Exelon Corp. v. Comm'rExelon Corp. v. Comm'r
P, a corporation engaged in the production, transmission, and distribution of electricity to residential, commercial, and industrial customers in Northern Illinois, sold its fossil fuel power plants in 1999 for $4.813 billion. Seeking to manage the taxable gain of $1.6 billion resulting from the sale, P pursued a series of like-kind exchanges employing sale-leaseback strategies between P and unrelated third parties C and M, each of the latter a tax-exempt public utility. P fully funded the transactions using the proceeds from the sale of its own power plants. In the transactions, C or M would lease a power plant to P for a term exceeding the plant‘s useful life, receiving in turn a lump-sum payment of cash, and P would sublease the power plant back to C or M. Part of the amount paid to C or M would be returned to P as a prepayment of the sublease, another part would be set aside for investment and to secure a cancellation option allowing C and M to purchase back their power plants at the end of the sublease periods, and the remainder would be retained by C and M and used for their own needs. Since exercising the cancellation options was expected to be the only economically viable option, the parties to the transactions anticipated that at the end of the sublease periods C and M would exercise their cancellation options and regain ownership of the power stations leased to P. The primary tax benefits that P expected to derive were from the deferral of income tax under
Held: The agreements between P and C and M are not true leases but rather properly characterized as loans since the transactions did not transfer the benefits and burdens of ownership to P. The substance of the transactions is not consistent with their form.
Held, further, P did not satisfy the requirements of
Held, further, P is not entitled to depreciation deductions claimed for 2001 with respect to its transactions with C and M.
Held, further, P may
Held, further, P must include in income for the 2001 tax year original issue discount income arising out of P‘s equity contribution, which is to be repaid with interest through the cancellation options in P‘s agreements with C and M.
Held, further, P is not entitled to deduct transaction costs related to its transactions with C and M for its 2001 tax year and must instead include them as an additional amount lent to C and M.
Held, further, P is liable for accuracy-related penalties under
David F. Abbott, Joel V. Williamson, Erin G. Gladney, Kristin M. Mikolaitis, Andrew W. Steigleder, Michelle A. Spiegel, and Michael D. Educate, for petitioner.1
Matthew I. Root, Elizabeth P. Flores, Steven N. Balahtsis, Abigail F. Dunnigan, Lisa M. Goldberg, Casey R. Kroma, and Michael T. Shelton, for respondent.
LARO, Judge: These cases are consolidated for purposes of trial, briefing, and opinion. Respondent determined the following deficiencies and penalties in petitioner‘s2 Federal income tax in timely issued notices of deficiency:
| Year | Deficiency | Penalty |
|---|---|---|
| 1999 | $431,174,592 | $86,234,918 |
| 2001 | 5,534,611 | 1,106,922 |
Petitioner timely filed petitions with the Court seeking redetermination of these deficiencies and penalties.
The deficiencies at issue arise out of petitioner‘s participation in six transactions that respondent labeled sale-in/lease-out
| Counterparty | Transaction name |
|---|---|
| City Public Service | Spruce |
| Municipal Electric Authority of Ga. | Scherer 1, Scherer 2, Scherer 3 |
| Municipal Electric Authority of Ga. | Wansley 1, Wansley 2 |
The parties have agreed, with the Court‘s approval, to reduce the number of transactions to be tried to three “test transactions“: Spruce, Scherer 1 (Scherer), and Wansley 1 (Wansley), and to apply the Court‘s methodology in this Opinion to the remaining transactions.4
The parties have resolved two issues by filing stipulations of settled issues with the Court. The parties have agreed that petitioner is entitled to the benefits of interest netting as provided in
We decide the following issues:
1. whether the substance of the test transactions is consistent with their form. We hold that it is not;
2. whether petitioner has satisfied the requirements of
3. whether petitioner is entitled to depreciation deductions claimed for 2001 with respect to the test transactions. We hold that it is not;
4. whether petitioner must include in income in 2001 original issue discount income related to the test transactions. We hold that it must;
6. whether petitioner is liable for penalties under
FINDINGS OF FACT
Some of the facts have been stipulated. The stipulations of fact and the facts drawn from stipulated exhibits are incorporated herein, and we find those facts accordingly. At the time of filing the petitions, Exelon, the primary petitioner, had its principal place of business in Chicago, Illinois. The parties agree that these cases are appealable to the Court of Appeals for the Seventh Circuit.
Background
I. Exelon and Its Subsidiaries
Commonwealth Edison Co. (ComEd) was organized in Illinois on October 17, 1913, as a result of the merger of Cosmopolitan Electric Co. into ComEd. Unicom Corp. (Unicom) was created in January 1994 as a holding company for ComEd. Unicom Investment, Inc. (UII), was created on April 23, 1999, as a wholly owned subsidiary of Unicom.
Exelon Corp. (Exelon), petitioner in these cases and the successor by merger to Unicom and its consolidated subsidiaries (Unicom Group), was incorporated in February 1999. Exelon became the parent corporation of PECO Energy Co. (PECO) and Unicom through merger on October 20, 2000. As a result of the merger of Exelon and Unicom, Unicom went out of existence. After the merger, Exelon wholly owned PECO and owned more than 99% of ComEd.
Both Unicom and Exelon used the calendar year as their tax year. Both companies were accrual basis taxpayers during all relevant periods.
II. Unicom‘s Decision To Sell Fossil Fuel Power Generation Assets
A. ComEd‘s Power Generation Business in 1999
In 1999 ComEd engaged in the production, transmission, and distribution of electricity to residential, commercial, and
B. Deregulation of the Electric Industry and Unicom
The 1990s marked a shift in the regulatory framework for the electric industry. Before 1996 most electric utility companies were vertically integrated conglomerates which, similarly to ComEd, owned a full spectrum of assets for production and delivery of electricity to the customers. By April 1996 the Federal Energy Regulatory Commission (FERC) had issued final rules requiring nondiscriminatory access to the transmission grid controlled by vertically integrated utilities.
These rules opened the market to smaller utilities and power generators and provided an opportunity for the formation of “wholesale” energy companies. Instead of investing in their own transmission capacity, smaller energy producers could now use the transmission system already in place regardless of who owned it to deliver power to their customers.
Many States pursued their own restructuring strategies for electric industry deregulation, some of them requiring separation of power generation from sales to final customers. On December 16, 1997, Illinois enacted the Electric Service Customer Choice and Rate Relief Law, codified at 220 Ill. Comp. Stat. Ann. 5/16-101 to -130 (West 2013). Unlike other States, Illinois did not enact deregulation legislation requiring divestiture of power generation and allowed electric utilities a choice of how they wished to pursue the transition.
To face the challenges of the changing market, Unicom decided to evaluate its operations in Illinois, including its nuclear and fossil fuel power plants. Although Unicom management believed the company was well positioned to succeed in the new market structure, the study revealed that Unicom would have to make significant changes to its operation model in order to stay competitive long term. Unicom and ComEd considered multiple options, including continued operation with accelerated depreciation, indefinite suspension from operation, a sale of assets to a third party, and retirement or closure of assets. Unicom needed of cash to maintain and expand its nuclear generation facilities and distribution system. After determining that operation of fossil fuel power plants would bring less value than immediate sale, Unicom decided in July 1998 that it was time to divest itself entirely of its fossil-fueled power generation business. At that time Unicom estimated it would receive approximately $2.5 billion from the sale.
C. Unicom‘s Sale of the Fossil Fuel Power Plants
Unicom started looking for an appropriate buyer for its fossil fuel power plants in 1999. One prospective buyer offered Unicom $3 billion for the plants. Unicom‘s management, however, believed that the company could get a better deal. Eventually, Edison Mission offered Unicom $4.8 billion for the fossil fuel power plants, almost twice the initial estimate.
The $4.8 billion offer would enable ComEd to upgrade its nuclear plants and make the necessary investments in its distribution system. On March 22, 1999, ComEd entered into an asset sale agreement with Edison Mission (EME agreement). To effect the sale, ComEd transferred its interests in the fossil fuel power plants to UII pursuant to an agreement dated May 11, 1999, subject to the EME agreement. UII agreed to pay ComEd $4.813 billion for the assets, in the
After receipt of the assets, UII would immediately transfer the assets to Edison Mission and receive $4.813 billion in cash. Immediately after receipt of the cash, UII would pay the $2.35 billion aggregate principal due to ComEd under the demand note. UII would pay the amount due under the demand note with interest-bearing term notes. Upon the notes’ maturity, UII would pay the principal amount of the notes. Edison Mission acted through its subsidiary, Midwest Generation. Deloitte & Touche LLP Valuation Group (Deloitte) performed a valuation allocating the sale price among the transferred power plants.
On December 15, 1999, UII closed the sale to Edison Mission with respect to two plants, the Collins Generating Station (Collins station or Collins power plant) and the Powerton Generating Station (Powerton station or Powerton power plant) for $930 million and $870 million, respectively. These stations together had a book value of approximately $1.3 billion at the time of the sale. Pursuant to EME agreement terms, UII transferred the Collins and Powerton stations to State Street Bank & Trust Co. (State Street), the qualified intermediary for the putative like-kind exchange described more fully in the following sections, and State Street then transferred the stations to Edison Mission in exchange for the consideration described above.
In its filings with the ICC, ComEd represented that the sale would not impair ComEd‘s obligations to provide power to customers because ComEd would be buying back the output generated by the sold power plants for a number of years and would also be able to buy energy on the open market. ComEd planned to reinvest some of the proceeds in its remaining lines of business and to pay the transaction expenses.
III. Unicom‘s Search for Tax Planning Opportunities
After Unicom announced the planned sale of the fossil fuel power plants in May 1999, it became clear that there would be a large taxable gain resulting from the sale. Unicom diligently searched for opportunities to minimize the tax impact and to reinvest some of the proceeds of the sale.
Mr. Roling approached Arthur Andersen (Unicom‘s auditor at the time), Pricewaterhouse Coopers (PwC), and Deloitte to identify the appropriate tax strategy. Arthur Andersen presented Unicom with a strategy involving a foreign currency swap, but Mr. Roling rejected it because it was too complex and did not align with the existing Unicom business. PwC first presented the idea of a like-kind exchange coupled with a sale-leaseback to Unicom sometime in August and September 1999.
In essence, PwC suggested that its strategy would allow Unicom to defer the recognition of gain on Unicom‘s sale of the fossil fuel power plants through a
The PwC strategy envisioned a lease term in the range of 20-25 years with an “enhancement and defeasance structure providing for AA rated or better enhancement of the lessee‘s entire financial obligations to Unicom.” PwC compared the costs for maintaining the new lease investment with maintaining a typical debt private placement. Under the strategy, Unicom would lease the exchange assets to the lessee under a triple net lease with an end-of-term fixed purchase option. Unicom would pass on a portion of its tax deferral benefit to the lessees through a reduction in rental obligation. The lessee would “defease its rental obligations,
PwC pointed out to petitioner that municipal utilities and rural electric cooperatives seeking to monetize tax benefits they could not use because of their tax-exempt status would be interested in entering into a sale-leaseback transaction. PwC also suggested that taxable entities desiring to obtain low cost/off-balance-sheet financing alternatives might also be interested.
After the initial consultation with PwC, Mr. Roling decided to present the idea of the like-kind exchange to his superiors.
IV. Unicom‘s Decision To Enter Into the Test Transactions
Mr. Roling first presented the PwC strategy to Mr. Berdelle. Although Mr. Berdelle initially did not fully understand the strategy, he decided it had promise and was in line with Unicom‘s tax strategy. John C. Bukovski, the chief financial officer of Unicom, gave Mr. Roling permission to move forward with the like-kind exchange strategy and present it to the Unicom‘s board of directors for consideration and approval.
On October 5, 1999, two months after receiving ICC approval to sell ComEd‘s fossil fuel power plants, ComEd submitted a notice to the ICC stating that it was considering entering into a like-kind exchange for at least several of the fossil fuel power plants.
On October 14, 1999, Unicom and PwC executed an agreement whereby Unicom retained PwC to act as its financial adviser in connection with the proposed like-kind exchange strategy. On October 20, 1999, Mr. Berdelle provided information on the strategy to Unicom‘s board of directors. He presented the strategy during the board meeting held on October 27, 1999, seeking and receiving approval for various preliminary steps necessary to pursue the concept and preserve the option of entering into a like-kind exchange transaction. Mr. Berdelle assembled a team to further evaluate the like-kind exchange opportunity. That team consisted of a number of Unicom‘s employees from various departments,
Neither Mr. Roling nor anyone on his staff in the tax department had any experience with like-kind exchanges. Because Unicom did not have the internal expertise necessary to adequately assess all of the legal and technical aspects of the proposed like-kind exchange, Unicom employed a number of consultants and advisers to work on the project, including performing due diligence of potential replacement properties.
Unicom retained a Chicago law firm, Winston & Strawn LLP (Winston & Strawn) to advise on the legal aspects of the transaction, including its tax consequences. In addition, in March or April of 2000 Unicom engaged Stone & Webster Management Consultants, Inc. (Stone & Webster), to provide engineering and environmental reports on prospective replacement properties. Unicom retained Deloitte to conduct an appraisal of the relinquished properties and potential replacement properties in November 1999. In addition, petitioner engaged PwC (financial and accounting adviser), Arthur Andersen (accounting adviser), Sidley Austin (regulatory counsel), Vinson & Elkins (Texas counsel), and Holland & Knight (Georgia counsel).
V. Identification of Properties To be Relinquished in the Like-Kind Exchange
On or about December 9, 1999, six days before the closing of the sale under the EME agreement, Unicom identified the Collins and Powerton stations as the properties it would try to exchange for like-kind replacement properties. Mr. Roling concluded, on the basis of the valuations from Deloitte, that the fair market value of the Collins station at that time was $930 million, with an expected taxable gain of $823 million, while the fair market value of Powerton station was $870 million, with an expected taxable gain of $683 million. Unicom did not plan to execute a like-kind exchange for any of the other fossil fuel power plants it was selling.
A. Identification of Replacement Properties
Because
By November 1999 PwC had identified 26 prospective lessees. Unicom did not participate in the initial identification process. On or about November 9-10, 1999, PwC, on behalf of Unicom, sent proposals to a number of potential lessees for the sale-leaseback portion of the like-kind exchange. PwC contacted both taxable and tax-exempt entities. City Public Service (CPS) and Municipal Electric Authority of Georgia (MEAG) were among the potential lessees contacted by PwC. Each proposal sent by PwC contained statements indicating that Unicom was simultaneously soliciting other prospective lessees for expressions of interest and that the proposal was subject to due diligence by Unicom and its consultants. After receiving initial expressions of interest from several potential lessees, Unicom and its advisers analyzed the submitted materials.
The closing of the sale of the two fossil fuel power plants under the EME agreement on December 15, 1999, started the clock under
B. Due Diligence on Replacement Properties
1. Engineering and Environmental Analysis
Walter Hahn, a mechanical engineer with expertise in plant operability and over 25 years’ experience working on power plants, was ComEd‘s director of technical services in 2000. Mr. Hahn coordinated engineering and environmental analysis efforts for the like-kind exchange project at ComEd. To perform the analysis, Mr. Hahn hired Stone & Webster, an engineering consulting firm that ComEd had previously used for other engineering studies.
Stone & Webster assessed the power plants’ contemporaneous condition and expected remaining life, the projected capital costs, operating and maintenance expenses, and environmental issues relating to the future operations and maintenance of the replacement stations and conducted an environmental permit review and permit compliance assessment. Stone & Webster‘s review process involved data collection, site visits, and the review and analysis of all information obtained before drafting reports and offering conclusions.
Stone & Webster‘s team found the Wansley and Scherer stations to be well maintained and in clean and orderly condition, probably in the top 2%-3% of units in the country in generation, efficiency, and overall availability and reliability. Stone & Webster‘s team found that the Spruce station was also well maintained, was running at good efficiency, and could run at high capacity factors. However, Stone & Webster did uncover certain problems with the plants. For example, Stone & Webster identified stress corrosion cracking in the low pressure turbine sections of the Wansley station. Stone & Webster also raised concerns about the potential for the U.S. Environmental Protection Agency to take action relating to maintenance activities at Wansley. At the Scherer station, Stone & Webster identified spills associated with transformer failures and fires. Unicom chose not to follow up on any of these and other findings.
involved only short site visits and interviews. ComEd engineers did not find any problems with any of the stations.
2. Appraisal of Replacement Properties
Deloitte prepared appraisal reports for all three replacement properties as well as for the fossil fuel power plants sold by Unicom under the EME agreement. The reports provided current valuations of the replacement properties, as well as valuation opinions as to the plants’ residual values and remaining useful lives, and the likelihood of the prospective lessees’ being economically compelled to exercise their cancellation or purchase options. In preparing the reports, Deloitte sought to address specific requirements set forth in Internal Revenue Service (IRS) published guidance on leasing transactions, such as the requirements articulated in
By letter dated December 29, 1999, Winston & Strawn provided Deloitte with a list of “appraisal conclusions we anticipate will be necessary to support our tax opinion issued in connection with any leasing transaction entered into by ComEd [Unicom’s subsidiary].” That list was later reproduced almost verbatim in Deloitte appraisal reports. The following table shows side by side some of the conclusions from the Winston & Strawn letter and conclusions appearing in the Deloitte appraisal reports.6
| Winston & Strawn Letter | Spruce Appraisal Report (Deloitte) |
|---|---|
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6) as of the Closing Date, it is reasonable to expect that the fair market value of the Leased Property will substantially exceed the applicable Early Termination Amount at all times during the Lease Term; |
6. As of the Closing Date, it is reasonable to expect that the fair market value of the Facility will substantially exceed the applicable Early Termination Amount at all times during the Lease Term; |
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7. The Cancellation Option Price is no less than 105% of the estimated “fair market value” of the Facility as of the expiration of the Lease Term, taking into account inflation and any reasonably anticipated improvements or modifications to the Facility and after subtracting from such value any cost to the Lessor of acquiring possession of the Facility at the end of the Lease Term; |
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8) as of the Closing Date, the Leased Property’s remaining economic useful life is __ years, and therefore the Leased Property will have a remaining economic useful life at the expiration of the maximum Service Agreement Term equal to at least 20 percent of its remaining useful life as of the Closing Date; |
8. As of the Closing Date, the Facility’s remaining economic useful life is expected to be 52 years, and therefore the Facility is expected to have a remaining economic useful life at the expiration of the maximum Service Agreement Term equal to at least 20 percent of its remaining useful life as of the Closing Date; |
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9) the Leased Property will have a “fair market value” at the expiration of the maximum Service Agreement Term (determined without regard to inflation or deflation or any future improvements) that is equal to at least 20 percent of the current “fair market value” of the Leased Property and after subtracting from such value any cost to the Lessor of acquiring possession of the Leased Property at the end of the Lease Term; |
9. The Facility will have a fair market value at the expiration of the Lease Term of 38.4 percent of Closing Date fair market value (determined without regard to inflation or deflation or any future improvements) and a fair market value at the expiration of the maximum Service Agreement Term of 20.0 percent of Closing Date fair market value (determined without regard to inflation or deflation or any future improvements). Both uninflated residual values are at least 20 percent of the current fair market value of the Facility and after subtracting from such value any cost to the Lessor of acquiring possession of the Facility at the end of the Lease Term; |
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13. Neither the physical attributes of the Facility, the financial standards of the Qualified Operator or Qualified Bidder, the applicable return provisions or other terms and conditions of the Lease, Operating Agreement or Power Toll Processing Agreement, nor any other identifiable factor known to the Appraiser after due inquiry, will create a material inducement to Lessee to exercise the Cancellation Option with respect to the Facility; |
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13) based on the comparative costs of the reasonably anticipated alternatives expected to be available to Lessee at the expiration of the Lease Term, Lessee will not be under any economic compulsion to exercise the Purchase Option; |
14. Based on the comparative costs of the reasonably anticipated alternatives expected to be available to Lessee at the expiration of the Lease Term, Lessee will not be under any economic compulsion to exercise the Cancellation Option; |
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17) the fixed net return required under the Service Agreement Option is less than 90% of the expected “fair market value” of such payments so that the Service Agreement Option does not create an economic compulsion for the Lessee to exercise the Purchase Option and it is expected that the Lessor will not exercise the Service Agreement Option; |
18. The fixed net return required under the Service Agreement Option is less than 95 percent of the expected “fair rental value” so that the Service Agreement Option does not create an economic compulsion for the Lessee to exercise the Cancellation Option and it is expected that the Lessor will not exercise the Service Agreement Option; |
Winston & Strawn provided continuous and substantial feedback to Deloitte on the drafts of the appraisal reports. Although Winston & Strawn did not give Deloitte directions as to the specific fair market value for each replacement property, Deloitte knew from its previous work on appraising Unicom’s plants sold under the EME agreement how much gain Unicom was looking to defer.
With respect to all three replacement properties, Deloitte discussed the results obtained under three standard valuation approaches: cost of replacement approach, market approach, and discounted cashflow approach. Deloitte concluded that the discounted cashflow analysis represented the most reliable approach to determining the current fair
To arrive at the fair market values of the replacement plants at the end of the sublease terms, Deloitte used the maximum Federal statutory corporate income tax rate of 35% and a State corporate income tax rate of 9% (total of 40.85%) even though the plants were in Texas, which did not have a State corporate income tax, and in Georgia, which had a 6% State corporate income tax rate.8 Deloitte used the same discount rate of 10% for all three plants and assumed inflation of 2.5% per annum. Deloitte did not perform any sensitivity analysis.
For the Spruce station, Deloitte assumed the plant capacity factor to be 90.3% in 2000, declining to 58.7% in 2032 and to 49.6% in 2052. For the Wansley station, Deloitte assumed the plant capacity factor to be 66.5% in 2000, declining to 39.2% in 2028 and to 32.6% in 2044. For the Scherer station, Deloitte assumed the plant capacity factor to be 66.5% in 2000, declining to 39.9% by 2030. Deloitte did not analyze in its appraisal reports how a change in a capacity factor might influence the future fair market value of the assets at issue.
After performing the analysis, Deloitte concluded that CPS and MEAG would not be economically compelled to exercise their cancellation or purchase options at the end of their respective subleases. If based on the Deloitte analysis, the fair market value of all the replacement properties at the end of the leaseback term would be less than the cancellation or purchase option price. In arriving at this conclusion, Deloitte did not consider noneconomic factors or any arrangements between the parties setting aside the money for the option payment at the beginning of the lease.
Ruth Ann Gillis, Unicom’s chief financial officer in 1999-2000, coordinated the financial and economic due diligence on the Spruce, Wansley, and Scherer transactions. Ms. Gillis reviewed both the creditworthiness of CPS and MEAG and the quality of the leased stations. At the end of the due diligence process, Ms. Gillis felt comfortable recommending that the board of directors enter into the transactions.
PwC acted as a financial adviser in connection with the like-kind exchange and the sale-leaseback transactions. PwC’s engagement included the following services: (i) assessing Unicom’s specific needs from economic, tax, accounting, commercial, and regulatory standpoints in connection with the proposed like-kind exchange; (ii) developing a strategy matching target replacement property with the relinquished property; (iii) identifying target replacement property owned by both tax-exempt lessees and taxable lessees; (iv) arranging for a tax and accounting analysis regarding the like-kind exchange; (v) providing economic analyses and pricing models and issuing reports regarding accounting treatment for the life of the like-kind exchange; and (vi) issuing an opinion regarding the application of accounting principles to the like-kind exchange. Subsequently, PwC also acted as the designated tax shelter organizer on behalf of Exelon and registered the transactions with the IRS as a confidential tax shelter.
Petitioner retained First Chicago Leasing Corp. (FCLC), a wholly owned subsidiary of Banc One Capital Corp. (Banc One), to serve as a supplemental investment adviser to the Unicom Group. FCLC provided Unicom with financial and risk analysis of, and advice relating to, the like-kind exchange. FCLC considered all material credit risks as having been adequately addressed through the transaction structure and financial enhancements such that the transactions at issue possessed above-average safety from a credit risk perspective with respect to payment of scheduled rent, purchase options, or early termination damage claims, thus protecting Unicom’s investment return. FCLC advised that CPS and MEAG were generally very credit-worthy, strong, investment-grade entities and would remain primarily liable for all rent and purchase option obligations. FCLC also concluded
With respect to the risk of bankruptcy of CPS or MEAG, FCLC concluded that “the potential adverse effects of the real estate classification in a bankruptcy are being borne in these transactions by the credit support parties and not Unicom.” FCLC further concluded that Unicom could rely on being able to get a full payout in cash if a bankruptcy of a lessee occurred. FCLC did not evaluate the risks related to the service contract period after the expiration of the sublease to CPS or MEAG.
Marsh USA, Inc., advised Unicom on standard insurance practices for the U.S. utility industry and the appropriate terms for property damage and commercial liability insurance in the Spruce, Wansley, and Scherer transactions.
4. Legal and Tax Analysis
Winston & Strawn analyzed the qualification of the replacement properties against the relevant tax tests for like-kind exchanges, helped negotiate the transactions with CPS and MEAG, drafted the various transaction documents, and analyzed the tax consequences thereof. Winston & Strawn also analyzed the relevant leasing authorities and legal risks associated with the Spruce, Wansley, and Scherer transactions. Winston & Strawn worked with local legal counsel in Illinois, Georgia, and Texas to assist with regulatory, corporate, real estate and title, and engineering and surveying issues with respect to the Spruce, Wansley, and Scherer stations.
Winston & Strawn was closely involved in the due diligence process, including marking up the engagement agreement with Deloitte and, as previously discussed, providing Deloitte with a list of desirable conclusions and comments on the appraisal report drafts.
Winston & Strawn provided two tax opinion packages containing opinion letters and supporting memoranda to Unicom, dated as of the closing of the sale-leaseback transactions, on the Federal income tax treatment of the transactions. The opinion package for the exchange of the Collins station for Spruce totaled 357 pages, while the opinion package
- The exchange of Unicom’s fossil fuel power generating facilities in Illinois with the lessees’ fossil fuel power generating facilities “should be treated as a valid exchange of like kind or like class property under section 1031 of the Code.”
- Each of the Spruce, Wansley, and Scherer leases “will be treated as a true lease for federal income tax purposes pursuant to which UII [Unicom] will directly or indirectly receive the taxable income and deductions associated with the ownership of” the Spruce, Wansley, and Scherer stations, respectively.
- Substantially all of the section 467 rental payments “will be treated” as loans to Unicom “rather than as current rental income.”
- The Spruce, Wansley, and Scherer leases “will transfer ownership” of the Spruce, Wansley, and Scherer stations to Unicom for Federal income tax purposes.
Although Winston & Strawn provided generally favorable opinions, it separately warned Unicom that there are certain risks related to Federal tax law, including recent guidance by the Internal Revenue Service on lease-in/lease-out (LILO) transactions and the possibility that the proposed transaction might be subsequently classified as a corporate tax shelter.
Unicom retained Vinson & Elkins LLP to provide legal advice and opinion as to Texas law relevant to the Spruce transaction. Unicom retained Holland & Knight LLP to provide legal advice and opinion as to Georgia law relevant to the Scherer and Wansley transactions.
With respect to the review by Unicom’s own employees of the analysis and conclusions provided in the Winston & Strawn legal opinions, Mr. Roling testified that he did not get beyond the first seven of several hundred pages of the opinion,9 and Unicom’s internal tax personnel also did not
C. Board Approval
At the March 9, 2000, Unicom board meeting, John Rowe, Chief Executive Officer and Chairman of ComEd and Unicom, introduced a discussion of the proposed like-kind exchange, and Mr. Berdelle presented information to the board on the like-kind exchange and the sale-leaseback proposal as it had developed since the December 1999 board meeting. On March 28, 2000, the board received a memorandum explaining the nature of the transactions and a credit and investment analysis, as well as expected economic results.
On April 4, 2000, Mr. Berdelle presented the proposed like-kind exchange to the board in more detail, and representatives of the Winston & Strawn team and Mr. Jenkins from PwC responded to the board’s questions about the credit risks, the tax risks, and the financial returns associated with the transaction. Mr. Rowe, Mr. Berdelle, and Ms. Gillis all recommended that the board approve the like-kind exchange, and the board followed their advice.
At the time the transactions were approved, some results of the due diligence, including legal opinions, valuation reports, and engineering due diligence reports, were not yet available in their final form. It is unknown whether the board reviewed the draft reports and opinions, but the board memorandum dated March 28, 2000, discussed some tax and legal risks.10
I. Spruce
A. CPS and Its Decision To Enter Into the Spruce Transaction
CPS is a municipal gas and electric utility owned by the City of San Antonio, Texas, that sells gas and electricity to its customers. CPS’ mission statement obligates CPS to provide low-cost, reliable gas and electricity service to its customers. As an entity owned by a municipality, CPS is tax exempt.
In the late 1990s CPS’ electric system served a territory consisting of substantially all of Bexar County, Texas, and small portions of seven adjacent counties. The CPS system was within the Electric Reliability Council of Texas (ERCOT) region, which was entirely within the State of Texas and served about 85% of Texas’ electrical load. ERCOT includes approximately 500 power plants. ERCOT is not connected to the national grid, and, as a result, Texas power producers are not subject to FERC regulations.
CPS owned 15 electric generating units and a 28% interest in the South Texas Project’s two nuclear generating units. The Spruce station’s generating capacity was approximately 12.3% of the generating capacity of CPS’ electric system. The electricity prices for CPS’ customers in 1999 were the lowest among the 20 largest cities in the United States and the lowest among major Texas cities.
CPS’ board of trustees has five members: one director is always the mayor of the City of San Antonio, and the other four each represent one quadrant of the city. As a part of the City of San Antonio, CPS has its financial statements included in the annual financial reports of the City of San Antonio. The City of San Antonio shares in CPS’ revenues, and the percentage of gross revenues to be paid over or credited to the City of San Antonio each fiscal year by CPS is determined (within the 14% limitation) by the governing body of the City of San Antonio.
CPS had been presented with other similar transaction opportunities before Unicom’s proposal, but CPS rejected these prior proposals for various reasons. After receiving the proposal from Unicom and reviewing valuations and the
In order to proceed with the Spruce transaction, the City of San Antonio brought suit in Texas State court to obtain a declaratory judgment on the continued validity of certain covenants in its outstanding public securities issued for the purpose of financing the construction and improvement of its electric and gas systems, which included the Spruce station. The City of San Antonio represented in the petition that the encumbrance would be limited to the value of the private company’s (Unicom’s) “future right to obtain a possessory leasehold interest in the [f]acility (a) after the 30-year lease back to the City has expired and (b) if the City elects not to exercise its right to cancel the [headlease] after the 30-year lease back to the City has expired.” In the initial draft of the petition, the City also represented that it intended to exercise the cancellation option. However, this statement was later deleted at the suggestion of Winston & Strawn and PwC, who reviewed the petition on behalf of Unicom and provided comments.
The City of San Antonio represented in its petition that it retained fee ownership in the Spruce station and retained possession and rights to operate it during the leaseback term. The City of San Antonio also represented that all the rent would be prepaid six months after the closing date on the leaseback transaction and that the City of San Antonio would make an investment that upon maturity would provide the amounts necessary to pay for the cancellation option.
The City estimated that the net present value of the rights which Unicom would acquire in the future was approximately $40 million.
1. Lease and Sublease
On June 2, 2000, the City of San Antonio, acting by and through CPS, entered into a sale-leaseback transaction with Unicom, through UII and its wholly owned subsidiaries, Spruce Equity Holdings, L.P., and Spruce Holdings Trust, with respect to the Spruce station. In essence, the money transferred by Unicom to CPS was to be split in three funds: the first fund would be returned to Unicom as a prepayment of sublease by CPS, the second fund would be set aside for investment that would secure the payment of the cancellation option should CPS decide not to reacquire the Spruce station at the end of the sublease, and the third fund would be retained by CPS and could be used for its current needs.
a. Spruce Headlease Agreement
Pursuant to the headlease agreement for the Spruce transaction (Spruce headlease), CPS leased the Spruce station to Unicom for a term of 65 years, starting June 2, 2000, and terminating on June 2, 2065 (Spruce headlease term), unless terminated earlier. The Spruce headlease term exceeded the Spruce station’s estimated remaining useful life of 52 years, as determined in the Deloitte appraisal report dated June 2, 2000 (Spruce appraisal). Since the headlease term exceeded the plant’s remaining useful life, the transaction could qualify as a sale, making it a SILO, not a LILO.
Under the Spruce headlease, Unicom agreed to pay $725 million to CPS on the closing date, June 2, 2000 (Spruce headlease rent). This amount was equal to the estimated fair market value of the Spruce station on the closing date according to the Spruce appraisal prepared by Deloitte. The appraised fair market value served as the basis for determining Unicom’s investment in the transaction, and the parties did not further negotiate the investment amount. Deloitte estimated that as of the end of the Spruce sublease in 2032 the fair market value of the Spruce station would be $626 million if based on the discounted cashflow analysis ($609.6 million if based on the cost approach).
Under the Spruce sublease agreement (Spruce sublease), CPS leased back from Unicom all of Unicom’s right, title, and interest in the Spruce station under the Spruce headlease. The sublease term commenced on June 2, 2000, and was scheduled to terminate on March 2, 2032, for a term of 31.75 years.
Under the Spruce sublease, CPS was obligated to prepay rent to Unicom for the entire sublease term in the amount of $557,329,539 on November 30, 2000 (Spruce base rent). The Spruce base rent accrued and was allocated annually pro rata, commencing on the first day of the sublease term. If the Spruce sublease terminated early, Unicom was required to return to CPS any unaccrued base rent.
The Spruce sublease was a net lease, requiring CPS to pay all costs and expenses in connection with the Spruce station. In addition, CPS was required to maintain insurance on the Spruce station under the terms of the sublease.
2. Default
The parties to the Spruce transaction agreed that the Spruce headlease could not be terminated or extinguished by any circumstances of any character or for any reason, with certain limited exceptions including CPS’ defaulting under the Spruce sublease terms.
The Spruce sublease provided for early termination if CPS were to default under the terms of the sublease. The events of default included, among other provisions, failure to pay the Spruce base rent, failure of any material representation or warranty made by CPS, or failure to properly maintain the Spruce station. In case there was significant damage to the Spruce station so as to render the station beyond repair, CPS could elect to either replace the Spruce station or terminate the Spruce sublease.
In any of these scenarios, Unicom had a number of remedies against CPS, including collecting the stipulated loss value of the Spruce sublease, and taking possession of the Spruce station to operate, sell, or sublease it to somebody else. The stipulated loss value was predetermined on the closing date and based on the Deloitte Spruce appraisal and was meant to ensure Unicom’s return on the investment.
Under the Spruce headlease, Unicom had the right to use, operate, and possess the Spruce station without interference from CPS. Unicom did not have any obligations to CPS in respect of maintenance, operation, or insurance of the Spruce station under the headlease. Upon the Spruce headlease expiration, Unicom could return the Spruce station to CPS. Unicom was not obligated to make any representations or warranties with respect to the Spruce station except that it was free and clear of liens in case CPS decided to exercise its cancellation option at the end of the Spruce sublease term.
The Spruce sublease was a triple-net lease, meaning that CPS was responsible for all the costs and expenses, foreseen or unforeseen, in connection with the Spruce station, including costs of operation, maintenance, insurance, improvements and other expenses. The Spruce sublease contained a covenant of quiet enjoyment in favor of CPS unless it defaulted under the sublease. CPS could, at its own expense, use, operate, service, repair, and maintain the property as long as it complied with the industry standards and applicable laws and did not have a material adverse effect on the Spruce station, did not result in risk of criminal liability, and did not involve any material risk of loss, forfeiture, or sale of the Spruce station. CPS was solely responsible for environmental compliance and any necessary remedial measures. CPS was also responsible for obtaining and maintaining property and liability insurance coverage meeting certain requirements set out in the Spruce sublease agreement.
Unicom’s rights under the Spruce sublease were very limited. Unicom had the right to inspect the Spruce station no more than once a year. CPS was required to seek Unicom’s consent with respect to proposed improvements, corporate consolidations, subleases, and assignments.
CPS had limited rights to encumber the property throughout the Spruce sublease term, and could not create any liens on the property after the Spruce sublease term expiration. Unicom, on the other hand, could incur liens on the property after the termination of the Spruce sublease, provided that CPS did not exercise its cancellation option.
If CPS decided to return the station to Unicom at the end of the sublease, CPS was required to arrange at its own expense for any necessary permits for Unicom to operate the Spruce station and for engineering and environmental inspections, as well as to arrange for Unicom fuel supply contracts and transmission agreements, together with other agreements necessary to operate the station. Failure to comply with these requirements would trigger a CPS default under the agreement, and Unicom could pursue its contractual remedies.
4. Cashflows
Unicom paid $725 million to CPS under the Spruce headlease on June 2, 2000. Of that amount, CPS retained a lump sum of approximately $88 million, of which the City of San Antonio received about $12.3 million.
On the same date, CPS entered into the collateralized payment undertaking agreement (CPUA) with AIG Financial Products (Jersey), Limited (AIG-FP). Under the CPUA, CPS would pay AIG-FP a fee of $88,995,790 (undertaking fee). In exchange, AIG-FP would use the proceeds from the undertaking fee to make payments to Unicom, for the benefit of CPS, at the end of the Spruce sublease term in the amounts and on the dates specified in the CPUA. In essence, the payments matched both in timing and amount the amounts CPS would owe to Unicom upon CPS’ exercise of the fixed purchase option (cancellation option) available to CPS at the end of the Spruce sublease term. The cancellation option allowed CPS to terminate the Spruce headlease at the end of the
The CPUA required AIG-FP to deliver the cash received as the undertaking fee to Wilmington Trust Co. to be held as collateral pledged primarily to Unicom until CPS paid its obligations under the various transaction agreements. In the event of an early termination of the Spruce sublease, Unicom would receive a “termination amount” under the terms of the CPUA from the undertaking fee proceeds.
As additional protection of Unicom’s interest in the amounts set aside under the CPUA, American International Group, Inc. (AIG), guaranteed the obligations of AIG-FP under the CPUA. CPS also obtained a financial guaranty insurance policy from Financial Security Assurance (FSA). Specifically, the policy provided certain protections to CPS in case of its bankruptcy or in the event of CPS’ default or early termination of the sublease.
Further, from the Spruce headlease rent, CPS transferred the following amounts to secure the Spruce sublease base rent due on November 30, 2000:
- about $327.3 million to Wilmington Trust Co. as custodian of an account that would be pledged to Unicom;
- about $50 million to an account pledged to AIG Financial Products Corp. to support CPS’ obligations under the letter of credit reimbursement agreement;
- about $162 million to an account pledged to FSA to support CPS’s obligations under the insurance and indemnity agreement to the Spruce sublease.12
C. End of Sublease Term
1. CPS’s Cancellation Option
At the end of the Spruce sublease term, March 2, 2032, CPS would have the option of terminating the Spruce sublease
If CPS chose not to exercise the cancellation option, it would trigger provisions of the Spruce sublease describing conditions for returning the Spruce station to Unicom. Among other things, CPS would have to ensure that the station meet operational standards, arrange for various inspections, obtain operating permits for Unicom, and arrange for Unicom to enter into fuel supply contracts, transmission agreements, and other contracts with third parties necessary to operate the Spruce station. Failure to comply with these requirements would trigger a default and the right of Unicom to seek contractual remedies, as discussed below.
2. Unicom’s Options
If CPS chose not to exercise the cancellation option at the end of the sublease term, Unicom would have three choices. First, Unicom could require CPS to arrange for a “qualified operator” to enter into an operating agreement with Unicom. Second, Unicom could require CPS to arrange for a “qualified bidder” to enter into a service agreement. If Unicom did not provide CPS with written notice of which option it decided to exercise, Unicom would be deemed to have exercised both the operating agreement and the service agreement options. Finally, Unicom could take possession of the Spruce station and could operate it and sell its energy production without exercising the operating agreement or service option.
If Unicom exercised the service agreement or operating agreement option and CPS failed to implement the service agreement or operating agreement option by the end of the Spruce sublease, such failure would constitute an event of default and trigger the right of Unicom to pursue appropriate remedies. However, under certain circumstances CPS would
a. Operating Agreement
Under the operating agreement option, CPS was required to find a qualified operator for the Spruce station. CPS could not be the qualified operator. A qualified operator would have to, among other requirements, have its senior long-term debt rated no lower than Aa2 by Moody’s and AA by S&P or have a comparable rating by another rating agency acceptable to Unicom or be deemed similarly creditworthy in the sole opinion of Unicom. Alternatively, a qualified operator could obtain a guaranty of its obligations under the operating agreement by any person with its senior unsecured long-term debt rated no lower than Aa2 by Moody’s and AA by S&P, or have a comparable rating by another rating agency acceptable to Unicom.
The operating agreement option contemplated that the electric output of the Spruce station would be sold to third parties under the power toll processing agreements, discussed in the next section.
Deloitte included in its appraisal a list of potential power purchasers and operators. The only entity with an acceptable credit rating was General Electric Corp., meaning that most potential qualified operators would have to make guaranty arrangements.
3. Service Agreement
If CPS did not elect to exercise its cancellation option and Unicom elected to exercise the service agreement option, CPS was required to arrange for the submission of one or more bids from qualified bidders to enter into the power toll processing agreement with Unicom for a term of 9.58 years. Unicom expected the power toll processing agreement to be substantially in the form attached to the Spruce sublease agreement. CPS was also required to arrange for the qualified bidder to satisfy all of the conditions precedent to entering into the power toll processing agreement on or before the expiration date for the Spruce sublease.
A qualified bidder would have to have--or have its obligations under the power toll processing agreement guaranteed by any person that had--senior unsecured long-term debt
The power purchase bids would have to provide Unicom with net power revenue in the amounts and at the times set forth in the Spruce sublease. Unicom could reject any bid if it concluded that the bid would require the Spruce station to be operated inconsistently with the standards and operational practices and policies of operators of similar facilities in similar circumstances. In that event, CPS would be entitled to arrange for one or more alternative bids. If CPS were unable to find a qualified bidder or Unicom rejected all bidders on or before the Spruce sublease expiration date, CPS would have to exercise the cancellation option.
II. Scherer and Wansley
A. MEAG and Its Decision To Enter the Scherer and Wansley Transactions
MEAG was created by the State of Georgia to own and operate electric generation and transmission facilities and supply bulk wholesale electric power to its 49 member municipalities, 48 cities, and one county in Georgia. MEAG’s mission is to deliver low-cost power to its participants and, with respect to its own generation plants, operate them at the lowest cost. MEAG sells power to its cities at cost and any profit it earns has to inure to the benefit of its cities.
MEAG is a member of a power marketing agency called the Energy Authority, which optimizes MEAG’s resources and identifies the most economical method for MEAG to supply power to its members. These options could entail selling output to the market from one of the power plants MEAG owns and then buying lower-cost power from a third party, or selling some of MEAG’s extra capacity during colder months to Florida, North Carolina, or Alabama.
MEAG’s portfolio of assets consists primarily of investments in power plants, including undivided ownership
MEAG is a governmental entity and is tax exempt. State law restricts MEAG’s investments primarily to U.S. Treasuries, repurchase agreements backed by treasuries and agencies, and money market funds that have treasuries and agencies. In 1999 MEAG opened an account with $435 million that was intended to grow with interest until 2008 when MEAG thought deregulation would occur, but the power market in Georgia was never deregulated.
James Fuller was MEAG’s treasurer at the time the Wansley and Scherer transactions were negotiated and closed. Mr. Fuller led MEAG in the negotiations with petitioner and the other third parties involved in the transactions. During the negotiations, Mr. Fuller reviewed the transaction documents and the terms relating to the fixed price purchase option. Mr. Fuller also reviewed the Deloitte appraisal, but MEAG did not do an appraisal of its own. MEAG originally acquired the Wansley and Scherer stations at cost.
Before entering into the Scherer and Wansley transactions, MEAG obtained certain consents from the coowners of the stations, Georgia Power Co., Oglethorpe Power Corp., and the City of Dalton. MEAG also retained R.W. Beck to evaluate the impact of the sale of these plants on MEAG’s participants to comply with the provisions of the bond indentures issued to finance the Wansley and Scherer stations.
B. Key Terms of the Scherer Transaction
Plant Robert W. Scherer Unit Nos. 1 and 2 (Scherer station) is on a 12,000-acre site near Forsythe, Georgia, and includes a powerhouse containing Units 1 through 4, various ash ponds, a water pond, a coal storage yard, a 550-kilovolt substation, and a man-made lake. Only Units 1 and 2 of the Scherer station were part of the leasing transactions with
1. Lease and Sublease
On June 9, 2000, Unicom, acting through Scherer Holdings 1, LLC, and UII, entered into a sale-leaseback transaction with MEAG involving an undivided interest in the Scherer station (Scherer transaction).
a. Headlease
Pursuant to the headlease agreement for the Scherer transaction (Scherer headlease), MEAG leased to Unicom (i) a 10.0% undivided interest in the Unit 1 site, the Unit 2 site and the unit common facilities site, and a 5.0% undivided interest in the Plant Scherer Common Facilities Site, (ii) a 10.0% undivided interest in Unit 1, Unit 2, and the unit common facilities, and (iii) a 5.0% undivided interest in the Plant 27 Scherer Common Facilities (collectively, Scherer station) for a term of 61.75 years, starting June 9, 2000 and terminating on September 9, 2061 (Scherer headlease term), unless terminated earlier. The Scherer headlease term exceeded the Scherer station’s estimated remaining useful life of 49 years, as determined in an appraisal report on the Scherer Station dated June 9, 2000, prepared by Deloitte (Scherer appraisal).
Under the Scherer headlease, Unicom agreed to pay MEAG $201,986,755 on the closing date, June 9, 2000 (Scherer headlease rent). The Scherer headlease rent equaled the estimated fair market value of the Scherer station as of June 9, 2000, as determined by Deloitte in the Scherer appraisal. The parties did not further negotiate the fair market value of the station, and Mr. Fuller could not recall whether MEAG had obtained written advice on the valuation of the Scherer station from anyone other than Deloitte.
MEAG had the right to inspect the Scherer station site throughout the duration of the headlease. Unicom did not have any obligations to MEAG as to maintenance, operation, or insurance of the interests conveyed under the headlease.
On the same date, June 9, 2000, Unicom and MEAG entered into an agreement to lease back the Scherer station (Scherer sublease). MEAG leased back from Unicom all of Unicom’s right, title, and interest in the Scherer station under the Scherer headlease. The sublease term commenced on June 9, 2000, and was scheduled to terminate on September 9, 2030, for a total term of 30.25 years (Scherer sublease term).
MEAG had an absolute and unconditional obligation to prepay Scherer sublease rent of $157,414,216 to Unicom on December 7, 2000. Similar to the Spruce transaction, the Scherer sublease was a triple net lease, meaning that MEAG was solely responsible for any expenses associated with the sublease. The parties allocated all the risks related to the Scherer sublease to MEAG. MEAG was also responsible for maintaining property and liability insurance which met the requirements set forth in the Scherer sublease.
2. Default
Similarly to the Spruce transaction, MEAG and CPS could not declare a default under the headlease. The Scherer sublease, however, had provisions outlining what events would constitute a default by MEAG. Such events included, among others, MEAG’s failure to pay the Scherer sublease rent on time, failure of material representation or warranty, or failure to properly maintain the Scherer station. MEAG had an opportunity to cure such defaults.
In addition, the Scherer sublease also specified certain “Events of Loss“, in case of which MEAG could elect to either rebuild or replace the specific unit in question or to terminate the sublease with respect to that unit.
In the event of default, Unicom had the following contractual remedies: (1) enforce performance by MEAG at MEAG’s cost or recover damages for a breach; (2) terminate the Scherer sublease and demand that MEAG return possession of the subleased assets to Unicom; or (3) demand that MEAG pay any supplemental sublease rent due plus the stipulated loss value, and, upon such payment, transfer all of its right, title, and interest in the leased assets back to MEAG. If Unicom chose to proceed with the second or third option, it
If an event of loss occurred and MEAG chose not to rebuild or replace a specific unit, MEAG would have to pay Unicom a stipulated loss value, as set forth in schedule 2 to the Scherer sublease agreement. Unicom would then have to pay to MEAG an early termination amount, which would reflect any unaccrued rent as of the date of the event of loss.
3. Property Rights and Obligations
Unlike the Spruce transaction, where Unicom received a 100% interest in the Spruce station, the Scherer headlease transferred only a partial interest in the Scherer station to Unicom. Unicom received a right of quiet enjoyment under the headlease. This, however, did not result in Unicom’s authority to operate the Scherer station.14 Unicom had the right to use the ground interest to construct, install, operate, use, repair, and relocate and remove facilities and structures on or under the Scherer site. Unicom, however, in general did not have any obligations to MEAG with respect to maintenance, operation, or insurance of the Scherer station interest under the headlease.
Upon the expiration of the Spruce headlease, Unicom was to return its interest to MEAG on the “as is” and “with all faults” basis. MEAG had the right to inspect the property after the expiration of the leaseback term. Unicom was responsible for a percentage of certain taxes and assessments with respect to the ground interest described in the Scherer headlease agreement from the date the leaseback to MEAG ended and until the end of the headlease. Both MEAG and Unicom agreed to limit their ability to incur liens with
Under the Scherer sublease, MEAG received the same interest in the Scherer station it transferred to Unicom under the Scherer headlease. Overall, the rights of MEAG under the sublease were similar to the rights of CPS under the Spruce sublease. MEAG’s rights with respect to subleasing its interest during the sublease term were broader than those of CPS: MEAG did not need separate approval for a sublease if it met certain requirements. Unicom had the right to inspect the premises during the sublease once a year and the right to consent to the assignment by MEAG of its rights under the Scherer sublease.
Under the Scherer sublease, MEAG took the Scherer station interest from Unicom on an as-is basis. If MEAG or other tenants in common of the Scherer station did not exercise the purchase option at the end of the Scherer sublease or if MEAG was required to return the Scherer station interest to Unicom after a default, MEAG was required to meet certain conditions, including having the Scherer station meet certain operational standards and be free from major defects, in good working order, and in a good state of repair. Unicom was entitled to receive, and MEAG agreed to deliver, the Scherer station with at least a 62% capacity factor based on 8,760 hours of operation per year and net energy output of 87.5%. In addition, MEAG was required to be in compliance with other agreements governing ownership and operation of the Scherer station and have no outstanding amounts due under those contracts.
If MEAG were required to return the Scherer station interest to Unicom, and Unicom chose the service agreement option, MEAG was to arrange at its own expense for any necessary permits for Unicom or a qualified bidder under the service agreement to operate the Scherer station. MEAG was also required to arrange for an environmental inspection, as well as to arrange for Unicom fuel supply contracts and transmission agreements, together with any other agreements necessary to operate the station. Failure to comply with the prerequisites to returning the Scherer station interest would trigger for MEAG, under certain circumstances, the requirement to pay to Unicom an amount equal to the diminution in the fair market sale value of the
4. Cashflows and Collateral Agreements
Unicom and MEAG chose to structure the cashflows for the Scherer and Wansley transactions differently from those for the Spruce transaction. In part this was so because of MEAG’s limited authority to invest in securities.
Pursuant to the Scherer headlease, on June 9, 2000, Unicom paid the Scherer headlease rent of $201,986,755 to MEAG.
On June 9, 2000, MEAG entered into the Government securities pledge agreement (Scherer pledge agreement) with Ambac Credit Products, LLC (Ambac Credit), and State Street, as agent and intermediary. Pursuant to the Scherer pledge agreement, MEAG would pay from the Scherer headlease rent $152,228,894 to State Street to purchase Government securities on the closing date of the Scherer transaction. The pledge agreement required MEAG to pledge these Government securities to Ambac Credit first and Unicom second to secure MEAG’s obligation under the Scherer sublease to make the Scherer base rent payment on December 7, 2000.
State Street also paid Ambac Credit $1,544,674 on the closing date of the Scherer 1 transaction on behalf of MEAG. In exchange, Ambac Credit agreed to make certain payments on behalf of MEAG pursuant to a credit swap agreement between Ambac Credit and UII (UII swap agreement). The payment also covered the financial guaranty insurance policy issued by Ambac Assurance Corp., No. SF0353BE, dated June 9, 2000 (Scherer FGIP).
Under the UII swap agreement, Ambac Credit was obligated to pay UII the excess of the stipulated loss value over all payments UII received with respect to the stipulated loss value or purchase option price from other sources, plus the early termination amount. In exchange, UII would be required to surrender its right, title, and interest under the Wansley transaction to Ambac Credit, the swap provider.
Under the Scherer FGIP, Ambac Assurance Corp. unconditionally and irrevocably guaranteed the payments by the swap provider under the UII swap agreement. The payment obligation under the UII swap agreement is triggered by the
On June 9, 2000, MEAG entered into a credit swap agreement with Ambac Credit (MEAG swap agreement). Ambac Credit paid MEAG $372,890, and MEAG agreed to make the payments described in the MEAG swap agreement. MEAG’s payment obligations under the MEAG swap agreement are the same as those described under the UII swap agreement. State Street paid $1,000,934 of various transaction expenses on the closing date of the Scherer transaction on behalf of MEAG.
On June 9, 2000, MEAG also transferred $47,576,143 to various collateral accounts for investment in short-term collateralized flex repurchase agreements. The collateral accounts served as collateral for MEAG’s purchase option obligation under the Scherer sublease.
The effect of the transactions discussed above was to set aside funds from the Scherer headlease rent to fund MEAG’s obligations to pay the Scherer rent and the purchase option under the Scherer sublease.
5. End of Sublease Term
Similarly to the Spruce transaction, at the end of the sublease term MEAG or one of its cotenants in common could exercise the purchase option to regain all the rights to the Scherer station. If that did not happen, Unicom could exercise its rights under the operating agreement or service agreement option, or could choose to purchase and sell its share of the Scherer output on the market.15
a. MEAG’s Purchase Option
At the end of the Scherer sublease term, September 9, 2030, MEAG has the option of terminating the Scherer sublease and causing Unicom to terminate the Scherer
MEAG chooses not to exercise the Scherer purchase option, one or more of MEAG‘s cotenants in common will then have the right to acquire Unicom‘s interest in the Scherer station.16 To exercise the Scherer purchase option, MEAG will have to give written notice to Unicom no later than January 15, 2029.
If neither MEAG nor its cotenants in common decide to exercise the Scherer purchase option, MEAG will have to comply with all of the requirements for returning the Scherer station interest to Unicom as described above.
b. Unicom‘s Options
i. Operating Agreement Option
Under the terms of the Scherer sublease, if neither MEAG nor its cotenants exercise their purchase options, Unicom can exercise the operating agreement option. This option will not be available to Unicom if, at the time of exercise, MEAG is not an operator of the Scherer station under the agreements governing MEAG‘s relationships with cotenants and management and operation of the Scherer station.
If MEAG is an operator of the Scherer station, Unicom can then require MEAG to arrange for a qualified third party to enter into an operating agreement with Unicom to operate the Scherer station. The electric output of the Scherer station would be sold to third parties under power purchase agreements while the station was operated and maintained on behalf of Unicom by the qualified operator.
A qualified operator would, among other requirements, have, or have its obligations guaranteed by a guarantor who has, a rating not lower than Aa2 by Moody‘s and AA by S&P, or be deemed similarly creditworthy by Unicom and be otherwise reasonably acceptable to Unicom. Failure by MEAG to implement its obligations under the operation agreement option would lead to MEAG‘s default under the Scherer sublease. Under certain circumstances, MEAG and its cotenants would get another opportunity to exercise the purchase option. If they decided not to do so, Unicom would have to
ii. Service Agreement Option
If MEAG or its cotenants chose not to exercise the purchase option and MEAG was not an operator of the Scherer station at that time, the only option available to Unicom would be to exercise its rights under the service agreement option.
Under the service agreement option, Unicom could require MEAG to arrange for the submission of one or more power purchase bids from “qualified bidders” to enter into power purchase agreements with Unicom.
Similarly to the Spruce transaction, a qualified bidder would have to meet certain creditworthiness requirements or have its obligations under the power purchase agreement guaranteed by an entity with sufficient creditworthiness. MEAG could itself submit a bid as a qualified bidder subject to meeting all the qualified bidder requirements. The parties contemplated that a qualified bidder would enter into a power purchase agreement and would purchase the electric output from the Scherer station for the term of 8.69 years. On the basis of the Deloitte appraisal, the parties believed that after the end of the power purchase agreement term, the remaining economic useful life of the assets under the Scherer headlease would be 10.6 years or 20.53% of the estimated overall useful life remaining as of the closing date in 2000.
The requirements for the net power revenue under the power purchase agreement to be received by Unicom were predetermined and set out as schedules to the Scherer sublease. However, these payments were not guaranteed unless the plant actually produced power in the required amounts and at certain efficiency standards.
Unicom could reject any bids at its sole discretion. If MEAG failed to provide Unicom with qualified bidders to enter into the power purchase agreement or if Unicom rejected all such bids, that would constitute an event of default under the agreement. Under certain circumstances, MEAG would have an additional opportunity to exercise the purchase option. Otherwise, Unicom could use the standard
Similar to the Spruce sublease, if Unicom did not give notice as to which option it elected, it would be deemed to have elected to exercise both the operating agreement and the service agreement options if both options are available. MEAG‘s failure to implement its obligations under both options would constitute its default under the sublease, which would result in either another chance to exercise the purchase option or Unicom‘s entitlement to other contractual remedies.
C. Key Terms of the Wansley Transaction
Power Plant Wansley (Wansley station), on a 5,225-acre site near Carrollton, Georgia, included two conventional power generation units, as well as a 320-acre ash disposal pond, a 126-acre potable water pond, a 40-acre coal storage yard, a 15-acre 500-kilovolt substation, and a 606-acre service water pond that provides cooling water for the plant. At the time of the transaction in 2000, Wansley station comprised two self-contained 865 MW coal-fired units. Units 1 and 2 are conventional coal-fired units equipped with a single boiler and turbine generator, commissioned in 1982 and 1984, respectively. The leased property did not include the coal stockpile, inventories, intangibles, and unit trains owned by MEAG at the sites.
1. Lease and Sublease
a. Headlease
On June 9, 2000, MEAG entered into the Wansley transaction with Unicom (through Wansley Holdings 1, LLC and UII) involving an undivided interest in Plant Hal Wansley Units 1 and 2 (together, Wansley station), as well as certain common facilities. In the Wansley transaction, MEAG leased a 10% undivided interest in the Wansley station17 to Unicom through its wholly owned subsidiaries for a term of 56.75 years (Wansley headlease). Deloitte appraised the undivided interest in the Wansley station as of the closing date of
On June 9, 2000, under the Wansley headlease, Unicom paid $172,185,430 to MEAG for the lease of the Wansley station (Wansley headlease rent). According to Deloitte, the Wansley headlease rent was approximately equal to the estimated fair market value of the Wansley station on June 9, 2000. The appraised fair market value served as the basis for determining Unicom‘s investment in the transactions, and the parties did not further negotiate the investment amount. Deloitte estimated that as of the end of the sublease the fair market value of the Wansley station would be about $485 million if based on the discounted cashflow approach and $481 million if based on the cost approach.18
b. Sublease
On June 9, 2000, MEAG and Unicom, through Wansley Holdings 1, LLC, entered into the sublease agreement, whereby MEAG leased the Wansley Station back (Wansley sublease) from Unicom for a term of 27.75 years. MEAG leased back from Unicom all of Unicom‘s rights, title, and interest in the Wansley station. The Wansley sublease was scheduled to terminate on March 9, 2028. Under the terms of the Wansley sublease, MEAG was obligated to pay rent to Unicom of $134,087,903, on December 7, 2000, six months after the closing of the Wansley transaction (Wansley base rent).
The Wansley sublease was a net lease, similar to the Spruce and Scherer subleases. MEAG was responsible for all costs and expenses associated with the Wansley station throughout the sublease. In addition, MEAG had to maintain property and liability insurance on the Wansley station meeting the requirements set out in the sublease.
2. Default
Provisions governing events of default and events of loss are substantially the same in the Wansley and Scherer transactions. The Wansley sublease outlines different operating
3. Property Rights
The property rights of Unicom and MEAG under the Wansley transaction are substantially identical to those in the Scherer transaction and need not be separately stated here.
4. Cashflows and Collateral Agreements
MEAG and Unicom used the same structure of cashflows and collateral agreements for the Wansley transaction as for the Scherer transaction.
Pursuant to the Wansley headlease, on June 9, 2000, Unicom paid the Wansley headlease rent of $172,185,430 to MEAG.
On June 9, 2000, MEAG entered into the Government securities pledge agreement with Ambac Credit and State Street as agent and intermediary. MEAG paid State Street $129,768,893 from the Wansley headlease rent to purchase Government securities on that same date. MEAG pledged the Government securities to Ambac Credit and Unicom to secure MEAG‘s obligation to pay the base rent under the Wansley sublease on December 7, 2000. It was projected that the Government securities would equal the Wansley base rent of $134,087,903.
On June 9, 2000, MEAG provided UII with the UII swap agreement and the financial guaranty insurance policy issued by Ambac Assurance Corp., No. SF0356BE, dated June 9, 2000 (Wansley FGIP). On the same date, State Street, on behalf of MEAG, paid Ambac Credit $1,200,317.76, in consideration of Ambac Credit‘s agreement to make the payments described in the UII swap agreement and in the Wansley FGIP. The obligations of the parties are the same as under the UII swap agreement and the Wansley FGIP in the Scherer transaction.
On June 9, 2000, MEAG entered into the MEAG swap agreement with Ambac Credit, and Ambac Credit paid MEAG $287,226 in consideration of MEAG‘s agreement to make the payments described in the credit swap between MEAG and Ambac Credit. MEAG‘s payment obligations
Also on the closing date, MEAG transferred $40,642,518 to collateral accounts for investment in short term collateralized flex repurchase agreements, as collateral for the purchase option, with a pledge first to Ambac Credit and second to UII.
5. End of Sublease Term
The end of sublease term options for Unicom and MEAG regarding the Wansley station are substantially the same as those in the Scherer transaction. MEAG and Georgia Power Co. could exercise the purchase option at the end of the Wansley sublease. The purchase option price was set at $143,543,915. If they chose not to do so, Unicom would be able to proceed with the operating agreement and service agreement options, similar to the provisions in the Scherer transactions. Alternatively, Unicom could get its share of the Wansley station output and sell it on the market.
Under the service agreement option, the electric output from the Wansley station would be purchased by third parties for the term of 8.09 years, and after the end of the power purchase agreement term the parties projected the remaining economic useful life of the Wansley station to be 9.17 years, or 20.38% of the estimated overall useful life remaining as of the closing date in 2000.
D. MEAG‘s Net Present Value Benefit
MEAG was entitled to receive a payment of approximately $110 million for its participation in the Scherer and Wansley transactions (MEAG NPV benefit). Mr. Fuller informed MEAG‘s board of directors in June 2000 that the MEAG NPV benefit for entering into the transactions would be approximately 11.19% of the value of each lease in the Wansley station and 12.34% of the value of each lease in the Scherer station. MEAG placed the NPV benefit into a trust account with State Street until 2014, at which time MEAG was expected to transfer the funds to the municipal competitive trust. MEAG‘s rights to use the NPV benefit until then were limited under the corresponding agreements because the trust
Post-Closing Events
I. Construction of Spruce II
At the time that CPS built the Spruce station, CPS had also intended to build, on an unspecified future date, a second generating plant (Spruce II) on the same site as the Spruce station. The Spruce transaction documents reflected the existence of such plans but in terms that did not convey absolute certainty.
On June 16, 2004, CPS informed Unicom in writing of CPS’ intention to exercise its right to install and use additional facilities on the site of the Spruce station. CPS intended for this expansion--Spruce II--to share facilities with the Spruce station, such as a “control room“, a “computer room“, “coal conveyers“, a “demineralizer“, a “limestone silo ball mill“, and a “limestone slurry storage tank“. Although CPS would also build other operational facilities strictly for the benefit of Spruce II‘s operations, those facilities would be situated on the same land occupied by the Spruce station.
The letter dated June 16, 2004, from CPS requested prior written approval of the Spruce II construction from Unicom under the terms of the Spruce headlease. In evaluating CPS’ request, Thomas Miller, Exelon‘s vice president of finance, and Randy Specht, from petitioner‘s engineering group, visited the Spruce site on December 17, 2004. Messrs. Miller and Specht met with CPS’ plant personnel and toured the facility. In addition to the tour, Mr. Miller requested written representations from CPS that the Spruce II station would not interfere with or harm petitioner‘s interest in the Spruce station. CPS provided such written representations. Exelon, which at the time became a successor to Unicom by virtue of merger, then executed an approval authorizing the construction of the Spruce II plant. Exelon did not visit the site after the Spruce II project was completed in 2010 to examine the outcome.
On or about April 5, 2000, before the closing of the test transactions, Winston & Strawn circulated the initial draft of a designation agreement whereby PwC as designated organizer agreed to register the Spruce, Scherer, and Wansley transactions as tax shelters with the IRS in accordance with
On or about June 1, 2000, PwC filed with the IRS in Kansas City, Missouri, Form 8264, Application for Registration of a Tax Shelter (Confidential Corporate Tax Shelter), for the Spruce transaction. On June 16, 2000, the IRS assigned tax shelter registration No. 00167000008 to the Spruce transaction.
On or about July 13, 2000, PwC filed a supplemental Form 8264 with the IRS in Kansas City, Missouri, for the Spruce, Scherer, and Wansley transactions. On July 18, 2000, the IRS issued tax shelter registration No. 00167000008 for the Scherer and Wansley transactions.
Unicom‘s tax return for its 1999 tax year included an appropriate disclosure statement under the then-effective regulations for a reportable transaction for UII on account of the test transactions. It also properly disclosed tax shelter registration No. 00167000008 on Form 8271, Investor Reporting of Tax Shelter Registration Number, issued by the IRS in connection with the Spruce, Scherer, and Wansley transactions. PwC monitored the status of the tax shelter registrations, including the registration No. 00167000008, for Unicom/UII and the Spruce, Scherer and Wansley transactions.
Enhancements in the Scherer and Wansley transactions were structured differently from those in the Spruce transaction. CPS and Unicom used a CPUA as credit enhancement to secure the sublease obligations and provide the funds for the cancellation option exercise to CPS at the end of the sublease. In the Scherer and Wansley transactions, MEAG and Unicom used credit swap contracts issued by Ambac Credit to secure the payment of the purchase option exercise price. Under the swap contracts, MEAG would pledge high-quality securities primarily to Ambac Credit and secondarily to UII to pay the termination fees under the subleases or purchase option price. MEAG determined how it wanted to invest the money, with the ultimate goal to have sufficient funds to pay the purchase option price at the end of the Scherer and Wansley subleases.
Initially MEAG decided to invest the funds in short-term repurchase agreements, Federal agency discount notes, and a managed portfolio with Government-backed agency and Treasury securities. These short-term investments were rolled over and reinvested as they came due. Any ongoing investment risk, such as changes in interest rates over time, was borne entirely by MEAG.
In 2001 MEAG first suggested changing its investment portfolio by investing either in adjustable rate mortgage securities guaranteed by a Federal agency or Government-sponsored enterprise or in short-term money market funds rated AAA. Exelon agreed to the substitution. The securities continued to be pledged to Ambac Credit and Exelon.
Because the early 2000s ended up being a period of low interest rates, the funds invested by MEAG grew at a rate insufficient to fully fund the future purchase options. In 2006 MEAG proposed another substitution to Exelon, whereby MEAG would replace the existing collateral with a pledge of MEAG‘s own newly issued bonds insured by Ambac Credit. In August 2006 Exelon agreed to MEAG‘s request. This allowed MEAG to receive the funds it needed for environmental compliance and certain operational needs. Overall, MEAG replaced $173 million worth of collateral securities with its own bonds. MEAG also pledged an extra $81,171,330 of securities to Ambac Credit in 2007. In
When Ambac Credit‘s credit rating declined, MEAG contacted Exelon and received a waiver of the requirement that the bond insurance company maintain a certain credit level.
IV. Postclosing Monitoring
After the closing dates of the Spruce, Wansley, and Scherer transactions, the lessees were required to provide Unicom with certain financial and operational information. For example, CPS contacted petitioner regarding the impact of higher property insurance rates following the September 11, 2001, attacks. In addition, as discussed above, Unicom consented to the construction of Spruce II and the MEAG collateral substitution.
In 2008 employees from Exelon‘s corporate finance and asset management groups inspected the Spruce, Wansley, and Scherer stations as part of a “compliance review” to ensure that the facilities were being operated and maintained properly. Before the on-site inspections, Exelon‘s employees reviewed various operating and financial performance indicators and data, and also requested applicable documents for the leased stations from CPS and MEAG. The review did not raise any red flags. Exelon did not conduct compliance reviews in any other years even though it had the right to visit the sites and request related documents each year.
V. Early Termination of the Spruce Transaction
Pursuant to an omnibus termination agreement, on or about February 26, 2014, CPS and Exelon terminated the Spruce transaction. Upon termination of the Spruce transaction, Exelon received $335 million in exchange for terminating its interests in the Spruce station. Possession of the Spruce station passed to CPS, free and clear of any claims or liens by Exelon.
I. Tax Returns
A. 1999 Tax Year
Unicom timely filed the Unicom Group‘s consolidated Federal income tax return for the 1999 tax year. On or about April 1, 2004, Exelon, as successor to Unicom, filed Form 1120X, Amended U.S. Corporation Income Tax Return, for the Unicom Group‘s 1999 tax year. On or about August 25, 2004, Exelon filed a second amended tax return for the Unicom Group‘s 1999 tax year. On or about January 9, 2007, Exelon filed a third amended tax return for the Unicom Group‘s 1999 tax year.
On its 1999 income tax return, Unicom had indicated taxable income of $2,484,829,531 and filed Form 8824, Like-Kind Exchanges, describing the transactions at issue here. Unicom had not included in income deferred section 1031 gain of $1,231,927,407 arising out of the test transactions.
B. 2001 Tax Year
On or about September 26, 2002, Exelon, as successor to Unicom, filed its consolidated Federal income tax return for the 2001 tax year. On or about April 1, 2004, Exelon filed an amended tax return for its 2001 tax year. On or about January 30, 2007, Exelon filed a second amended tax return for the 2001 tax year.
On its 2001 income tax return, Exelon reported taxable income of $1,412,586,105. With respect to the transaction with CPS, Exelon had claimed a depreciation deduction of $2,968,648 an interest expense deduction of $38,261,289, and an amortized transaction costs deduction of $183,708. Exelon reported $40,476,248 of taxable rental income. Exelon had not reported taxable original issue discount income with respect
With respect to the transactions with MEAG, Exelon had claimed a depreciation deduction of $5,447,849 an interest expense deduction of $46,547,887, and an amortized transaction costs deduction of $231,814. Exelon reported $50,370,556 of taxable rental income. Exelon had not reported taxable original issue discount income with respect to the transaction (which respondent determined claims to be $7,078,805 for the 2001 tax year).
II. Notices of Deficiency
A. 1999 Tax Year
On September 30, 2013, respondent timely issued a statutory notice of deficiency to petitioner for its income tax liabilities for the tax year ending December 31, 1999 (1999 notice of deficiency). Respondent determined a deficiency in tax for 1999 of $431,174,592 and a penalty under
Respondent disallowed petitioner‘s treatment of the transactions with CPS and MEAG as
The 1999 notice of deficiency determined a
B. 2001 Tax Year
On September 30, 2013, respondent timely issued a separate statutory notice of deficiency to petitioner for its income tax liability for the tax year ending December 31, 2001 (2001 notice of deficiency). Respondent determined a deficiency in tax for 2001 of $5,534,611 and a penalty under
The 2001 notice of deficiency disallowed depreciation deductions of $2,968,648 and $5,447,849 claimed by Exelon for the CPS and MEAG sale- leaseback transactions, respectively, because “the taxpayer failed to acquire and retain significant and genuine attributes of a traditional owner, including the benefits and burdens of ownership“. Respondent disallowed interest expense deductions of $38,261,289 and $46,547,887, and amortized transaction costs deductions of $183,708 and $231,814, for the CPS and MEAG transactions, respectively. Respondent determined
In the alternative, respondent determined that sale-leaseback transactions with CPS and MEAG lack economic substance and should be disregarded for Federal income tax purposes. Accordingly, respondent disallowed petitioner‘s deductions of depreciation, interest expense, and transaction costs, and reversed rental income.
The 2001 notice of deficiency imposed a 20% accuracy-related penalty under
In the alternative, respondent determined the
III. Trial
Exelon timely filed petitions in both cases on December 13, 2013. The Court held a three-week special trial session in Chicago, Illinois. During the trial, the parties presented the testimony of 16 fact witnesses and 10 expert witnesses. Both parties rely heavily on expert opinions to support their arguments. The parties’ expert witnesses, their qualifications, and their Court-recognized areas of expertise are listed below. We also briefly summarize the conclusions of the experts in their respective expert reports.
1. Stewart Myers
The Court recognized Stewart Myers as an expert in finance, valuation, and investments in the energy industry, as well as analysis of complex financial transactions including leases and real options. Prof. Myers has a Ph.D. in finance and economics from Stanford, and he is the Robert C. Merton professor of financial economics at the MIT Sloan School of Management, where he has taught since 1966.
Prof. Myers’ graduate-level textbook, Principles of Corporate Finance (with Professors Richard Brealey and Franklin Allen) is a highly regarded treatise. He has also published dozens of articles on corporate finance and financial economics. He was also a director for Entergy Corp., a large public utility and merchant power generator based in New Orleans, Louisiana, that also has generating plants in the eastern and northeastern United States.
In his expert report Prof. Myers discussed the primary factors that affect the decisions of the parties involved in the test transactions to exercise their respective options. Prof. Myers testified that, while both MEAG and CPS do not pay income tax, their tax-exempt status does not affect their valuation of the leased stations.
Prof. Myers also testified that the accepted financial practice always makes decisions based on after-tax cashflows and rates of return.
Prof. Myers conducted sensitivity analysis involving several variables such as inflation and electricity price to determine the range of future market values of residual interests in the Spruce, Scherer, and Wansley stations and to see how it would affect the decisions of CPS and MEAG to exercise their cancellation/purchase options at the end of the sublease terms. He concluded that both CPS and MEAG would return their respective interests in the subleased stations to Exelon if the values of these interests at the end of the sublease terms were less than the purchase option prices. This would also cover the “base” scenario outlined in the Deloitte appraisal.
We find Prof. Myers’ sensitivity analysis helpful because it illustrates that even a difference of 1%-2% in the inflation rate would dramatically change the future market value of an interest over a 30-year term. For example, in the case of
2. John Reed
The Court recognized John J. Reed as an expert in transactions involving energy, industry firms and assets, energy market economic analyses, and evaluation and financial analysis related to the energy industry. Mr. Reed is a graduate of the Wharton School of the University of Pennsylvania, where he received a bachelor of science degree in finance.
Mr. Reed is currently the chairman and CEO of Concentric Energy Advisors, Inc., a financial advisory and management consulting firm for energy industry firms. Mr. Reed has over thirty-five years of experience in the energy industry, including as an executive in energy consulting firms and as chief economist for Southern California Gas Co., the largest U.S. gas utility. He has also been involved in the purchase, sale, and valuation of energy-related assets, including the sales of over 50 fossil fuel power generating facilities.
In his expert report Mr. Reed concluded that, at the time Unicom, CPS, and MEAG entered into the test transactions, a significant uncertainty existed with respect to the future value of the Scherer, Spruce, and Wansley stations. Mr. Reed concluded that CPS’ and MEAG’s tax-exempt status would not influence their analysis of the future market value of the plants.
3. Karl A. McDermott
The Court recognized Karl A. McDermott as an expert in regulatory economics, the history of regulation, and capital investment decisionmaking in the power utility industry in the United States. Prof. McDermott has a Ph.D. in economics
Prof. McDermott provided the Court with a primer on the U.S. energy market that also covered the periods both before and after many States (including Illinois) deregulated. In his expert report Prof. McDermott concluded that Unicom’s investment in leases with CPS and MEAG allowed it to achieve the same risk and reward profile it had had before the deregulation of generation assets in Illinois. Prof. McDermott stated that bankruptcy of CPS or MEAG was a relatively low probability although such bankruptcies had occurred in other jurisdictions.
4. Stuart Gilson
The Court recognized Stuart Gilson as an expert in the financial consequences of bankruptcy, including decisionmaking and financial consequences relating to bankruptcy proceedings. Prof. Gilson has a Ph.D. in finance from the University of Rochester and is a tenured professor in the Finance Department of Harvard Business School. His academic and consulting experiences focus on corporate finance, business valuation, credit analysis, and corporate restructuring and bankruptcy; and he has written several articles and case studies on those subjects.
In his expert report Prof. Gilson concluded that Unicom faced a risk of loss arising from a CPS or MEAG bankruptcy.19 In the event of a CPS or MEAG bankruptcy,
years, of the remaining term of the sublease. In his analysis Prof. Gilson did not consider various credit enhancements and contractual provisions available to Unicom in the case of a CPS or MEAG bankruptcy. Prof. Gilson concluded that the net financial impact on Unicom of an early sublease rejection would depend on the fair market value of the facility at the time of rejection. At low fair market value, Unicom could experience a loss at sublease rejection, but with the fair market value increase the net financial impact on Unicom would become increasingly positive.
5. Mark E. Zmijewski
The Court recognized Mark E. Zmijewski as an expert in the field of accounting, and particularly accounting for financial analysis of leases. Prof. Zmijewski is the Leon Carroll Marshall professor of accounting at the University of Chicago Booth School of Business, where he has served on the faculty since 1984. Prof. Zmijewski has an M.B.A. in accounting and a Ph.D. in accounting from the State University of New York at Buffalo. Prof. Zmijewski teaches courses in valuation, mergers and acquisitions, financial analysis, accounting, and entrepreneurship. He has also published articles on accounting, discounted cashflow valuations, and securities regulation.
In his expert report Prof. Zmijewski concluded that the test transactions were structured as direct financing leases rather than SILOs. Prof. Zmijewski also concluded that the test transactions are not front loaded under any of the options available in the lease and are not tax driven.
6. Ingrid Sarapuu
The Court recognized Ingrid Sarapuu as an expert in lease financing, leasing, and asset financing. Ms. Sarapuu has an M.B.A. from the University of Chicago Booth School of Business. She has been a licensed securities principal with Series 7, 24, 63, and 79 certifications. She also has over 30 years of executive experience in leveraged leasing and corporate finance in the private sector. In her expert report Ms. Sarapuu concluded that the test transactions are consistent with traditional leasing structures. Ms. Sarapuu also opined
7. Nancy Heller Hughes
The Court recognized Nancy Heller Hughes as an expert in the valuation of power facilities. Ms. Hughes has an M.B.A. in finance and accounting from the University of Chicago Booth School of Business. She is also an accredited senior appraiser in the public utility discipline (as certified by the American Society of Appraisers) and a certified depreciation professional (as certified by the American Society of Appraisers). She has also performed many appraisal and depreciation studies for businesses in the energy industry.
Ms. Hughes opined in her expert report that the Deloitte appraisals of Spruce, Scherer, and Wansley used an appropriate process for the purpose of producing credible appraisal reports under the Uniform Standards of Professional Appraisal Practice (USPAP). Ms. Hughes concluded that Deloitte’s conclusions were appropriate, supported in its appraisal reports, and prepared in accordance with generally accepted appraisal procedures. Ms. Hughes did not offer an opinion of what the fair market value of the Spruce, Scherer, and Wansley stations would be at various stages of the test transactions.
B. Respondent’s Expert Witnesses
1. Douglas J. Skinner
The Court recognized Douglas J. Skinner as an expert in accounting and financial economics. Dr. Skinner is the deputy dean for faculty and Eric J. Gleacher distinguished service professor of accounting at the University of Chicago Booth School of Business. Dr. Skinner holds a Ph.D. in applied economics: accounting and finance from the University of Rochester. Dr. Skinner has published research on a variety of topics in accounting, auditing, and corporate finance, including how securities prices respond to corporate disclosures, how accounting information is used in contracts between various corporate stakeholders, the nature of corporate debt agreements, and many others.
Dr. Skinner concluded that the analyses in the Deloitte appraisals are flawed in a number of respects, but focused on
Dr. Skinner recalculated the value of each asset using Deloitte’s cashflows and applying a 0% tax rate and lower discount rates of 6.1% for Spruce and 6.3% for Wansley and Scherer. His calculations show an estimated value for each asset at the sublease expiration date that is substantially higher than the cancellation/purchase option exercise price. Thus, Dr. Skinner concluded that it was nearly certain that CPS and MEAG will exercise their respective cancellation/purchase options at the end of the sublease terms, allowing Exelon to obtain the option proceeds without ever bearing any significant risk of loss.
In addition Dr. Skinner opined that CPS and MEAG would be economically compelled to exercise their cancellation/purchase options because of the “onerous” conditions they would face if they did not exercise their respective options.
Dr. Skinner in his expert report shows that, absent tax benefits available under
2. Christopher Knittel
The Court recognized Christopher Knittel as an expert in energy and environmental economics, industrial organization, and regulation. Dr. Knittel is the William Barton Rogers professor of energy economics in the Sloan School of Management at the Massachusetts Institute of Technology. He has a Ph.D. in economics from the University of California at Berkeley. Dr. Knittel’s research focuses on energy
Dr. Knittel opined that the test transactions did not provide Exelon with new sources of operating profits, improve the company’s environmental impact or supply management, assist Exelon with gaining market-entry benefits, improve knowledge-sharing, or achieve economies of scale. Dr. Knittel also opined that the test transactions were not compelled by the Illinois Restructuring Act. On the basis of his analysis of the potential direct and ancillary economics, he concluded that the test transactions did not provide Exelon with any non-tax-related economic benefits.
3. Uppender Saraon
The Court recognized Uppender Saraon as an expert in structured finance and leasing transactions. Mr. Saraon is a former director of Citigroup with a graduate degree in management from the MIT Sloan School of Management. Mr. Saraon opined that the structure of the test transactions, including the credit enhancement provisions, was very different from traditional U.S. leveraged leases.
C. Concurrent Witness Testimony Procedure
The Court, with prior agreement of the parties, directed certain expert witnesses, including Prof. Myers, Dr. Skinner, and Mr. Reed, to testify concurrently. The procedure was implemented in substantially the same way as in Rovakat, LLC v. Commissioner, T.C. Memo. 2011-225, slip op. at 29-30, aff’d, 529 F. App’x 124 (3d Cir. 2013). See also Green Gas Del. Statutory Tr. v. Commissioner, 147 T.C. __, __ (slip op. at 52, 60-61) (July 14, 2016); Buyuk, LLC v. Commissioner, T.C. Memo. 2013-253, at *29-*30, *39-*40; Crimi v. Commissioner, T.C. Memo. 2013-51, at *34, *40-*43. The Court found the procedure especially helpful in illuminating the major aspects of certain issues in these cases and enabling the Court to facilitate its findings of fact.
I. Overview
While traditional LILOs and SILOs involved leveraged leases, petitioner invested the proceeds from the sale of its own power plants to fully fund the transactions. The purported tax benefits were primarily derived from the deferral of income tax under
We note that while these cases involve several issues separate from but related to the validity of the test transactions under
A. Overview of the Parties’ Arguments
1. Petitioner’s Arguments
In 1999 after conducting an evaluation of its strengths and weaknesses in the new deregulated energy market, petitioner decided to sell its entire fleet of fossil fuel power plants. After realizing that the sale would occur at a price almost two times higher than petitioner’s initial estimate, petitioner
Petitioner contends that the test transactions represent valid deferred
Petitioner opposes respondent’s attempts to characterize the test transactions as SILOs because they are structured not as leveraged leases but as direct leases financed entirely from petitioner’s own funds. As petitioner sees it, it merely reinvested the proceeds from the sale of its assets into similar assets in other geographical areas.
In doing so, petitioner maintains it acted in good faith and relied on services of independent and highly qualified advisers. Thus, petitioner argues that it should not be held liable for the penalties under
2. Respondent’s Arguments
Respondent primarily contends that the test transactions among petitioner, CPS, and MEAG did not transfer any benefits and burdens of ownership to petitioner because they were not true leases. Respondent argues that petitioner’s SILOs were “prepackaged, promoted tax products which subjected [p]etitioner to no residual value risk, only a theoretical, de minimis credit risk.” In essence, as respondent sees it, the test transactions are more similar to low-risk loans. Thus, because petitioner exchanged ownership interests in power plants for financial instruments (low-risk loans), petitioner failed to meet
Further, respondent argues that because the substance of each test transaction is a loan rather than a lease, these
In the alternative, respondent argues that the test transactions lack economic substance because they were driven by tax considerations and the desire to defer taxation of a $1.6 billion gain, not by a legitimate business purpose. Accordingly, respondent urges the Court to disregard the test transactions altogether and conclude that petitioner failed to enter into a like-kind exchange. Respondent maintains that petitioner never expected to realize pretax benefits from the test transactions alone. However, together with the tax deferral benefits available under
Further, respondent argues that petitioner is also liable for accuracy-related penalties under
B. Primer on Leveraged Leases, LILOs, and SILOs
We have discussed in detail the seminal cases and regulations related to leveraged leases, LILOs, and SILOs in this Court’s opinion in John Hancock Life Ins. Co. (U.S.A.) v. Commissioner, 141 T.C. 1, 15-16, 54-77 (2013). We briefly reiterate some of that analysis here to provide the reader with sufficient details relevant to the cases at hand.
Frank Lyon Co. v. United States, 435 U.S. 561 (1978), is the seminal Supreme Court case discussing leveraged lease transactions. The taxpayer in Frank Lyon engaged in a sale-leaseback transaction to finance the construction of a new building. Out of the required $7.64 million, Frank Lyon invested $500,000 of its own money and financed the remainder with a third-party lender through a secured mortgage with the building serving as a collateral. In addition, Frank Lyon made a promise to assume personal responsibility for the loan’s repayment and an assignment to the
The lease in Frank Lyon was a net lease requiring lessee to pay taxes, insurance, and utilities. Lessee had an option to purchase the building at certain times during the lease and at the end of the 25-year lease term. Lessee also had an option to renew the lease for additional periods of time. Frank Lyon claimed depreciation deductions and interest expense deductions related to the building. Id. at 567-569.
After considering the transaction, the Supreme Court held that the form of a sale-leaseback transaction will be respected for Federal tax purposes as long as the lessor retains significant and genuine attributes of a traditional lessor. Id. at 584. The Supreme Court recognized that these attributes necessarily depend on the facts of a particular case. Id. According to the Supreme Court, several factors weighed in favor of the taxpayer in Frank Lyon. Frank Lyon bore the financial risks of the transaction by assuming responsibility for loan repayment and investing its own money in the transaction. Id. at 581. The Supreme Court concluded that there was a real possibility that the lessor could walk away from the transaction at the end of the initial lease. The parties negotiated the deal in good faith and were independent of each other. The parties paid the same tax rates, making the transaction tax neutral. The rent and purchase option prices were reasonable, and Frank Lyon assumed the credit risk of the lessee’s defaulting on its rent payments. Id. at 575-584.
Around the time the Supreme Court issued its ruling in Frank Lyon, the Government was working on developing a set of rules to determine whether a leveraged lease transaction is a true lease or something else. In 1975 the Commissioner issued guidelines for advance ruling purposes on whether a leveraged lease will be respected for Federal tax purposes as a lease. Rev. Proc. 75-21, 1975-1 C.B. 715. In 1984 Congress enacted what has become known as the “Pickle rule“, which subjected property leased to a tax-exempt entity to unfavorable depreciation rules. Deficit Reduction Act of 1984, Pub. L. No. 98-369, sec. 31, 98 Stat. at 509.
The unintended consequence of the Pickle rule was the proliferation of LILO transactions with tax-exempt entities.
The sublease to a tax-exempt entity would typically be shorter than the initial lease term. At the end of the sublease, the tax-exempt entity usually has the option to purchase the remainder of the leasehold interest in the initial lease. Even if the tax-exempt entity decides not to exercise its purchase option, the taxable party could still compel the tax-exempt entity to renew the sublease, take possession of the asset, or procure the replacement sublease. To return the asset to the taxable party, the tax-exempt entity would typically need to meet certain conditions, including refinancing the nonrecourse loan involved in the
transactions. Failure to meet the return conditions meant that the tax-exempt entity had to exercise the purchase option. See Id.
In 1999 LILO transactions became less popular because of a change in the regulations under
A typical SILO transaction would be similar to a LILO except that the term of the initial lease extends beyond the remaining useful life of the asset, as is the case with the Spruce, Scherer, and Wansley test transactions here. Thus, the initial lease is treated as a sale for Federal tax purposes. The end-of-sublease options for the taxable entity usually include either compelling the lessee to arrange a service contract for the asset for a predetermined term or to take possession of the asset. Id.
The payments in SILO and LILO transactions are typically secured by the various defeasance instruments. Although the form of such instruments differs from one transaction to another, typically they entail setting aside several deposits with third-party financial institutions--payment
In 2002 the Commissioner issued
Congress eliminated the benefits associated with LILO and SILO transactions in the
C. Recent SILO/LILO Cases
As this Court observed in 2014 in John Hancock Life Ins. Co. (U.S.A.) v. Commissioner, 141 T.C. at 58, “[t]axpayers have lost their fight for claimed tax benefits in SILO and LILO transactions in all Courts of Appeals in which they have appeared.” This still remains true. The Commissioner has often used the doctrines of economic substance and substance over form to challenge the legitimacy of sale-leaseback transactions. See, e.g., Id. at 58-77 (analyzing prior SILO/LILO cases and arguments advanced by the litigants). We will discuss these judicial doctrines in more detail in other parts of this Opinion.
Our conclusion on whether petitioner entered into a valid like-kind exchange under
1. Consol. Edison
There are many factual similarities between the cases at hand and the facts in Consol. Edison, so we will briefly reiterate the key facts.
In the mid-to-late 1990s Consolidated Edison (ConEd) was a publicly held vertically integrated utility company organized and operating in New York. ConEd I, 90 Fed. Cl. at 232. In an attempt to offset the effects of the electric industry deregulation, ConEd underwent a major internal restructuring and decided to enter, through one of its subsidiaries, into one or more LILO investments. Id. at 233-234. On December 15, 1997, ConEd entered into a LILO transaction with EZH, a Dutch electric utility (ConEd LILO). Id. at 234-235.
ConEd retained Cornerstone Financial Advisors L.P. to obtain financial services in connection with the EZH LILO. Id. at 234. ConEd retained the law firms of Shearman & Sterling, LLP as its United States legal counsel, and Loeff, Claeys, Verbeke as its Dutch legal counsel, as well as Deloitte as its appraiser, Duke Engineering & Services as its independent engineer, and Tauw Milieu, International, as its environmental consultant. Id. at 235.
Under the terms of the ConEd LILO, ConEd leased from EZH a 47.47% undivided interest in a Dutch power plant for 43.2 years. ConEd II, 703 F.3d at 1370. ConEd immediately leased back the interest to EZH for a term of 20.1 years. Id. at 1370-1371. At the end of the sublease term, EZH could exercise the purchase option and terminate the transaction. Id. at 1372. If EZH declined to exercise the purchase option, ConEd could either force it to renew the sublease for an additional term of 16.5 years or take possession of the interest in
In its appraisal Deloitte concluded that there would be no “economic compulsion” for EZH to exercise the purchase option at the end of the sublease because the option price exceeded the projected value of the property. Id. at 1379. Richard Ellsworth, who led the Deloitte appraisal team, testified at trial that he did not consider any noneconomic factors in arriving at this conclusion. Id. at 1379-1380. On the basis of this conclusion and the record of the case as developed at trial, the trial court concluded that the ConEd LILO was a true lease. ConEd I, 90 Fed. Cl. at 340. The Court of Appeals for the Federal Circuit reversed and remanded the case. ConEd II, 703 F.3d at 1369.
The Court of Appeals explained that at the time the trial court rendered its ruling it did not have the benefit of the decision in another LILO/SILO case, Wells Fargo & Co. v. United States, 641 F.3d 1319 (Fed. Cir. 2011). ConEd II, 703 F.3d at 1377. Thus, the trial court used the wrong legal standard in determining whether ConEd acquired benefits and burdens of ownership in the ConEd LILO. Id. The Court of Appeals clarified that the relevant standard was whether there was a reasonable likelihood that the purchase option at the end of the sublease period would be exercised, not whether this outcome was “certain” or “virtually certain“. Id. at 1376.
The Court of Appeals concluded that the analysis performed by Deloitte for the ConEd LILO was “boilerplate” and was insufficient to support ConEd‘s claims. Id. at 1378-1379. The Court of Appeals noted that Richard Ellsworth, who prepared the appraisal for the ConEd LILO, admitted at trial that Deloitte “never once found that there was ‘economic compulsion’ to exercise a purchase option” in about a hundred appraisal reports prepared for LILO transactions. Id. at 1380. The Court of Appeals commented that the appraisal failed in several respects, including not considering noneconomic factors, defeasance of funds for the purchase option payment, and the costs to EZH that would result from ConEd‘s exercise of the renewal or retention options. Id. at 1379.
After considering the arguments of the parties in ConEd II, the Court of Appeals concluded that “EZH was reasonably
2. John Hancock Life Ins. Co. (U.S.A.) v. Commissioner
This Court first considered the Federal income tax consequences of SILO and LILO transactions in John Hancock Life Ins. Co. v. Commissioner, 141 T.C. 1. John Hancock Life Insurance Co. (John Hancock) entered into 27 LILOs and SILOs between 1997 and 2001. Id. at 6. The Court considered seven test transactions, including three LILOs and four SILOs (John Hancock test transactions). Id.
John Hancock invested in SILOs and LILOs primarily as a means to diversify its investments in domestic and international assets to provide it with sufficient cashflow. Id. at 8. All of the John Hancock test transactions had a typical structure for LILOs and SILOs, featuring a set of agreements including a headlease, a sublease with a fixed purchase option at the end, and various defeasance arrangements.
The Court considered the application of both the economic substance doctrine and the substance over form doctrine to the John Hancock test transactions: “In order to conclude that John Hancock is entitled to its claimed deductions, we must determine both that the test transactions have economic substance and that the substance of each test transaction is consistent with its form. There is no clear formula by which to answer these questions, nor do we attempt to create one.” Id. at 78.
The Court analyzed both objective and subjective sides of the John Hancock test transactions and concluded that they satisfied the economic substance inquiry because John Hancock had a realistic expectation of profit and a business purpose when entering into the transactions. Id. at 78-89.
To determine whether the John Hancock test transactions’ form was consistent with their substance, the Court followed the same analysis the Supreme Court used in Frank Lyon for leveraged leases. Id. at 89-90 (citing Frank Lyon, 435 U.S. at 584). Thus, the Court had to determine whether John Hancock held a true leasehold interest in each LILO property
After discussing various factors previously considered in other cases, the Court reiterated its commitment to evaluate the John Hancock test transactions on the basis of the overall facts and circumstances in determining whether the substance of the transactions was consistent with their form. Id. at 90-91 (citing Levy v. Commissioner, 91 T.C. 838, 860 (1988), Torres v. Commissioner, 88 T.C. 702, 721 (1987), Gefen v. Commissioner, 87 T.C. 1471, 1490-1495 (1986), Mukerji v. Commissioner, 87 T.C. 926, 967-968 (1986), and Estate of Thomas v. Commissioner, 84 T.C. 412, 433-438 (1985)). For each of the John Hancock test transactions, the Court considered risk allocation during the initial lease period, likelihood of purchase option exercise by the original property holder at the end of the sublease term, end-of-sublease alternatives for the parties involved in the transaction and related costs and risks.
The Court concluded that for all test transactions, John Hancock did not assume more than a de minimis risk during the sublease period because of contractual protections, various credit enhancements, and rent defeasance. Id. at 94, 113-114, 145.
Next, the Court evaluated the likelihood of the original property holders’ exercising their respective purchase options at the end of subleases. The Court recognized that “[t]he courts that have analyzed SILO and LILO cases have adopted varying standards in determining whether a party to a SILO or LILO transaction will exercise its purchase option.” Id. at 95. After analyzing various standards, the Court adopted the “reasonable likelihood” standard articulated by the Courts of Appeals for the Second Circuit in Altria Grp., Inc. v. United States, 658 F.3d 276, 286 (2d Cir. 2011), and the Federal Circuit in ConEd II, 703 F.3d at 1379, and Wells Fargo, 641 F.3d at 1329. Id. at 95-97. The inquiry into the likelihood of purchase option exercise is determinative because if the original property holder is reasonably expected to exercise the purchase option at the end of the sublease, the obligations of the parties under SILO/LILO would offset each other, so that a taxpayer would be insulated from any economic risk of loss and would not be
For the LILO transactions in John Hancock, the Court concluded that “any legal, political, industrial, or technical objections to the nonexercise of the purchase options can be overcome, and thus are not determinative of whether [the LILO counterparty] is reasonably likely to exercise its purchase option.” John Hancock Life Ins. Co. (U.S.A.) v. Commissioner, 141 T.C. at 99, 107. Thus, the Court based its ultimate conclusion primarily on financial analysis, including a comparison of the costs of the purchase option and alternative end-of-sublease options. In all LILO test transactions, the Court concluded that it was reasonably likely that the LILO counterparties would exercise their respective purchase options. Id. at 109-110. The Court came to the same conclusion for one of the SILO transactions, the SNCB SILO. Id. at 145. Thus, the Court held that the substance of all the LILO and SNCB SILO transactions was inconsistent with their form and that these transactions resembled loans because John Hancock did not acquire genuine attributes of ownership or leasehold interest. Id. at 109-110, 145. As a result, the Court held that John Hancock was not entitled to rental expense and depreciation deductions related to these transactions. Id. at 109-110, 145. The Court also disallowed the interest expense for the nonrecourse loans John Hancock took out to finance the transactions. Id. at 146-147. Further, the Court recharacterized the equity contributions into these transactions as a loan giving rise to the original issue discount (OID) income. Id. at 148. The Court held that pursuant to
For the remaining SILO transactions, the Court concluded, after considering financial analyses presented by the parties and various nonfinancial constraints, that exercising the purchase option at the end of the sublease was not the only financially viable alternative for the SILO counterparties. Id. at 123, 131-132. According to the appraisals, the projected fair market value of the assets involved in the remaining SILOs was going to be substantially lower than the purchase option exercise price. Id. at 114-115, 123-124. Thus, the Court assumed that these options would not be exercised and proceeded with the analysis of whether John Hancock had any economic risk after the end of the sublease and until the end of the lease. The Court then concluded that John Hancock indeed faced economic risks indicative of ownership during that period under the service contract option because any payments under that option were not guaranteed. Id. at 132-135. Thus, the Commissioner did not succeed with the substance-over-form argument for these remaining transactions.
With respect to the remaining SILO transactions, the Court held that John Hancock acquired a future interest in the transferred assets and was thus not entitled to depreciation deductions before the purchase option exercise date. John Hancock Ins. Co. (U.S.A.) v. Commissioner, 141 T.C. at 137. Because John Hancock had only future interest in the assets, the Court disallowed any interest deductions as well. Id. at 147. However, the Court refused to apply the OID rules to John Hancock‘s equity contributions in these transactions. Id. at 148. The Court allowed a deduction for transaction expenses related to the acquisition of a future interest in the underlying assets. Id. at 149.
II. Whether the Substance of the Test Transactions Is Consistent With Their Forms
We will first address the issue of whether the substance of the test transactions is consistent with their forms because this is the primary argument on which respondent challenges petitioner‘s 1999 like-kind exchange. From the notices of deficiency and the parties’ filings in these cases, it appears that respondent did not directly challenge the 1999 like-kind exchange gain deferral under the economic substance doctrine. Respondent asserts this economic substance argument only with respect to depreciation, interest, and transaction cost deductions reported on the 2000 tax return.
The courts have long used the substance over form doctrine to determine the true nature of a transaction and appropriately recast it for Federal income tax purposes. See Feldman v. Commissioner, 779 F.3d 448, 455 (7th Cir. 2015), aff‘g T.C. Memo. 2011-297, John Hancock Life Ins. Co. (U.S.A.) v. Commissioner, 141 T.C. at 57 (citing United States v. B.F. Ball Constr. Co., 355 U.S. 587 (1958), and Commissioner v. Court Holding Co., 324 U.S. 331 (1945)). We apply the substance over form principles only when warranted and generally respect the form of a transaction. John Hancock Life Ins. Co. (U.S.A.) v. Commissioner, 141 T.C. at 57 (citing Gregory v. Helvering, 293 U.S. 465 (1935), and Blueberry Land Co., Inc. v. Commissioner, 361 F.2d 93, 100-101 (5th Cir. 1966), aff‘g 42 T.C. 1137 (1964)).
We view the transactions as a whole to determine whether the substance over form doctrine applies. See Commissioner v. Court Holding Co., 324 U.S. at 334; John Hancock Life Ins. Co. (U.S.A) v. Commissioner, 141 T.C. at 91. As the Supreme Court held in Frank Lyon, 435 U.S. at 584, the form of a sale-leaseback transaction will be respected for Federal tax purposes as long as the lessor retains significant and genuine attributes of a traditional lessor. We also look at whether the taxpayer has undertaken substantial financial risk of loss of its investment on the basis of the value of the underlying property. Coleman v. Commissioner, 16 F.3d 821, 826 (7th Cir. 1994), aff‘g T.C. Memo. 1987-195 and T.C. Memo. 1990-99.
The courts considering SILO/LILO transactions have almost universally concluded that the taxpayers never obtained the benefits and burdens of ownership or attributes of a traditional lessor and, thus, were not entitled to claim various associated deductions. See ConEd II, 703 F.3d at 1381-1382 (finding that the LILO was not a genuine lease and sublease); Altria Grp., Inc. v. United States, 658 F.3d at 291 (affirming jury finding that a series of LILO and other transactions failed the substance over form inquiry); Wells Fargo, 641 F.3d at 1330 (sustaining the trial court‘s conclusion that the SILO transactions ran afoul of the substance over form doctrine); BB & T Corp. v. United States, 523 F.3d 461, 464 (4th Cir. 2008) (“[A]lthough the [transaction] form * * * involved
B. Spruce Transaction
1. Sublease Term Risks
Petitioner advances several arguments to support its contention that it indeed had acquired benefits and burdens of ownership during the sublease term. First, petitioner maintains that it made a meaningful equity contribution to acquire the leases. Unlike parties in traditional LILO/SILO transactions, petitioner did not use any loans to pay the Spruce headlease rent. Instead, it paid with the proceeds of a recent sale of its own power plant. CPS returned only 76.9% of the headlease rent to prepay the rent during the Spruce sublease term. Petitioner argues that the 23.1% CPS retained after prepayment of the Spruce sublease rent satisfies any equity tests derived from judicial decisions and administrative guidance.
Second, petitioner maintains that the rights and obligations conveyed by the Spruce headlease and sublease agreements are typical of traditional leases and significantly alter the rights of the parties. Specifically, petitioner cites the
Third, petitioner points to its extensive due diligence efforts as indicative of obtaining a true ownership interest in the Spruce station.
Finally, petitioner claims that it was exposed to a significant risk of loss in case of CPS’ bankruptcy and sublease rejection because of the limitations of
We begin with an observation that what made SILO and LILO transactions abusive was not only the amount of equity invested by the parties entering into such transactions but rather the circular flow of money such transactions created. As the Court of Appeals for the Federal Circuit explained in Wells Fargo, 641 F.3d at 1330:
[W]e are left with purely circular transactions that elevate form over substance. The 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. From the tax-exempt entity‘s point of view, the transaction effectively ended as soon as it began. The benefits to Wells Fargo continued to flow throughout the term of the sublease, however, in the form of deferred tax payments. The third-party lender and its affiliate were also compensated for their participation, as were the creators and promoters of the transactions. These transactions were win-win situations for all of the parties involved because free money--in the form of previously unavailable tax benefits utilized by Wells Fargo--was divided among all parties. The money was not entirely “free,” of course, because it was in effect transferred to Wells Fargo from the public fisc.
Here, the funds necessary to fund the headlease rent came from the untaxed proceeds of the Collins power plant sale by petitioner. In addition to attempting to reap the benefits of long-term tax deferral under the
Notes
We note that the cost approach would result in lower projected future fair market value according to Deloitte appraisals for the test transactions. We will use the discounted cashflow analysis because petitioner relied mostly on discounted cashflow in pricing the Spruce, Scherer, and Wansley transactions. We believe this will provide us with more consistent results.We are of the opinion that the discounted cash flow analysis provides a stronger indication of fair market value for the Facility than the cost approach since the discounted cash flow analysis reflects the impact to fair market value of the encumbered cash flows of the Facility. Since cash flows during this period are difficult to forecast with accuracy, we have conservatively relied upon the cost approach as the stronger indicator to estimate the residual value of the Facility at the end of the Lease Term and at the end of the Service Agreement Term.