Section 467 Rental Agreements; Treatment of Rent &
Interest Under Certain Agreements for the Lease of Tangible Property

DEPARTMENT OF THE TREASURY
Internal Revenue Service 26 CFR Part 1 [TD 8820] RIN 1545-AU11

TITLE: Section 467 Rental Agreements; Treatment of Rent and Interest
Under Certain Agreements for the Lease of Tangible Property

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

SUMMARY: This document contains final regulations relating to the
treatment of rent and interest under certain agreements for the
lease of tangible property. The regulations apply to certain rental
agreements that provide increasing or decreasing rents, or deferred
or prepaid rent, and provide guidance for lessees and lessors of
tangible property.

DATES: Effective Date: These regulations are effective on May 18,
1999.

Applicability Date: For dates of applicability of these regulations,
see Effective Dates under SUPPLEMENTARY INFORMATION.

FOR FURTHER INFORMATION CONTACT: Forest Boone of the Office of
Assistant Chief Counsel (Income Tax and Accounting) at (202) 622-
4960 (not a toll-free number).

SUPPLEMENTARY INFORMATION:

Background

Section 467 was added to the Internal Revenue Code by section 92(a)
of the Tax Reform Act of 1984 (Public Law 98-369 (98 Stat. 609)). On
June 3, 1996, the IRS and Treasury Department issued a notice of
proposed rulemaking (61 FR 27834 [IA-292-84, 1996-2 C.B. 462])
relating to section 467. The proposed regulations provide guidance
regarding the applicability of section 467, and the amount of rent
and interest required to be accrued under section 467. Comments
responding to the notice were received, and a public hearing was
held on September 25, 1996.

The IRS and Treasury Department issued interim guidance in Notice
97-72 (1997-2 C.B. 334), which informed taxpayers of certain
conditions under which a refinancing of indebtedness incurred by a
lessor to acquire property that is the subject of a rental agreement
will not be considered a substantial modification of that agreement
for purposes of section 467.

After considering the comments that were received in response to the
notice of proposed rulemaking and the statements made at the public
hearing, the proposed regulations are adopted as revised by this
Treasury decision. The significant comments and revisions are
discussed below.

Explanation of Provisions

1. Section 467 Rental Agreements

Under the proposed and final regulations, section 467 applies to any
rental agreement with increasing or decreasing rent and aggregate
rental payments or other consideration of more than $250,000. A
rental agreement has increasing or decreasing rents if the
annualized fixed rent allocated to any rental period exceeds the
annualized fixed rent allocated to any other rental period in the
lease term.

In determining whether a rental agreement has increasing or
decreasing rent, the proposed regulations provide that a rent
holiday at the beginning of the lease term is disregarded if the
rent holiday period is three months or less. Several commentators
requested that the rent holiday period be lengthened, arguing that
it should be the same as the rent holiday period permitted for
determining whether a leaseback or long-term agreement has tax-
motivated increasing rents (the lesser of 24 months or 10 percent of
the lease term). The final regulations do not adopt this suggestion.

Section 467(d)(1)(B) provides that a rental agreement will be
treated as a section 467 rental agreement if there are increases in
the amount to be paid as rent under the agreement.

Except for the $250,000 de minimis exception set forth in section
467(d)(2), section 467 does not contain any exceptions to the rule
that rental agreements with increasing rent are section 467 rental
agreements. The three-month rent holiday exception was added in the
proposed regulations to prevent relatively insubstantial rent
holidays from causing a rental agreement to be treated as a section
467 rental agreement. Accordingly, the three-month rent holiday
exception is intended merely as a de minimis exception and a rule of
administrative convenience. In contrast, Congress specifically
directed that a rent holiday safe harbor should be provided for
normal commercial practices in determining whether a leaseback or
long-term agreement has tax-motivated increasing rents. Thus, since
the policies that support a rent holiday exception for disqualified
leasebacks and long-term agreements are clearly not the same as the
policies that support a rent holiday exception for whether an
agreement has increasing rent and is therefore a section 467 rental
agreement, the IRS and Treasury Department do not believe the rent
holiday periods should be the same.

The proposed regulations also provide that a rental agreement has
increasing or decreasing rent if it requires (or may require) the
payment of contingent rent, other than contingent rent that is
contingent due to (a) a provision computing rent based on a
percentage of the lessee's gross or net receipts (but only if the
percentage does not vary throughout the term of the lease); (b)
adjustments based on a reasonable price index; or (c) a provision
requiring the lessee to pay real estate taxes, insurance premiums,
maintenance costs, or any other cost (other than a debt service
cost) that relates to the leased property and is not within the
control of the lessor or lessee or a person related to the lessor or
lessee. Several commentators requested additional exceptions for
other types of payments, as well as an expansion of the existing
exceptions.

The final regulations provide several additional types of contingent
payments that will not be taken into account in determining whether
a rental agreement has increasing or decreasing rent. Because of the
relationship between these contingent rent provisions and the
contingent rent provisions that are disregarded in determining
whether an agreement is a disqualified leaseback or long-term
agreement, the new contingent rent exceptions will be discussed
below in connection with the discussion of disqualified leasebacks
and long-term agreements.

2. Section 467 Rent

Under the proposed and final regulations, the section 467 rent for a
taxable year is the sum of the fixed rent for any rental periods
that begin and end in the taxable year, a ratable portion of the
fixed rent for other rental periods beginning or ending in the
taxable year, and any contingent rent that accrues in the taxable
year. The amount of fixed rent for a rental period depends on the
terms of the rental agreement and, under the regulations, will be
either the amount of fixed rent allocated to the period under the
agreement, the constant rental amount, or the proportional rental
amount.

A. Disqualified leaseback or long-term agreement

The proposed regulations provide that (a) the Commissioner, rather
than the parties to the rental agreement, will determine whether a
rental agreement is a disqualified leaseback or long- term agreement
and (b) a rental agreement will not be a disqualified leaseback or
long-term agreement unless it requires more than $2,000,000 in
rental payments and other consideration.

The proposed regulations also provide that, if either the lessor or
the lessee is not subject to Federal income tax on its income or is
a tax-exempt entity (within the meaning of section 168(h)(2)), the
rental agreement will be closely scrutinized, and clear and
convincing evidence will be required to establish that tax avoidance
is not a principal purpose for providing increasing or decreasing
rent. The proposed regulations include as safe harbors only the
provisions set forth in section 467(b)(5) and an uneven rent test
based on Rev. Proc. 75-21 (1975-1 C.B. 715).

Other factors that would be considered as evidence of tax avoidance
were not provided.

Several commentators requested additional safe harbors for other
types of payments, as well as an expansion of the existing safe
harbors. In response to these comments, several changes have been
made in the final regulations to the tax avoidance and safe harbor
provisions.

(i) Determining tax avoidance

The proposed regulations do not provide any substantive rules for
determining tax avoidance because a leaseback or long-term agreement
will not be treated as disqualified in the absence of an affirmative
determination by the Commissioner. As a result, the objective of
consistency of treatment between the lessee and lessor would have
been met without the need to promulgate factors or other rules that
taxpayers could use to determine whether tax avoidance was present.
While the final regulations retain the rule that only the
Commissioner may make a tax avoidance determination, the IRS and
Treasury Department believe that the combination of substantive
guidance on tax avoidance and additional safe harbors will permit
taxpayers to determine more readily whether their leasebacks or
long-term agreements will be determined to be disqualified by the
Commissioner. Accordingly, substantive provisions have been added to
the final regulations prescribing the circumstances in which Federal
income tax avoidance will be treated as a principal purpose for
providing increasing or decreasing rent.

The final regulations provide that, if a significant difference
between the marginal Federal income tax rates of the lessor and
lessee can reasonably be expected at some time during the lease
term, the agreement will be closely scrutinized and clear and
convincing evidence will be required to establish that tax avoidance
is not a principal purpose for providing increasing or decreasing
rent. The regulations provide rules to determine when there is a
significant difference in marginal tax rates of the lessor and
lessee. Under these rules, the marginal tax rates are determined not
only by reference to the Federal income tax status of the taxpayer
(for example, as a corporation, partnership, or individual), but
also to the specific circumstances of the taxpayer. Thus, if a
corporation either is subject to the alternative minimum tax or has
available net operating losses or credits to carry forward from an
earlier taxable year, the corporation's marginal tax rate will
differ from other corporations not subject to the alternative
minimum tax and not having available net operating losses or
credits.

Further, in the case of an S corporation or partnership, the
marginal tax rate will be determined by taking into account the
amounts of income or deduction allocable to its shareholders or
partners, respectively, and the marginal tax rates of the
shareholders or partners.

Finally, as noted above, the final regulations retain the rule of
the proposed regulations that only the Commissioner may determine
that a section 467 rental agreement should be treated as a
disqualified leaseback or long-term agreement. The final regulations
also provide that such determination may be made either on a case-
by-case basis or in regulations or other guidance published by the
Commissioner providing that a certain type or class of leaseback or
long-term agreement will be treated as disqualified and subject to
constant rental accrual.

(ii) Safe harbors

In response to comments, the final regulations include several safe
harbor provisions not included in the proposed regulations. The new
safe harbors are intended to cover a variety of payments that could
be made under the terms of a rental agreement. Under the final
regulations, tax avoidance is not considered a principal purpose for
providing increasing or decreasing rent if the increase or decrease
in rent is described in one of the contingent rent safe harbor
provisions. The IRS and Treasury Department believe that these
additional safe harbors and the expansion of the existing safe
harbors appropriately balance the need to provide a degree of
certainty for taxpayers with the need to limit the potential for tax
avoidance.

The final regulations add several safe harbors for various types of
contingent payments that either are intended to compensate the
lessor for costs unrelated to the lessor's continuing investment in
the leased property or are so contingent that they should not be
taken into account for purposes of section 467 until the liability
for such payment becomes fixed.

Accordingly, subject to the limitations in the regulations, safe
harbors are provided for payments required to be made by the lessee:
in the event of damage, destruction, or loss of the leased property;
in the case of a qualified motor vehicle operating agreement within
the meaning of section 7701(h)(2)(A), for the failure of the
property to maintain a specified residual value; for the failure of
the property to be returned to the lessor at the end of the lease
term in the condition specified in the agreement; or for the failure
of the lessor to obtain the income tax benefits contemplated by the
agreement. In addition, a provision requiring late payment charges
is also not taken into account in determining whether tax avoidance
is present in a leaseback or long-term agreement. Limitations on the
scope of these safe harbors are provided in order to ensure that
these provisions are included in the agreement for a valid business
purpose and that the provisions are not used to achieve tax
avoidance.

Several commentators suggested that rent adjustments based on the
lessor's indebtedness, which itself bears interest at a variable
rate, are not tax motivated. In response, a safe harbor has also
been added for certain variable interest rate provisions. Under this
safe harbor, a rent adjustment provision will be disregarded if it
is based solely on the dollar amount of changes in the lessor's
interest costs, and only if the lessor and the lender are not
related and the indebtedness is evidenced by a variable rate debt
instrument (within the meaning of §1.1275-5(a)(1)). However, no
inference may be drawn from this safe harbor (or any other provision
of the regulations relating to a variable interest rate adjustment)
concerning the effect of such an adjustment on the classification of
the rental agreement as a lease for Federal income tax purposes.

In addition, the final regulations expand the scope of the safe
harbors provided in the proposed regulations relating to percentage
rents, inflation adjustments, and reasonable rent holidays. A
provision in a lease will not fail to qualify for the percentage
rent safe harbor because, for example, it applies to receipts or
sales after making certain limited deductions, it applies different
percentages to different departments or floors, or it applies to
receipts or sales in excess of a determinable amount. In addition, a
provision will not fail to qualify as an increase based on a
reasonable price index because it may limit the adjustment to a
fixed percentage in some years. However, this inflation adjustment
safe harbor will not apply if the limitation in the rental agreement
represents, in substance, a series of fixed increases in rent. For
example, if the limitation on an annual inflation adjustment is
substantially below the level of inflation reasonably expected
during the lease term, the limitation is, in substance, a series of
fixed increases in rent.

The proposed regulations include a rent holiday safe harbor for the
determination of tax avoidance, which provision applies only if
there is a substantial business purpose for the rent holiday.
Commentators objected to this requirement because the requirement of
a business purpose was not set forth in the legislative history
accompanying the enactment of section 467.

The final regulations delete the requirement that there be a
substantial business purpose for the rent holiday, but add the
requirement that was set forth in the legislative history. H.R.

Conf. Rep. No. 861, 98 Cong., 2d Sess. 893 (1984). Under the th
additional rule in the final regulations, the reasonableness of the
rent holiday is determined by reference to the commercial practice
(as of the agreement date) in the locality where the use of the
property occurs. This commercial reasonableness requirement does not
apply, however, in the case of a rent holiday of three months or
less at the beginning of the lease term.

The proposed regulations also limit the rent holiday safe harbor to
rent holidays at the beginning of the lease term. The final
regulations remove this limitation and permit one consecutive period
at any point during the lease term to qualify for the rent holiday
safe harbor if the commercial reasonableness requirement is
satisfied and the rent holiday period does not exceed the lesser of
24 months or 10 percent of the lease term.

Finally, except in the case of the rent holiday safe harbor, the
safe harbor provisions discussed above also apply in determining
whether a rental agreement has increasing or decreasing rent and is
thus subject to section 467. Accordingly, if a type of contingent
rent in a rental agreement meets the requirements of the applicable
safe harbor provision, it is not taken into account in determining
whether the agreement has increasing or decreasing rent for purposes
of both the application of section 467 and the determination of
whether the agreement is a disqualified leaseback or long-term
agreement.

(iii) Uneven rent test

The proposed regulations contain a safe harbor providing that tax
avoidance will not be considered to be a principal purpose for
providing increasing or decreasing rents if the rents allocable to
each calendar year of the lease do not vary from the average annual
rents over the entire lease term by more than 10 percent. This A
uneven rent test @ is derived from the Conference Committee Report,
which stated that the Committee anticipated that regulations under
section 467 would adopt standards under which leases providing for
fluctuations in rents by no more than a reasonable percentage above
or below the average rent over the term of the lease will be deemed
not to be motivated by tax avoidance. The report cited the standards
for advance rulings on leveraged lease transactions in Rev. Proc.
75-21, and stated that such standards may not be appropriate for
real estate leases.

H.R. Conf. Rep. No. 861, 98th Cong., 2d Sess. 893 (1984). The
proposed regulations do not provide a safe harbor specifically
applicable to real estate leases but comments were requested on
whether a different uneven rent test should be established for real
estate leases.

Commentators requested that the basic A 90-110 @ test in Rev.

Proc. 75-21 be adopted without modification. The principal
modification to the basic 90-110 test in the proposed regulations
identified by the commentators was the use of the calendar year
rather than the lease year to test for uneven rents. These
commentators also requested that the alternate uneven rent test
(sometimes referred to as the Ab - a@ test) be adopted as an
additional safe harbor. Finally, these commentators requested
clarification of the application of these uneven rent tests in
certain circumstances.

In response to these comments, the final regulations expand and
clarify the scope of the uneven rent test in the proposed
regulations. First, the final regulations allow a rent holiday
period at the beginning of the lease term to be ignored in applying
the uneven rent test if its duration is not more than three months.
Further, all but two of the contingent rent provisions ignored for
purposes of determining tax avoidance are also disregarded in
applying the uneven rent test. Rules are also provided to assist
taxpayers in applying the uneven rent test if the rental agreement
contains a variable rent provision.

For long-term leases of real estate, the final regulations provide a
modified uneven rent test. Under the final regulations, all of the
rules relating to the uneven rent test will be applied to long-term
leases of real estate, except that a 15 percent variance will be
permitted in lieu of the 10 percent variance (the A 85-115 @ test)
and a rent holiday will be disregarded if it is commercially
reasonable and its duration does not exceed the lesser of 24 months
or 10 percent of the lease term.

The final regulations do not adopt the suggestion that the
alternative b - a test also be made available as an additional safe
harbor. Section 467 evidences recognition that tax avoidance may
result from the use of either increasing or decreasing rents in a
section 467 rental agreement, depending on the circumstances of the
lessor and lessee in the particular transaction. The IRS and
Treasury Department believe that the use of the b - a test may, in
some cases, result in substantial decreases in rent. Thus, the b - a
test is not included in the final regulations.

Furthermore, the final regulations retain the use of the calendar
year as the basis for applying the uneven rent test.

The IRS and Treasury Department believe that use of the calendar
year is most consistent with the structure of section 467, which
provides the calendar year as the basis for determining whether rent
is deferred.

Some commentators requested additional safe harbors and other
special rules for leases of real estate, including the allowance of
fixed increases that approximate the parties' expectations of
general price increases during the lease term.

The final regulations do not provide any additional provisions
relating to real estate leases except for the modified 85-115 uneven
rent test and the expanded rent holiday safe harbor. The IRS and
Treasury Department believe that any fixed increases in a real
estate lease that exceed the permitted variance under the relaxed
safe harbor should be tested for tax avoidance under the general
standards.

(iv) The $2,000,000 limitation

The proposed regulations provide that, among other limitations, a
rental agreement will not be treated as a disqualified leaseback or
long-term agreement unless it requires more than $2,000,000 in
rental payments and other consideration.

Although the $2,000,000 limitation has been retained in the final
regulations, the IRS and Treasury no longer believe such a
limitation is appropriate. Accordingly, the IRS and Treasury are
issuing proposed regulations that would eliminate the $2,000,000
limitation on a prospective basis.

B. Rental agreement accrual

Under the proposed and final regulations, if neither the constant
rental amount nor the proportional rental amount is required to be
accrued, the rent to be accrued for a rental period is the rent
allocated to that rental period in accordance with the section 467
rental agreement. The amount of rent allocated to a rental period by
the rental agreement depends on whether the agreement provides a
specific allocation of fixed rent. If a rental agreement provides a
specific allocation of fixed rent, the amount of rent allocated to
each rental period during the lease term is the amount of fixed rent
allocated to that period by the agreement. In general, a rental
agreement specifically allocates fixed rent if the agreement
unambiguously specifies, for periods of no longer than a year, a
fixed amount of rent for which the lessee becomes liable on account
of the use of the property during that period.

The proposed regulations provide that, in the absence of a specific
allocation of fixed rent, the amount of rent allocated to each
rental period during the lease term is the amount of fixed rent
payable during that rental period. A number of commentators
requested that the rule for allocating rent in the absence of a
specific allocation of fixed rent be amended. The commentators
stated that, if a rental agreement contains only a rent payment
schedule without a separate rent allocation schedule, the agreement
should be treated as one that does not provide for an allocation of
rents. In these circumstances, the commentators contend that the
agreement should be subject to constant rental accrual under section
467(b)(3)(B).

The final regulations do not adopt this suggestion.

Instead, the final regulations, like the proposed regulations,
provide that, in the absence of a specific allocation of fixed rent,
the amount of fixed rent allocated to a rental period is the amount
of fixed rent payable during that rental period. The IRS and
Treasury Department believe that it is inappropriate to apply the
constant rental accrual rules solely because a rental agreement does
not include a specific allocation of fixed rent, whether as a result
of inadvertence, failure to obtain professional tax advice, or
otherwise. Further, while the constant rental accrual method is not
available unless the Commissioner makes a tax avoidance
determination, parties wishing to accrue rent in accordance with the
constant rental accrual method may provide for an allocation
schedule in their rental agreement with tax consequences that
approximate the use of the constant rental accrual method.

C. Other applicable limitations

Some commentators suggested that the final regulations provide that
rental agreements will be closely scrutinized for substantial
economic effect in appropriate cases. For example, a rental
agreement may provide a specific allocation of fixed rent (or no
specific allocation of fixed rent) that, under the regulations,
would result in significant back-loaded or front-loaded rent, but
would not be subject to constant rental accrual because it is not a
leaseback or long-term agreement. In general, the rules of section
467 represent exceptions to the general rules of tax accounting
applicable to income and expense associated with rental agreements.
However, the IRS and Treasury Department do not believe that section
467 and the regulations thereunder override other principles of
Federal tax law in the case of income and expense associated with
rental agreements.

Thus, the final regulations explicitly provide that the Commissioner
may apply authorities other than section 467 and the regulations
thereunder, such as section 446(b) clear-reflection-of- income
principles, section 482, and the substance-over-form doctrine, to
determine the income and expense from a rental agreement (including
the proper allocation of fixed rent under a rental agreement).

3. Rental Agreements with Contingent Payments

The proposed regulations reserve guidance on the section 467
treatment of contingent rent, indicating that regulations addressing
this issue would provide rules for contingent rent similar to those
provided for computing original issue discount for contingent
payment debt instruments in §1.1275-4. The final regulations
continue to reserve on the section 467 treatment of contingent
payments. The IRS and Treasury Department expect that regulations
under §1.467-6 will be separately proposed, and continue to invite
comments regarding the treatment of contingent rent and the
application of the §1.1275-4 rules to section 467 rental agreements.

4. Recapture on Sale or Other Disposition of Property

Some commentators requested certain modifications and further
clarification of the recapture rules under section 467(c) in the
case of dispositions by gift, transfers at death, and certain tax-
free transactions. In response to these comments, additional rules
and examples illustrating those rules are provided in the final
regulations.

The purpose of the additional rules is to place the transferee in
the same tax position upon the subsequent disposition of the leased
property as the transferor would have been in if the transferor had
not transferred the property to the transferee. For example, if
property subject to a section 467 rental agreement is transferred in
a transaction subject to section 351, and if the transferor would
have recognized section 467(c) recapture upon a taxable disposition
of the property, the transferee may be subject to recapture upon a
subsequent taxable disposition of the property. The amount of the
recapture upon the subsequent taxable disposition will be determined
by taking into account the section 467 rent and section 467 interest
relating to the period of the transferor's ownership of the
property. Thus, if a leaseback or long-term agreement provides for
increasing rent but is not a disqualified leaseback or long-term
agreement, a taxable disposition of the property by the transferee
on or after the expiration of the lease term will not be subject to
section 467(c) recapture. Alternatively, a taxable disposition of
the property by the transferee before the expiration of the lease
term will be subject to the same amount of section 467(c) recapture
that would have applied if the transferor had continued to own the
property.

5. Other Disposition Rules

The proposed regulations reserve guidance on whether special rules
should be provided for transfers of property and leasehold interests
in transactions in which gain or loss is not recognized in whole or
in part. The IRS and Treasury Department believe, however, that
special rules are not necessary in the case of nonrecognition
transactions. As a general matter, because a section 467 loan is
treated as indebtedness for all purposes of the Internal Revenue
Code, the rules that apply to each of the nonrecognition provisions
in cases where the property transferred is encumbered by
indebtedness will apply to the transfer of property or a leasehold
interest subject to a section 467 loan.

Further, if the section 467 loan represents an additional asset of
the transferor, it is unlikely that any gain will be realized by the
transferor because, in most cases, the basis of the loan will be
equal to the sum of the principal amount of the loan and the accrued
interest thereon. Thus, the provisions of the proposed regulations
relating to special rules for transfers in nonrecognition
transactions have been deleted.

6. Treatment of Modifications

The proposed regulations provide that, if the lessor and lessee
agree to a substantial modification of the terms of an existing
lease, the modified lease is generally treated as a new rental
agreement for purposes of section 467. Thus, if the modified lease
provides for increasing or decreasing rent, or deferred or prepaid
rent, and the rent exceeds $250,000, it is treated under the
proposed regulations as a section 467 rental agreement, even if the
pre-modification lease was not a section 467 rental agreement.

Some commentators requested additional guidance regarding whether a
substantial modification of a lease has occurred, in view of the
significant potential consequences of such a modification. In
addition, the commentators suggested several types of modifications
that, in their view, should not be treated as a substantial
modification.

Other commentators indicated that the proposed regulations did not
clarify whether only the remaining portion of the modified lease is
to be taken into account for purposes of determining the section 467
rent and interest for rental periods following the modification.

The final regulations retain the general rule of the proposed
regulations under which a rental agreement would be treated as a new
lease for purposes of section 467 if the parties agreed to a
substantial modification. Under the final regulations, if a
substantial modification of a rental agreement occurs after June 3,
1996, the post-modification agreement is treated as a new agreement
for purposes of determining whether the agreement is a section 467
rental agreement or a disqualified leaseback or long-term agreement
and for purposes of applying the effective date provisions of the
section 467 regulations. These rules do not apply, however, to a
modification occurring on or before May 18, 1999, unless the rental
agreement being modified is a post-June 3, 1996, disqualified
leaseback or long-term agreement or the post-modification agreement
is a disqualified leaseback or long-term agreement.

In general, in determining whether a modified agreement is a section
467 rental agreement, or a disqualified leaseback or long-term
agreement, the modified agreement is considered to consist only of
the terms that relate to post-modification items (as described
below). However, if a principal purpose of the modification is to
avoid the purpose or intent of section 467 or the regulations
thereunder, the Commissioner may treat the entire agreement (as
modified) as a single agreement for purposes of section 467. The
final regulations also provide that the post-modification agreement,
notwithstanding its treatment as a new agreement, will be
characterized, in certain cases, in the same manner as the agreement
in effect before the modification. For example, if an agreement was
a leaseback or was subject to constant rental accrual before its
modification, the post-modification agreement will generally be
treated as a leaseback or as subject to constant rental accrual.
Similarly, if the agreement was a long-term agreement before its
modification and the entire agreement (as modified) is a long-term
agreement, the post-modification agreement will be treated as a
long-term agreement.

The final regulations also provide rules for accounting for the
effects of modifications occurring after May 18, 1999. In the case
of a substantial modification, the lessor and lessee must take pre-
modification items (generally, rent for periods before the
modification, interest thereon, and payments allocable thereto
(whether made before or after the modification)) into account under
the method of accounting used before the modification. In computing
section 467 rent, section 467 interest, and the amount of the
section 467 loan with respect to post-modification items, only post-
modification items are taken into account. In addition, the parties
to the agreement are required to take into account adjustments
necessary to prevent duplications and omissions resulting from the
modification.

In the case of a modification that is not substantial, section 467
rent and interest for periods affected by the modification are
determined under the terms of the entire agreement (as modified). In
addition, the parties to the agreement are required to recompute the
balance of the section 467 loan under the new terms and to take into
account (as either additional rent or a reduction in rent previously
taken into account) the change in the loan balance resulting from
the modification. They are also required to take into account any
amount necessary to prevent duplications or omissions resulting from
the modification.

The final regulations also provide additional guidance for
determining whether a substantial modification of a lease has
occurred, adopting some of the principles applicable to the
modification of debt instruments under §1.1001-3. Under the final
regulations, all of the facts and circumstances will be examined to
determine whether a substantial modification has occurred. Because
this determination is inherently factual, the regulations do not
provide more specific criteria for making this determination.
However, in order to ensure that relatively insubstantial changes to
the terms of a lease agreement and changes that do not implicate the
policies of section 467 are not treated as substantial modifications
under this rule, safe harbor provisions have been added.

In general, the modifications that are likely to affect the
character of a rental agreement for purposes of section 467 are
those that change the amount or timing of rent allocated or rent
payable for the use of the property, or the identity of the taxpayer
taking those amounts into account. Thus, a substantial modification
will not result from changes in any provision for the payment of
third-party costs or any other provision that is ignored for
purposes of determining whether the agreement provides for
contingent rents. In addition, the refinancing of a lessor's
indebtedness on a leveraged lease will generally not be treated as a
substantial modification of the lease, subject to compliance with
certain conditions and limitations. These conditions and limitations
are intended to permit refinancings to avoid classification as a
substantial modification in circumstances where the primary
objective of the lessee is to take advantage of favorable changes in
interest rates.

In the case of a transfer of leased property by a lessor or a
substitution of a lessee, the final regulations provide that the
transfer or substitution will be treated as a substantial
modification only if a principal purpose of the transaction is the
avoidance of Federal income tax. In determining whether a transfer
or substitution should be treated as a substantial modification, the
safe harbors and other principles that generally apply in tax
avoidance determinations are taken into account and the Commissioner
may treat the post-modification agreement as a new agreement or
treat the entire agreement (as modified) as a single agreement.

7. Definition of Lease Term

The proposed regulations provide that an option period, whether
exercisable by the lessor or the lessee, is included in the lease
term only if it is reasonably expected, as of the agreement date,
that the option will be exercised. In contrast, Rev. Proc. 75-21
provides a comparable rule only for options that are exercisable by
the lessee, while including the duration of all lessor renewal
options in the lease term. The IRS and Treasury Department believe
that nothing in section 467 justifies a deviation from the rule of
Rev. Proc. 75-21 in this instance.

Accordingly, for purposes of determining the term of a lease, the
final regulations retain the rule of the proposed regulations only
for lessee options, and treat all lessor options as if they had been
exercised.

8. Effective Dates

The regulations are applicable for (1) disqualified leasebacks and
long-term agreements entered into after June 3, 1996, and (2) other
rental agreements entered into after May 18, 1999. No inference
should be drawn concerning the treatment of rental agreements
entered into before the regulations are applicable. Moreover, the
IRS will, in appropriate circumstances, apply the provisions of
section 467 requiring constant rental accrual to rental agreements
entered into on or before June 3, 1996.

Some commentators requested that the effective date for disqualified
leasebacks and long-term agreements be deferred so that the
regulations would apply only to agreements entered into after the
date on which final regulations are published in the Federal
Register. The final regulations do not adopt this suggestion. The
IRS and Treasury Department believe that the additional safe harbors
provided in these regulations will prevent leasebacks and long-term
agreements entered into after June 3, 1996, and on or before May 18,
1999 (the interim period), from being inappropriately disqualified
in cases where the increasing or decreasing rents have not been
motivated by tax avoidance. Some of these commentators also
requested that the regulations not be applied to rental agreements
entered into pursuant to a contract that was binding on the
applicable effective date. The effective dates have been clarified
in response to these comments.

Other commentators requested that taxpayers be permitted to rely on
the provisions of the proposed regulations in the case of leasebacks
and long-term agreements entered into during the interim period.
According to these commentators, the terms of certain leasebacks and
long-term agreements entered into during the interim period were
structured so as to comply with the safe harbors and other
provisions of the proposed regulations in order to ensure that these
agreements would not be treated as disqualified leasebacks or long-
term agreements. In the absence of a provision permitting taxpayers
to rely on the provisions of the proposed regulations in these
cases, these agreements might lose their safe-harbor protection
because of changes made in the final regulations. Accordingly, the
final regulations permit taxpayers to rely on the provisions of the
proposed regulations in the case of any leaseback or long-term
agreement entered into during the interim period. No specific
election is required in the case of an agreement subject to this
provision.

9. Special Transitional Rule

Although the regulations do not apply to any rental agreement
entered into on or before June 3, 1996, and do not apply to any
rental agreement other than a disqualified leaseback or long-term
agreement entered into on or before May 18, 1999, some commentators
requested that they be allowed to change their method of accounting
to the constant rental accrual method for rental agreements
involving certain types of property financed by tax-exempt bonds
where the agreements were entered into prior to the issuance of the
section 467 regulations. The special rule was requested because,
prior to the issuance of regulations, lessees had entered into
rental agreements providing for disproportionately large payments of
rent in the later years of the lease term, but without specific
allocations of rents. In the view of the commentators, the
circumstances in which a schedule of rent payments would be treated
as a rent allocation schedule were not fully addressed by the
legislative history.

In response to the comments, the final regulations contain a special
transitional rule under which lessees may change their method of
accounting for certain agreements to the constant rental accrual
method. With respect to this special transitional rule, a lessee's
change in its method of accounting for a rental agreement does not
affect the method of accounting used by the lessor for the same
agreement. In the case of similar rental agreements entered into
after May 18, 1999, lessees will be able to obtain results
comparable to the constant rental accrual method only by providing a
specific allocation schedule that differs from the rent payment
schedule.

10. Issues Not Addressed

The final regulations do not address the application of section 467
to payments for services. With respect to the possible application
of section 467 to transactions sometimes referred to as A lease
strips @ or A stripping transactions @ , as described in Notice
95-53 (1995-2 C.B. 334), regulations under section 7701(l) were
proposed after the issuance of the proposed regulations under
section 467 setting forth the treatment of such transactions.
Consequently, the IRS and Treasury Department believe that no
specific guidance on the treatment of such transactions under
section 467 is necessary.

The final regulations also do not provide guidance concerning the
applicability of penalties or additions to tax when the Commissioner
determines that a section 467 rental agreement should be treated as
a disqualified leaseback or long-term agreement. No inference should
be drawn from the failure to address the issue in these regulations
concerning the Commissioner's authority to impose applicable
penalties and additions to tax in such circumstances.

Special Analyses

It has been determined that this Treasury decision is not a
significant regulatory action as defined in EO 12866. Therefore, a
regulatory assessment is not required. It also has been determined
that section 553(b) of the Administrative Procedure Act (5 U.S.C.
chapter 5) does not apply to these regulations, and, because the
regulations do not impose a collection of information on small
entities, the Regulatory Flexibility Act (5 U.S.C. chapter 6) does
not apply. Pursuant to section 7805(f) of the Internal Revenue Code,
the notice of proposed rulemaking preceding these regulations was
submitted to the Chief Counsel for Advocacy of the Small Business
Administration for comment on their impact on small businesses.

Drafting Information

The principal author of these regulations is Forest Boone of the
Office of Assistant Chief Counsel (Income Tax and Accounting).
However, other personnel from the IRS and Treasury Department
participated in their development.

List of Subjects in 26 CFR part 1

Income taxes, Reporting and recordkeeping requirements.

Adoption of Amendments to the Regulations Accordingly, 26 CFR part 1
is amended as follows:

PART 1--INCOME TAXES

Paragraph 1. The authority citation for part 1 is amended by adding
entries in numerical order to read, in part, as follows:

Authority: 26 U.S.C. 7805 * * *

§1.467-1 is also issued under 26 U.S.C. 467.

§1.467-2 is also issued under 26 U.S.C. 467.

§1.467-3 is also issued under 26 U.S.C. 467.

§1.467-4 is also issued under 26 U.S.C. 467.

§1.467-5 is also issued under 26 U.S.C. 467.

§1.467-6 is also issued under 26 U.S.C. 467.

§1.467-7 is also issued under 26 U.S.C. 467.

§1.467-8 is also issued under 26 U.S.C. 467.

§1.467-9 is also issued under 26 U.S.C. 467. * * *

Par. 2. In §1.61-8, the first sentence of paragraph (b) is revised
to read as follows:

§1.61-8 Rents and royalties.

* * * * *

(b) * * * Except as provided in section 467 and the regulations
thereunder, gross income includes advance rentals, which must be
included in income for the year of receipt regardless of the period
covered or the method of accounting employed by the taxpayer. * * *

* * * * *

Par. 3. In §1.451-1, paragraph (g) is added to read as follows:

§1.451-1 General rule for taxable year of inclusion.

* * * * *

(g) Timing of income from section 467 rental agreements.

For the timing of income with respect to section 467 rental
agreements, see section 467 and the regulations thereunder.

Par. 4. Section 1.461-1 is amended by:

1. Adding a sentence at the end of paragraph (a)(1).

2. Adding paragraph (a)(2)(iii)(E).

The additions read as follows:

§1.461-1 General rule for taxable year of deduction.

(a) * * *

(1) * * * See section 467 and the regulations thereunder for rules
under which a liability arising out of the use of property pursuant
to a section 467 rental agreement is taken into account.

(2) * * *

(iii) * * *

(E) Except as otherwise provided by regulations or other published
guidance issued by the Commissioner (See §601.601(b)(2) of this
chapter), in the case of a liability arising out of the use of
property pursuant to a section 467 rental agreement, the all events
test (including economic performance) is considered met in the
taxable year in which the liability is to be taken into account
under section 467 and the regulations thereunder.

* * * * *

Par. 5. Section 1.461-4 is amended by:

1. Redesignating the text of paragraph (d)(3)(ii) following the
heading as paragraph (d)(3)(ii)(A) and adding a heading for newly
designated paragraph (d)(3)(ii)(A).

2. Adding paragraph (d)(3)(ii)(B).

3. Adding two sentences at the end of the introductory text of
paragraph (d)(7).

The additions read as follows:

§1.461-4 Economic performance.

* * * * *

(d) * * *

(3) * * *

(ii) Exceptions--(A) Volume, frequency of use, or income.

* * *

(B) Section 467 rental agreements. In the case of a liability
arising out of the use of property pursuant to a section 467 rental
agreement, economic performance occurs as provided in §1.461-1(a)(2)
(iii)(E).

* * * * *

(7) * * * Assume further that the examples do not involve section
467 rental agreements and, therefore, section 467 is not applicable.
The examples are as follows:

* * * * *

Par. 6. Sections 1.467-0 through 1.467-9 are added to read as
follows:

§1.467-0 Table of contents.

This section lists the captions that appear in §§1.467-1 through
1.467-9.

§1.467-1 Treatment of lessors and lessees generally.

(a) Overview.

(1) In general.

(2) Cases in which rules are inapplicable.

(3) Summary of rules.

(i) Basic rules.

(ii) Special rules.

(4) Scope of rules.

(5) Application of other authorities.

(b) Method of accounting for section 467 rental agreements.

(c) Section 467 rental agreements.

(1) In general.

(2) Increasing or decreasing rent.

(i) Fixed rent.

(A) In general.

(B) Certain rent holidays disregarded.

(ii) Fixed rent allocated to a rental period.

(A) Specific allocation.

(1) In general.

(2) Rental agreements specifically allocating fixed rent.

(B) No specific allocation.

(iii) Contingent rent.

(A) In general.

(B) Certain contingent rent disregarded.

(3) Deferred or prepaid rent.

(i) Deferred rent.

(ii) Prepaid rent.

(iii) Rent allocated to a calendar year.

(iv) Examples.

(4) Rental agreements involving total payments of $250,000 or less.

(i) In general.

(ii) Special rules in computing amount described in paragraph (c)(4)
(i) of this section.

(d) Section 467 rent.

(1) In general.

(2) Fixed rent for a rental period.

(i) Constant rental accrual.

(ii) Proportional rental accrual.

(iii) Section 467 rental agreement accrual.

(e) Section 467 interest.

(1) In general.

(2) Interest on fixed rent for a rental period.

(i) In general.

(ii) Section 467 rental agreements with adequate interest.

(3) Treatment of interest.

(f) Substantial modification of a rental agreement.

(1) Treatment as new agreement.

(i) In general.

(ii) Limitation.

(2) Post-modification agreement; in general.

(3) Other effects of a modification.

(4) Special rules.

(i) Carryover of character; leasebacks.

(ii) Carryover of character; long-term agreements.

(iii) Carryover of character; disqualified agreements.

(iv) Allocation of rent.

(v) Difference between aggregate rent and interest and aggregate
payments.

(A) In general.

(B) Constant rental accrual prior to the modification.

(C) Agreements described in this paragraph (f)(4)(v)(C).

(vi) Principal purpose of tax avoidance.

(5) Definitions.

(6) Safe harbors.

(7) Special rules for certain transfers.

(i) In general.

(ii) Exception.

(g) Treatment of amounts payable by lessor to lessee.

(1) Interest.

(2) Other amounts. [Reserved]

(h) Meaning of terms.

(i) [Reserved]

(j) Computational rules.

(1) Counting conventions.

(2) Conventions regarding timing of rent and payments.

(i) In general.

(ii) Time amount is payable.

(3) Annualized fixed rent.

(4) Allocation of fixed rent within a period.

(5) Rental period length.

§1.467-2 Rent accrual for section 467 rental agreements without
adequate interest.

(a) Section 467 rental agreements for which proportional rental
accrual is required.

(b) Adequate interest on fixed rent.

(1) In general.

(2) Section 467 rental agreements that provide for a variable rate
of interest.

(c) Computation of proportional rental amount.

(1) In general.

(2) Section 467 rental agreements that provide for a variable rate
of interest.

(d) Present value.

(e) Applicable Federal rate.

(1) In general.

(2) Source of applicable Federal rates.

(3) 110 percent of applicable Federal rate.

(4) Term of the section 467 rental agreement.

(i) In general.

(ii) Section 467 rental agreements with variable interest.

(f) Examples.

§1.467-3 Disqualified leasebacks and long-term agreements.

(a) General rule.

(b) Disqualified leaseback or long-term agreement.

(1) In general.

(2) Leaseback.

(3) Long-term agreement.

(i) In general.

(ii) Statutory recovery period.

(A) In general.

(B) Special rule for rental agreements relating to properties having
different statutory recovery periods.

(c) Tax avoidance as principal purpose for increasing or decreasing
rent.

(1) In general.

(2) Tax avoidance.

(i) In general.

(ii) Significant difference in tax rates.

(iii) Special circumstances.

(3) Safe harbors.

(4) Uneven rent test.

(i) In general.

(ii) Special rule for real estate.

(iii) Operating rules.

(d) Calculating constant rental amount.

(1) In general.

(2) Initial or final short periods.

(3) Method to determine constant rental amount; no short periods.

(i) Step 1.

(ii) Step 2.

(iii) Step 3.

(e) Examples.

§1.467-4 Section 467 loan.

(a) In general.

(1) Overview.

(2) No section 467 loan in the case of certain section 467 rental
agreements.

(3) Rental agreements subject to constant rental accrual.

(4) Special rule in applying the provisions of §1.467-7(e), (f), or
(g).

(b) Principal balance.

(1) In general.

(2) Section 467 rental agreements that provide for prepaid fixed
rent and adequate interest.

(3) Timing of payments.

(c) Yield.

(1) In general.

(i) Method of determining yield.

(ii) Method of stating yield.

(iii) Rounding adjustments.

(2) Yield of section 467 rental agreements for which constant rental
amount or proportional rental amount is computed.

(3) Yield for purposes of applying paragraph (a)(4) of this section.

(4) Determination of present valU.S. (d) Contingent payments.

(e) Section 467 rental agreements that call for payments before or
after the lease term.

(f) Examples. §1.467-5 Section 467 rental agreements with variable
interest.

(a) Variable interest on deferred or prepaid rent.

(1) In general.

(2) Exceptions.

(b) Variable rate treated as fixed.

(1) In general.

(2) Variable interest adjustment amount.

(i) In general.

(ii) Positive or negative adjustment.

(3) Section 467 loan balance.

(c) Examples.

§1.467-6 Section 467 rental agreements with contingent payments.

[Reserved] §1.467-7 Section 467 recapture and other rules relating
to dispositions and modifications.

(a) Section 467 recapture.

(b) Recapture amount.

(1) In general.

(2) Prior understated inclusion.

(3) Section 467 gain.

(i) In general.

(ii) Certain dispositions.

(c) Special rules.

(1) Gifts.

(2) Dispositions at death.

(3) Certain tax-free exchanges.

(i) In general.

(ii) Dispositions covered.

(A) In general.

(B) Transfers to certain tax-exempt organizations.

(4) Dispositions by transferee.

(5) Like-kind exchanges and involuntary conversions.

(6) Installment sales.

(7) Dispositions covered by section 170(e), 341(e)(12), or 751(c).

(d) Examples.

(e) Other rules relating to dispositions.

(1) In general.

(2) Treatment of section 467 loan.

(3) [Reserved]

(4) Examples.

(f) Treatment of assignments by lessee and lessee-financed renewals.

(1) Substitute lessee use.

(2) Treatment of section 467 loan.

(3) Lessor use.

(4) Examples.

(g) Application of section 467 following a rental agreement
modification.

(1) Substantial modifications.

(i) Treatment of pre-modification items.

(ii) Computations with respect to post-modification items.

(iii) Adjustments.

(A) Adjustment relating to certain prepayments.

(B) Adjustment relating to retroactive beginning of lease term.

(iv) Coordination with rules relating to dispositions and
assignments.

(A) Dispositions.

(B) Assignments.

(2) Other modifications.

(i) Computation of section 467 loan for modified agreement.

(ii) Change in balance of section 467 loan.

(iii) Section 467 rent and interest after the modification.

(iv) Applicable Federal rate.

(v) Modification effective within a rental period.

(vi) Other adjustments.

(vii) Coordination with rules relating to dispositions and
assignments.

(viii) Exception for agreements entered into prior to effective date
of section 467.

(3) Adjustment by Commissioner.

(4) Effective date of modification.

(5) Examples.

(h) Omissions or duplications.

(1) In general.

(2) Example.

§1.467-8 Automatic consent to change to constant rental accrual for
certain rental agreements.

(a) General rule.

(b) Agreements to which automatic consent applies.

§1.467-9 Effective dates and automatic method changes for certain
agreements.

(a) In general.

(b) Automatic consent for certain rental agreements.

(c) Application of regulation project IA-292-84 to certain
leasebacks and long-term agreements.

(d) Entered into.

(e) Change in method of accounting.

(1) In general.

(2) Application of regulation project IA-292-84.

(3) Automatic change procedures.

§1.467-1 Treatment of lessors and lessees generally.

(a) Overview--(1) In general. When applicable, section 467 requires
a lessor and lessee of tangible property to treat rents consistently
and to use the accrual method of accounting (and time value of money
principles) regardless of their overall method of accounting. In
addition, in certain cases involving tax avoidance, the lessor and
lessee must take rent and stated or imputed interest into account
under a constant rental accrual method, pursuant to which the rent
is treated as accruing ratably over the entire lease term.

(2) Cases in which rules are inapplicable. Section 467 applies only
to leases (or other similar arrangements) that constitute section
467 rental agreements as defined in paragraph (c) of this section.
For example, a rental agreement is not a section 467 rental
agreement, and, therefore, is not subject to the provisions of this
section and §§1.467-2 through 1.467-9 (the section 467 regulations),
if it specifies equal amounts of rent for each month throughout the
lease term and all payments of rent are due in the calendar year to
which the rent relates (or in the preceding or succeeding calendar
year). In addition, the section 467 regulations do not apply to a
rental agreement that requires total rents of $250,000 or less. For
purposes of determining whether the agreement has total rents of
$250,000 or less, certain specified contingent rent is disregarded.

(3) Summary of rules--(i) Basic rules. Paragraph (c) of this section
provides rules for determining whether a rental agreement is a
section 467 rental agreement. Paragraphs (d) and (e) of this section
provide rules for determining the amount of rent and interest,
respectively, required to be taken into account by a lessor and
lessee under a section 467 rental agreement. Paragraphs (f) through
(h) and (j) of this section provide various definitions and special
rules relating to the application of the section 467 regulations.
Paragraph (i) of this section is reserved.

(ii) Special rules. Section 1.467-2 provides rules for section 467
rental agreements that have deferred or prepaid rents without
providing for adequate interest. Section 1.467-3 provides rules for
application of the constant rental accrual method, including
criteria for determining whether an agreement is subject to this
method. Section 1.467-4 provides rules for establishing and
adjusting a section 467 loan (the amount that a lessor is deemed to
have loaned to the lessee, or vice versa, pursuant to the
application of the section 467 regulations).

Section 1.467-5 provides rules for applying the section 467
regulations where a rental agreement requires payments of interest
at a variable rate. Section 1.467-6, relating to the treatment of
certain section 467 rental agreements with contingent payments, is
reserved. Section 1.467-7 provides rules for the treatment of
dispositions by a lessor of property subject to a section 467 rental
agreement and the treatment of assignments by lessees and certain
lessee-financed renewals of a section 467 rental agreement. Section
1.467-7 also provides rules for the treatment of modified rental
agreements. Section 1.467-8 provides special transitional rules
relating to the method of accounting for certain rental agreements
entered into on or before May 18, 1999. Finally, §1.467-9 provides
the effective date rules for the section 467 regulations.

(4) Scope of rules. No inference should be drawn from any provision
of this section or §§1.467-2 through 1.467-9 concerning whether--

(i) For Federal tax purposes, an arrangement constitutes a lease; or

(ii) For Federal tax purposes, any obligation of the lessee under a
rental agreement is treated as rent.

(5) Application of other authorities. Notwithstanding section 467
and the regulations thereunder, other authorities such as section
446(b) clear-reflection-of-income principles, section 482, and the
substance-over-form doctrine, may be applied by the Commissioner to
determine the income and expense from a rental agreement (including
the proper allocation of fixed rent under a rental agreement).

(b) Method of accounting for section 467 rental agreements.

If a rental agreement is a section 467 rental agreement, as
described in paragraph (c) of this section, the lessor and lessee
must each take into account for any taxable year the sum of--

(1) The section 467 rent for the taxable year (as defined in
paragraph (d) of this section); and

(2) The section 467 interest for the taxable year (as defined in
paragraph (e) of this section).

(c) Section 467 rental agreements--(1) In general. Except as
otherwise provided in paragraph (c)(4) of this section, the term
section 467 rental agreement means a rental agreement, as defined in
paragraph (h)(12) of this section, that has increasing or decreasing
rents (as described in paragraph (c)(2) of this section), or
deferred or prepaid rents (as described in paragraph (c)(3) of this
section).

(2) Increasing or decreasing rent--(i) Fixed rent--(A) In general. A
rental agreement has increasing or decreasing rent if the annualized
fixed rent, as described in paragraph (j)(3) of this section,
allocated to any rental period exceeds the annualized fixed rent
allocated to any other rental period in the lease term.

(B) Certain rent holidays disregarded. Notwithstanding the
provisions of paragraph (c)(2)(i)(A) of this section, a rental
agreement does not have increasing or decreasing rent if the
increasing or decreasing rent is solely attributable to a rent
holiday provision allowing reduced rent (or no rent) for a period of
three months or less at the beginning of the lease term.

(ii) Fixed rent allocated to a rental period--(A) Specific
allocation--(1) In general. If a rental agreement provides a
specific allocation of fixed rent, as described in paragraph (c)(2)
(ii)(A)(2) of this section, the amount of fixed rent allocated to
each rental period during the lease term is the amount of fixed rent
allocated to that period by the rental agreement.

(2) Rental agreements specifically allocating fixed rent.

A rental agreement specifically allocates fixed rent if the rental
agreement unambiguously specifies, for periods no longer than a
year, a fixed amount of rent for which the lessee becomes liable on
account of the use of the property during that period, and the total
amount of fixed rent specified is equal to the total amount of fixed
rent payable under the lease. For example, a rental agreement
providing that rent is $100,000 per calendar year, and providing for
total payments of fixed rent equal to the total amount specified,
specifically allocates rent. A rental agreement stating only when
rent is payable does not specifically allocate rent.

(B) No specific allocation. If a rental agreement does not provide a
specific allocation of fixed rent (for example, because the total
amount of fixed rent specified is not equal to the total amount of
fixed rent payable under the lease), the amount of fixed rent
allocated to a rental period is the amount of fixed rent payable
during that rental period. If an amount of fixed rent is payable
before the beginning of the lease term, it is allocated to the first
rental period in the lease term. If an amount of fixed rent is
payable after the end of the lease term, it is allocated to the last
rental period in the lease term.

(iii) Contingent rent--(A) In general. A rental agreement has
increasing or decreasing rent if it requires (or may require) the
payment of contingent rent (as defined in paragraph (h)(2) of this
section), other than contingent rent described in paragraph (c)(2)
(iii)(B) of this section.

(B) Certain contingent rent disregarded. For purposes of this
paragraph (c)(2)(iii), rent is disregarded to the extent it is
contingent as the result of one or more of the following
provisions--

(1) A qualified percentage rents provision, as defined in paragraph
(h)(8) of this section;

(2) An adjustment based on a reasonable price index, as defined in
paragraph (h)(10) of this section;

(3) A provision requiring the lessee to pay third-party costs, as
defined in paragraph (h)(15) of this section;

(4) A provision requiring the payment of late payment charges, as
defined in paragraph (h)(4) of this section;

(5) A loss payment provision, as defined in paragraph (h)(7) of this
section;

(6) A qualified TRAC provision, as defined in paragraph (h)(9) of
this section;

(7) A residual condition provision, as defined in paragraph (h)(13)
of this section;

(8) A tax indemnity provision, as defined in paragraph (h)(14) of
this section;

(9) A variable interest rate provision, as defined in paragraph (h)
(16) of this section; or

(10) Any other provision provided in regulations or other published
guidance issued by the Commissioner, but only if the provision is
designated as contingent rent to be disregarded for purposes of this
paragraph (c)(2)(iii).

(3) Deferred or prepaid rent--(i) Deferred rent. A rental agreement
has deferred rent under this paragraph (c)(3) if the cumulative
amount of rent allocated as of the close of a calendar year
(determined under paragraph (c)(3)(iii) of this section) exceeds the
cumulative amount of rent payable as of the close of the succeeding
calendar year.

(ii) Prepaid rent. A rental agreement has prepaid rent under this
paragraph (c)(3) if the cumulative amount of rent payable as of the
close of a calendar year exceeds the cumulative amount of rent
allocated as of the close of the succeeding calendar year
(determined under paragraph (c)(3)(iii) of this section).

(iii) Rent allocated to a calendar year. For purposes of this
paragraph (c)(3), the rent allocated to a calendar year is the sum
of--

(A) The fixed rent allocated to any rental period (determined under
paragraph (c)(2)(ii) of this section) that begins and ends in the
calendar year;

(B) A ratable portion of the fixed rent allocated to any other
rental period that begins or ends in the calendar year; and

(C) Any contingent rent that accrues during the calendar year.

(iv) Examples. The following examples illustrate the application of
this paragraph (c)(3):

Example 1. (i) A and B enter into a rental agreement that provides
for the lease of property to begin on January 1, 2000, and end on
December 31, 2003. The rental agreement provides that rent of
$100,000 accrues during each year of the lease term.

Under the rental agreement, no rent is payable during calendar year
2000, a payment of $100,000 is to be made on December 31, 2001, and
December 31, 2002, and a payment of $200,000 is to be made on
December 31, 2003. A and B both select the calendar year as their
rental period. Thus, the amount of rent allocated to each rental
period under paragraph (c)(2)(ii) of this section is $100,000.
Therefore, the rental agreement does not have increasing or
decreasing rent as described in paragraph (c)(2)(i) of this section.

(ii) Under paragraph (c)(3)(i) of this section, a rental agreement
has deferred rent if, at the close of a calendar year, the
cumulative amount of rent allocated under paragraph (c)(3)(iii) of
this section exceeds the cumulative amount of rent payable as of the
close of the succeeding year. In this example, there is no deferred
rent: the rent allocated to 2000 ($100,000) does not exceed the
cumulative rent payable as of December 31, 2001 ($100,000); the rent
allocated to 2001 and preceding years ($200,000) does not exceed the
cumulative rent payable as of December 31, 2002 ($200,000); the rent
allocated to 2002 and preceding years ($300,000) does not exceed the
cumulative rent payable as of December 31, 2003 ($400,000); and the
rent allocated to 2003 and preceding years ($400,000) does not
exceed the cumulative rent payable as of December 31, 2004
($400,000).

Therefore, because the rental agreement does not have increasing or
decreasing rent and does not have deferred or prepaid rent, the
rental agreement is not a section 467 rental agreement.

Example 2. (i) A and B enter into a rental agreement that provides
for a 10-year lease of personal property, beginning on January 1,
2000, and ending on December 31, 2009. The rental agreement provides
for accruals of rent of $10,000 during each month of the lease term.
Under paragraph (c)(3)(iii) of this section, $120,000 is allocated
to each calendar year. The rental agreement provides for a
$1,200,000 payment on December 31, 2000.

(ii) The rental agreement does not have increasing or decreasing
rent as described in paragraph (c)(2)(i) of this section. The rental
agreement, however, provides prepaid rent under paragraph (c)(3)(ii)
of this section because the cumulative amount of rent payable as of
the close of a calendar year exceeds the cumulative amount of rent
allocated as of the close of the succeeding calendar year. For
example, the cumulative amount of rent payable as of the close of
2000 ($1,200,000 is payable on December 31, 2000) exceeds the
cumulative amount of rent allocated as of the close of 2001, the
succeeding calendar year ($240,000). Accordingly, the rental
agreement is a section 467 rental agreement.

(4) Rental agreements involving total payments of $250,000 or
less--(i) In general. A rental agreement is not a section 467 rental
agreement if, as of the agreement date (as defined in paragraph (h)
(1) of this section), it is not reasonably expected that the sum of
the aggregate amount of rental payments under the rental agreement
and the aggregate value of all other consideration to be received
for the use of property (taking into account any payments of
contingent rent, and any other contingent consideration) will exceed
$250,000.

(ii) Special rules in computing amount described in paragraph (c)(4)
(i) of this section. The following rules apply in determining the
amount described in paragraph (c)(4)(i) of this section:

(A) Stated interest on deferred rent is not taken into account.
However, the Commissioner may recharacterize a portion of stated
interest as additional rent if a rental agreement provides for
interest on deferred rent at a rate that, in light of all of the
facts and circumstances, is clearly greater than the arm's-length
rate of interest that would have been charged in a lending
transaction between the lessor and lessee.

(B) Consideration that does not involve a cash payment is taken into
account at its fair market value. A liability that is either assumed
or secured by property acquired subject to the liability is taken
into account at the sum of its remaining principal amount and
accrued interest (if any) thereon or, in the case of an obligation
originally issued at a discount, at the sum of its adjusted issue
price and accrued qualified stated interest (if any), within the
meaning of §1.1273-1(c)(1).

(C) All rental agreements that are part of the same transaction or a
series of related transactions involving the same lessee (or any
related person) and the same lessor (or any related person) are
treated as a single rental agreement.

Whether two or more rental agreements are part of the same
transaction or a series of related transactions depends on all the
facts and circumstances.

(D) If an agreement includes a provision increasing or decreasing
rent payable solely as a result of an adjustment based on a
reasonable price index, the amount described in paragraph (c)(4)(i)
of this section must be determined as if the applicable price index
did not change during the lease term.

(E) If an agreement includes a variable interest rate provision (as
defined in paragraph (h)(16) of this section), the amount described
in paragraph (c)(4)(i) of this section must be determined by using
fixed rate substitutes (determined in the same manner as under
§1.1275-5(e), treating the agreement date as the issue date) for the
variable rates of interest applicable to the lessor's indebtedness.

(F) Contingent rent described in paragraphs (c)(2)(iii)(B)(3)
through (8) of this section is not taken into account.

(d) Section 467 rent--(1) In general. The section 467 rent for a
taxable year is the sum of--

(i) The fixed rent for any rental period (determined under paragraph
(d)(2) of this section) that begins and ends in the taxable year;

(ii) A ratable portion of the fixed rent for any other rental period
beginning or ending in the taxable year; and

(iii) In the case of a section 467 rental agreement that provides
for contingent rent, the contingent rent that accrues during the
taxable year.

(2) Fixed rent for a rental period--(i) Constant rental accrual. In
the case of a section 467 rental agreement that is a disqualified
leaseback or long-term agreement (as described in §1.467-3(b)), the
fixed rent for a rental period is the constant rental amount (as
determined under §1.467-3(d)).

(ii) Proportional rental accrual. In the case of a section 467
rental agreement that is not described in paragraph (d)(2)(i) of
this section, and does not provide adequate interest on fixed rent
(as determined under §1.467-2(b)), the fixed rent for a rental
period is the proportional rental amount (as determined under
§1.467-2(c)).

(iii) Section 467 rental agreement accrual. In the case of a section
467 rental agreement that is not described in either paragraph (d)
(2)(i) or (ii) of this section, the fixed rent for a rental period
is the amount of fixed rent allocated to the rental period under the
rental agreement, as determined under paragraph (c)(2)(ii) of this
section.

(e) Section 467 interest--(1) In general. The section 467 interest
for a taxable year is the sum of--

(i) The interest on fixed rent for any rental period that begins and
ends in the taxable year;

(ii) A ratable portion of the interest on fixed rent for any other
rental period beginning or ending in the taxable year; and

(iii) In the case of a section 467 rental agreement that provides
for contingent rent, any interest that accrues on the contingent
rent during the taxable year.

(2) Interest on fixed rent for a rental period--(i) In general.
Except as provided in paragraph (e)(2)(ii) of this section and
§1.467-5(b)(1)(ii), the interest on fixed rent for a rental period
is equal to the product of B

(A) The principal balance of the section 467 loan (as described in
§1.467-4(b)) at the beginning of the rental period; and

(B) The yield of the section 467 loan (as described in §1.467-4(c)).

(ii) Section 467 rental agreements with adequate interest.

Except in the case of a section 467 rental agreement that is a
disqualified leaseback or long-term agreement, if a section 467
rental agreement provides adequate interest under §1.467- 2(b)(1)(i)
(agreements with no deferred or prepaid rent) or §1.467-2(b)(1)(ii)
(agreements with adequate interest stated at a single fixed rate),
the interest on fixed rent for a rental period is the amount of
interest provided in the rental agreement for the period.

(3) Treatment of interest. If the section 467 interest for a rental
period is a positive amount, the lessor has interest income and the
lessee has an interest expense. If the section 467 interest for a
rental period is a negative amount, the lessee has interest income
and the lessor has an interest expense.

Section 467 interest is treated as interest for all purposes of the
Internal Revenue Code.

(f) Substantial modification of a rental agreement--(1) Treatment as
new agreement--(i) In general. If a substantial modification of a
rental agreement occurs after June 3, 1996, the post-modification
agreement is treated as a new agreement and the date on which the
modification occurs is treated as the agreement date in applying
section 467 and the regulations thereunder to the post-modification
agreement. Thus, for example, the post-modification agreement is
treated as a new agreement entered into on the date the modification
occurs for purposes of determining whether it is a section 467
rental agreement under this section, whether it is a disqualified
leaseback or long-term agreement under §1.467-3, and whether it is
entered into after the applicable effective date in §1.467-9.

(ii) Limitation. In the case of a substantial modification of a
rental agreement occurring on or before May 18, 1999, this paragraph
(f) applies only if--

(A) The rental agreement was a disqualified leaseback or long-term
agreement before the modification and the agreement date, determined
without regard to the modification, is after June 3, 1996; or

(B) The post-modification agreement would, after application of the
rules in this paragraph (f) (other than the special rule for
disqualified agreements in paragraph (f)(4)(iii) of this section),
be a disqualified leaseback or long-term agreement.

(2) Post-modification agreement; in general. For purposes of
determining whether a post-modification agreement is a section 467
rental agreement or a disqualified leaseback or long-term agreement
under paragraph (f)(1) of this section, the terms of the post-
modification agreement are, except as provided in paragraph (f)(4)
of this section, only those terms that provide for rights and
obligations relating to post-modification items (within the meaning
of paragraph (f)(5)(iv) of this section).

(3) Other effects of a modification. For rules relating to amounts
that must be taken into account following certain modifications, see
§1.467-7(g).

(4) Special rules--(i) Carryover of character; leasebacks.

If an agreement is a leaseback prior to its modification and the
lessee prior to the modification (or a related person) is the lessee
after the modification, the post-modification agreement is a
leaseback even if the post-modification lessee did not have an
interest in the property at any time during the two-year period
ending on the date on which the modification occ U.S.

(ii) Carryover of character; long-term agreements. If an agreement
is a long-term agreement prior to its modification and the entire
agreement (as modified) would be a long-term agreement, the post-
modification agreement is a long-term agreement.

(iii) Carryover of character; disqualified agreements. If an
agreement (as in effect before its modification) is a disqualified
leaseback or long-term agreement as the result of a determination
(whether occurring before or after the modification) under
§1.467-3(b)(1)(ii) and the post-modification agreement is a section
467 rental agreement (or the entire agreement (as modified) would be
a section 467 rental agreement), the post-modification agreement
will, notwithstanding its treatment as a new agreement under
paragraph (f)(1)(i) of this section, be subject to constant rental
accrual unless the Commissioner determines that, because of the
absence of tax avoidance potential, the post-modification agreement
should not be treated as a disqualified leaseback or long-term
agreement.

(iv) Allocation of rent. If the entire agreement (as modified)
provides a specific allocation of fixed rent, as described in
paragraph (c)(2)(ii)(A)(2) of this section, the post-modification
agreement is treated as an agreement that provides a specific
allocation of fixed rent. If the entire agreement (as modified) does
not provide a specific allocation of fixed rent, the fixed rent
allocated to rental periods during the lease term of the post-
modification agreement is determined by applying the rules of
paragraph (c)(2)(ii)(B) of this section to the entire agreement (as
modified).

(v) Difference between aggregate rent and interest and aggregate
payments--(A) In general. Except as provided in paragraph (f)(4)(v)
(B) of this section, a post-modification agreement described in
paragraph (f)(4)(v)(C) of this section is treated as a section 467
rental agreement subject to proportional rental accrual (determined
under §1.467-2(c)).

(B) Constant rental accrual prior to the modification. A post-
modification agreement described in paragraph (f)(4)(v)(C) of this
section is treated as a section 467 rental agreement subject to
constant rental accrual if--

(1) Constant rental accrual is required under paragraph (f)(4)(iii)
of this section; or

(2) The post-modification agreement involves total payments of more
than $250,000 (as described in paragraph (c)(4) of this section),
and the Commissioner determines that the post-modification agreement
is a disqualified leaseback or long-term agreement.

(C) Agreements described in this paragraph (f)(4)(v)(C). A post-
modification agreement is described in this paragraph (f)(4)(v)(C)
if the aggregate amount of fixed rent and stated interest treated as
post-modification items does not equal the aggregate amount of
payments treated as post-modification items.

(vi) Principal purpose of tax avoidance. If a principal purpose of a
substantial modification is to avoid the purpose or intent of
section 467 or the regulations thereunder, the Commissioner may
treat the entire agreement (as modified) as a single agreement for
purposes of section 467 and the regulations thereunder.

(5) Definitions. The following definitions apply for purposes of
this paragraph (f) and §1.467-7(g):

(i) A modification of a rental agreement is any alteration,
including any deletion or addition, in whole or in part, of a legal
right or obligation of the lessor or lessee thereunder, whether the
alteration is evidenced by an express agreement (oral or written),
conduct of the parties, or otherwise.

(ii) A modification is substantial only if, based on all of the
facts and circumstances, the legal rights or obligations that are
altered and the degree to which they are altered are economically
substantial. A modification of a rental agreement will not be
treated as substantial solely because it is not described in
paragraph (f)(6) of this section.

(iii) A modification occurs on the earlier of the first date on
which there is a binding contract that substantially sets forth the
terms of the modification or the date on which agreement to such
terms is otherwise evidenced.

(iv) Post-modification items with respect to any modification of a
rental agreement are all items (other than pre-modification items)
provided under the terms of the entire agreement (as modified).

(v) Pre-modification items with respect to any modification of a
rental agreement are pre-modification rent, interest thereon, and
payments allocable thereto (whether payable before or after the
modification.) For this purpose--

(A) Pre-modification rent is rent allocable to periods before the
effective date of the modification, but only to the extent such rent
is payable under the entire agreement (as modified) at the time such
rent was due under the agreement in effect before the modification;
and

(B) Pre-modification items are identified by applying payments, in
the order payable under the entire agreement (as modified) unless
the agreement specifies otherwise, to rent and interest thereon in
the order in which amounts accrue.

(vi) The entire agreement (as modified) with respect to any
modification is the agreement consisting of pre-modification terms
providing for rights and obligations that are not affected by the
modification and post-modification terms providing for rights and
obligations that differ from the rights and obligations under the
agreement in effect before the modification. For example, if a 10-
year rental agreement that provides for rent of $25,000 per year is
modified at the end of the 5th year to provide for rent of $30,000
per year in subsequent years, the entire agreement (as modified)
provides for a 10-year lease term and provides for rent of $25,000
per year in years 1 through 5 and rent of $30,000 per year in years
6 through 10. The result would be the same if the modification
provided for both the increase in rent and the substitution of a new
lessee.

(6) Safe harbors. Notwithstanding the provisions of paragraph (f)(5)
of this section, a modification of a rental agreement is not a
substantial modification if the modification occurs solely as the
result of one or more of the following--

(i) The refinancing of any indebtedness incurred by the lessor to
acquire the property subject to the rental agreement and secured by
such property (or any refinancing thereof) but only if all of the
following conditions are met--

(A) Neither the amount, nor the time for payment, of the principal
amount of the new indebtedness differs from the amount and time for
payment of the remaining principal amount of the refinanced
indebtedness, except for de minimis changes;

(B) For each of the remaining rental periods, the rent allocation
schedule, the payments of rent and interest, and the amount accrued
under section 467 are changed only to the extent necessary to take
into account the change in financing costs, and such changes are
made pursuant to the terms of the rental agreement in effect before
the modification;

(C) The lessor and the lessee are not related persons to each other
or to any lender to the lessor with respect to the property (whether
under the refinanced indebtedness or the new indebtedness); and

(D) With respect to the indebtedness being refinanced, the lessor
was granted a unilateral option (within the meaning of §1.1001-3(c)
(3)) by the creditor to repay the refinanced indebtedness,
exercisable with or without the lessee's consent;

(ii) A change in the obligation of the lessee to make any of the
contingent payments described in paragraphs (c)(2)(iii)(B)(3)
through (8) of this section; or

(iii) A change in the amount of fixed rent allocated to a rental
period that, when combined with all previous changes in the amount
of fixed rent allocated to the rental period, does not exceed one
percent of the fixed rent allocated to that rental period prior to
the modification.

(7) Special rules for certain transfers--(i) In general.

For purposes of this paragraph (f), a substitution of a new lessee
or a sale, exchange, or other disposition by a lessor of property
subject to a rental agreement will not, by itself, be treated as a
substantial modification unless a principal purpose of the
transaction giving rise to the modification is the avoidance of
Federal income tax. In determining whether a principal purpose of
the transaction giving rise to the modification is the avoidance of
Federal income tax--

(A) The safe harbors and other principles of §1.467-3(c) are taken
into account; and

(B) The Commissioner may treat the post-modification agreement as a
new agreement or treat the entire agreement (as modified) as a
single agreement.

(ii) Exception. Notwithstanding the provisions of paragraph (f)(7)
(i) of this section, the continuing lessor and the new lessee (in
the case of a substitution of a new lessee) or the new lessor and
the continuing lessee (in the case of a sale, exchange, or other
disposition by a lessor of property subject to a rental agreement)
may, in appropriate cases, request the Commissioner to treat the
transaction as if it were a substantial modification in order to
have the provisions of paragraph (f)(4)(iii) of this section and
§1.467-7(g)(1) apply to the transaction.

(g) Treatment of amounts payable by lessor to lessee--(1) Interest.
For purposes of determining present value, any amounts payable by
the lessor to the lessee as interest on prepaid rent are treated as
negative amounts.

(2) Other amounts. [Reserved] (h) Meaning of terms. The following
meanings apply for purposes of this section and §§1.467-2 through
1.467-9:

(1) Agreement date means the earlier of the lease date or the first
date on which there is a binding written contract that substantially
sets forth the terms under which the property will be leased.

(2) Contingent rent means any rent that is not fixed rent, including
any amount reflecting an adjustment based on a reasonable price
index (as defined in paragraph (h)(10) of this section) or a
variable interest rate provision (as defined in paragraph (h)(16) of
this section).

(3) Fixed rent means any rent to the extent its amount and the time
at which it is required to be paid are fixed and determinable under
the terms of the rental agreement as of the lease date. The
following rules apply for the purpose of determining the extent to
which rent is fixed rent:

(i) The possibility of a breach, default, or other early termination
of the rental agreement and any adjustments based on a reasonable
price index or a variable interest rate provision are disregarded.

(ii) Rent will not fail to be treated as fixed rent merely because
of the possibility of impairment by insolvency, bankruptcy, or other
similar circumstances.

(iii) If the lease term (as defined in paragraph (h)(6) of this
section) includes one or more periods as to which either the lessor
or the lessee has an option to renew or extend the term of the
agreement, rent will not fail to be treated as fixed rent merely
because the option has not been exercised.

(iv) If the lease term includes one or more periods during which a
substitute lessee or lessor may have use of the property, rent will
not fail to be treated as fixed rent merely because the
contingencies relating to the obligation of the lessee (or a related
person) to make payments in the nature of rent have not occurred.

(v) If either the lessor or the lessee has an unconditional option
or options, exercisable on one or more dates during the lease term,
that, if exercised, require payments of rent to be made under an
alternative payment schedule or schedules, the amount of fixed rent
and the dates on which such rent is required to be paid are
determined on the basis of the payment schedule that, as of the
agreement date, is most likely to occur. If payments of rent are
made under an alternative payment schedule that differs from the
payment schedule assumed in applying the preceding sentence, then,
for purposes of paragraph (f) of this section, the rental agreement
is treated as having been modified at the time the option to make
payments on such alternative schedule is exercised.

(4) Late payment charge means any amount required to be paid by the
lessee to the lessor as additional compensation for the lessee's
failure to make any payment of rent under a rental agreement when
due.

(5) Lease date means the date on which the lessee first has the
right to use of the property that is the subject of the rental
agreement.

(6) Lease term means the period during which the lessee has use of
the property subject to the rental agreement, including any option
to renew or extend the term of the agreement other than an option,
exercisable by the lessee, as to which it is reasonably expected, as
of the agreement date, that the option will not be exercised. The
lessor's or lessee's determination that an option period is either
included in or excluded from the lease term is not binding on the
Commissioner. If the lessee (or a related person) agrees that one or
both of them will or could be obligated to make payments in the
nature of rent (within the meaning of §1.168(i)-2(b)(2)) for a
period when another lessee (the substitute lessee) or the lessor
will have use of the property subject to the rental agreement, the
Commissioner may, in appropriate cases, treat the period when the
substitute lessee or lessor will have use of the property as part of
the lease term. See §1.467-7(f) for special rules applicable to the
lessee, substitute lessee, and lessor.

(7) A loss payment provision means a provision that requires the
lessee to pay the lessor a sum of money (which may be either a
stipulated amount or an amount determined by reference to a formula
or other objective measure) if the property subject to the rental
agreement is lost, stolen, damaged or destroyed, or otherwise
rendered unsuitable for any use (other than for scrap purposes).

(8) A qualified percentage rents provision means a provision
pursuant to which the rent is equal to a fixed percentage of the
lessee's receipts or sales (whether or not receipts or sales are
adjusted for returned merchandise or Federal, state, or local sales
taxes), but only if the percentage does not vary throughout the
lease term. A provision will not fail to be treated as a qualified
percentage rents provision solely by reason of one or more of the
following additional terms:

(i) Differing percentages of receipts or sales apply to different
departments or separate floors of a retail store, but only if the
percentage applicable to a particular department or floor does not
vary throughout the lease term.

(ii) The percentage is applied to receipts or sales in excess of
determinable dollar amounts, but only if the determinable dollar
amounts are fixed and do not vary throughout the lease term.

(9) A qualified TRAC provision means a terminal rental adjustment
clause (as defined in section 7701(h)(3)) contained in a qualified
motor vehicle operating agreement (as defined in section 7701(h)
(2)), but only if the adjustment to the rental price is based on a
reasonable estimate, determined as of any date between the agreement
date and the lease date (or, in the event the agreement date is the
same as or later than the lease date, determined as of the agreement
date), of the fair market value of the motor vehicle (including any
trailer) at the end of the lease term.

(10) An adjustment is based on a reasonable price index if the
adjustment reflects inflation or deflation occurring over a period
during the lease term and is determined consistently under a
generally recognized index for measuring inflation or deflation (for
example, the non-seasonally adjusted U.S. City Average All Items
Consumer Price Index for All Urban Consumers (CPI-U), which is
published by the Bureau of Labor Statistics of the Department of
Labor). An adjustment will not fail to be treated as one that is
based on a reasonable price index merely because the adjustment may
be limited to a fixed percentage, but only if the parties reasonably
expect, as of any date between the agreement date and the lease date
(or, in the event the agreement date is the same as the lease date,
as of such date), that the fixed percentage will actually limit the
amount of the rent payable during less than 50 percent of the lease
term.

(11) For purposes of determining whether a section 467 rental
agreement is a leaseback within the meaning of §1.467- 3(b)(2), two
persons are related persons if they are related persons within the
meaning of section 465(b)(3)(C). In all other cases, two persons are
related persons if they either have a relationship to each other
that is specified in section 267(b) or section 707(b)(1) or are
related entities within the meaning of sections 168(h)(4)(A), (B),
or (C).

(12) Rental agreement includes any agreement, whether written or
oral, that provides for the use of tangible property and is treated
as a lease for Federal income tax purposes.

(13) A residual condition provision means a provision in a rental
agreement that requires a payment to be made by either the lessor or
the lessee to the other party based on the difference between the
actual condition of the property subject to the agreement,
determined as of the expiration of the lease term, and the expected
condition of the property at the expiration of the lease term, as
set forth in the rental agreement. The amount of any such payment
may be determined by reference to any objective measure relating to
the use or condition of the property, such as miles, hours or other
duration of use, units of production, or similar measure. A
provision will be treated as a residual condition provision only if
the payment represents compensation for the use of, or wear and tear
on, the property in excess of, or below, a standard set forth in the
rental agreement, and the standard is reasonably expected, as of any
date between the agreement date and the lease date (or, in the event
the agreement date is the same as or later than the lease date, as
of the agreement date), to be met at the expiration of the lease
term.

(14) A tax indemnity provision means a provision in a rental
agreement that may require the lessee to make one or more payments
to the lessor in the event that the Federal, foreign, state, or
local income tax consequences actually realized by a lessor from
owning the property subject to the rental agreement and leasing it
to the lessee differ from the consequences reasonably expected by
the lessor, but only if the differences in such consequences result
from a misrepresentation, act, or failure to act on the part of the
lessee, or any other factor not within the control of the lessor or
any related person.

(15) Third-party costs include any real estate taxes, insurance
premiums, maintenance costs, and any other costs (excluding a debt
service cost) that relate to the leased property and are not within
the control of the lessor or lessee or any person related to the
lessor or lessee.

(16) A variable interest rate provision means a provision in a
rental agreement that requires the rent payable by the lessee to the
lessor to be adjusted by the dollar amount of changes in the amount
of interest payable by the lessor on any indebtedness that was
incurred to acquire the property subject to the rental agreement (or
any refinancing thereof), but--

(i) Only to the extent the changes are attributable to changes in
the interest rate; and

(ii) Only if the indebtedness provides for interest at one or more
qualified floating rates (within the meaning of §1.1275- 5(b)), or
the changes are attributable to a refinancing at a fixed rate or one
or more qualified floating rates.

(i) [Reserved].

(j) Computational rules. For purposes of this section and §§1.467-2
through 1.467-9, the following rules apply--

(1) Counting conventions. Any reasonable counting convention may be
used (for example, 30 days per month/360 days per year) to determine
the length of a rental period or to perform any computation. Rental
periods of the same descriptive length, for example annual,
semiannual, quarterly, or monthly, may be treated as being of equal
length.

(2) Conventions regarding timing of rent and payments--(i) In
general. For purposes of determining present values and yield only,
except as otherwise provided in this section and §§1.467-2 through
1.467-8--

(A) The rent allocated to a rental period is taken into account on
the last day of the rental period;

(B) Any amount payable during the first half of the first rental
period is treated as payable on the first day of that rental period;

(C) Any amount payable during the first half of any other rental
period is treated as payable on the last day of the preceding rental
period;

(D) Any amount payable during the second half of a rental period is
treated as payable on the last day of the rental period; and

(E) Any amount payable at the midpoint of a rental period is
treated, in applying this paragraph (j)(2), as an amount payable
during the first half of the rental period.

(ii) Time amount is payable. For purposes of this paragraph (j)(2),
an amount is payable on the last day for timely payment (that is,
the last day such amount may be paid without incurring interest,
computed at an arm's-length rate, a substantial penalty, or other
substantial detriment (such as giving the lessor the right to
terminate the agreement, bring an action to enforce payment, or
exercise other similar remedies under the terms of the agreement or
applicable law)).

(3) Annualized fixed rent. Annualized fixed rent is determined by
multiplying the fixed rent allocated to the rental period under
paragraph (c)(2)(ii) of this section by the number of periods of the
rental period's length in a calendar year.

Thus, if the fixed rent allocated to a rental period is $10,000 and
the rental period is one month, the annualized fixed rent for that
rental period is $120,000 ($10,000 times 12).

(4) Allocation of fixed rent within a period. A rental agreement
that allocates fixed rent to any period is treated as allocating
fixed rent ratably within that period. Thus, if a rental agreement
provides that $120,000 is allocated to each calendar year in the
lease term, $10,000 of rent is allocated to each calendar month.

(5) Rental period length. Except as provided in §1.467- 3(d)(1)
(relating to agreements for which constant rental accrual is
required), rental periods may be of any length, may vary in length,
and may be different as between the lessor and the lessee as long
as--

(i) The rental periods are one year or less, cover the entire lease
term, and do not overlap;

(ii) Each scheduled payment under the rental agreement (other than a
payment scheduled to occur before or after the lease term) occurs
within 30 days of the beginning or end of a rental period; and

(iii) In the case of a rental agreement that does not provide a
specific allocation of fixed rent, the rental periods selected do
not cause the agreement to be treated as a section 467 rental
agreement unless all alternative rental period schedules would
result in such treatment.

§1.467-2 Rent accrual for section 467 rental agreements without
adequate interest.

(a) Section 467 rental agreements for which proportional rental
accrual is required. Under §1.467-1(d)(2)(ii), the fixed rent for
each rental period is the proportional rental amount, computed under
paragraph (c) of this section, if--

(1) The section 467 rental agreement is not a disqualified leaseback
or long-term agreement under §1.467-3(b); and

(2) The section 467 rental agreement does not provide adequate
interest on fixed rent under paragraph (b) of this section.

(b) Adequate interest on fixed rent--(1) In general. A section 467
rental agreement provides adequate interest on fixed rent if,
disregarding any contingent rent--

(i) The rental agreement has no deferred or prepaid rent as
described in §1.467-1(c)(3);

(ii) The rental agreement has deferred or prepaid rent, and--

(A) The rental agreement provides interest (the stated rate of
interest) on deferred or prepaid fixed rent at a single fixed rate
(as defined in §1.1273-1(c)(1)(iii));

(B) The stated rate of interest on fixed rent is no lower than 110
percent of the applicable Federal rate (as defined in paragraph (e)
(3) of this section);

(C) The amount of deferred or prepaid fixed rent on which interest
is charged is adjusted at least annually to reflect the amount of
deferred or prepaid fixed rent as of a date no earlier than the date
of the preceding adjustment and no later than the date of the
succeeding adjustment; and (D) The rental agreement requires
interest to be paid or compounded at least annually;

(iii) The rental agreement provides for deferred rent but no prepaid
rent, and the sum of the present values (within the meaning of
paragraph (d) of this section) of all amounts payable by the lessee
as fixed rent (and interest, if any, thereon) is equal to or greater
than the sum of the present values of the fixed rent allocated to
each rental period; or

(iv) The rental agreement provides for prepaid rent but no deferred
rent, and the sum of the present values of all amounts payable by
the lessee as fixed rent, plus the sum of the negative present
values of all amounts payable by the lessor as interest, if any, on
prepaid fixed rent, is equal to or less than the sum of the present
values of the fixed rent allocated to each rental period.

(2) Section 467 rental agreements that provide for a variable rate
of interest. For purposes of the adequate interest test under
paragraph (b)(1) of this section, if a section 467 rental agreement
provides for variable interest, the rental agreement is treated as
providing for fixed rates of interest on deferred or prepaid fixed
rent equal to the fixed rate substitutes (determined in the same
manner as under §1.1275-5(e), treating the agreement date as the
issue date) for the variable rates called for by the rental
agreement. For purposes of this section, a rental agreement provides
for variable interest if all stated interest provided by the
agreement is paid or compounded at least annually at a rate or rates
that meet the requirements of §1.1275-5(a)(3)(i)(A) or (B) and (a)
(4).

(c) Computation of proportional rental amount--(1) In general. The
proportional rental amount for a rental period is the amount of
fixed rent allocated to the rental period under §1.467-1(c)(2)(ii),
multiplied by a fraction. The numerator of the fraction is the sum
of the present values of the amounts payable under the terms of the
section 467 rental agreement as fixed rent and interest thereon. The
denominator of the fraction is the sum of the present values of the
fixed rent allocated to each rental period under the rental
agreement.

(2) Section 467 rental agreements that provide for a variable rate
of interest. To calculate the proportional rental amount for a
section 467 rental agreement that provides for a variable rate of
interest, see §1.467-5.

(d) Present value. For purposes of determining adequate interest
under paragraph (b) of this section or the proportional rental
amount under paragraph (c) of this section, the present value of any
amount is determined using a discount rate equal to 110 percent of
the applicable Federal rate. In general, present values are
determined as of the first day of the first rental period in the
lease term. However, if a section 467 rental agreement calls for
payments of fixed rent prior to the lease term, present values are
determined as of the first day a fixed rent payment is called for by
the agreement. For purposes of the present value determination under
paragraph (b)(1)(iv) of this section, the fixed rent allocated to a
rental period must be discounted from the first day of the rental
period. For other conventions and rules relating to the
determination of present value, see §1.467-1(g) and (j).

(e) Applicable Federal rate--(1) In general. The applicable Federal
rate for a section 467 rental agreement is the applicable Federal
rate in effect on the agreement date. The applicable Federal rate
for a rental agreement means--

(i) The Federal short-term rate if the term of the rental agreement
is not over 3 years;

(ii) The Federal mid-term rate if the term of the rental agreement
is over 3 years but not over 9 years; and

(iii) The Federal long-term rate if the term of the rental agreement
is over 9 years.

(2) Source of applicable Federal rates. The Internal Revenue Service
publishes the applicable Federal rates, based on annual, semiannual,
quarterly, and monthly compounding, each month in the Internal
Revenue Bulletin (see §601.601(d) of this chapter). However, the
applicable Federal rates may be based on any compounding assumption.
To convert a rate based on one compounding assumption to an
equivalent rate based on a different compounding assumption, see
§1.1272-1(j), Example 1.

(3) 110 percent of applicable Federal rate. For purposes of
§1.467-1, this section and §§1.467-3 through 1.467-9, 110 percent of
the applicable Federal rate means 110 percent of the applicable
Federal rate based on semiannual compounding or any rate based on a
different compounding assumption that is equivalent to 110 percent
of the applicable Federal rate based on semiannual compounding. The
Internal Revenue Service publishes 110 percent of the applicable
Federal rates, based on annual, semiannual, quarterly, and monthly
compounding, each month in the Internal Revenue Bulletin (see
§601.601(d)(2) of this chapter).

(4) Term of the section 467 rental agreement--(i) In general. For
purposes of determining the applicable Federal rate under this
paragraph (e), the term of the section 467 rental agreement includes
the lease term, any period before the lease term beginning with the
first day an amount of fixed rent is payable under the terms of the
rental agreement, and any period after the lease term ending with
the last day an amount of fixed rent or interest thereon is payable
under the rental agreement.

(ii) Section 467 rental agreements with variable interest.

If a section 467 rental agreement provides variable interest on
deferred or prepaid fixed rent, the term of the rental agreement for
purposes of calculating the applicable Federal rate is the longest
period between interest rate adjustment dates, or, if the rental
agreement provides an initial fixed rate of interest on deferred or
prepaid fixed rent, the period between the agreement date and the
last day the fixed rate applies, if this period is longer. If, as
described in §1.1274-4(c)(2)(ii), the rental agreement provides for
a qualified floating rate (as defined in §1.1275-5(b)) that in
substance resembles a fixed rate, the applicable Federal rate is
determined by reference to the lease term.

(f) Examples. The following examples illustrate the application of
this section. In each of these examples it is assumed that the
rental agreement is not a disqualified leaseback or long-term
agreement subject to constant rental accrual. The examples are as
follows:

Example 1. (i) C agrees to lease property from D for five years
beginning on January 1, 2000, and ending on December 31, 2004. The
section 467 rental agreement provides that rent of $100,000 accrues
in each calendar year in the lease term and that rent of $500,000
plus $120,000 of interest is payable on December 31, 2004. Assume
that the parties select the calendar year as the rental period and
that 110 percent of the applicable Federal rate is 10 percent,
compounded annually.

(ii) The rental agreement has deferred rent under §1.467- 1(c)(3)(i)
because the fixed rent allocated to calendar years 2000, 2001, and
2002 is not paid until 2004. In addition, because the rental
agreement does not state an interest rate, the rental agreement does
not satisfy the requirements of paragraph (b)(1)(ii) of this
section.

(iii)(A) Because the rental agreement has deferred fixed rent and no
prepaid rent, the agreement has adequate interest only if the
present value test provided in paragraph (b)(1)(iii) of this section
is met. The present value of all fixed rent and interest payable
under the rental agreement is $384,971.22, determined as follows:
$620,000/(1.10) = $384,971.22. The present value of all fixed rent
allocated under the rental agreement (discounting the amount of
fixed rent allocated to a rental period from the last day of the
rental period) is $379,078.68, determined as follows:

$379,078.68 = $100,000 x 1-(1.10) -5 .10

(B) The rental agreement provides adequate interest on fixed rent
because the present value of the single amount payable under the
section 467 rental agreement exceeds the sum of the present values
of fixed rent allocated.

(iv) For an example illustrating the computation of the yield on the
rental agreement and the allocation of the interest and rent
provided for under the rental agreement, see §1.467- 4(f), Example
2.

Example 2. (i) E and F enter into a section 467 rental agreement for
the lease of equipment beginning on January 1, 2000, and ending on
December 31, 2004. The rental agreement provides that rent of
$100,000 accrues for each calendar month during the lease term. All
rent is payable on December 31, 2004, together with interest on
accrued rent at a qualified floating rate set at a current value (as
defined in §1.1275-5(a)(4)) that is compounded at the end of each
calendar month and adjusted at the beginning of each calendar month
throughout the lease term.

Therefore, the rental agreement provides for variable interest
within the meaning of paragraph (b)(2) of this section.

(ii) On the agreement date the qualified floating rate is 7.5
percent, and 110 percent of the applicable Federal rate, as defined
in paragraph (e)(3) of this section, based on monthly compounding,
is 7 percent. Under paragraph (b)(2) of this section, the fixed rate
substitute for the qualified floating rate is 7.5 percent and the
agreement is treated as providing for interest at this fixed rate
for purposes of determining whether adequate interest is provided
under paragraph (b) of this section. Accordingly, the requirements
of paragraph (b)(1)(ii) of this section are satisfied, and the
rental agreement has adequate interest.

Example 3. (i) X and Y enter into a section 467 rental agreement for
the lease of real property beginning on January 1, 2000, and ending
on December 31, 2002. The rental agreement provides that rent of
$800,000 is allocable to 2000, $1,000,000 is allocable to 2001, and
$1,200,000 is allocable to 2002. Under the rental agreement, Y must
make a $3,000,000 payment on December 31, 2002. Assume that both X
and Y choose the calendar year as the rental period, X and Y are
calendar year taxpayers, and 110 percent of the applicable Federal
rate is 8.5 percent compounded annually.

(ii) The rental agreement fails to provide adequate interest under
paragraph (b)(1) of this section. Therefore, under §1.467-1(d)(2)
(ii), the fixed rent for each rental period is the proportional
rental amount.

(iii)(A) The proportional rental amount is computed under paragraph
(c) of this section. Because the rental agreement does not call for
any fixed rent payments prior to the lease term, under paragraph (d)
of this section, the present value is determined as of the first day
of the first rental period in the lease term. The present value of
the single amount payable by the lessee under the rental agreement
is computed as follows:

$2,348,724.30 = $3,000,000 (1 + .085) 3 (B) The sum of the present
values of the fixed rent allocated to each rental period
(discounting the fixed rent allocated to a rental period from the
last day of such rental period) is computed as follows:

$2,526,272.20 = $800,000 +$1,000,000 +$1,200,000 (1 + .085) (1 +
.085) (1 + .085) 2 3

(C) Thus, the fraction for determining the proportional rental
amount is .9297194 ($2,348,724.30/$2,526,272.20). The section 467
interest for each of the taxable years within the lease term is
computed and taken into account as provided in §1.467-4. The section
467 rent for each of the taxable years within the lease term is as
follows:

Taxable year Section 467 rent
2000 $ 743,775.52 ($ 800,000 x .9297194)
2001 929,719.40 ($1,000,000 x .9297194)
2002 1,115,663.28 ($1,200,000 x .9297194)
§1.467-3 Disqualified leasebacks and long-term agreements.

(a) General rule. Under §1.467-1(d)(2)(i), constant rental accrual
(as described under paragraph (d) of this section) must be used to
determine the fixed rent for each rental period in the lease term if
the section 467 rental agreement is a disqualified leaseback or
long-term agreement within the meaning of paragraph (b) of this
section. Constant rental accrual may not be used in the absence of a
determination by the Commissioner, pursuant to paragraph (b)(1)(ii)
of this section, that the rental agreement is disqualified. Such
determination may be made either on a case-by-case basis or in
regulations or other guidance published by the Commissioner (see
§601.601(d)(2) of this chapter) providing that a certain type or
class of leaseback or long-term agreement will be treated as
disqualified and subject to constant rental accrual.

(b) Disqualified leaseback or long-term agreement--(1) In general. A
leaseback (as defined in paragraph (b)(2) of this section) or a
long-term agreement (as defined in paragraph (b)(3) of this section)
is disqualified only if--

(i) A principal purpose for providing increasing or decreasing rent
is the avoidance of Federal income tax (as described in paragraph
(c) of this section);

(ii) The Commissioner determines that, because of the tax avoidance
purpose, the agreement should be treated as a disqualified leaseback
or long-term agreement; and

(iii) The amount determined with respect to the section 467 rental
agreement under §1.467-1(c)(4) (relating to the exception for rental
agreements involving total payments of $250,000 or less) exceeds
$2,000,000.

(2) Leaseback. A section 467 rental agreement is a leaseback if the
lessee (or a related person) had any interest (other than a de
minimis interest) in the property at any time during the two-year
period ending on the agreement date. For this purpose, interests in
property include options and agreements to purchase the property
(whether or not the lessee or related person was considered the
owner of the property for Federal income tax purposes) and, in the
case of subleased property, any interest as a sublessor.

(3) Long-term agreement--(i) In general. A section 467 rental
agreement is a long-term agreement if the lease term exceeds 75
percent of the property's statutory recovery period.

(ii) Statutory recovery period--(A) In general. The term statutory
recovery period means--

(1) In the case of property depreciable under section 168, the
applicable period determined under section 467(e)(3)(A);

(2) In the case of land, 19 years; and

(3) In the case of any other tangible property, the period that
would apply under section 467(e)(3)(A) if the property were property
to which section 168 applied.

(B) Special rule for rental agreements relating to properties having
different statutory recovery periods. In the case of a rental
agreement relating to two or more related properties that have
different statutory recovery periods, the statutory recovery period
for purposes of paragraph (b)(3)(ii)(A) of this section is the
weighted average, based on the fair market values of the properties
on the agreement date, of the statutory recovery periods of each of
the properties.

(c) Tax avoidance as principal purpose for increasing or decreasing
rent--(1) In general. In determining whether a principal purpose for
providing increasing or decreasing rent is the avoidance of Federal
income tax, all relevant facts and circumstances are taken into
account. However, an agreement will not be treated as a disqualified
leaseback or long-term agreement if either of the safe harbors set
forth in paragraph (c)(3) of this section is met. The mere failure
of a leaseback or long-term agreement to meet one of these safe
harbors will not, by itself, cause the agreement to be treated as
one in which tax avoidance was a principal purpose for providing
increasing or decreasing rent.

(2) Tax avoidance--(i) In general. If, as of the agreement date, a
significant difference between the marginal tax rates of the lessor
and lessee can reasonably be expected at some time during the lease
term, the agreement will be closely scrutinized and clear and
convincing evidence will be required to establish that tax avoidance
is not a principal purpose for providing increasing or decreasing
rent. The term A marginal tax rate @ means the percentage determined
by dividing one dollar into the amount of the increase or decrease
in the Federal income tax liability of the taxpayer that would
result from an additional dollar of rental income or deduction.

(ii) Significant difference in tax rates. A significant difference
between the marginal tax rates of the lessor and lessee is
reasonably expected if--

(A) The rental agreement has increasing rents and the lessor's
marginal tax rate is reasonably expected to exceed the lessee's
marginal tax rate by more than 10 percentage points during any
rental period to which the rental agreement allocates annualized
fixed rent that is less than the average rent allocated to all
calendar years (determined by taking into account the rules set
forth in paragraph (c)(4)(iii) of this section); or

(B) The rental agreement has decreasing rents and the lessee's
marginal tax rate is reasonably expected to exceed the lessor's
marginal tax rate by more than 10 percentage points during any
rental period to which the rental agreement allocates annualized
fixed rent that is greater than the average rent allocated to all
calendar years (determined by taking into account the rules set
forth in paragraph (c)(4)(iii) of this section).

(iii) Special circumstances. In determining the expected marginal
tax rates of the lessor and lessee, net operating loss and credit
carryovers and any other attributes or special circumstances
reasonably expected to affect the Federal income tax liability of
the taxpayer (including the alternative minimum tax) are taken into
account. For example, in the case of a partnership or S corporation,
the amount of rental income or deduction that would be allocable to
the partners or shareholders, respectively, is taken into account.

(3) Safe harbors. Tax avoidance will not be considered a principal
purpose for providing increasing or decreasing rent if--

(i) The uneven rent test (as defined in paragraph (c)(4) of this
section) is met; or

(ii) The increase or decrease in rent is wholly attributable to one
or more of the following provisions--

(A) A contingent rent provision set forth in §1.467- 1(c)(2)(iii)
(B); or

(B) A single rent holiday provision allowing reduced rent (or no
rent) for one consecutive period during the lease term, but only
if--

(1) The rent holiday is for a period of three months or less at the
beginning of the lease term and for no other period; or

(2) The duration of the rent holiday is reasonable, determined by
reference to commercial practice (as of the agreement date) in the
locality where the use of the property occurs, and does not exceed
the lesser of 24 months or 10 percent of the lease term.

(4) Uneven rent test--(i) In general. The uneven rent test is met if
the rent allocated to each calendar year does not vary from the
average rent allocated to all calendar years (determined in
accordance with the rules set forth in paragraph (c)(4)(iii) of this
section) by more than 10 percent.

(ii) Special rule for real estate. Paragraph (c)(4)(i) of this
section is applied by substituting A 15 percent @ for A 10 percent @
if the rental agreement is a long-term agreement and at least 90
percent of the property subject to the agreement (determined on the
basis of fair market value as of the agreement date) consists of
real property (as defined in §1.856-3(d)).

(iii) Operating rules. In determining whether the uneven rent test
has been met, the following rules apply:

(A) Any contingent rent attributable to a provision set forth in
§1.467-1(c)(2)(iii)(B)(3) through (9) is disregarded.

(B) If the lease term includes one or more partial calendar years (a
period less than a complete calendar year), the average rent
allocated to each calendar year is the total rent allocated under
the rental agreement, divided by the actual length (in years) of the
lease term. The rent allocated to a partial calendar year is
annualized by multiplying the allocated rent by the number of
periods of the partial calendar year's length in a full calendar
year and the annualized rent is treated as the amount of rent
allocated to that year in determining whether the uneven rent test
is met.

(C) In the case of a rental agreement not described in paragraph (c)
(4)(ii) of this section, an initial rent holiday period and any rent
allocated to such period are disregarded for purposes of this
paragraph (c)(4) if taking such period and rent into account would
cause the agreement to fail to meet the uneven rent test. For
purposes of this paragraph (c)(4), an initial rent holiday period is
any period of three months or less at the beginning of the lease
term during which annualized fixed rent (determined by treating such
period as a rental period for purposes of §1.467-1(j)(3)) is less
than the average rent allocated to all calendar years (determined
before the application of this paragraph (c)(4)(iii)(C)).

(D) In the case of a rental agreement described in paragraph (c)(4)
(ii) of this section, one qualified rent holiday period and any rent
allocated to such period are disregarded for purposes of this
paragraph (c)(4) if taking such period and rent into account would
cause the agreement to fail the uneven rent test. For this purpose,
a qualified rent holiday period is a consecutive period that is an
initial rent holiday period or that meets the following conditions:

(1) The period does not exceed the lesser of 24 months or 10 percent
of the lease term (determined before the application of this
paragraph (c)(4)(iii)(D)).

(2) Annualized fixed rent during the period (determined by treating
the period as a rental period for purposes of §1.467- 1(j)(3)) is
less than the average rent allocated to all calendar years
(determined before the application of this paragraph (c)(4) (iii)
(D)).

(3) Providing less than average rent for the period is reasonable,
determined by reference to commercial practice (as of the agreement
date) in the locality where the use of the property occU.S. (E) If
the rental agreement contains a variable interest rate provision,
the uneven rent test is applied by treating the rent as having been
fixed under the terms of the rental agreement for the entire lease
term using fixed rate substitutes (determined in the same manner as
§1.1275-5(e), treating the agreement date as the issue date) for the
variable rates of interest provided under the terms of the lessor's
indebtedness.

(d) Calculating constant rental amount--(1) In general.

Except as provided in paragraph (d)(2) of this section, the constant
rental amount is the amount that, if paid at the end of each rental
period, would result in a present value equal to the present value
of all amounts payable under the disqualified leaseback or long-term
agreement as rent and interest. In computing the constant rental
amount, the rules for determining present value are the same as
those provided in §1.467-2(d) for computing the proportional rental
amount. If constant rental accrual is required, all rental periods
(other than an initial or final short period of not more than one
month) must be equal in length and satisfy the requirements of
§1.467-1(j)(5).

(2) Initial or final short periods. If a disqualified leaseback or
long-term agreement has an initial or final short rental period, the
constant rental amount for the initial or final short period may be
determined under any reasonable method.

However, the sum of the present values of all the constant rental
amounts must equal the present values of all amounts payable under
the disqualified leaseback or long-term agreement as rent and
interest. Any adjustment necessary to eliminate the section 467 loan
balance because of the method used t