
payments as facilitative costs under Treas. Reg. § 1.263(a)-4(e).

POSTU-108243-19
6

into the amounts paid under section 1.263(a)-4(c) of the regulations as costs to acquire
an intangible. The payments at issue are part of (or in the case of equipment leases the
entire amount of) the purchase price of the lease agreement. This is a direct cost of
acquiring the leases. These payments represent what the Taxpayer, as the buyer, is
willing to pay the seller for a valuable intangible asset. For the auto leases, the price of
the leases is directly tied to the expected profit and the lease rate negotiated with the
customer. For the equipment leases, the purchase price is tied to the equipment being
financed through the lease.

   Taxpayer argues that the dealer is acting as an intermediary to assign the leases

to Taxpayer, and as such, there is no sale of an intangible asset for tax purposes. This
argument is contrary to Taxpayer’s master agreements, which specifically state that
there is no agency relationship between Taxpayer and the dealer. The master
agreements with the auto dealers clearly describe the transaction as a purchase of a
lease contract; the master agreements with the equipment manufacturers state that the
manufacturer assigns and transfers the lease for consideration. Both of these
transactions qualify as a “purchase or similar transaction” under section 1.263(a)-
4(c)(1). Even if Taxpayer were to successfully argue that the transaction did not
constitute the acquisition of an intangible, the amount would then be considered paid to
create an intangible under section 1.263(a)-4(d)(6) and would nevertheless have to be
capitalized.

   Taxpayer also argues that since the payments do not comprise or equate to the

principal value of the lease contracts, they represent compensation to the dealer for
services. Taxpayer has provided no evidence to support that these payments may be
treated other than as the acquisition of a lease.

  Therefore, Taxpayer’s situation is clearly covered by section 1.263(a)-4(c)(1)(vi),

and the excess markup payments and the participation payments must be capitalized.

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