An Introduction to Tax-Exempt Equipment Leasing

Transcription

1 An Introduction to Tax-Exempt Equipment Leasing By Bob Downey As lessors look for new growth opportunities, many of them may consider tax-exempt leasing. The state and local government tax-exempt leasing market is substantial. Each year the states and their various political subdivisions (each a government ) enter into tax-exempt leases worth billions of dollars. The demand for tax-exempt leasing should continue to grow over the next several years as widespread budget shortfalls will force many of these government entities to consider alternatives to paying cash for their equipment purchases. However, it is a marketplace that is dissimilar in some important aspects from the commercial leasing equipment marketplace in which most lessors operate. The lease approval process is complicated and can take several months. Government entities tend to negotiate more than commercial lessees and are also more likely to be inflexible with respect to document requirements. Also, most domestic commercial lease and loan transactions are governed at least in part by the Uniform Commercial Code, which brings to the documentation and lease enforcement process a significant measure of standardization across state lines. Conversely, the laws governing transactions with government entities vary by state and by the type of government involved and often offer complicated regulatory structures. Thus being familiar with the laws of one state will not necessarily aid in the analysis of a similar transaction in a different state. This article explores the basic issues of taxexempt leasing 1 to government entities via a question-and-answer format. The author hopes the article will serve as a high-level review of these issues and at the very least provide some direction for those interested in further researching the risks and benefits of tax-exempt leasing. 1. What is a tax-exempt lease? Let us start by making clear what a tax-exempt lease is not. A tax-exempt lease is not a true lease or an operating lease. Tax-exempt does not refer to the fact that the lessee is exempt from taxes (as most government entities are) but refers to the federal tax treatment of the interest component of the lease payments made by the government. As further discussed in question 4, the use of lease terminology is confusing because a taxexempt lease has to comply with both federal law and state law. Federal law provides that in order for the lease to be tax-exempt the government has to have incurred a debt. (In order for there to be an interest component there has to be a principal component.) In other words, the tax-exempt lease is really a disguised sale or loan and is both economically and accounting-wise the equivalent of a conditional sales contract. State constitutions and statutes, on the other hand, impose significant restrictions on government entities ability to incur debt. Thus the tax-exempt lease under state law has to be treated as a lease and not debt. Tax-exempt equipment leases to government entities (each a 103 lease ) derive from Section 103 of the Internal Revenue Code, which provides that, subject to several exceptions, gross income [for most taxpayers] does not include interest on any state or local bond. Section 103 defines state or local bond as an obligation of a state or political subdivision thereof. Obligation is defined to mean only those obligations incurred by the government relating to the exercise of its borrowing power. In other words, the government s voluntary decision to incur a payment obligation 2 is the basis for excluding the interest component from the lessor s income for federal income tax purposes.

2 If called upon to evaluate a potential lessee, the lessor should review, at a minimum, the legislation creating the entity to see whether it is granted sovereign powers. 2. Why should a government use taxexempt leasing to acquire equipment? Among the first questions a lessor interested in entering the 103 lease marketplace ought to consider are these: What is the market for this type of product? and Why would a government use tax-exempt leasing as a financing option? A government generally has three options when acquiring equipment: pay cash, incur debt in the form of long-term bonds, or use a 103 lease. In the context of middle-market financing (transactions up to $10 million), both the bond option and the pay-as-you-go option have negatives that make tax-exempt leasing the best option. There are two points to consider. First, for those government entities that slog through the process of issuing bonds to pay for equipment purchases, using a 103 lease is faster, cheaper, and subject to fewer regulatory burdens. It is faster because voter approval is not required, as is often the case for bond deals. It is cheaper because the laws governing 103 leases are less extensive than those governing bond deals and contain fewer compliance requirements. Also, many federal or state securities laws and regulations do not apply to 103 leases, contrary to many bond deals, because 103 leases are generally not considered securities for the purposes of these regulations. Lastly, because 103 leases are generally not debt for state law purposes, they are not subject to statutes that establish ceilings on how much debt can be incurred by a government. Second, paying cash for equipment may not be the best option. Even in good economic times, a government operating on a pay-as-you-go basis may not have enough resources to meet other needs or unexpected expenditures. Moreover, during periods when revenues are limited, paying-as-you-go may mean that necessary equipment purchases are deferred due to the lack of available funds. Surprisingly, even at this late date, not all government entities appreciate the advantages of 103 leases. Thus it is important for lessors to ensure that they educate government entities as to the advantages of tax-exempt leasing. Any marketing plan should include a strong educational component. 3. What is a government for 103 lease purposes? Generally, any state (including the District of Columbia), any political subdivision of a state, any territory of the United States, or any federally recognized Indian tribe 3 could be the lessee under a 103 lease. The federal government and its agencies cannot be a lessee under a 103 lease. Usually, there is little difficulty in determining if a particular lessee qualifies as a government. Obvious examples include cities, towns, counties, and other municipalities and their various departments and agencies. The answer is not always obvious, however, when considering other types of entities created by statute for a special or limited purpose. Whether these public or quasi-public entities can enter into a 103 lease depends on whether the entity has sufficient attributes of a sovereign entity. What makes an entity a sovereign entity is that it has the powers to (a) tax, (b) exercise eminent domain, and (c) exercise police power (the power to make and enforce laws). The proposed lessee does not need to have all three sovereign powers so long as it has power comparable to a political subdivision of the state. Examples of entities that are not traditional political subdivisions of a state yet have enough sovereign powers to be issuers of tax-exempt obligations include water districts; volunteer fire departments; school districts; hospital districts; and some commissions, authorities, and agencies. If called upon to evaluate a potential lessee, the lessor should review, at a minimum, the legislation creating the entity to see whether it is granted any of these sovereign powers. However, one hopes the entity has a track record of issuing tax-exempt obligations so the lessor can avoid extensive due diligence regarding the government s ability to enter into the 103 lease. 2 J O U R N A L O F E Q U I P M E N T L E A S E F I N A N C I N G F A L L V O L. 2 2 / N O. 2

3 4. How does one determine what is "debt" for state law purposes? What happens if a 103 lease is deemed debt? As noted in question 1, the lessor in a 103 lease has to ensure that the lease evidences a debt for Internal Revenue Code purposes at the same time it ensures that the lease is not debt for state law purposes. What conjurer s trick does the lessor have to use to solve this conundrum? Luckily, no sleight of hand is required. The answer lies in how the states define debt. Although a lessor would have to review the laws of each state for the specific contours of debt as used in that state s constitution and statutes, in most states an obligation incurred by a government will be debt only if the term of the obligation extends beyond the government s current appropriation period (usually one fiscal year but in some states this period is two fiscal years). Expenses that arise and are satisfied in the same appropriation period are considered current expenses. However, as most tax-exempt leases have multiyear terms under this definition would they not still be deemed debt for state law purposes? The answer is yes unless the lease contains a nonappropriation clause. (See question 5; see also question 10 for discussion of a state that does not require a nonappropriation clause.) What happens if a 103 lease is considered debt for state statutory or constitutional purposes? To validly incur debt, a government typically has to follow rigorous procedures involving public notice of the proposed debt, voter or taxpayer approval done via a ballot item, and compliance with limitations on how much debt can be incurred. If a 103 lease is considered debt for state purposes and if the government did not comply with the state laws regarding the creation of debt, the 103 lease will probably be void. It may be treated as if it never existed, and the lessor will be unable to enforce any of its terms against the government. Payments already received from the government will have to be returned, and the lessor will not have an action against the government arising from the 103 lease because it is a nullity. Therefore, it is essential for the lessor to ensure that its 103 lease is not deemed debt because it is unlikely the government would have complied with the statutory or constitutional provisions applicable to the issuance of debt. Although the obligation to comply with these statutes falls on the government, the consequences of not doing so falls much more heavily on the lessor. The lessor will, however, be able to recover its equipment. 5. What is a nonappropriation, and what is its impact on a 103 lease? A government s right to nonappropriate means that the government has the ability to terminate the 103 lease without penalty if it does not appropriate, in its budget for a fiscal period, funds that are designated to meet its payment obligations under the lease. 4 This has the effect of limiting the government s contractual payment obligations to those arising in the fiscal period for which an appropriation has been made. The government is not required to make future appropriations, and the result is that the lease payments are deemed a current expense and not debt. It is important to understand that a nonappropriation is not an event of default. It does not give rise to any lessor remedies or rights to demand damages, except to recover the equipment. It is also important to understand that the right of nonappropriation is a necessary evil. Without it 103 leases would not be permitted in most states. Thus, be very careful of trying to contractually limit the government s ability to nonappropriate. The end result could be that the 103 lease is void because it is deemed to be debt in violation of applicable law. Question 8 discusses one method to contractually limit the nonappropriation right and the dire consequences that sometimes result. The principle of nonappropriation is not uniform among the states, so a review of applicable law should be made before first doing business in a state. For example, in Texas and Georgia the right to terminate as of the end of any budget period has to be unqualified. The government cannot be required to first nonappropriate. In those two states the government It is essential for the lessor to ensure that its 103 lease is not deemed debt because it is unlikely the government would have complied with the statutory or constitutional provisions applicable to the issuance of debt. J O U R N A L O F E Q U I P M E N T L E A S E F I N A N C I N G F A L L V O L. 2 2 / N O. 2 3

4 Nonappropriation is the proverbial tempest in a teacup, as the combined rate of default and nonappropriation is appreciably less than the rate of nonperformance in similarly sized commercial equipment leases. can terminate without regard to its ability to fund the lease payments, and a lessor s 103 lease form has to reflect this distinction. Also note that California law does not require the use of a nonappropriation clause. California is an abatement state, as explained in question 10. If a nonappropriation does occur, the rights and obligations of the lessor and the government are determined to a large degree by the terms of the nonappropriation provision contained in the 103 lease. A well-drafted nonappropriation provision will contain the government s agreement to a. give the lessor immediate notice of the nonappropriation, b. return the equipment to the lessor at the government s sole expense no later than the last day of the appropriation period for which appropriations were made, c. pay all lease payments and other payments due under the lease for which moneys were appropriated or are otherwise available, and d. pay month-to-month rent at the rate set forth in the lease for each month or part thereof that the government fails to return the equipment after the end of the current appropriation period. 6. How significant is the risk of nonappropriation or default? Nonappropriation is a popular topic in the taxexempt leasing industry. It is on the agenda of every tax-exempt leasing conference and seminar and is the subject of frequent articles, newsletters, and surveys. However, in the author s view, the nonappropriation risk is not a significant risk and all the attention makes a nominal risk seem major. Nonappropriation is the proverbial tempest in a teacup, as the combined rate of default and nonappropriation is appreciably less than the rate of nonperformance in similarly sized commercial equipment leases. To illustrate just how low the nonperformance risk is, consider the results of two surveys done by an industry trade group, the Association for Governmental Leasing and Finance. AGL&F polled its members in 1998 on their experiences with government nonperformance in their entire portfolio of tax-exempt leases ( the 1998 survey ) and in 1999 on their experiences with tax-exempt leases under $100,000 ( the 1999 survey ). The 1998 survey showed that the 83 survey respondents had entered into, collectively, during the survey period, 78,176 tax-exempt lease transactions with total lease volume of $12.7 billion. Out of that total volume there had been 11 defaults over the prior seven years and 23 nonappropriations over the prior 16 years, constituting approximately a combined 0.04% of all transactions and 0.18% of lease volume. The 1999 survey focused on AGL&F members experiences with small-ticket, tax-exempt leases during the preceding five years. Almost 80% of the respondents reported not having a single default or nonappropriation during this period, while the 20% suffered a total of 36 defaults and 38 nonappropriations. However, these 74 defaults and nonappropriations amounted to only 0.54% of these respondents total tax-exempt leasing transactions and 0.53% of total dollar volume. 7. Are there ways to minimize the risk of nonappropriation? Even though all evidence shows that nonappropriation is extremely rare, lessors nevertheless should be able to spot the warning signs. The 1999 AGL&F survey, along with other studies of transactions that have been the subject of a nonappropriation, indicates that a lessor can minimize the risk of nonappropriation by considering the following factors: a. Is the leased equipment essential to the government s performance of a governmental function? If the equipment fulfills an important government function, nonappropriation is less likely because the government will have to still perform that function. On the other hand, equipment leased for a nonessential function can be returned without the government having to address the consequences of failing to offer an essential government service. Consider the difference 4 J O U R N A L O F E Q U I P M E N T L E A S E F I N A N C I N G F A L L V O L. 2 2 / N O. 2

5 between a lease of golf carts for a municipal golf course and a lease of school buses for a school district. b. Does the equipment work? If equipment fails to perform as warranted, one option available to the government is to claim a lack of funds and nonappropriate. c. How is the government getting the funds to pay for the equipment? If the funds are coming from a specific source the risk is greater that the lease will be non-appropriated if that source goes away. For example, if the state government is funding the project for which the equipment is being acquired and it decides to stop funding the project, the local government is more likely to nonappropriate with respect to the equipment if it is not needed elsewhere. d.is the government a good credit? Do not neglect basic credit criteria. A significant portion of nonappropriations occur because the government is having fiscal difficulties. e. Is there political risk? Was the government s decision to enter into the lease controversial? If the governing body approved the lease over opposition, what might happen after the next election if those opposed to the lease gain control of the governing body? f. Have you educated the government? Nonappropriation and lease cancellation are not issues that government entities have typically thought through. When a lessor learns that a government is thinking of nonappropriating, the lessor should contact the government immediately and point out that (a) if there is a nonappropriation other lessors will be less likely to lease to it, and (b) the government s other financing options may become more expensive, given that the perceived increased risk of nonperformance might be factored into pricing. Also offer to work to find an acceptable solution with the government. For example, the lessor can restructure the lease to spread out the lease payments. 8. What is a nonsubstitution clause and can it limit the risk of nonappropriation? A nonsubstitution clause is a provision in a 103 lease that prevents the government from nonappropriating and then acquiring equipment to perform the same function as the previously leased equipment. 5 Although nonsubstitution clauses still appear in 103 leases, the majority view (with which the author agrees) seems to be that having a nonsubstitution clause in a 103 lease actually damages the lessor s interest. Here is the rationale: If the nonsubstitution clause prohibits the government from performing an essential government function, such a clause may be used to show that the lessor, while purporting to recognize the unrestricted right of the government to nonappropriate, nevertheless imposed coercive sanctions on the government in the event that the government exercised such right. The right to nonappropriate becomes illusory. The nonsubstitution clause becomes the basis for an argument that the 103 lease creates debt. The government still has to perform the essential government function being served by the equipment. If it is unable to acquire new equipment to perform that function subsequent to a nonappropriation, nonappropriation is not a real option and the lease is essentially a multiyear hellor-high-water obligation. Courts in several states, including Texas, Oregon, Colorado, and Florida, have already found that including a nonsubstitution clause turns the 103 lease into debt. In each of these cases, because the procedures for incurring debt were not complied with, the 103 lease was void. In light of this and because experience shows the clause is rarely if ever enforced, it offers no real benefit to lessors. Limiting its reach by the phrase to the extent permitted by law may mitigate some of the negative consequences, 6 but it does little to make the provision more helpful. 9. Who owns the equipment leased pursuant to a 103 lease? In some states such as Arizona, California, Although nonsubstitution clauses still appear in 103 leases, the majority view seems to be that having a nonsubstitution clause in a 103 lease actually damages the lessor s interest. J O U R N A L O F E Q U I P M E N T L E A S E F I N A N C I N G F A L L V O L. 2 2 / N O. 2 5

6 Although state laws vary, most 103 leases will be subject to open meetings laws, which require that the lease be discussed and voted on in a public session of the government s governing body. Florida, and Ohio, the lessor must retain title to the equipment during the full lease term. In these title retention states, the 103 lease should provide that title is transferred to the government only upon payment of all the lease payments and the purchase option price, if any. In other states, title may be transferred at lease inception. Where title to the equipment resides is an important issue because in some states it affects the enforceability of the 103 lease. Thus a careful review of applicable law is necessary. 10. Do all states require the government to have the right to nonappropriate? Most state constitutions or statutes do not explicitly provide that having a nonappropriation clause in a 103 lease saves the lease from being deemed debt. Typically, this is a determination reached by the courts in interpreting applicable statutory and constitutional provisions. The courts of many states have not yet addressed this issue, so in those states it is not certain that nonappropriation will save a 103 lease from being debt (although based on history that is the likely result). Among the states that have addressed this issue either by statute or case law, California is the only state that clearly does not require a 103 lease to contain a nonappropriation clause. California allows government entities to budget and appropriate funds for periods longer than the then-current fiscal period. However, California s 103 leases have to provide that the government is not required to pay the lease payments for any period during which the equipment is not available for use. The lease payments are not canceled: they are suspended until the equipment again becomes available for use. These 103 leases are known as abatement leases. 7 To minimize the impact of an abatement on the lessor s income stream, California s 103 leases often require the government to obtain business interruption or abatement insurance. Offered by commercial carriers, this insurance covers the lease payments during the abatement period What is the process by which a government enters into a 103 lease? There are two methods for a government to acquire financing under a 103 lease: private negotiation and public bid. Whether a government has to use one or the other depends on applicable statute. Many statutes leave the decision up to the discretion of the government, whereas other statutes mandate that contracts be awarded by public bid. These statutes may designate a certain type of contract or a contract over a certain dollar amount as being awarded by public bid only, whereas other contracts may be awarded through private bid or negotiation. If a 103 lease is to be awarded by private negotiation, it typically is by requesting bids from persons named on the government s approved vendor list, which is a list containing those vendors preapproved to offer the services being requested. When public bidding is used, the government will state its specifications and request bids. The request for bids will be published in trade publications such as The Bond Buyer, on the government s website, a trade association website, or a commercial website that facilitates public bids for government contracts. 12. In addition to the public bidding requirements that might be in place, are 103 leases subject to other state laws? Although state laws vary, most 103 leases will be subject to open meetings laws, which require that the lease be discussed and voted on in a public session of the government s governing body. Public notice has to be given in a local newspaper and as otherwise required by law that the 103 lease is on the governing body s agenda so that concerned citizens can attend and voice their opinions prior to the vote. To further ensure that citizens get a chance to consider the 103 lease, it may have to be on the agenda for two consecutive meetings before a vote can be taken. A quorum must be present for the vote of the governing body to be valid. In many instances, prior to a vote being taken, the 6 J O U R N A L O F E Q U I P M E N T L E A S E F I N A N C I N G F A L L V O L. 2 2 / N O. 2

7 governing body s counsel will have to opine in the meeting that the 103 lease complies with all relevant laws. Failure to comply with any of these procedural requirements may result in the 103 lease being declared null and void and treated as if it never existed. This is an appropriate time to underscore, first, that a lessor contracting with a government is bound at its peril to know the authority of that government, and second, that the risk of a government s failure to comply with applicable laws, including the Internal Revenue Code, as noted above, is a risk that falls squarely on the lessor. The consequences of such a failure may result in the lease being voided or the interest component of the lease payments being taxable. If the lease is not voided and the lease so provides, the lessor may seek to recover from the government, by virtue of the lease s indemnity provision, any damages it suffers because of the government s failure to comply with the law, although we think that enforcing an indemnity provision against a government is almost always an uncertain prospect. In addition, any indemnity payment would be subject to approval and appropriation by the government s governing body. Should that not occur, the lessor s legal options are limited. 13. If a 103 lease does not comply with state law, is the interest component of the lease payments still tax-deductible? It depends on whether the 103 lease is valid under state law despite the failure to comply with the law. If the lease is void then the interest paid and retained, if any, is not tax-exempt. For the interest to be treated as an obligation of a state or subdivision thereof, the Internal Revenue Code requires that the underlying obligation be a valid and enforceable obligation of the government. 14. Does the Internal Revenue Code require any specific provisions to be addressed in a 103 lease? The code requires that a 103 lease contain a statement that a portion of the lease payments constitutes interest. It is not necessary to state what portion of the lease payments constitutes interest or to include an amortization schedule. Although not necessary, including an amortization schedule makes sense, especially if the government has the right to purchase the equipment during the lease term (as is sometimes stated in the request for bid). 15. What is a Form 8038 and who has to file it? To keep track of how much tax-exempt debt is outstanding, the Internal Revenue Service requires government entities to file a disclosure form known as Form The version of Form 8038 that has to be filed and the time by which it has to be filed depend on the size of the 103 lease. If the principal owing under the 103 lease is: a. $100,000 or more: The government must file a Form 8038-G not later than the 15th day of the second calendar month after the close of the calendar quarter in which the lease was closed, or if b. less than $100,000: The government must file a Form 8038-GC by either the 15th day of the second calendar month after the close of the calendar quarter in which the lease was closed or, on a consolidated basis (for all deals under $100,000 for which an 8038-GC was not already filed), by February 15 of the year following the year in which the lease was closed. Although the filing of Form 8038 is an obligation of the government, the failure to file the form may result in the loss of the tax exemption. Therefore, the lessor should make sure the appropriate form is submitted and it should retain a copy for its files. The Internal Revenue Service will not acknowledge receipt of a Form Can tax-exempt financing be used to reimburse a lessee for cash purchases? Yes, provided the government adopts a reimbursement resolution setting forth its official intent to reimburse expenditures with the 103 lease. This resolution must describe the project or equipment for which reimbursement is sought A lessor contracting with a government is bound at its peril to know the authority of that government. Also, the risk of a government's failure to comply with applicable laws is a risk that falls squarely on the lessor. J O U R N A L O F E Q U I P M E N T L E A S E F I N A N C I N G F A L L V O L. 2 2 / N O. 2 7

8 The proceeds of a 103 lease may be used to reimburse the government for expenditures made no more than 60 days prior to the adoption of the reimbursement resolution. and the maximum amount of tax-exempt obligations to be issued to fund this reimbursement. The reimbursement must be for capital expenses except, and subject to Internal Revenue Code-imposed ceilings, for costs of issuance of the tax-exempt obligations as well as preliminary expenses for the project. The proceeds of a 103 lease may be used to reimburse the government for expenditures made no more than 60 days prior to the adoption of the reimbursement resolution. Any expenditure outside of this 60-day period is not subject to reimbursement. To actually enter into the 103 lease, the government has from 18 months to 36 months (depending on the amount of tax exempt obligations the government issued in that year) after the date the expenditure was paid or the date on which the equipment was delivered whichever comes later. 17. What is the de minimis rule? At one time banks and other financial institutions owned most of the tax-exempt obligations issued by government entities. One of the advantages for banks was that they were able to deduct as a business expense the cost of buying these tax-exempt obligations. In other words, financial institutions were getting a tax deduction for the interest expense of borrowing to buy tax exempt obligations and getting a tax exemption for the interest earned on the tax exempt obligations. The Internal Revenue Code was changed to eliminate this double benefit. At present, financial institutions, except for tax-exempt obligations issued by government entities that anticipate issuing less than $10 million in tax-exempt obligations in the then-current calendar year, are not able to deduct the expenses of acquiring tax exempt obligations. However, the IRS created an exception to this rule to address situations when the financial institution s investment in tax-exempt obligations is considered insignificant. This is the de minimis rule. It provides that the IRS will not challenge a financial institution s deduction of the interest expense of borrowing funds to acquire tax-exempt obligations if the total of all tax-exempt obligations held by the financial institution during the thencurrent calendar year averages less than 2% of the average total U.S.-based assets of the financial institution. The de minimis rule does not apply to dealers in tax-exempt obligations. 18. Does the 103 lease have to be in any particular form? No, provided the contract that is used complies with applicable state law regarding form and substance and evidences a sale of equipment to the government. If it meets those qualifications, the contract can be in the form of an equipment lease, a lease-purchase agreement, a lease with purchase option, or a conditional or installment sales contract. 19. Where can someone obtain further information about 103 leases? The Equipment Leasing Association and the AGL&F are good sources for materials about taxexempt leasing. Each association has at least one conference annually dedicated to tax-exempt leasing, and further information can be obtained from their websites. 1 There are several different types of tax-exempt financing options: The tax-exempt lease is only one. This article does not address these other options. For a detailed description of the various types of tax-exempt financings and related issues see M. David Gelfand, ed., State and Local Government Debt Financing (Thomson- West, 2002). 2 Not all financial obligations incurred by a government are done so under its borrowing power. For example, if a government takes property pursuant to its right of eminent domain and offers to pay for the property with an interest-bearing note, the interest on the note is not tax-exempt because the taking of the property was not part of a voluntary transaction and the government was not acting like a borrower. 3 The ability of Indian tribes to issue tax-exempt obligations is found in Section 7871 of the Internal Revenue Code and the regulations issued thereunder, which make clear that an Indian tribal government shall be treated as a State and a subdivision of an Indian tribal government shall be treated as a political subdivision of a State for purposes of any obligation 8 J O U R N A L O F E Q U I P M E N T L E A S E F I N A N C I N G F A L L V O L. 2 2 / N O. 2

9 issued by such government or subdivision under section 103 (relating to interest on certain governmental obligations) if such obligation is part of an issue substantially all of the proceeds of which are to be used in the exercise of an essential governmental function (26 C.F.R. sec ). Thus not all obligations issued by Indian tribes are tax-exempt. The Internal Revenue Code has detailed tests for taxexempt status, but generally any function that is usually performed by a state or local government with general taxing powers will qualify. Debt to build a casino will not be tax-exempt, but funds to build a school may be borrowed on a tax-exempt basis. Also, because Indian tribes are not subject to the debt limitation provisions of any state, a 103 lease with an Indian tribe does not have to contain a nonappropriation clause (see question 5). A 103 lease with an Indian tribe can be a hell-or-high-water lease for a multiyear term. 4 A standard nonappropriation clause reads as follows: If Lessee's governing body fails to appropriate sufficient moneys in any fiscal period for Rental Payments or other Payments due under this Lease and if other funds are not available for such Payments, then a Nonappropriation shall be deemed to have occurred. Typically, the lease will require that prior to declaring a nonappropriation, the government has to make a good-faith effort or use its best efforts to appropriate the necessary funds. 8 Although California law does not require that the government have the right to nonappropriate, government entities sometimes request that right as a matter of contract. There is no evidence that California government entities that bargain for a contractual right to nonappropriate are any more likely to nonappropriate than those government entities entitled to such right as a matter of law. Bob Downey bob.downey@cat.com Bob Downey is a senior corporate counsel with Caterpillar Financial Services Corp. in its transactional practice group, resident in Nashville, Tennessee. His practice is focused on domestic and international transactions, including equipment financings, receivables financings, and other asset-based transactions. He also provides transactional support to FCC Equipment Financing Inc., a Caterpillar Financial affiliate. He formerly practiced with Mudge Rose Guthrie Alexander & Ferdon and the CIT Group/Equipment Financing Inc. 5 A standard nonsubstitution clause reads as follows: If a nonappropriation occurs in connection with this Lease, Lessee agrees, to the extent permitted by law, not to purchase, lease or rent, borrow, seek appropriations for, acquire or otherwise receive the benefits of any personal property to perform the same functions as, or functions taking the place of, the equipment leased hereunder. 6 For example, New York state limits nonsubstitution clauses to 60 days. 7 A sample abatement clause provides that in the event of damage, destruction or loss of use through eminent domain of the Equipment, Lessee s obligation to pay Rental Payments hereunder shall abate to the extent of such damage, destruction or loss of use, the amount of abatement will be such that the resulting rental payment represents fair consideration for the use of the portions of the Equipment as to which damage, destruction or loss of use, does not substantially interfere with the use and right of possession of Lessee. In the event of abatement, [Rental Payments] shall be paid from rental interruption insurance proceeds or other legally available funds, if any. J O U R N A L O F E Q U I P M E N T L E A S E F I N A N C I N G F A L L V O L. 2 2 / N O. 2 9