TABLE OF CONTENTS Foreword Chapter 1: Introduction Chapter 2: Transaction/lease characterization aspects v 1 7 2.1. Introduction 7 2.2. Lease characterization in the United States 7 2.2.1. True lease: prerequisite for obtaining the tax advantage 7 2.2.2. The IRS view 8 2.2.2.1. Revenue Ruling 55-540: IRS view on what constitutes a true lease 8 2.2.2.2. Revenue Procedure 75-21: Detailed Guidelines for granting advance rulings 9 2.2.2.3. Revenue Procedure 2001-28 12 2.2.3. Judicial developments 13 2.2.3.1. Case law developments vis-à-vis the Guidelines requirements: a comparison 13 2.2.3.2. Court decisions on transaction characterization: lease v. sale 14 2.3. Lease characterization in the United Kingdom 16 2.3.1. Definition of finance lease 17 2.3.1.1. Relevance of Generally Accepted Accounting Principles 17 2.3.1.2. Definition of finance lease under SSAP 21 17 2.3.2. Court decision on characterization of lease transaction 18 2.4. Lease characterization in Germany 18 2.4.1. Significance of economic ownership 18 2.4.2. Definition of economic ownership 18 2.4.3. German Supreme Fiscal Court decision on transfer of economic ownership 19 2.4.4. Tax circulars on attribution of economic ownership 19 2.5. Lease characterization in the Netherlands 20 2.5.1. Significance of economic ownership 20 2.5.2. Hoge Raad decision on economic ownership 20 2.5.3. Lease arrangement 21 2.6. Lease characterization in Japan 23 vii
2.6.1. Lease v. sale 23 2.6.2. Finance lease 25 Chapter 3: Depreciation/capital allowances aspects 27 3.1. Introduction 27 3.2. General scheme of depreciation allowance 28 3.2.1. United States 28 3.2.1.1. Generally applicable method of depreciation 29 3.2.1.2. Applicable recovery period 29 3.2.1.3. Applicable convention 29 3.2.2. United Kingdom 30 3.2.2.1. General 30 3.2.2.2. Capital allowances for cars 31 3.2.3. Germany 32 3.2.4. Netherlands 32 3.2.5. Japan 33 3.3. Eligibility for depreciation allowance (ownership criterion) 33 3.3.1. United States 34 3.3.2. United Kingdom 34 3.3.3. Germany 35 3.3.3.1. Economic ownership 35 3.3.3.2. Circulars issued by the Federal Ministry of Finance 36 3.3.3.2.1. Full pay-out v. non-full pay-out leasing 36 3.3.3.2.2. Attribution of the economic ownership in the case of full pay-out leasing 37 3.3.3.3. Attribution of the economic ownership in the case of non-full pay-out leasing 37 3.3.4. Netherlands 39 3.3.5. Japan 40 3.4. Accelerated depreciation/capital allowances 40 3.4.1. United States 40 3.4.2. United Kingdom 40 3.4.2.1. First-year allowances 40 3.4.2.2. Capital allowances for ships 41 3.4.2.3. Rollover relief in respect of disposal of ships 42 3.4.3. Germany 43 3.4.4. Netherlands 44 3.4.5. Japan 44 viii
3.5. Restrictions on depreciation/capital allowances in case of leasing 45 3.5.1. United States 45 3.5.1.1. Alternative Depreciation System (ADS) 45 3.5.1.2. Exceptions 46 3.5.1.2.1. Qualified technological equipment (QTE) 46 3.5.1.2.2. Other exceptions 48 3.5.2. United Kingdom 48 3.5.2.1. Denial of the first-year allowance 48 3.5.2.2. Restriction in the case of a purchase option 49 3.5.2.3. Restriction on capital allowances in the year of acquisition 49 3.5.2.4. Restrictions in the case of overseas/export leasing 50 3.5.2.5. Restriction in respect of free depreciation on the ships used for overseas leasing 51 3.5.2.6. Restrictions in the case of sale and finance leaseback arrangements 52 3.5.2.7. Restrictions in the case of sale and finance leaseback on defeased terms 52 3.5.3. Germany and the Netherlands 53 3.5.4. Japan 53 Chapter 4: Income recognition aspects 55 4.1. Introduction 55 4.2. Relevant income recognition rules in the USA (IRC Sec. 467 and Final Sec. 467 Regulations) 56 4.2.1. Applicability of IRC Sec. 467 56 4.2.2. Consequences of applicability of Sec. 467: income taxation on an accrual basis 57 4.2.3. Rent accruals under Sec. 467 57 4.2.3.1. Rent accrual in the case of agreements not perceived as tax avoidance transactions 57 4.2.3.1.1. Relevant provision in IRC Sec. 461(b)(1) 57 4.2.3.1.2. Rent computation formulae prescribed under the Regulations 58 4.2.3.2. Rent accrual in the case of perceived tax avoidance transactions 59 4.2.3.2.1. Tax treatment of rents under the perceived tax avoidance transactions 59 ix
4.2.3.2.2. Meaning of the perceived tax avoidance transactions 60 4.2.4. Sec. 467 interest 61 4.2.5. Safe-harbour provisions 61 4.3. Relevant income recognition rules in the United Kingdom 62 4.3.1. Taxation of operating lease rental income 62 4.3.2. Taxation of finance lease rental income 62 4.3.2.1. Background 62 4.3.2.2. Return of investment in capital form 62 4.3.2.3. Negative depreciation 64 4.4. Relevant income recognition rules in Germany 65 4.5. Relevant income recognition rules in the Netherlands 66 4.6. Relevant income recognition rules in Japan 66 Chapter 5: Limits of tax-driven cross-border leasing transactions 69 5.1. Introduction 69 5.2. Relevant anti-avoidance rules in select jurisdictions: a brief overview 70 5.2.1. United States 70 5.2.1.1. The sham transaction doctrine 71 5.2.1.2. The step transaction doctrine 71 5.2.1.3. The business purpose Doctrine 72 5.2.1.4. The substance-over-form doctrine 73 5.2.1.5. The economic substance or the economic sham transaction doctrine 73 5.2.1.6. The US Supreme Court decision in the Frank Lyon case 75 5.2.1.7. Application of two-fold test by the lower courts in the United States 76 5.2.2. United Kingdom 77 5.2.2.1. The Ramsay principle (W.T. Ramsay v. IRC) 77 5.2.2.2. The step-transaction doctrine (Furniss v. Dawson and Craven v. White) 78 5.2.2.3. Trading transactions v. transactions with the sole objective of obtaining tax advantage (Overseas Containers (Finance) Ltd. v. Stoker (Inspector) and Lupton v. F.A. & A.B. Ltd.) 78 x
5.2.2.4. The limits of the Ramsay principle (MacNiven (Inspector of Taxes) v. Westmoreland Investments Ltd) 79 5.2.3. Germany and the Netherlands 81 5.3. Legal system: impact on tax-driven cross-border leasing transactions 82 5.4. Tax-driven leasing transaction structures 85 5.4.1. Sale and leaseback 85 5.4.1.1. Nature of the transaction 85 5.4.1.2. The US: Court of Appeals decision in Sun Oil Co. v. Commissioner of Internal Revenue 86 5.4.1.3. United Kingdom 86 5.4.1.3.1. Restrictive provision under the Capital Allowances Act 2001 86 5.4.1.3.2. UK Court of Appeals decision in BMBF case 88 5.4.1.4. Netherlands: technolease cases 88 5.4.2. Chain-lease structure 89 5.4.2.1. Nature of the transaction 89 5.4.2.2. BMBF (No 24) v. Inland Revenue Commissioners 89 5.4.2.2.1. Relevant facts 89 5.4.2.2.2. Relevant statutory provisions 91 5.4.2.2.3. Relevant issues before the High Court 92 5.4.2.2.4. Decision by the High Court on applicability of Sec. 42(3) to headlease or sublease 92 5.4.2.2.5. Critical remarks on the High Court decision 95 5.4.3. Double-dip leasing 95 5.4.3.1. Nature of transaction 95 5.4.3.2. Typical double-dip lease structure 96 5.4.3.3. How does double-dip leasing provide a tax advantage? 97 5.4.3.4. Can double-dip lease, per se, be regarded as abusive? 98 5.4.4. Two-tier double-dip structures 99 5.4.4.1. Nature of transaction 99 5.4.4.2. Use of two-tier double-dip structures in Japan 99 5.4.4.3. Can two-tier double-dip leasing, per se, be regarded as abusive? 100 5.4.5. Leveraged leasing 102 5.4.5.1. Nature of transaction 102 xi
5.4.5.2. Comparative analysis of anti-deferral provisions (to counter rear-loaded leases) under the US and the UK tax laws 103 5.4.5.3. Use of non-recourse debt funding in leveraged leases: position in the United States and the United Kingdom 105 5.4.5.3.1. United States: at risk provisions of Sec. 465 of the IRC 105 5.4.5.3.2. United Kingdom: House of Lords decision in Ensign Tankers case 106 5.4.5.3.3. United Kingdom: implications of Ensign Tankers decision on leveraged leases involving non-recourse debt financing 111 5.4.5.4. German leveraged leases 114 5.4.5.5. Modified German leveraged leases (modified subsequent to Sec. 2b introduction) 115 5.4.5.6. Japanese leveraged leases 117 5.4.6. Replacement leases 118 5.4.7. Like-kind exchange structure 119 5.4.8. Lease-in-lease-out (LILO) 120 5.4.9. Tax sparing credit (TSC) structures 121 5.4.10. Japanese safe-harbour structures (agreement between Japanese tax authorities and Japan Leasing Association) 122 5.4.11. Tokumei Kumiai arrangements 123 5.4.12. Japanese operating leasing 124 5.4.13. Defeasance structures 126 5.4.13.1. Nature of transaction 126 5.4.13.2. United Kingdom Court of Appeals decision in Barclays Mercantile Business Finance Ltd. v. Mawson (Inspector of Taxes) 127 5.4.13.2.1. Relevant facts 127 5.4.13.2.2. Position taken by the tax authorities 129 5.4.13.2.3. Decision by Special Commissioners 129 5.4.13.2.4. High Court decision 130 5.4.13.2.5. Court of Appeals decision 131 xii
Chapter 6: Tax treaty implications of lease income characterization 133 6.1. Introduction 133 6.2. Tax treaty definition of royalties vis-à-vis lease rentals for ICS equipment 133 6.2.1. The OECD position 133 6.2.2. Definition of royalties in tax treaties 134 6.3. The characterization issue: effect on treaty distributive rules 135 6.3.1. Complexity of the issue 135 6.3.2. Characterization: from which state s perspective? 135 6.4. Characterization of the finance lease income 137 6.4.1. Finance lease rentals vis-à-vis royalties in treaty context 137 6.4.2. Finance lease rentals and interest in treaty context 138 6.4.2.1. The characterization issue 138 6.4.2.2. OECD position 139 6.4.2.3. Definition of interest in tax treaties 139 6.4.2.4. Scope of definition of interest (version a): income from debt claims (similar to OECD definition) 140 6.4.2.5. Scope of definition of interest (version b): income assimilated to income from money lent 142 6.4.2.5.1. Position in the United States 142 6.4.2.5.2. Position in the United Kingdom 143 6.4.2.5.3. Position in Germany and the Netherlands 146 6.5. Characterization of operating lease income 147 Chapter 7: Tax treaty aspects of taxation of cross-border leasing income in the source state 149 7.1. Introduction 149 7.2. Differing provisions in bilateral tax treaties 149 7.2.1. Differing provisions concerning royalties 149 7.2.1.1. Right to tax royalty income and treaty definition of royalties 149 7.2.1.2. Withholding tax: rate differences 150 7.2.1.3. Beneficial ownership requirement 150 xiii
7.2.2. Differing provisions concerning interest income 150 7.2.2.1. Taxing right and rate differences 150 7.2.2.2. Beneficial ownership requirement 151 7.2.3. Differing provisions concerning taxation of capital gains 151 7.2.4. Implications of differing provisions in bilateral tax treaties 151 7.3. Entitlement to treaty benefits in case of improper use of tax treaties (by third-country residents) 153 7.3.1. Relevance of the issue in cross-border leasing transactions 153 7.3.2. Entitlement in case of improper use of tax treaties: contemporary position 154 7.3.2.1. The OECD view 154 7.3.2.1.1. The 1977 and 1992 OECD MC Commentaries 154 7.3.2.1.2. The OECD Conduit Companies Report 154 7.3.2.1.3. The 2003 version of the OECD MC Commentary 155 7.3.2.2. Views expressed by commentators 157 7.3.2.3. Court decisions on treaty entitlement of interposed entities 158 7.3.2.3.1. Court decisions in the United States 158 7.3.2.3.2. Court decisions in the Netherlands 160 7.3.2.3.3. Court decisions in Germany 161 7.3.2.4. Conclusion 162 7.4. Anti-abuse tax treaty provisions relevant for cross-border leasing transactions 163 7.4.1. Beneficial ownership 163 7.4.1.1. The beneficial owner requirement 163 7.4.1.2. Purpose of the beneficial owner requirement 163 7.4.1.3. Definition of the term beneficial owner 164 7.4.1.4. OECD Commentary on the term beneficial owner 165 7.4.1.5. International tax language meaning of beneficial owner 166 7.4.1.6. Beneficial ownership of income rather than the income-producing asset 167 7.4.1.7. Implications of absence of beneficial ownership requirement in a tax treaty 167 7.4.1.8. The two sublease case studies vis-à-vis the beneficial ownership requirement 171 7.4.2. Limitation on benefits article 172 xiv
Chapter 8: Relevance of the EC Treaty (cross-border leasing between the EC Member States) 175 8.1. Scope of the chapter 175 8.2. UK capital allowance restrictions in the case of outbound leases 176 8.2.1. The restrictive provision 176 8.2.2. Conflict with a Treaty freedom 177 8.2.3. Potential justifications for the restrictive national tax law provision 178 8.2.3.1. Need to prevent loss of revenue 178 8.2.3.2. Fiscal cohesion 180 8.2.3.2.1. Fiscal cohesion argument: seldom accepted by the ECJ 180 8.2.3.2.2. Bachman and Commission v. Belgium 180 8.2.3.2.3. The two prerequisites for acceptance of the fiscal cohesion argument 181 8.2.3.2.4. The UK restriction of capital allowance on outbound leases: the two conditions for the fiscal cohesion argument not satisfied 184 8.2.3.3. The abuse argument 185 8.2.3.3.1. Argument not yet accepted by the ECJ in tax cases 185 8.2.3.3.2. Can the Treaty be relied upon to shield abusive transactions? 188 8.2.3.3.3. The abuse argument vis-à-vis the UK restriction of capital allowances in the case of outbound leases 191 8.2.3.4. Fiscal supervision 191 8.2.3.5. Territoriality argument 193 8.2.4. Main conclusion on the issue 193 8.3. Denial of group relief in respect of losses suffered by subsidiaries resident in other Member States 193 8.3.1. The issue 193 8.3.2. The Marks & Spencer case 194 8.3.3. Conflict with a Treaty freedom (freedom of establishment) 198 8.3.4. Potential justifications for the restrictive national tax law provision 199 8.3.4.1. The argument relating to the need to prevent loss of revenue 200 8.3.4.2. The fiscal cohesion argument 200 8.3.4.3. The abuse argument 203 xv
8.3.4.4. Fiscal supervision argument 204 8.3.4.5. Territoriality argument 205 8.3.5. Main conclusion on the issue 206 8.4. Final conclusions 206 Chapter 9: Summary, conclusions and recommendations 207 9.1. Background 207 9.2. Summary and conclusions 207 9.2.1. Income recognition aspects 207 9.2.1.1. The tax deferral advantage of rear-loaded lease rentals 207 9.2.1.2. Relevant anti-avoidance provisions in select jurisdictions 207 9.2.1.3. Effectiveness of anti-avoidance provisions in the United States vis-à-vis the United Kingdom 208 9.2.2. Depreciation aspects 208 9.2.2.1. Significance of depreciation allowance in tax-driven leasing transactions 208 9.2.2.2. General scheme of depreciation allowances in the select jurisdictions 209 9.2.2.3. Eligibility criteria for depreciation allowance (legal v. economic ownership) 210 9.2.2.4. Incentives and restrictions 212 9.2.3. Transaction characterization aspects 212 9.2.3.1. Significance of transaction characterization 212 9.2.3.2. Transaction characterization in select jurisdictions 213 9.2.4. Legal systems, anti-avoidance principles and aggressively tax-driven transaction structures 215 9.2.4.1. Tendencies of taxpayers towards aggressively tax-driven transactions 215 9.2.4.2. Scope of general anti-avoidance rules 216 9.2.4.3. Impact of legal systems on tax-driven cross-border leasing transactions 217 9.2.4.4. Tax-driven transaction structures 219 9.2.4.4.1. Sale and leaseback transactions 219 9.2.4.4.2. Chain-lease transaction structure 219 9.2.4.4.3. Double-dip leasing 220 9.2.4.4.4. Two-tier double-dip leasing 220 9.2.4.4.5. Leveraged leasing 220 xvi
9.2.4.4.5.1. Leveraged leases with uneven rents 220 9.2.4.4.5.2. Leveraged leases involving non-recourse financing 220 9.2.4.4.5.3. German leveraged and modified leveraged leases 221 9.2.4.4.6. Defeasance structures 221 9.2.5. Tax treaty implications of transaction characterization 221 9.2.5.1. Tax treaty definition of royalties 221 9.2.5.2. Tax treaty characterization in the case of operating lease 221 9.2.5.3. Tax treaty characterization in the case of finance lease 222 9.2.5.3.1. The issue of tax treaty characterization as royalties 222 9.2.5.3.2. The issue of tax treaty characterization as interest 222 9.2.6. Differing provisions in tax treaties and improper use of tax treaties 223 9.2.6.1. Differing provisions in tax treaties 223 9.2.6.2. Improper use of tax treaties and entitlement to treaty application 224 9.2.6.3. Implications of absence of beneficial ownership requirement in tax treaties 225 9.2.6.4. Effect of typical Limitation on benefits article on leasing entities 225 9.2.7. Relevance of EC Treaty in the context of cross-border leasing 226 9.2.7.1. EC freedom to provide services: leasing constitutes a service 226 9.2.7.2. Overseas leasing: capital allowance restrictions 226 9.2.7.3. Compatibility of group relief regimes with the EC Treaty 226 9.3. Recommendations 227 9.3.1. Amendments to UK tax law for taxation of finance lease rentals on an accrual basis 227 9.3.2. UK safe-harbour rules for leasing transactions 228 9.3.3. Amendments to the Capital Allowances Act 2001 (UK) in respect of cross-border leases with lessees resident in the other EC Member States 229 xvii
9.3.4. Amendments to group relief regimes under the tax laws of the United Kingdom, Germany and the Netherlands 229 9.3.5. Strengthening specific anti-avoidance regime under the UK tax law 230 9.3.6. United Kingdom: specific restrictive provision concerning interest on non-recourse finance 232 9.3.7. Inclusion of clarifications in tax treaties: aspects relating to characterization of finance lease income 232 Appendices 235 Appendix 1 US case law on lease v. conditional sale 235 Appendix 2 Special and accelerated depreciation in Japan 249 Appendix 3 List of treaties examined 253 Appendix 4 ECJ cases examined for ascertaining arguments advanced by the Member States to justify restrictive provisions under the national direct tax laws 255 Bibliography Table of case law 257 263 xviii