The Fading Pickle Lease InternationalTreasurer1995Aug7 Pickle

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  • 8/10/2019 The Fading Pickle Lease InternationalTreasurer1995Aug7 Pickle


    nternational TreasurerThe Journal of Global Treasury and Financial Risk ManagementAugust 7, 1995

    Performance measurement


    By Brian StrangeCurrency Performance Analytics

    Treasurers analyzing the performance of currency managers/a visory services for bothpension fund and X management need tocompare apples with apples.

    Imagine you are the pension investments manager of a multinational with a significant portion of its assets invested in overseas markets .(Or an FX manager charged with managingcash flows remitted from international affi I ates). Your CFO, has suggested that you investigate currency overlay management (COM) as ameans of protecting the plan assets (long cashflow positions) from swings in value resultingfrom currency movements . Suppose the CFOasks the following:

    Does it add value? Which style of management produces the

    best returns? Which has the lowest risk? Ca n firms add value without taking on

    more currency exposures and simply protectth ones we hav e?

    How can you accurately compare manager performance?

    No problem, you answer . I' ll just call ourinvestment consultants , they ' ll have plenty ofdata.

    Apples and oranges?

    Soon you learn that numerous investment consulting firms collect real return numbers. Youlook through the data and decide that a currency return of 3% by Manager A pales in comparison with the 6% return of Manager B-unt i lyou dig a little deeper and discover that:

    Manager A's underlying portfolio consistedmainly of Canadian and Aussie dollar, whileB's comprised more volatile Japanese yen and

    co ntinu e o n page 4

    US ta x regulations

    IRS ttacksPickle LeasingBy Jay ZukermanErnst & Young

    Lease transactions from the US a b r o a d agrowing t r end have been hampered and perhaps derailed by regulations proposed by theIRS last April 20. These regulations target the

    widely-used cross border leasing techniqueknown as Pickle Accelerators (or replacementleases). Market forces will determine whethernew evolutions or alternative lease structuresput US-initiated, cross-border equipment leasing back on its growth trend.

    The cross-border leasing business has beenshaken considerably by the IRS ' targeting ofPickle Accelerators. The proposed regulationsto shut down this technique may be seen as afurther effort by the US tax authorities to limitthe ta x advantages of leasing to ta x-exempt,including non-US , entities. Thus , US lessorsand their tax advisors are left to search for othermethods of obtaining ta x advantages on equipment lease transactions abroad--or alternative-

    ' ly may stick to domestic transactions.

    Pickle background

    By all accounts , the development of theAccelerator technique dramatically enhancedthe cross-border leasing market for US lessors.Estimates of completed transactions range

    from several hundred million dollars in assetvalue in 1990 to $4 billion in 1994. Prior tothe release of the proposed regs, similargrowth was forecast for 1995 .

    Pickle Accelerators were favorable, becausethey allowed US lessors to minimize therecovery period on lease transactions used tofinance a wide variety of assets including, railroad rolling stock, aircraft and, most recentlypower plant facilities. Also , as opposed to USForeign Sales Corporations (see IT 9/19/94)and Japanese leveraged lease alternatives,

    continued on page

    BenchmarkingX Managers

    , By Brian StrangeCurr ency PerformanceAnalytics

    How to benchmark theperformance of curren-

    ' cy overlay managersand apply this analysisto treasur y controlledpension and X management programs .

    pa ge 1

    IRS AnacksPickle LeasingBy jay Zuk e rm anErnst Young

    Proposed IRS regs willmake US-initiated

    1 cross-border leasesmore difficult t structure for tax benefits .page 1

    APAs for FinancialTransactionsWhile maintainingsupporting documentation is the critical issue ,financial entities concerned with transferpricing penaltiesshould consider negotiating advanced pricingagreements.

    pa ge 6

    ' Free Trade &BankingBy Jose ph Neu

    The US still supportsfree trade in \inancialservices , despite therecent WTO snub .Thus , global bankingrelationships are notlikely to be any lesseffective .

    page 8

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    Treasury Tax lanning

    continued from pa ge

    Pickle Accelerators are appropriate fornew and used assets of varying economic useful lives . They are also notlimited to assets manufactured withinthe US.

    The legislative history against Pickleleases began with an effort to curb thepossibility th t US investment incentives could be passed through to taxexempt entities. In 1984, the US enacted legislation sponsored by HouseRepresentative Pickle (hence the namePickle lease) and Senator Dole thatsubstantially reduced the depreciationbenefits avai lable to US lessors in leas to tax-exe m p t e ntiti es, includin gthose abroad.

    Specifically, the so-called Pickle

    rules mandated both a deceleratedmethod of computing the depreciationallowance i .e ., straight line rather thanaccelerated) and a longer recoveryperiod (the greater of the asset's guideline class or 125% of the lease term) .As a resu lt , few Pickle transactionswere consummated during the balanceof the 1980s.

    By late 1989 , an adaptation of thePickle lease began to emerge, knownas the Accelerator or replacementlease. This technique allowed the

    lessor to shorten the equipment'srecovery period (thus enhancing itsdepreciation deduction), while simultaneously reducing taxable income ,resulting in an increased after-taxyield. It is this technique that the proposed regulation attempts to close out .

    A sample transaction

    The basic structure of the Acceleratoris as follows see diagram at right):

    1) The US lessor (typically, a specialpurpose corporate subsidiary) contributes 13 percent of equipment costto a Trust. The Trust is deemed a soca lled grantor trust for US tax purposes so that all the tax attributes ofthe Trust position (rental income , interest expense , and depreciat ionallowance) are passed through to theUS lessor.

    2) The Trust acquires the equipmentfrom the manufacturer or other vendor

    (including, in the case of refinancing ofused assets pursuant to a sale/leaseback , the non-US lessee) for a cashpurchase price.

    (3) The Trust borrows 87% of theequipment cost from a lender, on anonrecourse basis, pledging the equipment and the lessee's obi igations(described below) as co ll atera l forrepayment of the loan. The loan isamortized over an economic termapproximating a leveraged lease transaction without an Accelerator (e.g ., 20years for an aircraft transaction).

    4) The Trust leases the equipment tothe non-US lessee for a term significantly shorter than the loan amortization period 1 0 years in our example).

    To protect the US lessor and lender,the non-US lessee agrees , at the expiryof the initial term, to effectuate one ofthe following:

    a. Purchase the equipment pursuantto a purchase option at a fixed price( FPO ) determined to approximate orexceed the projected fair market value( FMV ) of the equipment upon theexpiry date; or

    b. Pay a termination value or walkaway payment ( TVP ) in an amountdiscounted from a nt icipated FMV andreturn the equipment to the lessor (withany third-party proceeds utilized toreimburse the lessee) ; or

    c Arrange for a suitable replacementlessee to enter into a replacementlease ( R L ) with terms sufficient tofund the remainin g amortization o f theloan .

    The non-US le ssee's obligations are

    typically guaranteed by the lessee'scorporate parent.The benefit: The intended results and

    tax benefits of the Accelerator tech-

    Diagram: U Pickle Lease Accelerator Structure

    Trustee(US Trust Co.)


    Parent ofLessee

    US Parent

    US Equity

    $ l .13 Equttyt

    Trust(US Grantor Trust)

    I10-year Lease Rent

    Non-US Lessee

    1 0 0 ~I

    Equipment SaleI

    $8 7 LoanL~0-year Note

    DefeasanceCurrency and/or

    Interest Rate Swap

    At Lease Expiry

    eoreoraSour ce: Ernst & Yo ung *No t e : Ve ndor can be non-US Lessee Sal e/ Lea seback) .

    Inte rn a tio na l Treas u re r/ August 7 , 199 5

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    nique are twofold : The recovery period is computed

    on the basis of the shorter lease term1 0 years X 125 = 12.5 years , ratherthan a 20 years X 125 = 25-yearrecovery period) ; and

    The rental income to the US lessoris reduced during the shorter 1 0-year)term due to the longer (20-year) loanamortization term.

    Defeasances, interest rate and /or currency swaps are typically utilized toaccomplish certain economic, loansecurity, and withholding tax objectives . Additionally, in some instances,a p a rt of the debt is p rovid ed b y th enon-US lessee (or an affiliate), ratherthan by a third-party, unrelated lender .

    he point ot anack

    The proposed regulations directlyattack the Pickle Accelerator structureby stating that the term of the lease forthe purposes of determining the applicable depreciation recovery periodshould include any period where thelessee (or a person related to the lessee)retains a financial obligation to pay rentor make a payment in the nature ofrent. Further, a payment in the natureof rent is defined explicitly to includea payment intended to substitute forrent or to fund or supplement the rentalpayments of another party.

    The regulations provide as an example of such a payment, any paymentrequired t be made in the event that (i)tne leased property is not leased for aspecified additional period ; or (ii) theleased property is leased for the additional period under terms that do notsatisfy specified terms and conditions;

    or (iii) there is a failure to make a payment of rent with respect to such additional period . In other words, the proposed regulations target exactly thereplacement lease option that is typically utilized in the Accelerator structure.

    Accordingly, using our example,under the proposed regulations, thelease term would be recharacterized as20, rather the 1 0 years ; and consequently , the depreciation recoveryperiod go to 25 years from 12.5 .

    Inte rn at ion a l Treas ur e r/A ugust 7, 1 995

    According to market estimates, theresulting cost to the US lessor (assuming the loan term payments and rentalsremain unchanged) approach 400basis points , using an after tax yieldanalysis. If the loan amort izat ionrequired increased rentals as a consequential result of any restructuring , thecost would further increase and the USlessor ' s after tax yield would deteriorate further.

    At such cost, the dramatic impact onthe marketplace resulting from therelease of the proposed regulationsbecomes readily understood .

    The future is now

    The effective date of the proposed regulations ( if finalized as proposed)would trigger retroactively to theannouncement date : April 20, 1995.Thus , the IRS is not providing for atransition period to allow affected taxpayers to complete pending transactions. The market effect is immediateand pervasive.

    Further , while the regulations wouldnot apply to transactions consummatedprior to the effective date, the IRSspecifically reserved the right to question and recharacterize the lease termof earlier, closed transactions underexisting legal principles and authorities .

    Planning considerations. Many questions have arisen in the wake of theproposed regulations . Foremost , ofcourse , is wheth e r stru c tur a l evo lutio nswill be able to return some (or all) ofthe benefit stripped away from US-initiated cross-border leases.

    Plannin g opportunities may arise, forexample , which would permit the US

    lessor substantially the same benefitswithout running afoul of the proposedregulations . Some alternative strategiesmay generate greater economic risk forthe lender . This risk will l ikely bepassed on resulting in greater transaction costs .

    Cost sharing thus would become acrucial aspect of negotiations betweenthe U lessor and the non US lessee.

    Treasury/Tax Planning

    Opportuni t ies that do not createthese transaction costs (apart frommore limited FSC and Japanese lever-aged leases) may create greater taxrisks. The market will have to evolvefurther to determine who will bearwhich risks and who will be entitled towhat compensation .

    During this transition risk managerswith Pickle related leasing activitiesshould be careful to identify andattempt to quantify exposure andcost benefit on a risk adjusted basis.

    In eva lu ati n g t he tax r isk in p a rt lcular, US lessors should decide whetherthe proposed regulations represent an

    interpretation of specific tax law; or ,rather, in a macro sense, an expressionof a general distaste for any tax planning in the Pickle lease area. Underthis view, US taxpayers may see themselves as having been placed on noticenot to engage in these sorts of transactions and that any future structuralevolution may be challenged back toApri/20, 1995.

    Given this tax risk, it would not besurprising to see some US l e ssorsdecide not to proceed with any Picklelease structures at this time. However,others have raised the issue as towhether the proposed regulations areconsistent with legislative history, noting that under the Accelerator structurethe property must always be d epr ec ia ted o ve r a p er io d n o snorter than t n easset ' s guideline class life. This m ylead to revisions in the final regulations that would ameliorate some ofthe adverse impact.

    Ultimately, market forces such as the

    alternative domestic or FSC transactions available to US lessors, alternative sources of funds available to nonUS lessees (such as from Japaneseleveraged leases) , and the fle x ibility oflenders will shape and determine thescope of the continued US-initiatedcross-border leasing market.

    Mr . Zukerman is director o f easing ta x ser-vices for Ernst & Young . He is reach e d at272 ) 773 3270 .