Hopkins Partners; Cleveland Airport Hotel Limited Partnership, Tax Matters Partner, Petitioners

4-- T .C . Memo . 2009-10 7

UNITED STATE S

TAX COUR T

,HOPKINS PARTNERS, CLEVELAND AIRPORT HOTEL LIMITED .PARTNERSHIPP, TAX MATTERS PARTNER, F i AL ., COMMISSIONER OF'INTERNAL REVENUE,' Responden t Petitioner v .

T Docket Nos . 19563-04, 19877-05 .

17269- 0 5, Filed May' 19, '2009 .

Stephen L . Kadish , Mat thew Kadish , and Aaron . H . Bullof , 1 for petitioner .

John Tkacik, Jr . , for respondent .

'Cases of the following petitlioners are consolidate d herewith : Hopkins Airport Hotel oartnership, Cleveland Airpor t Hotel Limited Partnership ., Tax Matters Partner, docket .No'. .1 .7.269 1- i o 05 ; and Hopkins Partners, .Clevelaid Airport-Hotel Limite d Partnership, T-ax Matters Partner, docket No .,,.19877- .05 .

MEMORANDUM FINDINGS OF FACT AND OPINIO N

,WELLS, Judge :

In these consolidated cases , respondent issued notices of final partnership administrative adjustment in which he determined adjustments of $2,323,107, $274,130, $280,685, and $225,469 increasing the income of Hopkins Partners (partneryship)2 for taxable years 2000, 2001, 2002, and 2003 respectively . The issues to be decided are : (1) Whether certain leasehold improvements made by the partnership were substitute s FC~ V for rent ; and (2) if so, (a) whether the deductibility of improvements made in lieu .of rent is limited to the early period of th,e`'lease or to a certain . fraction of .the total rent expense ; (b) whether the transfer of the improvements in issue wa s illusory ; i (c) whether the rent credit arrangement in issue (rent credit) lacked economic . substance ; (d) whether the use of the rent credits was a clear reflection of income ; (e) whether the use of the rent credits was an accounting method change ; and (f ) whether respondent properly proposed an adjustment under section 481(a)3 for taxable year 2000 .

.,For purposes of the instant cases, references to the partnership include Hopkins Partners and its predecessors-in- interest .

3Unless otherwise indicated, all .section references are to the Internal Revenue Code, as amended, and all Rule references are to the Tax Court Rules of Practice and Procedure .

FINDINGS OF FAC T

Some of the facts and certain exhibits have been stipulated .

The stipulations of fact are incorporated in this opinion b y reference and are-found as . facts .

The partnership is an Ohio general .-partnership formed o n September 28 1995 .

The partnership operates the Sheraton Cleveland, Airpor t Hotel (hotel) . The hotel is at Cleveland Hopkins Internationa l Airport . (Airport) and ., is . owned by,the City of Cleveland, Ohio ' (city) .

The partnership operat ( facilities under a leasehold interest assigned to it by it s immediate predecessor-in-interest . The leasehold interest wa s created by a lease from th e the partnership during 19571 Thereafter, various entities wh i were predecessors-in-interest to the partnership held th e leasehold/operator interes t and modifications between 1957 and''1`990 . a The partnership currently has the .'leasehold right . to operate the . hotel throughNovember 13', 2048 .

The Early Lease s The first lease , the Lease by at Cleveland-Hopkins Airport (195 7 December 12, 1957 .

The 1957 lease required the partnership to construct and opera'te .;a hotel on the airport premises . The 1957 lease had a total term of 31 years, 4 months .

Under the 1957 lease, title to the hotel passed immediately to the city, and upon termination of the 1957 lease, the .hotel premises and all structures and improvements thereon were to remain the property of the city with the exception of furniture, furnishings, fixtures, and equipment that were the personal property-of the : partnership . After the initial 16-month : term, the 1957 lease required the partnership to pay rent of the greater of $4,800 per year or a percentage of gross receipts .

The Supplemental Lease by Way of Concession (supplemental lease) dated July 30, 1962, gave the partnership the useof additional land to be used as parking for customers, and th e right to sell food and beverages . The supplemental lease also i⁴ increased the minimum annual rent to $6,000 per year .

The Second Supplemental Lease dated November 14, 19 .66 '(second supplemental lease),,provided additional land for' parking ; increased the minimum annual rental to $75,000 ; an d extended the term to 35 years from the date of execution . The second supplemental lease also required the partnership t o construct an addition to the hotel and to spend $2 .8 million on improvements over 5 years .

.

The Third Supplementa l Lease .

dated March 6, 1969 (thir d supplemental lease), allowe d the~ p artnership to construct hotel ., , additions or improvements o n lan d previously designated fo r parking .

The Fourth Supplement supplemental lease) dated Januar y the 1957 lease through November 1 3 2023, and required th e partnership to spend at least $1 . 2 5 millio n the initial .-5-year . period fth e ourth supplemental lease and ' $500,000 on improvementsi n each s ubsequent5-year period . Th'~ fourth supplemental lease a lso pro vided that all . furniture and j fixtures would become the propert y of the cityupon terminatio n of the 1957 lease , as amended .

T h e minimum annual rent under th e I fourth supplemental lease was incrl eased to $150,000 for the initial year of the fourth,jsupplemental lease and was to increas e by an additional $9,000'in~jeach subsequent year of. the fourth ' supplemental-lease .

The Negotiation ` of Rent Credit s During the mid-to-lat e business and civic rejuvenation f o New highway construction facilitated acces s to the airport .

the same time, the hotel had fallen .:into disrepair .

The partnership was losing-significant amounts of(cid:127)mone .y the hotel,,with projected losses in excess of $500,000 each~ .year i 6 - through 1997 . The partnership was looking for a way to make the hotel',~profitable . The partnership believed that . the rent under the 1969 lease was significantly above the prevailing marke t .r.ate,'and it was seeking rent relief to achieve its objective of making the hotel profitable .

The city was concerned about the condition of the hotel because the hotel was a visitor's`first impression of Cleveland .

The city wanted the hotel renovated to address the city's concerns,arid threatened to allow construction of a, second hotel on the Airport premises if the partnership failed to renovate the hotel . Construction of a second hotel on the Airport premises would'have put the partnership out of business .

The partnership did not have sufficient cash to make improvements to the hotel, so it attempted to expand its mortgage to cover the cost of improvements . The lender, American :Real Estate Group, indicated that it believed'the land rent on the hotel was substantially above market and conditioned any additional advance of funds on a substantial reduction in the land rent .

During 1987 the partnership informed the city that the partnership was unable to borrow additional funds to cover th e cost of necessary repairs and improvements to the hotel . Th e partnership proposed a modification of the lease which would hav e increased the minimum annual rent to $300,000 but would have decreased the percentage rent . Th e proposed, change was expected i to result in an,overall .deccrease . i n rent, .

Negoti-ations,regardingi the pr oposed :improvements and .th e change to the rent under the`, lease and the city . The city waslin a, s trong,negotiating,positio n because the economic clima t city at : that time wa s conducive to finding anew operato new hotel if the city did not obta wanted .

The partnership submitted to which it again requested that the rent,b.e reduced or, in the , alternative, that,the'cost- of improvements be credited agains t that proposal but later,subinitted .a counterproposal adopting the m rent credit approach . The,counterproposal allowed, .th e partnership :to :,credit the cost-of certain~eligible improvement s against annual ;rent .in .excess of $300, 000 . The partnershi p accepted the counterproposal subject to,requested changes .

The partnership was concerned with the . profitability,(or, .

i lack thereof) of the hotel and was agreeable-to using . either a rent reduction or rent credits to achieve its goal . of-making the j hotel profitable . . However, .~the parties believed that the Cleveland . City, Council ;. which had-to-adopt an ordinance approvin g any 1 ease mo d i f cat on, wasunlikely to agree to a rent reduction . . Additionally, the parties believed that -it was mor e efficient for the partnership to make improvements than for the city to do-so because it avoided the necessity of the City Council's having-to approve each step of .thos.e improvements . The, ultimate decision to structure the leases to include rent credit s rather than a rent reduction was motivated by the foregoing concerns, not by tax considerations .

The 1`°989 Lease Supplemen t The, Sixth Supplement to Lease by Way of Concession (1989 lease supplement), dated August 11, 1989, increased the minimum annual rent from $195 ;000 to $300(cid:127),000 . The percentage'rent remained unchanged . However, the 1989 lease supplement entitled the partnership to credits against the percentage rent for certain : eligible improvements. Eligible improvements were defined in the 198 9.lease supplement and were subject to<approva l by the"city . The partnership was required to spend at least $900,000 every 3 years on eligible improvements . The rent credit' in any given year was capped at $400,000, but any eligible improvements made in excess of that limit could be carried forward,to,future years .

The 1990 Amended Leas e The partnership and the city executed the Amended and Restated Lease by . Way of Concession dated December 31, 1990 (1990 amended lease) . The 1990 amende d lease was effective during the ` years at issue and remains in effect today .

The 1990 amended leas e extended the term'of the 1'957° lea's e for an additional 35 years . It also permitted the partnership, t o demolish a portion of the hptel,and to convert- that area into, & parking lot for hotel patrons and ~ublic parking patrons .

, The 1990 amended lease required the partnership to renovat e the hotel tower at a minimum cost of $5 million . The costs related to the renovation were subject to :approval by the city and .were eligible for rent credits . Additionally, the 199 0 amended lease required the partnership to spend $1 .5 million on improvements every ,3 years . ; Those expenditures also qualifie d for rent credits .

The 1990 amended lease' increased the maximum amount of rent ; credit in any given year toa$650,000 and allowed- any .eligible j improvements made in excesslof that limit to be carried forwar d to future years .

.

The Parking Leas e The partnership -and the city also entered into a- separate .i Amended and Restated Lease key Way of Concession dated December ; 31, 1990 (parking lease), allowin g the partnership to operat e parking lot on the hotel property . The parking lease . was i n effect during the years in . issue and .reinained in effect throug h trial .

10 - The parking . lease required the partnership to demolish a portion of the hotel and in its place to construct and operate a parking lot and parking facility .

The parking lease required the partnership to pay annua l rent equal to the greater of $100,000 or 10 percent of .the gros s revenues from parking operations .

The parking lease allowed the partnership a credit against percentage rent for eligible improvements . Any eligible,, improvements in excess of percentage rent in a given year could be carried forward to be used as a credit against percentage ren t in subsequent years .

The 198 9. lease supplement, the 1990 amended lease , and the parking lease are sometimes hereinafter referred to collectively as the lease agreements .

The Rent Credit Proces s lAtthe start of each year the partnership provided the city with a detailed list of planned eligible improvements . The city had the right to reject planned improvements and occasionally did so . Pursuant to the lease agreements, a failure to comment by the city was . deemed an approval .

At :the end of each year the partnership submitted to the city a detailed list of expenditures along with documentation of those expenditures . Pursuant to the lease agreements the city had the'right to audit the detailed list of expenditures and occasionally rejected items from-the'list'. Eventually, the .

partnership and'the city agreed on improvements for'that year .

Each year the partners'hip_dec improvements the partnership woul d partnership documented the 'eligibl improvement s was using to obtain rent credit on a detailed spread shee t provided to the city . In accordanice with the lease agreements" ' title to the eligible improvements vested in the . city at the en d of the year in which those--improve ents were credited against H Generally, the partnership elected to receive rent credit' s for leasehold improvements ~ather I equipment .(FF&E) .` The partnershi p avoid the detailed . inventory tracking requirement s burdensome and unsightly tagging associated with FF&E .

When the partnership msde .eligible improvements, i t accounted for them by recording them on its books as capital-- assets . . Where the partnershipf .received a credit agains t the full cost ofLLan eligible4improvement in the yea r improvement was made , it deducted that cost as a rent expense ; , its Federalincome tax return for that yea r improvement was not credite`d'against .rent in the year it wa s made, the partnership kept that eligible improvement as a capital asset and depreciated that asset in accordance with sections`'°167 and 168 . When the partnership received a rent credit for an eligible improvement for which it had claimed a depreciation deduction in a previous year, it treated that as a sale of ;the eligible improvement for an amount equal to the rent credit and recognized gain, including depreciation recapture, as applicable . The partnership then deducted the cost of the eligible, improvement as a rent expense in the year in which it was credited against rent . 4 .The partnership consistently followed the above procedure and that procedure was reviewed by two independent accounting f i rms,, .

OPINIO N

I .

Whether the Leasehold Improvements Were a Substitute for Ren t As a general rule, the Commissioner's determinations ar e presumed correct and the burden of proving an error is on th e 'Respondent disallowed the partnership's deduction of the cost of eligible improvements as a rent expense in all instances whether the deduction was claimed in the year the improvements were made or in a later year . Respondent's arguments, however, do not distinguish between the two situations, and we note that not a'll",of the arguments are equally applicable to instances where the cost of eligible improvements was deducted in the year they. were made (and so were never depreciated) and instances where the partnership depreciated the improvements before using them for rent credit . Since we are not convinced by any of respondent's arguments, we need not consider whether any of the arguments are a basis for disallowing the deduction in one instance but not in the other .

- 1 3 taxpayer . Rule 142(a) Welch v . Helverina ; 290 .U .S : . . 11 . 1 .11 5 (1933) . The parties agree that peltitioner has the burden of , proof .

Generall section 162~( a y, )allws as a current .deduction fro m gross income all the ordinary and necessary expenses .incurred`ln .N carrying on a trade or business . However, sections- .161 .and,26 1 have the effect of subordinating . :p,rovisions :such as sectio n 162(a) to provisions such as section-263(a)(1), thereb y disallowing the current deduction of . capital expenditures that , otherwise would have been currently deductible trade or-business , expenses .

Commissioner v .'Idaho Power Co . ,`418 U .S . 1 .; 17 (1974) .

Unless some other, pecial ; rule applies,(see, e .g ., section 263 ( a) (1)) , - a taxpayer's . deductions for capital - expenditures, if allowable at al1° generally come by way o f amortization or depreciation ; i .e ., the capital expenditure is ; deductible over a period-ofitime . Secs . 167 ; 168, and 169 .

INDOPCO, Inc . v . Commissioner ., 503 U .S :, ;79 ; 83 ( 1 992) .

Capital expenditures are, with limited exceptions, an y amounts paid out .for .new buildings, permanent . improvements, an d restoration .

Sec : 263(a), . The parties agree . that the eligible ;" improvements in issue are capital of section 263 (a ) A taxpayer's entitlement to depreciation~~deductions for .

leasehold' improvements hinges not on legal title but on a 14 - recognized investment in the property .

Gladding Dry Good's Co . v .

Commissioner , 2 B .T .A . 336, 338 (1925) ; see also Mayerson-v .

Comm issioner , 47 T .C . 340, 350 (1966) . Consequently, the important question is whether the taxpayer made an investment of capital that the taxpayer is entitled to recover .

Gladdina Dry Goods Go . v . Commissioner , supra at 338 ("The one who made the investment is entitled to its return .") . If a lessor makes improvements at the lessor's own expense ; the lessor is'entitled to depreciation deductions despite the fact that the lessee has the use and enjoyment of the improvements .

Id .

If a lessee makes improvements and the title to the improvements vests immediately in the lessor, the lessor's bare legal title does not preclude the lessee .from recovering that lessee's investment through depreciation deductions ; Id .

!'Generally, where a lessee makes . and invests in improvements on the property leased by the lessee, the lessee is entitled t o recover that investment through depreciation deductions rather , than through a current business expense deduction . Sec . 1 .162- 11 (b)!l,"Income Tax Regs . There is, however, an exception `where a lessee places improvements on real estate that constitute a substitute for rent . In that case, section 1 .61-8(c), Income Tax Regs ., provides that the cost of the improvements made in lieu of rent is-rental income to the lessor . Section 1 .61-8(c), Income Tax Regs ., expressly addresses only the . amount to be included in the income of the lessor ; it doe s any, that-are deductible by ; the . le ssee . However,' section 1 .61 ;p F 8 (c) , Income Tax . Regs ., ,doers make ` clear ;tha t improvements in lieu of rent, are rental income to the lessor, and rent is a current l 1 y* p deductible expense for a lessee under. section 162(a)(3) .

a .Additionally, caselaw provides .that,_where an . :improvement is in lieu of rent, the amount invested in the improvement is currentl y deductible by the lessee asa .rent expense .

Your Health Club', :

Inc . v . Commissioner , 4 T .Cf: 385, 390-(1944) ; McGrath v .

Commissioner , T .C . Memo . 20 0 2-231 , .affd . without published, opinion 92 AFTR 2d 6159, 2003-2,USTC(cid:127)par . 50,663 (5th .Cir . 2003 ) Where improvements are'in`lieu of rent, the c.ost .of those improvements is actually borne by the' lessor . through the rent 'f credit, and the lessee hasno capital . investment . to depreciate !

Your . Health Club, Inc . .

.v . Commissioner , supra at .390 :

, Whether the value of,improvements. constitutes rent turn s upon the intent of . the parties . to the lease .

M . E . Blatt Co .'

United States , 305 U .S . 267, 277 (1938) ; Cunnincham v .

Commissioner , 28 T .C . 670, 680 (1957), affd . 258 F .2d 231 (9th Cir . 1958) ; McGrath v . Commissioner , supra ; see also sec .

1 .6 .1 8(c), Income . Tax Regs . . The intent of the parties to the lease'i s derived from the terms of the lease' as well as the surroundin g circumstances Cunningham`v . Commissioner , supra at 680 ; sec .

1 .61-8(c), Income . Tax Regs .1 Even when the'improvementsar.e required by the terms of the lease, they will not be deemed ren t unless the intention,of the parties to the lease to treat them as rent is plainly disclosed .

M .E . Blatt Co . v . United States , supra Cat .277 .

We consider whether the partnership and the city intende d that the eligible improvements be a substitute for rent .

Respondent contends that petitioner failed to introduce evidence of the city's intent with respect to the lease agreements, alleging, that petitioner relied only on the self-serving y testimony of its own agents . 5 ietitioner did 'introduce evidence of the intent of the parties to the lease agreements, most notably the lease agreements themselves . Additionally- petitioner introduced the testimony of credible witnesses regarding the lease negotiations and the circumstances surrounding those negotiations . Respondent did n,ot,discredit those witnesses at trial, nor did responden t introduce-witnesses to rebut the testimony of petitioner's witn efsses .

5Respondent also asserts that petitioner's failure to introduce testimony from the city gives rise to an inference underF Wichita Terminal Elevator Co . v . Commissioner , 6 T .C . 1158, 1165 (1946), affd . 162 F .2d 513 (10th Cir . 1947), that the testimony would have been unfavorable . However, Wichita Terminal applies to"the failure of a party to introduce evidence within his possession Id . (emphasis-added) . It is inapplicable in this case because petitioner has shown that testimony of,the city's agents who negotiated the lease . agreements was unavailable .

- 1 7 In determining the intent of the parties to the leas e agreements, we first . look.alt the e xpress terms of the documen t .

Article IV .D of the 1990 amlended 1 ease states that th e partnership "shall .be entitlled to receive a ' credit ,towards` the y payment of the annua-l-~ Perce'htage R ent, in an amount equal to the' cost of eligible improvemen~s * * (p which-have been made and , p ai d for prior to the completion of the lease year" . The parkin g lease , in article IV, paragraph A .

5, provides that th e partnership "may deduct the lcost of eligible improvements made!

and paid for in a lease year from any Percentage Rent due fore i that lease year ." In Brown v . Commissioner , 22 T .C . 147, 14 8 (1954), affd . 220 .F .2d 12 (7th Cir . 1955), we held that a simila r provision requirin g that the cost of improvements . " `be credite d to the Lessee from the rental due and owing by it under this lease "' resulted in income to-the lessor .

The . express language of the lease agreements clearly indicates that .the parties t o those documents intended that the partnership's expenditures for t eligible improvements were in lie u of its payment of percentag ' rent .

When determining whether the parties'tothe lease intended' to treat the cost of improvements as a,substitute for rent, consideration must be given to the surrounding circumstances in t addition to the express language of the particular lease .

Cunningham v . Commissioner ,! supra at 680 . One relevant factor~~is I how the parties to the lease treated the expenditure for ta x purposes . over the course of the lease .

Brown v . Commissioner , 220 F .2d at 17 (lessee treated the cost of improvements as a rent expense,~and the improvements were held to be a rent subs .titute) ; Cunningham v . Commissioner , supra at 681 (lessee treated the cost of improvements as a capital expense, not a rent expense,'and the improvements were held not to be a rent substitute) . The partnership consistently treated the eligible improvements, bot h on its books and in its tax returns, as a deductible rent expense in the year that it obtained a rent credit for the cost of those eligible}improvements . That treatment is consistent with th e express language of the lease agreements indicating that the eligible improvements were intended by the parties to the lease agreements to be in lieu of rent .

Respondent further argues that "Petitioner's claim that it was the intent of the parties to the lease that the petitioner's capital ; expenditures were to be made in lieu of rent is furthe r undermined by the fact that the city * * * was a tax indifferent party;", citing CMA Consol ., Inc . v . Commissioner , T .C . Memo .

2005-1 6 . In CMA Consolidated , the presence of a tax indifferent party was a consideration in deciding whether the transaction lacked economic substance, but it is . not probative on how the parties intended to structure the transaction . Respondent ha s cited no case standing for the proposition that tax indifferenc e is a consideration in .decid{ing whether . the parties to a lease , intended capital expenditures ;to be .made in lieu of rent .

However, we have consideredi the . tax indifference of the city,, , we are persuaded by the record`that-the;=city' s tax indifferenc e did not play .a .significant !role in the-negotiations between th e city and the partnership orithe ci provisions of the lease agreement s Accordingly, .,we-- conclue that the parties to the lease agreements intended, as evidenced by the express language of,At leases and the surrounding,-circumstances, that-the eligibl e improvements be substitutes for rent ., Notwithstanding the inten t of the parties to,the . leasel agreem ents to . Ttreat the eligible .

improvements as substitutes for rent, respondent advances severa l reasons the eligible improvements, should . not be treated a s deductible rent expenses .

We address each of . these; contention s below ..

II .

Whether Rent Credits Must . Be Limited(cid:127)in Duration .or-Amoun t Res den -F contends that Your Hea1th,rlub Inc v Commissioner , 4 T .C . 385- (lp⁴⁴) arid ; McGrath . v . Commissioner ; Memo . 2002-231 "can clearly ; be dis'tinguishedin that the ren t 6We address the issue of economic substance below in sec .

substitute in both cases was'limited to the initial start-up period of the business and the rent substitute made up only a small'fraction of the amount claimed as a-deduction for rent expense ."

While respondent correctly points out that in . Your Health Club , Inc . the rent credit was limited to the initial yea r of th'el!+lease'and was just under one-third of the total rent deduction for that year , those limits were imposed by the partie s the lease . In Your Health Club, Inc . this Court had no reaso n to consider a larger credit, and we in no way indicated that a larger credit would have been impermissible . In McGrath this Court+; did limit the amount allowed as a rent substitute . That limitation, however, was based on the intent of the parties to the lease, not on a decision that a larger or longer term rent credit would in all cases be impermissible or incorrect depending on the intent of the parties to .other such leases . In McGrath we explicitly concluded that neither the lease nor the surrounding circumstances showed that the parties to the lease intended to treat the entire cost of the improvements as a rent substitute .

As discussed above, the parties to the lease agreements di d intend to treat the eligible improvements as a substitute for rent :tothe extent of .the percentage rent each year .

Accordingly, we conclude-that respondent's argument that rent credits should be limited in duration and amount is not supported by the cited cases and is inconsistent with the intent of the' ' parties to-the lease agreements .

III . Whether the-Transfer of Eliaiitle Improvements Was Illusor y A . I and article VII .A of the parking lease, 'title' to eligible improvements' vested in the city in the year that thos e improvements-were credited against treated' each transfer as-a' deeme d improvement to the city in`exchangefor,the rent credit . .

Respondent contends that the partnership's transfers of eligible , improvements in exchange for rent credits were illusory .

support of that contention,~respondent notes that`the partnershi p retained control over .and the right to th e eligible improvements . Additiona l the partnership could not transfer the eligible improvements the city because, under the' lease agreements , title to thos e improvements would vest, in the city at the end of the lease .

was a transfer of the benefits and McKay Realty, Inc . v . Commissioner Grodt & .McKay Realty, Inc . lists .s determining where the benefits and burdens lie .' In the case of leasehold improvements, the balancing factors have been refine d by caselaw and the regulations, which provide us with significant guidance in deciding whether the benefits and burdens (and thus .the depreciable interest) lie with the lessor or the-lessee .

Depreciation is not predicated upon ownership of property but rather upon an investment in the property .

Mayerson v .

Commissioner , 47 T .C . 340 (1966) (citing Gladding Dry Goods Co .

v . Commissioner ', 2 B .T .A . 336 (1925)) . Where leasehold improvements are involved, legal title and the right of possession and enjoyment are not determinative ; the important question is whether the lessor or the lessee made the investment in those . improvements .

Gladding Dry Goods Co . v . Commissioner , supra `at ;338 . Generally, where the lessor makes improvements at the lessor's own expense, it is the lessor that has a depreciable interest in the improvements .

Id .

If the lessee make s improvements . at the lessee' s expense , it is generally theilesse e that has a . depreciable interest in the improvements .

Id . ; sec .

'These factors include : (1) Which party to the transaction has legal title ; (2) how the parties to the transaction treated the transaction ; (3) whether equity was acquired by th e purchaser ; (4) whether the purchaser was required to make a present payment ; (5) which party to the transaction had the right of possession ; (6) which party to the transaction paid property taxes ; (7) which party to the transaction bore the risk of loss ; and (8) which party to the transaction received the profits generated by the property . Commissioner , 77 T .C . 1221, 1237-1238 (1981) .

Grodt & McKay Realty, Inc . v .

V 1 .162-11(b), Income Tax Regs ., However, where a .Lessee makes improvements as a substitute for-rent, the .lessee-has n o depreciable interest in those improvements .

Your Health-Club , Inc . v . Commissioner , supra )- .at 390 . Such a transaction is no t different from one where the . .lessor paid for the improvements .

directly and the lessee paid thee full, rent .

-Id .

When the lesso r an increased investment in the property,, resulting in a .higher basis and increased depreciation' deductions .

Brown v .

Commissioner , 22'T .C . .at 151 .

The partnership made the eligible improvements at its . own ; expense . To the extent that it received a rent credit in the year it made the improvements', it appropriately treated the coy of those"improvements as a rent .expense and deducted that cost .

currently . See Your HealthlClub, Inc .- v .~Commissioner , 4 T C .,'I 385 (1944) . To the extent,that the partnership did not receive a rent credit in the year that it made'the eligible improvements , it had a depreciable intere',st,in t ose improvements .8 Se e Gladding Dry Goods Co v . Commissioner , supra at,338 . When-th e BWe note that had the eligible improvements been .consider e advance rent, the lessor would presumably have had the depreciable . interest in those eliglible improvements beginning in ~ .the year that they were made . However, because the partnershi p often made eligible improvements in excess of those required under the lease, it was not certain which eligible improvement s would eventually be credited against rent . Accordingly, w e conclude that the eligible improvements were not advance .ren t paid in the year they were made .

24 - city credited the cost of an eligible improvement made in an earlier year against the partnership's rent, the city assumed the cost of that improvement, and the depreciable interest in that eligible improvement was transferred from the partnership to the city .,,, With the cost of that improvement now borne by the city through,ithe rent credit, the partnership no longer had acapital investment to depreciate . See Your Health Club v . Commissioner , supra .

Accordingly, we conclude that the benefits and burdens surrounding the eligible improvements shifted from the partnership to the city in the year those improvements were "transferred" and credited against rent .

The partnership properly treated the transfer'of its, depreciable interest to the city in exchange for a rent credit as a deemed sale . See United States v . Gen . Shoe Corp . , 282!F .2d 9 (6th Cir .'1960) . The partnership claimed a rent expens e deduction equal to the rent credit it received . and treated the amount of that rent credit as the amount it realized on the transfer . The partnership recognized gain to the extent that the rent credit exceeded its depreciated basis in the eligible improvement and effectively recaptured any depreciation claimed .

on the eligible improvement in prior years .

IV .

. Whether the Rent Credit Arrangement Lacked Economic Substanc e Even where a transaction complies with the formal requirements for obtaining a deduction, courts have long looked beyond that formal compliance' .and .analyzed the substance of(cid:127)th e transaction . Knetsch v . United S t ltes , -,364 U .S .-361'(1.960), ; reflects its substance and hat- the deduction . is- permissible .

IRS v-. CM Holdings, Inc . , 301 F .3d 96 ; 102 .(3d°Ci-r . 2002 ) Re snondent .contends,that-the rent-credit provisions in issu e lacked economic substance and we-re not part,of a bona fide 4g .business transaction . In .consideringwhether-a transaction ha s economic substance, courts l-ook .at both the.-objective-economlcl effect (i .e . whether, absent-tax benefits, theataxpayer .benef'ite d from the transaction) and the subjective, business motivation .- tax benefits) of the transaction . I Id .

The hotel was-not profitable and was in need„of renovation i' in order to have any hope of becomIing profitable ., The , partnership did not have-the fund s unable to borrow funds for the .re n arrangement structured .as it was before 198 .9-. With .the- introduction of . rent credits in the 1989 lease, the annua l able to make improvements to the hotel and credit thos e year . . Clearly, the rent, credits provided a financia'1(cid:127) benefit' to . the partnership in that the partnership obtained the improvements that it wanted 'and needed and could reduce its rent on the basis of its cash outla y for t;he'F,improvements . The negotiation of the lease agreements to include rent credits provided the partnership with a significant benefit-independent of any tax considerations .

Petitioner's .witnesses testified that the ; partnership's goal in negotiating rent credits was to find a way to make the improivementsto help it make a,profit on the . hotel . Petitioner"s witnesses also credibly testified that tax considerations' were not discussed at the time of the negotiations and that it wa s only„later that the partnership considered how the rent credits would be handled for tax purposes .

PPetitioner .also introduced credible testimony that the parties to(cid:127)the lease agreements chose rent credits over othe r alternatives for business, not tax, reasons . The mentioned alternatives were for the city to make the improvements, aft it s own expense or to grant the partnership reduced rent and-allow (or require) the partnership to make the improvements . Regarding the first alternative, there was concern that the City Council would be unwilling to approve a rent reduction . There was also concern'that,if the city made the improvements, it would .involv e a cumbersome process of obtaining City Council approval repeatedly rather than the single City Council approval needed to modify the lease to include rent credits for improvements made by - 2 7 the partnership .

The record show s ,and we 'conclude that th e partnership's motivatio n in negot i ating rent credits was to tur n the hotel into a profitable' enter p rise anal that ,the parties' t the lease agreements had valid bu s mess reasons for choosing the y rent credit . structure over a leas e providing for reduced-yenta Respondent makes much of th e fact that° the cfty(cid:127) is ta x exempt . Where one of the partie s is tax exempt, as is the` cit y there is potential for abus ;e . . How ever, respondent points to authority that . would support a ho l ding ghat a transactio n involving a tax-exempt party cannot have economic substance .

Res ondent asserts that a taxable entity similarly .situated' wi t P b the city would not have accepted(cid:127)the .,. .lease terms involving ren credits . However, it is clear'from the evidence that the city wanted to see the hotel renovated-and was not-simply,-going along, d with the partnership's proposal .

For the reasons discussed yil:

above , we conclude : that a t"axable''.

entity in the . city's positio n could have favored the rent credit structure . for business reasons,,despite that fact that another structure might have produced greater tax savings for t .

We conclude -that tax considerations were, not a significan t motivating factor in the negotiation of the rent credits . On ",`th e basis of the record, we conclude-that the rent credi t '.I arrangements in issue . had a subjective business purpose . We»a 1so conclude that the rent credit arrangement had objective economic substance,.

V .

Whether the Use of Rent Credits Clearly Reflected Income If a taxpayer's method of accounting does not clearl y reflect income, section 446(b) allows the Commissioner to ; compute taxable income under such method as, in the opinion of the Commissi''oner, does clearly reflect income . Respondent asserts that the partnership's use of rent credits does not clearl y reflect income because it,-"converts depreciable property to rent expense, . computed at the historical cost of the asset, thereby inflating its deductions that significantly reduces taxable income"I : Respondent-further. alleges that the partnership .i. s "clearly, . understating income" by taking a current deduction for the,cost of long-term eligible improvements .

As respondent notes, a method of accounting clearly reflect s income when it results in accurately reporting taxable income under : a'recognized method of .accounting .

RLC Indus . Co . & Subs .

v. . Commissioner, 98 T .C . 457, : 491 ( 1992 ), affd . 58 . F .3d 4113 (9th Cir . 1995 ) . " The Commissioner ' s .,determination with respect to clear reflection of-income is entitled to more than the usual presumption of correctness , and the taxpayer bears a heavy burden of overcoming a . determination that a method of accounting does not clearly reflect income ."

Hamilton Indus ., Inc . v .

Comm issioner , 97 T .C . 120, 128 ( 1991 ) .

The Co mm issioner has broad discretion but-cannon requi r e a taxpayer ~to change from,'a n - 2 9 accounting method that clearly ref lects income merely because'-th e .

Commissioner, considers an alternat e method to more clearl y reflect income .

RLC Indus .I Co . & Subs . v . Commissioner , supra a t 491 . If a taxpayer's method of ac counting is authorized by the Internal Revenue Code or the under lying, regulations and has beien, applied consistently, the Commissi oner cannot arbitrarily requir e a change or reject the taxp;ayer's'method .

Id .

We review respondent's determination for abulse of ..discretion . See Thor , Power Tool Co . v . Commissioner , 439 U .S . 5.22 (1979) .

As discussed above, the methold of treating the cost . o f r improvements credited against rent as a deductible rent expens e has been accepted by. both the cour i s and the regulations .

Seell i Your Health Club, Inc . v . Co mm issioner ,

.-l .61-8(c), Income Ta x Regs . Respondent correctly points out that by treating the co s of improvements as a rent expense rather than depreciating (o r continuing to depreciate) the costs, the partnership . does increase its°current deductions and reduce its .taxable incom e nf, the year of the rent credit . However, since -the partnership'!, i consistently accounted for its eligible improvements using an, approved accounting method,! respondent is not at . liberty to require the partnership to use a different method of accounting , even if respondent believes that-another method would more clearly, reflect income .9 See RLC Indus . Co . & Subs . v .

Commissioner , supra at 491 .

Respondent's concern with the use of historical cost is unfounded . It is true that if the eligible improvements were not credited against rent in the year made, the partnership initially depreciated them . However, in the year that the partnership received a rent credit for the eligible improvements, the„ partnership treated that as a deemed sale of the capital 'asset for an amount'equal to the rent credit it received, which was equal to the historical cost of the eligible improvement . By recognizing gain to the extent that the rent credit exceeded the partnership's depreciated basis in the eligible improvement, the partnership effectively recaptured any depreciation it had previously claimed on that improvement . See United States v .

Gen . Shoe Corp . , 282 F .2d at 12-13 . . By doing so, the partnership received the same deduction that it would have received if that eligible improvement had been credited against rent in the year it was made . Accordingly, the use of rent credits computed at the historical cost of the improvements did not inappropriately increase the overall deductions ; it merely accelerated the tim e 9Respondent's proposed accounting method would have the partnership continue to depreciate the eligible improvements even after they are credited against rent . Because the partnership no longer had a depreciable interest in the eligible improvements at that point, respondent's proposed method of accounting is not an authorized method of accounting and would not be a clear reflection of the partnership's income .

I at the which the partnership claimed-those deductions . Whil e such an acceleration generally wouIIld -not--be'permissible for a capital asset, as discussedfabove, there,is'an exception that ; ' applies in the-instant cases that allows the current deduction ; I capital expenses that-are incurred and credited as a substitut e for rent .

See Your Health -Club, (cid:127) Ikc . v . ` Co mmissioner , ~ suupra at .

390 ; McGrath v . Commissioner, supra ; .sec . 1 :61'8(c), Income Tax Regs .

Accordingly, we conclude thatlthe partnership's method of i accounting for eligible improvements made in lieu-`of ren t clearly reflect income and that respondent abused his discretion' ; in determining that the partnershi'p's method-did not clearl y reflect income .

VI .

Whether the Use of Rent Credits Was an Accounting Metho d Chang e consent of the Secretary before changing his method o f The reason for this rule is that a "change in a n accounting method will frequently cause`,a,distortion o f taxable. income in the year of change ; therefore, the Commissioner is empowered to prevent such-distortion . and consequent windfall to the taxpayer . by conditioning his consent. on the taxpayer's acceptance of adjustments that would eliminate any distortion . * * * [ Woodward Iron Co :j v . ,United' States , 3 .96E F . .2d 552 ; 554 (5th''Cir . 1968) .]

32 - Respondent contends that the partnership's change from depreciating to deducting the cost of an eligible improvement i n the year,, in which- the partnership received- .;a rent credit for suc h improvement is a change in accounting-method . We disagre e becau ;e ;,as discussed above, when the partnership . received a ren t credit-for the cost of"an eligible improvement, the depreciabl e interest in that eligible improvement was transferred from the $ ill partnership to the city . At that point, the partnership, a s required by law, . see Your Health Club v . Commissioner , supra a t 390 ; Gladdina Dry Goods v . Commissioner , 2 B .T .A . at 338, discontinued depreciating the eligible improvement because it no longer had an investment to depreciate. . In the same year„the partnership deducted as a rent expense, as it was entitled to do by law, see Your Health Club, Inc . v . Commissioner , su ra`at 390 ; McGrath v . Commissioner , su ra ; sec . 1 .61-8(c), Income Tax .Regs ., the value of the interest that it transferred to the city in partial satisfaction of its rent obligation . The partnership appropriately treated that transfer as the deemed sale of the eligible improvement . See United States v .. Gen . Shoe Corp .

, supra at„12-13 . Because the partnership recognized gain on tha t sale to the extent that its depreciated basis was less than the rent credit, it properly recaptured any depreciation previousl y claimed and there was-no duplication of deductions . The metho d used by the partnership in treating the matter as a deemed sale - 3 3 was used consistently throughout t he term of the lease .

Accordingly, we find that the part nership's treatment of eligibl e improvements,did not result in an accounting method change .

VII .,Whether Respondent Properly Proposed an Adjustment Under .

' Section 481(a) for Taxable Year 200 0 Where there is a chang e of accounting method, section 481(a ) require s adjustments to prevent omission s or duplications and !

allows the Commissioner to .includ e i r.

the adjustment amounts tha t are attributable to taxable years for which assessment is bar e d ' by the statute of limitations . Hamilton Indus ., Inc . v .

Commissioner , 97 T .C . 120 (1991) . As discussed above, becau s there has been no change of accounting method , section 481(a) is , not applicable .

VIII . Conclusio n On the basis of the foregoing , we conclude that th e partnership and the city intended that eligible improvements Se,II substitutes for rent ; the leases in issue had economic substanc e and were not shams designed merely to reduce taxes ; th e partnership's treatment of eligible improvements was a clear, ; reflection of income ; the chang e rom depreciating to deduct i g the cost of the eligible improvements in the year o£1a ren t credit was not a change of ;1accoun ting method ; and the partnershi p appropriately deducted thecost o f an eligible improvement a.s{ a~ ' rent expense in the year in whic h that eligible improvement w a s'l credited against rent .

To reflect the foregoing, Decisions will be entere d for petitioner .

fI

4. T .C . at 390 ; McGrath1v .` Commissioner , T .C. Memo . 20b02-231 ; sec .