In a recent article in Equipment Leasing Today (ELT), the Equipment Leasing Association monthly magazine, ELA President Mike Fleming observed: "Not every company is going to originate business internationally. But most companies can find a role to play that will increase growth, diversify their business and bring profitability." See: Industry Talk and Silence - What’s been on lessors’ minds this winter and spring, ELT at page 26, 36 (May 2005).

International Opportunities

Although Fleming suggests that the leasing industry has been relatively silent about international transactions, certain lessors and lenders in the asset-based lending (ABL) community have been actively structuring and developing international transactions. These transactions focus on asset-intense, middle market companies located outside the U.S. For these entities, local banks do not serve transactions that outstrip their credit authority. In contrast, the high-profile public or multinational transactions overlook these companies because their needs are too small for the affected players.

*Opportunity Point: In the international/non-U.S. markets, companies representing sub-investment grade credits with transactions ranging from $50 million to $300 million present the greatest opportunity for ABL lenders and lessors. A significant component of these transactions often includes machinery and equipment (M&E) and potentially software, which U.S. lessors can finance in properly structured transactions. See: Cross-Border ABL Market: Multinational Platforms Support Expanding Needs, by Paul De Domenico, abfjournal at p. 6 (July/August 2004). U.S. manufacturers increased foreign direct investment abroad in 2005 after three flat years, to more than $54 billion, according to Deloitte Research. The investment surged in highly developed markets such as Western Europe, the Asia Pacific Region and Canada, while investment declined in low-wage economies such as China and India. See: U.S. Investment Overseas Up 90 Percent -Companies are not ramping up these investments strictly to save on wages, the study also found; 81 percent is directed at high-wage, developed markets, by Stephen Taub, CFO.com (June 3, 2005).

Types of Cross-Border or International Transactions

Several different types of marketing approaches exist to originate international transactions. Fleming suggests two of them, in which lessors:
 

• Follow their customers outside the U.S. where the customers expect to increase the percentage of volume of their business and investment over the next five years; and

• Establish relationships with non-U.S. companies (through joint ventures or other collaborative arrangements) and act as a referral source for transactions initiated outside the U.S. for completion inside the U.S.

Lessors, ABL lenders and equipment lenders will also:

• Create local operating companies outside the U.S. to do business in the foreign jurisdiction where the operating unit is located (for example, an Irish bank does business in Europe using its base of operations and licensing in Ireland); and

• Finance inbound U.S. transactions with elements of risk and assets in U.S. and/or foreign markets, such as a U.S. subsidiary of a foreign company (a gambit that multinational finance companies and banks will likely dominate for the foreseeable future, and should improve spreads and asset-based financing opportunities).

A Few Primary Risk Factors

Fleming notes in his comments that U.S. lessors remain largely silent about internationalizing leasing. Perhaps lessors still see an ample market in the U.S. However, after all the regulatory challenges in the U.S., the various attacks on leasing ranging from the Enron to Norvergence cases, and SEC, State Attorney General and IRS scrutiny of leasing transactions, it’s clear that leasing has lost some of its luster. See: BLN Case & Comment: Norvergence Strikes Again - Preferred Capital, Inc. v. Thomas E. Strellec, by David G. Mayer, Business Leasing News (March 2005). This situation has given rise to financing equipment more often than entering into true leases. Further, lessees and borrowers continue to gain more knowledge of lease pricing and still have the benefit of relatively low interest rates that propel borrowing instead of leasing.

Despite these challenges, leasing still has considerable tax pricing power, residual play, syndication and securitization potential and equipment/risk management attributes. Each of these elements can be managed in international transactions with the willingness of the parties to address them methodically, if not slowly, under local laws and business practices. In general, the unique aspects of a country’s legal system must be addressed as the primary risk factor in each foreign transaction. See: What Are the Top Five Issues in Cross-Border Transactions? By David G. Mayer, Business Leasing News (March 2004).

Other Challenges in International Transactions

Some of the transaction and pricing efficiencies of the U.S. market are spreading around the world. For example, business aviation financing in Europe provides margins for lenders and lessors that rival the existing slim returns over cost of funds in the U.S. However, for many transactions, the returns remain favorable for lenders and lessors, due in part to unique challenges in international markets and the lack of needed credit for growing companies. These challenges include the following:

• Regulatory, Ownership and System Risk. Many countries have complex regulatory regimes that require licensing or other permits and approvals to do business, increasing compliance and transaction costs, regulatory scrutiny and transaction time, coupled with a lack of a predictable, consistent and user-friendly judicial system. The formation by a U.S. company of a foreign subsidiary or affiliate often requires that local interests own a certain portion of the foreign entity, affecting control and operational issues.

*Tip: It is critical to identify capable local counsel to assist with formation, regulations, licensing, approvals and permits, with overall U.S. counsel coordinating and reviewing the input in the English language (translated if necessary for certainty and analysis).

• Tax Consequences. In virtually every cross-border ABL and leasing transaction, the parties should consider withholding taxes on interest or rents, which can increase finance costs for the customer. Further, where a U.S. parent seeks financing for an asset-rich subsidiary abroad, the ABL transaction may trigger deemed dividends under Section 956 of the Internal Revenue Code of 1986, as amended, and impose additional income on the parent company. Property, value-added and other sales taxes add cost and compliance elements to transactions.

*Tip: As a U.S. or foreign participant in these transactions, retain internationally capable tax counsel to assist in the analysis and structuring of transactions to minimize or eliminate the impact of cross-border taxes. These taxes can, if not properly managed, impair the pricing benefits for all parties. Strong tax indemnities should be included in favor of the financing parties. For cross-border tax-oriented leases, such tax counsel would be indispensable, especially as many large ticket structures have been attacked as a tax abuse or in violation of local law.

• Secured Transactions and Leasing Laws. Aside from the Uniform Commercial Code (UCC) in the U.S. and the Personal Property Security Act (PPSA) in Canada, most foreign markets do not afford a simple approach to creating, perfecting and enforcing security interests in a financing lease or ABL loan involving equipment or other assets. The parties often must spend more time structuring these transactions in foreign markets to accomplish approximately the same or similar results as they obtain under the UCC or PPSA. Certain common leasing provisions and structures face challenges in foreign markets. For example, Peru or Colombia may not enforce the critical "hell-or-high water" clause. Other countries will treat a lease containing any fixed purchase option as a financing instead of a true lease.

*Warning: Transaction parties may incorrectly assume that they can require adherence to a choice of law and submission to a particular U.S. court, such as New York, or a neutral foreign market such as the U.K. In any enforcement action, you should expect foreign authorities and courts to review and perhaps openly resist these provisions based on public policy and local procedure. Moreover, a judgment could be rendered in a foreign currency, which could impose a separate and significant risk on a U.S. lessor or lender in today’s volatile currency exchange markets. Currency indemnities, which require conversion to, or equivalent payment in, U.S. Dollars should help mitigate currency risk for U.S. financial institutions and finance companies.

International Treaties Improve Legal Structure

As new international treaties enter into force, asset-based transactions, whether as leases or loans, should continue to spread. For example, the approaching effectiveness of the Cape Town Convention relating to high-value mobile equipment, such as aircraft and engines, will ease the challenges of completing transaction in foreign jurisdictions. See: Aviation Finance Players Focus on Potential Impact of Cape Town Convention, by David G. Mayer, Business Leasing News (March 2005).

Other conventions that should facilitate international transactions include:

• Model Secured Transactions Law - European Bank for Reconstruction and Development (EBRD) (Secured Transactions Project)

• 2005 Model Inter-American Law on Secured Transactions (OAS)

• Convention on International Financial Leasing (Ottawa, 28 May 1988) - Institute for the Unification of International Private Law (UNIDROIT)

Bright Future for the Informed and Active

Almost no one will suggest that closing international transactions represents a slam-dunk opportunity to expand leasing and loan volume. However, the future should be bright for those who today forge ahead into the international markets, create foreign operations for local transactions abroad and acquire the knowledge of how to structure and close cross-border and international transactions successfully. The globalization of business is a given. The question for U.S. lenders and lessors is when they will jump on board to claim their share of its current and future profits.

2. Amid Controversy, Reagan Airport to Reopen to Business Aviation

Reagan Washington National Airport (DCA) will soon reopen for business aviation, but with extreme limitations. On May 25, 2005, the Department of Homeland Security announced the reopening long sought by general aviation. DCA has been closed to most business flights since September 11, 2001, because of heightened security in the Washington, DC area. The security controls that will be a part of any renewed access reflect the government’s lingering concerns. Only 48 flights into DCA will be allowed each day from only twelve "gateway" airports. The gateways are: Seattle-Tacoma; Boston Logan; Houston Hobby; White Plains; LaGuardia; Chicago Midway; Minneapolis/St. Paul; West Palm Beach; San Francisco; Teterboro; Philadelphia; and Lexington, Ky. Flights from other airports will have to stop at one of the gateways before proceeding to DCA. Operators and crews must be registered and qualified in advance.

*Tip: Participants in the Transportation Security Administration Certificate (TSAC) program may have an advantage. The Transportation Security Administration (TSA) and the National Business Aviation Association have created a TSAC program at several airports, which may provide the covered personnel with an advantage because their crews have already undergone background checks.

TSA screeners will also inspect the crews, passengers, baggage and aircraft before departure. Passenger and crew manifests will have to be submitted 24 hours ahead. Finally, an armed law enforcement officer will have to be on board each flight. General aviation flights are expected to resume about 90 days after TSA publishes an interim final rule in the Federal Register.

*Prediction: Few will be satisfied with this rule. The limited number of gateways makes it inconvenient. Operators will incur substantial expense in making extra stops, using only pre-qualified crews and paying for law enforcement officers to ride on their aircraft. Some will find the TSA inspections intrusive.

This approach of TSA is unlikely to be the last word in this long-running story, but it clearly is a step in the right direction for general aviation’s relationship with the security establishment in the U.S. Rep. Edward Markey (D-Mass.), a senior member of the House Committee on Homeland Security, recently criticized the TSA plan to reopen Reagan National Airport to general aviation; so, the issue remains in play.

Thanks to our partner Steve McHale, formerly Deputy Administrator of TSA and member of our Aviation Team, for contributing this article.

3. IRS Issues Rules to Reduce Deductions for Personal Use of Company Aircraft

The Internal Revenue Service published IRS Notice 2005-45 (Notice) last month as interim guidance on the tax consequences of personal use of company aircraft under the Internal Revenue Code of 1986, as amended (Code). The new rules tightly restrict deductibility of expenses when certain executives and owners of companies use their company aircraft for personal entertainment, amusement or recreational reasons. The rules will remain effective until the IRS promulgates regulations, which should follow the conceptual framework of the Notice.

*Tip: The more restrictive tax rules impact executives just as the Securities and Exchange Commission (SEC) has increased pressure for disclosure of the costs of personal use by executives of public companies. The combined regulatory scrutiny will likely cause companies to reconsider whether to allow personal use of their aircraft or, if such uses continue, how much compensation they impute to the owners and executives for their personal use. Also, companies may reconsider the leasing option rather than buying their own aircraft if leasing can minimize the increases in compensation for their owners and executives needed to allow full deductions of expenses for personal trips. See: Amid Crackdown, the Jet Perk Suddenly Looks a Lot Pricier, For CEOs, Personal Flight Costs Can Reach Six Figures; Their Tax Bill Stays Low, by Mark Maremont, The Wall Street Journal, S.W. Ed., Page A:1, Col. 5-6 (May 25, 2005).

Change in Law - What Happened to the Old Way?

The shift in the law occurred on October 22, 2004. Section 907 of The Jobs Creation Act of 2004, Public Law No: 108-357 (Act) amended Section 274(e) of the Code. Before the change, a company could deduct all of the expenses attributable to personal use of its aircraft if the users were treated as receiving compensation for their use, which frequently amounted to significantly less that the actual operating expenses incurred by their company. After the change, the Act limited a company's deduction to the dollar amount actually treated as compensation to the users. See: Case & Comment: Jobs Act Ends Sutherland Lumber Aircraft Deductions, by David G. Mayer, Business Leasing News (Nov. 2004).

*Technical Point: Under Section 274(a)(1)(A) of the Code, no deduction is allowed for entertainment, amusement or recreation, unless the taxpayer establishes that the activity is directly related to or, in certain cases, associated with the active conduct of the taxpayer's trade or business. Section 274(a)(1)(B) of the Code disallows deductions for facilities (including business aircraft) used in connection with entertainment, amusement, or recreational activity, regardless of the connection to the taxpayer's trade or business. The Notice does not address other uses of aircraft, such as to take a chief executive officer (CEO) to a meeting of an unrelated board of directors on which the CEO serves, that are not for entertainment, amusement or recreation.

Who Is Affected by the Change in Law?

Amended Section 274(e) describes the "specified individual" whose personal use (rather than business use) of the aircraft triggers the more restrictive rule. A person is a specified individual if he or she is subject to Section 16(a) of the Securities Exchange Act of 1934, or would be subject to that section if the company were a public issuer under that section. By using Section 16, the Act generally covers officers such as the CEO, chief financial officer (CFO) and even vice presidents (with decision authority) along with directors and 10+% equity owners. Though often seen as a large C-corporation issue, the rules also apply to specified individuals of S-corporations, personal service corporations and partnerships. A director or officer of a tax-exempt entity is also a "specified individual." The Notice also treats a spouse, a family member and others as "specified individuals." See: Treas. Reg. §1.61-21(a)(4) and Executive Compensation - Fringe Benefits Audit Techniques Guide (IRS 02-2005).  The Notice clarifies that the rules apply to personal use of aircraft of related parties, such as a specified individual in one company using the aircraft owned by a sister company in a corporate group.

The Notice provides two methods for allocating expenses to personal uses - "occupied seat hours" and "occupied seat miles." It also requires that the chosen method be used for the whole taxable year. These terms mean the total number of hours (miles) flown by the aircraft multiplied by the number of seats occupied for each hour (mile).
*Example: Five passengers on a four-hour personal use flight (covering 1,600 miles) would create 20 occupied seat hours (5 passengers x 4 hrs. = 20 occupied seat hours) or 8,000 occupied seat miles (5 passengers x 1600 miles = 8,000 occupied seat miles). Note that a deadhead flight (no passengers) creates an additional 20 hours (8,000 miles) of personal use in this example.

How Do You Figure Trips With Both Non-Business and Business Use?

The Notice provides a specific rule for allocations involving a trip with both business and personal use legs. The personal use expense is the excess of the total expenses allocated to all flight legs over what would have been the expenses without the personal use legs of the trip. To illustrate, a business trip to one city followed by a personal use trip to a second city and then home would require the occupied seat hour (mile) computations for all the legs to be compared to just the out-and-back-legs for the one-city business trip. The excess of expenses for all the associated legs over just the out-and-back legs is allocated to personal use.

*Technical Point: For a company with multiple aircraft, you can make the allocation of expenses plane-by-plane or aggregated for aircraft with "similar cost profiles," but the Notice explicitly prohibits aggregating a jet with a turboprop or a twin-engine jet with a four-engine jet.

Covered Expenses

The restrictions set out in the Notice apply to "...all expenses of maintaining and operating the aircraft (all fixed and operating costs)." The non-exclusive list includes:

• depreciation (and Code Section 179 small business expensing);

• management fees, fuel, salaries for pilots and other personnel plus meals and lodging of flight personnel, airport fees and maintenance;

• for charters, expenses include all costs paid by the company; and

• for leased aircraft, lease payments by the company.

Annual Calculation of Expenses for Personal Use

When a company computes the total annual expenses for an aircraft, the expense per occupied seat hour (mile) is determined by dividing the aggregate expenses by the total annual hours (miles) for the year. This dollar amount is then multiplied by the corresponding personal use for specified individuals to determine the maximum amount subject to the disallowance rule.

*Example: If a taxpayer's aircraft is determined to have an expense per occupied seat hour of $2,000 and all of the specified individuals had total personal uses of 400 hours for the year in that aircraft, the total personal use expense is $800,000 for the year.

Prior to the Act, the law would have allowed full deductibility by the company of the $800,000 if the specified individuals had been treated as receiving compensation from the company (generally far less than the $800,000). Under the Act, the new provision prohibits the deduction of expenses in excess of the dollar amount actually treated as compensation to these individuals for their various flights. As a result, if the total compensation imputed to the users equals $300,000, the company will be limited to $300,000 of deductions for personal use flights for the year and $500,000 will not be deductible. This non-deductible portion increases the after-tax cost of the use of the company aircraft.

*Technical Point: If a specified individual reimburses the company for some expenses, the reimbursed amount reduces the non-deductible amount. As a result, if a CEO writes a check to the company in the preceding example for $500,000, the company has no increased cost associated with non-deductible expenses and can say it could fully deduct the company's cost. This approach enables companies to minimize the appearance of spending large amounts on non-deductible executive perks.

Aircraft users have generally received some income attributable to their personal use fringe benefit under a formula called the Standard Industry Fare Level (SIFL) rates (that is, cents-per-mile rates and terminal charges). See: Treas. Reg. 1.61-21(g)(5). The Notice makes a significant change regarding the calculation of income. Currently, the regulations require a taxpayer to use the SIFL formula for all employees during the year if that method is used for any single employee. The Notice indicates that the regulations will be amended to allow a taxpayer company to apply a fair market value to personal uses by specified individuals. At the same time, a company may apply SIFL to all other users.

*Comment: The IRS may be encouraging companies to increase compensation to presumably high marginal rate individuals, but this special rule may also provide the SEC with a way to harmonize its views on pricing of executive perks with the IRS rules, by pushing for fair market value benefits and disclosure of those benefits.

Prior to the changes in the Act, users of company aircraft had a sweet deal on personal use of the company plane. Now, the cost that may be imposed by the Act and Notice may leave a bitter taste in the mouths of those who use company aircraft for personal reasons.

Thanks to Cliff Massa of our Tax and Tax Policy Groups for contributing this article and to George Schutzer of our Tax Group for his comments on this article.

4. Leasing 101: What is an "AS IS" Sale?

When a lessor leases or a company finances equipment such as a computer, a printing press or aircraft, the lessor or company often buys the equipment "AS IS" or "AS IS, WHERE IS" or even "AS IS, WHERE IS AND WITH ALL FAULTS." These words seem clear don’t they? An "AS IS" sale occurs when the buyer (Section 2-103(a)) purchases without any warranties absent fraud; and the seller (Section 2-103(d)) makes no warranties to the buyer. It’s "buyer beware".

But are these ideas really true in all sales? No, they are not; and the seller should watch out because these words don’t carry the plain meaning you would expect in certain sales of goods (Section 2-105). The term goods includes equipment under Article 2 of the Uniform Commercial Code-Sales (UCC).

Implied Warranties

An implied warranty is a type of promise by a seller to a buyer. A buyer receives this promise automatically by operation of law in certain sale transactions. Two types of implied warranties exist. The first implied warranty is commonly called a "warranty of merchantability"—Section 2-314.  The second type of implied warranty is often called the "implied warranty of fitness for a particular purpose"—Section 2-315. A seller can use the "AS IS" type language to disclaim implied warranties (that is, exclude them)—Section 2-236(3)(a).

*Technical Point: Section 2-314 (merchantability warranty) says: "…[A] warranty that the goods shall be merchantable …(arises) if the seller is a merchant with respect to goods of that kind." Note that only merchants of goods, such as equipment, of the type involved in the sale transaction can give this implied warranty. Section 2-104(1) defines a "Merchant" as "a person who deals in goods of the kind or otherwise by his occupation holds himself out as having knowledge or skill peculiar to the practices or goods involved in the transaction…." For example, a broker who sells printing presses for a living is likely to be treated as a merchant in goods such as printing presses. To exclude or modify the implied warranty of merchantability or any part of it the language must mention merchantability and in case of a writing must be CONSPICUOUS—2-316(2).  The fitness warranty provides: "Where the seller at the time of contracting has reason to know any particular purpose for which the goods are required and that the buyer is relying on the seller's skill or judgment to select or furnish suitable goods, there is …an implied warranty that the goods shall be fit for such purpose." To exclude or modify any implied warranty of fitness, the exclusion must be by a writing and must be CONSPICUOUS (bold, capitalized or highly visible words in a document)—2-316(2).

Express Warranties

Try as a seller might, a seller usually can’t kill off an express warranty—Section 2-317.  An express warranty is an affirmation of fact or promise made by a seller which becomes a basis of the bargain in a sale transaction with a buyer. A seller can make an express warranty by showing a sample or model to the buyer of the equipment a buyer decides to buy or by merely describing the item to the buyer in an invoice that becomes a part of buyers decision to buy. Section 2-313. A seller can make an express warranty without saying that it "guarantees" or "warrants" the equipment—Section 2-313(2). For example, by showing a buyer a book binding machine in a showroom and/or describing it in an invoice as a "1994 Brehmer Saddle Stitcher, Model S1000 C", the seller makes an express warranty as to that specific type of item. It’s difficult to disclaim this warranty. Consequently, if a buyer received a 1992 machine instead of the 1994 binder that it relied upon in making its buy decision, the seller may have breached its express warranty.

Warranties of Title

Another type of warranty exists. It also arises by operation of law, but is not treated the same as the implied warranties. It is commonly called a "warranty of title"—Section 2-312. It generally protects the buyer by requiring that the seller rightfully transfers the equipment with good title, free of liens, encumbrances or security interests. However, like the implied warranties, a seller can disclaim this warranty. Section 2-312(3) provides such a warranty "will be excluded or modified only by specific language or by circumstances which give the buyer reason to know that the person selling does not claim title in himself or that he is purporting to sell only such right or title as he or a third person may have."

*Warning:  When closing transactions, the parties often exchange purchase agreements, invoices and/or bills of sale with warranties and disclaimers in them with little or no review, such as the sale is made "AS IS."  The language often tracks the UCC. Don’t take these provisions for granted. Ask your counsel to make sure that as a lessor or lender, your lessee or borrower receives warranties of good title (without exclusions or modifications). As a lessee or borrower, when you buy or contract for your lessor to buy equipment, make sure you get the warranties you expect without unacceptable exclusions or modifications. As a seller, understand how express and implied warranties work and which ones you make because the deal you close today may in fact remain very much open as your warranties continue to remain effective well into the future. Check your state’s UCC as variations may exist in the statutory language.

5.  BLN Case & Comment: Lessors Prevail Over United Airlines in Section 1110 Contest

6. About Patton Boggs LLP and My Law Practice; Recent Publications; Upcoming Speeches

Patton Boggs LLP is a law firm of more than 400 lawyers located in five offices in the United States and internationally in Doha, Qatar. The firm has extensive capabilities in four major practice areas: Business Transactions, Intellectual Property, Public Policy and Litigation. I am a member of the Business Transactions Group. This group includes over 100 lawyers with a broad array of skills in equipment leasing and finance, corporate finance, secured transactions, syndications, wind power and other project finance, oil and gas transactions, mezzanine financing, hedge fund work and related creditors rights/bankruptcy, real estate and technology law. We regularly work in cost-effective teams to meet our client’s needs.

Our leasing and equipment finance work entails a full range of transactions. We help our clients buy, sell, finance and lease real and personal property, including business and commercial aircraft, energy assets, facilities, vehicles, production equipment, technology hardware and software and health care equipment. We have specific teams specifically for aviation, infrastructure/power, health care, federal leasing/finance/marketing, municipal leasing/finance and more.

We work with our clients from the "front-end" to the "back-end" of a variety of transactions. For example, we can assist in the development, construction and financing of infrastructure and power projects, structure and close securitizations, syndications and asset sales, and complete large asset-based company financings. We also restructure troubled credits, appear in court on complex bankruptcies, and act for our clients in such routine matters as repossessions, lift stay actions, true lease contests, workouts and forbearance arrangements. We provide extensive litigation resources with a record of proven success.

You are welcome to call me at 214.758.1545 or e-mail me at dmayer@pattonboggs.com. We value your contact with us on any topic, including questions arising from BLN articles or about our law practice.

Recent Publications

Here are a few feature articles published in January by David G. Mayer:

• Norvergence Strikes Again – Problems With Forum Selection Clauses, by David G. Mayer, The Monitor at page 26-27 (May 2005).

• Off Balance Sheet Leasing: Is the End in Sight?, by David G. Mayer, The Monitor (Jan. 2005). Mindy Berman of 42 North Structured Finance, Inc. commented on this article.

• The Bright Side of Big Deficits, by David G. Mayer, Equipment Leasing Today (Jan. 2005) (on federal leasing). Michael Guiffre of Patton Boggs LLP edited this article.