Recharacterization: The Hidden Risks

As described last month, the lease is the second element of the tripartite lease transaction. (The tripartite transaction in question consists of two elements and three parties: the first element involves the transfer of equipment from a supplier to a finance lessor, and the second element consists of the lease of such equipment from the finance lessor to the lessee with a supplier support guarantee.) The hidden recharacterization risk is embedded in the first element, that is the transfer of title of the equipment from the supplier to the finance lessor. Depending upon the nature and extent of a supplier guarantee that may be required to support the lease in these tripartite transactions, this transfer may be considered by a reviewing court as a loan instead of a sale.

The following example of a common commercial leasing transaction illustrates the hidden risk. Assume that a supplier finds an end-user to lease a piece of equipment. The supplier then transfers title of the equipment to a finance lessor in a transaction that is documented as a sale, at a purchase price that is: 1) stated to be the full retail price of the equipment; and 2) used to compute the lease payments to the end-user. The finance lessor then enters into an operating lease with the end-user. In an effort to provide economic support or credit enhancement, the supplier executes a written guaranty of the lessee's lease obligations under the operating lease to the finance lessor. The supplier also agrees to repurchase the equipment at the end of the lease term at the scheduled residual price fixed at the inception of the lease, which residual is computed as the retail price paid by the lessor to the supplier at the inception of the transaction, plus accrued interest, less the amount of the lease payments made by the lessee under the operating lease.