Acquisition of Replacement Property Equipment from Related Party Dealer Violates Section 1031(f): ILM 201013038 (April 2, 2010)
In a Chief Counsel Advice Legal Memorandum, the IRS advised that a heavy equipment lessor could not acquire replacement property (RP) in an exchange from its related party dealer when the buyer of the relinquished property (RQ) was an unrelated party. The IRS ruled that transaction was structured (in part) to avoid the § 1031(f) restrictions on exchanges between related parties. Further, the taxpayer did not establish that the transaction met the § 1031(f)(2)(C) exception to the restrictions on exchanges between related parties.
Dealer sold a certain brand of equipment at retail. Taxpayer, a related party to dealer under IRC § 267(b), leased that type of equipment to unrelated customers in the course of its trade or business. Under a master exchange agreement described in Rev. Proc. 2003-39 http://services.taxanalysts.com/taxbase/irsrevproc.nsf/Dockey/rev.+proc.+2003-39?OpenDocument, Taxpayer used a QI to exchange its old equipment for new equipment acquired from Dealer. Basis shifting occurred because Dealer sold inventory into the exchange at its cost (realizing no gains), while Taxpayer attempted to defer its gain from the disposition of RQ by taking a substituted basis (the high basis of RP for the low basis of RQ). Taxpayer acknowledged that it could have obtained RP directly from the unrelated manufacturer of RP or an unrelated dealer. Taxpayer represented that it had independent business reasons for always acquiring its RP from Dealer. These included the proximity of Dealer's inventory to Taxpayer's business, the possibility of financing discounts for patronizing Dealer, and the stability of supply due to the good will and established business relations between Dealer and the manufacturer. In addition, the manufacturer provided incentives to Dealer for each unit of equipment sold by Dealer.
The Memorandum first finds that the transaction falls within § 1031(f)(4) and Rev. Rul. 2002-83 http://services.taxanalysts.com/taxbase/ta16.nsf/Dockey/rev.+rul.+2002-83?OpenDocument . Thus, it is an invalid exchange unless Taxpayer can show, under § 1031(f)(2)(C), that Taxpayer’s independent business reasons established that tax avoidance was not one of Taxpayer's principal purposes for structuring the transaction as an exchange. The legislative history of 1031(f) lists three examples of transactions that fit within 1031(f)(2)(C) as non tax avoidance exceptions: an exchange of undivided interests, a disposition of property in a nonrecognition transaction by one of the related parties, or a non basis-shifting transaction. The Memorandum states that the Taxpayer’s exchange clearly resulted in basis shifting and thus did not fit within the listed exceptions. The Memorandum further states that the Service has consistently limited § 1031(f)(2)(C) to the situations described in the legislative history, and the Service is not willing to expand the exception to cover Taxpayer's situation.
The Memorandum goes on to state that while the Taxpayer cited its independent business reasons as evidence that tax avoidance was not its sole objective, 1031(f)(2)(C) excepts transactions only if none of the principal purposes for the structure is tax avoidance. Thus, even though Taxpayer may have had some non-tax-avoidance reasons for structuring the exchange, immediate tax reduction was also clearly one of Taxpayer's principal objectives.
Comment: The Service has set a high bar for non tax avoidance exceptions other than those listed in the legislative history. The tax deferral in such a situation would have to be minimal for it not to be a principal objective of the exchange. Or perhaps the business reason would have to be so overriding that the tax deferral is only a side effect.
*Information source FEA
