[Federal Register Volume 65, Number 172 (Tuesday, September 5, 2000)]
[Rules and Regulations]
[Pages 53584-53587]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 00-22669]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Parts 1 and 602

[TD 8901]
RIN 1545-AW16


Qualified Lessee Construction Allowances for Short-Term Leases

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

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SUMMARY: This document contains final 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 final 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 final 
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.

DATES: Effective Date: These regulations are effective October 5, 2000.
    Date of Applicability: For date of applicability of Sec. 1.110-1, 
see Sec. 1.110-1(d).

FOR FURTHER INFORMATION CONTACT: Paul Handleman, (202) 622-3040 (not a 
toll-free number).

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

    The collections of information contained in these final regulations 
have been reviewed and approved by the Office of Management and Budget 
in accordance with the Paperwork Reduction Act of 1995 (44 U.S.C. 3507) 
under control number 1545-1661. Responses to these collections of 
information are mandatory.
    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.
    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.
    Comments concerning the accuracy of these burden estimates and 
suggestions for reducing these burdens should be sent to the Internal 
Revenue Service, Attn: IRS Reports Clearance Officer, OP:FS:FP, 
Washington, DC 20224, and 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.
    Books or records relating to this 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

    On September 20, 1999, the IRS published proposed regulations (REG-
106010-98) in the Federal Register (64 FR 50783) inviting comments 
under section 110. A public hearing was held January 19, 2000. Numerous 
comments have been received. After consideration of all the comments, 
the proposed regulations are adopted as revised by this Treasury 
decision.

Public Comments

    In accordance with section 110(a), the proposed regulations 
provided that 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. The proposed regulations defined a 
qualified lessee construction allowance as 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, provided the purpose and expenditure 
requirements are met.

Expenditure Requirement

    The proposed regulations required that a qualified lessee 
construction allowance be 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 the retail space. 
However, the proposed regulations deemed an amount 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.
    Several commentators maintained that the proposed rule prescribing 
a time limit for making the expenditure is not required by the statute 
or the legislative history and should be eliminated. One commentator, 
for example, pointed out the absence of an explicit expenditure 
requirement in section 110 like the one found in section 118(c)(2)(B), 
which requires that an expenditure relating to a nontaxable 
contribution in aid of construction be made before the end of the 
second taxable year after the year in which such amount was received.
    Section 110 does not provide an explicit expenditure time limit, 
but it also does not toll the statute of limitations until the taxpayer 
notifies the Secretary that the amount has been expended as does 
section 118. The lack of a statute of limitation tolling provision in 
section 110 would be troublesome if there was no limitation on the time 
period to make the qualified expenditure. In addition, section 110(a) 
provides that an amount may be excluded only to the extent that such 
amount does not exceed the amount expended by the lessee for the 
construction or improvement of qualified long-term real property.
    The IRS and Treasury Department believe that the absence of an 
extension of the statute of limitations and use of the term 
``expended'' in the past tense indicate that the amount must be 
expended by the end of the taxable year it is received. Accordingly, 
the final regulations retain the expenditure time limitation. However, 
in recognition that a lessee may not be able to expend the amount in 
the same taxable year the lessee receives the construction allowance 
from the lessor, the final regulations also retain the 8\1/2\ month 
rule provided in the proposed regulations. This 8\1/2\ month rule, 
which grants the lessee an additional 8\1/2\ months after the close of 
the taxable year in which the construction allowance was received to 
expend the amount, is consistent with the time period, including 
extensions, that a corporate taxpayer has to file its return for the 
taxable year in which the construction allowance is received.
    Commentators requested that to the extent the final regulations 
retain the expenditure requirement, the requirement should be modified 
to include construction allowances used to reimburse lessee 
expenditures made in a prior year. In response to these comments, the 
final regulations clarify that, provided the lessee has not

[[Page 53585]]

depreciated the expenditures, reimbursements received in a taxable year 
after the year in which the expenditures are made by the lessee are 
timely for purposes of the expenditure requirement.

Purpose Requirement

    Consistent with section 110(a), the proposed regulations provided 
that a qualified lessee construction allowance must be under a short-
term lease of retail space and for the purpose of constructing or 
improving qualified long-term real property for use in the lessee's 
trade or business at the retail space. The proposed regulations 
required that the lease agreement for the retail space expressly 
provide 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. The purpose 
requirement was intended to further Congressional intent of ensuring 
consistency in the treatment of the construction allowance by both the 
lessor and the lessee.
    Commentators suggested deleting the requirement in the proposed 
regulations that the lease agreement ``expressly provides'' that a 
construction allowance be for the purpose of constructing or improving 
qualified long-term real property. Other commentators suggested 
changing this language to ``substantially provides'' or using a 
standard that would lead a reasonable person to conclude that the 
purpose of the construction allowance amount is for the construction or 
improvement of qualified long-term real property. The final regulations 
do not adopt these suggestions. The IRS and the Treasury Department 
believe that this express language is consistent with the requirements 
of section 110(a) and is necessary to help ensure that the lessor and 
the lessee take consistent tax positions.
    In addition, commentators noted that lease agreements do not 
necessarily address construction allowances. The construction allowance 
provisions may be contained in another document executed 
contemporaneously with the lease agreement or executed during the lease 
term. For example, the lessor may provide a construction allowance 
during the lease term for the remodeling of the retail space by the 
lessee. In response to these comments, the final regulations clarify 
that an ancillary agreement executed contemporaneously with the payment 
of a construction allowance, whether executed with the lease or during 
the term of the lease, is considered a provision of the lease agreement 
for this purpose.

Definition of Retail Space

    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. The proposed regulations specifically requested 
comments on whether the definition of ``retail space'' needs to be 
clarified.
    In response to comments, the final regulations clarify that offices 
for hair stylists, tailors, shoe repairmen, doctors, lawyers, 
accountants, insurance agents, financial advisors, stock brokers, 
securities dealers (including dealers who sell securities out of 
inventory), and bankers are included in the definition of retail space. 
The final regulations also clarify that a taxpayer is selling to the 
general public if the products or services for sale are made available 
to everyone even though only certain customers or clients are targeted.
    A commentator suggested that retail space should include back-
office support functions that are contiguous to the retail sales area 
and not be limited only to areas where customers purchase products and 
services. Section 110(c)(3) and the proposed regulations only require 
that the property be used ``in the trade or business'' of selling 
tangible personal property or services to the general public. In 
response to these comments, the final regulations state that the term 
``retail space'' includes not only the space where the retail sales are 
made, but also space where activities supporting the retail activity 
are performed (such as an administrative office, a storage area, and an 
employee lounge).

Definition of Lease Term

    Consistent with section 110(c)(2), the proposed regulations defined 
a short-term lease as 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)). Section 168(i)(3) provides rules on determining when 
renewal options will be considered part of the lease term. Section 
168(i)(3)(B) provides that, in the case of nonresidential real property 
or residential rental property, any option to renew at fair market 
value, determined at the time of renewal, is not taken into account for 
purposes of determining the lease term.
    A commentator suggested that the final regulations stipulate that 
certain common renewal options will be considered to be at fair market 
value. For example, the commentator suggested that if a lease sets rent 
at a certain percentage of sales for the original lease term and uses 
that same percentage of sales for renewal options, the renewals should 
be considered to be at fair market value. As the comment relates to the 
determination of lease term under section 168 and would affect other 
provisions in addition to section 110 that reference section 168(i)(3), 
such as sections 142 and 280F, the comment is beyond the scope of this 
regulation. Accordingly, the final regulations do not adopt the 
suggested comment.

Information Requirement

    The proposed regulations required qualified lessee construction 
allowance information to be furnished by the lessor and the lessee to 
the IRS, and described the time and manner for providing that 
information to the IRS. The proposed regulations also provided that a 
lessor or a lessee that fails to furnish the required information may 
be subject to a penalty under section 6721.
    A commentator suggested that the required information to be 
furnished should be the information that is current at the time the 
lease is executed. According to the commentator, it would not be 
unusual for a lease to be executed years prior to the payment and 
receipt of the construction allowance. One of the parties to the lease 
may have been acquired by another taxpayer or its name and address may 
have changed.
    The final regulations do not adopt the suggestion. The purpose of 
the information reporting by the lessor and the lessee is to ensure 
consistent treatment of the construction allowance as nonresidential 
property owned by the lessor. Accordingly, it is imperative that the 
identity of the persons paying and receiving the construction allowance 
amount and relevant information provided be correct.
    A commentator suggested that the information requirement should 
absolve the party filing the information statement from any penalty 
under section 6721 if the party relied upon incorrect information 
received from the other party or if the information cannot be obtained 
from the other party after reasonable efforts. Section 6724(a) provides 
that no penalty shall be imposed under section 6721 with respect to any 
failure if it is shown that such failure is due to reasonable cause and 
not willful neglect. Thus, no penalty under section 6721 will apply to 
a lessor (or a lessee) if the failure to furnish qualified lessee 
construction allowance information resulted from the lessee (or the 
lessor) providing incorrect information to the other party to the lease 
upon which the lessor (or the lessee) relied in good faith.

[[Page 53586]]

    Another commentator suggested that the information to be furnished 
by a lessor is duplicative because the lessee is required to furnish 
the same information to the IRS. According to the commentator, the 
lessee should bear the entire burden of filing the required information 
because the lessee is the primary beneficiary of section 110. The final 
regulations do not adopt the commentator's suggestion. The information 
provided by the lessor is helpful in corroborating the information 
provided by the lessee and ensures that the lessor treats the amount as 
nonresidential real property on its return. Moreover, the reporting 
requirement in section 110(d) specifically provides that both the 
lessor and the lessee should furnish information.

Effective Date

    The proposed regulations proposed an effective date applicable to 
leases entered into on or after the date final regulations are 
published in the Federal Register. A commentator suggested delaying the 
effective date of the final regulations to allow businesses a short 
period to conform their business practices to the final regulations. 
The final regulations adopt this suggestion by making the regulations 
effective 30 days after the date the final regulations are published in 
the Federal Register.
    Although the final regulations do not provide for an election to 
apply the regulations retroactively, taxpayers who comply with the 
rules set forth in the regulations for leases entered into after August 
5, 1997, and prior to the effective date of the regulations (other than 
the reporting requirement) will be treated as meeting the requirements 
of section 110.

Special Analyses

    It has been determined that this Treasury decision is not a 
significant regulatory action as defined in Executive Order 12866. 
Therefore, a regulatory assessment is not required. It also has been 
determined that section 553(b) of the Administrative Procedure Act (5 
U.S.C. chapter 5) does not apply to these regulations. 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, the 
notice of proposed rulemaking preceding these regulations was submitted 
to the Chief Counsel for Advocacy of the Small Business Administration 
for comment on its impact on small business.

Drafting Information

    The principal author of these regulations is Paul F. Handleman, 
Office of the Associate Chief Counsel (Passthroughs and Special 
Industries), IRS. However, other personnel from the IRS and Treasury 
Department participated in their development.

List of Subjects

26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

26 CFR Part 602

    Reporting and recordkeeping requirements.

Amendments to the Regulations

    Accordingly, 26 CFR parts 1 and 602 are 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. The term retail space includes not only 
the space where the retail sales are made, but also space where 
activities supporting the retail activity are performed (such as an 
administrative office, a storage area, and employee lounge). Examples 
of services typically sold to the general public include services 
provided by hair stylists, tailors, shoe repairmen, doctors, lawyers, 
accountants, insurance agents, stock brokers, securities dealers 
(including dealers who sell securities out of inventory), financial 
advisors and bankers. For purposes of this paragraph (b)(2)(iii), a 
taxpayer is selling to the general public if the products or services 
for sale are made available to the general public, even if the product 
or service is targeted to certain customers or clients.
    (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 
the retail space. An ancillary agreement between the lessor and the 
lessee providing for a construction allowance, executed 
contemporaneously with the lease or during the term of the lease, is 
considered a provision of the lease agreement for purposes of the 
preceding sentence, provided the agreement is executed before payment 
of the construction allowance.
    (4) Expenditure requirement--(i) In general. Expenditures referred 
to in paragraph (b)(1)(iii) of this section may 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

[[Page 53587]]

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--
    (A) The amount is expended by the lessee within 8\1/2\ months after 
the close of the taxable year in which the amount was received; or
    (B) The amount is a reimbursement from the lessor for amounts 
expended by the lessee in a prior year and for which the lessee has not 
claimed any depreciation deductions.
    (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:
    (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 October 5, 2000.

PART 602--OMB CONTROL NUMBERS UNDER THE PAPERWORK REDUCTION ACT

    Par. 3. The authority citation for part 602 continues to read as 
follows:

    Authority: 26 U.S.C. 7805.

    Par. 4. In Sec. 602.101, paragraph (b) is amended by adding an 
entry for 1.110-1 to the table in numerical order to read as follows:


Sec. 602.101  OMB Control numbers.

* * * * *
    (b) * * *

------------------------------------------------------------------------
                                                             Current OMB
        CFR part or section identified and described         control No.
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                  *        *        *        *        *
1.110-1....................................................    1545-1661
 
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Robert E. Wenzel,
Deputy Commissioner of Internal Revenue.

    Approved: August 29, 2000.
Jonathan Talisman,
Acting Assistant Secretary of the Treasury.
[FR Doc. 00-22669 Filed 9-1-00; 8:45 am]
BILLING CODE 4830-01-U