Court Finds Compelled Purchase Option in SILO Case

In the recently decided AWG Leasing Trust case, No. 1:07-CV-857 (N.D. Ohio 2008), a federal district court found against a taxpayer that engaged in a cross-border sale-leaseback of a waste-to-energy facility located in Germany. The court found, as a matter of fact, that the lessee, a consortium of German municipalities that burned its garbage and purchased electricity from the plant, was “nearly certain” to exercise its fixed price purchase option at the end of the lease term. Based on that finding of a compelled exercise of the purchase option, the court used a “substance over form” legal underpinning to hold that the leaseback was not a “true lease” ' use and possession of the asset were certain to be returned to the lessee at the end of the lease. The case is appealable to the Court of Appeals for the Sixth Circuit, and we understand at press time that the taxpayers intend to appeal.

The court disregarded the sale-leaseback and disregarded the nonrecourse debt that the taxpayer had incurred to purchase the facility. The overall transaction was recharacterized as a financing (non-true lease) of the equity portion of the purchase price that was paid by the taxpayer lessor to the lessee at closing. This deemed loan from the lessor to the lessee results in original issue discount (interest) income to the lessor. In addition all of the depreciation and interest expense deductions claimed by the taxpayer with respect to the facility and the nonrecourse debt were disallowed.

SILO Transactions

The case provides a thoughtful discussion of a sale-leaseback with a tax-exempt entity, the type of transaction that the IRS refers to as a sale-in/lease-out (SILO). The National Office of the IRS has been conducting a coordinated national audit of SILO transactions and the AWG Trust case is one of several docketed SILO cases in litigation. The big question raised by this decision is whether other courts will reach a different conclusion when presented with transactions that are similar in some factual respects to the AWG Trust transaction but also bear meaningful differences.

Several different types of transactions fall within the broad definition of a “SILO” for purposes of the IRS-coordinated audit. Very generally, SILOs may be classified by transaction structure, asset type, and whether the lessee is a foreign or domestic tax-exempt entity. Each SILO transaction has its own unique defeasance structure. Most transactions involve 100% defeasance (collateralization) of the portion of the lessee's payments that service the nonrecourse debt. Defeasance of the equity portion of the lessee's payment obligations may involve collateral for the basic equity payments, as well as credit support of the “strip” excess of termination value over the value of the basic equity defeasance. Some transactions require the posting of equity collateral only upon a credit downgrade (or similar event) of the lessee, after the closing of the transaction.

QTE Transactions

The two predominant transaction structures are the QTE transaction and the lease-to-service contract transaction. The typical QTE transaction involves a sale-leaseback of “qualified technological equipment,” or “QTE” ' computers and related equipment. Asset types include fixed line and mobile telecommunications equipment, passenger train control and monitoring equipment, train ticketing and toll collection systems, and aircraft flight simulators. In a typical QTE transaction, the lessor acquires the asset by way a transfer of title or a long-term head lease whose term exceeds the expected remaining useful life of the asset, and leases the asset back to the lessee for 20 to 25 years. About five years before the end of the lease, the lessee has a fixed price purchase option (early buy-out or “EBO”). If the EBO is not exercised, the lease continues for its remaining term, and the lessee must either guarantee that the lessor will receive a specified minimum residual value upon a sale of the asset at the end of the lease term, or provide a third-party insurance policy that covers that guaranteed amount. Based upon the expected value of the asset at the end of the lease term (as estimated by appraisal on the closing date), it is not expected that the lessee will be required to provide this guarantee because the asset value is expected to exceed the guaranteed amount. Aside from its obligation to provide the residual value guarantee or insurance, the lessee has no financial obligations that result from its non-exercise of the purchase option other than its obligation to pay rent for the remaining term of the lease and to comply with the return conditions at the end of the lease.

Lease-to-Service Contracts

The typical lease-to-service contract transaction involves a sale-leaseback of long-lived facilities and equipment. Asset types include immovable facilities like wastewater treatment facilities, municipal sewer systems, power plants, and manufacturing facilities. Moveable equipment with a long useful life, such as trains, are also common in lease-to-service contract transactions. In a typical transaction, the lessor acquires the asset by way a transfer of title or a long-term head lease whose term exceeds the expected remaining useful life of the asset, and leases the asset back to the lessee. At the end of the lease, the lessee has a fixed price purchase option (“FPO”). If the FPO is not exercised, the lessee has the obligation to: 1) arrange a service contract for a specified period under which the lessor (or its designee) will operate the asset and lessee (or a third party) agrees to purchase the output of the asset for minimum charges specified at the closing of the sale-leaseback; 2) arrange for a refinancing of the outstanding balance of the debt; and 3) in some cases, arrange for third-party residual value insurance payable if the asset does not achieve a specified minimum value at the end of the service contract period.

Several taxpayers are litigating their cases against the IRS in court. There are at least 10 docketed cases in various courts involving Lease-in/Lease-out (LILO) and SILO transactions. To date, two cases have been decided, both against the taxpayer, the BB&T case and the AWG Leasing Trust case. In a third case, Fifth Third Bancorp v. United States, No. 1:05-CV-350 (S.D. Ohio), a cross-border LILO case involving a jury trial, the jury verdict was delivered in a form of confusing responses to interrogatories posed by the judge. Each party has filed post-trial motions, each arguing that the jury verdict was in its favor. The trial judge has not yet entered a judgment in the Fifth Third case.

BB&T Corp. v. United States

BB&T Corp. v. United States, 523 F.3d 461 (4th Cir. 2008), aff'g BB&T Corp. v. United States, 2007 WL 37798 (M.D.N.C. 2007), was a cross-border LILO transaction involving the head lease of an undivided interest in a pulp manufacturing facility owned and used by Sodra, a Swedish wood pulp manufacturer. BB&T leased the facility back to Sodra for a term shorter than the head lease. At the end of the initial term of the sublease, Sodra had the option to purchase BB&T's remaining interest under the head lease for a fixed price. If Sodra did not elect its purchase option, BB&T could require Sodra to extend the sublease, lease the facility to a third party or take possession of the facility. Sodra's financial obligations under the sublease, including the fixed price purchase option, were entirely economically defeased at the closing of the transaction.

The court first concluded that the transaction could not be disregarded on the ground that it lacked economic substance because BB&T had demonstrated a reasonable expectation of pre-tax profit. However, the court then applied a “substance over form” analysis and found that the transaction was in substance a financing arrangement and not a genuine lease and sublease. Critical to the court's finding was the conclusion that Sodra would exercise its fixed price purchase option, because the defeasance accounts would fully fund the purchase and Sodra had no economic incentive not to exercise the purchase option. The IRS and BB&T commissioned experts as to the likelihood of exercise of the purchase option. The court was convinced that exercise was the only viable option for Sodra because the purchase price was “prefunded” by the defeasance and because Sodra might incur dislocation costs and costs of replacing lost manufacturing capacity if it did not exercise the purchase option.

The BB&T case was decided at the lower court level without trial, by granting the IRS a motion for summary judgment. On June 13, 2008, BB&T filed with the Fourth Circuit a petition for rehearing and rehearing en banc. The petition argued that the court improperly decided the case in the context of a motion for summary judgment. There were disputed facts in the case ' mainly whether the lessee would exercise its purchase option ' as to which BB&T had presented expert testimony, and BB&T was entitled to a trial of that fact issue. The petition for rehearing was denied.

AWG Leasing Trust

AWG Leasing Trust involves a SILO lease-to-service contract transaction. A partnership composed of affiliates of Key Bank and PNC Bank (the “Partnership”) purchased a waste-to-energy disposal and treatment facility located in Germany from AWG, a consortium of German municipalities that purchased the energy produced by the facility. The Partnership acquired the facility under a long-term head lease, and funded its purchase of the facility with $55 million in equity and $331 million in nonrecourse debt. The Partnership leased the facility back to AWG under a 25-year net lease. At the end of the lease term, AWG had the option to purchase the Partnership's interest in the facility for a fixed price. If AWG did not elect the purchase option, AWG would be required to enter into a service contract under which the Partnership would provide waste disposal and energy services to AWG for a 12-year term, and AWG would be required to arrange for a refinancing of the nonrecourse debt with an outstanding balance of $383 million. AWG's financial obligations under the lease, including the fixed price purchase option should it be exercised, were entirely economically defeased at the closing of the transaction.

The transaction's defeasance/collateral structure involved: 1) defeasance of 100% of the “debt portion” of the lessee's payment obligations payment undertaking agreements (although it appears that with respect to 10% of the debt amount, the PUA was not pledged to the lender); 2) defeasance of the basic “equity portion” of the lessee's payment obligations through an AIG payment undertaking agreement; and 3) a letter of credit to cover the “strip” excess of scheduled termination value and the assumed value from time to time of the basic equity collateral.

The court found that the transaction could not be disregarded on the ground that it lacked economic substance because AWG had demonstrated a reasonable expectation of pre-tax profit. However, the court concluded that it was “nearly certain” that AWG would exercise its fixed-price purchase option at the end of the lease term, and, as a consequence, the Partnership had not acquired the benefits and burdens of ownership of the facility. The court offered a number of reasons why it felt the exercise of the purchase option was compelled, including: 1) it was highly unlikely that AWG would be able to refinance the debt at the end of the lease term, so the service contract option was not a feasible alternative to the purchase option; 2) the service contract option would be “politically unpopular” in light of AWG's obligations to provide waste disposal and energy services to its constituents; 3) the economic costs to AWG of the service contract option, as estimated by the Partnership's appraiser, were based on “unsupported assumptions”; 4) AWG had no economic incentive to elect the service contract option; and 5) the funds necessary to exercise the option were available to AWG in the form of the defeasance accounts.

The AWG court was convinced that exercise of the purchase option was the only viable option for the lessee, and this fact was known to the parties at the closing of the transaction. Because the lessor's “purchase” of the facility on the closing date was subject to the inevitable repurchase of the facility by the lessee, the lessor never acquired an ownership interest in the facility. The BB&T court also found that, in the context of the LILO transaction involved, the exercise of the purchase option by the lessee was the near-certain result.

This discussion concludes in next month's issue.

Philip H. Spector is a tax partner in the New York office of Troutman Sanders LLP. His practice focuses on domestic and cross-border asset and project finance. He can be reached at [email protected].

In the recently decided AWG Leasing Trust case, No. 1:07-CV-857 (N.D. Ohio 2008), a federal district court found against a taxpayer that engaged in a cross-border sale-leaseback of a waste-to-energy facility located in Germany. The court found, as a matter of fact, that the lessee, a consortium of German municipalities that burned its garbage and purchased electricity from the plant, was “nearly certain” to exercise its fixed price purchase option at the end of the lease term. Based on that finding of a compelled exercise of the purchase option, the court used a “substance over form” legal underpinning to hold that the leaseback was not a “true lease” ' use and possession of the asset were certain to be returned to the lessee at the end of the lease. The case is appealable to the Court of Appeals for the Sixth Circuit, and we understand at press time that the taxpayers intend to appeal.

The court disregarded the sale-leaseback and disregarded the nonrecourse debt that the taxpayer had incurred to purchase the facility. The overall transaction was recharacterized as a financing (non-true lease) of the equity portion of the purchase price that was paid by the taxpayer lessor to the lessee at closing. This deemed loan from the lessor to the lessee results in original issue discount (interest) income to the lessor. In addition all of the depreciation and interest expense deductions claimed by the taxpayer with respect to the facility and the nonrecourse debt were disallowed.

SILO Transactions

The case provides a thoughtful discussion of a sale-leaseback with a tax-exempt entity, the type of transaction that the IRS refers to as a sale-in/lease-out (SILO). The National Office of the IRS has been conducting a coordinated national audit of SILO transactions and the AWG Trust case is one of several docketed SILO cases in litigation. The big question raised by this decision is whether other courts will reach a different conclusion when presented with transactions that are similar in some factual respects to the AWG Trust transaction but also bear meaningful differences.

Several different types of transactions fall within the broad definition of a “SILO” for purposes of the IRS-coordinated audit. Very generally, SILOs may be classified by transaction structure, asset type, and whether the lessee is a foreign or domestic tax-exempt entity. Each SILO transaction has its own unique defeasance structure. Most transactions involve 100% defeasance (collateralization) of the portion of the lessee's payments that service the nonrecourse debt. Defeasance of the equity portion of the lessee's payment obligations may involve collateral for the basic equity payments, as well as credit support of the “strip” excess of termination value over the value of the basic equity defeasance. Some transactions require the posting of equity collateral only upon a credit downgrade (or similar event) of the lessee, after the closing of the transaction.

QTE Transactions

The two predominant transaction structures are the QTE transaction and the lease-to-service contract transaction. The typical QTE transaction involves a sale-leaseback of “qualified technological equipment,” or “QTE” ' computers and related equipment. Asset types include fixed line and mobile telecommunications equipment, passenger train control and monitoring equipment, train ticketing and toll collection systems, and aircraft flight simulators. In a typical QTE transaction, the lessor acquires the asset by way a transfer of title or a long-term head lease whose term exceeds the expected remaining useful life of the asset, and leases the asset back to the lessee for 20 to 25 years. About five years before the end of the lease, the lessee has a fixed price purchase option (early buy-out or “EBO”). If the EBO is not exercised, the lease continues for its remaining term, and the lessee must either guarantee that the lessor will receive a specified minimum residual value upon a sale of the asset at the end of the lease term, or provide a third-party insurance policy that covers that guaranteed amount. Based upon the expected value of the asset at the end of the lease term (as estimated by appraisal on the closing date), it is not expected that the lessee will be required to provide this guarantee because the asset value is expected to exceed the guaranteed amount. Aside from its obligation to provide the residual value guarantee or insurance, the lessee has no financial obligations that result from its non-exercise of the purchase option other than its obligation to pay rent for the remaining term of the lease and to comply with the return conditions at the end of the lease.

Lease-to-Service Contracts

The typical lease-to-service contract transaction involves a sale-leaseback of long-lived facilities and equipment. Asset types include immovable facilities like wastewater treatment facilities, municipal sewer systems, power plants, and manufacturing facilities. Moveable equipment with a long useful life, such as trains, are also common in lease-to-service contract transactions. In a typical transaction, the lessor acquires the asset by way a transfer of title or a long-term head lease whose term exceeds the expected remaining useful life of the asset, and leases the asset back to the lessee. At the end of the lease, the lessee has a fixed price purchase option (“FPO”). If the FPO is not exercised, the lessee has the obligation to: 1) arrange a service contract for a specified period under which the lessor (or its designee) will operate the asset and lessee (or a third party) agrees to purchase the output of the asset for minimum charges specified at the closing of the sale-leaseback; 2) arrange for a refinancing of the outstanding balance of the debt; and 3) in some cases, arrange for third-party residual value insurance payable if the asset does not achieve a specified minimum value at the end of the service contract period.

Several taxpayers are litigating their cases against the IRS in court. There are at least 10 docketed cases in various courts involving Lease-in/Lease-out (LILO) and SILO transactions. To date, two cases have been decided, both against the taxpayer, the BB&T case and the AWG Leasing Trust case. In a third case, Fifth Third Bancorp v. United States, No. 1:05-CV-350 (S.D. Ohio), a cross-border LILO case involving a jury trial, the jury verdict was delivered in a form of confusing responses to interrogatories posed by the judge. Each party has filed post-trial motions, each arguing that the jury verdict was in its favor. The trial judge has not yet entered a judgment in the Fifth Third case.

BB&T Corp. v. United States

BB&T Corp. v. United States , 523 F.3d 461 (4th Cir. 2008), aff'g BB&T Corp. v. United States, 2007 WL 37798 (M.D.N.C. 2007), was a cross-border LILO transaction involving the head lease of an undivided interest in a pulp manufacturing facility owned and used by Sodra, a Swedish wood pulp manufacturer. BB&T leased the facility back to Sodra for a term shorter than the head lease. At the end of the initial term of the sublease, Sodra had the option to purchase BB&T's remaining interest under the head lease for a fixed price. If Sodra did not elect its purchase option, BB&T could require Sodra to extend the sublease, lease the facility to a third party or take possession of the facility. Sodra's financial obligations under the sublease, including the fixed price purchase option, were entirely economically defeased at the closing of the transaction.

The court first concluded that the transaction could not be disregarded on the ground that it lacked economic substance because BB&T had demonstrated a reasonable expectation of pre-tax profit. However, the court then applied a “substance over form” analysis and found that the transaction was in substance a financing arrangement and not a genuine lease and sublease. Critical to the court's finding was the conclusion that Sodra would exercise its fixed price purchase option, because the defeasance accounts would fully fund the purchase and Sodra had no economic incentive not to exercise the purchase option. The IRS and BB&T commissioned experts as to the likelihood of exercise of the purchase option. The court was convinced that exercise was the only viable option for Sodra because the purchase price was “prefunded” by the defeasance and because Sodra might incur dislocation costs and costs of replacing lost manufacturing capacity if it did not exercise the purchase option.

The BB&T case was decided at the lower court level without trial, by granting the IRS a motion for summary judgment. On June 13, 2008, BB&T filed with the Fourth Circuit a petition for rehearing and rehearing en banc. The petition argued that the court improperly decided the case in the context of a motion for summary judgment. There were disputed facts in the case ' mainly whether the lessee would exercise its purchase option ' as to which BB&T had presented expert testimony, and BB&T was entitled to a trial of that fact issue. The petition for rehearing was denied.

AWG Leasing Trust

AWG Leasing Trust involves a SILO lease-to-service contract transaction. A partnership composed of affiliates of Key Bank and PNC Bank (the “Partnership”) purchased a waste-to-energy disposal and treatment facility located in Germany from AWG, a consortium of German municipalities that purchased the energy produced by the facility. The Partnership acquired the facility under a long-term head lease, and funded its purchase of the facility with $55 million in equity and $331 million in nonrecourse debt. The Partnership leased the facility back to AWG under a 25-year net lease. At the end of the lease term, AWG had the option to purchase the Partnership's interest in the facility for a fixed price. If AWG did not elect the purchase option, AWG would be required to enter into a service contract under which the Partnership would provide waste disposal and energy services to AWG for a 12-year term, and AWG would be required to arrange for a refinancing of the nonrecourse debt with an outstanding balance of $383 million. AWG's financial obligations under the lease, including the fixed price purchase option should it be exercised, were entirely economically defeased at the closing of the transaction.

The transaction's defeasance/collateral structure involved: 1) defeasance of 100% of the “debt portion” of the lessee's payment obligations payment undertaking agreements (although it appears that with respect to 10% of the debt amount, the PUA was not pledged to the lender); 2) defeasance of the basic “equity portion” of the lessee's payment obligations through an AIG payment undertaking agreement; and 3) a letter of credit to cover the “strip” excess of scheduled termination value and the assumed value from time to time of the basic equity collateral.

The court found that the transaction could not be disregarded on the ground that it lacked economic substance because AWG had demonstrated a reasonable expectation of pre-tax profit. However, the court concluded that it was “nearly certain” that AWG would exercise its fixed-price purchase option at the end of the lease term, and, as a consequence, the Partnership had not acquired the benefits and burdens of ownership of the facility. The court offered a number of reasons why it felt the exercise of the purchase option was compelled, including: 1) it was highly unlikely that AWG would be able to refinance the debt at the end of the lease term, so the service contract option was not a feasible alternative to the purchase option; 2) the service contract option would be “politically unpopular” in light of AWG's obligations to provide waste disposal and energy services to its constituents; 3) the economic costs to AWG of the service contract option, as estimated by the Partnership's appraiser, were based on “unsupported assumptions”; 4) AWG had no economic incentive to elect the service contract option; and 5) the funds necessary to exercise the option were available to AWG in the form of the defeasance accounts.

The AWG court was convinced that exercise of the purchase option was the only viable option for the lessee, and this fact was known to the parties at the closing of the transaction. Because the lessor's “purchase” of the facility on the closing date was subject to the inevitable repurchase of the facility by the lessee, the lessor never acquired an ownership interest in the facility. The BB&T court also found that, in the context of the LILO transaction involved, the exercise of the purchase option by the lessee was the near-certain result.

This discussion concludes in next month's issue.

Philip H. Spector is a tax partner in the New York office of Troutman Sanders LLP. His practice focuses on domestic and cross-border asset and project finance. He can be reached at [email protected].