Did a transaction qualifying as a federal safe-harbor lease under former I.R.C. section 168(f)(8) receive the same lease treatment for California tax purposes?

Plain-English summary

California Legal Ruling 419 held that federal "safe-harbor lease" status under former I.R.C. section 168(f)(8) did not determine California tax treatment.

California had no comparable safe-harbor provision. FTB continued to use the preexisting federal revenue procedures and ruling listed in the decision to determine whether a purported lease was a real lease for California purposes.

If the transaction failed those substance tests, California either disregarded a purported sale-leaseback or treated a purported standard lease as a conditional sale. The result affected basis, depreciation, payment deductions, unitary ownership, and the property factor.

What the federal safe harbor did

The 1981 federal provision allowed qualifying parties to elect lease treatment for investment tax credits and accelerated depreciation even when the transaction would not have been treated as a lease under prior substance rules.

The ruling described a typical structure in which a user sold equipment to a corporate "lessor" for cash and a note, immediately leased it back for payments offsetting the debt service, and repurchased it for one dollar at the end. The federal arrangement transferred tax benefits to a corporation able to use them and passed part of their value back to the user through cash or reduced payments.

FTB said California did not recognize that election automatically.

Purported sale and leaseback

When a sale-leaseback failed the referenced lease standards, California disregarded both the sale and lease elements and followed the transaction's substance.

Seller/lessee

Amounts received for transferring the federal tax benefits reduced the seller/lessee's basis in the property. The asset remained owned by the seller/lessee for unitary-tax purposes.

For the property factor, acquisition cost was reduced by the payment received. Accelerated depreciation otherwise available to the seller/lessee continued, but depreciable basis was reduced by those payments.

Buyer/lessor

FTB viewed amounts paid as the purchase of federal tax benefits. California disregarded the payment transaction, and the buyer/lessor could not deduct or amortize the payments for state tax purposes.

Purported standard lease or finance lease

If a purported standard lease failed the existing lease tests, California treated it as a conditional sales contract.

The lessee was treated as acquiring the asset at a reduced cost after considering the financing element and federal-credit effect. A sale was treated as occurring for all purposes, including depreciation and unitary taxation.

For the purported lessor, the ruling said losses on the deemed sale were not recognized because part of the cost basis associated with federal tax benefits was retained. Unless the agreement specifically designated the tax-benefit transfer amounts, gain was recognized only to the extent the actual amount realized after financing exceeded cost.

Substance tests FTB retained

The decision continued to rely on Revenue Procedures 75-21, 75-28, and 76-30 and Revenue Ruling 55-540.

The ruling described the pre-safe-harbor advance-ruling requirements as including a 20% at-risk investment, a profit motive apart from tax benefits, no bargain purchase right for the lessee, no lessee funding or guarantee of the lessor's acquisition debt, and commercially feasible post-lease use by someone other than the lessee.

What this means for you

Equipment users and lessors

Federal form did not control the state answer. California examined whether the transaction was substantively a lease, a financing arrangement, or a sale.

Corporate tax departments

The classification changed who owned the asset for California depreciation and unitary purposes and how the asset entered the property factor.

Accountants and tax professionals

This ruling concerns a repealed historical federal regime. Use it to understand California's nonconformity approach at the time, not as a current safe-harbor leasing rule.

Common questions

Q: Did federal safe-harbor qualification guarantee California lease treatment?

A: No. California applied separate substance-based lease standards.

Q: What happened if a sale-leaseback failed those standards?

A: California disregarded the sale and lease, reduced the seller/lessee's basis by amounts received, and disregarded the buyer/lessor's payments for state tax purposes.

Q: Who owned the asset for unitary-tax purposes in that failed sale-leaseback?

A: The purported seller/lessee continued to be treated as the owner.

Q: What happened if a standard lease was really financing?

A: California treated it as a conditional sale, including for depreciation and unitary taxation.

Q: Is former I.R.C. section 168(f)(8) a current rule?

A: This ruling addresses the 1981 safe-harbor leasing provision and should be treated as historical guidance.

Citations and references

• Former I.R.C. § 168(f)(8)
• Former I.R.C. § 38
• Rev. Proc. 75-21, 1975-1 C.B. 715
• Rev. Proc. 75-28, 1975-1 C.B. 752
• Rev. Proc. 76-30, 1976-2 C.B. 647
• Rev. Rul. 55-540, 1955-2 C.B. 39

Source

• Landing page: California FTB Legal Rulings
• Official HTML: Legal Ruling 419

Original ruling text

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Legal ruling 419

STATE OF CALIFORNIA
Franchise Tax Board - Legal Division

December 18, 1981

California Treatment of the Federal Safe-Harbor Leasing Rules Under IRC Section 168 (f) (8)

Question

What is the California tax effect of an arrangement qualifying as a "safe harbor" lease under IRC Section 168 (f) (8)?

Decision

The Franchise Tax Board will continue to be guided by the provisions of Rev. Proc. 75 21, 1975 1 C.B. 715; Rev. Proc. 75 28, 1975 1 C.B. 752; Rev. Proc. 76 30, 1976 2 C.B. 647; and Rev. Ruling 55 540, 1955 2 C.B. 39 in determining whether certain transactions purporting to be leases are, in fact, leases for California tax purposes.

If a transaction purporting to be a sale and leaseback fails to qualify as such under the standards set forth in the above referenced federal rulings and procedures, the sale and lease elements of the transaction will be disregarded. Amounts received pursuant to such a transaction will reduce the basis of the property in the hands of the purported seller/lessee. Amounts paid by the purported buyer/lessor pursuant to such a transaction are viewed as the purchase of federal tax benefits and will be disregarded for California tax purposes.

If a transaction purporting to be a standard lease fails to satisfy the tests referenced above, the finance lease transaction will continue to be treated as a conditional sales contract.

Facts

The Economic Recovery Tax Act of 1981, in enacting into law Section 168(f)(8), IRC, made substantial changes in the treatment of transactions which purport to be sales and leasebacks or to be standard leases which, under prior law, would have been disregarded in the former case or treated as a conditional sales contract in the latter case.

Under the federal guidelines in effect before Section 168(f)(8) was enacted, in order to qualify for an advance ruling that a particular transaction constituted a lease, the following requirements had to have been met:

(1) the lessor, at all times must have a minimum "at risk" investment in the asset of at least 20 percent of its cost;

(2) the lessor must be able to show that the transaction was entered into for profit, apart from the transaction's tax benefits (i.e., without consideration of the tax deductions, allowances, credits, and other tax attributes arising from the transaction);

(3) the lessee must not have a contractual right to purchase the property at less than its fair market value nor may the lessor have a contractual right to cause any party to purchase the asset;

(4) the lessee may not have furnished any part of the purchase price of the asset nor have loaned or quaranteed any indebtedness created in connection with the acquisition of the property by the lessor; and

(5) the use of the property at the end of the lease term by a person other than the lessee must be commercially feasible to the lessor n1

Section 168(f) (8) creates a "safe harbor" that guarantees that a transaction will be treated as a lease for purposes of allowing investment tax credits and accelerated cost recovery depreciation allowances to the "lessor". As indicated in the Senate Committee Report, it was expected that "lessees" would receive a significant portion of the "lessor's" tax advantages through reduced rental charges for the property in the case of finance leases, or cash payments and/or reduced rental charges in the case of sale-leaseback transactions. The net effect would be to accelerate the availability of tax benefits to those users of property who may not have sufficient federal tax liability to absorb these benefits.

In order to qualify under Section 168(f)(8), both the lessor and lessee must elect to treat the lessor as owner of the property. In general terms, the lessor must be a corporation and have 10 percent of the adjusted basis in the property at risk throughout the lease. The lease property must constitute new Section 38 (investment tax credit) property and the term of the lease cannot exceed 90 percent of the asset's useful life or 150 percent of its asset Depreciation Range (ADR) class life.

The typical sale and leaseback arrangement contemplated under Section 168(f)(8), IRC, is illustrated in the example provided in Appendix 1 of the Joint Committee on Taxation Staff Paper Explaining Safe Harbor Leasing Provisions Under Accelerated Cost Recovery System, released October 20, 1981:

Corporation X purchases new equipment having a 10-year ADR life for $1,000,000. X "sells" the asset to corporation Y for $200,000 cash and an $800,000 note. Y then "leases" the equipment to X for 15 years, for an amount which exactly offsets the debt service. The only money which changes hands on the transaction is the $200,000 payment from Y to X. At the end of the lease Y sells the asset to X for one dollar.

As the deemed owner under Section 168(f)(8), IRC, Corporation Y is entitled to investment tax credit and accelerated depreciation with respect to its "leased" asset. The report states that Corporation Y has effectively purchased tax savings with a present value of something more than $200,000 for $200,000. Corporation X has effectively purchased a $1,000,000 asset for $800,000.

Discussion

California has no provision in the law comparable to Section 168(f) (8), IRC. Accordingly, the prevailing law in the area of purported lease transactions continues to apply. The Franchise Tax Board will continue to be guided by the provisions of Rev. Proc. 75 21, 1975 1 C.B. 715; Rev. Proc. 75 28, 1975 1 C.B. 752; Rev. Proc. 76 30, 1976 2 C.B. 647; and Rev. Ruling 55 540, 1955 2 C.B. 39 in determining whether certain transactions purporting to be leases are, in fact, leases for California tax purposes.

When a transaction which purports to be a sale and leaseback fails to meet these guidelines, the substance of the transaction will control. Accordingly, where the substance of the transaction indicates that no lease occurred, the sale and leaseback elements of the transaction will be disregarded.

Once the nature of the transaction has been so characterized, the question of the characterization of the amounts received by the purported seller/lessee remains. When an asset is purchased, the party acquiring the asset acquires a "bundle of rights" in connection with that asset, some of which include the existing federal tax rights. When the federal tax rights are transferred under a purported sale and leaseback, a portion of the owner's bundle of rights" has been relinquished to the buyer of such rights. Because the inherent value of the retained asset has been diminished as a result of the transfer, and because property has been received in substitution therefor, the basis in the asset is reduced by the amount of money and the fair market value of property received in connection with the transfer of such benefits.

This analysis is in harmony with the position of the federal Joint Committee on Taxation Staff Paper which characterizes the payments under these transactions as an effective reduction in acquisition cost of the asset.

The amount paid by the "buyer/lessor" pursuant to a purported sale and leaseback is an effective purchase of tax benefits. Since there is a correlation between the amounts paid and the reduced federal tax liability, the payment transaction is viewed as effective payment of federal tax, an event which the State of California will not take cognizance, even where the actual tax benefit received exceeds the amount paid. Accordingly, as to the payor, the transaction will be disregarded for state purposes and the payor will not be entitled to deduct or amortize such payments in computing its state tax liability.

For purposes of unitary taxation, the asset subject to the purported sale and leaseback will at all times be considered to have been owned by the purported seller/lessee. However, for purposes of the property factor, the acquisition cost of the asset is reduced by the payment received with respect to such asset.

Because the purported sale and leaseback is desregarded for state purposes, accelerated methods of depreciation continue to be available to the "seller/lessee" to the extent allowable before the purported transaction was undertaken. Depreciable basis, of course, will be reduced to the extent of payments received pursuant to such transaction.

In cases involving so-called finance leases, i.e., where a purported standard lease in fact constitutes a sale under existing guidelines, the fact that a transaction reflects reduced "lease" payments because of the availability of federal credits to the "lessor" will be disregarded. The "lessee" will be considered, after taking into consideration the financing element of the transaction, to have acquired the asset at a reduced cost. For all purposes, including depreciation and unitary taxation, a sale will be considered to have taken place.

With respect to the "lessor" in purported standard lease transactions, losses in connection with the deemed sale will not be recognized for state purposes. This is because a portion of the cost basis of the transferred asset (relating to the federal tax benefits) has been retained by the "lessor," and an asset of reduced value has been transferred to the "lessee." Unless the amounts relating to the transfer of federal tax benefits are specifically designated in the transfer agreement, gain will be recognized by the "lessor" only to the extent that the actual amount realized on the deemed sale (after taking into consideration the financing interest element) exceeds cost.

n1 Rev. Proc. 75 21, 1975 1 C.B. 715; Rev. Proc. 75 28, 1975 1 C.B. 752; Rev. Proc. 76 30, 1976 2 C.B. 647.

Last updated: 09/24/2025