IRS SILO Settlement Initiative

On Aug. 6, 2008, the IRS announced settlement initiatives for more than 45 large corporate taxpayers that engaged in Lease-In/Lease-Out (“LILO”) or Sale-In/Lease-Out (“SILO”) transactions, which were designated as listed transactions in 2000 and 2005 respectively. About 45 corporate taxpayers received letters inviting participation in the settlement initiative. The resolution program represents the first time that LILO and SILO transactions have been the subject of a nationally coordinated taxpayer settlement initiative. The IRS is offering the initiatives, presumably based on the government-favorable decisions in BB&T Corp. v. United States, 523 F.3d 461 (4th Cir. 2008) and AWG Leasing Trust v. United States, 2008 U.S. Dist. LEXIS 42761 (N.D. Ohio May 28, 2008), in an effort to resolve the hundreds of LILO and SILO transactions currently being examined and litigated. The IRS has issued and posted to its Web site answers to questions raised by the original announcement: www.irs.gov/businesses/article/0,,id=186294,00.html. Originally given a 30-day window, taxpayers had until Oct. 5, 2008 to accept the offer.

As described in previous articles, in a LILO or SILO transaction, a U.S. taxpayer leases (LILO) or purchases (SILO) an asset from the asset owner by contributing an equity investment (typically around 20% of asset cost) and obtaining loans to finance the remainder of asset cost. The taxpayer then leases the asset back to the asset owner (as lessee) in exchange for rental payments. At the end of the lease period or earlier, the lessee generally has the right to purchase the asset for a fixed price early buyout option (“EBO”). In many transactions, the lessee economically defeases its rent and purchase option payment obligations by depositing the majority of the closing date asset sale proceeds with creditworthy banks or similar arrangements. That deposit is then pledged to the lessor as collateral to secure the lessee's payment obligations.

Elements of the Basic Settlement Proposal

The basic settlement proposal embodies these elements:

• The IRS will concede 20% of the tax benefits claimed by taxpayers in LILO and SILO transactions. In addition, the IRS has recharacterized the transactions as a loan of the equity investment by the taxpayer in return for the lessee's repayment under the EBO. As a result, the transactions accrue original issue discount (“OID”). Under the resolution program, the IRS requires the taxpayer to report 80% of the accrued OID for tax years through 2007.
• The taxpayer must currently recognize as ordinary income any gain on a deemed termination of the transaction as of Dec. 31, 2008. Gain on a deemed termination is the value of the equity defeasance account less the taxpayer's basis. Basis is calculated as the taxpayer's equity investment reduced by the 20% of allowable tax benefits increased by the 80% of reported OID.
• Where a transaction is not terminated by Dec. 31, 2008, the taxpayer must recognize 100% of the OID until the taxpayer is able to actually terminate the transaction. When the taxpayer with a deemed terminated transaction is able to actually terminate the transaction prior to Jan. 1, 2011 and realizes an actual gain on the transaction that is lower than the deemed gain that was recognized, the taxpayer is allowed an ordinary deduction for the taxable year in which the transaction is actually terminated. Presumably, the taxpayer's basis will be adjusted for the full amount of the OID that it reported (rather than 80%).
• No accuracy-related penalties will be imposed.

It's “all or nothing”: A taxpayer with multiple LILO or SILO transactions cannot selectively participate in the initiative, but must agree to resolve all of its transactions on the settlement terms. However, once the taxpayer enters into the initiative, the taxpayer and the IRS will then seek to agree to specific application of the settlement terms to the taxpayer's transactions. Nothing is binding on the taxpayer unless and until those terms are memorialized in a written closing agreement.

Within 30 days from the date of acceptance, a taxpayer must provide the IRS with certain documents to enable the parties to agree to specific closing terms. Among other things, the taxpayer must provide a list of all the taxpayer's LILO and/or SILO transactions (and transactions the same as or substantially similar to LILO and SILO transactions) for which the taxpayer claimed losses or deductions in any taxable year. This itself may be a point of contention as the IRS and the taxpayer may disagree on the classification of certain transactions as “SILOs.” For example, transactions that are not defeased or only partially defeased, or where collateral is required to be posted by the lessee only upon the occurrence of specified credit downgrades. The list of information to be provided also includes equity collateral schedules (schedules detailing beginning equity collateral and equity portion of rent, and/or EBO payments), which, again, may not exist in the context of a transaction with no “day one” equity collateral.

Notwithstanding the IRS attention to FAQs on its Web site, many sub stantive questions surrounding the specific application of the settlement terms to particular transactions remain, including their application to OFSC (ownership FSC) transactions (commonly done with commercial Boeing aircraft), the application of the rules in certain partnership contexts, and the calculation of basis and OID. Nevertheless, some taxpayers are likely to initially accept the offer to enter the initiative with the understanding that they can exit the program if they cannot reach a satisfactory closing agreement with the IRS. Exiting the program should not prejudice the taxpayer's rights to continue to contest the transactions within the administrative appeals process, or in litigation.

A Final Observation

One final observation. As of this writing, we are in the middle of a financial crisis that has seen the collapse, demise, or rescue of several (formerly highly rated financial institutions. AIG, for example, provided the equity collateral in many LILO and SILO transactions. The downgrading of AIG has caused many of those transactions to be restructured as the lessees scramble to replace AIG with suitable alternative collateral. In light of these developments, the IRS' argument that the provision of collateral in LILO and SILO transactions renders them riskless, is wearing thinner and thinner.

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].

On Aug. 6, 2008, the IRS announced settlement initiatives for more than 45 large corporate taxpayers that engaged in Lease-In/Lease-Out (“LILO”) or Sale-In/Lease-Out (“SILO”) transactions, which were designated as listed transactions in 2000 and 2005 respectively. About 45 corporate taxpayers received letters inviting participation in the settlement initiative. The resolution program represents the first time that LILO and SILO transactions have been the subject of a nationally coordinated taxpayer settlement initiative. The IRS is offering the initiatives, presumably based on the government-favorable decisions in BB&T Corp. v. United States , 523 F.3d 461 (4th Cir. 2008) and AWG Leasing Trust v. United States, 2008 U.S. Dist. LEXIS 42761 (N.D. Ohio May 28, 2008), in an effort to resolve the hundreds of LILO and SILO transactions currently being examined and litigated. The IRS has issued and posted to its Web site answers to questions raised by the original announcement: www.irs.gov/businesses/article/0,,id=186294,00.html. Originally given a 30-day window, taxpayers had until Oct. 5, 2008 to accept the offer.

As described in previous articles, in a LILO or SILO transaction, a U.S. taxpayer leases (LILO) or purchases (SILO) an asset from the asset owner by contributing an equity investment (typically around 20% of asset cost) and obtaining loans to finance the remainder of asset cost. The taxpayer then leases the asset back to the asset owner (as lessee) in exchange for rental payments. At the end of the lease period or earlier, the lessee generally has the right to purchase the asset for a fixed price early buyout option (“EBO”). In many transactions, the lessee economically defeases its rent and purchase option payment obligations by depositing the majority of the closing date asset sale proceeds with creditworthy banks or similar arrangements. That deposit is then pledged to the lessor as collateral to secure the lessee's payment obligations.

Elements of the Basic Settlement Proposal

The basic settlement proposal embodies these elements:

• The IRS will concede 20% of the tax benefits claimed by taxpayers in LILO and SILO transactions. In addition, the IRS has recharacterized the transactions as a loan of the equity investment by the taxpayer in return for the lessee's repayment under the EBO. As a result, the transactions accrue original issue discount (“OID”). Under the resolution program, the IRS requires the taxpayer to report 80% of the accrued OID for tax years through 2007.
• The taxpayer must currently recognize as ordinary income any gain on a deemed termination of the transaction as of Dec. 31, 2008. Gain on a deemed termination is the value of the equity defeasance account less the taxpayer's basis. Basis is calculated as the taxpayer's equity investment reduced by the 20% of allowable tax benefits increased by the 80% of reported OID.
• Where a transaction is not terminated by Dec. 31, 2008, the taxpayer must recognize 100% of the OID until the taxpayer is able to actually terminate the transaction. When the taxpayer with a deemed terminated transaction is able to actually terminate the transaction prior to Jan. 1, 2011 and realizes an actual gain on the transaction that is lower than the deemed gain that was recognized, the taxpayer is allowed an ordinary deduction for the taxable year in which the transaction is actually terminated. Presumably, the taxpayer's basis will be adjusted for the full amount of the OID that it reported (rather than 80%).
• No accuracy-related penalties will be imposed.

It's “all or nothing”: A taxpayer with multiple LILO or SILO transactions cannot selectively participate in the initiative, but must agree to resolve all of its transactions on the settlement terms. However, once the taxpayer enters into the initiative, the taxpayer and the IRS will then seek to agree to specific application of the settlement terms to the taxpayer's transactions. Nothing is binding on the taxpayer unless and until those terms are memorialized in a written closing agreement.

Within 30 days from the date of acceptance, a taxpayer must provide the IRS with certain documents to enable the parties to agree to specific closing terms. Among other things, the taxpayer must provide a list of all the taxpayer's LILO and/or SILO transactions (and transactions the same as or substantially similar to LILO and SILO transactions) for which the taxpayer claimed losses or deductions in any taxable year. This itself may be a point of contention as the IRS and the taxpayer may disagree on the classification of certain transactions as “SILOs.” For example, transactions that are not defeased or only partially defeased, or where collateral is required to be posted by the lessee only upon the occurrence of specified credit downgrades. The list of information to be provided also includes equity collateral schedules (schedules detailing beginning equity collateral and equity portion of rent, and/or EBO payments), which, again, may not exist in the context of a transaction with no “day one” equity collateral.

Notwithstanding the IRS attention to FAQs on its Web site, many sub stantive questions surrounding the specific application of the settlement terms to particular transactions remain, including their application to OFSC (ownership FSC) transactions (commonly done with commercial Boeing aircraft), the application of the rules in certain partnership contexts, and the calculation of basis and OID. Nevertheless, some taxpayers are likely to initially accept the offer to enter the initiative with the understanding that they can exit the program if they cannot reach a satisfactory closing agreement with the IRS. Exiting the program should not prejudice the taxpayer's rights to continue to contest the transactions within the administrative appeals process, or in litigation.

A Final Observation

One final observation. As of this writing, we are in the middle of a financial crisis that has seen the collapse, demise, or rescue of several (formerly highly rated financial institutions. AIG, for example, provided the equity collateral in many LILO and SILO transactions. The downgrading of AIG has caused many of those transactions to be restructured as the lessees scramble to replace AIG with suitable alternative collateral. In light of these developments, the IRS' argument that the provision of collateral in LILO and SILO transactions renders them riskless, is wearing thinner and thinner.

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].