MSU LIBRARIES RETURNING MATERIALS: PIace in book drop to remove this checkout from your record. FINES wiII be charged if book is returned after the date stamped below. THE INFORMATIONAL EFFICIENCY OF TAX BENEFIT TRANSFERS THROUGH LEASING: AN EMPIRICAL STUDY By Joel Mark ShuIman A DISSERTATION Submitted to Michigan State University in partiaI fquiIIment of the requirements for the degree of DOCTOR OF PHILOSOPHY Department of Finance and Insurance 1984 ABSTRACT THE INFORMATIONAL EFFICIENCY OF TAX BENEFIT TRANSFERS THROUGH LEASING: AN EMPIRICAL STUDY By Joel Mark Shulman The Economic Recovery Tax Act (ERTA) of l98l relaxed the restrictions on tax-benefit transfers between financially stable (lessor) and financially unstable (lessee) firms, through the enactment of Safe Harbor Leasing. This study investigates whether safe harbor lease transactions created market inefficiencies, as alluded to by the popular press, and will attempt to ascertain the effect of safe harbor lease transactions on the equity shareholder returns. Stock return data of firms identified as actively involved with tax benefit transfers through the enactment of ERTA will be analyzed to examine the likelihood of shareholders having earned excess risk adjusted rates of returns, along with any resultant significant risk changes. The event date will focus on November l3, l98l. Risk adjusted returns prior to the event date will be com- pared with the residuals subsequent to the event date using an intervention time series model of risk and return. Results and conclusions about the claims found in the popular press will be offered. DEDICATION To Linda, for all of her support and encouragement. ii ACKNOWLEDGMENTS I am deeply indebted to my chairman, Larry Johnson, and to Professor John O'Donnell for their many insights and comments. I am also grateful to Professor James Marshall for his helpful sug- gestions. TABLE OF CONTENTS Acknowledgments. List of Tables . List of Figures. CHAPTER I INTRODUCTION II EVOLUTION OF LEASING. Court Criteria. Equity Interest Intent Title Transfer. . Judicial Treatment IRS Audit . III OVERVIEW. . . Safe Harbor Law . . . . . Tax-Benefit Transfer: An Example An Example . . Efficiency of Safe-Harbor Leases. . Accounting for Safe Harbor Leases in Finan- cial Statements . . . . . . . Disqualifying Events. . . Avoiding Disqualification . . Unwind and Indemnification Clauses . Insurance . . TaxlEquity and Fiscal Responsibility Act of 982 . . Effective Dates Finance Leases. IV LITERATURE REVIEW. . . Development of a Safe- Harbor Model . TBT Lease Valuation Model . V METHODOLOGY. . . An Intervention-Market Model of Security Returns . . . . iv Page ii vi CHAPTER VI VII RESULTS. SUMMARY AND CONCLUSIONS BIBLIOGRAPHY . Page 105 Ill TABLE l.l 3.1 3.2 3.3 3.4 3.5 3.6 3.7 6.1 6.2 6.3 LIST OF TABLES Distribution of Benefits from Safe-Harbor Transactions. . . . . . . Results to Lessor . Results to Lessee . Distribution of "Treasury Loss" Distribution of Benefits According to Size of Transaction . . . . . . . . Use of Safe- Harbor Leasing by Industry ($ Millions). . Distribution of Transactions According to Execution Date (Percentages) Depreciation Deductions under the New Act . Approaches to Lease Evaluation. Distribution of Transactions According to Execution Date (Percent). Model Parameters Parameter Differences and Standard Errors . vi Page 41 43 45 46 47 59 7O 98 99 TOT FIGURE 5.1 5.2 5.3 LIST OF FIGURES Illustration of Significance Interval Illustration of Abnormal Performance. Cumulative Average Residual Patterns Caused by Changing Betas or Information . . . vii Page 88 90 CHAPTER I INTRODUCTION 'He made money hand over fist."1 “Come Monday, November 13, 1981 deadline, there's going to be a lot of blood on the floor."2 "Leasing accords involve billions in gear as [the] initial round of tax credit sales ended."3 These and other quotes concern- ing the new safe harbor leasing law filled the pages of most major 4 newspapers and magazines during the fourth quarter of 1981, creat- ing quite a stir in the press5 and in Congress. For a while, safe harbor leasing was the hottest tax issue in Washington.6 Many openly debated the effectiveness of the new law and its ability to 7 spur capital investment. Consequently, within a few short months after the enactment of the new law, several prominent Congressmen were discussing the repeal of the tax provision.8 The Economic Recovery Tax Act (ERTA) of 1981 relaxed the restrictions on tax benefit transfers between financially stable (lessor) and financially unstable (lessee) firms through controver- sial safe harbor leasing provisions. The safe harbor lease (so called because such transactions were safe from Internal Revenue Service (IRS) scrutiny as long as IRS regulations were followed) provided lessees with a large cash down-payment and allowed lessors to take investment tax credits and future depreciation write-offs (using what is popularly termed a "wash lease"). Much of the controversy surrounding these leases focused on lost Treasury revenues and inefficiency in the marketplace. John M. Samuels, a former Treasury Department official, noted: "There is tremendous Congressional dissatisfaction with the rules . . The drain on Treasury revenues looms larger each day. And rather than help[ing] ailing firms, as was intended, the original bill appears to have become more of a tax loophole for profitable ones."9 Politically, the issue heated up when General Electric Co. took advantage of safe-harbor leases to reduce its 1981 tax liability to near zero and sought refunds totaling $150 million for the three preceding years.10 The issue was further complicated when a few highly profitable firms, notably Occidental Petroleum and CSX Corp. were able t0.§211 credits, since they had a surplus of credits after reducing their domestic tax liability to zero for 1981.11 Much of the popular press alerted potential investors to the uses and abuses of the world's largest corporations. Terms such as "bonanza" were often used in conjunction with large numbers, 12 to describe a safe harbor lease transaction. For example, Indus- try Week magazine had an article depicting safe harbor leasing which stated, "Bonanza; A major black eye for safe harbor is the inescapable fact--and public embarrassment--that it has enabled Profitable companies to reduce their tax bills markedly. G. E. saved roughly $280 million, International Business Machines Corp. about $170 million." Similar articles appeared in the Wall Street Journal,13 Fortune, and Business Week, among others. Table I, computed by the U.S. Treasury Department, attests to the magnitude of safe harbor lease transactions and the resulting loss of Treasury revenues .14 Professor Hempel, in his presidential address to the thir- teenth annual meeting of the Financial Management Association, noted: There are numerous areas in financial management as well as other areas of finance in which we could benefit from quality research in the future. In a theoretical vein (I believe there is no chasm between good theory and practice), we need to learn even more about underlying contractual (or agency) relationships among a business' owners, creditors, and managers and we need to develop a more dynamic theory of financing decisions over time. Rather than add one more variable to a lengthy esoteric regression, we might use empirical research to test some of the many assumptions of and questions about efficient markets and to try to develop improved measures of risk. Practical research ideas can be obtained almost daily by reading the Wall Street Journal. . . Quality research in any of these practical areas, if communicated in an understandable way, would seem valuable to peers, business people, and students.15 This study does precisely what Professor Hempel recommended: It analyzes the impact of these tax-benefit transfers on both lessors and lessees, using the form of an event study. The popularity of firm-specific event studies is well docu- mented, and has been increasing in recent years. Event studies explore the effect of new information (an event variable) TABLE l.l--Distribution of Benefits from Safe-Harbor Transactions Amount of Benefit Share of Benefits . (millions) Benefit (%) Seller/Lessee $ 4,262 76.5 Buyer/Lessor 1,202 21.5 Third Party Assets 109 2.0 Present Value of Revenue Loss $ 5,571 100.0 on a security's specific return. The critical issue is whether or not an investor receives an abnormal rate of return. These studies provide a direct test of market efficiency. Stephen Brown and Jerold Warner further note: Systematically nonzero abnormal security returns which persist after a particular type of event, are inconsistent with the hypothesis that security prices adjust quickly to fully reflect new infor- mation. In addition, to the extent that the event is unanticipated, the magnitude of abnormal per- formance at the time the event actually occurs is a measure of the impact of that type of event on the wealth of the firms' claimholders. Any such abnormal performance is consistent with market efficiency, however, since the abnormal returns would only have been attainable by an investor if the occurrence of the event could have been pre- dicted with certainty.]5 The ensuihg analysis explores the merits of the assertions in the popular press as they pertain to the safe-harbor lessee and lessor, and also investigates whether or not safe harbor lease transactions create market inefficiencies. An attempt is made to ascertain the effect of safe harbor lease transactions on equity shareholders. Stock-return data for firms identified as having been actively involved in tax-benefit transfers enabled by ERTA are analyzed to examine the likelihood that shareholders have earned excess risk adjusted rates of returns, along with any resultant significant risk changes. The event date is November 13, 1981--a critical trading deadline-—and is explored in depth. Risk adjusted returns prior to the event date are compared with the residuals sub- sequent to the event date using an intervention time series model of risk and return. Results and conclusions related to claims found in the popular press are presented. This study is divided into seven sections. Chapter II examines the legislative history of leasing, and addresses the 17 associated with the significant inequities and inefficiencies safe harbor leasing bill. Alternatives are suggested and explored. Chapter III discusses the safe harbor leasing law, and provides an example explaining how it operates. The law that superceded the safe-harbor law, TEFRA 1982, is also examined. Chapter IV provides a chronological review of the finance-leasing literature, and a model for calculating safe harbor leasing benefits. Chapter V describes the methodology chosen for this study, and justifies its use vis-a-vis other commonly applied techniques. Chapter VI pres sents the results of the study, and Chapter VII offers concluding statements. ENDNOTES Cha ter I 1Quote during a telephone conversation with a finance Vice President of a Fortune 500 company who was extensively involved with his firm's safe harbor leasing. 2Wall Street Journal, November 13, 1981, quote by Peter K. Nevitt President of Bank of America's Leasing Unit, "Drive For Tax Gains on Lease Accords Mired in Confusion as Deadline Nears." 3Wall Street Journal, November 16, 1981. 4Wall Street Journal, New York Times, Fortune, Time, Business Week, etc. 5Wall Street Journal, October 29, 1981, letter to the editor by Arthur Schlesinger criticizing President Reagan's proposal fer cutting federal taxes and spending. 6Business Week, "Safe Harbor Leasing's Stormy Future", Decenber , . 71bid. 8Arthur Anderson & Co. "Survey of Selected Participants in Safe Harbor Lease Transactions Pursuant To Internal Revenue Code Section 168(b)(8)." 9Industry Week, January 11, 1982, "Safe Harbor Tax Leases May be sunk“? lOuThe Assault on Safe Harbor Leasing," Industry Week, June 14, 1982. 1""Safe Harbor Leasings Stormy Future", Business Week, December 21, 1981. 12"The Assault on Safe Harbor Leasing." Industry Week, June 14, 1981, and Nall Street Journal, November 13, 1981. 13Particularly around November 13, 1981 (a deadline date)- 14The Treasury estimated that $17.4 billion of property was covered by safe harbor leases. This amount was equivalent to an approximate discounted present value of $5.6 billion in tax benefits. 15Journal of Financial Management, Winter 1983. 16"Measuring Security Price Performance", Stephen Brown and Jerold Warner, Journal of Financial Economics (8) 1980, 205-258. 17The U.S. Congress and Senate in Report Bulletin 27, Anal - sis of Safe-Harbor Leasing_defined an "inefficiency" as a loss of Treasury revenue caused by tax benefit transfers. This usage should be kept distinct from the interpretation of "efficiency" applied in a capital market context. CHAPTER II EVOLUTION OF LEASING The evolution of leasing law in sale-leaseback transactions, and the tax consequences of a particular transaction, involve dif- ferent approaches and a myriad of judicial hearings, IRS regulations, and taxpayer interpretations. Past legal issues focused on the intent of the parties involved and an analysis of whether the transaction was a valid sale-leaseback for tax purposes, a mere financing device, or a sham. Treatment of taxpayers was often inconsistent and woefully inadequate. Proper legal and accounting forethought often made the difference between an acceptable sale- leaseback transaction and a sham. This chapter offers a brief descriptive analysis of the 1 sale-leaseback evolution and addresses the equity issues raised by the law prior to the Economic Recovery Tax Act of 1981 (ERTA). Court Criteria The courts consider numerous factors in determining the validity of a sale-leaseback transaction for tax purposes. In Frank Lyon Co. v. U.S. (435 U.S. 561), the U.S. Supreme Court men- tioned 25 factors in support of a ruling that the transaction was a financial arrangement, not a bonafide lease. The court failed to note which factors were controlling in the decision, and 10 thus offered minimal guidance for the future concerns of judges and tax planners. Prior to the ERTA, courts consistently referred to four conditions in assuring the validity of sale-leaseback transactions. The first factor often used by courts involved the determination of which party held equity interest in the property. Such character- istics of equity interest included the reasonableness of the rental payments, the option price, the sale prices, and the burdens and benefits of ownership. Second, the courts assessed the intent of the parties and the legitimacy of the business purpose. A third factor employed by courts concerned the transferability of title during the normal course of the lease contract. Finally, the courts calculated present values of the lease contract in an attempt to ascertain the economic substance of the lease contract. This chapter will examine the treatment of these four factors, and will provide a necessary history which existed prior to the ERTA. Only after a careful review of the case history and the IRS rules and regulations can the uninformed investor truly appreciate the magnitude of the safe harbor leasing law, and why it had such a significant impact in the capital marketplace. Equity Interest One of the fundamental considerations of courts in determin- ing the appropriateness of a sale-leaseback transaction, and which Party was legally entitled to the tax deductions, was in estimating the relative equity interests of the parties involved. Code section ll 162(a)(3) specifically denied rent deductions to a leasee that acquired an equity interest in leased property. Similarly, Section 167 specifically precluded a depreciation deducation unless a capi- tal investment existed. The following categories enclosed were often examined in courts to decide the extent and relationship of equity interest. 1. Rental payments. Excessive or unreasonably high lease payments indicated that an equity interest might have been transferred to the leasee. The point was illustrated in Frenzel v Commissioner (TC Memo. 1963-276). A large lease payment was especially suspect if it coincided with a low option price agreement. However, a low option price in addition to large rental payments was not always a guarantee that the leasee had an equity interest. ‘Bglz Investment Co. v. Comm (72 TC 1209) demonstrated that the inherent riskiness of the business opera- tions was an important criterion in assessing whether or not lease payments were “reasonable". Rental payments judged unreasonably low did not indicate an equity interest in the lessee. The courts, however, questioned the validity of this arrangement, and usually ruled that the transaction was a financing device and not a bona-fide sale- leaseback (Helvering v.F. & R. Lazarus & Co.. 308 12 U.S. 252). The courts generally held that sale-leasebacks which were in substance mere financing arrangements would not entitle purchasor-lessors to consequent tax benefits (see American Realty Trust v. U.S., 498 F. 2d 1194). In Lazarus, the IRS sought to deny depreciation deductions to the lessee on the premise that the right to depreciations followed legal title. The Supreme Court permitted the deductions, and explained that transfers of title should be disregarded when given only as security for a loan. Although the IRS lost in Lazarus, it continued to employ the Supreme Court's analysis in challenging sale-leasebacks which appeared to be motivated solely by the desire for tax benefits.2 Option price. The Belg case, previously mentioned, indicated that the value of the option price was often observed in accordance with the reasonableness of the leasee payments in deciding whether the lessee had an equity interest. The courts often focused on whether the lessee company had a "compulsion to exercise" the option. Compulsion was often described as the situation arising when the option price was set considerably 3 lower than the fair-market value of the property. If the courts ruled that the lessee was compelled to 13 exercise his option, then he would be considered as having an equity interest, and the transaction would be identified as a financing arrangement. An option price less than fair-market value was not automatically construed to be compelling by courts. In American Realty Trust v. U.S. 498 F. 2d 1194, the court rejected the "economic compulsion" argument, holding that the seller eventually exercised his repur- chase option as a result of the sudden availability of wraparound financing, not economic compulsion. The court noted that the seller initially sold for a fair price, not an unreasonably low one, and distinguished from the bargain price in Lazarus. The court also differentiated the 99-year initial lease term in Lazarus from the 21-year lease term in American Realty Trust.4 The length of the option period was critical in determining economic compulsion, since the courts were hesitant to speculate what the fair market value would be at the end of a long option period. Thus, the price of the option and length of the option period were considered in conjunction with other factors, such as the useful life of the property in relation to the lease term plus renewals. For example, a lessee engaged in a long-term lease would perhaps not be compelled to 14 exercise an option if he already had all of the benefits associated with the property. Sale price. The sale price is an important factor in determining an equity interest. If the sale price of the property approximated the fair-market value, then the courts generally held that the purchaser-lessor had an equity interest. However, if the sales price greatly exceeded the fair-market value of the property, and non-recourse financing was involved, the courts have sometimes held the transaction invalid and denied both interest and depreciation deductions. In gstgtg_ of Franklin v= QQEm'r (544 F. 2d 1045), the court held that when the purchase price in a sale-leaseback cannot be shown to approximate the fair-market value of the property, the "stuff of substance" is the purchaser- lessor's equity in the property. The court stated that a true investment "will rather quickly yield an equity in the property which a purchaser cannot prudently abandon."5 The purchaser-lessor was denied an equity interest in the property, since the unpaid balance exceeded the fair market value of the property. The purchaser-lessor had only a minor chance to benefit from appreciation of the property, yet could abandon the arrangement at any time. 15 Burdens and benefits. In establishing an equity interest, the courts often considered such factors as burdens, benefits, risks, responsibilities and other miscellaneous factors identified in the lease contract. One sale-leaseback case which discussed burdens and benefits at great length was Sun Oil Co. v. Comm'r (562 F. 2d 258. cert. den., 436 U.S. 944). The court denied the rental deductions taken by the seller-lessee and made the following findings: (a) Sun_911_retained essentially all of the risks and responsibilities of the leased property, including casualty or condemnation. (b) Sun Oil maintained all of the benefits and pre- requisites of ownership of the land through its repurchase options. (c) The rentals did not reflect the fair-market value of the leased property. (d) The absolute repurchase options would not appreciably benefit the lessor, since the appraised value of the property would have to consider lease encum- brances, which when discounted to a present-value term, amounted to nil. The court surmised that Sun Oil in essence assumed the risks and burdens of the leased property as well as the benefits through its options and repurchase 16 agreements. The transaction was viewed as a financing arrangement which amounted to little more than a loan on a security of land with a stated rate of interest.6 m In addition to addressing the equity concern, the courts often attempted to ascertain the true intent of the parties engaged in the lease contract. An intent test utilized by the courts' consisted of similar information used in determining an equity ' interest, as well as the conduct of the parties and the underlying business purpose. FritozLay Inc. v. U.S. (209 F. Supp 886) demon- strated that, on occasion, past conduct of the parties indicated that a sale was never intended. The absence of tax avoidance is a significant issue which the courts used to infer intent. Such was the case with American Realty Trust, in which the court held in favor of the defendants that the parties intended ownership rights to transfer to the lessor. It was important for the parties to justify the transaction apart from the tax motives. In Hilton v. Comm'r (74 TC 305, aff'd per cur., 671 F. 2d 316), the court reasoned that the nature of financ- ing a project was insufficient justification for determining a valid business purpose. This reasoning seriously reduced the appeal of sale-leaseback transactions, since a major advantage of this type of financing over mortgage financing arose from the tax advantages it offered. Although transactions financed by mortgage financing and sale-leaseback financing had essentially the same economic 17 consequences, namely provision of immediate capital and effective control over the property, the disparate tax consequences caused the IRS to intervene on the sale-leaseback transactions.7 Title Transfer Generally, the transfer of title to the leasee by the end of the lease term resulted in the characterization by the courts that the transaction was a sale, not a lease. Frito Lay and Frenzel are two examples where the courts held that the lessees had title because they never released certain controls. However, in Lyon, where the title was not transferred to the lessee, the Supreme Court commented that "taxation is not so much concerned with the refinements of title as it is with actual command over the property taxed--the actual benefit for which the tax is paid." Consequently, the nontransfer of title did not necessarily indicate the worthiness of the lease. Judicial‘Treatment It should now be readily apparent that on occasion, the courts gave overlapping and inconsistent treatment to transactions of similar form. The courts often tried to differentiate economic substance from its form. However, the multitude of factors involved and the minor nuances between cases caused inadequancies to develop in the effective rulings by the courts. The IRS attempted to sub- stantiate the criteria viewed important, and issued Rev. Proc. 75-21 (1975-1 ca 715) and Rev. Proc. 75-28 (1975-1 ca 752). The IRS 18 guidelines mentioned six criteria which a lease had to meet prior to being judged acceptable for federal income tax purposes. The guidelines also provided an opportunity for an advanced revenue ruling by the IRS. The following is a brief review of the six criteria under Rev. Proc. 75-21. 1. Minimum unconditional at-risk investment. The intent of this rule was to guarantee lessor representation in the ownership risk in the leased asset. This rule provides that the lessor must have a minimum uncondi- tional investment equal to or greater than 20 percent of the value of the asset at the inception of the lease. Furthermore, the lessor had to maintain this minimum unconditional investment throughout the lease period, and its value had to be at least 20 percent of the original purchase price at the termination of the lease. Lease term and renewal options. This is a clause which defines "lease term" to include "all renewal or exten- sion periods except those which are at the option of the lessee at fair rental value at the time of such renewal or extension." Purchase and sale rights. The lessee was not entitled to enter a contractual agreement which would have per- mitted him to purchase the leased asset for a price which would be less than the fair market value. 19 No investment by the lessee. The lessee was not allowed to provide any part of the cost of any nonremovable improvement or additions to the leased property. Main- tenance expenses or ordinary repairs were not prohibited by the guidelines. No lessee loans or guarantees. The lessee was precluded from providing funds to the lessor or guaranteeing the lessor's indebtedness in connection with the purchase of the leased property. Profit requirement. The lessor had to demonstrate a profit motive apart from the tax consequences. Again, it should be noted that although specific criteria have been presented, the varying interpretations and general sub- jectivity of the subject matter could have resulted in inconsistent treatment between two similar taxpayers. IRS Audit Guidelines The Freedom of Information Act made the IRS audit guidelines public infbrmation in 1975. The IRS had ten criteria for establish- ing whether a lease was a valid transaction. The following is a listing of the criteria which could indicate a sale rather than a The lessee gains equity in the leased property through lease payments. The lessee acquires title to the asset. 20 3. The total amount of the lease payments made by the lessee occur during a short period of time, and substantially include the value of the leased asset. 4. The lease payments are considerably in excess of the fair rental value. 5. The lessee has a nominal purchase option at the ter- mination of the lease agreement. 6. The lessee provides loan guarantees to the lessor. 7. The lessor assumes little at-risk investment in the asset. The IRS also considered the following factors to ascertain whether the transaction was a sale or a lease: (a) burdens and benefits of ownership; (b) a calculation of the present value of cash flows; and (c) the economic purpose and viability of the lease arrangement. The IRS Guidelines offered little support to the taxpayer, since they were vague rather than specific and made no mention as to the combinations of criteria necessary to insure lease status. In 1976, the Financial Accounting Statements Board (FASB) issued Statement No. 13, in which four criteria were established for deter- mining whether a capital lease exists and whether the lessee should be considered the owner of the property: (a) the lease transfers 0""9r5hlp of the property to the lessee by the end of the lease tEPM; (b) the lease contains a bargain purchase option; (c) the 21 lease term is equal to 75 percent or more of the estimated economic life of the leased property; and (d) at the beginning of the lease term, the present value of the minimum lease payments is at least 90 percent of the fair-market value of the leased property. The taxpayer was beseiged by rules, regulations, guidelines and opinions. There should be little wonder then, that the govern- ment introduced a new leasing law which relaxed the standards and clarified some of the confusion and inconsistency of prior court cases and IRS mandates. The new law was predicated upon four basic principles essential to rational tax treatment:8 1. Specificity. The rules should be absent of ambiguities and be well defined. 2. Feasibility. The information used to characterize the lease should be readily available. 3. Eggjty, The transactions should comport to horizontal and vertical equity standards. Horizontal equity refers to similar economic groups being treated fairly. Vertical equity refers to treatment among different groups. 4. ’Economic reality. The rules should be defined in a manner which allows economic substance to be recognized over form. Much of the popular press dealt with the inequities and inefficiencies of the new law. For instance, Alan Greenspan, while 22 chairing the White House Council of Economic Advisors in the Ford Administration was quoted as commenting that the new leasing law is "'sort of the equivalent of food stamps for under-nourished corpora- tions'. . . . The leasing law will 'basically subsidize capital investment in areas which the markethouldn't support'."9 Senator Claiborne Pell (0., RI) added that "leasing helps concerns that don't need aid and 'inefficient, noncompetitive' ones that don't deserve it.”0 The balance of this section will explore the merits of these arguments along with providing an in-depth analysis of tax expenditures and alternatives the government decided against. The term tax expenditure generally refers to the tax incen- tives within the Internal Revenue Code-~i.e., credits, deductions, etc.--which have been established by Congress in an effort to 11 While the format differs from accomplish non-tax objectives. issuing a check directly to the firm or individual of interest, the intent is essentially the same. The Treasury in either case loses revenues which otherwise might be spent elsewhere. Opponents to particular tax expenditures or direct-funding programs almost always argue the efficiency of a single program vis-a-vis other "more pressing" problems. Indeed, the safe-harbor bill testifies to the advantages of having a strong, coordinated contingent lobbying in Congress. The legislative history indicates that the original bill was targeted to aid six distressed industries: the automotive, airline, steel, 23 paper, mining and railroad industries.12 Nonetheless, the final draft enabled many unmentioned firms to share the rewards and sell tax benefits in ways that previously would have been ruled illegal.13 The primary purpose of the safe harbor leasing law was to provide immediate support to those industries that needed it the most--i.e., unprofitable or distressed industries. It further narrowed the competitive gap that existed between profitable and unprofitable firms. The Department of Treasury argued that companies with taxable income could immediately realize tax benefits, while those without income could not. Consequently, the after-tax cost of an investment for a profitable firm would be lower than the cost for an unprofitable firm, thus placing the latter group at "an "14 The new law enabled intolerable competitive disadvantage. "start-up companies" and "loss companies" to share in the tax bene- fits by openly permitting them to sell depreciation and tax credits for recently purchased equipment. Generally, the sellers of these tax benefits were tax-loss firms--firms which paid no taxes and had no use for tax benefits unless they could be transferred or sold. However, it was conceiVable that a firm paying taxes at a high effective tax rate would be willing to bid these benefits away from even profitable firms, if those firms were being taxed at lower effective rates. In such cases, even taxable firms would be sellers 15 of tax credits. Thus, the leasing safe haven law was implemented to extend tax incentives for capital investment to all business entities. regardless of their tax liabilities.16 24 The popularity of this leasing tax expenditure has been well documented, and most certainly led to the quick demise of the safe harbor tax law. In many of the large scale capital intensive indus- tries, investment tax credits were "piling up" because the firms were unable to use them.17 Net revenue lbsses from the leasing safe-haven were conservatively estimated by the Treasury to be $33.6 billion through fiscal 1986.18 Other sources speculated that the losses could total as much as $58 billion over the next five years.19 Many critics attacked the safe-harbor proVisions as a tax bonanza for the most profitable corporations and a subsidy for losers. They criticized the "trafficking" in tax benefits as a dangeous precedent which, if extended, could undermine the entire tax system.20 Others expressed concern about the open-ended nature of the tax expenditure. In other words, the tax expenditure, unlike a direct relief program, is unbounded. The amount of revenue loss is solely a function of taxpayer response to a particular tax pro- vision.21 The Congressional Budget Office once described a tax expen- diture program as follows: A tax expenditure is analogous to an entitlement program on the spending side of the budget; the amount expended is not subject to any legislated limit but is dependent solely upon taxpayer response to the particular provision. In this respect tax expenditure closely resemble spend- ing programs that have no ceilings. The tax expenditure had a number of other severe deficien- cies which included the following:23 25 Tax expendituresypermit windfalls. Many taxpayers received a payment (or reduction in taxes) for an action which they would have taken anyway. In those cases, the law would not have stimulated the economy, but rather would have provided the involved parties with a windfall. Tax expenditures are ineguitable. Inequity often arises when the tax expenditure is in the form of a deduction, exclusion or deferral of income. Taxpayers in the highest income tax brackets usually benefit the most. Tax expenditures keep tax rates high. Since tax expenditures reduce the aggregate Treasury revenue, the tax rates applied to the remaining balance must remain relatively high in order to maintain the funds needed to function normally. Tax expenditures are often directly affected by changes in the tax rates. The value of a tax expenditure is dependent on the tax rate. If tax rates change, for reasons independent of the tax expenditure, then the objective of the tax expenditure might suddenly be impaired. Tax expenditures complicate the tax laws. Each program has its own set of definitions, issues, objectives, etc. Additional laws burden a limited staff and complicate existing law.24 26 Further criticism has been directed at the members of the tax-writing committees of Congress--namely, the House Committee on Ways and Means and the Senate Committee on Finance. Tax expendi- tures have often been enacted without serious consideration of the resulting complications for the tax system, legislative process, 25 or executive-branch administration. Senator Kennedy made the following remarks on the ability of the tax-writing committees to competently review and adequately evaluate all of the issues under- lying many of the proposed spending programs.26 It is humanly impossible for the 18 members of the Finance Committee and the 37 members of the Ways and Means Committee to be Renaissance men and women in employment, commerce, energy, health, education, housing, banking, State and local finance transpor- tation, investment, the cities, shipping, agriculture, foreign trade, life insurance, the environment, military personnel, veterans, the elderly, the handi- capped, and all the other areas in which tax spend- ing programs are now being used and in which expertise in the areas is obviously required.27 Perhaps the most controversial issue concerning the safe harbor leasing law dealt with the inefficiencies involved. Ineffi- ciencies are described as the process in which "in the end only a Part of the money goes to the activity which the tax expenditure is intended to assist."28 Inefficiencies were a function of the respective bargaining positions of the related parties as well as the fees charged by the intermediaries. The latter amount was a non-trivial sum. The Treasury Department estimated that lessees paid third parties approximately $109 million for fees related to 29 these transactions. Senator Durenberger commented on the 27 "inordinate amounts of money [that] are siphoned off by intermed- iaries" and the notion that the complexities associated with leases "limit the market for buyers and sellers of tax incentives to rela- tively large and sophisticated institutions able and willing to undergo the pain, expense, and uncertainty of closing this kind of transaction."30 Data suggest that transaction costs arising from brokers, lawyers, bankers, syndicators and other intermediaries amounted to an average of 1.3 percent of all tax benefits associated with safe- harbor leases.31 In addition, the lessors retained approximately 14.2 percent of the discounted value of the tax benefits to compen- sate them for transactions costs and profits.32 The overall impact of the inefficiency of the lease mechanism was a lower level of investment by tax-loss firms than Congress intended.33 The inefficiency, and the resulting transfer of wealth to large profitable corporations, also led to the quick demise of the leasing law. The popular press (referred to earlier) focused atten- tion on this tax subterfuge, and the public became increasingly "ARV of the costs of the tax expenditure compared to the benefits received by the nation. It is unlikely that the American public would have supported a direct expenditure program designed to subsi- dize distressed business, especially in a year in which the federal deficit reached nearly $100 bi11ion.34 Among other members of Congress, Senator Robert Dole (R.- Kan.) Chair of the Senate Committee on Finance and a leading critic 28 of safe-harbor leasing, started to talk of repealing the leasing safe haven as early as November 1981, just three months after ERTA was enacted.35 ”A lot of members are talking about repealing leasing, root and branch," said one Capitol Hill source. The source further added that some members of Congress didn't understand the complicated laws providing cash to some profitable firms and were embarrassed to read stories regarding General Electric, IBM and other corporate giants which used the credits to reduce their ' federal taxes. "The problem with leasing is that it doesn't create much faith in the equity of the [tax] system," the Capitol Hill source said. "It makes the system look stupid."36 Senator Dole significantly curtailed trading of tax benefits in February 1982 when he declared that "Congress will either repeal or significantly tighten the controversial law allowing firms to trade tax benefits."37 Although the Reagan Administration at that time continued to support the leasing law and vowed to fight any repeal, the Congress persisted, and on August 19, 1982 enacted the Tax Equity Fiscal Responsibility Act (TEFRA), which significantly restricted the leasing safe haven of ERTA.38 It appears that ERTA's safe harbor leasing provisions were ill-suited to effectuate Congress's intent to provide assistance to the distressed industries and maintain tax equity. The ERTA Proved to be an inefficient and uncontrollable means by which to Provide support. It is unclear whether the Administration intended to provide aid to all of the firms which were legally eligible, or 29 whether subsidy to all lessees was considered a necessary and acceptable cost in order to provide assistance to the targeted industries.39 Critics maintained that a direct subsidy would have allowed better control on costs and priorities.40 The ERTA law is testimony to the notion that a direct subsidy would not have been politically Fr feasible. Nonetheless, there seems to be little basis for a tax expenditure if the government is unwilling to appropriate the funds 41 The leasing law was inefficient, insufficiently planned. directly. and allocated resources to industries which the market refused to support. In the absence of safe harbor leasing, creative tax attorneys would have designed leases which could be accommodated within the IRS Code and the legislative history. However, the burden of policing this option would have been placed on the already over- burdened IRS.42 An alternative policy to leasing might be full refundability of tax benefits. This policy calls for the Treasury to issue a check for all benefits attainable through purchase of an asset.43 The administration would simply send a refund to the firm upon receipt of valid proof of eligibility. The refund policy is desirable in that it would avoid the inefficiencies which plagued the safe-haven leasing law. A refund form would be filed with the normal tax return. Furthermore, a refund policy would ensure equitable tax treatment among taxpayers in different income-tax brackets. The firm would accordingly make its most productive investment without regard to its tax status.44 30 The new system would require additional forms and IRS monitoring costs, but the IRS would be performing these functions anyway. Depreciation deductions and leasing forms, are already part of the IRS process, and as such should not add to the IRS burden.45 A refunding policy could be further refined to include incentives for stimulating "desirable purchases." Such a policy could more efficiently direct future assistance to particular industries and resources of concern. A refunding policy has the added benefits of simplicity and equity in purpose and use. Firms which previously did not have the wherewithall (sufficient tax and legal resources) to benefit from the safe-harbor provision would now be able to enjoy the tax amenities to the full extent of the law. Enactment of a refund policy could fill the gaps left open by the 1981 ERTA and TEFRA 1982. That is, a refund policy could improve efficiency and equity, and provide an immediate incentive to purchase new capital equipment. 31 ENDNOTES Chapter II 1The chronological summary of leasing law, by Harmelink and Shurtz, is reflected in the first part of this chapter. Sale-Leaseback Transactions Involving Real Estate: A Proposal for Defined Tax Rules. P. J. Harmelink, N. C. Shurtz So Calif L. Rev 55:833-94 My 1982. 2Hilton v Commissioner: Sale-leaseback Analysis Sharpened Virginia Tax Review, Vol. 2, No. 2. PP. 375-392, 1982. 3 4Sale and Leaseback: A Hollow Sound when tapped? - Part II Louis A. Del Cotto Tax Law Review, Vol. 37, No. 1, pp. 1-50, 1981. 5 6 In Lyon and Lazarus, for instance. Hilton v Commissioner Tax Law Review - Sale and Leaseback A Hollow Sound When Tapped. 7Hilton v Commissioner. 8Sale-Leaseback Transactions Involving Real Estate: A Proposal for Defined Tax Rules. P. J. Harmelink, N. C. Shurtz So Calif L. Rev. 55:833-94 My 1982. 9Wall Street Journal, August 27, 1981, at 1,Col. 6. 10Wall Street Journal, December 9, 1981, at 1, Col. 5. 11Survey, Tax Incentives as a Device for Implementing Govern- ment Policy: A Comparison with Direct Expenditures, 83 Harvard L. Rev. 705, 706 (1970). 12Staff of Joint Comm. on Taxation, 97th Cong 1st Sess Summary of Administrative Tax Proposals Before the Committee on Ways and Means Industry representatives included: Vice Chairman of Phelps Dodge Corporation, President and Chief Executive Officer of the Air Tr§n5port Association of America, Chairman of CSX Corporation (Chessie Railroad), Special Consultant to the President of the UAW, Congres- Sional Steel Caucaus, Chairman of the Capital Formation Committee of the American Mining Congress, and President of Transportation Associa- tion of America. 32 ‘3John Chapoton (Assistant Secretary of the Treasury) acknowl- edged that "(t)his (the revised temporary regulations) will help Chrysler do a lease." Moreover, "(i)t may also help some other, smaller concerns as well." Wall Street Journal, Nov. 11, 1981, at 4, Col. . 14Office of Tax Analysis, Department of the Treasury, Pre- liminary Report on Safe Harbor Leasing Activity in 1981, March 26, 1982. 15S. Survey, Pathways to Tax Reform 310 n. 14 (1973). 16 17Tax Reduction Proposals: Hearings Befbre the Senate Comm. on Finance, 97th Cong., lst Sess. 236, 239-40 (statement of John Snow) at 245 Robert Peabody indicated that $13-$14 billion pool of unused investment tax credits existed. 18 19Stephen Brobeck of Consumer Federation of America. See the MacNeil-Lehrer Report, Transcript No. 1615 (Dec. 4, 1981). 20Tax Expenditures Limitations and Control Act of 1981: Hear- ings on S 193 Before the Senate Comm. on the Budget, 97th Cong. lst Sess. (1981). 21Surrey and McDaniel, The Tax Expenditure Concept: Current Developments and Emerging Issues. 20 3+ Indus. & Com L. Rev 225, 355 (1978-1979). 22The Leasing Safe Haven of the Economic Recovery Tax Act of 1981: Another Tax Expenditure Wisconsin Law Review - 1982. Nancy Delacenscrie. 23 S. Rep. No. 144 97th Cong. lst Sess 61-62 (1981). Wall Street Journal, Feb. 22, 1982. Surrey and McDaniel. . _ 24McDaniel. Simplification Symposium Federal Income Tax Simplification: The Political Process, 34 Tax L. Rev. 27 (1978-79). 25Surrey, Tax Incentives as a Device for Implementing Govern- ment Policy: A Comparison With Direct Expenditures, 83 Harv. L. Rev. 705. 706 (1970). 26The Leasing Haven of The Economic Recovery Tax Act Of 198]: Another Tax Expenditure 1982 His L. Rev. 117-49 1982. 27124 Cong. Rec. 10347 (1978). 33 28$. Surrey, Pathways to Tax Reform 310 n. 14 (1973). 29Treasury Preliminary Report. 30Tax Reduction Hearings 97th Cong. lst Sess. at 278. 31Preliminary Report by the Treasury. 32Ibid. 33Stanford Law Review. Safe Harbor Lease: The Costs of Tax Benefit Transfers 6/82 Vol. 34:1309. . 34Wisconsin Law Review. 35Ibid. 36Wall Street Journal, Nov. 19, 1981, at 6, C01. 2. 37Wall Street Journal, Feb. 22, 1982. 38H.R. 4961, Conference Report on The Tax Equity and Fiscal Responsibility Act of 1982, 97th Cong. 2d. Sess. 39Wisconsin Law Review. 4°Ibid. 41Ibid. 42Tax Reduction Hearings 97th Cong. 43Senator Kennedy's Proposal of 1977 and a recent House bill included a direct refund provision. See Tax Reduction and Simplifica- tion Act of 1977: Hearings on H.R. 3477 Before the Senate Comm. on » Finance, 95th Cong. lst Sess. 179 (1977), The Refundable Investment Tax Credit Refund Act of 1981, H.R. 1863 97th Cong. lst Sess. (1981). 44Stanford Law Review. Vol. 34:1309 Safe Harbor Lease: July 1982, The Cost of Tax Benefit Transfers. 45Ibid. CHAPTER III OVERVIEW Virtually any asset that can be purchased can be leased. A lease is a means, usually contractual, by which a firm can acquire the economic use of an asset for a stated period of time.1 Although there are essentially four different forms through which the user of the asset (the lessee) may engage in a lease contract with the owner of the asset (the lessor), this analysis will focus primarily on the sale and leaseback transaction. Under a sale and leaseback arrangement, a firm may sell an asset it already owns to another party and then lease it back from the buyer. In this manner, the lessee receives the sale price in cash and the economic use of the asset during the basic lease period. In turn, the lessor receives the transfer of tax benefits, such as asset depreciation and the investment tax credit, in addition to any residual value upon disposition. However, the lessor does not enjoy complete retention of the tax benefits, since in competitive markets some of the benefits will accrue to the lessee in the form of reduced 2 lease payments. Although different tax brackets of both the lessor and lessee provide an opportunity for a mutually advantageous endeavor, it is the amount and timing of such tax considerations which will inevitably determine the final success of a sale and leaseback trans- action. Consider, for instance, when a lessee is in a tax-loss 34 35 position or has investment tax credit carry-forwards and does not reasonably expect an improvement in tax-loss position in the foresee- able future. If the lessee could transfer tax benefits to a lessor in exchange for lower financing costs, both parties would gain. The Economic Recovery Tax Act of 1981 provided an opportunity for exactly that type of lease financing, and accordingly, resulted in a tremendous amount of use and abuse by those eligible for such consideration.3 In addition to providing new "safe-harbor" rules which condoned the practice of tax-benefit transfers. Congress enacted a new Accelerated Cost Recovery System (ACRS). By increasing the available asset amortization expense, the ACRS created the oppor- tunity for more taxpayers to be in tax-loss and/or investment credit carry-over positions, and consequently expanded the respective bargaining positions of both lessor-lessees. 'The net effect of ERTA was such an amount of leasing activity and lost Treasury revenue4 that overbearing criticisms prevailed and the transfer of tax benefits (via leasing) has been impeded through the enactment of the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA). This chapter will continue with the analysis of the previous chapter which pertained to the rules and regulations regarding leas- ing activity prior to the ERTA of 1981. This chapter will include (a) the subsequent benefits and efficiency of leasing during the effective period of ERTA, and (b) the expected impact on safe-harbor leases of TEFRA. 36 Safe Harbor Law A leasing agreement was provided safe harbor or federal lease status under Code Sec. l68(f)(8) only if the following five general conditions were met: (a) all the parties to the agreement entered into a written agreement and safe-harbor status; (b) the lessor was in effect a regular corporation; (c) the lessor had at-risk investment in the property at all times; (d) the duration of the lease did not exceed certain prescribed minimum and maxi- mum limits; and (e) the lease covered only "qualified lease property." If any of these conditions were not met, either at the time the arrangement was entered into or at a later date, the arrangement could be denied or lose its safe-harbor status.6 1. Agreement of the parties. All parties had to elect in the lease agreement to treat the agreement as a safe-harbor lease for income-tax purposes and elect in writing to treat the lessor as the owner of the property. 2. A gualified lessor. The lessor must have been (a) a corporation other than a tax-option, Subchapter S Corporation, or personal holding company; (b) a partner- ship in which all the partners were composed of such qualifying corporations; or (c) a grantor trust whose grantor and beneficiaries were all either qualified corporations or qualified partnerships. 37 Lessor's minimum at-riSk investment. The lessor had to have a minimum "at-risk" investment of not less than 10 percent of the adjusted basis of the property (a) at the time the property was first placed in service, and (b) at all times during the term of the lease. Term of lease requirements. The maximum term of the lease (including all options to extend) could not exceed the larger of (a) 90 percent of the useful life of the leased property, or (b) 150 percent of asset deprecia- tion range midpoint class life of the leased property. Qualified leasedyproperty. To be qualified property, the leased property had to (a) be new Sec. 38 property (eligible for the investment credit as defined in Code Sec. 48(b); (b) be new Sec. 38 when acquired; (c) be leased within three months after it was placed in ser- vice; (d) have an adjusted basis to the lessor that was not in excess of that of the lessee, and (e) have quali- fied mass commuting vehicles7 that were financed in whole or in part by tax-exempt obligations. Although Sec. 168 rules generally specify that property qualifies for safe-harbor treatment only if the lease was entered into within three months after the property was placed into service, the Code also provides an exception for all qualified property placed in service after 1980 and before August 13, 1981, if the lease was entered into by November 13, 1981. 8 This "window period" 38 enabled taxpayers to transfer substantial unexpected tax bene- fits. A transaction meeting all the above requirements would have qualified as a lease for Federal income tax purposes regardless . of any other characterisitcs. Thus, the transaction could have included a fixed price purchase option of only $1. There was no requirement that the lessor had to derive a pre-tax profit or generate a positive cash flow from the agreement. In addition, the lessee could provide the financing or guarantee the lessor's debt except for the required 10 percent minimum investment. These rules were clearly a deviation from the law prevailing prior to ERTA of 1981. The prior rules attempted to distinguish between true leases, in which the lessor held title to the asset for tax purposes, and conditional sales or financing arrangements, in which the user of the property owned the property for tax purposes. Typically; the final determination under prior law required a case- by-case analysis. The general principles applied were not written in the Internal Revenue Code; rather, they evolved over the years through a series of court cases, revenue rulings, and revenue pro- cedures issued by the IRS. The following example will offer insight into how a safe- harbor lease operated and the ease with which tax benefits were transferred. The example also demonstrates the importance of the timing of the cash flows. 39 Tax-Benefit Transfer: An Example A tax-benefit transfer essentially operated as follows. A lessee bought an asset with his own funds and then "sold" it to a buyer subject to the terms of the 1981 ERTA. The lessor gave a cash downpayment to the lessee and assumed a nonrecourse note for the balance. No additional funds ever changed hands, since the lessee immediately leased the property back with the lease payments being identical to the debt-service payments from the nonrecourse note. At the termination of the lease, the lessee was granted the option to purchase the asset for a token amount (often $1). Although the lessee would retain all incidents of State law ownership, the lessor would be granted the associated Federal income tax deductions, such as depreciation and the investment tax credit. However, the lessor would be required to recognize as income the excess of lease rent over interest for any taxable year.9 The lessee, accordingly, would have a deduction for the same amount. Since it was in the best interests of both parties to postpone any tax payable by the lessor, the parties typically agreed to maximize the interest rate payable on the nonrecourse note. The IRS prescribed that the maximum interest rate was not to exceed three percentage points above other specified interest rates, such as the rate charged by the IRS on underpayments and overpayments. Since the IRS rate has been 20 percent as of February 1, 1982, most trans- actions used the maximum 23 percent rate permitted.10 40 An Example Assume that a user of property recently purchased a $100,000 asset, is in a tax-loss position, and does not reasonably expect to 1] The lessee would like to be taxable in the foreseeable future. transfer some of the tax benefits to a lessor in the fonn of a sale-leaseback arrangement. Assume the buyer purchases the property from the user (lessee) for $22,000 down and a 12-percent note for $78,000 payable on a level basis (principal and interest) over 10 years. The lessor (buyer) then leases the property to the lessee for 10 years at a rental exactly equal to the debt service on the note. The user retains legal title to the property, and ultimately will repurchase the property at the end of the 10 year lease term for $1. The taxable income and cash flows to the lessor and lessee are described in the following paragraphs. What may initially appear as a dubious investment for the lessor makes economic sense once the timing of the cash flow is evalu- ated. The lessor is receiving positive cash inflow in years 2-5, which, when reinvested at current interest rates, will more than com- pensate the investor for the cash outflows in years 6-10. Similarly, the lessee is receiving a lump sum of cash in year 1, and will receive added tax shields throughout the lease term shou1d the firm ever attain profitability. Both parties gain. 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a/aP > -1, such that: 8V i . n -n 3P T (1 + 1)" -1] E j r :)1( r) 3 The price at which the lessor is indifferent is derived by setting at zero the value given by (6) and solving for P P = 1 - 1 - c* - 10* 1 - 11 ln 1 [1 - 11 + 1)"(1 + r)‘” (l + i) - l r - i (7) If the lessee is currently in a tax-loss position and expects to remain that way for the foreseeable future, then the net benefit to the lessee is entirely comprised of the down payment received from the lessor. Since the only direct cost to the lessor is the 79 down payment, which is a dollar-foradollar cost, the joint benefit to both parties, Vj (at the Treasury‘s expense), can be eStimated by dropping the down payment term from (6): VJ. = c* + 10* - 1(1 - P) E 1' 1U - fl +1)"(1+ r)‘"] (1 + 1)" -1 r -1 (8) This value is increasing in the price paid by the lessor to the extent indicated by: 3V 751 .TE .- ][1-(1+1)"11+r)'"1 (9) (1+1)”-1 r-1 The maximum joint benefit occurs when the lessor receives zero bene- fit, and is stated in (7). Fabozzi and Yaari (1983) addressed a hypothetical situation in which the participants of the transaction stipulated an a-priori agreement on how to best maximize the tax benefits and subdivide the portions thereof." Equation (8) implies a maximization of benefits when payment equals the full asset price (P = 1). Such a situation, however, would be inconsistent with the existence of differential tax effects between the lessee and the lessor. If the parties agreed that the lessee was to receive a stipulated percentage 0») of the joint benefit, then the correct price paid could be determined by substituting (6) and (8) in V = (l - w)Vj, and solving for P, 80 where: l - wC* - 10* l - wT[ i ] [1 ' (1 + i)" (1 = r)-n) ] (1+1)"-1 r-l (10) The loss of tax revenue to the Treasury (or joint tax benefit) is also affected by the duration of the lease and the interest rate charged on the phantom wash loan. The rate of interest charged should have no tax effect on the lessee. The increase in interest income should be offset by an increase in rental expense. The same result does not hold for the lessor. An identical increase in total interest expense and rental income would result in the lessor having a net tax benefit in the early years. The tax benefit is caused by the concentration of interest expanse owing to a large initial principal balance. Consequently, the tax benefit accruing to the lessor increases as the phantom interest rate increases. 9 The IRS recognized the anomoly early in the safe-harbor proceedings, and mandated a ceiling on the interest rate charged. The rate utilized by the parties could not exceed the existing penalty rate charged by the IRS for underpayment of taxes. Since the concentration of the interest payments in early years favors the lessors, any increase in term of the lease would have a greater impact on the tax effect of rental income than on the tax shield of interest expense. The extension of the lease term 10 would therefore enlarge the tax benefit to the lessor. The IRS 81 recognized this feature as well,,and stipulated that the lease term plus extensions could not exceed (a) 90 percent of the extended recovery period of the leased asset, or (b) 120 percent of the asset depreciation range midpoint class life. The Tax Benefit Transfer'lease formula provides a means by which to price the tax benefits received by the lessor and the lessee. The model encompasses the impact of changes in the sharing of bene- fits as well as changes in the interest rate charged and the term structure of the lease agreement. The final price paid was a func- tion of these variables, as well as implicit time constraints, respective bargaining positions, and any inherent learning curves. However, the redeeming qualities of this model though relevant and precise for large firms--are perhaps inconsequential to small firms, since it fails to consider the intermediary costs, legal fees, and insurance provisions. These expenses could easily be cost prohibi- tive for small entities, and were the single most important factor attributed to the nonparticipation of these firms.11 82 ENDNOTES Chapter IV ‘See Table 1. 2M111er and Upton (1976). Further explained that leasing firms specialize for this primary purpose. 3This application of efficiency should be differentiated from the Treasury's usage of "inefficiency", as defined and applied in Chapters I, II and III. The balance of the dissertation will refer to "efficiency“ in the context of pricing assets in capital markets. 4See Table l for comparison of studies and implicit assumptionS- 5Adapted from Richard S. Bower, "Issues in Lease Financing" (1973). 6This model and analysis was adopted from the paper by Emil Sunley (1982). 7Business week, April 19, 1982, as well as The Wall Street Journal elaborated on this issue. 8This variable was added on to the Fabozzi/Yaari model for completeness. It does not appear again in the context of the remaining formuli. 9Proof available in Appendix A of Fabozzi and Yaari (1983). 10Proof available in Appendix B of Fabozzi and Yaari (1983). nLeasing Safe Haven of the Economic Recovery Tax Act of 1981: Another tax expenditure, 1982 His L Rev 117-49, 1982. CHAPTER V METHODOLOGY Efficiency is of paramount concern in an event study. Uncer- tainty arises over whether the leases were "accurately priced," or any of the parties settled for a sub-optimal amount, given time constraints and the strength of the respective bargaining positions. Assuming relevant information was available to "informed investors," stock prices should have been an accurate reflection of updated cash flow and tax information. Additionally, stock prices should have reflected significant risk changes caused by new leasing information. Several articles have addressed the issues of market effi- ciency and the ability of the market to disseminate new information. A brief review follows. Fama (1970, 1976) established three types of market effi- ciency: weak-form, semi-strong-fonm, and strong-form. Each differs by amount of information disclosed. The weak-form hypothesis presumes that no investor will earn excess returns from trading rules based on historical price information. The semi-strong model states that no investor will earn excess returns from trading rules based on any publicly available information. The strong form suggests that no investor will earn extess returns based on any information, including inside information. All forms imply'that prices fully reflect all 83 84 relevant information. Consequently, an event study such as the one posited could test either semi-strong or strong-form market effi- ciency, depending upon the assumptions made regarding leasing infor- mation disclosure. Grossman and Stiglitz (1975, 1976, 1980) addressed the effi- ciency of the stock markets with traders utilizing diverse informa- tion. In essence, they postulated that prices reflect the informa- tion of "informed" individuals (arbitrageurs) only1 the extent that they are compensated for expending resources to obtain their infor- mation. Equilibrium prices are established through the manipulation of "informed" investors buying and selling on the basis of informa- tion which is subsequently made public to the "uninformed” or naive investor. Both investors are satisfied in equilibrium to the extent they are being adequately compensated for their risk and resources expended (i.e., time, capital, etc.). The "informed" investor may receive a larger absolute gross return than the "uninformed“investor, but this is not considered "abnormal" or "excessive" given the con- siderations previously mentioned. Prior to concluding that a return is abnormal, a return- generating model must first be established, describing an expected or normal return. Several readily available market models may serve as a benchmark in generating ex-ante expected returns. The test hypothesis should be defined so that a return is considered abnormal or excessively risk adjusted only if the ex-post returns are significantly different than the returns predicted under the ex-ante 85 process. Some of the market models assessed in an event study include the following. The mean adjusted return model assumes that risks and returns are constant for each particular security. Consequently, a security j may have a constant return kj such that the ex-ante return E(Rjt) = k.. The corresponding ex-post return in time period t will thus J be equal to kj. The abnormal return E't is equal to the difference J between the actual return Rjt and the expected return kJ.(Ejt = Rjt_ - kj). This model is deficient in its descriptive power, since risk is not explicitly defined. It is, however, robust for mis-specifi- cations in the measurement of risk and return relationships. Market and risk adjusted return models have more descriptive power, since risk and risk-return relationships are explicitly defined. These models are not robust for mis-specifications in either the risk measure or the risk—return relationship. Most tests of the efficient market hypothesis (EMH) use a version of the Capital Asset PriCing Model (CAPM) introduced by Sharpe and Lintner (1964). The typical one-factor market model ~ stated by Sharpe and Lintner is (Rjt - th) = aj + Bj (Rmt - th) + Ejt’ where aj and Bj are parameters pertaining to security j and are constant over time. The Ejt component; it has a mean of zero and varies randomly over time. term is the firm specific return Although much has been written regarding EMH tests and models,“ care should be exercised with the results and subsequent inferences of data. Notable controversy originating with Richard 86 Roll's (1969) critique addressed the problem of tests of the efficient-market hypothesis as always being joint tests of market efficiency and the corresponding market model. However, Mayers and Rice (1979) pursued the Roll critique and concluded that tests of portfolio performance using the security market benchmark, tests of the effects of informations events through residual analysis, and tests of the CAPM itself, though plagued with potential problems, are still valid.2 A methodology commonly utilized to determine if excess risk adjusted returns exist around an event date is the cumulative aver- age residual technique (CAR), as initially demonstrated by Fama, Fisher, Jensen, and Roll (1969). This technique explores the per- formance of averagelnarket model residuals of the sample securities about a hypothesized event date. The CAR for a given month t is defined as the value of the CAR in the previous month plus the value of the current period's average residual, ARt. T CAR= Z ARt, t=l where: 1 N AR = —- - 2 E. = the average abnormal return in a t N j=l jt given month. N = number of months A significance test would be designed for whether the value of CAR, during an event period, drifted significantly away from 87 zero. The behavior of CAR can be compared to the random-walk hypothesis. Small drifts in residuals would be interpreted as normal or abnormal depending upon the corresponding significance region encompassing the CAR data (see Figure 5.1). If abnormal performance truly existed then the spike illustrated in Figure 5.2 should be in evidence (Brown and'Narner, 1980). Researchers would conclude that such a spike was an indica- tion of an abnormal performance in time period (3). In the past, event studies generally used the CAR technique and were testing for a spike similar to that illustrated in Figure 5.2. Rogers and Owers (1983) used the CAR technique to test for excess risk adjusted returns arising from safe harbor lease trans— actions using an August 13, 1981 event date--the date the ERTA went into effect. They concluded that investors did not earn abnormal rates of return. The CAR methodology is deficient in that it does not account for changes in 8.3 There may be many a priori reasons to expect a 8 change throughout an event study. Further complications arise due to the nonstationarity of 8.4 Consquently, the CAR technique, in ignoring 8 changes, might produce biased results.5 Sunder addressed this problem, (1973) and cited the following pitfalls: (a) such analysis may indicate abnormal price changes when in fact none exist: (b) even when abnormal price changes are present, this analysis may not be able to detect them due to the presence of changes in relative risk; and (c) in the presence of risk changes,.estimated abnormal 95% Confidence Region CAR * * * * CAR (Not Abnormal) * 'k ‘ * * ‘_———7_——“_—“_~_.~““_““-——95% Confidence Region Time Figure 5.l--Illustration of Significance Interval Cumulative Average Residual J. 3 Time Period Figure 5.2--Illustration of Abnormal Performance 89 returns on stock are dependent on the time series data used for estimation of relative risk; and to the extent that this choice is made arbitrarily, estimated abnormal performance is also arbitrary. Larcker, Gordon and Pinches (1980) analyzed the confounding that could occur with shifts in 8. They examined four possible com- binations of shifts in B and information which would result in an identical CAR pattern (Figure 5.3). Figure 5.3(a) depicts the normal situation, for which the CAR methodology is well suited: The B is stationary throughout the event study, and the positive infor- mation in the preannouncement period causes the CAR to rise. This figure indicates excess risk-adjusted returns. Figure 5.3(b) has a similar CAR pattern, but does ngt exhibit risk-adjusted returns. The increase in the residuals during the to -to-t+1 period are attributed to a nonstationary downward shift in 6. Figure 5.3(C) represents an occurrence where a 8 increase in the pre-announcement period coincides with a release of positive information. Although a naive investor in that situation might believe he is receiving an abnormal return, he in actuality is receiving a normal risk-adjusted rate of return. In other words, the return is commensurate with the increased adjustment for risk (8). No excess risk-adjusted return is therefore demonstrated by Figure 5.3(c). Figure 5.3(d) presents a situation where 8 increases in both the pre- and post-announcement periods. Again, the confounding variables illustrates a similar CAR pattern. However, negative excess risk-adjusted returns are observed in the post-announcement period. (a.) B Stationary Positive Information Cumulative Average Residual 0 1 Information (c. ) B Nonstationary, Positive Information Cumulative Average Residual Information I I I I I I . I _____;///z//””’T_____T— . I I g I I I I t--2 f-i :0 ‘11 I I I I I I 31 j 52 ' 93 3 I I ; I g . -0- ' Positive I -O— I :Information: : I B2 I I I I B . B ' I 3 I I I I _ : Positive : : 'Information' ' Time period t 2 to t 1 preannouncemenf period, fl is the estimation period, t t is the announcement date, and t is the post-announcement riod. 90 Cumulative Average Residual 0 (5.)5 lonstationary. No Information I I . I . I g I . I : l S t I I t I '2 7 I0 11 I I : 3| 8 ' 3 l I : 3 E I I I I ' -0- I 1 = - Informationl -0- (d.) I Nonstationary, Negative Information Cumulative Average Residual Information opoooooo. awegm; . :tivc : IInfor-o mation is the to t+1 FIGURE 5.3.--Cumulative Average Residual Patterns Caused by Changing Betas or Information 91 An Intervention-Market Model of Security Returns Abnormal return effects such as those described are simple to detect if the risk level is assumed to be constant. However, such a simplistic assumption can lead to erroneous conclusions when risk levels change. Consequently, models of this nature have limited application. The implementation of the Economic Recovery Tax Act (ERTA) provisions created an opportunity for risk levels to change for both lessees and lessors. Lessees received large cash infusions as part of the lessors' downpayment in the wash-lease agreement. The lessees' debt-to—equity ratios would by necessity drop, thus lending credence to the lower risk entity argument.6 A commensurate risk reduction would accordingly be expected from the lessor. Many lessors established low level risk investment portfolios by insuring their tax credits and depreciation through reputable agencies, and properly utilizing indemnification clauses in their lease contracts.7 Systematic risk among lessors would be expected to decline simply by virtue of increased investment in low-risk assets. Larcker, Gordon and Pinches (1980) criticize the use of the traditional CAR methodology, since it fails to detect a change in the systematic risk (3) of a firm as a result of an announcement. The intervention technique is able to differentiate the information effect in the return series as distinct from the information effect in the risk changes. This particular methodology requires a 92 case-by-case analysis. Individual-case examination would be preferred to grouped data because aggregated information might obscure signi- ficant individual difference, and naive conclusions might be drawn from CARs comprised of a few skewed cases. The traditional CAR methodology does not enable a determination to be made whether the CAR pattern is a function of excess risk-adjusted returns or due to a shifting of systematic risk. The intervention technique which is being employed can be used to test for a change in either the risk or return in the pre- and post-announcement periods. The basic model can be explained as: Rt f (w, 6) + Nt where: :0 II t return on a specific security in time period w = exogenous variables 09 II the intervention variable which may change the level of return Nt = noise The preferred model would include possible changes in the systematic risk of a firm as a function of the intervention variable. The model can be broken into pre-announcement and post-announcement period risk components as expressed by the following: R = a + s R I (t) + B R I (t) t 1 mt [t_],to] 2 mt [t0,t+1] + a] I[t_1,t0](t) + 62 I[t0,t+]](t) + 9 (b) 3(t) (1) where 93 B] = pre-announcement systematic risk 82 = post-announcement systematic risk Rmt = return on the market portfolio in period t t0 = intervention date t_1 = pre-announcement period t+1 = post-announcement period 6(b) = noise model corrected for autocorrelation B and e are the model parameters 8] and e are the intervention coefficients in the pre- announcement and post-announcement periods, respectively. In this model, either 8 or a may shift around the event date. The following interpretations of e are considered. 81 = O, 82 = O announcement period 0, = positive 0') .=.I II 62 no excess risk adjusted return in the pre- or post- post-announcement excess risk adjusted return, no pre-announcement EXCESS risk adjusted return - positive, ll 0 anticipatory excess adjusted return, no' In _.I I risk cor- responding post-announcement excess return - positive, positive anticipatory excess adjusted return, sub (*1 N risk sequent post-announcement excess risk adjusted return Consequently, a shift in 8, corresponding to (81 = o, 82 = 0) would imply not excess risk-adjusted return but a shift in risk and a visible shift in returns. In other words, returns wo uld 94 appear to be different, but could be "explained" by a change in the systematic risk. Use of the CAR methodology might incorrectly interpret a shift in B as an abnormal return. The intervention model provides an opportunity to detect these differences in risk and hence returns around the event date. This study will simultaneously test the following two null r- hypotheses. The parameter estimates were obtained using the Pack program.8 Significant Risk (Hypothesis 1) r Ho: 81 - 82 = 0 Significant Return (Hypothesis II) H = 0 o: 8l ‘ €2 H e e l 1 - 2 f 0 changes were determined using the following statistical tests for 3 and e shifts.9 B1 ' 82 e1 ' é2 where the standard error (6) between risk and return changes are: 6181 - 82) = 62121) + 62(le-2 Cov