The economics of leasing and the arm’s length standard

By Dr. Harold McClure, New York City

On September 23, the EU General Court ruled that the Spanish tax lease system constitutes illegal state aid, in a case often referred to as the Lico Leasing case.

The Spanish tax lease system is a complex arrangement with a long history. It involves the use of tax advantages from leasing assets as opposed to purchasing the assets using debt. These tax advantages of leasing exist when the tax benefits from depreciation expenses are lower for the operating entity using equipment when compared to these tax benefits for the formal owner of the leased equipment.

The Spanish tax lease system is similar to other controversies in other nations, including the UK and the US, where the tax benefits from depreciation expenses are lower for the operating entity using equipment as compared to these tax benefits for the formal owner of the leased equipment.

The IRS has attacked versions of this system arguing that they lack economic substance, which is defined as having lease payments below what would be expected under arm’s length pricing. In these litigations, an affirmative defense for the taxpayers is that the owner of the leased property received adequate compensation for the leased property.

Economic substance is, therefore, similar to evaluating whether the intercompany lease payments are arm’s length for transfer pricing purposes. A model of what would compensate arm’s length lease payments is presented and applied to a ship leasing illustration.

The converse situation occurs when the equipment is owned by an entity facing a low effective rate and leased to an operating affiliate facing a high income tax rate. In such cases, multinationals would be tempted to charge intercompany lease rates in excess of the arm’s length standard.

Spanish tax lease system and the European controversy

Shipping companies that purchase ships directly from Spanish shipyards can do so either with equity financing or debt financing. If the assets are purchased with debt, the shipping company would incur interest expenses and can also deduct depreciation expenses.

Leasing is an alternative to debt financing, where the leasing entity deducts the depreciation expenses and charges rent to the shipping company to cover its economic depreciation and provide for a reasonable return to the leased assets.

The Spanish tax lease system was an elaborate version of this leasing alternative, involving leasing companies and an economic interest grouping which attracts investors.

The Spanish tax lease system involves an array of contracts, where the leasing companies and economic interest grouping, collectively, act as the lessor entities that collect rent from the shipping company and arrange for how the depreciation allowances would be deducted.

The European Commission, which first challenged the scheme in 2013, asserted that the tax advantages for the leasing entities translated into a 20 percent reduction on the price charged by the shipyard. The General Court of the European Union initially ruled that this system did not constitute state aid but the Court of Justice of the European Union set aside this ruling, setting the stage for the General Court’s September 23 ruling.

Leasing and tax advantages in the UK

British tax law introduced tax depreciation in 1878 in the form of a wear and tear allowance, a form of tax depreciation that could differ considerably from economic or even accounting depreciation.

Not long afterward, taxpayers began to exploit the tax benefits of intercompany leasing, as detailed in a recent discussion by James Hollis (“Union Cold Storage and the Birth of Multinational Tax Planning, 1897–1922”, January 2019). One of these creative forms involved intercompany leasing.

As described by Hollis, National Cold Storage Company of New York was typical of such schemes. National Cold Storage established a UK affiliate that owned equipment leased to National Cold Storage in exchange for intercompany rent payments.

Hollis notes this transfer pricing issue as well as other transfer pricing issues, but he concedes that the UK government was not actively pursuing transfer pricing during this period.

 If UK income tax rates were lower than the income tax rates paid by the New York affiliate, it would be in the interest of National Cold Storage’s owners to have intercompany lease payments lower than the arm’s length standard.

Leveraged lease transactions

The IRS has challenged the tax implications of leveraged lease transactions, known as lease-in/lease-out (LILO) and sale-in/lease-out (SILO).

These lease arrangements transfer depreciation allowances from entities that would have modest or no benefits from these deductions to taxpayers that would derive greater benefits.

While the legal grounds for these IRS challenges have differed in different litigations, the IRS often argues that these transactions lack “economic substance,” which means that the owner of the leased asset does not have an expectation of earning a reasonable return on its investment.

In these litigations, an affirmative defense for the taxpayers would have been that the owner of the leased property received adequate compensation for the leased property. Economic substance is, therefore, similar to evaluating whether the intercompany lease payments are arm’s length.

The case Andantech LLC v. Comr., represented an IRS win on this issue (TC, Nos. 15332-98, 4277-00 and 6348-00, TC Memo 2002-97).

Economics of leasing and the economic substance doctrine

The lease payment compensates the formal owner of the leased asset for the expected rate of economic depreciation plus a reasonable return to its assets and any operating expenses borne by the formal owner.

The expected return to leased assets can be seen as the risk-free rate plus the premium for bearing ownership or obsolescence risk.

If the risk-free rate is 4 percent, the premium for bearing obsolescence risk is 2 percent, then the owner’s expected return to leased assets is 6 percent. The value of the leased assets represents the present value of cash flows over the life of the leased asset.

The expert witnesses for the taxpayer and the IRS in the Andantech litigation relied on a general model expressed as a standard discounted cash flow analysis of what was a five-year lease contract beginning in September 1993.

The standard discounted cash model can be expressed as follows:

V = S C_t/(1 + r)^t + R/(1 + r)ⁿ, where

V = the value of the property at the beginning of the lease contract; n = the term (number of years) of the lease contract; R = the expected residual value of the property at the end of the lease contract;

C_t = cash flows to the lessor, which are the lease payments net of any maintenance costs borne by the lessor; and r = a reasonable return to investment for the lessor.

The equipment was mainframe computers, which were valued at $125 million as of September 1993.

Let’s assume that the lease payments were $25.69 million per year, which represents the cash flows over the term of the lease.

A key point of contention was what would be a reasonable expectation of the residual value of the computers as of September 1998.

The taxpayer’s expert witness assumed that R = $25 million, which suggests an expected return to the lessor equal to 6.5 percent.

Given that the five-year government bond rate as of September 1993 was 4.75 percent, a 6.5 percent expected return is consistent with a premium for bearing obsolescence risk equal to 1.75 percent.

The IRS expert witness noted that this was likely on the low end of an acceptable range. If we assume a range for this premium from 1.75 to 2.25 percent, then the range for overall expected returns would be between 6.5 percent and 7 percent.

The IRS expert witnesses, however, convinced the court that a reasonable expectation for the residual value of the leased equipment was at most $10 million. As such, the lease payments translated into an expected return equal to 3.34 percent, which was below the risk-free rate. As the court noted:

we conclude that under the objective economic substance test, the leveraged sale-leaseback transaction involved herein had no reasonable opportunity for economic profit.

If R = $10 million and r = 6.5 percent, an arm’s length lease payment would need to be $28.32 million per year instead of $25.69 million per year.

While such a lease structure would make the user of the computer mainframes indifferent between debt financing versus leasing, the incentives to transfer its leasing deduction would not exist.

The general concern of the IRS is that LILO and SILO transactions are structured so that the formal owner accepts lower lease payments in exchange for lease deductions that have greater value to the formal owner of equipment than the operating entity that uses the equipment.

Evaluating economic substance in these cases is similar to evaluating whether the intercompany lease payments are arm’s length.

Shipping example

The lease to value ratio under the arm’s length standard can be seen as the sum of the economic rate of depreciation, the appropriate discount rate, and operating expenses borne by the formal owner of the equipment (if any), relative to the value of the equipment.

Global Ship Lease is a containership owner, leasing ships to container shipping companies under industry-standard, fixed-rate time charters.

Table 1 presents financial data from 2015 to 2019 for this third party shipping leasing company.

Operating expenses include vessel operating expenses, time charter and voyage operating expenses, and general and administrative expenses.

The value of its ships is approximately $1.17 billion so its lease-to-value ratio is 15.55 percent while operating expenses relative to value is 5.54 percent.

Table 1: Financials for Global Ship Lease, Inc.

Millions	2015	2016	2017	2018	2019	Average	Lease/value
Revenues	$165.3	$166.8	$159.3	$157.1	$261.1	$181.9	15.55%
Expenses	$57.0	$52.3	$49.1	$60.1	$105.6	$64.8	5.54%
Net proceeds	$108.3	$114.5	$110.2	$97.0	$155.5	$117.1	10.01%

Let net proceeds equal the difference, which provides a measure of the lease-to-value ratio for a lessor that only incurs depreciation expenses. A net proceed-to-value ratio = 10 percent is consistent with an expected return to capital equal to 6 percent if the depreciation rate = 4 percent.

Table 2 presents four versions of a leasing arrangement for a ship whose market value = €120 million. In each version, the lessee pays the formal owner of the ship monthly lease payments for ten years.

The first version assumes a monthly lease payment equal to €1 million per month, which is consistent with an annualized lease to value ratio equal to 10 percent

The first version also assumes a 6 percent discount rate, which reflects a 4 percent risk-free rate and a 2 percent premium for bearing ownership or obsolescence risk.

From 2001to 2010, ten-year German government bond rates ranged from 2.3 percent to 5.2 percent, averaging 3.9 percent. As such, a 4 percent risk-free rate is a reasonable assumption for 10-year lease contracts entered into during this period.

This policy of letting the lease payment equal to €1 million per month or an annual lease to value ratio equal to 10 is consistent with arm’s length pricing.

Table 2: present value of shipping lease arrangement (millions of Euros)

Discount rate	Lease payment	Residual value	PV of lease	PV of residual
6.00%	€1.0	€53.6	€90.1	€29.9
6.00%	€0.8	€53.6	€72.1	€29.9
3.35%	€0.8	€53.6	€81.5	€38.5
6.00%	€0.8	€85.9	€72.1	€47.9

The other three versions assume lease payments are only €0.8 million per month, which is the mechanism for rewarding the ship’s operating entity for the transfer of depreciation expenses to the formal owner of the ship.

If we continue to assume a 6 percent discount rate, the present value of the lease payments is lower by €18, so the combined present value (PV) of the lease payments and the present value of the residual value is only €102 million as noted in the second version of table 2.

Since the value of the ship, however, is €120 million, the lower lease payments reduced the expected return to the formal owner of the ships to only 3.35 percent as long as the residual value = €53.8 million, as noted in the table’s third version.

This expected return is even below the risk-free rate, so the owner has “no reasonable opportunity for economic profit,” to quote the court decision in the Andantech litigation. This low expected return to the value of the leased ship is equivalent to having intercompany lease rates below the arm’s length standard.

The last version of Table 2 notes how assuming an inflated residual value can seemingly offer a defense of this lower lease rate.

 If the analyst assumed that the expected residual value was €85.9 million, the analyst could conclude that the expected return would be 6 percent.

In effect, the analyst would excuse the lower lease to value ratio by assuming a much lower economic depreciation rate.

We should caution, however, that this attempt to assume a high residual value by the expert witnesses in the Andantech litigation was not seen as credible.

Lease payments equal to only €0.8 million per month would be less than the arm’s length standard.

If the Spanish tax lease system were evaluated in terms of the US economic substance test which is effectively an arm’s length test, such low lease payments could be seen as state aid.

Concluding comments

The Spanish tax lease system has similar motivations as the LILO and SILO transactions in the US where a user that would receive few tax benefits from the depreciation of equipment transfers those benefits to a high tax entity in a lease contract where the high tax entity becomes the formal owner of the equipment.

The formal owner leases the equipment to the user in exchange for these tax benefits.

The tax authorities are generally concerned that the parties are gaming the tax system by structuring lease arrangements with lease payments below what one would expect in an arm’s length arrangement in the absence of these tax considerations.

The economics of leasing ships is similar to the economics of leasing aircraft, which I address in a recent paper (“Aircraft Intercompany Leasing: Domestic Use Tax and International Tax Considerations,” Journal of Multistate Taxation and Incentives, March 2020):

Even if a multinational airline purchased a plane, it may structure the financing such that a tax haven affiliate formally owns the plane with the operating affiliate allowed to use the plane through an intercompany lease agreement … Singapore updated its Aircraft Leasing Scheme on February 20, 2017, to allow for a concessionary tax rate of 8 percent on income derived from leasing aircraft. On March 10, 2017, the Hong Kong Inland Revenue Department (IRD) allowed a concessionary tax rate of 8.25 percent on such income. Both concessionary tax rates are approximately half the statutory rates for these two jurisdictions and are substantially lower than the corporate tax rates of other Asian jurisdictions, such as China, Japan, South Korea, and Taiwan.

Where the formal owner of the leased equipment has a lower tax rate than the user of the equipment, there is an incentive for the parties to charge lease payments in excess of the arm’s length standard.

The economic model for evaluating whether lease payments are consistent with the arm’s length standard is the same regardless of the tax motivations.