Taxpayer Victory in Con Edison LILO Shocks IRS

It has been over a year since we reported on the contest between the IRS and corporate taxpayers over the tax treatment of equipment leasing transactions with tax-exempt lessees known as LILOs and SILOs. See Spector, “Court Finds Compelled Purchase Option in SILO Case,” 27 Equipment Leasing Newsletter 8, 9 (September/October 2008). Last year's taxpayer defeat in the AWG case nudged many taxpayers into unfavorable settlements with the IRS. See AWG Leasing Trust v. United States , 592 F. Supp. 2d 953. But, as reported here, the AWG decision left open the possibility of a taxpayer victory in a properly argued trial of the question of fact of whether the lessee in a LILO or SILO was certain to exercise its fixed price purchase option ' a question which, if answered in the affirmative, defeats the lessor's claim to tax ownership under longstanding judicial precedent. That trial occurred earlier this year in the Federal Court of Claims and the result, reported last month, is a stunning victory for the taxpayer, Consolidated Edison Company v. United States, No. 06-305T (Fed. Ct. Cl.), October 21, 2009. To access the text of the opinion, go to www.cofc.uscourts.gov/sites/default/files/HORN.CONSOLIDATED102109.pdf.

The Decision

In the above-mentioned case, the taxpayer's tax treatment of a LILO transaction was upheld by the court, and all tax benefits claimed by the taxpayer were sustained. Naturally, some muckraking columnists hurried to criticize the Con Edison decision, expressing disappointment that the court actually applied historic leasing case law to a well-developed factual record. Despite their whining, the case demonstrates that the IRS (and the muckrakers) was wrong to treat all LILO and SILO transactions as though they were some prepackaged tax-shelter commodity. Each case turns on its facts, and the taxpayer wins in a properly chosen and argued case.

However, for many taxpayers that did LILO and SILO transactions, the good news comes too late. After its back-to-back victories in the BB&T case and in AWG, the IRS launched an aggressive settlement program, and many taxpayers (representing perhaps as much as 80% of all disputed LILO and SILO taxes) were persuaded to settle their claims at 20 cents on the dollar and no penalties ' basically nuisance value. For those taxpayers whose cases for whatever reason remain open at IRS appeals or are docketed in litigation, the Con Edison decision provides the backbone for a more taxpayer-favorable outcome. One of those taxpayers, Wells Fargo Bank, has its case before the Federal Court of Claims, the same court that decided Con Edison. That case was also tried earlier this year and a decision is expected soon.

Con Ed and Its LILO and SILO Transactions

The Con Edison transaction follows the basic pattern of most LILO and SILO transactions. However, despite the structural similarities of all LILO and SILO transactions, the tax treatment of a specific deal turns on the rights and obligations of the parties under the particular transaction documents and an analysis of economic and other factors that will bear on how the parties can be expected to exercise those rights ' something one commentator has called “the pretty world created by the documents.”

In its LILO, Con Ed's grantor trust (Con Ed trust) leased an undivided 48% interest in a Dutch power plant for 44 years, 80% of its remaining useful life, then subleased it back to its Dutch owner, EZH, for 20 years. The EZH plant was a state-of-the-art, gas-fueled cogeneration plant. As is typical for net leases, under the sublease EZH was required to maintain and insure the plant at its own expense. Some of the equipment was already subject to a German lease financing, which contained a bargain purchase option and was treated as a secured loan for U.S. tax purposes. This lease-sublease structure is facially similar to a SILO sale-leaseback, except that the taxpayer acquires a long-term leasehold interest, rather than on ownership interest, the property, and claims deductions for rent rather than for depreciation.

Rent to EZH under the LILO head lease was prepaid for the first six years in the amount of $120 million, for which the trust used $39 million of cash and a 7% nonrecourse loan of $81 million from a subsidiary of ABN-AMRO, a Dutch bank. The only other rent payment to EZH, due in 44 years, was $832 million. Rent to Con Ed trust under the sublease was roughly $7 million per year. All rent payments were economically defeased through accounts maintained by EZH with ABN-AMRO Bank. That is, at closing EZH set up cash collateral accounts at ABN-AMRO in the amount of $81 million to provide a funding source for a portion of its future rent payment obligations. EZH also maintained a U.S. account containing $30 million of stripped Treasury securities for the benefit of Con Ed trust (equity collateral). The $9 million difference between the $120 million and the $111 million set aside was the net cash benefit realized by EZH on the closing date.

Three Options

There were three options at the end of the 20-year sublease term: the purchase option, the sublease renewal option, and the retention option. The purchase option allowed EZH to buy out the remainder of Con Ed trust's head lease term for $215 million, which exceeded the expected fair market value of the plant. If EZH exercised this option, it could fund the purchase with the amounts remaining in the defeasance accounts and Treasury securities. If EZH did not exercise its purchase option, those funds would revert to EZH.

The sublease renewal option would require EZH to renew the sublease for another 17 years, still not quite the full head lease term. Renewal rents were set at 90% of the projected fair rental value. EZH could use the balances in the defeasance accounts to fund its renewal period rent payments, and was required to maintain a letter of credit. EZH also would be required to find new financing for ABN-AMRO's loan to Con Ed trust. The latter would be required to collateralize its final $832 million rent payment under the head lease. At the end of the renewal period, Con Ed would still have a seven year “shirt-tail” remaining under its head lease, during which period Con Ed would have effective ownership and operating risk.

The retention option would allow Con Ed trust to keep the plant until the end of the 44-head lease term. Con Ed trust would be required to collateralize its final $832 million rent payment under the head lease. Con Ed trust would have ownership and operating risk under the retention option for the period from 2018 to 2044.

Agreement Before the Trial

Before the trial, the parties agreed that there were three issues to be decided: 1) whether the form of the transaction would be respected for tax purposes; 2) whether the ABN-AMRO nonrecourse loans should be respected; and 3) whether the transaction had economic substance. As in all tax refund suits, the taxpayer bore the burden of proof on all three issues. The court decided all three in favor of the taxpayer.

The court adopted the “economic substance” test, previously used by the Federal Circuit Court in Coltec Industries v. United States , 464 F.3d 1340 (Fed. Cir. 2006). In Coltec, the Federal Circuit (to which the Con Ed decision can be appealed) ruled that the economic substance of a transaction must be viewed objectively rather then subjectively. A transaction will be disregarded only if it both lacks economic substance and is motivated solely by tax avoidance. The economic substance prong of this test is an “objective determination of whether a reasonable possibility of profit from the transaction existed” at the time the taxpayer entered into the transaction. The court weighed evidence presented on this issue, including the expected residual value of the plant after the sublease term, and concluded that under any scenario ' exercise of purchase option, renewal option or retention option, the taxpayer stood to derive a reasonable pre-tax profit from the transaction. The court also found that in applying the objective pre-tax profit test, discounting of future cash flows (including the expected residual value of the leased asset) is not required. The opportunity to make a higher profit with other investments is not evidence that the transaction in question is not profitable.

'Substance over Form'

The court then turned to what would be the key issue in the case. Addressing the question in the context of “substance over form,” the court asked whether Con Ed trust acquired the benefits and burdens or ownership of a long-term leasehold interest in the plant. The court first put to rest the government's theory that “circularity of funds” in a leveraged lease ' the fact that rents match debt service in timing and amount ' deprives the lessor of ownership. It is refreshing to find a LILO/SILO court finally acknowledge that this fact, tirelessly characterized by the IRS as evidence of a “sham,” is an accepted structural feature and a neutral factor in the ownership analysis. The court declined to ignore some 20 years of case law ' as the IRS and some courts have been inclined to do. Similarly, the court rejected the IRS's argument that the economic defeasance/collateralization of EZH's payment obligations nullified those obligations and the obligations of Con Ed trust to make payments on the nonrecourse loan. The court observed that the defeasance mitigated, but did not eliminate credit risk in the transaction, noting the recent receivership of a major German bank (AIG also comes to mind) and that EZH remains primarily liable for all sublease payment obligations. The court also found that credit enhancement of a lessee's payment obligations was a common occurrence and not the basis for disregarding a transaction.

The Ownership Issue

The key to understanding the benefits and burdens of ownership issue, the court decided, is whether the purchase option necessarily will be exercised by EZH at the end of the sublease term. The court took abundant testimony from expert witnesses on this question and concluded that the taxpayer had demonstrated that it was not certain that EZH would exercise its purchase option. The IRS's theory was that the taxpayer did not acquire a present leasehold interest because the plant would inevitably be returned to EZH at the end of the sublease term when EZH exercises its purchase option. EZH was certain to purchase, the IRS argued, because the option was a “cashless” option ' EZH had access to the defeasance accounts to fund the purchase, it necessarily would do so. The theory was rejected because EZH could recover the defeasance accounts and treasuries and apply them to fund the less expensive alternative renewal / retention options. The government's own expert admitted that the funds in the defeasance accounts belong to EZH and are not inevitably bound to fund the purchase option. Under the retention option, EZH would simply walk away with $123 million for its own use.

The government's experts conceded that it would be “pure speculation” to predict certain of the driving factors that would influence EZH's decision to be made 20 years in the future. Certainly one fact bearing on the court's conclusion was that the fixed option price was greater than the expected fair market value of the plant at the end of the sublease term. EZH's purchase option was not guaranteed to the exercised and therefore, the court concluded, “contrary to some other LILO cases,” the taxpayer had the benefits and burdens of ownership of a long term leasehold interest and the form of the transaction, and the deductions claimed by the taxpayer, are respected.

The court spent a fair amount of time demonstrating how a leasehold interest in a Dutch power generation facility was consistent with Con Edison's business operations, establishing a particularly convincing non-tax business purpose for the transaction. While Con Ed's ability to itself own, operate and exploit a power plant certainly enhanced its story, it would be difficult to conclude that this factor was the deciding factor in the judge's opinion. Another business purpose cited is the beneficial financial accounting treatment for lessors in leveraged leasing transactions. The court noted “numerous business purposes” and that the government failed to establish that the transaction was motivated “solely” by tax consequences.

The Future

How does this case compare with AWG and BB&T, and what does it portend for the future? The BB&T case is of little precedential value. The court found that the lessee was certain to exercise its purchase option without a trial of that issue of fact. The court simply granted the government's motion for summary judgment and its opinion is largely a reiteration of the government's brief in the case. The taxpayer never had the opportunity to present a case.

That leaves AWG. The Con Edison court gave careful consideration to the decision in AWG, but like BB&T, was readily able to distinguish it. The AWG court determined that it was a “near certainty” that the lessee will exercise its purchase option, and the court's analysis of “near certainty” was the most important reason for the conclusion that the taxpayer did not acquire the benefits and burdens or ownership. In Con Edison, the taxpayer met its burden of proof on this issue.

Conclusion

Each tax case, and each LILO or SILO case, must undergo a very fact-specific analysis. So far, only the AWG and Con Edison cases have undergone that analysis in front of a judge. In AWG, the taxpayer was unable to establish that the lessee's alternatives to the purchase option were alternatives that would be economically and politically feasible for the lessee. In Con Edison, the taxpayer met that burden of proof. In AWG, the taxpayer's case suffered slightly from the cross-border nature of the deal. In Con Edison, the taxpayer's being in the same industry as the lessee enhanced its business purpose and the residual value of the asset. Most investors in LILO and SILO transactions were banks, not industrial companies.

Wells Fargo Bank, one such investor, completed the trial of its SILO case earlier this year. The case is before the same court as Con Edison, and the taxpayer is represented by the same legal team. The Wells Fargo case involves domestic SILO transactions involving rolling stock and other equipment leased to municipal transit agencies in the United States. Like AWG, it involves a bank lessor in a lease-to-service contract transaction. But the similarities may be outshined by the differences: The Wells Fargo deals were domestic transactions without any cross-border “hair.”

The transactions were also actively encouraged by the Federal Transit Administration as a financing alternative for urban transit agencies. What is a bank doing in the business of running a subway car? It is not in the business of running them, but financing them, just like the bank lessor in the famous Supreme Court case Frank Lyon. Every case will turn on its facts. Stay tuned for the next (but not final) chapter.