                       T.C. Memo. 2009-107



                     UNITED STATES TAX COURT



 HOPKINS PARTNERS, CLEVELAND AIRPORT HOTEL LIMITED PARTNERSHIP,
           TAX MATTERS PARTNER, ET AL.,1 Petitioner v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket Nos. 19563-04, 17269-05,   Filed May 19, 2009.
                 19877-05.



     Stephen L. Kadish, Matthew F. Kadish, and Aaron H. Bulloff,

for petitioner.

     John Tkacik, Jr., for respondent.




     1
      Cases of the following petitioners are consolidated for
purposes of trial, briefing, and opinion: Hopkins Airport Hotel
Partnership, Cleveland Airport Hotel Limited Partnership, Tax
Matters Partner, docket No. 17269-05; and Hopkins Partners,
Cleveland Airport Hotel Limited Partnership, Tax Matters Partner,
docket No. 19877-05. These cases are collectively referred to
herein as “case”.
                               - 2 -

             MEMORANDUM FINDINGS OF FACT AND OPINION


     WELLS, Judge:   In the instant case, 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 (partnership)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 substitutes for rent;

and (2) if so, (a) whether the deductibility of improvements made

in lieu of rent is limited to the early period of the lease or to

a certain fraction of the total rent expense; (b) whether the

transfer of the improvements in issue was illusory; (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.




     2
      For purposes of the instant case, references to the
partnership include Hopkins Partners and its predecessors-in-
interest.
     3
      Unless 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.
                               - 3 -

                         FINDINGS OF FACT

     Some of the facts and certain exhibits have been stipulated.

The stipulations of fact are incorporated in this opinion by

reference and are found as facts.

     The partnership is an Ohio general partnership formed on

September 28, 1995.

     The partnership operates the Sheraton Cleveland Airport

Hotel (hotel).   The hotel is at Cleveland Hopkins International

Airport (airport) and is owned by the City of Cleveland, Ohio

(city).

     The partnership operates the hotel and attendant parking

facilities under a leasehold interest assigned to it by its

immediate predecessor-in-interest.     The leasehold interest was

created by a lease from the city to a predecessor-in-interest to

the partnership during 1957.   Thereafter, various entities which

were predecessors-in-interest to the partnership held the

leasehold/operator interest through a series of lease concessions

and modifications between 1957 and 1990.

      The partnership currently has the leasehold right to

operate the hotel through November 13, 2048.

The Early Leases

     The first lease, the Lease by Way of Concession for a Hotel

at Cleveland-Hopkins Airport (1957 lease), was executed on

December 12, 1957.
                               - 4 -

     The 1957 lease required the partnership to construct and

operate 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 dated July 30,

1962 (supplemental lease), gave the partnership the use of

additional land to be used as parking for customers, and the

right to sell food and beverages.   The supplemental lease also

increased the minimum annual rent to $6,000 per year.

     The Second Supplemental Lease dated November 14, 1966

(second supplemental lease), provided additional land for

parking; increased the minimum annual rental to $75,000; and

extended the term to 35 years from the date of execution.    The

second supplemental lease also required the partnership to

construct an addition to the hotel and to spend $2.8 million on

improvements over 5 years.
                                 - 5 -

     The Third Supplemental Lease dated March 6, 1969 (third

supplemental lease), allowed the partnership to construct hotel

additions or improvements on land previously designated for

parking.

     The Fourth Supplement to Lease by Way of Concession dated

January 26, 1984 (fourth supplemental lease), extended the term

of the 1957 lease through November 13, 2023, and required the

partnership to spend at least $1.25 million on improvements in

the initial 5-year period of the fourth supplemental lease and

$500,000 on improvements in each subsequent 5-year period.    The

fourth supplemental lease also provided that all furniture and

fixtures would become the property of the city upon termination

of the 1957 lease, as amended.    The minimum annual rent under the

fourth supplemental lease was increased to $150,000 for the

initial year of the fourth supplemental lease and was to increase

by an additional $9,000 in each subsequent year of the fourth

supplemental lease.

The Negotiation of Rent Credits

     During the mid-to-late 1980s, the city was enjoying a

business and civic rejuvenation following a difficult period.

New highway construction facilitated access to the airport.    At

the same time, the hotel had fallen into disrepair.

     The partnership was losing significant amounts of money on

the hotel, with projected losses in excess of $500,000 each year
                               - 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 market

rate, 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 and 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 the

cost of necessary repairs and improvements to the hotel.     The

partnership proposed a modification of the lease which would have

increased the minimum annual rent to $300,000 but would have
                                 - 7 -

decreased the percentage rent.    The proposed change was expected

to result in an overall decrease in rent.

     Negotiations regarding the proposed improvements and the

change to the rent under the lease ensued between the partnership

and the city.   The city was in a strong negotiating position

because the economic climate in the city at that time was

conducive to finding a new operator to construct and operate a

new hotel if the city did not obtain the renovations the city

wanted.

     The partnership submitted to the city a modified proposal in

which it again requested that the rent be reduced or, in the

alternative, that the cost of improvements be credited against

any land rent in excess of $300,000 per year.   The city rejected

that proposal but later submitted a counterproposal adopting the

rent credit approach.   The counterproposal allowed the

partnership to credit the cost of certain eligible improvements

against annual rent in excess of $300,000.   The partnership

accepted the counterproposal subject to requested changes.

     The partnership was concerned with the profitability (or

lack thereof) of the hotel and was agreeable to using either a

rent reduction or rent credits to achieve its goal of making the

hotel profitable.   However, the parties believed that the

Cleveland City Council, which had to adopt an ordinance approving

any lease modification, was unlikely to agree to a rent
                                 - 8 -

reduction.   Additionally, the parties believed that it was more

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 those improvements.    The

ultimate decision to structure the leases to include rent credits

rather than a rent reduction was motivated by the foregoing

concerns, not by tax considerations.

The 1989 Lease Supplement

     The Sixth Supplement to Lease by Way of Concession, dated

August 11, 1989 (1989 lease supplement), increased the minimum

annual rent from $195,000 to $300,000.    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 1989 lease supplement and were subject to approval

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 Lease

     The partnership and the city executed the Amended and

Restated Lease by Way of Concession dated December 31, 1990 (1990
                                - 9 -

amended lease).    The 1990 amended lease was effective during the

years at issue and remains in effect through trial.

     The 1990 amended lease extended the term of the 1957 lease

for an additional 35 years.   It also permitted the partnership to

demolish a portion of the hotel and to convert that area into a

parking lot for hotel patrons and public parking patrons.

     The 1990 amended lease required the partnership to renovate

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 1990

amended lease required the partnership to spend $1.5 million on

improvements every 3 years.   Those expenditures also qualified

for rent credits.

     The 1990 amended lease increased the maximum amount of rent

credit in any given year to $650,000 and allowed any eligible

improvements made in excess of that limit to be carried forward

to future years.

The Parking Lease

     The partnership and the city also entered into a separate

Amended and Restated Lease by Way of Concession dated December

31, 1990 (parking lease), allowing the partnership to operate a

parking lot on the hotel property.      The parking lease was in

effect during the years in issue and remained in effect through

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 annual

rent equal to the greater of $100,000 or 10 percent of the gross

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 rent

in subsequent years.

      The 1989 lease supplement, the 1990 amended lease, and the

parking lease are sometimes hereinafter referred to collectively

as the lease agreements.

The Rent Credit Process

      At the 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
                              - 11 -

occasionally rejected items from the list.   Eventually, the

partnership and the city agreed on what qualified as eligible

improvements for that year.

     Each year the partnership decided which eligible

improvements the partnership would use for rent credit.    The

partnership documented the eligible improvements the partnership

was using to obtain rent credit on a detailed spread sheet

provided to the city.   In accordance with the lease agreements,

title to the eligible improvements vested in the city at the end

of the year in which those improvements were credited against

rent.

     Generally, the partnership elected to receive rent credits

for leasehold improvements rather than furniture, fixtures, and

equipment (FF&E).   The partnership made that election in order to

avoid the detailed inventory tracking requirements and the

burdensome and unsightly tagging associated with FF&E.

     When the partnership made eligible improvements, it

accounted for them by recording them on its books as capital

assets.   Where the partnership received a credit against rent for

the full cost of an eligible improvement in the year that the

improvement was made, it deducted that cost as a rent expense on

its Federal income tax return for that year.   When an eligible

improvement was not credited against rent in the year it was

made, the partnership kept that eligible improvement on the books
                              - 12 -

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

firms.

                              OPINION

I.   Whether the Leasehold Improvements Were a Substitute for
     Rent

     As a general rule, the Commissioner’s determinations are

presumed correct and the burden of proving an error is on the


     4
      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 all 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.
                                 - 13 -

taxpayer.    Rule 142(a); Welch v. Helvering, 290 U.S. 111, 115

(1933).     In the instant case, the parties agree that petitioner

has the burden of proof.

     Generally, section 162(a) allows as a current deduction from

gross income all the ordinary and necessary expenses incurred in

carrying on a trade or business.     However, sections 161 and 261

have the effect of subordinating provisions such as section

162(a) to provisions such as section 263(a)(1), thereby

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 special rule applies (see, e.g.,

section 263(a)(1)), a taxpayer’s deductions for capital

expenditures, if allowable at all, generally come by way of

amortization or depreciation; i.e., the capital expenditure is

deductible over a period of time.      Secs. 167, 168, and 169;

INDOPCO, Inc. v. Commissioner, 503 U.S. 79, 83 (1992).

     Capital expenditures are, with limited exceptions, any

amounts paid out for new buildings, permanent improvements, and

restoration.     Sec. 263(a).   The parties agree that the eligible

improvements in issue are capital expenditures within the meaning

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 Goods Co. v.

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

Commissioner, 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.      Gladding Dry

Goods Co. 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 to

recover that investment through depreciation deductions rather

than through a current business expense deduction.     Sec. 1.162-

11(b), 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
                              - 15 -

the income of the lessor; it does not address the amounts, if

any, that are deductible by the lessee.   However, section 1.61-

8(c), Income Tax Regs., does make clear that improvements in lieu

of rent are rental income to the lessor, and rent is a currently

deductible expense for a lessee under section 162(a)(3).

Additionally, caselaw provides that, where an improvement is in

lieu of rent, the amount invested in the improvement is currently

deductible by the lessee as a rent expense.    Your Health Club,

Inc. v. Commissioner, 4 T.C. 385, 390 (1944); McGrath v.

Commissioner, T.C. Memo. 2002-231, affd. without published

opinion 92 AFTR 2d 6159, 2003-2 USTC par. 50,663 (5th Cir. 2003).

Where improvements are in lieu of rent, the cost of those

improvements is actually borne by the lessor through the rent

credit, and the lessee has no capital investment to depreciate.

Your Health Club, Inc. v. Commissioner, supra at 390.

     Whether the value of improvements constitutes rent turns

upon the intent of the parties to the lease.   M.E. Blatt Co. v.

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

Commissioner, 28 T.C. 670, 680 (1957), affd. 258 F.2d 231 (9th

Cir. 1958); McGrath v. Commissioner, supra; see also sec. 1.61-

8(c), Income Tax Regs.   The intent of the parties to the lease is

derived from the terms of the lease as well as the surrounding

circumstances.   Cunningham v. Commissioner, supra at 680; sec.

1.61-8(c), Income Tax Regs.   Even when the improvements are
                               - 16 -

required by the terms of the lease, they will not be deemed rent

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 at 277.

     We consider in the instant case whether the partnership and

the city intended 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 testimony of its own agents.5

     Petitioner 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 not discredit those witnesses at trial, nor did respondent

introduce witnesses to rebut the testimony of petitioner’s

witnesses.


     5
      Respondent also asserts that petitioner’s failure to
introduce testimony from the city gives rise to an inference
under 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.
                              - 17 -

     In deciding the intent of the parties to the lease

agreements, we first look at the express terms of the documents.

Article IV.D of the 1990 amended lease states that the

partnership “shall be entitled to receive a credit towards the

payment of the annual Percentage Rent, in an amount equal to the

cost of eligible improvements * * * which have been made and paid

for prior to the completion of the lease year”.   The parking

lease, in article IV, paragraph A.5, provides that the

partnership “may deduct the cost of eligible improvements made

and paid for in a lease year from any Percentage Rent due for

that lease year.”   In Brown v. Commissioner, 22 T.C. 147, 148

(1954), affd. 220 F.2d 12 (7th Cir. 1955), we held that a similar

provision requiring that the cost of improvements “‘be credited

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 to

those documents intended that the partnership’s expenditures for

eligible improvements were in lieu of its payment of percentage

rent.

     When determining whether the parties to the lease intended

to treat the cost of improvements as a substitute for rent,

consideration must be given to the surrounding circumstances in

addition to the express language of the particular lease.

Cunningham v. Commissioner, supra at 680.   One relevant factor is
                              - 18 -

how the parties to the lease treated the expenditure for tax

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 substitute);

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).    In the

instant case, the partnership consistently treated the eligible

improvements, both 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 the 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 further

undermined by the fact that the city * * * was a tax indifferent

party”, citing CMA Consol., Inc. v. Commissioner, T.C. Memo.

2005-16.   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
                              - 19 -

parties intended to structure the transaction.6   In the instant

case, respondent has cited no case standing for the proposition

that tax indifference is a consideration in deciding whether the

parties to a lease intended capital expenditures to be made in

lieu of rent.   However, we have considered the tax indifference

of the city, and we are persuaded by the record that the city’s

tax indifference did not play a significant role in the

negotiations between the city and the partnership or the city’s

intent regarding the provisions of the lease agreements.

      Accordingly, we conclude that the parties to the lease

agreements intended, as evidenced by the express language of the

leases and the surrounding circumstances, that the eligible

improvements be substitutes for rent.   Notwithstanding the intent

of the parties to the lease agreements to treat the eligible

improvements as substitutes for rent, respondent advances several

reasons the eligible improvements should not be treated as

deductible rent expenses.   We address each of these contentions

below.

II.   Whether Rent Credits Must Be Limited in Duration or Amount

      Respondent contends that Your Health Club, Inc. v.

Commissioner, 4 T.C. 385 (1944) and McGrath v. Commissioner, T.C.

Memo. 2002-231 “can clearly be distinguished in that the rent


      6
       We address the issue of economic substance below in sec.
IV.
                              - 20 -

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 year

of the lease and was just under one-third of the total rent

deduction for that year, those limits were imposed by the parties

to the lease.   In Your Health Club, Inc. this Court had no reason

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, in the instant case, the parties to the lease

agreements did intend to treat the eligible improvements as a

substitute for rent to the 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
                              - 21 -

supported by the cited cases and is inconsistent with the intent

of the parties to the lease agreements.

III. Whether the Transfer of Eligible Improvements Was Illusory

     In accordance with article VII.A of the 1990 amended lease

and article VII.A of the parking lease, title to eligible

improvements vested in the city in the year that those

improvements were credited against rent, and the partnership

treated each transfer as a deemed sale of the eligible

improvement to the city in exchange for the rent credit.

Respondent contends that the partnership’s transfers of eligible

improvements in exchange for rent credits were illusory.    In

support of that contention, respondent notes that the partnership

retained control over and the right to the use of the transferred

eligible improvements.   Additionally, respondent contends that

the partnership could not transfer the eligible improvements to

the city because, under the lease agreements, title to those

improvements would vest in the city at the end of the lease.

     In deciding whether there has been a sale or exchange

sufficient to transfer the depreciable interest in an asset from

one taxpayer to another, this Court has looked at whether there

was a transfer of the benefits and burdens of ownership.     Grodt &

McKay Realty, Inc. v. Commissioner, 77 T.C. 1221, 1237 (1981).

Grodt & McKay Realty, Inc. lists several factors relevant in
                                - 22 -

determining where the benefits and burdens lie.7      In the case of

leasehold improvements, the balancing factors have      been refined

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 makes

improvements at the lessee’s expense, it is generally the lessee

that has a depreciable interest in the improvements.       Id.; sec.


     7
      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 the
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. Grodt & McKay Realty, Inc. v.
Commissioner, 77 T.C. 1221, 1237-1238 (1981).
                                - 23 -

1.162-11(b), Income Tax Regs.    However, where a lessee makes

improvements as a substitute for rent, the lessee has no

depreciable interest in those improvements.      Your Health Club,

Inc. v. Commissioner, supra at 390.      Such a transaction is not

different from one where the lessor paid for the improvements

directly and the lessee paid the full rent.      Id.   When the lessor

bears the cost of improvements via a rent credit, the lessor has

an increased investment in the property, resulting in a higher

basis and increased depreciation deductions.      Brown v.

Commissioner, 22 T.C. at 151.

     In the instant case, 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 cost of those improvements as a rent

expense and deducted that cost currently.     See Your Health Club,

Inc. v. Commissioner, 4 T.C. 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 interest in

those improvements.8   See   Gladding Dry Goods Co. v.

     8
      We note that had the eligible improvements been considered
advance rent, the lessor would presumably have had the
depreciable interest in those eligible improvements beginning in
the year that they were made. However, because the partnership
often made eligible improvements in excess of those required
under the lease, it was not certain which eligible improvements
would eventually be credited against rent. Accordingly, we
conclude that the eligible improvements were not advance rent
                                                   (continued...)
                              - 24 -

Commissioner, supra at 338.   When the 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

the rent credit, the partnership no longer had a capital

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 expense

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.




     8
      (...continued)
paid in the year they were made.
                               - 25 -

IV.   Whether the Rent Credit Arrangement Lacked Economic
      Substance

      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 the

transaction.    Knetsch v. United States, 364 U.S. 361 (1960);

Gregory v. Helvering, 293 U.S. 465 (1935).    The taxpayer has the

burden of showing that the form of the transaction accurately

reflects its substance and that the deduction is permissible.

IRS v. CM Holdings, Inc., 301 F.3d 96, 102 (3d Cir. 2002).

      In the instant case, respondent contends that the rent

credit provisions in issue   lacked economic substance and were

not part of a bona fide business transaction.    In considering

whether a transaction has economic substance, courts look at both

the objective economic effect (i.e. whether, absent tax benefits,

the taxpayer benefited from the transaction) and the subjective

business motivation (i.e. whether the taxpayer was motivated by

considerations beyond tax benefits) of the transaction.     Id.

      In the instant case, the hotel was not profitable and was in

need of renovation in order to have any hope of becoming

profitable.    The partnership did not have the funds to renovate

the hotel and was unable to borrow funds for the renovations with

the lease arrangement structured as it was before 1989.     With the

introduction of rent credits in the 1989 lease, the annual

percentage rent did not change.   However, the partnership was
                              - 26 -

able to make improvements to the hotel and credit those

improvements against its rent for the year.    Clearly, the rent

credits provided a financial 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 outlay

for the 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

improvements to 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 was

only later that the partnership considered how the rent credits

would be handled for tax purposes.

     Petitioner also introduced credible testimony that the

parties to the lease agreements chose rent credits over other

alternatives for business, not tax, reasons.    The mentioned

alternatives were for the city to make the improvements at its

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 involve
                                - 27 -

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

the partnership.   The record shows and we conclude that the

partnership’s motivation in negotiating rent credits was to turn

the hotel into a profitable enterprise and that the parties to

the lease agreements had valid business reasons for choosing the

rent credit structure over a lease providing for reduced rent.

     Respondent makes much of the fact that the city is tax

exempt.    Where one of the parties is tax exempt, as is the city,

there is potential for abuse.    However, respondent points to no

authority that would support a holding that a transaction

involving a tax-exempt party cannot have economic substance.

Respondent asserts that a taxable entity similarly situated with

the city would not have accepted the lease terms involving rent

credits.   However, it is clear from the evidence that the city

wanted to see the hotel renovated and was not simply going along

with the partnership’s proposal.    For the reasons discussed

above, we conclude that a taxable entity in the city’s position

could have favored the rent credit structure for business

reasons, despite that fact that another structure might have

produced greater tax savings for it.

     We conclude that tax considerations were not a significant

motivating factor in the negotiation of the rent credits.     On the
                              - 28 -

basis of the record, we conclude that the rent credit

arrangements in issue had a subjective business purpose.    We also

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 clearly

reflect income, section 446(b) allows the Commissioner to compute

taxable income under such method as, in the opinion of the

Commissioner, does clearly reflect income.    In the instant case,

respondent asserts that the partnership’s use of rent credits

does not clearly 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”.   Respondent further alleges that the

partnership is “clearly understating income” by taking a current

deduction for the cost of long-term eligible improvements.

     As respondent notes, a method of accounting clearly reflects

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 413 (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
                               - 29 -

not clearly reflect income.”    Hamilton Indus., Inc. v.

Commissioner, 97 T.C. 120, 128 (1991).    The Commissioner has

broad discretion but cannot require a taxpayer to change from an

accounting method that clearly reflects income merely because the

Commissioner considers an alternate method to more clearly

reflect income.    RLC Indus. Co. & Subs. v. Commissioner, supra at

491.    If a taxpayer’s method of accounting is authorized by the

Internal Revenue Code or the underlying regulations and has been

applied consistently, the Commissioner cannot arbitrarily require

a change or reject the taxpayer’s method.    Id.   We review

respondent’s determination for abuse of discretion.     See Thor

Power Tool Co. v. Commissioner, 439 U.S. 522 (1979).

       As discussed above, the method of treating the cost of

improvements credited against rent as a deductible rent expense

has been accepted by both the courts and the regulations.      See

Your Health Club, Inc. v. Commissioner, 4 T.C. at 390; McGrath v.

Commissioner, T.C. Memo. 2002-231; sec. 1.61-8(c), Income Tax

Regs.    In the instant case, respondent correctly points out that

by treating the cost of improvements as a rent expense rather

than depreciating (or continuing to depreciate) the costs, the

partnership does increase its current deductions and reduce its

taxable income in the year of the rent credit.     However, since

the partnership consistently accounted for its eligible

improvements using an approved accounting method, respondent is
                                - 30 -

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


     9
      Respondent’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.
                              - 31 -

the historical cost of the improvements did not inappropriately

increase the overall deductions; it merely accelerated the time

at which the partnership claimed those deductions.   While such an

acceleration generally would not be permissible for a capital

asset, as discussed above, there is an exception that applies in

the instant cases that allows the current deduction of capital

expenses that are incurred and credited as a substitute for rent.

See Your Health Club, Inc. v. Commissioner, supra at 390; McGrath

v. Commissioner, supra; sec. 1.61-8(c), Income Tax Regs.

      Accordingly, we conclude that the partnership’s method of

accounting for eligible improvements made in lieu of rent did

clearly reflect income and that respondent abused his discretion

in determining that the partnership’s method did not clearly

reflect income.

VI.   Whether the Use of Rent Credits Was an Accounting Method
      Change

      Section 446(e) provides that a taxpayer must secure the

consent of the Secretary before changing his method of

accounting.

      The reason for this rule is that a change in an
      accounting method will frequently cause a distortion of
      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. v. United States, 396 F.2d 552, 554 (5th Cir.
      1968).]
                              - 32 -

     In the instant case, respondent contends that the

partnership’s change from depreciating to deducting the cost of

an eligible improvement in the year in which the partnership

received a rent credit for such improvement is a change in

accounting method.   We disagree because, as discussed above, when

the partnership received a rent credit for the cost of an

eligible improvement, the depreciable interest in that eligible

improvement was transferred from the partnership to the city.      At

that point, the partnership, as required by law, see Your Health

Club v. Commissioner, supra at 390; Gladding 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, supra at 390; McGrath v. Commissioner,

supra; 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 that sale to the extent that

its depreciated basis was less than the rent credit, it properly

recaptured any depreciation previously claimed and there was no

duplication of deductions.   The method used by the partnership in
                             - 33 -

treating the matter as a deemed sale was used consistently

throughout the term of the lease.   Accordingly, we find that the

partnership’s treatment of eligible improvements did not result

in an accounting method change.

VII. Whether Respondent Properly Proposed an Adjustment Under
     Section 481(a) for Taxable Year 2000

     Where there is a change of accounting method, section 481(a)

requires adjustments to prevent omissions or duplications and

allows the Commissioner to include in the adjustment amounts that

are attributable to taxable years for which assessment is barred

by the statute of limitations.    Hamilton Indus., Inc. v.

Commissioner, 97 T.C. 120 (1991).   As discussed above, because

there has been no change of accounting method in the instant

case, section 481(a) is not applicable.

VIII. Conclusion

     On the basis of the foregoing, we conclude that the

partnership and the city intended that eligible improvements be

substitutes for rent; the leases in issue had economic substance

and were not shams designed merely to reduce taxes; the

partnership’s treatment of eligible improvements was a clear

reflection of income; the change from depreciating to deducting

the cost of the eligible improvements in the year of a rent

credit was not a change of accounting method; and the partnership

appropriately deducted the cost of an eligible improvement as a

rent expense in the year in which that eligible improvement was
                             - 34 -

credited against rent.

     To reflect the foregoing,


                                       Decisions will be entered

                                  for petitioner.
