In this tax refund suit, Altria Group, Inc. claims $24,337,623 in depreciation, interest, and transaction cost deductions for the tax years 1996 and 1997. The claimed deductions result from Altria’s participation in nine leveraged lease transactions with tax-indifferent entities. In each transaction, Altria leased a strategic asset from a tax-indifferent entity; immediately leased back the asset for a shorter sublease term; and provided the tax-indifferent entity a multimillion dollar “accommodation fee” for entering the transaction and a fully-funded purchase option to terminate Altria’s residual interest at the end of the sublease term. The Government described these transactions as tax shelters — or more precisely, as attempts by Altria to purchase unused tax deductions and transfer money from the public fisc to itself.
After an eleven-day trial before the District Court for the Southern District of New York (Holwell, /.), the jury found that Altria was not entitled to the claimed tax deductions. Applying the substance over form doctrine, the jury rejected Altria’s contention that it retained a genuine ownership or leasehold interest in the assets and therefore was entitled to the tax deductions. The district court denied Altria’s motion for judgment as a matter of law or for a new trial and entered judgment for the Government. Altria appeals, arguing, inter alia, that the district court erred in instructing the jury regarding the substance over form doctrine.
I.
Because this appeal “comes to us after a jury verdict, we view the facts of the case in the light most favorable to the prevailing party,” here, the Government.
Brady v. Wal-Mart Stores, Inc.,
A.
This appeal concerns tax deductions that Altria claimed in 1996 and 1997, and which the Internal Revenue Service (“IRS”) disallowed. Altria claimed the tax deductions after entering into nine leasing transactions, four of which the parties agreed to focus on at trial. Of these four transactions, three fit the structure of a “sale-in/sale-out” (“SILO”) transaction and one fits the structure of a “lease-in/lease-out” (“LILO”) transaction. See generally, e.g., Robert W. Wood & Steven E. Hollingworth, SILOs and LILOs Demystified, 129 Tax Notes 195 (Oct. 11, 2010) (defining and describing SILOs and LILOs); Maxim Shvedov, Cong. Research Serv., CRS Report for Congress: Tax Implications of SILOs, QTEs, and Other Leasing Transactions with Tax-Exempt Entities (2004), available at http://digital.library.unt.edu/ ark:/67531/metacrs6848 (last visited July 15, 2011) (same). Altria’s SILO and LILO transactions share three common features, described briefly below: (1) lease and leaseback; (2) debt financing and rent; and (3) options at sublease termination.
1.
In the four representative SILO and LILO transactions, Altria, a taxable entity, entered into a primary or “head” lease with a tax-indifferent entity, such as a government agency or foreign entity, for
The tax-indifferent entities could not themselves benefit from tax deductions derived from utilization of these assets. Altria, however, as a profitable taxable entity, could benefit from tax deductions resulting from use of those assets. Therefore, both Altria and the tax-indifferent entities would benefit from a transaction in which Altria was treated as the owner or lessee of the facility (taking full tax deductions and paying the tax-indifferent entity an “accommodation fee”); the tax-indifferent entity was able to continue free, uninterrupted use of its facility; and both parties’ economic risk of loss was minimized.
To allow the tax-indifferent entities to continue using the facilities, Altria immediately leased back each facility to the tax-indifferent entity, using a sublease. Each sublease had a shorter term than Altria’s corresponding head lease, but (as discussed below) at the end of the sublease period the tax-indifferent entity could repurchase the facility (terminating Altria’s head lease) using no funds of its own but exclusively funds that Altria had placed in escrow for that purpose. During the sublease periods, each tax-indifferent party had full operational control over the facility and was required to pay all insurance, maintenance, improvement, repair, and regulatory costs. As Altria described in a presentation at a worldwide Altria conference:
ALTHOUGH [ALTRIA] HAS THE TITLE AND IS THE OWNER OF THE ASSET,
THE LESSEE BEARS ALL THE COSTS AND RISKS OF OWNERSHIP DURING THE LEASE TERM.
2.
The financing for each of Altria’s SILO and LILO transactions principally entailed: (a) the head lease rent owed by Altria; (b) the sublease rent owed by the tax-indifferent entity; (c) the debt service obligations incurred by Altria to pay the head lease rent; and (d) an accommodation fee paid by Altria to the tax-indifferent entity.
To pay its head lease rent, Altria borrowed about 80% of the needed money through a nonrecourse loan. For the rest, Altria contributed its own cash. For each transaction, Altria paid the entire amount due under the head lease (which included the amount needed by the tax-indifferent entity to repurchase the facility at the conclusion of its sublease) in a single upfront payment.
Cf. Reisinger v. Comm’r,
For each transaction, Altria created a debt defeasance account and an equity defeasance account. Each debt defeasance account contained the money Altria borrowed for the transaction. Each equity
The undertaker of each debt defeasance account was responsible for using the funds to pay the tax-indifferent entity’s rent on its sublease. However, the debt undertaker did not pay the sublease rent directly to Altria, but to Altria’s lender to satisfy Altria’s debt service obligations on its nonrecourse loan. The sublease rent and the debt service obligations were set to match, in timing and amount, with very few exceptions. Thus, in each transaction the funds were transferred in a loop from the lender, to Altria (the nonrecourse loan), to the tax-indifferent entity (to pay the head lease rent), to the debt undertaker (to pay the sublease rent), and then back to the lender (to pay the debt service obligations). Because the debt undertaker and the lender were affiliates, the actual funds never even left the bank for the duration of the transaction. Moreover, the tax-indifferent entities could not control or access the funds in the debt defeasance account.
For each equity defeasance account, the cash contributed by Altria was invested in U.S. Treasury securities, in an apparent attempt to give the transaction a veneer of economic substance. David P. Hariton, Sorting Out the Tangle of Economic Substance, 52 Tax L. 235, 325-36 (1999) (noting it is always possible to produce a non-adjusted “profit” simply by including equity in a transaction). Altria prevented the tax-indifferent entities from accessing or exercising any control over the accounts during the sublease term. Even after their subleases ended, the tax-exempt entities had no entitlement to withdraw the funds, as discussed below.
3.
At the end of each sublease term, the SILO and LILO agreements provided the tax-indifferent entities with a unilateral option to (re)purchase the facilities at issue, thus terminating Altria’s remaining head lease interest. The agreements set the exercise price at a fixed amount, determined at the start of the transaction, equal to or greater than the property’s projected fair market value at the end of the sublease term. The purchase option was fully funded by the U.S. Treasury securities in the equity defeasance account, which would increase in value during the sublease term to precisely the purchase option price. If the tax-indifferent entity exercised the purchase option, the funds in the equity defeasance account would flow in a loop, like the funds in the debt defeasance account: from Altria, to the undertaker, back to Altria.
Under the SILO and LILO agreements, if the tax-indifferent entity did not exercise its fully-funded purchase option, Altria had three general options: (1) force the tax-indifferent entity to renew the sublease or enter into a service contract; (2) enter into a replacement sublease with a third party; or (3) take possession of the leased property. The options were designed to allow the tax-indifferent entity to retain control of the asset, while reducing Altria’s risk of economic loss.
This structure differs from a traditional leveraged lease in a number of ways. Because of the single-purpose nature of the
Altria was aware that for tax purposes it needed to maintain a genuine ownership or leasehold interest in the facilities. Thus, Altria obtained financial appraisals for each of the SILO and LILO transactions. At least one appraisal was not completed until years after the transaction, and none were shared with the tax-indifferent entities before the transactions. Each appraisal concluded that (1) the tax-indifferent entity would not exercise its fully-funded purchase option at the end of the sublease period; and (2) Altria would choose to enter into a replacement sublease with a third party.
Strikingly, Altria reached the opposite conclusions internally. Altria’s internal memoranda concluded that (1) each tax-indifferent entity would “exercise its purchase option [at sublease termination] in order to regain control of the leasehold interest”; and (2) even if it did not, Altria would require the tax-indifferent entity to renew the sublease “at rates that will give [Altria] its economic return” by transferring the funds in the equity defeasance account to Altria. That is, Altria would not exercise its options to find a replacement lessee or take possession if the tax-indifferent entity declined to exercise its purchase option. And for good reason: If Altria could benefit from bringing in a replacement sublessee or taking possession of the leased asset (because of the asset’s high resale value), then the tax-indifferent entity, if rational, would exercise its unilateral, fully-funded purchase option to obtain those benefits for itself. If economic conditions were not so beneficial at the end of the sublease, Altria nevertheless could force the tax-indifferent entity to renew the sublease at a predefined price, covered by the funds in the equity defeasance account.
Given these two scenarios, both covered by funds in the equity defeasance account, and both continuing the tax-indifferent party’s control of the facility, Altria’s memoranda stated that the risks of the transactions were “nominal” and would not expose Altria to any residual value risk. Despite the fundamental inconsistency between Altria’s internal memoranda and the appraisals it obtained, no one at Altria questioned this difference. This was not an oversight: “[T]he principal purpose” of the appraisals, one witness testified, “was to support [Altria’s] tax position.”
Other documents confirmed this purpose. At a worldwide Altria conference, Altria described the SILO and LILO transactions:
THE NAME OF THE GAME HERE IS TO USE DOLLARS THAT WOULDOTHERWISE HAVE BEEN REMITTED TO THE FEDERAL GOVERNMENT AND INSTEAD INVEST THE PROCEEDS IN ADDITIONAL INCOME PRODUCING ASSETS.
Altria’s counterparties agreed. In a board presentation before the Altria transaction, the hydroelectric facility owner stated that the “purpose” of the transaction was to “[transfer tax benefits (accelerated depreciation or' accelerated rental expense) to [the] investor.” This owner described the transaction as a “Sale for tax purposes” involving “Tax benefits sold to Equity Investors,” because “Tax benefits [are] not beneficial to [us].” Similarly, the rail yard owner described the Altria transaction as a “tax benefit transfer” and the electrical plant owner stated that its “objective” was to obtain a “cash benefit” — “through the mon[e]tization of tax benefits.”
B.
For tax years 1996 and 1997, Altria claimed various tax deductions arising from its SILO and LILO transactions. Altria claimed depreciation deductions with respect to the facilities at issue in the SILO transactions, see 26 U.S.C. § 167(a); rental expense deductions for the facility at issue in the LILO transaction, see id. §§ 162(a)(3), 178(a); amortization deductions with respect to transaction costs, see id. § 162; and interest deductions with respect to the nonrecourse loans, see id. § 163.
The IRS denied Altria’s claims for tax deductions, assessing income tax deficiencies. On July 11, 2006, Altria filed amended tax returns and paid the assessed deficiencies. As relevant here, Altria requested tax refunds of $4,405,646 for 1996 and $19,931,977 for 1997. On August 23, 2006, the IRS disallowed Altria’s claims for tax refunds. Altria had the right to appeal the decision to the U.S. Tax Court, where a judge would decide the appeal. See 26 U.S.C. § 6214. Instead, Altria filed suit on October 16, 2006 in the U.S. District Court for the Southern District of New York, pursuant to 26 U.S.C. § 7422, where either party could opt for a jury, see 28 U.S.C. §§ 1346(a)(1), 2402. In its answer to Altria’s complaint, the Government requested a jury trial.
In March 2008, both parties moved for summary judgment. After oral argument, the district court denied both motions. The district court found that there were genuine issues of material fact regarding “the practical effect of the transactions’ defeasance structure,” “the level of financial risk that Altria assumed,” and whether there was “any legitimate business purpose for entering into the transactions.”
The case proceeded to a jury trial, over eleven days in June and July 2009. After the close of evidence, the district court instructed the jury to analyze Altria’s four representative transactions under two common law disallowance methods: the substance over form doctrine and the economic substance doctrine. Following deliberation, the jury found that both doctrines barred Altria’s tax refund claims. On March 17, 2010, the district court denied Altria’s motion for judgment as a matter of law and for a new trial.
See Altria,
II.
A.
The extent to which taxpayers may minimize their taxes by choosing one form for a transaction rather than another “has preoccupied lawyers and administrators since the inception of the federal income tax.” Marvin A. Chirelstein,
Learned Hand’s Contribution to the Law of Tax
However, even if a transaction’s form matches “the dictionary definitions of each term used in the statutory definition” of the tax provision, “it does not follow that Congress meant to cover such a transaction” and allow it a tax benefit.
Id.
Instead, “ ‘the question for determination is whether what was done, apart from the tax motive, was the thing which the statute intended.’ ”
Knetsch v. United States,
This principle may be summarized by the statement that “[i]n tax law, ... substance rather than form determines tax consequences.”
Raymond v. United States,
B.
Under Section 167(a) of the Internal Revenue Code, Congress allows, “as a depreciation deduction”:
a reasonable allowance for the exhaustion, wear and tear (including a reasonable allowance for obsolescence)—
(1) of property used in the trade or business, or
(2) of property held for the production of income.
26 U.S.C. § 167(a).
“Only a taxpayer who has a depreciable interest in property may take the deduction.... ”
Reisinger v. Comm’r,
Where two parties purport to transfer an interest in an asset, courts may disregard the purported transfer, for federal tax purposes, “where the transferor continues to retain many of the benefits and burdens of ownership.”
Bailey v. Comm’r,
Thus, Altria was not eligible for depreciation deductions with respect to the litigated transactions unless it obtained, in substance, a genuine ownership interest in, the facilities at issue. Whether Altria obtained such an interest is determined by the substance and economic realities of the transaction that gave rise to the asserted interest.
See Helvering v. F. & R. Lazarus & Co.,
Here, Altria was required to prove that it had the benefits and burdens of owning or leasing the facilities at issue in the four representative transactions.
See Knight,
Instead, the district court instructed the jury to consider “all the relevant facts and circumstances” and stated that the factors the jury “may consider” “include, but are not limited to”: (1) control over the facility; (2) equity investment in the facility; (3) cash flows between the parties; (4) whether the transaction was motivated by “legitimate business purposes, or solely by a desire to create tax benefits”; (5) regulatory realities; (6) whether the facility had an expected useful life beyond the leaseback that Altria could benefit from; (7) whether it was reasonable to expect that the facility would have meaningful value at the end of the leaseback that Altria could benefit from; and (8) whether Altria had the potential to benefit from an increase in the facility’s value and suffer a loss of its equity investment in the facility as a result of a decrease in the facility’s value.
Altria,
C.
Altria challenges four aspects of the district court’s jury instructions that differed from Altria’s proposed instructions. The first three challenges concern the factors a jury may use to determine whether, in substance, a taxpayer established a genuine ownership or leasehold interests in an asset. The fourth challenge concerns the district court’s instruction regarding Altria’s claim for interest expense deductions with respect to the nonrecourse loans it used to finance the challenged transactions.
We review challenges to a district court’s jury instructions de novo.
Cameron v. City of New York,
1.
First, Altria challenges the district court’s instruction that the jury “may consider ... the likelihood that the lessee would exercise its purchase option” in determining whether Altria retained genuine ownership or leasehold interests in the leased assets.
Altria,
Altria contends that the instruction regarding the likelihood that the lessee would exercise its purchase option “allowed the jury to disregard Altria’s residual stake in the leased assets (certainly the most important factor in determining a lessor’s status) if it believed simply that
We disagree. As the district court aptly noted, Altria’s argument misunderstands the Government’s theory of the case, which was that:
there were a number of scenarios, including, but not limited to, those where the lessee exercised its purchase option, in which Altria would never take possession of the assets. The cumulative effect of these scenarios, according to the Government, was that Altria only acquired a speculative possibility of assuming the traditional benefits and burdens of ownership.
Altria,
Altria purported to lease an asset from a tax-indifferent party, immediately lease it back for a shorter period of time, and retain a future interest whose scope would be determined at the end of the sublease term. In this context, an instruction that the purchase option must be “certain or virtually certain” would have precluded the jury from considering all of the various post-sublease scenarios, which together shed light on whether Altria retained an asset with meaningful value at the end of the sublease term. See Simonson, supra, at 3-18. For example, even if the tax-indifferent entity did not exercise its unilateral, fully-funded purchase option, Altria could force the entity to renew the sublease and maintain the status quo (as it indicated it would in internal memoranda). Indeed, the Government argued that these two scenarios were the only likely ones. The purchase option was costless; the tax-exempt entity would receive no additional money by declining to exercise it; and if economic conditions made the purchase option unattractive to the tax-indifferent entity, those same conditions would make Altria unwilling to take possession or lease the property to a third party.
Moreover, neither this Court nor the Supreme Court has held that the true substance of the transaction is limited to events that are “certain or virtually certain” to occur. In
Knetsch,
for example, the Supreme Court disregarded a possible, but “wholly unlikely,” assumption regarding the taxpayer’s future behavior and then concluded that Congress did not intend to provide a tax deduction for such “sham” transactions.
Lastly, contrary to Altria’s argument, the district court’s instruction did not “allow[ ] the jury to disregard Altria’s residual stake in the leased assets ... if it believed simply that there was a ‘likelihood’ that the lessee would exercise its purchase option.” Rather, the district court listed factors the jury could (and could decline to) consider; “emphasize[d] ... that no single factor [was] determinative”; and stated that “[i]n the end, the question is whether Altria retained significant and genuine attributes of traditional owner (or lessor) status,”
Altria,
2.
Second, Altria argues that “the district court failed to provide any guidance on what levels of equity investment or residual value are ‘meaningful’ in the leasing context.” Absent such instruction, Altria argues, “lay jurors could have no basis for determining what is ‘meaningful’ in this technical, non-intuitive situation,” which must “necessarily” have “produced a lawless result.”
The two challenged instructions provided that the jury “may consider”:
Equity Investment: Whether Altria made a meaningful equity investment in the facility, and whether Altria was at risk of losing its equity investment. [...]
Residual Value: Whether, at the time the transaction began, it was reasonable to expect that the facility would have meaningful value at the end of the leaseback that Altria could benefit from....
Altria,
Altria requested an instruction stating that a 6% equity investment would satisfy the equity investment factor, and an expected residual value greater than or equal to 10 to 20% of the facility’s value would satisfy the residual value factor.
Neither the Code, the regulations, nor our case law lays down specific numbers to determine whether an entity retained the benefits and burdens of ownership. Rather, the existence of a depreciable interest in an asset depends on the particular facts of the case. In
Frank Lyon,
the Supreme Court was careful to avoid “condoning manipulation by a taxpayer through arbitrary labels and dealings that have no economic significance.”
3.
Third, Altria argues that “[t]he district court also instructed the jury that it could consider two factors in the benefits-and-burdens analysis — ‘Control Over the Facility’ and ‘Cash Flows’ — that are virtually ubiquitous elements of leveraged leases.” Altria argues that these factors are “neutral” and “therefore simply are not relevant to determining traditional lessor status.”
We reject this argument. First,
Frank Lyon
expressly stated that the tax-indifferent entity’s control over the facility during the lease is an important factor in determining ownership.
Frank Lyon,
Second, the absence of cash flows supports the inference that Altria had no equity interest in the property and that the tax-indifferent counterparty lacked control over the money. Other courts have agreed that this is a relevant consideration under
Frank Lyon.
As the Federal Circuit noted regarding a similar transaction, “[t]he only flow of funds between the parties to the transaction was the initial lump sum given to the tax-exempt entity as compensation for its participation in the transaction.”
Wells Fargo,
4.
Fourth, Altria argues that the district court erred when it instructed the jury regarding whether Altria could properly claim interest expense deductions with respect to the nonrecourse loans it used to finance the challenged transactions. A taxpayer may properly deduct interest expenses only if the debt is “genuine.”
See Bailey v. Comm’r,
Altria does not accurately describe our precedent. We did not hold in Bailey that nonrecourse debt that does not exceed the value of the collateral security is always genuine. Rather, we recognized that such debt is “generally” genuine because if the taxpayer defaults, she will lose an asset worth more than the amount of the debt. Id. at 292. Here, however, the pledged nature of the debt defeasance accounts effectively eliminated any possibility that Altria would default on the nonrecourse loans. We find no error in the district court’s instruction that the jury could consider other factors in determining whether the nonrecourse debt Altria incurred was genuine, including the circularity of the parties’ obligations.
In sum, Altria has not shown that the district court erred in instructing the jury regarding the substance over form doctrine.
D.
Altria also argues that the district court erred by denying Altria’s renewed motion for judgment as a matter of law because “the record ... shows definitively that Altria retained significant and genuine attributes of traditional lessor status.”
Under Federal Rule of Civil Procedure 50(a), a district court may “enter judgment as a matter of law against a party on an issue [only if] there is no legally sufficient evidentiary basis for a reasonable jury to find for that party on that issue.”
Cobb v. Pozzi,
There is not such an absence of evidence here. A reasonable jury could find that Altria did not retain assets of value at the end of the sublease terms; did not retain either the upside potential for economic gain or the downside risk of economic loss; and did not retain significant control over the facilities.
See Frank Lyon,
The evidence also reasonably supported1 the jury’s finding that the nonre
We agree with the district court that, as here, “[a] pointlessly complex transaction with a tax-indifferent counter-party that insulates the taxpayer from meaningful economic risk of loss or potential for gain cries out for [substance over form] treatment.”
Aitria,
In sum, we affirm the jury’s finding that Aitria did not obtain a genuine ownership or leasehold interest in the four facilities or incur genuine debt, and therefore Aitria was not entitled to a tax refund for any of its claimed deductions. As a result, we need not review the jury’s determinations that none of the four Aitria transactions had economic substance. The substance over form doctrine and the economic substance doctrine are independent bases to deny a claimed tax deduction. “The IRS ... is entitled in rejecting a taxpayer’s characterization of an interest to rely on a test less favorable to the taxpayer,
even [if] the interest has economic substance.” TIFD III-E, Inc. v. United States,
* * *
For the foregoing reasons, we AFFIRM the judgment of the district court.
Notes
. Similarly, an entity purporting to hold a lease interest in property used in business or held for the production of income may deduct its rental payments, but only if the entity has a genuine leasehold interest. Regarding whether Altria’s investments lacked economic substance and whether their form accurately reflected their substance, the district court instructed the jury that it may consider Altria's claims of (1) genuine ownership of the facilities on which it claimed depreciation deductions; and (2) genuine leasehold interest in the facility for which it claimed deductions for its rental payments. The jury found against Altria as to all of the transactions. In the rest of this opinion, we discuss only the depreciability of the assets over which Altria claimed ownership. We do not separately discuss the deductibility of rental expense for the allegedly leased facility because the ques