By Mike Stone
February 9, 2004

The Senate Finance Committee has reported out the JOBS bill (S 1637) that includes provisions which will significantly restrict or limit the ability of cities and other government and tax- exempt entities from using leasing to raise capital and acquire needed equipment. The Bush Administration is proposing similar provisions in its FY 2005 Budget.

The primary thrust of the proposals would impose broad and far reaching limitations on deductions allocable to property leased to or used in connection with the provision of services to cities, states and all other tax-exempt entities such as hospitals, transit authorities or even charities and relief organizations. Currently, leasing transactions to these entities provide over $20 Billion in efficient and flexible lease financing each year.

Cities and other local tax-exempt entities and authorities use leasing for a wide range of capital needs. These needs include mass transit, water and waste water systems, telecommunication networks, information technology systems, medical equipment needs and safety vehicles.

Under longtime current law and practice, a lessor of equipment and a provider of services to a tax-exempt entity is entitled to take tax depreciation on the equipment. This tax depreciation, while beneficial, is significantly less than allowable when the lease is to a taxable user of equipment. Further, to encourage tax exempts to deploy productive technology based equipment such as computer systems and diagnostic equipment, The Congress in 1984 provided that qualifying technology equipment leased to tax-exempt entities would be eligible for the same tax depreciation as allowable for taxable entities.

Section 476 of S 1637 and the Administration's Budget adds some severe restrictions to the historic use of allowable deductions. The provision limits the allowable deductions for the lessor or provider of services to the amount of income reported to each such lease or service contract in a taxable year. This proposal takes away the efficiency of the lease or service contact and the effectiveness of investment incentive for the city or tax-exempt entity. Because the incentive of tax depreciation is that it can defer taxable income (not avoid it), the Senate Proposal removes the economic benefit for the city or tax exempt.

"Make no mistake about the impact of this," Michael Fleming, President of The Equipment Leasing Association of America, told the recent Winter Conference of Mayors. Fleming spoke at the closing luncheon Friday, January 23, following Senator Hillary Rodham Clinton. "Typically a lease provides 25 per cent more benefit in financing than traditional tax exempt borrowing such as a bond." The proposals would effectively eliminate the exemption for qualified technology equipment. Fleming described how a tax-exempt hospital's lease payments on a single CAT Scanner would increase by over $38,000 a year.

Section 472 of S 1637 and the Administration's Budget requires that the term of a lease include any service contract or similar arrangement subsequent to a lease. In 1984 Congress provided that the allowable depreciation on property leased to tax-exempt entities would be a term equal to the greater of the property's ADR class life or 125% of the lease term. Simultaneously, and as part of the same legislation, Congress enacted the "service contract" rules, which were established to define the kind of arrangement with tax-exempt entities that could be entered into without application of the depreciation limitations described above. These service contact rules have established the model for many privatization arrangements for twenty years. For example, may municipal solid waste disposal facilities were financed with a combination of leases to operators and service contracts to the municipalities. In another form of transaction that has been used for many years, a lessor can provide a lease financing at a lower up front rental cost by allowing a significant portion of its equity to remain invested until termination of the lease. At that time, the lessee (i.e.: a city or authority) can either exercise its purchase option and re-acquire the asset or arrange privatization of the asset through, for example, a service contract.

By requiring that the tax depreciation period be an aggregation of the lease term and the service contract term, the economic benefits of depreciation, and therefore the transaction, are destroyed for the city or tax-exempt. This aggregation is forced without regard to longtime rules for determining whether purchase options are expected to be exercised or even whether the lessee and the privatization are the same party.

How did all of this get started? The Chairman of the Senate Finance Committee became driven by two goals: Enact a doctrine of Economic Substance in the federal tax code which would among other things provide that a transaction must have business or economic purpose outside of just tax purposes; and, eliminate loopholes and other tax abuse. Leases and Service Contracts involving tax-exempts ran afoul of the Senator's objectives. What got his attention primarily were sale and leaseback transactions done or in progress on a range of infrastructure, water and wastewater facilities and transit systems.

Transactions had been done all over the United States and in foreign countries and have been pending in Atlanta, New York, St. Louis, Chicago and Boston, and in cities in Connecticut, California, and New Jersey. Several major transportation transactions were done in Texas under enabling legislation there in the mid 90's. The U.S. Department of Transportation has been an active proponent of the mass transit transactions, even to the point of endorsing them on the web sit of the Federal Transit Administration. However, at the urging of Treasury Assistant Secretary for Tax Policy, Pam Olsen, DOT has suspended the FTA promotion and approval process.

The suspension is holding up important transactions such as Chicago's Orange Line and transit projects in places such as Santa Clara, Atlanta, SEPTA, San Mateo, Portland, Connecticut DOT and others. People in tax-exempt entities and the leasing industry are perplexed by the Treasury's sudden characterization of leases to tax-exempts as "loopholes or abuse". Treasury has not taken any actions or used its regulatory authority to provide any guidance in this area even though they are very transparent and appear to conform to current law.

Cities and other tax-exempt entities and their organizations are now contacting the Bush Administration and their Congressional Delegation to voice concern and opposition to the proposals to take away an important method of finance at a very difficult time.

In her remarks to the Mayors' Winter Conference, Senator Hillary Rodham Clinton (NY) acknowledged that the issue had been brought to her attention and recognized that it was a serious fiscal threat for cities. The legislation is up for consideration by the entire Senate later in February or early March and the Administration's Budget will begin receiving consideration this winter.