Selected Issues in Domestic Tax-Exempt Leasing Transactions

Any governmental authority or agency contemplating entering into a sale leaseback transaction must have the authority to do so. Ensuring that the transaction is authorized entails making sure that all necessary substantive approvals have been obtained and that all appropriate procedures have been followed. The precise requirements vary from jurisdiction to jurisdiction and authority to authority. Most public bodies have some sort of formal procurement process. Accordingly, the selection of a lease advisor will often involve a competitive selection process. As part of this process, the agency or authority will generally be required to issue a formal request for proposals, rank the responses and interview prospective advisors. A similar process may be required for other service providers to the transaction such as legal counsel and the appraiser. While there may be circumstances in which process waivers are available, procedures will nevertheless have to be followed to ensure that waivers have been properly obtained.

The substantive authority to enter into a transaction can also be a subject of considerable complexity, since the transaction will commonly involve the long-term lease and theoretical sale of a substantial public asset. (Even though most facility transactions are implemented on the basis of a long-term head lease for a period substantially exceeding the useful life of the facility, there will be circumstances, such as default or non-exercise of the lessee's purchase option, under which the equity will expect to obtain title.) In some circumstances voter approval may be required to alienate a major public asset. This usually makes a transaction less than attractive. However, even when the agency has the legal authority to transfer its assets, its doing so may be a sensitive matter. In most jurisdictions some form of “sunshine” provision is applicable. This may take the form of an open meetings law or a requirement that records be available to the public. In any event, the members of any board likely to approve a substantial transaction involving a public asset will be aware that their dealings will be a matter of public record. The individuals involved will tend to have extensive public experience either as senior administrators or as elected officials and will tend to be quite sensitive to the public perception of the transaction. Accordingly, transactions will have to be explained to lessees in great detail and in a way that allows their benefits to be quickly perceived by the public without creating undue alarm.

The open nature of the approval process puts a great deal of pressure on two particular aspects of a transaction. First, broken deal expenses is a difficult topic in the public sector. While a private entity might reasonably weigh the risks and rewards of accepting responsibility for broken deal expenses, a public entity is likely to be greatly concerned of the possibility that it will have to absorb broken deal expenses and thus be accused of having wasted the taxpayers or ratepayers money, despite having made a reasonable analysis of risks and rewards. A more subtle issue can arise when the transaction has a substantial cash net economic benefit. Then, the problem is avoiding potential rate shocks. Often a public agency or authority will view the net economic benefit of a leasing transaction as a way to fund a capital improvement or other program for which funds were not readily attainable or as a supplement to the funds otherwise available for normal growth. However, in other instances, an agency or authority may be required to treat the net economic benefit as a reduction in its operating costs. When this happens and the agency or authority is operating on a cost pass through basis, a reduction in operating costs may translate to an immediate rate reduction. This seeming economic boon is, in reality, a political problem because the immediate reduction will be followed by increases to restore rates to the normal range in the year following the year of the transaction. As observers of political forces, board members will be highly sensitive to the public perception of a rate increase following the absorption of a benefit. To avoid this issue, some lessees may prefer to have the benefit structured such that it comes in over a period of years and does not result in a shock, in either direction, for the ratepayers.

It may well be that the agency or authority that has title to the asset to be leased does not have the authority to enter into the transaction without consent from other governmental agencies. Sometimes this state of affairs arises from the existence of supervisory authority. At other times it can result when an agency owns an asset, for example a transportation system, which crosses or makes use of the property of another public agency. Obtaining consent from additional parties can sometimes be a matter of essentially procedural review to ascertain whether the transaction proposed meets technical administrative requirements. At other times a more judgmental review as to whether the transaction is in the public interest may be required. Then, the authority whose additional consent is required can condition its response on the sharing of benefit. When this is the case, the possibility of benefit sharing may reduce the incentive of the lessee to enter into the transaction at all. While, in an ideal world, government agencies would cooperate for the greatest total benefit, it often happens that agencies and authorities view their own net benefit as the only goal of the transaction.

Different jurisdictions confer different amounts of power on their agencies and authorities in regard to certain issues that may be critical to investors. The power to declare bankruptcy or be put in bankruptcy involuntarily generally depends on the state law. Some agencies and authorities can become bankrupt and others cannot. Agencies or authorities that cannot become bankrupt and reject a lease in bankruptcy proceedings will be perceived by investors as much better credit risks. Indemnification powers also vary. Net leases typically require that the lessee indemnify the lessor against all tort claims. However, in many jurisdictions, agencies and authorities do not have the power to indemnify for damages that do not arise out of the actions of the agency or authority. Since investors expect protection against damages caused by the actions of third parties, including illegal acts and unauthorized conduct, the effect of such a restriction on the power to indemnify is that insurance will be required. If an agency has previously had the benefit of sovereign immunity and been able to keep its insurance costs relatively low, this may add a significant insurance cost burden to the transaction.

A typical sale leaseback arrangement with a state or local agency or authority will involve an economic defeasance arrangement. In a typical defeasance arrangement, the defeasing party, here the lessee, will invest funds it receives at the outset of a transaction and use the proceeds of these investments to fund its obligations and provide for a possible future purchase option exercise. Some jurisdictions have restrictions on the way public funds can be invested. Any such restrictions need to be examined to ensure that they do not prevent common forms of either debt or equity defeasance.

In a sale leaseback transaction, the investor expects to become the owner of the property, at least for federal income tax purposes. This usually entails ownership for state and local tax purposes as well. State and local tax ownership, however, may have substantial state and local tax consequences. Local property tax laws need to be examined to ensure that they are consistent with the transaction. During the lease term, the lessee will indemnify the investor for property taxes. If the lessee and the taxing authority are the same jurisdiction, then no problems should arise. However, if the taxing authority is a different jurisdiction, the lessee could find itself indemnifying a lessor for taxes paid to another jurisdiction. Sometimes a property tax will be avoided during the lease term because of the nature of the lessee, but subsequent to the lease term, the property may become subject to property tax. If that is the case, the economic model of the cash flows from the transaction will have to take into account the cost of any property taxes. Sales taxes present similar issues. If the private operation of the property will become subject to sales taxes following the lease term, sales taxes payable by the investor in the course of its operation of the property need to be considered. The issue is more focused for transfer taxes. If there is a transfer of title contemplated as a result of nonexercise of the purchase option, the economic model of the transaction will have to take the payment of that transfer tax into account. Since such a tax is typically for the lessee's account, the effect must be considered in the tax compulsion analysis.

Although the complexities of tax-exempt debt are beyond the scope of this article, differences between cross-border and U.S. tax-exempt leasing practices arise from the fact that U.S. state and local governments have financing options not available to their foreign counterparts. Within limits, many U.S. state and local agencies and authorities can finance most capital projects with some form of tax-exempt debt. As a result, a prospective investor in a U.S. transaction must be able to provide an overall financing package that is more attractive than customary tax-exempt debt financing. By contrast, foreign governments do not have a tax-exempt borrowing privilege. Accordingly, they must pay commercial borrowing rates, and lease financing is very often more attractive. The contrast applies even when the lease transactions are defeased. Even though a lessee may defease all of its rental obligations and view the transaction only as a generator of a net up-front benefit, the transaction as a whole must still comply with all relevant tax rules. Compliance with these rules starts with bond counsel. If counsel cannot be satisfied that tax exempt status of bonds outstanding on the property to be sold and leased back is not altered by the transaction, then bond remediation will be required. Remediation essentially involves issuing taxable bonds and using the proceeds to repurchase or defease the tax-exempt bonds or to finance other projects which would otherwise be eligible for tax exempt financing. Remediation can be worthwhile in the right circumstances, but its cost and complexity weigh on any potential transaction.

Public agencies and authorities will often have received grants or special loans to construct or maintain their facilities. Because a sale leaseback transaction disturbs the ownership of the leased facility, the transaction may affect past grants and loans. It may also affect the availability of future grants and loans. This has generally not been an issue for transit rolling stock because the Federal Transit Administration looks to the continued use of the assets for transit purposes in determining eligibility. However, as transactions are considered for nontransit facilities, the issue of grants and loans will need to be considered closely. In many cases, it will turn out that prior grants and loans do not have to be recaptured or that the recapture cost is minimal. However, for facilities where continuing capital improvements are needed and those improvements are incorporated into the leased property, special attention will have to be paid to make sure that the agency continues to be eligible for grant and loan programs.

Although considerable effort can be required to deal with these and other issues potentially involved in a U.S. state or local transaction, fortunately, not all of the issues arise in all transactions and many issues can be resolved if addressed at the outset, so for the knowledgeable and persistent, rewarding transactions are possible.

Lease investors have been participating in cross-border transactions for a wide variety of municipal facilities for several years. Assets have included water and sewer systems, electric and gas distribution systems, rail rolling stock and infrastructure, and convention centers. Investors have also been participating in transactions involving U.S. state and local government entities for several years. However, the preponderance of the U.S. transactions closed to date have involved rolling stock or transit facilities.

Although the tax law governing both cross-border transactions and U.S. state and local government transactions is the same and the structures used (most commonly sale leaseback followed by a service contract with most rent payment obligations economically defeased, and potential purchase option exercise provided for) are similar, the U.S. market has not yet grown to encompass the breadth of asset types seen in the foreign market. Many considerations interact to make U.S. state and local transactions difficult to do despite their clear economic attractions. While some of these factors are common to all transactions with governments and government-controlled entities, many of them are particular to U.S. state and local government entities. The purpose of this article is to explore some of the issues surrounding U.S. state and local transactions.

The nature of U.S. state and local government in the context of a federal system creates issues which a leasing transaction must address. In contrast with jurisdictions outside of the United States, where local processes tend to be relatively uniform within a given country, there is a substantial variation in governmental processes which may apply to U.S. state and local transactions. State laws governing fundamental aspects of leasing transactions vary from state to state. Moreover, assets are often in the hands of special authorities that have unique rules. This variety of applicable law adds substantial complexity and uncertainty to the transaction process. In addition, tax exempt state and local financing provides competition for leasing and an additional layer of complication.

Any governmental authority or agency contemplating entering into a sale leaseback transaction must have the authority to do so. Ensuring that the transaction is authorized entails making sure that all necessary substantive approvals have been obtained and that all appropriate procedures have been followed. The precise requirements vary from jurisdiction to jurisdiction and authority to authority. Most public bodies have some sort of formal procurement process. Accordingly, the selection of a lease advisor will often involve a competitive selection process. As part of this process, the agency or authority will generally be required to issue a formal request for proposals, rank the responses and interview prospective advisors. A similar process may be required for other service providers to the transaction such as legal counsel and the appraiser. While there may be circumstances in which process waivers are available, procedures will nevertheless have to be followed to ensure that waivers have been properly obtained.

The substantive authority to enter into a transaction can also be a subject of considerable complexity, since the transaction will commonly involve the long-term lease and theoretical sale of a substantial public asset. (Even though most facility transactions are implemented on the basis of a long-term head lease for a period substantially exceeding the useful life of the facility, there will be circumstances, such as default or non-exercise of the lessee's purchase option, under which the equity will expect to obtain title.) In some circumstances voter approval may be required to alienate a major public asset. This usually makes a transaction less than attractive. However, even when the agency has the legal authority to transfer its assets, its doing so may be a sensitive matter. In most jurisdictions some form of “sunshine” provision is applicable. This may take the form of an open meetings law or a requirement that records be available to the public. In any event, the members of any board likely to approve a substantial transaction involving a public asset will be aware that their dealings will be a matter of public record. The individuals involved will tend to have extensive public experience either as senior administrators or as elected officials and will tend to be quite sensitive to the public perception of the transaction. Accordingly, transactions will have to be explained to lessees in great detail and in a way that allows their benefits to be quickly perceived by the public without creating undue alarm.

The open nature of the approval process puts a great deal of pressure on two particular aspects of a transaction. First, broken deal expenses is a difficult topic in the public sector. While a private entity might reasonably weigh the risks and rewards of accepting responsibility for broken deal expenses, a public entity is likely to be greatly concerned of the possibility that it will have to absorb broken deal expenses and thus be accused of having wasted the taxpayers or ratepayers money, despite having made a reasonable analysis of risks and rewards. A more subtle issue can arise when the transaction has a substantial cash net economic benefit. Then, the problem is avoiding potential rate shocks. Often a public agency or authority will view the net economic benefit of a leasing transaction as a way to fund a capital improvement or other program for which funds were not readily attainable or as a supplement to the funds otherwise available for normal growth. However, in other instances, an agency or authority may be required to treat the net economic benefit as a reduction in its operating costs. When this happens and the agency or authority is operating on a cost pass through basis, a reduction in operating costs may translate to an immediate rate reduction. This seeming economic boon is, in reality, a political problem because the immediate reduction will be followed by increases to restore rates to the normal range in the year following the year of the transaction. As observers of political forces, board members will be highly sensitive to the public perception of a rate increase following the absorption of a benefit. To avoid this issue, some lessees may prefer to have the benefit structured such that it comes in over a period of years and does not result in a shock, in either direction, for the ratepayers.

It may well be that the agency or authority that has title to the asset to be leased does not have the authority to enter into the transaction without consent from other governmental agencies. Sometimes this state of affairs arises from the existence of supervisory authority. At other times it can result when an agency owns an asset, for example a transportation system, which crosses or makes use of the property of another public agency. Obtaining consent from additional parties can sometimes be a matter of essentially procedural review to ascertain whether the transaction proposed meets technical administrative requirements. At other times a more judgmental review as to whether the transaction is in the public interest may be required. Then, the authority whose additional consent is required can condition its response on the sharing of benefit. When this is the case, the possibility of benefit sharing may reduce the incentive of the lessee to enter into the transaction at all. While, in an ideal world, government agencies would cooperate for the greatest total benefit, it often happens that agencies and authorities view their own net benefit as the only goal of the transaction.

Different jurisdictions confer different amounts of power on their agencies and authorities in regard to certain issues that may be critical to investors. The power to declare bankruptcy or be put in bankruptcy involuntarily generally depends on the state law. Some agencies and authorities can become bankrupt and others cannot. Agencies or authorities that cannot become bankrupt and reject a lease in bankruptcy proceedings will be perceived by investors as much better credit risks. Indemnification powers also vary. Net leases typically require that the lessee indemnify the lessor against all tort claims. However, in many jurisdictions, agencies and authorities do not have the power to indemnify for damages that do not arise out of the actions of the agency or authority. Since investors expect protection against damages caused by the actions of third parties, including illegal acts and unauthorized conduct, the effect of such a restriction on the power to indemnify is that insurance will be required. If an agency has previously had the benefit of sovereign immunity and been able to keep its insurance costs relatively low, this may add a significant insurance cost burden to the transaction.

A typical sale leaseback arrangement with a state or local agency or authority will involve an economic defeasance arrangement. In a typical defeasance arrangement, the defeasing party, here the lessee, will invest funds it receives at the outset of a transaction and use the proceeds of these investments to fund its obligations and provide for a possible future purchase option exercise. Some jurisdictions have restrictions on the way public funds can be invested. Any such restrictions need to be examined to ensure that they do not prevent common forms of either debt or equity defeasance.

In a sale leaseback transaction, the investor expects to become the owner of the property, at least for federal income tax purposes. This usually entails ownership for state and local tax purposes as well. State and local tax ownership, however, may have substantial state and local tax consequences. Local property tax laws need to be examined to ensure that they are consistent with the transaction. During the lease term, the lessee will indemnify the investor for property taxes. If the lessee and the taxing authority are the same jurisdiction, then no problems should arise. However, if the taxing authority is a different jurisdiction, the lessee could find itself indemnifying a lessor for taxes paid to another jurisdiction. Sometimes a property tax will be avoided during the lease term because of the nature of the lessee, but subsequent to the lease term, the property may become subject to property tax. If that is the case, the economic model of the cash flows from the transaction will have to take into account the cost of any property taxes. Sales taxes present similar issues. If the private operation of the property will become subject to sales taxes following the lease term, sales taxes payable by the investor in the course of its operation of the property need to be considered. The issue is more focused for transfer taxes. If there is a transfer of title contemplated as a result of nonexercise of the purchase option, the economic model of the transaction will have to take the payment of that transfer tax into account. Since such a tax is typically for the lessee's account, the effect must be considered in the tax compulsion analysis.

Although the complexities of tax-exempt debt are beyond the scope of this article, differences between cross-border and U.S. tax-exempt leasing practices arise from the fact that U.S. state and local governments have financing options not available to their foreign counterparts. Within limits, many U.S. state and local agencies and authorities can finance most capital projects with some form of tax-exempt debt. As a result, a prospective investor in a U.S. transaction must be able to provide an overall financing package that is more attractive than customary tax-exempt debt financing. By contrast, foreign governments do not have a tax-exempt borrowing privilege. Accordingly, they must pay commercial borrowing rates, and lease financing is very often more attractive. The contrast applies even when the lease transactions are defeased. Even though a lessee may defease all of its rental obligations and view the transaction only as a generator of a net up-front benefit, the transaction as a whole must still comply with all relevant tax rules. Compliance with these rules starts with bond counsel. If counsel cannot be satisfied that tax exempt status of bonds outstanding on the property to be sold and leased back is not altered by the transaction, then bond remediation will be required. Remediation essentially involves issuing taxable bonds and using the proceeds to repurchase or defease the tax-exempt bonds or to finance other projects which would otherwise be eligible for tax exempt financing. Remediation can be worthwhile in the right circumstances, but its cost and complexity weigh on any potential transaction.

Public agencies and authorities will often have received grants or special loans to construct or maintain their facilities. Because a sale leaseback transaction disturbs the ownership of the leased facility, the transaction may affect past grants and loans. It may also affect the availability of future grants and loans. This has generally not been an issue for transit rolling stock because the Federal Transit Administration looks to the continued use of the assets for transit purposes in determining eligibility. However, as transactions are considered for nontransit facilities, the issue of grants and loans will need to be considered closely. In many cases, it will turn out that prior grants and loans do not have to be recaptured or that the recapture cost is minimal. However, for facilities where continuing capital improvements are needed and those improvements are incorporated into the leased property, special attention will have to be paid to make sure that the agency continues to be eligible for grant and loan programs.

Although considerable effort can be required to deal with these and other issues potentially involved in a U.S. state or local transaction, fortunately, not all of the issues arise in all transactions and many issues can be resolved if addressed at the outset, so for the knowledgeable and persistent, rewarding transactions are possible.