Court Finds Compelled Purchase Option in SILO Case

In last month's issue, we discussed that fact that 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 their 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 that the taxpayers intend to appeal.

We conclude this discussion herein.

Lessor Did Not Acquire a Genuine Ownership Interest

In addition to its key finding that the purchase option was certain to be exercised, the court also pointed to the following factors in support of its conclusion that the lessor did not acquire a genuine ownership interest in the facility.

Net Lease

First, the court noted that the rights and duties of the lessee with respect to the facility did not change as a result of the transaction ' the lessee at all times retains use and possession of the facility, remains responsible for the operation and maintenance of the facility, maintains insurance on the facility, and makes capital improvements. These rights and obligations typically are retained by the lessee in any conventional “net lease,” and many judicial decisions have cited these factors as neutral factors in analyzing the question of tax ownership in a sale-leaseback. Nevertheless, the AWG court did not take notice of this case law and instead cited these traditional net lease attributes in support of its conclusion.

Foreign Law/Double Dip

Second, the court placed a fair amount of emphasis on the treatment of the transaction under German law. Retention of title to the facility by AWG meant that AWG could continue to claim depreciation allowances for German tax purposes. The transaction also was not recorded as a sale by AWG for financial accounting purposes. AWG did not meet applicable German regulatory requirements that would have applied to a sale of the facility. In the context of leasing tax case law, no prior court has taken foreign tax or accounting treatment into account in determining ownership for U.S. tax purposes. In AWG, the court cited these factors as evidence that AWG did not transfer to the lessor the substantive rights or liabilities associated with ownership.

Offsetting Payments

Third, the court observed the effect of the defeasance arrangements on the cash flows, and that, after the closing date, all of the lessee's remaining payment obligations were funded by the defeasance accounts. The rent and debt payment schedules are identical in both timing and amount ' “perfectly off-setting, circular payments.” The lessee did not have to go into its “own pocket” to pay rent or to exercise the purchase option. Many courts have cited the fact that rent matches debt service as a neutral factor in analyzing tax ownership in a sale-leaseback. The AWG court did not take notice of this case law, but it cited the matching payments in support of its conclusion.

Credit Risk

The court found that the structure of the transaction effectively protected the lessor from “any possible risk of financial loss” of its equity investment. The court concluded that the risk of bankruptcy of the debt defeasance parties ' two German landesbanks ' was “highly improbable.” The court also noted that in the event of an early termination, the lessor's return of and on its equity investment were guaranteed by the basic and strip equity collateral. Finally, the court noted that even if AWG did not exercise its purchase option and could satisfy the requirements of the service contract option, the lessor was guaranteed a return ' and had eliminated any residual risk ' because of the minimum charges that would be payable by AWG under the service contract. The court concluded that these risk mitigants “undermine” the lessor's claim of ownership.

Compelled Purchase Option

Although these foregoing four factors were cited by the court in support of its ultimate conclusion that the lessor did not acquire an ownership interest, it is clear from the opinion that the “most important” factor in the court's analysis was the certainty that the lessee would exercise its purchase option. Absent that critical finding, the court probably would not have ruled in favor of the IRS in this case. The key facts underlying the court's conclusion that AWG was compelled to exercise the purchase option were:

It will not be economically feasible for AWG to exercise the service contract option because it will not be able secure a refinancing of the debt. Refinancing of the debt “seems impossible” because the loan-to-value ratio is too high, the service contract payments that would serve as collateral for the loan are not “hell or high water” payment obligations, and it is highly unlikely that the municipal shareholders of AWG would guarantee the service contract payments.

AWG has no economic incentive to exercise the service contact option. The court found that the appraiser's “avoided costs” economic compulsion test was based on “unsupported assumptions” about AWG's ability to deduct service contract payments for German tax purposes, and found that the service contract payment obligations far exceeded the amounts in the defeasance accounts that AWG would receive if it elects the service contract option.

The service contract option would be “politically unpopular” because control over the asset, which provides electrical power to the constituent members of AWG, would have to be turned over an independent third party operator, and AWG would be required to raise the rates it charges its members for power in order to fund the increasing service contract payments.

Tax Ownership in a SILO Transaction

The AWG case is the first to decide the tax ownership issue in a SILO transaction. The court was very careful to limit the scope of its decision to the transaction involved in the case, because the issues are so highly fact-specific. The court stated: “Facts and contract provisions drive any determination regarding whether a transaction sufficiently transfers an ownership interest. Each transaction need be judged on its own conditions.” Although the court did cite and rely on the BB&T case in making its decision, it only did so because it found that the facts presented by the BB&T case were similar to the facts in AWG, and because in both cases the exercise of purchase option was the near certain result.

The legal analysis underlying the AWG decision, and its conclusion, are not controversial when considered in light of the court's findings of fact. The finding that the lessee was nearly certain to exercise its fixed price purchase option is a crucial finding of fact. The resulting legal conclusion ' that the lease was not a “true lease” ' naturally follows from that finding of fact. So the AWG case does not break new legal ground. Case law firmly supports the principle that a purported lease is not a true lease where the lessee is certain to exercise a purchase option. The AWG decision does fail to follow case law in certain other respects, which is one disturbing aspect of the decision. In addition, the case raises interesting questions about the disposition of many other “SILO” transactions (in litigation and in Appeals).

Aside from the critical fact that the lessee was certain to exercise its purchase option, the court also cited in support of its conclusion that the lessor had not acquired an ownership interest the fact the possession and operation of the facility did not change during the lease term; the fact the lessee remained obligated to maintain, improve and insure the facility; the fact that the lessor and the lenders had third-party credit support for the lease payment obligations (in the form of pledged deposit arrangements); the fact that the lessee, a foreign entity, treated the transaction differently for foreign tax and accounting purposes than the lessor did for U.S. tax purposes. All of these factors have been cited by the courts (and the IRS in the case of the foreign law treatment) as “neutral factors” in determining tax ownership in a sale-leaseback. The court could have explicitly acknowledged those authorities in its consideration of these factors, and could have concluded that these factors taken into account in combination with the fact that exercise of the lessee's purchase option was compelled support the conclusion that the lessor did not acquire an ownership interest. Unfortunately it did not and we are left asking the question whether, absent its finding on the purchase option, these other factors would have supported the ultimate ownership conclusion. We are left wondering whether the thousands of “conventional” leveraged lease transactions that incorporate these features are now open to attack, whether or not a compelled purchase option can be demonstrated.

The most interesting question raised by the AWG case is whether taxpayers will have better success in litigation (or settling) SILO transactions that are factually distinguishable from AWG. The court's decision turns on a finding of fact that the lessee's purchase option was compelled. That finding in turn was founded on a review of the economic, political and practical consequences to the lessee of either exercising the purchase option, or instead electing the service contract option. Those consequences are themselves unique to each individual transaction, which, as the court stated, “need be judged on its own conditions.” So the court very clearly crafted its decision in a way that allows other courts considering SILO cases to distinguish those cases from AWG on their facts.

Differences of Fact

What differences of fact will sway a court to distinguish a transaction from AWG? There could be many. For example, in any lease-to-service contract transaction, cross-border or domestic, taxpayers will be able to demonstrate the likelihood that the lessee will have the ability and the economic incentive to elect the service contract option. A lease-to-service contract transaction involving passenger trains leased to a municipal transit agency can be distinguished from AWG on a number of important grounds. A court could find that the purchase option is not compelled because a railcar (unlike the fixed facility in AWG) is moveable and easily replaced by the lessee. In the case of a domestic transaction, the taxpayer could also demonstrate that the transaction was encouraged by the transit agency's regulators (the Federal Transit Administration) and did not raise difficult foreign political issues (as was the case in AWG). Most QTE transactions do not require the lessee to elect between a purchase option and a service contract option. The alternative to the purchase option is simply to allow the lease to run to term, and arrange some residual value protection for the lessor. Yes, the fixed price option and the residual protection do form a “collar” on the lessor's interest in the asset that is present in AWG, but the collar is looser. A court could find that the lessee's alternative to the purchase option is not burdensome in a QTE transaction as it might be in a lease-to-service contract transaction.

Conclusion

The AWG case is a disappointing outcome for the taxpayer, but was highly dependent on its facts as the basis fore the court's conclusion. Depending on the facts of other cases, and the courts' willingness to analyze those factual differences, the case may not spell the last word on SILO cases.

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. Spector can be reached at [email protected].

In last month's issue, we discussed that fact that 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 their 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 that the taxpayers intend to appeal.

We conclude this discussion herein.

Lessor Did Not Acquire a Genuine Ownership Interest

In addition to its key finding that the purchase option was certain to be exercised, the court also pointed to the following factors in support of its conclusion that the lessor did not acquire a genuine ownership interest in the facility.

Net Lease

First, the court noted that the rights and duties of the lessee with respect to the facility did not change as a result of the transaction ' the lessee at all times retains use and possession of the facility, remains responsible for the operation and maintenance of the facility, maintains insurance on the facility, and makes capital improvements. These rights and obligations typically are retained by the lessee in any conventional “net lease,” and many judicial decisions have cited these factors as neutral factors in analyzing the question of tax ownership in a sale-leaseback. Nevertheless, the AWG court did not take notice of this case law and instead cited these traditional net lease attributes in support of its conclusion.

Foreign Law/Double Dip

Second, the court placed a fair amount of emphasis on the treatment of the transaction under German law. Retention of title to the facility by AWG meant that AWG could continue to claim depreciation allowances for German tax purposes. The transaction also was not recorded as a sale by AWG for financial accounting purposes. AWG did not meet applicable German regulatory requirements that would have applied to a sale of the facility. In the context of leasing tax case law, no prior court has taken foreign tax or accounting treatment into account in determining ownership for U.S. tax purposes. In AWG, the court cited these factors as evidence that AWG did not transfer to the lessor the substantive rights or liabilities associated with ownership.

Offsetting Payments

Third, the court observed the effect of the defeasance arrangements on the cash flows, and that, after the closing date, all of the lessee's remaining payment obligations were funded by the defeasance accounts. The rent and debt payment schedules are identical in both timing and amount ' “perfectly off-setting, circular payments.” The lessee did not have to go into its “own pocket” to pay rent or to exercise the purchase option. Many courts have cited the fact that rent matches debt service as a neutral factor in analyzing tax ownership in a sale-leaseback. The AWG court did not take notice of this case law, but it cited the matching payments in support of its conclusion.

Credit Risk

The court found that the structure of the transaction effectively protected the lessor from “any possible risk of financial loss” of its equity investment. The court concluded that the risk of bankruptcy of the debt defeasance parties ' two German landesbanks ' was “highly improbable.” The court also noted that in the event of an early termination, the lessor's return of and on its equity investment were guaranteed by the basic and strip equity collateral. Finally, the court noted that even if AWG did not exercise its purchase option and could satisfy the requirements of the service contract option, the lessor was guaranteed a return ' and had eliminated any residual risk ' because of the minimum charges that would be payable by AWG under the service contract. The court concluded that these risk mitigants “undermine” the lessor's claim of ownership.

Compelled Purchase Option

Although these foregoing four factors were cited by the court in support of its ultimate conclusion that the lessor did not acquire an ownership interest, it is clear from the opinion that the “most important” factor in the court's analysis was the certainty that the lessee would exercise its purchase option. Absent that critical finding, the court probably would not have ruled in favor of the IRS in this case. The key facts underlying the court's conclusion that AWG was compelled to exercise the purchase option were:

It will not be economically feasible for AWG to exercise the service contract option because it will not be able secure a refinancing of the debt. Refinancing of the debt “seems impossible” because the loan-to-value ratio is too high, the service contract payments that would serve as collateral for the loan are not “hell or high water” payment obligations, and it is highly unlikely that the municipal shareholders of AWG would guarantee the service contract payments.

AWG has no economic incentive to exercise the service contact option. The court found that the appraiser's “avoided costs” economic compulsion test was based on “unsupported assumptions” about AWG's ability to deduct service contract payments for German tax purposes, and found that the service contract payment obligations far exceeded the amounts in the defeasance accounts that AWG would receive if it elects the service contract option.

The service contract option would be “politically unpopular” because control over the asset, which provides electrical power to the constituent members of AWG, would have to be turned over an independent third party operator, and AWG would be required to raise the rates it charges its members for power in order to fund the increasing service contract payments.

Tax Ownership in a SILO Transaction

The AWG case is the first to decide the tax ownership issue in a SILO transaction. The court was very careful to limit the scope of its decision to the transaction involved in the case, because the issues are so highly fact-specific. The court stated: “Facts and contract provisions drive any determination regarding whether a transaction sufficiently transfers an ownership interest. Each transaction need be judged on its own conditions.” Although the court did cite and rely on the BB&T case in making its decision, it only did so because it found that the facts presented by the BB&T case were similar to the facts in AWG, and because in both cases the exercise of purchase option was the near certain result.

The legal analysis underlying the AWG decision, and its conclusion, are not controversial when considered in light of the court's findings of fact. The finding that the lessee was nearly certain to exercise its fixed price purchase option is a crucial finding of fact. The resulting legal conclusion ' that the lease was not a “true lease” ' naturally follows from that finding of fact. So the AWG case does not break new legal ground. Case law firmly supports the principle that a purported lease is not a true lease where the lessee is certain to exercise a purchase option. The AWG decision does fail to follow case law in certain other respects, which is one disturbing aspect of the decision. In addition, the case raises interesting questions about the disposition of many other “SILO” transactions (in litigation and in Appeals).

Aside from the critical fact that the lessee was certain to exercise its purchase option, the court also cited in support of its conclusion that the lessor had not acquired an ownership interest the fact the possession and operation of the facility did not change during the lease term; the fact the lessee remained obligated to maintain, improve and insure the facility; the fact that the lessor and the lenders had third-party credit support for the lease payment obligations (in the form of pledged deposit arrangements); the fact that the lessee, a foreign entity, treated the transaction differently for foreign tax and accounting purposes than the lessor did for U.S. tax purposes. All of these factors have been cited by the courts (and the IRS in the case of the foreign law treatment) as “neutral factors” in determining tax ownership in a sale-leaseback. The court could have explicitly acknowledged those authorities in its consideration of these factors, and could have concluded that these factors taken into account in combination with the fact that exercise of the lessee's purchase option was compelled support the conclusion that the lessor did not acquire an ownership interest. Unfortunately it did not and we are left asking the question whether, absent its finding on the purchase option, these other factors would have supported the ultimate ownership conclusion. We are left wondering whether the thousands of “conventional” leveraged lease transactions that incorporate these features are now open to attack, whether or not a compelled purchase option can be demonstrated.

The most interesting question raised by the AWG case is whether taxpayers will have better success in litigation (or settling) SILO transactions that are factually distinguishable from AWG. The court's decision turns on a finding of fact that the lessee's purchase option was compelled. That finding in turn was founded on a review of the economic, political and practical consequences to the lessee of either exercising the purchase option, or instead electing the service contract option. Those consequences are themselves unique to each individual transaction, which, as the court stated, “need be judged on its own conditions.” So the court very clearly crafted its decision in a way that allows other courts considering SILO cases to distinguish those cases from AWG on their facts.

Differences of Fact

What differences of fact will sway a court to distinguish a transaction from AWG? There could be many. For example, in any lease-to-service contract transaction, cross-border or domestic, taxpayers will be able to demonstrate the likelihood that the lessee will have the ability and the economic incentive to elect the service contract option. A lease-to-service contract transaction involving passenger trains leased to a municipal transit agency can be distinguished from AWG on a number of important grounds. A court could find that the purchase option is not compelled because a railcar (unlike the fixed facility in AWG) is moveable and easily replaced by the lessee. In the case of a domestic transaction, the taxpayer could also demonstrate that the transaction was encouraged by the transit agency's regulators (the Federal Transit Administration) and did not raise difficult foreign political issues (as was the case in AWG). Most QTE transactions do not require the lessee to elect between a purchase option and a service contract option. The alternative to the purchase option is simply to allow the lease to run to term, and arrange some residual value protection for the lessor. Yes, the fixed price option and the residual protection do form a “collar” on the lessor's interest in the asset that is present in AWG, but the collar is looser. A court could find that the lessee's alternative to the purchase option is not burdensome in a QTE transaction as it might be in a lease-to-service contract transaction.

Conclusion

The AWG case is a disappointing outcome for the taxpayer, but was highly dependent on its facts as the basis fore the court's conclusion. Depending on the facts of other cases, and the courts' willingness to analyze those factual differences, the case may not spell the last word on SILO cases.

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. Spector can be reached at [email protected].