Qualified Lessee Construction Allowances for
Short-Term Leases

DEPARTMENT OF THE TREASURY              
Internal Revenue Service 26 CFR Parts 1 and 602 [TD 8901] RIN 1545-
AW16

TITLE: Qualified Lessee Construction Allowances for Short-Term
Leases

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

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
	   §1.110-1, see §1.110-1(d).

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

SUPPLEMENTARY INFORMATION:

Paperwork Reduction A t

        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 8½ 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 8½
month rule provided in the proposed regulations. This 8½ month rule,
which grants the lessee an additional 8½ 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 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.

        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 Lgnificant 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:

§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 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 8½ 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 §602.101, paragraph (b) is amended by adding an
entry for 1.110-1 to the table in numerical order to read as
follows:

§602.101 OMB Control numbers.

* * * * *

         (b) * * *

____________________________________________________________________

CFR part or section Current OMB identified and described control No.

* * * * *

1.110-1 .................................................1545-1661

* * * * *
____________________________________________________________________


Robert E. Wenzel           
Deputy Commissioner of Internal Revenue                        
Approved: August 29, 2000                
Jonathan Talisman            
Acting Assistant Secretary of the Treasury

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