Qualified Lessee Construction Allowances for
Short-Term Leases

DEPARTMENT OF THE TREASURY
Internal Revenue Service 26 CFR Part 1 [REG-106010-98] RIN 1545-AW16

TITLE: Qualified Lessee Construction Allowances for Short-Term
Leases

AGENCY: Internal Revenue Service (IRS), Treasury.

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

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 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 Servi e , 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 §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 hoU.S. 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 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 81/2 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 10 th Street entrance,
located between Constitution and Pennsylvania Avenues, NW. In
addition, all visitors must present photo identification to enter
the building. Because of access 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:

§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 81/2 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:

(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

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