Business Leasing and Finance News (BLFN) First Quarter 2011
By David G. Mayer
As the recession slowly fades, financiers seek ways to close new deals and meet increased budgets. Although some appear optimistic about doing more business this year than in the last two, others express frustration that few deals can pass muster in credit committee or even fit within narrow criteria required by their organizations.
Setting an annual budget is a normal process for most leasing or finance businesses. In 2011, bottom line success may not be achieved in a linear fashion. The recovery is still too fragile and unpredictable; the recession too severe to snap back rapidly to pre-recession levels. The tragedy in Japan will have an unknown toll in all its human and economic respects.
Financiers know they must be creative and open-minded yet cautious in the type of deals they elect to fund. Some say they will look for and fund a few atypical deals if they can obtain an attractive rate of return, manage the risk conservatively, use their intellectual capital to add value and diversify their assets or collateral. In short, these financiers may be opportunistic this year in order to make budget, compensate originators and drive earnings.
Taking an opportunistic approach is not a panacea; nor is it a substitute for meeting prescribed deal criteria. It also does not mean throwing caution to the wind. In contrast, if done correctly, acting opportunistically can help lenders and lessors meet budget without making some of the same mistakes that landed us all in the recession in the first place. We can, and perhaps we should, be receptive to new opportunistic ways to make money in a sound and appropriate manner.
1. Bundled Technology Financing Unfolds in Latin America
While technology financing in the United States continues to mature, financiers in several Latin American countries have experienced a surge in demand for innovative ways to finance and lease technology assets in their markets.
Latin American countries, including Brazil, Colombia, Honduras, Mexico, Nicaragua, Panama and Peru, have developed bundled finance or lease structures similar to those used in the U.S. market. The one-payment financing or leasing structure bundles selected Technology Items (as described below) into one transaction for the benefit of each customer, as the borrower or the lessee (Customer).
Colloquially speaking, in this type of bundled transaction, Customers want “one throat-to-choke.” Should any problem arise with respect to Equipment or related products, software or services in the bundle, a seller-servicer can respond immediately, enabling Customers to avoid downtime and use their IT personnel more effectively. In addition, bundled financings or leasing allows Customers to reduce the number and type of creditors, service providers and vendors involved in their technology functions.
*Terms to Know: A bundled financing or leasing transaction may involve some or all of the following components (Technology Item(s)):
- “Consumables” - supplies or other products used up during the operation or maintenance of technology Equipment.
- “Equipment” - any moveable item such as a computer. See the definition of “goods” under Article 2A-103(i)(h), Article 9-102(a)(44), and Article 2-105 of the Uniform Commercial Code (UCC) enacted in the United States, which includes moveable technology assets and embedded software.
- “Services” – any scheduled or unscheduled maintenance, warranty repairs, routine upgrades, remote monitoring, training and other negotiated obligations of the service provider.
- “Software” – a computer program and any supporting information provided in connection with a transaction relating to the program other than embedded software. See UCC Article 9-102(a)(75).
- “Soft Costs” - any cost other than Equipment, Services, Consumables or Software, including costs for transportation, sales taxes, first installation and shipping insurance. Soft costs may overlap Consumables and Services if the parties do not clearly separate them from the other items in the purchase, finance or lease documentation.
The fundamental issue is whether a legal structure can preserve the business objectives of closing bundled leasing or financing deals while protecting the diverse or divergent interests of the parties. Legal structures that use separate service and financing documents may dilute the business intent of using one agreement for both the finance or lease and service of the Technology Items.
The question becomes how to balance the terms of transactions that, to the extent feasible, protect the rights and remedies of a financier and/or its assignee (Funder), on one hand, while providing the Customer a one-payment financing solution for all Technology Items in an integrated document, on the other hand. In addition, the interest of the manufacturer and/or those of the seller, dealer or captive finance company, as lessor (Lessor), continue to be relevant to completing the sale and delivering the related services.
*Term to Know: A captive finance company is a subsidiary or division of a specific dealer, vendor or manufacturer that may act as the Lessor. The captive usually retains a direct relationship with its Customer and offers simultaneous sales and financing for the Customer’s convenience. The Lessor may assign the lease or loan documentation and asset to a Funder, which, through its financing, pays the purchase price of the asset and services to the manufacturer and servicer.
Despite the risks to Funders of bundled deals, Manufacturers often exert pressure on Funders to complete transactions to book a sale on signing the bundled contracts (or soon thereafter). Funders can frequently justify the risks if the payment by the Customer includes a premium over Equipment-only financing or leasing deal, and the credit of the Customer is acceptable to the Funder.
*Insight Point: As the bundled transaction market matures in Latin America, lawyers can expect to experience, and have already encountered, pressure to make optimal legal structures and terms second to closing a sale, lease and/or financing of Technology Items.
Three of the Most Common Bundled Lease Structures
Manufacturers of Equipment frequently arrange financing for their Customers through a “vendor leasing program” in which a Funder typically purchases equipment for lease to Customers.
The Funder, with exceptions, remains in the background unless a situation occurs, such as an event of default by the Customer, which authorizes the Funder to appear and deal with the Customer directly—sometimes called a “dooms-day” scenario. A captive finance company and its parent company may enter into a program agreement.
*Term to Know: The program agreement prescribes the basic terms of a bundled transaction and the rules for a Funder and seller to cooperate and process transactions. It usually includes the forms of the Customer’s finance and lease documents.
Many variations of structures exist for bundled lease transactions. Domestic and cross-border transactions often use one of the three structures described below:
- Bundling Under a Standard Master Lease: Some bundled transactions use a typical short-form master equipment lease. In a master equipment lease, the parties usually attach one or more schedules to the master lease setting forth the Equipment description and, among other deal terms, the costs that the Funder will pay for the Equipment and other Technology Items subject to the master lease.
Because bundled Technology Items (tangible assets and services) each have distinct business terms and legal rights, the Funder may face significant issues on enforcement of the lease terms. When a simple bundling of rights occurs, the true rights of the parties may seem muddled to a court and result in the court unraveling the structure of the transaction. Each Latin American jurisdiction may characterize the rights differently than the UCC, but the following similar structures and issues exist regardless of the applicable law:
• A court may treat a lease as a financing transaction. Software and Services do not constitute goods under the UCC, and therefore, cannot be leased under the UCC (except software embedded in, and customarily considered part of, the Equipment or software owned by a person who acquires the right to use the program in connection with the goods). If a master lease is not treated as a lease, then the Funder will likely be treated as a lender rather than the owner of Equipment. This determination deprives the Funder of beneficial title to the Technology Items and may adversely affect its enforcement rights on lessee default.
• The Funder may not be able to compute damages arising out of the Equipment lease. This problem may arise in part because the single payment for all Technology Items in a bundled transaction differs from (and presumably is greater than) the payment due for damages pertaining solely to the lease of the Equipment. The Funder may have difficulty unbundling the single periodic payment to show damages for a Customer’s breach of the Equipment lease.
• A court may not enforce a lessor’s disclaimers of warranties. If the bundled master lease delivers Services and Software, as well as Equipment, the Customer may argue that the Lessor can not disclaim warranties on Services and Software that it delivers and warrants (or may appear to do so for the manufacturer) under the lease.
• Litigation may disclose proprietary blind pricing. Funder yields, and other pricing information in a bundling transaction, may be dismantled to allocate payments to the various items in the bundle. Funders do not want to provide information which may disclose business secrets. In addition, once a Customer knows about the true pricing, it may insist that the Lessor or Funder reduce payments as part of resolving a default.
• The Customer may challenge the “hell and high water” clause. If the Service provider fails to meet industry standards or the Software does not operate as promised, the Customer may stop all payments to the Lessor or Funder. As a result, this situation sets up a dispute between the Funder and the Customer of whether the “hell and high water clause” is effective in the particular transaction. In some U.S. or Latin American transactions, this clause may not even be included in documentation, depending on the sophistication of the parties and the desire of the Customer to be able to “choke the Lessor’s throat.”
*Term to Know: A “hell and high water” or “hell-or-high water” clause requires a lessee (like a Customer) to make payments to the lessor regardless of the lessor’s alleged breach of its obligations to the lessee. The clause is critical to Funders as it offers a high level of assurance that any alleged breach of the lease by the Lessor will not entitle the lessee to refuse to pay the rent to the Funder. Stated differently, if a Funder believes the lessee can refuse to make a lease payment when due because of a problem with the performance of the lessor, the Software or the Equipment, a Funder may refuse to enter into the transaction. A Funder may strictly be a passive lender or owner/lessor. Consequently, it typically will not take performance risks with respect to the Lessor or other supplier. See: “Leasing 101: The "Hell-or-High Water" Clause: A Critical Provision in Leasing,” Business Leasing News (July 2002).
• The Customer may assert that the Lessor is responsible for delivering all of the Customer’s rights to the licensed Software: If any dispute or other circumstances arise that limit or affect the Customer’s use of, or rights in, the Software, the Customer may insist that the Lessor transfer or deliver software rights it needs as if the Lessor were the manufacturer of the software. Even if the manufacturer has rights to the software, it almost never transfers more than a non-exclusive license to the Customer.
The various issues arising under a master lease structure underscore that it is not the optimal agreement for bundled transactions.
- Bundling Under a Severed Lease: In this structure, the lease is a separate agreement. It only covers the Equipment and other items that customarily may be considered part of the Equipment. The Equipment lease often covers related Soft Costs. The Software license and service agreements stand alone.
The Lessor usually retains the Customer contact. Funders in many instances remain in the background in a form of “blind” financing vis-à-vis the Customer. Funders can still collect rent or other payments pertaining to Technology Items, and pass the net sum on to the lessor, vendors, captive finance companies or manufacturers entitled to receive their portion of the payment. In other words, Funders may act as a collection agent for the Lessor, vendors, captive finance companies or manufacturers entitled to a portion of the bundled payment—until a serious money default occurs.
This structure partially unravels the bundled transaction. As a result, the Customer may express concern that the manufacturer, seller, deal or financing/leasing company is not providing the desired transaction. The Customer may also question the allocation of the payments to software license fees, services and rent, potentially forcing disclosures by the Funder of its true pricing and triggering more price negotiations. In the process of sorting out the components of the payments, the parties may encounter other issues similar to those arising under the standard master lease discussed above.
- Unbundling the Bundled Transaction: Little or no bundling occurs in this structure. Depending on several variables, each Technology Item is covered by its own separate agreement between the Customer and the vendor or manufacturer of the items, except that an equipment lease can cover other items that customarily may be considered part of the Equipment, such as certain Soft Costs. For example, the manufacturer of Software delivers the Software directly to the Customer under a separate software license, and the Customer pays for or finances the Software fees directly to the licensor.
*Tip: The parties can still develop structures that grant collateral security in Equipment, Software and other Technology Items in one transaction depending on the applicable laws and agreements of the parties. For example, in certain Latin American countries, a Customer can lease a license in Software. However, the Customer may not lease the Software directly from the owner of the Software.
Even if the Funder collects all payments as agent for the suppliers, manufacturers, captives or vendors, this structure essentially defeats the business objective of delivering a one-payment solution with all Technology Items in one agreement. Further, from a business point of view, the transaction may no longer be competitive with, and does not function as, a bundled transaction. Once unbundled, the Customer no longer has “one throat to choke.” It has to seek remedies against the counterparty to each agreement relating to the Technology Item. As a result, the transactions then open into separate Software licenses, service contracts (Services), secured transactions (financed assets), Equipment Leases (Equipment and Soft Costs) and supply agreements (Consumables).
*Insight Point: *Insight Point: For a bundling transaction to be competitive, Funders may have to take materially greater risks in legal structures to obtain higher yields frequently attained in bundled finance and lease transactions. Although Funders use a variety of structures that minimize their risk and maximize their economic returns, Funders often treat these transactions as unsecured loan transactions. They recognize that the Technology Items realistically have little or no residual value and should be treated as if the Customer is the borrower that owns or has superior rights to the Funder or Lessor in the Technology Items.
Three Top Structuring Points for All Bundled Structures
Regardless of the structure selected in a bundled transaction, each Funder and Lessor should:
- Use defensible residual values (value remaining at the end of the lease term) in pricing based on applicable tax, commercial and other laws to support the treatment of the bundled lease as a valid lease transaction.
- Agree to lease Equipment in a bundled transaction only if the Technology Items are critical to the Customer’s core operations. If so, a Customer is less likely to default, challenge the form or substance of a bundled lease transaction as a financing or take a risk that the Lessor or Funder will repossess the Equipment and/or shut down the Software functionality or connectivity.
- Request transaction approvals only if the transaction meets applicable credit, management team and performance criteria regarding each Customer, Equipment manufacturer, Software vendor and Service provider.
Funders and lessors in any market, including Latin America, strive to retain and satisfy the financing needs of their Customers. As more Customers in Latin America discover the apparent simplicity and business value of bundled lease transactions, Funders and Lessors there should, despite the inherent legal and business risks, experience a growing demand for these financial products.
By meeting the demand, manufacturers can increase sales; Customers can obtain financing or leasing solutions to support their equipment requirements; and Funders can potentially earn a higher yield on bundled deals than Equipment-only financing. In Latin America, as in the U.S., a bundled financing or leasing solution carries risks, but can provide substantial rewards for all parties.
2. Dodd-Frank Revealed: Five Questions for the New Bureau of Consumer Financial Protection
The historic Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act) paints a wide swath of new laws affecting virtually all financial institutions, domestic or foreign, operating under U.S. law.
Signed into law on July 21, 2010, the Dodd-Frank Act is merely the end of the first phase of the effort to modernize the U.S. financial regulatory system. The Dodd-Frank Act directs a number of federal agencies, including the U.S. Securities and Exchange Commission (SEC), the Federal Reserve Board of Governors (Federal Reserve), the Commodity Futures Trading Commission (CFTC) and the Federal Trade Commission (FTC), to undertake significant rulemakings to effectuate the goals of the legislation.
Key Elements of the Dodd-Frank Act
Patton Boggs LLP lists a number of key provisions of the Dodd-Frank Act in its paper titled, “Dodd-Frank Regulatory Rulemaking: Financial Reform’s Second Act.” The key regulatory elements include the following: (1) the establishment and regulatory authority of the Financial Stability Oversight Council (FSOC); (2) a new orderly liquidation mechanism for financial institutions; (3) changes in bank regulatory structure; (4) regulation of investment advisers to private investment funds; (5) regulation of the insurance industry; (6) prohibitions on proprietary trading and certain relationships with hedge funds and private equity funds; (7) regulation of over-the-counter derivatives markets; (8) a possible new fiduciary standard for investment advisers to retail customers; (9) regulation of credit rating agencies; (10) the establishment of the Consumer Financial Protection Bureau (Bureau or CFPB); (11) changes to the Federal Reserve System; (12) mortgage reform; (13) the Financial Crisis Assessment Fund; and (14) executive compensation. See the Firm’s explanation of these 14 points in its summary of the Dodd-Frank Act.
The CFPB: A Cornerstone of the Dodd-Frank Act
The Dodd-Frank Act established the new, independent Consumer Financial Protection Bureau within the Federal Reserve. On September 17, 2010, President Obama named Elizabeth Warren the assistant to the president and special advisor to the secretary of the Treasury on the Consumer Financial Protection Bureau. The CFPB has opened for business under her leadership. See “Elizabeth Warren’s New Consumer Financial Protection Bureau Opens for Business,” posted by Stephanie Eidelman, Forbes.com (Feb. 21, 2011). The CFPB offers an unusually friendly government website for consumers to use.
As part of the Federal Reserve System, the CFPB will regulate the mortgage industry, credit cards and other consumer financial products; work with the FSOC to identify and address systemic risks posed by large, complex companies, products and activities before they threaten the stability of the economy; and establish new regulations for the over-the-counter derivatives markets. The Bureau’s charge is to become, with certain exceptions, the chief federal regulator for all consumer financial products and services in the United States with the authority to define financial products, proscribe certain conduct and enforce its regulations.
In typical rulemakings, the applicable agency initiates the regulatory process and acts with a great degree of autonomy. However, the Dodd-Frank Act specifically enumerates a number of agency rulemakings that Congress will continue to monitor throughout the rulemaking process.
*Action Point: If you are an interested stakeholder, you should consider engaging with regulators and participating in the process that will produce these new rules and regulations that you can accept or at least understand.
Five Issues Congress Left to the Bureau
Patton Boggs LLP lists five key questions about the Bureau in its newsletter spotlight titled, “Dodd-Frank Regulatory Rulemaking: Financial Reform’s Second Act.” A paraphrasing of the questions follows:
- Is the Bureau’s rulemaking authority as broad as it seems?
Yes. The Bureau’s director “may prescribe rules and issue orders or guidance, as may be necessary or appropriate to enable the Bureau to administer and carry out the purposes and objectives of the federal consumer financial laws, and to prevent evasions thereof.” Simply put, the Bureau’s principal mission is to ensure “that all consumers have access to markets for consumer financial products and services and that those markets for financial consumer markets and services are fair, transparent and competitive.” This broad mandate means that virtually any consumer financial product or service, or any person offering such product or service, is likely to come under scrutiny, and potentially, regulation, even if the legislation does not explicitly provide for it. Examples include products and services offered by banks, credit unions, mortgage lenders, pawn brokers and other lenders. The Bureau will have the authority to adopt rules defining the types of financial consumer products, services and entities it will regulate and which ones will be exempted.
- Which products and services will the Bureau regulate?
The Bureau’s oversight authority over financial products and services is broad, encompassing a number of categories. These categories go well beyond traditional deposit-taking activities in banks and credit unions and extend to any non-depository covered person, such as debt collection, check cashing and financial advisory services. The Bureau must adopt a complex set of rules and guidelines to effectuate this regulatory scheme and consult with the Federal Trade Commission (FTC) when appropriate. The legislation explicitly excludes the business of insurance and electronic conduit services from Bureau oversight.
- What entities will the Bureau regulate and which entities will it exempt?
In addition to large banks and credit unions, the Bureau’s authority extends to any non-depository covered person, which is broadly defined as anyone who engages in offering or providing a consumer financial service or product covered in part under Dodd-Frank Act Section 1024(a); namely anyone who:
o “offers or provides origination, brokerage, or servicing of loans secured by real estate” for home mortgages or foreclosure relief (Dodd-Frank Act Section 1024(a)(1)(A));
o provides private educational loans (Dodd-Frank Act Section 1024(a)(1)(D));
o engages or is likely to engage in conduct posing a risk to consumers;
o offers payday loans (Dodd-Frank Act Section 1024(a)(1)(E)); or
o “is a larger participant of a market for other consumer financial products as defined by rule . . .” (Dodd-Frank Act Section 1024(a)(1)(B)).
*Action Point: Consult with your legal advisors to determine whether your institution is covered by or exempt from the Bureau’s regulations. Understand the scope of and plan for regulation of “consumer” financial services in which you may be involved.
The Bureau must adopt a rule in connection with this last category in consultation with the FTC and within one year of the yet-to-be determined date on which all financial consumer protection is fully vested in the Bureau. The Bureau will have to establish rules to facilitate its supervision of these entities. This could include requiring background checks on all principal officers, directors or key personnel to ensure that the entity is able to perform its obligations.
The legislation also sets forth specific exemptions from the Bureau’s oversight authority, such as persons regulated by the SEC, retailers, accountants and auto dealers. Review these exemptions with your legal advisors to determine whether you fall within an exemption.
Additionally, the Bureau may adopt rules to exempt any class of covered persons, service providers or financial products from its jurisdiction as it finds “necessary or appropriate to carry out the purposes and objectives of this title.” In so doing, the Bureau must take the following factors into consideration: 1) the total assets of the class of covered persons under review; 2) the volume of transactions; and 3) the extent to which existing law protects consumers.
While Congress provided the Bureau with this starting point, the weight that each of these, or other factors, will have in the rulemaking process remains largely within the Bureau’s discretion. The Bureau’s Director will inevitably play an important role in setting the course at the Bureau…
*Tip: You may be able to qualify under a listed exemption or one that is set forth in rules created by the Bureau.
- What are unfair and abusive practices and how will the Bureau regulate them?
The Bureau may, but is not required to, adopt rules making it unlawful for persons and entities subject to its authority to engage in any “unfair, deceptive, or abusive” act or practice in connection with the offering or provision of a consumer product or service. Unlike many federal agencies, the Bureau will have the authority to prosecute violations of its rules by, among other things, bringing administrative actions to obtain cease and desist orders or filing civil actions in U.S. District Courts.
The standard for determining that an act or practice is unfair is subjective in that the Bureau must have “a reasonable basis to conclude” that: 1) an act or practice causes or is likely to cause substantial and reasonably unavoidable injury to consumers, and 2) the substantial harm to consumers does not outweigh the benefits to consumers or competition. While the Bureau may consider “established public policies,” these policies may not be the primary basis for any decision. In determining that an act or practice is abusive, the Bureau must show that it “materially interferes” with the consumer’s ability to understand a term or condition of the product or service to the point that the transaction takes unreasonable advantage of the consumer’s “reasonable” reliance on the provider of the product or service to act in the interest of the consumer.
- How Will the Bureau Coordinate its Supervisory and Enforcement Authority Over Very Large Banks, Savings Associations and Credit Unions?
The Dodd-Frank Act grants the Bureau exclusive authority to require reports from, conduct examinations of, and enforce federal consumer laws against the nation's largest insured banks, savings associations and credit unions (those with assets in excess of $10 billion). The transfer of this authority from the prudential regulators (the FDIC and the NCUA) and state bank regulatory authorities to the Bureau ushers in a new regulatory regime for these “very large” institutions. To minimize the regulatory burden on these institutions, the legislation requires the Bureau to coordinate its rulemaking activities with the prudential regulators and state regulators. It is not clear, however, how this will work in practice. The Bureau will develop guidelines for the content of its required reports and use its discretion in determining what information it will require to effectively monitor these institutions and in what form the information must be presented.
For a more expansive treatment of the five issues, see Bureau Authority.
Not only is the Dodd-Frank Act historic, it is also a massive piece of legislation. The formation of the Bureau enables the government to establish potentially extensive and burdensome rules designed to protect consumers from improper actions by covered financial institutions. Congress gave the Bureau enough authority to create a potential minefield for nearly all financial institutions. If the Bureau enforces its rules as expected, the most cost-effective way to address them may be to engage in a rigorous discussion before they are finalized by the Bureau.
Thanks to Joshua C. Greene and Matthew B. Kulkin for contributing this article. Josh is a public policy partner, and Matthew is a public policy and business associate in the Firm’s Financial Services and Products practice. They work in the Washington, DC office.
3. Codified Economic Substance Doctrine Creates Uncertainty in Tax-Oriented Transactions
Would you close a transaction motivated in part by the use of tax benefits and also by pre-tax profit? Would you change your mind if you could not be sure whether the Internal Revenue Service (IRS) might attack your deal as abusive under applicable tax law?
Congress clouded these issues last year when it enacted a statutory version of the economic substance doctrine (ESD), codified in IRC section 7701(o).
IRC section 7701(o) generally provides that a transaction will be treated as having economic substance only if “(A) the transaction changes in a meaningful way (apart from federal income tax effects) the taxpayer's economic position, and (B) the taxpayer has a substantial purpose (apart from federal income tax effects) for entering into such transaction.”
Violations of the ESD are now subject to a strict liability penalty (20 percent of the tax due with, and 40 percent without, disclosure), and under a new pretax profit test (PPT), the present value of a transaction’s reasonably expected pretax profit must be substantial in relation to its expected net tax benefits.
Widely divergent interpretations exist of how the new present value requirement may be implemented. For example, views of tax experts differ as to which discount rates apply and whether indirect financing costs (including, potentially, the cost of both equity and debt capital) may be attributed to transactions.
It has become clear that transactions that are not otherwise abusive may be subject to the codified ESD and violate the PPT under some of these interpretations but not others. See the New York State Bar Association’s (Tax Section) “Report on Codification of the Economic Substance Doctrine” (Jan. 5, 2011).
*Warning: Until the Internal Revenue Service (IRS) clarifies the PPT, tax advisers must struggle with how they can render favorable ESD opinions.
In many cases, tax advisers may need to interpret the PPT without having much precedent. Even if not otherwise required, tax advisers should nonetheless consider opining on the ESD issue because there may only be a few other effective ways to communicate the risk of failing to satisfy the PPT. They may also generally need to recommend full disclosure of the transaction to the IRS in order to avoid the risk of the 40 percent penalty.
Section 7701(o) provides a way to avoid satisfying the PPT. Transactions to which the common law ESD are not “relevant,” including transactions that are clearly consistent with congressional intent, are not subject to the codified ESD and related penalties.
*Insight Point: Many tax advisers believe this escape path is open to transactions, such as renewable energy investments, that are eligible for the tax credits or Treasury cash grants in lieu of credits.
In general, the Tax Court’s recent decision in Historic Boardwalk Hall v. Commissioner, 136 T.C. No. 1 (2011), supports this view. Because of the many ways in which the tax equity investor in that case was protected against loss, however, its favorable holding was certainly not predicted by the IRS. Tax advisers should be vigilant in identifying aspects of a transaction, especially tax equity financing transactions which could be considered abusive.
Should you enter into a transaction that might be deemed abusive by the IRS? You may, but do so with close analysis of the ESD, and pay attention to your audit position should the IRS come calling.
Thanks to , partner, Piedmont Law Partners, for submitting this article.
4. As the FAA Implements Re-Registration of More Than 350,000 Aircraft, Will Chaos Prevail?
Has the requirement that owners re-register their aircraft with the Federal Aviation Administration (FAA) triggered chaos in the aviation world? While the FAA seems to be managing re-registration in an orderly manner, the potential for severe consequences for owners lingers in the bureaucratic process for those who fail to comply.
The FAA believes that about one-third of the 357,000 registered aircraft registrations are incorrect. It reports that incomplete or erroneous registrations impede the efficiency of government and law enforcement. To mitigate these concerns and restore the integrity of its registration database, the FAA decreed that all existing registrations will expire and must be re-registered.
Effective October 1, 2010, the FAA began to force aircraft owners to comply with its final rule titled, “Re-Registration and Renewal of Aircraft Registration,” 75 Fed. Reg. 41968 (July 20, 2010). This new rule gives law enforcement agencies access to accurate records, thereby improving the efficacy of their missions. It also allows the FAA and manufacturers to reduce costs in mailing Airworthiness Directives, safety notices and surveys to aircraft owners, thereby improving aviation safety through more reliable notification.
How Re-registration Works
Because of the scope of this undertaking, the FAA decided to stagger the re-registration schedule, based on the month the aircraft was initially registered, and to provide a lead time to register to allow the FAA enough time to handle the workload. For example, if an aircraft was registered in March of any year, the registration expires March 31, 2011 (six months from the effective date of the final rule).
*Warning: If you own an aircraft registered in March of any year, you should have already applied for registration between November 1, 2010, and January 31, 2011 (a 90-day window).
For registrations initially made in April of any year the expiration date is 3 months later (June 30, 2011), and the 90-day window starts on February 1, 2010, and ends on April 30, 2011. Under this schedule, the last stage of registrations, for aircraft initially registered in February of any year, the registration will expire December 31, 2013. The complete expiration and re-registration filing schedule is contained in revised 14 C.F.R. 47.40(a), 75 Fed. Reg. 41982.
The FAA believes it will have enough time (90-day filing window plus 60 days before expiration) to process an application and issue and deliver a certificate of registration, and no critical backlogs in registration, renewal or normal workload are expected as a result of this final rule.
However, the FAA makes no guarantee that it will complete the process in all cases within this time period. And, if an aircraft is not re-registered by its expiration date, the aircraft must be grounded until the FAA issues a certificate of registration. Should the Federal Government be forced to “shut down” because of a failure to enact a continuing appropriation, it is uncertain whether FAA Aircraft Registry personnel would continue to go to work like air traffic controllers and safety inspectors
Registrations will be required to be renewed once every three years. An expiration date will be provided in the new certificate of registration. Owners will be required to apply any time within six months before the expiration date.
There is no provision for a “pink slip,” as is used when aircraft ownership is transferred by purchase. Thus, it is imperative that aircraft owners apply for registration within the filing window—earlier rather than later. There is no provision in the rule to obtain an extension of time.
*Action Point: If you own an aircraft subject to this rule, you should correct or update any registration information as soon as possible. Check the schedule for re-registration that applies to your aircraft. Title companies and aviation lawyers, among others, can help you complete this registration. You can re-register online. However, online processing is available only if there are no changes to the registration information (e.g., name and address of owner). A paper filing must be done to reflect any changes.
The FAA will send out notices about six months before a registration expires, which will provide instructions on how to file, including the code to be used to file online. This is another reason for aircraft owners to verify the address on their current registration, because if it is incorrect, the owner may not receive this notice. Aircraft owners can track their registration status and obtain other information at the FAA webpage, FAA Registry – N-Number Inquiry.
Cancellation of Registration
Owners who do not apply within the filing time window will receive a dunning notice from the FAA soon after the window closes. A second dunning notice will be sent if an application has not been filed by the expiration date. This notice will inform the owner that the aircraft must be grounded pending re-registration. The FAA will likely wait before actually canceling the aircraft registration, but under the rule the aircraft must be grounded after the expiration date, without regard to when the FAA gets around to canceling the registration.
Grounding an aircraft on account of a failure to obtain a new registration certificate has many collateral consequences. An owner may lose its N-number, thereby triggering the costs to repaint the aircraft and change relevant documents. There may be insurance implications resulting from the failure to comply with an explicit rule to keep the aircraft registered under the insurance policy covering the aircraft. If the aircraft is leased or financed, loss of registration could constitute a default and subject lessor and lenders to a variety of commercial risks, such as the issue of whether a security interest in an unregistered aircraft remains valid if the aircraft is de-registered.
With this final rule, aircraft registrations will no longer be effective indefinitely (or until the aircraft is sold or deregistered). For now, however, FAA lightening will not strike the aircraft with an immediate cancellation of registration upon a failure to re-register by the due date, but owners should not wait for storm clouds to appear on the horizon.
Thanks to Greg Walden, a former FAA chief counsel, practicing in the Transportation and Infrastructure practice group in the Firm’s Washington, DC office, for contributing this article.
5. Leasing 101: What is the “Lease Accounting Project?”
Most U.S. lessees enjoy lease accounting rules that allow them to keep “operating leases” off their balance sheets. The good times appear to be coming to an end, and could force organizations to put approximately a trillion dollars of lease obligations back on their balance sheet within the next few years. See Leases may move to balance sheets in proposed rule, Reuters (Aug. 17, 2010).
The International Accounting Standards Board (IASB) and the Financial Accounting Standards Board (FASB) have been engaged in a joint project to overhaul current lease accounting rules under the Statement of Financial Accounting No. 13 (FAS 13). The FASB issues U.S. accounting rules, and the IASB sets accounting standards for over 100 countries. They published their proposals in an Exposure Draft for Leases on August 17, 2010 (ED). The IASB and FASB may issue a final standard this summer.
The mission of the project is to harmonize FASB’s lease accounting rules and the lease accounting standards of the IASB. The FASB, the Securities and Exchange Commission (SEC) and the IASB expect to replace FAS 13 with provisions consistent with leasing guidance in effect under the auspices of the IASB.
The proposals contained in the ED would limit the use of off-balance sheet accounting, which has generated trillions of dollars in lease financing. For years, the FASB, the SEC and the IASB, among others, have complained that off-balance sheet lease accounting rules in the U.S. promote a lack of transparency in disclosing total obligations of lessees, mislead investors regarding actual payments of rent and other obligations of lessees under operating leases, and permit, if not encourage, lessees to game the rules to claim the benefits of off-balance sheet lease accounting.
The ED contains proposals requiring lessors and lessees to account for leases under a “right-of-use” model instead of classifying leases under FAS 13 into two categories: capital leases (which recognize assets and liabilities), and operating leases (which do not recognize assets and liabilities). If adopted, the changes will result in the capitalization of all lease obligations on the lessee’s balance sheet. In addition, the new rules would eliminate leveraged lease accounting, which has encouraged capital investment and benefited leasing for decades. These changes would occur without the “grandfathering” of transactions existing on the date of initial application of the final rules.
*Action Items: As the FASB prepares to issue a final rule around June 30, 2011, consider taking the following additional steps to minimize the surprise on the part of lenders and other lessors if you:
- Assess the potential impact of the Project on your balance sheet, lease documents and/or loan documents.
- Prepare for a potential reduction in availability of loans or lease line advances.
- Renegotiate terms in your loan, lease and other documents or at least obtain prospective waivers now in anticipation of the changes resulting from the completion of the Project
- Follow pronouncements by the FASB concerning transition rules that may force you to recharacterize and/or report your lease transactions, including those you think should be unaffected.
- Review your leverage and other negative financial covenants before and after FASB finalizes the rules arising out of the Project.
- Check your representations, warranties and covenants in your current lease and loan documents to assure that, when given, your representations, warranties and covenants remain true and accurate.
- Contact counsel or an accountant so you can remain informed on the effect of the Project as its final rules transitions into full force and effect.
The FASB has long considered making substantial changes to its lease accounting rules. Although in the past FASB has not finalized a proposal for that purpose, it seems more likely to achieve its goal this time in collaboration with the IASB. If FASB succeeds, leasing, as it now exists, will face a world of change. However, the latest Duke University/CFO Magazine Global Business Outlook Survey finds that only 22.9 percent of Chief Financial Officers are ready to comply with these changes. See IFRS Outlook: Hurry Up and Wait, by David M. Katz, CFO.com (March 11, 2011).
Thanks to Shawn Halladay, Alta Group, Managing Director – Professional Development, for editing this article.
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