International Treasurer

Benchmarking
FX Managers
,

The Journal of Global Treasury and Financial Risk Management

August 7, 1995

'
Performance measurement

US ta x regulations

Benchmarking

FX Managers

IRS Attacks
Pickle Leasing

By Brian Strange
Currency Performance Analytics

By Jay Zukerman
Ernst & Young

Treasurers analyzing the performance of currency managers/a visory services- for both
pension fund and FX management-need to
compare apples with apples.

How to benchmark the

performance of currency overlay managers
and apply this analysis
to treasury controlled
pension and FX management programs.
page 1

IRS Anacks
Pickle Leasing

Lease transactions from the US abroad-a

growing trend- have been hampered and perhaps derailed by regulations proposed by the
IRS last April 20. These regulations target the
widely-used cross-border leasing technique
known as Pickle Accelerators (or replacement
leases). Market forces will determine whether
new evolutions or alternative lease structures
put US-initiated, cross-border equipment leasing back on its growth trend.

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 managing
cash flows remitted from international affi I iThe cross-border leasing business has been
ates). Your CFO, has suggested that you investishaken considerably by the IRS' targeting of
gate currency overlay management (COM) as a
means of protecting the plan assets (long cash
Pickle Accelerators. The proposed regulations
to shut down this technique may be seen as a
flow positions) from swings in value resulting
from currency movements . Suppose the CFO
further effort by the US tax authorities to limit
asks the following:
the ta x advantages of leasing to ta x-exempt,
" Does it add value?"
including non-US , entities. Thus, US lessors
" Which style of management produces the
and their tax advisors are left to search for other
best returns?"
methods of obtaining ta x advantages on equip "Which has the lowest risk?"
ment lease transactions abroad--or alternative "Ca n firms add value without taking on ' ly may stick to domestic transactions.
more currency exposures and simply protect
the ones we have?"
Pickle background
"How can you accurately compare manager performance?"
By all accounts , the development of the
" No problem," you answer. " I' ll just call our
Accelerator technique dramatically enhanced
investment consultants, they' ll have plenty of
the cross-border leasing market for US lessors.
Estimates of completed transactions range
data."
from several hundred million dollars in asset
value in 1990 to $4 billion in 1994. Prior to
Apples and oranges?
the release of the proposed regs, similar
Soon you learn that numerous investment congrowth was forecast for 1995 .
sulting firms collect real return numbers. You
Pickle Accelerators were favorable, because
they allowed US lessors to minimize the
look through the data and decide that a currency return of 3% by Manager A pales in comparrecovery period on lease transactions used to
ison with the 6% return of Manager B-until
finance a wide variety of assets including, railroad rolling stock, aircraft and, most recently
you dig a little deeper and discover that:
Manager A's underlying portfolio consisted
power plant facilities. Also, as opposed to US
mainly of Canadian and Aussie dollar, while
Foreign Sales Corporations (see IT, 9/19/94)
B's comprised more volatile Japanese yen and
and Japanese leveraged lease alternatives,
continued on page 4

By Bri an Strange
Currency Performance
Analytics

continued on page 2

By j ay Zukerm an
Ernst & Young

Proposed IRS regs will

make US-initiated
cross-border leases
more difficult to structure for tax benefits.
page 1

APAs for Financial

Transactions
While maintaining
supporting documentation is the critical issue,
financial entities concerned with transfer
pricing penalties
should consider negotiating advanced pricing
agreements.
page 6

' Free Trade & Banking

By Joseph Neu

The US sti ll supports

free trade in \inancial
services, despite the
recent WTO snub.
Thus, global banking
relationships are not
likely to be any less
effective.
page 8

Treasury/Tax Planning
continued from page 1

Pickle Accelerators are appropriate for

new and used assets of varying economic useful lives . They are also not
limited to assets manufactured within
the US.
The legislative history against Pickle
leases began with an effort to curb the
possibility that US investment incentives could be passed through to taxexempt entities. In 1984, the US enacted legislation sponsored by House
Representative Pickle (hence the name
Pickle lease) and Senator Dole that
substantially reduced the depreciation
benefits avai lable to US lessors in leasing to tax-exe mpt entiti es, including
those abroad.
Specifically, the so-called Pickle
rules mandated both a decelerated
method of computing the depreciation
allowance (i .e., straight line rather than
accelerated) and a longer recovery
period (the greater of the asset's guideline class or 125% of the lease term) .
As a resu lt, few Pickle transactions
were consummated during the balance
of the 1980s.
By late 1989, an adaptation of the
Pickle lease began to emerge, known
as the "Accelerator" or replacement
lease. This technique allowed the
lessor to shorten the equipment's
recovery period (thus enhancing its
depreciation deduction), while simul taneously reducing taxable income,
resulting in an increased after-tax
yield. It is this technique that the proposed regulation attempts to close out.

(including, in the case of refinancing of

used assets pursuant to a sale/leaseback, the non-US lessee) for a cash
purchase price.
(3) The Trust borrows 87% of the
equipment cost from a lender, on a
nonrecourse basis, pledging the equipment and the lessee's obi igations
(described below) as co ll atera l for
repayment of the loan. The loan is
amortized over an economic term
approximating a leveraged lease transaction without an Accelerator (e.g., 20
years for an aircraft transaction).
(4) The Trust leases the equipment to
the 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 expiry
of the initial term, to effectuate one of
the following:

a. Purchase the equipment pursuant

to a purchase option at a fixed price
("FPO") determined to approximate or
exceed the projected fair market value
("FMV") of the equipment upon the
expiry date; or
b. Pay a termination value or "walkaway" payment ("TVP" ) in an amount
discounted from anticipated FMV and
return the equipment to the lessor (with
any third-party proceeds utilized to
reimburse the lessee); or
c. Arrange for a suitable replacement
lessee to enter into a replacement
lease ("R L" ) with terms sufficient to
fund the remaining amortization of the
loan .
The non-US lessee's obligations are
typically guaranteed by the lessee's
corporate parent.
The benefit: The intended results and
tax benefits of the Accelerator tech-

Diagram: US Pickle Lease-Accelerator Structure

US Parent

US Equity

... $100~

l .

$ 13 Equtty

t
Trustee
(US Trust Co.) 1--

Equipment Sale
I

Trust
(US Grantor Trust)

A sample transaction
The basic structure of the Accelerator
is as follows (see diagram at right):
(1) The US lessor (typically, a special
purpose corporate subsidiary) contributes 13 percent of equipment cost
to a Trust. The Trust is deemed a soca ll ed "grantor trust" for US tax purposes so that all the tax attributes of
the Trust position (rental income, interest expense , and depreciation
allowance) are passed through to the
US lessor.
(2) The Trust acquires the equipment
from the manufacturer or other vendor
2

$8 7 Loan

~
L

20-year Note

Guarantee

Parent of
Lessee

10-year Lease

Defeasance
Currency and/or
Interest Rate Swap

Rent

Non-US Lessee

At Lease Expiry

eoreora
Source: Ernst & Yo ung

*Note: Vendor can be non-US Lessee (Sale/Leaseback) .

Intern ati o nal Treasure r/ August 7, 199 5

Treasury/Tax Planning
nique are twofold :
The recovery period is computed
on the basis of the shorter lease term
(1 0 years X 125%= 12.5 years, rather
than a 20 years X 125%= 25-year
recovery period); and
The rental income to the US lessor
is reduced during the shorter (1 0-year)
term due to the longer (20-year) loan
amortization term.
Defeasances, interest rate and/ or currency swaps are typically utilized to
accomplish certain economic, loan
security, and withholding tax objectives . Additionally, in some instances,
a part of the debt, is p rovided by th e
non-US lessee (or an affiliate), rather
than by a third-party, unrelated lender.

The point ot anack

The proposed regulations directly
attack the Pickle Accelerator structure
by stating that the term of the lease for
the purposes of determining the applicable depreciation recovery period
should include any period where the
lessee (or a person related to the lessee)
retains a financial obligation to pay rent
or make a payment in the nature of
rent. Further, "a payment in the nature
of rent" is defined explicitly to include
a payment intended to substitute for
rent or to fund or supplement the rental
payments of another party.
The regulations provide as an example of such a payment, any payment
required to be made in the event that (i)
tne leased property is not leased for a
specified additional period ; or (ii) the
leased property is leased for the additional period under terms that do not
satisfy 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 the
replacement lease option that is typically utilized in the Accelerator structure.
Accordingly, using our example,
under the proposed regulations, the
lease term would be recharacterized as
20, rather the 1 0 years ; and consequently, the depreciation recovery
period go to 25 years from 12.5 .
Intern ational Treasurer/August 7, 1995

According to market estimates, the

resulting cost to the US lessor (assuming the loan term payments and rentals
remain unchanged) approach 400
basis points, using an after tax yield
analysis. If the loan amortization
required increased rentals as a consequential result of any restructuring, the
cost would further increase and the US
lessor' s after tax yield would deteriorate further.
At such cost, the dramatic impact on
the marketplace resulting from the
release of the proposed regulations
becomes readily understood .

The future is now

The effective date of the proposed regulations (if finalized as proposed)
would trigger retroactively to the
announcement date : April 20, 1995.
Thus, the IRS is not providing for a
transition period to allow affected taxpayers to complete pending transactions. The market effect is immediate
and pervasive.
Further, while the regulations would
not apply to transactions consummated
prior to the effective date, the IRS
specifically reserved the right to question and recharacterize the lease term
of earlier, closed transactions under
existing legal principles and authorities.
Planning considerations. Many questions have arisen in the wake of the
proposed regulations . Foremost, of
course, is wheth er stru ctural evolutions
will be able to return some (or all) of
the benefit stripped away from US-initiated cross-border leases.
Planning opportunities may arise, for
example, which would permit the US
lessor substantially the same benefits
without running afoul of the proposed
regulations . Some alternative strategies
may generate greater economic risk for
the lender . This risk will likely be
passed on resulting in greater transaction costs .

Cost-sharing thus would become a

crucial aspect of negotiations between
the US lessor and the non-US lessee.

Opportunities that do not create

these transaction costs (apart from
more limited FSC and Japanese leveraged leases) may create greater tax
risks. The market will have to evolve
further to determine who will bear
which risks and who will be entitled to
what compensation .

During this transition risk managers

with Pickle-related leasing activities
should be careful to identify and
attempt to quantify exposure and
cost-benefit on a risk-adjusted basis.
In evalu ating the tax risk in part"lcular, US lessors should decide whether
the proposed regulations represent an
interpretation of specific tax law; or,
rather, in a macro sense, an expression
of a general distaste for any tax planning in the Pickle lease area. Under
this view, US taxpayers may see themselves as having been placed on notice
not to engage in these sorts of transactions and that any future structural
evolution may be challenged back to
Apri/20, 1995.
Given this tax risk, it would not be
surprising to see some US l essors
decide not to proceed with any Pickle
lease structures at this time. However,
others have raised the issue as to
whether the proposed regulations are
consistent with legislative history, noting that under the Accelerator structure
the property must always be depreciated over a period no snorter than tne
asset' s guideline class life. This may
lead to revisions in the final regulations that would ameliorate some of
the 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 Japanese
leveraged leases), and the flexibility of
lenders will shape and determine the
scope of the continued US-initiated
cross-border leasing market.

Mr. Zukerman is director of leasing tax services for Ernst & Young . He is reached at
(272) 773-3270.
3