[Federal Register Volume 64, Number 181 (Monday, September 20, 1999)]
[Proposed Rules]
[Pages 50783-50787]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 99-24321]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[REG-106010-98]
RIN 1545-AW16


Qualified Lessee Construction Allowances for Short-Term Leases

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking and notice of public hearing.

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SUMMARY: This document contains proposed regulations concerning an 
exclusion from gross income for qualified lessee construction 
allowances provided by a lessor to a lessee for the purpose of 
constructing long-lived property to be used by the lessee pursuant to a 
short-term lease. The proposed regulations affect a lessor and a lessee 
paying and receiving, respectively, qualified lessee construction 
allowances that are depreciated by a lessor as nonresidential real 
property and excluded from the lessee's gross income. The proposed 
regulations provide guidance on the exclusion, the information required 
to be furnished by the lessor and the lessee, and the time and manner 
for providing that information to the IRS. This document also provides 
notice of a public hearing on these proposed regulations.

DATES: Written and electronic comments must be received by December 20, 
1999. Outlines of topics to be discussed at the public hearing 
scheduled for January 19, 2000, must be received by December 29, 1999.

ADDRESSES: Send submissions to: CC:DOM:CORP:R (REG-106010-98), room 
5226, Internal Revenue Service, POB 7604, Ben Franklin Station, 
Washington, DC 20044. Submissions may be hand delivered Monday through

[[Page 50784]]

Friday between the hours of 8 a.m. and 5 p.m. to: CC:DOM:CORP:R (REG-
106010-98), Courier's Desk, Internal Revenue Service, 1111 Constitution 
Avenue, NW., Washington, DC. Alternatively, taxpayers may submit 
comments electronically via the Internet by selecting the ``Tax Regs'' 
option on the IRS Home Page, or by submitting comments directly to the 
IRS Internet site at http://www.irs.ustreas.gov/tax__regs/
regslist.html. The public hearing will be held in room 2615, Internal 
Revenue Building, 1111 Constitution Avenue, NW., Washington, DC.

FOR FURTHER INFORMATION CONTACT: Concerning the regulations, Paul 
Handleman, (202) 622-3040; concerning submissions, the hearing, and/or 
to be placed on the building access list to attend the hearing, Michael 
Slaughter, (202) 622-7180 (not toll-free numbers).

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

    The collection of information contained in this notice of proposed 
rulemaking has been submitted to the Office of Management and Budget 
for review in accordance with the Paperwork Reduction Act of 1995 (44 
U.S.C. 3507(d)). Comments on the collection of information should be 
sent to the Office of Management and Budget, Attn: Desk Officer for the 
Department of the Treasury, Office of Information and Regulatory 
Affairs, Washington, DC 20503, with copies to the Internal Revenue 
Service, Attn: IRS Reports Clearance Officer, OP:FS:FP, Washington, DC 
20224. Comments on the collection of information should be received by 
November 19, 1999.
    Comments are specifically requested concerning:
    Whether the proposed collection of information is necessary for the 
proper performance of the functions of the IRS, including whether the 
information will have practical utility;
    The accuracy of the estimated burden associated with the proposed 
collection of information (see below);
    How the quality, utility, and clarity of the information to be 
collected may be enhanced;
    How the burden of complying with the proposed collection of 
information may be minimized, including through the application of 
automated collection techniques or other forms of information 
technology; and
    Estimates of capital or start-up costs and costs of operation, 
maintenance, and purchase of services to provide information.
    The requirement for the collection of information in this notice of 
proposed rulemaking is in Sec. 1.110-1(c). The information is required 
so that a taxpayer receiving a construction allowance as lessee from 
the lessor may establish the amount qualifying for the safe harbor 
under section 110(a). The collection of information is mandatory. The 
likely respondents are businesses and other for-profit organizations.
    Estimated total annual reporting burden: 10,000 hours.
    The estimated annual burden per respondent varies from .5 hours to 
1.5 hours, depending on individual circumstances, with an estimated 
average of 1 hour.
    Estimated number of respondents: 10,000.
    Estimated annual frequency of responses: once.
    An agency may not conduct or sponsor, and a person is not required 
to respond to, a collection of information unless the collection of 
information displays a valid control number assigned by the Office of 
Management and Budget.
    Books or records relating to a collection of information must be 
retained as long as their contents may become material in the 
administration of any internal revenue law. Generally, tax returns and 
tax return information are confidential, as required by 26 U.S.C. 6103.

Background

    This document contains proposed amendments to the Income Tax 
Regulations (26 CFR part 1) to provide regulations under section 110 of 
the Internal Revenue Code of 1986. Section 110 was added to the Code by 
section 1213(a) of the Taxpayer Relief Act of 1997, Public Law 105-34 
(Act). Under section 1213(e) of the Act, the amendment made by section 
1213(a) applies to leases entered into after August 5, 1997.

Explanation of Provisions

Tax Treatment of Lessee Construction Allowances

    Section 61(a) provides that gross income means ``all income from 
whatever source derived'' except as otherwise provided in subtitle A of 
the Internal Revenue Code. Generally, the receipt of a construction 
allowance by a lessee from a lessor for property to be constructed and 
used by the lessee pursuant to a lease represents an accession to 
wealth includible in gross income in the year of receipt. However, 
amounts received by a lessee that are expended by the lessee on assets 
owned by the lessor are not includible in the lessee's gross income 
because there is no accession to wealth. Thus, the proper tax treatment 
of construction allowances turns on whether the lessee or the lessor 
owns the property constructed with the allowance.
    Ownership for tax purposes generally is determined by applying a 
``benefits and burdens of ownership'' test to the facts and 
circumstances surrounding the transaction. The benefits and burdens of 
ownership test was developed by the Tax Court to determine whether a 
purported lease should be treated as a sale for Federal income tax 
purposes. The court set forth the following factors to determine 
whether the taxpayer had the benefits and burdens of ownership of the 
leased property: (1) whether legal title passes; (2) how the parties 
treat the transaction; (3) whether an equity interest was acquired in 
the property; (4) whether the contract creates a present obligation on 
the seller to execute and deliver a deed and a present obligation on 
the purchaser to make payments; (5) whether the right of possession is 
vested in the purchaser; (6) which party pays the property taxes; (7) 
which party bears the risk of loss or damage to the property; and (8) 
which party receives the profits from the operation and sale of the 
property. See Grodt & McKay Realty, Inc. v. Commissioner, 77 T.C. 1221 
(1981), and Coleman v. Commissioner, T.C. Memo. 1987-195, aff'd, 16 
F.3d 821 (7th Cir. 1994).
    In a coordinated issue paper dated October 7, 1996, the IRS 
enumerated certain specific factors that help establish whether the 
benefits and burdens of ownership of the leasehold improvements are 
with the lessee or the lessor; i.e., who carries personal property and 
liability insurance on the leasehold improvements; who is the 
beneficiary under those policies; who is responsible for replacing the 
leasehold improvements if they wear out prior to the end of the lease 
term; and, if the usefulness of the leasehold improvements extends 
beyond the lease term, who has the remainder interest in the 
improvements.
    To the extent the lessee holds the benefits and burdens of 
ownership of the leasehold improvements constructed with the 
construction allowance, the lessee has an accession to wealth and 
income under section 61(a). However, to the extent the lessor holds the 
benefits and burdens of ownership, the lessee is acting merely as an 
agent of the lessor and the construction allowance is not includible in 
the gross income of the lessee.
    Congress was concerned that the traditional factors used by the IRS 
in making the determination of who is the

[[Page 50785]]

tax owner of property may be applied differently by the lessor and the 
lessee and may lead to controversies between the IRS and taxpayers.
    H.R. Rep. No. 148, 105th Cong., 1st Sess. 423 (1997) (House 
Report); S. Rep. No. 33, 105th Cong., 1st Sess. 232-33 (1997) (Senate 
Report). Consequently, the Act provides a safe harbor whereby it is 
assumed that a construction allowance is used to construct or improve 
lessor property (and is properly excludable by the lessee) when long-
lived property is constructed or improved and used pursuant to a short-
term lease. The Act also provides a reporting requirement to ensure 
that both the lessee and the lessor consistently treat the property 
subject to the construction allowance as nonresidential real property 
owned by the lessor. House Report at page 424; Senate Report at page 
233.

Safe Harbor Under Section 110

    Section 110(a) provides, in general, that gross income of a lessee 
does not include any amount received in cash (or treated as a rent 
reduction) by a lessee from a lessor under a short-term lease of retail 
space, for the purpose of such lessee's constructing or improving 
qualified long-term real property for use in such lessee's trade or 
business at such retail space, but only to the extent that such amount 
does not exceed the amount expended by the lessee for such construction 
or improvement.
    Section 110(c)(1) defines the term ``qualified long-term real 
property'' as nonresidential real property which is part of, or 
otherwise present at, the retail space referred to in section 110(a) 
and which reverts to the lessor at the termination of the lease. 
Section 110(c)(2) defines the term ``short-term lease'' as a lease (or 
other agreement for occupancy or use) of retail space for 15 years or 
less (as determined under the rules of section 168(i)(3)). Section 
110(c)(3) defines the term ``retail space'' as real property leased, 
occupied, or otherwise used by a lessee in its trade or business of 
selling tangible personal property or services to the general public.
    Consistent with section 110(c)(1), the proposed regulations define 
the term ``qualified long-term real property'' as nonresidential real 
property under section 168(e)(2)(B), which is section 1250 property 
other than residential rental property and property with a class life 
of less than 27.5 years. The proposed regulations do not require a 
direct tracing of the construction allowance, but assume that the 
construction allowance is used to construct or improve the lessor's 
property if qualified long-term real property is constructed by the 
lessee at the leased retail space. The IRS and the Department of 
Treasury specifically request comments on whether the definition of 
``retail space'' needs to be clarified.
    The proposed regulations recognize that a lessee may not be able to 
construct the qualified long-term real property in the same taxable 
year as it receives the construction allowance from the lessor. Thus, 
the proposed regulations give the lessee additional time to satisfy the 
safe harbor by allowing the construction allowance to be expended for 
qualified long-term real property until 8\1/2\ months after the close 
of the taxable year in which the construction allowance was received by 
the lessee.
    The legislative history of the Act states that no inference is 
intended as to the treatment of amounts that are not subject to the 
safe harbor provision. In such cases, the provisions of IRS coordinated 
issue paper and present law (including case law) will continue to apply 
where applicable. H.R. Conf. Rep. No. 220, 105th Cong., 1st Sess. 658-
59 (1997). Thus, a construction allowance failing to qualify under the 
safe harbor provision is not includible in the lessee's gross income if 
the lessor has the benefits and burdens of ownership of the property 
constructed with the construction allowance. Ownership of the property 
is determined under general principles of Federal tax law based on all 
the facts and circumstances.

Consistency Between Lessee and Lessor and Reporting Requirements

    Section 110(b) provides that qualified long-term real property 
constructed or improved in connection with any amount excluded from a 
lessee's income by reason of section 110(a) shall be treated as 
nonresidential real property of the lessor (including for purposes of 
section 168(i)(8)(B)).
    Section 110(d) provides that, under regulations, the lessee and 
lessor described in section 110(a) must, at such times and in such 
manner as may be provided in such regulations, furnish to the Secretary 
information concerning the amounts received (or treated as a rent 
reduction) and expended as described in section 110(a), and any other 
information which the Secretary deems necessary to carry out the 
provisions of section 110.
    The Act provides that the lessor will treat any qualified long-term 
real property constructed or improved with a construction allowance 
excluded from the lessee's gross income under section 110(a) as 
nonresidential real property owned by the lessor. However, the lessee's 
exclusion is not dependent upon the lessor's treatment of the property 
as nonresidential real property. House Report at page 424; Senate 
Report at page 233.
    The proposed regulations prescribe the information required to be 
furnished by the lessor and the lessee and the time and manner for 
providing that information to the IRS. A lessor or a lessee that fails 
to furnish the required information may be subject to a penalty under 
section 6721.

Proposed Effective Date

    The regulations are proposed to be applicable to leases entered 
into on or after the date final regulations are published in the 
Federal Register.

Special Analyses

    It has been determined that this notice of proposed rulemaking is 
not a significant regulatory action as defined in Executive Order 
12866. Therefore, a regulatory assessment is not required. It is hereby 
certified that the collection of information in these regulations will 
not have a significant economic impact on a substantial number of small 
entities. This certification is based upon the fact that any burden on 
taxpayers is minimal. Accordingly, a Regulatory Flexibility Analysis 
under the Regulatory Flexibility Act (5 U.S.C. chapter 6) is not 
required. Pursuant to section 7805(f) of the Internal Revenue Code, 
this notice of proposed rulemaking will be submitted to the Chief 
Counsel for Advocacy of the Small Business Administration for comment 
on its impact on small business.

Comments and Public Hearing

    Before these proposed regulations are adopted as final regulations, 
consideration will be given to any written comments (a signed original 
and eight (8) copies) or electronic comments that are submitted timely 
to the IRS. The IRS and Treasury Department specifically request 
comments on the clarity of the proposed rule and how it may be made 
easier to understand. All comments will be available for public 
inspection and copying.
    A public hearing has been scheduled for Wednesday, January 19, 
2000, at 10 a.m. in room 2615, Internal Revenue Building, 1111 
Constitution Avenue, NW., Washington, DC. Due to building security 
procedures, visitors must enter at the 10th Street entrance, located 
between Constitution and Pennsylvania Avenues, NW. In addition, all 
visitors must present photo identification to enter the building. 
Because of access

[[Page 50786]]

restrictions, visitors will not be admitted beyond the immediate 
entrance area more than 15 minutes before the hearing starts. For 
information about having your name placed on the building access list 
to attend the hearing, see the FOR FURTHER INFORMATION CONTACT section 
of this preamble.
    The rules of 26 CFR 601.601(a)(3) apply to the hearing.
    Persons who wish to present oral comments at the hearing must 
submit an outline of the topics to be discussed and the time to be 
devoted to each topic (signed original and eight (8) copies) by 
December 29, 1999.
    A period of 10 minutes will be allotted to each person for making 
comments.
    An agenda showing the scheduling of the speakers will be prepared 
after the deadline for receiving outlines has passed. Copies of the 
agenda will be available free of charge at the hearing.
    Drafting information. The principal author of these regulations is 
Paul F. Handleman, Office of the Assistant Chief Counsel (Passthroughs 
and Special Industries), IRS. However, other personnel from the IRS and 
Treasury Department participated in their development.

List of Subjects in 26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

Proposed Amendments to the Regulations

    Accordingly, 26 CFR part 1 is proposed to be amended as follows:

PART 1--INCOME TAXES

    Paragraph 1. The authority citation for part 1 is amended by adding 
an entry in numerical order to read in part as follows:

    Authority: 26 U.S.C. 7805 * * *

    Section 1.110-1 also issued under 26 U.S.C. 110(d); * * *
    Par. 2. Section 1.110-1 is added to read as follows:


Sec. 1.110-1  Qualified lessee construction allowances.

    (a) Overview. Amounts provided to a lessee by a lessor for property 
to be constructed and used by the lessee pursuant to a lease are not 
includible in the lessee's gross income if the amount is a qualified 
lessee construction allowance under paragraph (b) of this section.
    (b) Qualified lessee construction allowance--(1) In general. A 
qualified lessee construction allowance means any amount received in 
cash (or treated as a rent reduction) by a lessee from a lessor--
    (i) Under a short-term lease of retail space;
    (ii) For the purpose of constructing or improving qualified long-
term real property for use in the lessee's trade or business at that 
retail space; and
    (iii) To the extent the amount is expended by the lessee in the 
taxable year received on the construction or improvement of qualified 
long-term real property for use in the lessee's trade or business at 
that retail space.
    (2) Definitions--(i) Qualified long-term real property is 
nonresidential real property under section 168(e)(2)(B) that is part 
of, or otherwise present at, the retail space referred to in paragraph 
(b)(1)(i) of this section and which reverts to the lessor at the 
termination of the lease. Thus, qualified long-term real property does 
not include property qualifying as section 1245 property under section 
1245(a)(3).
    (ii) Short-term lease is a lease (or other agreement for occupancy 
or use) of retail space for 15 years or less (as determined pursuant to 
section 168(i)(3)).
    (iii) Retail space is nonresidential real property under section 
168(e)(2)(B) that is leased, occupied, or otherwise used by the lessee 
in its trade or business of selling tangible personal property or 
services to the general public.
    (3) Purpose requirement. An amount will meet the requirement in 
paragraph (b)(1)(ii) of this section only to the extent that the lease 
agreement for the retail space expressly provides that the construction 
allowance is for the purpose of constructing or improving qualified 
long-term real property for use in the lessee's trade or business at 
that retail space.
    (4) Expenditure requirement--(i) In general. Expenditures referred 
to in paragraph (b)(1)(iii) of this section will be treated as being 
made first from the lessee's construction allowance. Tracing of the 
construction allowance to the actual lessee expenditures for the 
construction or improvement of qualified long-term real property is not 
required. However, the lessee should maintain accurate records of the 
amount of the qualified lessee construction allowance received and the 
expenditures made for qualified long-term real property.
    (ii) Time when expenditures deemed made. For purposes of paragraph 
(b)(1)(iii) of this section, an amount is deemed to have been expended 
by a lessee in the taxable year in which the construction allowance was 
received by the lessee if the amount is expended within 8\1/2\ months 
after the close of that taxable year.
    (5) Consistent treatment by lessor. Qualified long-term real 
property constructed or improved with any amount excluded from a 
lessee's gross income by reason of paragraph (a) of this section must 
be treated as nonresidential real property owned by the lessor (for 
purposes of depreciation under 168(e)(2)(B) and determining gain or 
loss under section 168(i)(8)(B)). For purposes of the preceding 
sentence, the lessor must treat the construction allowance as fully 
expended in the manner required by paragraph (b)(1)(iii) of this 
section unless the lessor is notified by the lessee in writing to the 
contrary. General tax principles apply for purposes of determining when 
the lessor may begin depreciation of its nonresidential real property. 
The lessee's exclusion from gross income under paragraph (a) of this 
section, however, is not dependent upon the lessor's treatment of the 
property as nonresidential real property.
    (c) Information required to be furnished--(1) In general. The 
lessor and the lessee described in paragraph (b) of this section who 
are paying and receiving a qualified lessee construction allowance, 
respectively, must furnish the information described in paragraph 
(c)(3) of this section in the time and manner prescribed in paragraph 
(c)(2) of this section.
    (2) Time and manner for furnishing information. The requirement to 
furnish information under paragraph (c)(1) of this section is met by 
attaching a statement with the information described in paragraph 
(c)(3) of this section to the lessor's or the lessee's, as applicable, 
timely filed (including extensions) Federal income tax return for the 
taxable year in which the construction allowance was paid by the lessor 
or received by the lessee (either in cash or treated as a rent 
reduction), as applicable. A lessor or a lessee may report the required 
information for several qualified lessee construction allowances on a 
combined statement. However, a lessor's or a lessee's failure to 
provide information with respect to each lease will be treated as a 
separate failure to provide information for purposes of paragraph 
(c)(4) of this section.
    (3) Information required--(i) Lessor. The statement provided by the 
lessor must contain the lessor's name (and, in the case of a 
consolidated group, the parent's name), employer identification number, 
taxable year and the following information for each lease:

[[Page 50787]]

    (A) The lessee's name (in the case of a consolidated group, the 
parent's name).
    (B) The address of the lessee.
    (C) The employer identification number of the lessee.
    (D) The location of the retail space (including mall or strip 
center name, if applicable, and store name).
    (E) The amount of the construction allowance.
    (F) The amount of the construction allowance treated by the lessor 
as nonresidential real property owned by the lessor.
    (ii) Lessee. The statement provided by the lessee must contain the 
lessee's name (and, in the case of a consolidated group, the parent's 
name), employer identification number, taxable year and the following 
information for each lease:
    (A) The lessor's name (in the case of a consolidated group, the 
parent's name).
    (B) The address of the lessor.
    (C) The employer identification number of the lessor.
    (D) The location of the retail space (including mall or strip 
center name, if applicable, and store name).
    (E) The amount of the construction allowance.
    (F) The amount of the construction allowance that is a qualified 
lessee construction allowance under paragraph (b) of this section.
    (4) Failure to furnish information. A lessor or a lessee that fails 
to furnish the information required in this paragraph (c) may be 
subject to a penalty under section 6721.
    (d) Effective date. This section is applicable to leases entered 
into on or after the date final regulations are published in the 
Federal Register.
Robert E. Wenzel,
Deputy Commissioner of Internal Revenue.
[FR Doc. 99-24321 Filed 9-17-99; 8:45 am]
BILLING CODE 4830-01-U