John Hancock Life Ins. Co. v. Comm'r

• Decision Date: 05 August 2013
• Docket Number: Nos. 6404–09,7084–10.,7083–10,s. 6404–09
• Citation: 141 T.C. 1,141 T.C. No. 1
• Parties: JOHN HANCOCK LIFE INSURANCE COMPANY (U.S.A.), as Successor in Interest to John Hancock Life Insurance Company (f.k.a. John Hancock Mutual Life Insurance Company) and Subsidiaries, et al., Petitioners v. COMMISSIONER OF INTERNAL REVENUE, Respondent.
• Court: U.S. Tax Court

?141 T.C. No. 1
141 T.C. 1

JOHN HANCOCK LIFE INSURANCE COMPANY (U.S.A.), as Successor in Interest to John Hancock Life Insurance Company (f.k.a. John Hancock Mutual Life Insurance Company) and Subsidiaries, et al.,¹ Petitioners
v.
COMMISSIONER OF INTERNAL REVENUE, Respondent.

Nos. 6404–09, 7083–10, 7084–10.

United States Tax Court.

Aug. 5, 2013

Decision for IRS in part and for taxpayer in part.

JH is primarily in the business of selling life insurance policies, annuities, long-term care insurance, and other retirement services. To fulfill its contractual obligations under these services JH invests the premiums it receives. In 1979 JH began investing in leveraged leases. A leveraged lease is a lease in which the equity investor borrows money from a third-party lender to finance a portion of the purchase price of the asset involved and leases the asset to its ultimate user.

In 1997 JH began investing in lease-in-lease-out (LILO) transactions and in 1999 began investing in sale-in-lease-out (SILO) transactions. JH participated in 19 LILO transactions and 8 SILO transactions between 1997 and 2001.

With respect to the LILO transactions, JH claimed deductions for rental expenses for the prepaid rent paid to the tax-indifferent entities and interest expenses related to the repayment of the nonrecourse loans. JH also amortized transaction costs related to the LILO transactions. With respect to the SILO transactions, JH claimed deductions for depreciation and interest expenses and amortized the related transaction costs. R disallowed these deductions for the years at issue and determined that JH had OID income with respect to the LILO and SILO transactions.

The parties agreed to litigate three LILO transactions and four SILO transactions and use them as test transactions for the remaining LILO and SILO transactions at issue.

A transaction will be respected for Federal income tax purposes if it has economic substance and the substance of the transaction is consistent with its form. P argues that the LILO and SILO test transactions have economic substance because JH derived a pretax profit from each transaction and entered into the transactions with the primary purpose of making a profit. P also argues that the substance of each LILO and SILO transaction is consistent with its form because JH held a true leasehold interest in each of the LILO assets and obtained an ownership interest in each of the SILO assets. R argues that the LILO and SILO test transactions lack economic substance and the substance of the transactions is not consistent with their form. Specifically, R argues that JH failed to acquire a substantive leasehold interest in the LILO assets and failed to acquire a substantive ownership interest in the SILO assets. Thus, R argues the true substance of the LILO and SILO transactions is a loan from JH to the tax-indifferent entities. R argues in the alternative with respect to the LILO and SILO transactions that at most P acquired a future interest in the LILO and SILO assets.

The parties also dispute the location of JH's principal place of business.

Held: JH's principal place of business is Boston, Massachusetts.

Held, further, R failed to prove that the three LILO and four SILO test transactions lack economic substance.

Held, further, the substance of the three LILO test transactions is not consistent with their form. The LILO test transactions resemble financial arrangements, and JH is therefore denied its claimed rental expense, interest expense, and transaction cost deductions with respect to them.

Held, further, the substance of three of the SILO test transactions is consistent with their form; however, JH did not acquire a present interest in the SILO test transaction properties and is therefore denied its claimed depreciation and interest expense deductions.

Held, further, the substance of the fourth SILO test transaction is not consistent with its form. That SILO test transaction resembles a financial arrangement, and JH is therefore denied its claimed depreciation expense, interest expense, and transaction cost deductions with respect to that transaction.

Held, further, JH had OID income with respect to the three LILO test transactions and the fourth SILO test transaction but not with respect to the first three SILO test transactions, in which it failed to acquire a present interest.

Arthur L. Bailey, Jean A. Pawlow, James W. Johnson, Kevin J. Cloherty, Alexis A. Maclvor, Thomas K. Spencer, and Nathaniel J. Dorfman, for petitioners.

Daniel A. Rosen, Lyle B. Press, Steven N. Balahtsis, Allison Ickovic, and Abigail F. Dunnigan, for respondent.

HAINES, Judge:

CONTENTS
FINDINGS OF FACT								12
Background							12
I.	John Hancock's History					12
II.	Investment Process and Review					14
III.	Leasing					16
IV.	LILO and SILO Transactions					16
A.	Basic Structure				16
B.	History				24
C.	Due Diligence				26
D.	The Hoosier Transaction				28
The LILO Test Transactions							30
I.	OBB LILO					31
A.	Lease and Sublease				31
1.	The Asset			31
2.	Terms			33
3.	Rent and Financing			33
a.	Initial Lease		33
b.	Sublease and Defeasance		33
4.	Property Rights and Obligations			35
5.	Default			36
B.	End of Sublease Term				37
1.	OBB's Purchase Option			37
2.	John Hancock's Options			38
a.	Renewal Option		38
b.	Replacement Option		39
c.	Retention Option		40
II.	SNCB 2 and SNCB 5 Lot 1 LILO Transactions					40
A.	Lease and Sublease				40
1.	The Assets			40
2.	Terms			42
3.	Rent and Financing			42
a.	Initial Lease		42
b.	Sublease and Defeasance		43
4.	Property and Default Rights and Obligations			4 4
B.	End of Sublease Term				44
The SILO Test Transactions							45
I.	TIWAG					46
A.	Lease and Sublease				46
1.	The Assets			46
2.	Terms			47
3.	Rent and Financing			47
a.	Initial Lease		47
b.	Sublease and Defeasance		48
4.	Property Rights and Obligations			51
5.	Default			52
B.	End of Sublease Term				53
1.	TIWAG's Purchase Option			53
2.	John Hancock's Options			53
II.	Two Dortmund Transactions					56
A.	Lease and Sublease%				56
1.	The Asset			56
2.	Terms			58
3.	Rent and Financing			59
a.	Initial Lease		59
b.	Sublease and Defeasance		59
4.	Property and Default Rights and Obligations			6 1
B.	End of Sublease Term				61
III.	SNCB SILO					63
A.	Grant and Subgrant				63
1.	The Asset			63
2.	Terms			64
3.	Rent and Financing			64
a.	Grant		64
b.	Subgrant and Defeasance		65
4.	Property and Default Rights and Obligations			6 7
B.	End of Subgrant Term				67
Tax Returns, Notices of Deficiency, and Trial							68
I.	Procedural History					68
A.	Notice of Deficiency (Docket No. 6404–09)				69
B.	Notice of Deficiency (Docket No. 7084–10)				70
C.	Notice of Deficiency (Docket No. 7083–10)				72
D.	Pretrial Motions				76
II.	Trial					76
A.	Petitioners' Expert Witnesses (Alphabetical Order)				77
1.	Mr. John Dolan			77
2.	Dr. Paul Doralt			77
3.	Mr. Hans Haider			78
4.	Dr. Friedrich Hey			78
5.	Dr. Friedrich Popp			79
6.	Dr. Thomas Schurrle			79
7.	Dr. Norbert Stoeck			80
8.	Dr. Frederik Vandendriessche			80
B.	Respondent's Expert Witnesses (Alphabetical Order)				81
1.	Dr. Ignaas Behaeghe			81
2.	Dr. Stefan Diemer			81
3.	Dr. Matthias Heisse			81
4.	Dr. Thomas Lys			82
5.	Dr. F.H. Rolf Seringhaus			83
6.	Mag. Alexander Stolitzka			83
7.	Dr. Vukan Vuchic			84
8.	Dr. Peter Wundsam			84
OPINION								85
Burden of Proof							85
Principal Place of Business							86
Leveraged Lease Transactions							87
I.	Frank Lyon					87
A.	Economic Substance				90
B.	Substance Over Form				92
II.	LILO and SILO Litigation					93
A.	BB & T				96
B.	AWG				100
C.	Wells Fargo				106
D.	Altria				113
E.	Consolidated Edison				119
The Test Transactions							125
I.	Economic Substance					126
A.	Objective Inquiry				127
B.	Subjective Inquiry				143
II.	Substance Over Form					144
A.	OBB and SNCB LILO Transactions				147
1.	OBB Purchase Option Decision			153
a.	Financial Considerations		159
b.	Retention Option		161
c.	Renewal and Replacement Options		161
2.	SNCB Purchase Option Decision			168
3.	Conclusion			176
B.	SILO Test Transactions				177
1.	TIWAG and Dortmund Transactions			179
a.	Sublease Term		179
b.	Purchase Options		183
I.	TIWAG Transaction	184
ii.	Dortmund Transactions	199
c.	SService Contract Benefits and Burdens		213
d.	SFuture Interest		219
2.	SNCB			222
a.	S Purchase Option Decision		223
b.	SSubgrant Term		232
c.	SConclusion		235
Interest Deductions							236
Original Issue Discount							238
Transaction Expenses							241
Conclusion							242

[141 T.C. 6]

These cases are consolidated for purposes of trial, briefing, and opinion. Respondent determined the following deficiencies in petitioners' Federal income tax for 1994 ² and 1997–2001 (years at issue): ³

Year	Deficiency
1994	$8,860,564
1997	65,746,621
1998	173,497,367
1999	59,899,141
2000	108,046,947
2001	143,516,079

These deficiencies stem from 27 leveraged lease transactions (leveraged leases) that petitioners participated in between 1997 and 2001. For purposes of resolving this action expeditiously, the parties agreed to try seven of the leveraged leases (test transactions) and apply a formula to determine the deficiency, if any, with respect to the remaining leveraged leases. The test transactions comprise three lease-in-lease-out (LILO) transactions and four sales-in-lease-out (SILO) transactions.⁴

The test transactions were identified at trial and are referred to herein by the lease counterparty to each transaction. The counterparties for the LILO test transactions are:

[141 T.C. 7]

(1) Osterreichische Bundesbahnen (OBB), a Government-owned Austrian corporation that operates the Austrian Federal railway system, and (2) Societe Nationale des Chemins de Fer Belges (SNCB), a Belgian company that owns and operates the national rail system of Belgium.⁵ THE COUNTERPARTIES for the silo test transacTIONs are: (1) tiwag–Tiroler Wasserkraft AG (TIWAG), an Austrian corporation that is...