Use A Synthetic Lease To Finance Equipment Under A Local Government Tax Incentive Program

Fall 2000

By: Henry J. Tucker, Jr.

A number of state and local governments have been promoting economic development by using extraordinary tax incentive programs to attract new businesses or to encourage existing businesses to expand their operations in the jurisdiction. In one incentive program frequently used by local government units, a business entity is offered a significant reduction in certain ad valorem (personal property) taxes on machinery and equipment to be used by the business entity or pays a flat fee in lieu of payment of those taxes. Lease financing can be an integral component of this type of incentive program. We have developed valuable experience with certain leasing companies and local government entities in structuring and documenting the mechanics of the program. In general terms, here's how it works:

The lessee acquires the equipment by entering into a synthetic lease with the lessor. Under a synthetic lease, for state law purposes, legal title to the equipment is held by the lessee and the lessee is treated for tax purposes as the owner of the equipment. The lessor retains a security interest in the equipment as security for the payment of rent and the performance by the lessee of its other obligations under the synthetic lease. For accounting purposes, the balance sheet of the lessee reflects neither an asset for the value of the equipment nor a liability for the rents payable to the lessor.

The lessee then sells its interest in the equipment leased under the synthetic lease to a political subdivision of the state or county, generally an industrial development authority (Authority). Pursuant to a bill of sale given by the lessee to the Authority, the lessee conveys to the Authority all of the lessee's right, title and interest in the equipment, expressly subject and subordinate to the rights and interests of the lessor under the synthetic lease, including the lessor's security interest in the equipment under the synthetic lease. Concurrently with the execution and delivery of the lessee's bill of sale, (1) the lessor executes and delivers a Consent to Sale in which the lessor consents to the sale of the equipment as provided in the lessee's bill of sale, and (2) the Authority executes and delivers a Certification and Confirmation of Subordination in which the Authority certifies and confirms that its interest in the equipment acquired pursuant to the lessee's bill of sale is subject and subordinate to the rights and interests of the lessor under the synthetic lease, including the lessor's security interest in the equipment.

The lessor also executes and delivers a quitclaim bill of sale, pursuant to which the lessor conveys to the Authority whatever interest the lessor may have in the equipment, expressly reserving the rights and interests of the lessor under the synthetic lease, including the lessor's security interest in the equipment. Concurrently with the execution and delivery of the lessor's quitclaim bill of sale, (1) the lessee executes and delivers a Consent to Sale in which the lessee consents to the transfer of the lessor's interest in the equipment as provided in the lessor's quitclaim bill of sale, and (2) the Authority executes and delivers a second Certification and Confirmation of Subordination in which the Authority certifies and confirms that its interest in the equipment acquired pursuant to the lessor's quitclaim bill of sale is subject and subordinate to the rights and interests of the lessor under the synthetic lease, including the lessor's security interest in the equipment.

Concurrently with the execution and delivery of the lessee's bill of sale, the lessee purchases from the Authority a non-recourse bond, the principal amount of which is equal to the purchase price payable by the Authority to the lessee for the equipment. Thus, the lessee purchases the bond from the Authority and the Authority pays the lessee the purchase price for the equipment, resulting in a zero cash flow impact on the lessee.

The lessor receives nominal consideration from the Authority for the conveyance of the lessor's interest in the equipment pursuant to the lessor's quitclaim bill of sale.

Upon execution of the two bills of sale, the Authority and the lessee enter into a lease agreement (Authority Lease) with respect to the equipment. Under the Authority Lease, the Authority and the lessee acknowledge and agree, among other things, that their respective right, title and interest in the equipment, including the rights and remedies of the Authority upon the occurrence of a default under the Authority Lease, are subject and subordinate to the rights and interests of the lessor under the synthetic lease, including the lessor's security interest in the Equipment.

Under the Authority Lease, the lessee is obligated, among other things, to pay rent to the Authority. The amount and timing of each installment of rent payable by the lessee to the Authority under the Authority Lease is exactly the same as the amount and timing of each installment of principal and interest payable by the Authority to the lessee under the bond. Therefore, when the lessee makes a rent payment to the Authority under the Authority Lease, the lessee concurrently receives from the Authority an installment of principal and interest under the bond in an amount exactly equal to the rent payment, thereby resulting in a zero cash flow impact on the lessee. (Under a variation, the lessee's obligation to pay rent under the Authority Lease and the Authority's obligation to pay principal and interest under the bond automatically offset each other, and no money changes hands.)

The lessee makes rent payments to the lessor in accordance with the terms of the synthetic lease.

Under the synthetic lease, the lessee's end-of-term options include the option to return the equipment to the lessor or to purchase the equipment from the lessor. The synthetic lease may also provide for an early termination option that is exercisable by the lessee with respect to some or all of the equipment. Under the Authority Lease, the lessee is granted an option to purchase the equipment from the Authority prior to the expiration of the term of the Authority Lease. In cases where the purchase option under the Authority Lease is not exercised, the lessee, upon the expiration of the term of the Authority Lease, can purchase the Authority's title to the equipment for a nominal amount, generally $100.00.

The Authority, the lessor and the lessee enter into an Assignment of Purchase Option Agreement, pursuant to which the lessee assigns to the lessor, with the acknowledgment and consent of the Authority, the lessee's purchase option under the Authority Lease. This assignment is made so that the lessor can acquire possession of, and rights to, the equipment (1) in order to sell the equipment (or exercise other default remedies) in the event of (i) a default by the lessee under the synthetic lease, or (ii) the election of the lessee to return the equipment at the expiration of the term of the synthetic lease, or (iii) the exercise by the lessee of the early termination option, or (2) in order to transfer title to the lessee in the event the lessee elects to purchase the equipment from the lessor.

The Assignment of Purchase Option further provides that, upon the exercise of the purchase option by the lessor, the lessee shall cancel the bond, and the lessor shall have no obligation to pay any rents that are due and payable, or become due and payable, by lessee under the Authority Lease.

Under a variation of this incentive program, the Authority Lease sets forth the schedule of personal property taxes that are payable by the lessee on the equipment. Under another variation, the lessee and the Authority agree that the assessed value of the equipment will be the leasehold value, rather than the market value, of the equipment for purposes of personal property taxes. Under a third variation, the lessee agrees to pay a fee in lieu of personal property taxes on the equipment or to pay a fee based on the value of the lessee's leasehold interest in the equipment. In any case, the lessee realizes significant savings in personal property taxes otherwise payable with respect to the equipment and can still finance its acquisition of the equipment.