LILOs and SILOs: The Final Chapter?

If the tax-exempt lessee chooses not to exercise its purchase option, the taxpayer can elect either the “return option,” under which the taxpayer takes possession and control of the asset immediately, or the “service contract option.” Under the service contract option, the tax-exempt entity is required to arrange for the continued operation of the asset under a third-party service contract and satisfy other conditions. Under either option, the lessee receives the balance of the funds in the two accounts.

SILOs offer three tax benefits to the taxpayer. First, as owner of the asset for tax purposes, the taxpayer may take depreciation deductions on the asset, although, because the lessee is tax-exempt, the deductions are straight-line under the “Pickle rule.” Second, the taxpayer may take deductions for interest on the nonrecourse loan. Third, the taxpayer may deduct certain transaction costs associated with the transaction. If the lessee exercises its purchase option, or if the asset is ultimately sold to a third party, these tax benefits are offset at the end of the lease by taxes owed on the taxpayer's gain from the sale of the asset.

A Long-Running Battle

SILOs evolved in response to a long-running battle among Congress, the IRS, and enterprising taxpayers regarding the boundaries of permissible leasing of tax-exempt property to generate tax benefits. In 1981, Congress enacted “safe-harbor leasing rules” that allowed taxpayers to lease property from tax-exempt entities. The safe-harbor rules, however, were quickly repealed the following year. In 1984, Congress enacted the so-called “Pickle rule,” which provides that property leased from a tax-exempt entity would be depreciated at a slower rate than other property in order to limit the tax benefits generated by such transactions. Taxpayers then began to employ creative strategies to avoid the Pickle rule and receive greater tax benefits from the property of tax-exempt entities. The Federal Transit Administration at various times promoted SILOs (and their predecessor, LILOs) as a means of providing cash infusions for financially troubled public transit agencies. In 2004, Congress put an end to the tax benefits generated from SILO transactions by amending the Internal Revenue Code (see ' 470).

From 1997 to 2003, Wells Fargo entered into several SILO transactions with tax-exempt entities. For tax year 2002, Wells Fargo claimed $115 million in deductions based on 26 SILO transactions. When the IRS denied the deductions, Wells Fargo paid the disputed amount and filed a refund suit in the Court of Federal Claims. Before trial, the parties agreed to let the court's disposition of five representative SILO transactions guide the resolution of the entire claim. Four of these representative transactions involved leases of passenger trains to domestic transit agencies, and one transaction was a QTE transaction involving cellular telecommunications equipment owned by Belgacom.

The Court of Federal Claims' Decision

Following a four-week bench trial addressing the five representative SILO transactions, the Court of Federal Claims denied Wells Fargo's claim in its entirety. See Wells Fargo Company v. United States, 91 Fed. Cl. 35 (Fed. Cl. 2010) and my analysis of that decision, “Taxpayer Suffers SILO (Pre-Tax) Loss in Wells Fargo,” LJN's Equipment Leasing Newsletter, March 2010. In so ruling, the court found that transactions had to be disregarded for tax purposes under both the “substance-over-form” doctrine and the “economic substance” doctrine. The trial court found that the transactions in substance never transferred the benefits and burdens of ownership to the taxpayer because as a factual matter the lessees were virtually certain to exercise their purchase options. The trial court also found that the transactions lacked economic substance because the taxpayer failed to demonstrate that it had a reasonable expectation of pre-tax profit.

On Appeal

On appeal, Wells Fargo argued that the trial court: 1) employed an inappropriate mathematical test to determine that the lessees were economically compelled to exercise their purchase options; and 2) in applying economic substance principles, used the wrong test to measure pretax profit and misapplied the “nontax business purpose” test. The first argument is directed to the “substance-over-form” doctrine. The remaining arguments relate to the “economic substance” doctrine. The Circuit Court affirmed the trial court's decision on “substance-over-form” and never reached the economic substance issues.

Seeking to undermine the trial court's finding that the lessees were highly likely to exercise the purchase options, Wells Fargo challenged the testimony of the government's expert on financial economics. When the lessees make the decision whether to exercise their purchase options, they will compare the economic costs and benefits and burdens of exercising the option with the economic costs and benefits of the alternative options. Prior to closing the transactions at issue, Wells Fargo's appraisers analyzed the expected benefits to the lessee from the purchase option and the service contract option. The appraisers concluded that the respective benefits and costs of the two options would be such that the lessees would not be under any economic compulsion to exercise the purchase option. The government's expert conducted the same analysis but came to the opposite conclusion.

The crux of the disagreement between the government's expert and the appraisers is the discount rate that the tax-exempt entity would apply in calculating the net present value of its alternatives at the decision point. The appraisers selected the weighted average cost of capital (“WACC”) prevailing in the industry sector in which the lessee operated (e.g., the rail industry) as the discount rate that the entity would use to compare net present values of the purchase and service contract options. The government used a discount rate equal to the rate at which the tax-exempt entity could borrow funds (a lower rate than the WACC). Wells Fargo's expert, however, testified that the use of the debt rate as the discount rate “violate[d] a fundamental tenet of finance.”

The Circuit Court held that the question of likelihood of exercise did not turn exclusively on resolution of the discount rate issue. Other witness testimony demonstrated that the options were virtually certain to be exercised. An urban public transportation expert testified that the transit agencies were “very likely” to exercise their purchase options due to the uncertainty and potential difficulties of complying with the service contract option requirements within a short time frame. The witness testimony regarding the four transit agency SILOs was supported by documentary evidence. Prior to the closing of the transactions, Wells Fargo did obtain written expert opinions as to the feasibility of the service contract option to the effect that the requirements were not so onerous as to cause the lessee to be practically compelled to exercise the purchase option. However, it does not appear that convincing evidence was provided at trial.

In light of the extensive witness testimony and documentation relied on by the trial court, even in the absence of the government's economic analysis of the transactions, the Circuit Court found that the trial court had compelling evidence of the very high likelihood that the lessees would exercise their purchase options. The trial court did not clearly err in concluding that the lessees were virtually certain to repurchase the assets and that in substance the taxpayer never acquired ownership of the assets.

Prior to Wells Fargo

Prior to the decision in Wells Fargo, a number of courts disallowed deductions claimed in LILO and SILO transactions between taxpayers and tax-exempt entities. BB&T Corp. v. United States, 523 F.3d 461 (4th Cir. 2008), rehearing denied (4th Cir. June 27, 2008); AWG Leasing Trust, 592 F. Supp. 2d 953 (N.D. Ohio 2008); Altria Group, Inc. v. United States, 694 F. Supp. 2d 259 (S.D.N.Y. 2010).

The sole exception is Consolidated Edison Co. v. United States, 90 Fed. Cl. 228 (2009), a case still awaiting final judgment. In Consolidated Edison, the Court of Federal Claims allowed deductions in a LILO transaction after finding that it was uncertain whether the tax-exempt entity would exercise its option to repurchase the leased assets. Whether that finding was supported by the evidence and whether the Consolidated Edison court applied the correct legal standard on the issue of probability are not questions addressed by the Wells Fargo case. Clearly, the finders of fact in that case and in Wells Fargo reached different conclusions regarding the likelihood of the tax-exempt lessee exercising its purchase option.

None of these cases resolve the “economic substance” issues raised by the taxpayer on appeal in Wells Fargo, but never addressed by the Circuit Court. The trial court held ' somewhat gratuitously in light of its finding as to tax ownership ' that the taxpayer also failed to demonstrate that the transactions were reasonably expected to generate pre-tax profit. The issue again turned on discount rate ' whether the pre-tax profit must be measured on a present value basis, and if so, what discount rate is applicable. Until this decision, no case had required that cash flows be discounted for purposes of demonstrating expected pre-tax profit. The issue has been rendered somewhat moot by the enactment of ' 7701(o) ' the so-called statutory codification of the economic substance doctrine. For transactions entered into after March 30, 2010, taxpayers cannot rely on pre-tax profit to demonstrate economic substance unless the present value of the reasonably expected pre-tax profit from the transaction is substantial in relation to the present value of the expected net tax benefits that would be allowed if the transaction were respected. To date, the Treasury Department has not issued and does not intend to issue guidance as to the application of these present value principles.

Tune in Next Time

The final chapter in the SILO saga? Possibly, but not likely. Although no appeal has been filed in the Consolidated Edison case, the taxpayer has filed a notice of appeal in the Altria Group case, to the Second Circuit. Finally, a case involving SILOs done by Union Bank of California was set to go to trial when the trial judge stayed the action pending the outcome of the Wells Fargo appeal. UnionBanCal Corporation & Subsidiaries v. United States (Fed Ct Cl., No.06-587C), June 9, 2010. In granting the government the stay, the court stated: “The Federal Circuit's decision [in Wells Fargo] will most likely help clarify and simplify evidence to be presented at trial and will conserve judicial resources.” Did it? Tune in next time.

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.renewableinsights.com.

In what may be the final chapter in the years of litigation over tax-exempt entity leasing transactions, the Circuit Court of Appeals affirmed the Federal Claims Court's decision disallowing Wells Fargo's deductions from SILO transactions. Wells Fargo & Company v. United States, Fed. Cir. 2010-5108 (April 15, 2011). For your recollection, in a sale-in, lease-out (“SILO”) transaction the tax-exempt entity sells an asset it owns to the taxpayer. The taxpayer leases the asset back to the tax-exempt entity for a term less than the asset's remaining useful life. The lease is a net lease, meaning that the tax-exempt entity is responsible for all expenses normally associated with ownership of the asset. (In lieu of a sale, the tax-exempt entity may retain legal title to the asset and sell the property (for tax purposes) via a head lease for a term extending beyond the remaining useful life of the asset.)

The taxpayer funds the asset purchase price in part with its own funds and in part with a nonrecourse loan. The lessee places 95% of the proceeds in two cash collateral accounts, one for the taxpayer's equity portion and one for the debt portion. Each account generates investment income and sufficient cash to fund the lessee's rent payment obligations, which fund the lessor's debt service on the debt. The payment obligations are economically “defeased” ' dedicated funds are set aside for the purpose of paying the obligations.

At the end of the lease term, the lessee has the option to purchase the asset for a fixed price. The purchase option price is fixed at the beginning of the transaction, and is set at an appraiser's estimate of the expected fair market value of the property at the time the option is exercisable. If the lessee exercises its option to repurchase the asset, the funds in the collateral account are sufficient to fund the purchase.

If the tax-exempt lessee chooses not to exercise its purchase option, the taxpayer can elect either the “return option,” under which the taxpayer takes possession and control of the asset immediately, or the “service contract option.” Under the service contract option, the tax-exempt entity is required to arrange for the continued operation of the asset under a third-party service contract and satisfy other conditions. Under either option, the lessee receives the balance of the funds in the two accounts.

SILOs offer three tax benefits to the taxpayer. First, as owner of the asset for tax purposes, the taxpayer may take depreciation deductions on the asset, although, because the lessee is tax-exempt, the deductions are straight-line under the “Pickle rule.” Second, the taxpayer may take deductions for interest on the nonrecourse loan. Third, the taxpayer may deduct certain transaction costs associated with the transaction. If the lessee exercises its purchase option, or if the asset is ultimately sold to a third party, these tax benefits are offset at the end of the lease by taxes owed on the taxpayer's gain from the sale of the asset.

A Long-Running Battle

SILOs evolved in response to a long-running battle among Congress, the IRS, and enterprising taxpayers regarding the boundaries of permissible leasing of tax-exempt property to generate tax benefits. In 1981, Congress enacted “safe-harbor leasing rules” that allowed taxpayers to lease property from tax-exempt entities. The safe-harbor rules, however, were quickly repealed the following year. In 1984, Congress enacted the so-called “Pickle rule,” which provides that property leased from a tax-exempt entity would be depreciated at a slower rate than other property in order to limit the tax benefits generated by such transactions. Taxpayers then began to employ creative strategies to avoid the Pickle rule and receive greater tax benefits from the property of tax-exempt entities. The Federal Transit Administration at various times promoted SILOs (and their predecessor, LILOs) as a means of providing cash infusions for financially troubled public transit agencies. In 2004, Congress put an end to the tax benefits generated from SILO transactions by amending the Internal Revenue Code (see ' 470).

From 1997 to 2003, Wells Fargo entered into several SILO transactions with tax-exempt entities. For tax year 2002, Wells Fargo claimed $115 million in deductions based on 26 SILO transactions. When the IRS denied the deductions, Wells Fargo paid the disputed amount and filed a refund suit in the Court of Federal Claims. Before trial, the parties agreed to let the court's disposition of five representative SILO transactions guide the resolution of the entire claim. Four of these representative transactions involved leases of passenger trains to domestic transit agencies, and one transaction was a QTE transaction involving cellular telecommunications equipment owned by Belgacom.

The Court of Federal Claims' Decision

Following a four-week bench trial addressing the five representative SILO transactions, the Court of Federal Claims denied Wells Fargo's claim in its entirety. See Wells Fargo Company v. United States , 91 Fed. Cl. 35 (Fed. Cl. 2010) and my analysis of that decision, “Taxpayer Suffers SILO (Pre-Tax) Loss in Wells Fargo,” LJN's Equipment Leasing Newsletter, March 2010. In so ruling, the court found that transactions had to be disregarded for tax purposes under both the “substance-over-form” doctrine and the “economic substance” doctrine. The trial court found that the transactions in substance never transferred the benefits and burdens of ownership to the taxpayer because as a factual matter the lessees were virtually certain to exercise their purchase options. The trial court also found that the transactions lacked economic substance because the taxpayer failed to demonstrate that it had a reasonable expectation of pre-tax profit.

On Appeal

On appeal, Wells Fargo argued that the trial court: 1) employed an inappropriate mathematical test to determine that the lessees were economically compelled to exercise their purchase options; and 2) in applying economic substance principles, used the wrong test to measure pretax profit and misapplied the “nontax business purpose” test. The first argument is directed to the “substance-over-form” doctrine. The remaining arguments relate to the “economic substance” doctrine. The Circuit Court affirmed the trial court's decision on “substance-over-form” and never reached the economic substance issues.

Seeking to undermine the trial court's finding that the lessees were highly likely to exercise the purchase options, Wells Fargo challenged the testimony of the government's expert on financial economics. When the lessees make the decision whether to exercise their purchase options, they will compare the economic costs and benefits and burdens of exercising the option with the economic costs and benefits of the alternative options. Prior to closing the transactions at issue, Wells Fargo's appraisers analyzed the expected benefits to the lessee from the purchase option and the service contract option. The appraisers concluded that the respective benefits and costs of the two options would be such that the lessees would not be under any economic compulsion to exercise the purchase option. The government's expert conducted the same analysis but came to the opposite conclusion.

The crux of the disagreement between the government's expert and the appraisers is the discount rate that the tax-exempt entity would apply in calculating the net present value of its alternatives at the decision point. The appraisers selected the weighted average cost of capital (“WACC”) prevailing in the industry sector in which the lessee operated (e.g., the rail industry) as the discount rate that the entity would use to compare net present values of the purchase and service contract options. The government used a discount rate equal to the rate at which the tax-exempt entity could borrow funds (a lower rate than the WACC). Wells Fargo's expert, however, testified that the use of the debt rate as the discount rate “violate[d] a fundamental tenet of finance.”

The Circuit Court held that the question of likelihood of exercise did not turn exclusively on resolution of the discount rate issue. Other witness testimony demonstrated that the options were virtually certain to be exercised. An urban public transportation expert testified that the transit agencies were “very likely” to exercise their purchase options due to the uncertainty and potential difficulties of complying with the service contract option requirements within a short time frame. The witness testimony regarding the four transit agency SILOs was supported by documentary evidence. Prior to the closing of the transactions, Wells Fargo did obtain written expert opinions as to the feasibility of the service contract option to the effect that the requirements were not so onerous as to cause the lessee to be practically compelled to exercise the purchase option. However, it does not appear that convincing evidence was provided at trial.

In light of the extensive witness testimony and documentation relied on by the trial court, even in the absence of the government's economic analysis of the transactions, the Circuit Court found that the trial court had compelling evidence of the very high likelihood that the lessees would exercise their purchase options. The trial court did not clearly err in concluding that the lessees were virtually certain to repurchase the assets and that in substance the taxpayer never acquired ownership of the assets.

Prior to Wells Fargo

Prior to the decision in Wells Fargo, a number of courts disallowed deductions claimed in LILO and SILO transactions between taxpayers and tax-exempt entities. BB&T Corp. v. United States , 523 F.3d 461 (4th Cir. 2008), rehearing denied (4th Cir. June 27, 2008); AWG Leasing Trust, 592 F. Supp. 2d 953 (N.D. Ohio 2008); Altria Group, Inc. v. United States , 694 F. Supp. 2d 259 (S.D.N.Y. 2010).

The sole exception is Consolidated Edison Co. v. United States , 90 Fed. Cl. 228 (2009), a case still awaiting final judgment. In Consolidated Edison, the Court of Federal Claims allowed deductions in a LILO transaction after finding that it was uncertain whether the tax-exempt entity would exercise its option to repurchase the leased assets. Whether that finding was supported by the evidence and whether the Consolidated Edison court applied the correct legal standard on the issue of probability are not questions addressed by the Wells Fargo case. Clearly, the finders of fact in that case and in Wells Fargo reached different conclusions regarding the likelihood of the tax-exempt lessee exercising its purchase option.

None of these cases resolve the “economic substance” issues raised by the taxpayer on appeal in Wells Fargo, but never addressed by the Circuit Court. The trial court held ' somewhat gratuitously in light of its finding as to tax ownership ' that the taxpayer also failed to demonstrate that the transactions were reasonably expected to generate pre-tax profit. The issue again turned on discount rate ' whether the pre-tax profit must be measured on a present value basis, and if so, what discount rate is applicable. Until this decision, no case had required that cash flows be discounted for purposes of demonstrating expected pre-tax profit. The issue has been rendered somewhat moot by the enactment of ' 7701(o) ' the so-called statutory codification of the economic substance doctrine. For transactions entered into after March 30, 2010, taxpayers cannot rely on pre-tax profit to demonstrate economic substance unless the present value of the reasonably expected pre-tax profit from the transaction is substantial in relation to the present value of the expected net tax benefits that would be allowed if the transaction were respected. To date, the Treasury Department has not issued and does not intend to issue guidance as to the application of these present value principles.

Tune in Next Time

The final chapter in the SILO saga? Possibly, but not likely. Although no appeal has been filed in the Consolidated Edison case, the taxpayer has filed a notice of appeal in the Altria Group case, to the Second Circuit. Finally, a case involving SILOs done by Union Bank of California was set to go to trial when the trial judge stayed the action pending the outcome of the Wells Fargo appeal. UnionBanCal Corporation & Subsidiaries v. United States (Fed Ct Cl., No.06-587C), June 9, 2010. In granting the government the stay, the court stated: “The Federal Circuit's decision [in Wells Fargo] will most likely help clarify and simplify evidence to be presented at trial and will conserve judicial resources.” Did it? Tune in next time.

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.renewableinsights.com.