Reg-106010-98

Part IV. Items of General Interest
Notice of Proposed Rulemaking
and Notice of Public Hearing
Qualified Lessee Construction
Allowances for Short-Term
Leases

tion on the IRS Home Page, or by submitting comments directly to the IRS Internet
site at http://www.irs.ustreas.gov/ tax_
regs/regslist.html. The public hearing will
be held in room 2615, Internal Revenue
Building, 1111 Constitution Avenue, NW,
Washington, DC.

REG–106010–98
AGENCY: Internal Revenue Service
(IRS), Treasury.
ACTION: Notice of proposed rulemaking and notice of public hearing.
SUMMARY: This document contains
proposed regulations concerning an exclusion from gross income for qualified
lessee construction allowances provided
by a lessor to a lessee for the purpose of
constructing long-lived property to be
used by the lessee pursuant to a shortterm lease. The proposed regulations affect a lessor and a lessee paying and receiving, respectively, qualified lessee
construction allowances that are depreciated by a lessor as nonresidential real
property and excluded from the lessee’s
gross income. The proposed regulations
provide guidance on the exclusion, the information required to be furnished by the
lessor and the lessee, and the time and
manner for providing that information to
the IRS. This document also provides notice of a public hearing on these proposed
regulations.
DATES: Written and electronic comments must be received by December 20,
1999. Outlines of topics to be discussed
at the public hearing scheduled for January 19, 2000, must be received by December 29, 1999.
ADDRESSES: Send submissions to:
CC:DOM:CORP:R (REG–106010–98),
room 5226, Internal Revenue Service,
POB 7604, Ben Franklin Station, Washington, DC 20044. Submissions may be
hand delivered Monday through Friday
between the hours of 8 a.m. and 5 p.m. to:
CC:DOM:CORP:R (REG–106010–98),
Courier’s Desk, Internal Revenue Service,
1111 Constitution Avenue, NW, Washington, DC. Alternatively, taxpayers may
submit comments electronically via the
Internet by selecting the “Tax Regs” op-

1999–40 I.R.B.

FOR FURTHER INFORMATION CONTACT: Concerning the regulations, Paul
Handleman, (202) 622-3040; concerning
submissions, the hearing, and/or to be
placed on the building access list to attend
the hearing, Michael Slaughter, (202) 6227180 (not toll-free numbers).
SUPPLEMENTARY INFORMATION:
Paperwork Reduction Act
The collection of information contained in this notice of proposed rulemaking has been submitted to the Office of
Management and Budget for review in accordance with the Paperwork Reduction
Act of 1995 (44 U.S.C. 3507(d)). Comments on the collection of information
should be sent to the Office of Management and Budget, Attn: Desk Officer for
the Department of the Treasury, Office of
Information and Regulatory Affairs,
Washington, DC 20503, with copies to
the Internal Revenue Service, Attn: IRS
Reports Clearance Officer, OP:FS:FP,
Washington, DC 20224.
Comments on the collection of information should be received by November 19,
1999.
Comments are specifically requested concerning:
Whether the proposed collection of information is necessary for the proper performance of the functions of the IRS, including whether the information will have
practical utility;
The accuracy of the estimated burden associated with the proposed collection of
information (see below);
How the quality, utility, and clarity of the
information to be collected may be enhanced;
How the burden of complying with the
proposed collection of information may
be minimized, including through the application of automated collection techniques or other forms of information technology; and

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Estimates of capital or start-up costs and
costs of operation, maintenance, and purchase of services to provide information.
The requirement for the collection of information in this notice of proposed rulemaking is in §1.110–1(c). The information
is required so that a taxpayer receiving a
construction allowance as lessee from the
lessor may establish the amount qualifying
for the safe harbor under section 110(a).
The collection of information is mandatory. The likely respondents are businesses
and other for-profit organizations.
Estimated total annual reporting burden:
10,000 hours.
The estimated annual burden per respondent varies from .5 hours to 1.5 hours, depending on individual circumstances,
with an estimated average of 1 hour.
Estimated number of respondents :
10,000.
Estimated annual frequency of responses:
once.
An agency may not conduct or sponsor,
and a person is not required to respond to,
a collection of information unless the collection of information displays a valid
control number assigned by the Office of
Management and Budget.
Books or records relating to a collection of information must be retained as
long as their contents may become material in the administration of any internal
revenue law. Generally, tax returns and
tax return information are confidential, as
required by 26 U.S.C. 6103.
Background
This document contains proposed
amendments to the Income Tax Regulations (26 CFR part 1) to provide regulations under section 110 of the Internal
Revenue Code of 1986. Section 110 was
added to the Code by section 1213(a) of
the Taxpayer Relief Act of 1997, Public
Law 105-34 (Act). Under section 1213(e)
of the Act, the amendment made by section 1213(a) applies to leases entered into
after August 5, 1997.
Explanation of Provisions
Tax Treatment of Lessee Construction
Allowances
Section 61(a) provides that gross income means “all income from whatever

October 4, 1999

source derived” except as otherwise provided in subtitle A of the Internal Revenue
Code. Generally, the receipt of a construction allowance by a lessee from a
lessor for property to be constructed and
used by the lessee pursuant to a lease represents an accession to wealth includible
in gross income in the year of receipt.
However, amounts received by a lessee
that are expended by the lessee on assets
owned by the lessor are not includible in
the lessee’s gross income because there is
no accession to wealth. Thus, the proper
tax treatment of construction allowances
turns on whether the lessee or the lessor
owns the property constructed with the
allowance.
Ownership for tax purposes generally
is determined by applying a “benefits and
burdens of ownership” test to the facts
and circumstances surrounding the transaction. The benefits and burdens of ownership test was developed by the Tax
Court to determine whether a purported
lease should be treated as a sale for Federal income tax purposes. The court set
forth the following factors to determine
whether the taxpayer had the benefits and
burdens of ownership of the leased property: (1) whether legal title passes; (2)
how the parties treat the transaction; (3)
whether an equity interest was acquired in
the property; (4) whether the contract creates a present obligation on the seller to
execute and deliver a deed and a present
obligation on the purchaser to make payments; (5) whether the right of possession
is vested in the purchaser; (6) which party
pays the property taxes; (7) which party
bears the risk of loss or damage to the
property; and (8) which party receives the
profits from the operation and sale of the
property. See Grodt & McKay Realty,
Inc. v. Commissioner, 77 T.C. 1221
(1981), and Coleman v. Commissioner,
T.C. Memo. 1987-195, aff’d, 16 F.3d 821
(7th Cir. 1994).
In a coordinated issue paper dated October 7, 1996, the IRS enumerated certain
specific factors that help establish whether
the benefits and burdens of ownership of
the leasehold improvements are with the
lessee or the lessor; i.e., who carries personal property and liability insurance on
the leasehold improvements; who is the
beneficiary under those policies; who is
responsible for replacing the leasehold im-

October 4, 1999

provements if they wear out prior to the
end of the lease term; and, if the usefulness of the leasehold improvements extends beyond the lease term, who has the
remainder interest in the improvements.
To the extent the lessee holds the benefits and burdens of ownership of the
leasehold improvements constructed with
the construction allowance, the lessee has
an accession to wealth and income under
section 61(a). However, to the extent the
lessor holds the benefits and burdens of
ownership, the lessee is acting merely as
an agent of the lessor and the construction
allowance is not includible in the gross income of the lessee.
Congress was concerned that the traditional factors used by the IRS in making
the determination of who is the tax owner
of property may be applied differently by
the lessor and the lessee and may lead to
controversies between the IRS and taxpayers. H.R. Rep. No. 148, 105th Cong.,
1st Sess. 423 (1997) (House Report); S.
Rep. No. 33, 105th Cong., 1st Sess. 23233 (1997) (Senate Report). Consequently,
the Act provides a safe harbor whereby it
is assumed that a construction allowance
is used to construct or improve lessor
property (and is properly excludable by
the lessee) when long-lived property is
constructed or improved and used pursuant to a short-term lease. The Act also
provides a reporting requirement to ensure that both the lessee and the lessor
consistently treat the property subject to
the construction allowance as nonresidential real property owned by the lessor.
House Report at page 424; Senate Report
at page 233.
Safe Harbor under Section 110
Section 110(a) provides, in general,
that gross income of a lessee does not include any amount received in cash (or
treated as a rent reduction) by a lessee
from a lessor under a short-term lease of
retail space, for the purpose of such
lessee’s constructing or improving qualified long-term real property for use in
such lessee’s trade or business at such retail space, but only to the extent that such
amount does not exceed the amount expended by the lessee for such construction
or improvement.
Section 110(c)(1) defines the term
“qualified long-term real property” as

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nonresidential real property which is part
of, or otherwise present at, the retail space
referred to in section 110(a) and which reverts to the lessor at the termination of the
lease. Section 110(c)(2) defines the term
“short-term lease” as a lease (or other
agreement for occupancy or use) of retail
space for 15 years or less (as determined
under the rules of section 168(i)(3)). Section 110(c)(3) defines the term “retail
space” as real property leased, occupied,
or otherwise used by a lessee in its trade
or business of selling tangible personal
property or services to the general public.
Consistent with section 110(c)(1), the
proposed regulations define the term
“qualified long-term real property” as
nonresidential real property under section
168(e)(2)(B), which is section 1250 property other than residential rental property
and property with a class life of less than
27.5 years. The proposed regulations do
not require a direct tracing of the construction allowance, but assume that the
construction allowance is used to construct or improve the lessor’s property if
qualified long-term real property is constructed by the lessee at the leased retail
space. The IRS and the Department of
Treasury specifically request comments
on whether the definition of “retail space”
needs to be clarified.
The proposed regulations recognize
that a lessee may not be able to construct
the qualified long-term real property in
the same taxable year as it receives the
construction allowance from the lessor.
Thus, the proposed regulations give the
lessee additional time to satisfy the safe
harbor by allowing the construction allowance to be expended for qualified
long-term real property until 81⁄2 months
after the close of the taxable year in which
the construction allowance was received
by the lessee.
The legislative history of the Act states
that no inference is intended as to the
treatment of amounts that are not subject
to the safe harbor provision. In such
cases, the provisions of IRS coordinated
issue paper and present law (including
case law) will continue to apply where applicable. H.R. Conf. Rep. No. 220, 105th
Cong., 1st Sess. 658–59 (1997). Thus, a
construction allowance failing to qualify
under the safe harbor provision is not includible in the lessee’s gross income if the

1999–40 I.R.B.

lessor has the benefits and burdens of
ownership of the property constructed
with the construction allowance. Ownership of the property is determined under
general principles of Federal tax law
based on all the facts and circumstances.
Consistency between Lessee and Lessor
and Reporting Requirements
Section 110(b) provides that qualified
long-term real property constructed or improved in connection with any amount excluded from a lessee’s income by reason
of section 110(a) shall be treated as nonresidential real property of the lessor
(including for purposes of section
168(i)(8)(B)).
Section 110(d) provides that, under
regulations, the lessee and lessor described in section 110(a) must, at such
times and in such manner as may be provided in such regulations, furnish to the
Secretary information concerning the
amounts received (or treated as a rent reduction) and expended as described in
section 110(a), and any other information
which the Secretary deems necessary to
carry out the provisions of section 110.
The Act provides that the lessor will
treat any qualified long-term real property
constructed or improved with a construction allowance excluded from the lessee’s
gross income under section 110(a) as nonresidential real property owned by the
lessor. However, the lessee’s exclusion is
not dependent upon the lessor’s treatment
of the property as nonresidential real
property. House Report at page 424; Senate Report at page 233.
The proposed regulations prescribe the
information required to be furnished by
the lessor and the lessee and the time and
manner for providing that information to
the IRS. A lessor or a lessee that fails to
furnish the required information may be
subject to a penalty under section 6721.
Proposed Effective Date
The regulations are proposed to be applicable to leases entered into on or after
the date final regulations are published in
the Federal Register.
Special Analyses
It has been determined that this notice
of proposed rulemaking is not a significant regulatory action as defined in Exec-

1999–40 I.R.B.

utive Order 12866. Therefore, a regulatory assessment is not required. It is
hereby certified that the collection of information in these regulations will not
have a significant economic impact on a
substantial number of small entities. This
certification is based upon the fact that
any burden on taxpayers is minimal. Accordingly, a Regulatory Flexibility Analysis under the Regulatory Flexibility Act (5
U.S.C. chapter 6) is not required. Pursuant to section 7805(f) of the Internal
Revenue Code, this notice of proposed
rulemaking will be submitted to the Chief
Counsel for Advocacy of the Small Business Administration for comment on its
impact on small business.

An agenda showing the scheduling of
the speakers will be prepared after the
deadline for receiving outlines has
passed. Copies of the agenda will be
available free of charge at the hearing.
Drafting Information
The principal author of these regulations is Paul F. Handleman, Office of the
Assistant Chief Counsel (Passthroughs
and Special Industries), IRS. However,
other personnel from the IRS and Treasury Department participated in their
development.
* * * * *
Proposed Amendments to the Regulations

Comments and Public Hearing
Before these proposed regulations are
adopted as final regulations, consideration will be given to any written comments (a signed original and eight (8)
copies) or electronic comments that are
submitted timely to the IRS. The IRS and
Treasury Department specifically request
comments on the clarity of the proposed
rule and how it may be made easier to understand. All comments will be available
for public inspection and copying.
A public hearing has been scheduled for
Wednesday, January 19, 2000, at 10 a.m.
in room 2615, Internal Revenue Building,
1111 Constitution Avenue, NW, Washington, DC. Due to building security procedures, visitors must enter at the 10th Street
entrance, located between Constitution
and Pennsylvania Avenues, NW. In addition, all visitors must present photo identification to enter the building. Because of
access restrictions, visitors will not be admitted beyond the immediate entrance
area more than 15 minutes before the
hearing starts. For information about having your name placed on the building access list to attend the hearing, see the
“FOR FURTHER INFORMATION CONTACT” section of this preamble.
The rules of 26 CFR 601.601(a)(3)
apply to the hearing.
Persons who wish to present oral comments at the hearing must submit an outline of the topics to be discussed and the
time to be devoted to each topic (signed
original and eight (8) copies) by December 29, 1999.
A period of 10 minutes will be allotted
to each person for making comments.

495

Accordingly, 26 CFR part 1 is proposed to be amended as follows:
PART 1—INCOME TAXES
Paragraph 1. The authority citation for
part 1 is amended by adding an entry in
numerical order to read in part as follows:
Authority: 26 U.S.C. 7805 * * *
Section 1.110–1 also issued under 26
U.S.C. 110(d); * * *
Par. 2. Section 1.110–1 is added to
read as follows:
§1.110–1 Qualified lessee construction
allowances.
(a) Overview. Amounts provided to a
lessee by a lessor for property to be constructed and used by the lessee pursuant
to a lease are not includible in the lessee’s
gross income if the amount is a qualified
lessee construction allowance under paragraph (b) of this section.
(b) Qualified lessee construction allowance—(1) In general. A qualified
lessee construction allowance means any
amount received in cash (or treated as a
rent reduction) by a lessee from a lessor–
(i) Under a short-term lease of retail
space;
(ii) For the purpose of constructing or
improving qualified long-term real property for use in the lessee’s trade or business at that retail space; and
(iii) To the extent the amount is expended by the lessee in the taxable year
received on the construction or improvement of qualified long-term real property
for use in the lessee’s trade or business at
that retail space.

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(2) Definitions—(i) Qualified longterm real property is nonresidential real
property under section 168(e)(2)(B) that
is part of, or otherwise present at, the retail space referred to in paragraph
(b)(1)(i) of this section and which reverts
to the lessor at the termination of the
lease. Thus, qualified long-term real
property does not include property qualifying as section 1245 property under section 1245(a)(3).
(ii) Short-term lease is a lease (or other
agreement for occupancy or use) of retail
space for 15 years or less (as determined
pursuant to section 168(i)(3)).
(iii) Retail space is nonresidential real
property under section 168(e)(2)(B) that
is leased, occupied, or otherwise used by
the lessee in its trade or business of selling tangible personal property or services
to the general public.
(3) Purpose requirement. An amount
will meet the requirement in paragraph
(b)(1)(ii) of this section only to the extent
that the lease agreement for the retail
space expressly provides that the construction allowance is for the purpose of
constructing or improving qualified longterm real property for use in the lessee’s
trade or business at that retail space.
(4) Expenditure requirement—(i) In
general. Expenditures referred to in paragraph (b)(1)(iii) of this section will be
treated as being made first from the
lessee’s construction allowance. Tracing
of the construction allowance to the actual
lessee expenditures for the construction or
improvement of qualified long-term real
property is not required. However, the
lessee should maintain accurate records of
the amount of the qualified lessee construction allowance received and the expenditures made for qualified long-term
real property.
(ii) Time when expenditures deemed
made. For purposes of paragraph
(b)(1)(iii) of this section, an amount is
deemed to have been expended by a
lessee in the taxable year in which the
construction allowance was received by
the lessee if the amount is expended
within 81⁄2 months after the close of that
taxable year.
(5) Consistent treatment by lessor.
Qualified long-term real property con-

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structed or improved with any amount excluded from a lessee’s gross income by
reason of paragraph (a) of this section
must be treated as nonresidential real
property owned by the lessor (for purposes of depreciation under 168(e)(2)(B)
and determining gain or loss under section
168(i)(8)(B)). For purposes of the preceding sentence, the lessor must treat the construction allowance as fully expended in
the manner required by paragraph
(b)(1)(iii) of this section unless the lessor
is notified by the lessee in writing to the
contrary. General tax principles apply for
purposes of determining when the lessor
may begin depreciation of its nonresidential real property. The lessee’s exclusion
from gross income under paragraph (a) of
this section, however, is not dependent
upon the lessor’s treatment of the property
as nonresidential real property.
(c) Information required to be furnished—(1) In general. The lessor and
the lessee described in paragraph (b) of
this section who are paying and receiving
a qualified lessee construction allowance,
respectively, must furnish the information
described in paragraph (c)(3) of this section in the time and manner prescribed in
paragraph (c)(2) of this section.
(2) Time and manner for furnishing information. The requirement to furnish information under paragraph (c)(1) of this
section is met by attaching a statement
with the information described in paragraph (c)(3) of this section to the lessor’s
or the lessee’s, as applicable, timely filed
(including extensions) Federal income tax
return for the taxable year in which the
construction allowance was paid by the
lessor or received by the lessee (either in
cash or treated as a rent reduction), as applicable. A lessor or a lessee may report
the required information for several qualified lessee construction allowances on a
combined statement. However, a lessor’s
or a lessee’s failure to provide information with respect to each lease will be
treated as a separate failure to provide information for purposes of paragraph
(c)(4) of this section.
(3) Information required—(i) Lessor.
The statement provided by the lessor must
contain the lessor’s name (and, in the case
of a consolidated group, the parent’s

496

name), employer identification number,
taxable year and the following information for each lease:
(A) The lessee’s name (in the case of a
consolidated group, the parent’s name).
(B) The address of the lessee.
(C) The employer identification number of the lessee.
(D) The location of the retail space (including mall or strip center name, if applicable, and store name).
(E) The amount of the construction allowance.
(F) The amount of the construction allowance treated by the lessor as nonresidential real property owned by the lessor.
(ii) Lessee. The statement provided by
the lessee must contain the lessee’s name
(and, in the case of a consolidated group,
the parent’s name), employer identification number, taxable year and the following information for each lease:
(A) The lessor’s name (in the case of a
consolidated group, the parent’s name).
(B) The address of the lessor.
(C) The employer identification number of the lessor.
(D) The location of the retail space (including mall or strip center name, if applicable, and store name).
(E) The amount of the construction allowance.
(F) The amount of the construction allowance that is a qualified lessee construction allowance under paragraph (b)
of this section.
(4) Failure to furnish information. A
lessor or a lessee that fails to furnish the
information required in this paragraph (c)
may be subject to a penalty under section
6721.
(d) Effective date. This section is applicable to leases entered into on or after
the date final regulations are published in
the Federal Register.
Robert E. Wenzel,
Deputy Commissioner
of Internal Revenue.
(Filed by the Office of the Federal Register on September 17, 1999, 8:45 a.m., and published in the
issue of the Federal Register for September 20,
1999, 64 F.R. 50783)

1999–40 I.R.B.