Taxpayer Suffers SILO (Pre-tax) Loss in Wells Fargo

In our January 2010 report in this newsletter, we examined the Consolidated Edison LILO case, in which Judge Marian Blank Horn of the Court of Federal Claims resisted the government's urging to categorize all LILO and SILO transactions as “abusive corporate tax shelters.” The judge resisted the temptation to simply adopt the IRS' hyperbole as gospel and the text of the government's brief as the court's opinion. Instead, Judge Horn engaged in an objective approach to the facts, exhibits, and witnesses, and applied and analyzed the principles of law in light of the facts presented. Quite differently, the judge in Wells Fargo appears to have been quite predisposed to the government's position, and adopted it without significant analysis. Even worse, the court applied a quantitative test for demonstrating pre-tax profit (and “economic substance”) that lacks support in case law or IRS guidance, and which if adopted more generally could allow the IRS challenge of a host of transactions that taxpayers reasonably believe will produce a positive cash-on-cash return apart from tax benefits.

The Con Edison decision proved that there are “good” and “bad” LILOs and SILOs. Based on that case, a fully economically defeased transaction where the lessee has a fixed-price purchase option can be sustained if the taxpayer can demonstrate that it acquired the benefits and burdens of ownership and the transaction satisfies requirements for “economic substance.” The ownership issue is framed under the “substance over form” doctrine, and the taxpayer can meet its burden by showing that the lessee's purchase option is not reasonably certain to be exercised. The economic substance issue is resolved in the taxpayer's favor if it can demonstrate that it reasonably expected to earn a profit from the transaction aside from the value of the tax benefits associated with it.

The Wells Fargo Case

In the Wells Fargo case the taxpayer and the IRS tried five SILO transactions, allowing the court's ruling on these five to guide the resolution of several more transactions at issue. Four transactions are lease-to-service contract financings with domestic municipal transit agencies for passenger trains or buses. One transaction was a sale-leaseback of “qualified technological equipment” (“QTE”) with a state-supported European telecommunications company. With five different transactions at issue, the court was given the opportunity to segregate the “good” from the “bad” transactions by engaging in the critical factual analysis we saw in Con Ed. The court was also burdened by the considerable discovery and trial work involved for five complex transactions, let alone one. But the court found little merit in the taxpayer's defense of all five transactions. The court found for the government in all five cases, and disposed of five cases in a 71-page opinion, whereas in Con Edison it took Judge Horn more than 125 pages to present a critical, well-reasoned analysis of a single transaction.

Ignoring Arguments and Witnesses

The opinion in Wells Fargo is more or less a reiteration of the government's brief and when read in light of the briefs produced for trial, discloses a penchant for simply ignoring the taxpayer's arguments and witnesses. Thus, the court adopts the government's fallacious argument that because the lessee has set aside funds that it can use to exercise a fixed price purchase option, the lessee is compelled to exercise that option. Statements to the effect that the lessee “pays nothing” or “does not need to use any of its own funds” to exercise the purchase option simply ignore the fact that the monies set aside (the defeasance accounts) are the lessee's own funds ' that money belongs to the lessee, and will revert to the lessee if it does not exercise the purchase option. The government's own witness acknowledged that if a lessee decided to use the defeasance accounts to purchase new railcars, that purchase would be no more or less “cashless” than its use of the money to exercise the purchase option.

This hyperbole begs the question: Is it virtually certain that the lessee will use the money in the defeasance account to exercise the purchase option, or is it as likely that the lessee would return the leased equipment to the lessor and use the money in the defeasance account to fund other alternatives? Those alternatives could include purchasing new or used equipment with that money, or entering into an arrangement where the funds are used to pay a third party to operate the leased equipment under a service contract.

For each transaction the taxpayer demonstrated that the purchase option price exceeds the projected value of the equipment, so exercise of the option certainly is not compelled for being “in the money.” But for each transaction the court held that notwithstanding that the lessee would be paying more for the equipment than it is expected to be worth, the lessee was still virtually certain to exercise the option because the alternatives to the option will be too expensive or onerous and ultimately less economic to the lessee. A review of the trial record reveals, however, that the judge either ignored entirely or discounted without justification mounds of evidence to the contrary.

In the case of the lease-to-service contract transactions, the taxpayer presented testimony of representatives of the transit agencies that they had not made any decision regarding the exercise of the purchase options ' they testified as to the inherent uncertainty in any attempt to speculate on whether a purchase option would be exercised some 20 years in the future. The taxpayer presented and the IRS failed to rebut evidence that the cost to the lessees of purchasing the leased equipment exceeded the probable costs to the lessees of exercising other alternatives. The government attempted to create an issue out of the fact that the lessee was required to notify the lessor of whether it would exercise the purchase option only a year before the lease expired ' that this did not give the transit agency enough time to decide on whether to buy the leased equipment or use the defeasance funds to buy or lease other railcars. But, as noted by the taxpayer, the expectation was that the transit agencies would be making their alternative plans well in advance of the notice date, which the IRS' own experts confirmed. Indeed, one transit agency official testified that the agency was planning to replace the railcars currently leased from the taxpayer, and so did not plan to exercise the purchase option. Other arguments made by the government ' that the service contract option was not feasible or not consistent with market practice ' were rebutted by rail industry expert witnesses whose testimony is completely ignored in the opinion. In fact, three of the four transit agencies at issue already employed third-party operator service contracts in their current operations. In short, the trial record does not support the conclusion that the service contract alternative compelled the lessees to exercise the purchase option.

The Belgacom Transaction

The Belgacom transaction is the first QTE transaction to be considered by a court. Unlike the transit agency cases, it does not have a service contract option. At the end of the lease term, the lessee's choice is to either buy the equipment, renew the lease, or return the equipment and replace it with other equipment. The defeasance funds belong to the lessee for any of these purposes. The government argued (and the court concluded) that the return conditions were “onerous” and compelled the exercise of the purchase option. The court concluded that the requirement that the lessee return computer equipment installed with the most recent hardware and software releases from the equipment manufacturer was “onerous.” This conclusion ignores the evidence in the record, including the government's own witnesses. I would expect that for a major telecoms company like Belgacom, these kinds of upgrades are standard operating procedure, not onerous. Both taxpayer and government witnesses testified that it would be impossible to predict whether Belgacom would exercise its purchase option, and that the return conditions would not influence that decision.

To further support its conclusion that in substance the taxpayer did not possess the benefits and burdens of ownership, the court resorted to that litany of features common to all sale-leasebacks that the IRS argues negate the taxpayer's claim to ownership ' that the lessee remains responsible for maintenance and insurance, the use of non-recourse debt, and that rents match debt service. Interestingly, the court in Con Edison concluded that while all of these features were present in that case, they did not vitiate the taxpayer's claim to ownership. How could two judges reviewing the same features in two comparable transactions reach such different conclusions? The answer is that one followed case law precedent and the other did not.

The court also endorsed the IRS' claim that the defeasance arrangements, purchase option, and service contract option all served to eliminate “financial risk of loss” of the taxpayer's investment. But the court ignored the fact that at the end of the lease term, and even at the end of the service contract period, there remains an expected significant residual value to which the taxpayer remains at risk. Further, the court fails to appreciate that defeasance arrangements do not eliminate credit risk. Lessees can become insolvent, and can fail to obtain appropriations to fund rent payments. The parties with whom the lessees placed their defeasance accounts ' AIG, Ambac, and others ' can also default. Many transit agencies have, in fact, been required to replace or upgrade the collateral for their transactions as a result of defeasance parties' downgrades and defaults. To argue that these arrangements eliminated the taxpayer's credit risk is to ignore the painful reality of the financial markets' instability over the last two years. As the judge in Con Edison stated, the defeasance accounts “reduce credit risk” but “do not defeat true lease status.” Again, how could two judges reviewing the same defeasance feature in two comparable transactions reach such different conclusions?

A Gratuitous Detour

Perhaps the most damage done to the law in this decision relates to the “economic substance” doctrine and the court's frolic and detour in the area of pre-tax profit. This was a gratuitous detour because the court could have ignored the issue and decided the case solely on the grounds that the taxpayer did not acquire the benefits and burdens of ownership under the “substance over form” doctrine. In AWG Leasing Trust, for example, the court held that the transaction failed under substance over form principles, but that the transaction had economic substance because the taxpayer demonstrated that under any end-of-term scenario, the taxpayer was reasonably likely to earn a pre-tax profit. Instead of going that route, the court seized on the testimony of one government witness to create a test for calculating pre-tax profit that has no support in case law or IRS guidance. None of the transactions at issue in this case could pass this test, but I suspect that neither could hundreds of other customary transactions in the market ' not just in leasing or asset finance but in any financial arena. Under the traditional test endorsed by the courts and the IRS, positive pre-tax profit is present for “economic substance” purposes when the sum of the cash in over the term of the transaction exceeds the sum of the cash out, determined without present valuing the cash flows back to the closing date. This is the precedent in the Court of Federal Claims (including the Con Edison case), and is the test adopted by every court to consider the issue in a SILO or LILO case. This is also the test used by the IRS to determine whether a pre-tax profit exists for purposes of its leveraged leasing advance ruling guidelines.

The Wells Fargo judge's test first requires that cash flows be discounted (present valued) back to the closing date. In a leveraged lease, where the cash flows in are highly back-loaded, this requirement will tend to diminish the value of the pre-tax cash. In addition, the judge required the taxpayer to reduce its cash flow by a completely hypothetical cost of funds to the taxpayer. Even though Wells Fargo did not actually borrow to fund its equity investment in these transactions, the court required its cash flow to be reduced by a fictional cost of funds. The combination of these two requirements ensured that under this methodology the taxpayer could not demonstrate positive pre-tax profit. However, under the traditional method, Wells' transactions were expected to produce profit and cash flow aside from the expected tax benefits in the range of 2% to 4%, which are within the range consistent with leveraged leasing transactions. Even the IRS' own advance ruling guidelines require only a nominal profit on a non-discounted cash-on-cash basis. The taxpayer presented expert witnesses and briefed the court on these issues, but the court seemingly ignored both the evidence and the legal precedent. The court's decision on substance over form is a fact-based one, highly dependent on the evaluation of expert testimony. The court's decision on economic substance is simply an inappropriate application of the law.

Not Yet Over

No, the story is not over. A number of LILO/SILO cases remain docketed, so we could still see decisions at the district court and Claims Court level. The Con Edison case and the Wells Fargo case can be appealed to the D.C. Circuit Court of Appeals. We will report on the next chapter here.

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]. Troutman Sanders represents market participants in a variety of equipment leasing and project finance transactions. For more information, visit www.troutmansanders.com.

Recently publicized budget cuts at the New York Metropolitan Transportation Authority (“MTA”) caused the closing of two subway lines and left thousands of New York City public-school children without the buses they usually take to school. Perhaps if Congress had not shut down SILOs in 2004, the MTA and many other major U.S. transit agencies would not be in such a financial bind. Thankfully, no one is asking the transits to disgorge the hundreds of millions of dollars of cash they raised doing LILOs and SILO sale-leaseback transactions on their railcars and buses. After all, their own regulator, the Federal Transit Administration, actively encouraged the transit agencies to engage in these “innovative financing transactions” (their name for SILOs). But that did not stop the IRS from litigating the tax benefits claimed by the banks and other corporations that provided the much-needed capital to the transit agencies in these transactions.

In Wells Fargo & Company v. United States, (Fed. Ct. Cl. No. 06-628T, Jan. 8, 2010), a court considered for the first time SILOs involving domestic municipal transit agency lessees. While one would have thought that the domestic and federally approved nature of the transactions would have some influence on the decision, they did not. The judge's decision and description of LILO and SILO transactions as “rotten to the core” reflect an unwelcome return to the result-oriented pro-government decision-making that has characterized most of the decided LILO/SILO cases.

The Consolidated Edison Case

In our January 2010 report in this newsletter, we examined the Consolidated Edison LILO case, in which Judge Marian Blank Horn of the Court of Federal Claims resisted the government's urging to categorize all LILO and SILO transactions as “abusive corporate tax shelters.” The judge resisted the temptation to simply adopt the IRS' hyperbole as gospel and the text of the government's brief as the court's opinion. Instead, Judge Horn engaged in an objective approach to the facts, exhibits, and witnesses, and applied and analyzed the principles of law in light of the facts presented. Quite differently, the judge in Wells Fargo appears to have been quite predisposed to the government's position, and adopted it without significant analysis. Even worse, the court applied a quantitative test for demonstrating pre-tax profit (and “economic substance”) that lacks support in case law or IRS guidance, and which if adopted more generally could allow the IRS challenge of a host of transactions that taxpayers reasonably believe will produce a positive cash-on-cash return apart from tax benefits.

The Con Edison decision proved that there are “good” and “bad” LILOs and SILOs. Based on that case, a fully economically defeased transaction where the lessee has a fixed-price purchase option can be sustained if the taxpayer can demonstrate that it acquired the benefits and burdens of ownership and the transaction satisfies requirements for “economic substance.” The ownership issue is framed under the “substance over form” doctrine, and the taxpayer can meet its burden by showing that the lessee's purchase option is not reasonably certain to be exercised. The economic substance issue is resolved in the taxpayer's favor if it can demonstrate that it reasonably expected to earn a profit from the transaction aside from the value of the tax benefits associated with it.

The Wells Fargo Case

In the Wells Fargo case the taxpayer and the IRS tried five SILO transactions, allowing the court's ruling on these five to guide the resolution of several more transactions at issue. Four transactions are lease-to-service contract financings with domestic municipal transit agencies for passenger trains or buses. One transaction was a sale-leaseback of “qualified technological equipment” (“QTE”) with a state-supported European telecommunications company. With five different transactions at issue, the court was given the opportunity to segregate the “good” from the “bad” transactions by engaging in the critical factual analysis we saw in Con Ed. The court was also burdened by the considerable discovery and trial work involved for five complex transactions, let alone one. But the court found little merit in the taxpayer's defense of all five transactions. The court found for the government in all five cases, and disposed of five cases in a 71-page opinion, whereas in Con Edison it took Judge Horn more than 125 pages to present a critical, well-reasoned analysis of a single transaction.

Ignoring Arguments and Witnesses

The opinion in Wells Fargo is more or less a reiteration of the government's brief and when read in light of the briefs produced for trial, discloses a penchant for simply ignoring the taxpayer's arguments and witnesses. Thus, the court adopts the government's fallacious argument that because the lessee has set aside funds that it can use to exercise a fixed price purchase option, the lessee is compelled to exercise that option. Statements to the effect that the lessee “pays nothing” or “does not need to use any of its own funds” to exercise the purchase option simply ignore the fact that the monies set aside (the defeasance accounts) are the lessee's own funds ' that money belongs to the lessee, and will revert to the lessee if it does not exercise the purchase option. The government's own witness acknowledged that if a lessee decided to use the defeasance accounts to purchase new railcars, that purchase would be no more or less “cashless” than its use of the money to exercise the purchase option.

This hyperbole begs the question: Is it virtually certain that the lessee will use the money in the defeasance account to exercise the purchase option, or is it as likely that the lessee would return the leased equipment to the lessor and use the money in the defeasance account to fund other alternatives? Those alternatives could include purchasing new or used equipment with that money, or entering into an arrangement where the funds are used to pay a third party to operate the leased equipment under a service contract.

For each transaction the taxpayer demonstrated that the purchase option price exceeds the projected value of the equipment, so exercise of the option certainly is not compelled for being “in the money.” But for each transaction the court held that notwithstanding that the lessee would be paying more for the equipment than it is expected to be worth, the lessee was still virtually certain to exercise the option because the alternatives to the option will be too expensive or onerous and ultimately less economic to the lessee. A review of the trial record reveals, however, that the judge either ignored entirely or discounted without justification mounds of evidence to the contrary.

In the case of the lease-to-service contract transactions, the taxpayer presented testimony of representatives of the transit agencies that they had not made any decision regarding the exercise of the purchase options ' they testified as to the inherent uncertainty in any attempt to speculate on whether a purchase option would be exercised some 20 years in the future. The taxpayer presented and the IRS failed to rebut evidence that the cost to the lessees of purchasing the leased equipment exceeded the probable costs to the lessees of exercising other alternatives. The government attempted to create an issue out of the fact that the lessee was required to notify the lessor of whether it would exercise the purchase option only a year before the lease expired ' that this did not give the transit agency enough time to decide on whether to buy the leased equipment or use the defeasance funds to buy or lease other railcars. But, as noted by the taxpayer, the expectation was that the transit agencies would be making their alternative plans well in advance of the notice date, which the IRS' own experts confirmed. Indeed, one transit agency official testified that the agency was planning to replace the railcars currently leased from the taxpayer, and so did not plan to exercise the purchase option. Other arguments made by the government ' that the service contract option was not feasible or not consistent with market practice ' were rebutted by rail industry expert witnesses whose testimony is completely ignored in the opinion. In fact, three of the four transit agencies at issue already employed third-party operator service contracts in their current operations. In short, the trial record does not support the conclusion that the service contract alternative compelled the lessees to exercise the purchase option.

The Belgacom Transaction

The Belgacom transaction is the first QTE transaction to be considered by a court. Unlike the transit agency cases, it does not have a service contract option. At the end of the lease term, the lessee's choice is to either buy the equipment, renew the lease, or return the equipment and replace it with other equipment. The defeasance funds belong to the lessee for any of these purposes. The government argued (and the court concluded) that the return conditions were “onerous” and compelled the exercise of the purchase option. The court concluded that the requirement that the lessee return computer equipment installed with the most recent hardware and software releases from the equipment manufacturer was “onerous.” This conclusion ignores the evidence in the record, including the government's own witnesses. I would expect that for a major telecoms company like Belgacom, these kinds of upgrades are standard operating procedure, not onerous. Both taxpayer and government witnesses testified that it would be impossible to predict whether Belgacom would exercise its purchase option, and that the return conditions would not influence that decision.

To further support its conclusion that in substance the taxpayer did not possess the benefits and burdens of ownership, the court resorted to that litany of features common to all sale-leasebacks that the IRS argues negate the taxpayer's claim to ownership ' that the lessee remains responsible for maintenance and insurance, the use of non-recourse debt, and that rents match debt service. Interestingly, the court in Con Edison concluded that while all of these features were present in that case, they did not vitiate the taxpayer's claim to ownership. How could two judges reviewing the same features in two comparable transactions reach such different conclusions? The answer is that one followed case law precedent and the other did not.

The court also endorsed the IRS' claim that the defeasance arrangements, purchase option, and service contract option all served to eliminate “financial risk of loss” of the taxpayer's investment. But the court ignored the fact that at the end of the lease term, and even at the end of the service contract period, there remains an expected significant residual value to which the taxpayer remains at risk. Further, the court fails to appreciate that defeasance arrangements do not eliminate credit risk. Lessees can become insolvent, and can fail to obtain appropriations to fund rent payments. The parties with whom the lessees placed their defeasance accounts ' AIG, Ambac, and others ' can also default. Many transit agencies have, in fact, been required to replace or upgrade the collateral for their transactions as a result of defeasance parties' downgrades and defaults. To argue that these arrangements eliminated the taxpayer's credit risk is to ignore the painful reality of the financial markets' instability over the last two years. As the judge in Con Edison stated, the defeasance accounts “reduce credit risk” but “do not defeat true lease status.” Again, how could two judges reviewing the same defeasance feature in two comparable transactions reach such different conclusions?

A Gratuitous Detour

Perhaps the most damage done to the law in this decision relates to the “economic substance” doctrine and the court's frolic and detour in the area of pre-tax profit. This was a gratuitous detour because the court could have ignored the issue and decided the case solely on the grounds that the taxpayer did not acquire the benefits and burdens of ownership under the “substance over form” doctrine. In AWG Leasing Trust, for example, the court held that the transaction failed under substance over form principles, but that the transaction had economic substance because the taxpayer demonstrated that under any end-of-term scenario, the taxpayer was reasonably likely to earn a pre-tax profit. Instead of going that route, the court seized on the testimony of one government witness to create a test for calculating pre-tax profit that has no support in case law or IRS guidance. None of the transactions at issue in this case could pass this test, but I suspect that neither could hundreds of other customary transactions in the market ' not just in leasing or asset finance but in any financial arena. Under the traditional test endorsed by the courts and the IRS, positive pre-tax profit is present for “economic substance” purposes when the sum of the cash in over the term of the transaction exceeds the sum of the cash out, determined without present valuing the cash flows back to the closing date. This is the precedent in the Court of Federal Claims (including the Con Edison case), and is the test adopted by every court to consider the issue in a SILO or LILO case. This is also the test used by the IRS to determine whether a pre-tax profit exists for purposes of its leveraged leasing advance ruling guidelines.

The Wells Fargo judge's test first requires that cash flows be discounted (present valued) back to the closing date. In a leveraged lease, where the cash flows in are highly back-loaded, this requirement will tend to diminish the value of the pre-tax cash. In addition, the judge required the taxpayer to reduce its cash flow by a completely hypothetical cost of funds to the taxpayer. Even though Wells Fargo did not actually borrow to fund its equity investment in these transactions, the court required its cash flow to be reduced by a fictional cost of funds. The combination of these two requirements ensured that under this methodology the taxpayer could not demonstrate positive pre-tax profit. However, under the traditional method, Wells' transactions were expected to produce profit and cash flow aside from the expected tax benefits in the range of 2% to 4%, which are within the range consistent with leveraged leasing transactions. Even the IRS' own advance ruling guidelines require only a nominal profit on a non-discounted cash-on-cash basis. The taxpayer presented expert witnesses and briefed the court on these issues, but the court seemingly ignored both the evidence and the legal precedent. The court's decision on substance over form is a fact-based one, highly dependent on the evaluation of expert testimony. The court's decision on economic substance is simply an inappropriate application of the law.

Not Yet Over

No, the story is not over. A number of LILO/SILO cases remain docketed, so we could still see decisions at the district court and Claims Court level. The Con Edison case and the Wells Fargo case can be appealed to the D.C. Circuit Court of Appeals. We will report on the next chapter here.

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]. Troutman Sanders represents market participants in a variety of equipment leasing and project finance transactions. For more information, visit www.troutmansanders.com.