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Where there is a genuine multiple-party transaction with economic substance which is compelled or encouraged by business or regulatory realities, is imbued with tax-independent considerations, and is not shaped solely by tax-avoidance features that have meaningless labels attached, the government should honor the allocation of rights and duties effectuated by the parties. Expressed another way, so long as the lessor retains significant and genuine attributes of the traditional lessor status, the form of the transaction adopted by the parties governs for tax purposes. What those attributes are in any particular case necessarily depends upon its facts. It suffices to say that a sale-and-leaseback, in and of itself, does not necessarily operate to deny a taxpayer's claim for deductions.
A state bank, which was a member of the Federal Reserve System, upon realizing that it was not feasible, because of various state and federal regulations, for it to finance by conventional mortgage and other financing a building under construction for its headquarters and principal banking facility, entered into sale-and-leaseback agreements by which Frank Lyon Company (Lyon) took title to the building and leased it back to the bank for long-term use, Lyon obtaining both a construction loan and permanent mortgage financing. The bank is obligated to pay rent equal to the principal and interest payments on Lyon’s mortgage and has an option to repurchase the building at various times at prices equal to the then unpaid balance of Lyon’s mortgage and initial $500,000 investment. On its federal income tax return for the year in which the building was completed and the bank took possession, Lyon accrued rent from the bank and claimed as deductions depreciation on the building, interest on its construction loan and mortgage, and other expenses related to the sale-and-leaseback transaction. The Commissioner of Internal Revenue disallowed the deductions on the ground that Lyon was not the owner of the building for tax purposes but that the sale-and-leaseback arrangement was a financing transaction in which Lyon loaned the bank $500,000 and acted as a conduit for the transmission of principal and interest to Lyon’s mortgagee. This resulted in a deficiency in Lyon’s income tax, which it paid. After its claim for a refund was denied, it brought suit in the District Court to recover the amount so paid. That court held that the claimed deductions were allowable, but the Court of Appeals reversed, agreeing with the Commissioner.
Is Lyon entitled to the claimed deductions?
The Court reversed the lower court's judgment holding that Lyon could not recover income taxes it had paid to the government following a deficiency judgment. Lyon had engaged in a sale-and-leaseback arrangement, by taking title to a building under construction and leasing it back to the company constructing it. The case differed from precedent in that the transaction involved a third-party, and the transaction was best characterized as a mortgage agreement with the construction company, and a loan from plaintiff to that company. Lyon would not realize a return on the loan unless the construction company exercised its options under the contract. Lyon was entitled to recover depreciation because its capital was invested in the building. Business realities compelled the nature of the transaction, and tax-independent considerations meant that the transaction was not a sham. The sale-and-leaseback nature of the transaction did not in itself deny Lyon’s claim for a depreciation deduction.