Exelon Corp. v. Comm'r of Internal Revenue

• Citation: 906 F.3d 513
• Decision Date: 03 October 2018
• Docket Number: Nos. 17-2964,17-2965,s. 17-2964
• Parties: EXELON CORPORATION, Petitioner-Appellant, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee.
• Court: United States Courts of Appeals. United States Court of Appeals (7th Circuit)

906 F.3d 513

EXELON CORPORATION, Petitioner-Appellant,

v.COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee.

Nos. 17-2964

17-2965

United States Court of Appeals, Seventh Circuit.

Argued May 24, 2018

Decided October 3, 2018

David Abbott, Kristin M. Mikolaitis, Attorneys, MAYER BROWN LLP, New York, NY, Paul D. Clement, Erin Murphy, Attorneys, KIRKLAND & ELLIS LLP, Washington, DC, for Petitioner-Appellant.

Jacob Earl Christensen, Attorney, DEPARTMENT OF JUSTICE, Tax Division, Appellate Section, Gilbert Steven Rothenberg, Attorney, DEPARTMENT OF JUSTICE, Office of the Attorney General, Richard Farber, Attorney, DEPARTMENT OF JUSTICE, Civil Division, Immigration Litigation, Washington, DC, for Respondent-Appellee.

Emily Sanford Fisher, Attorney, EDISON ELECTRIC INSTITUTE, Washington, DC, Amicus Curiae for EDISON ELECTRIC INSTITUTE.

Before Manion and Barrett, Circuit Judges, and Gettleman, District Judge.^*

Gettleman, District Judge.

Petitioner-Appellant Exelon Corporation ("Exelon")¹ appeals from a decision of the United States tax court which upheld a determination by the Commissioner of Internal Revenue that Exelon is liable for a deficiency of $431,174,592 for the 1999 tax year and $5,534,611 for the 2001 tax year. The tax court also affirmed the imposition of $87 million in accuracy-related penalties. We affirm both decisions.

I.

In 1999, after deregulation of the energy industry in Illinois, Exelon, an Illinois-based energy company, decided to sell its fossil-fuel power plants, intending to use the proceeds to finance improvements to its nuclear plants and infrastructure. It sold all of its fossil-fuel power plants for $4.8 billion, over $2 billion more than expected. Using $2.35 billion of the proceeds to update its nuclear fleet, Exelon was left with approximately $2.45 billion to invest. It was also left with a significant tax bill. It thus began looking for a strategy that could reduce or defer the tax on the gain.

Enter PricewaterhouseCoopers ("PwC"), one of Exelon's accounting firms. PwC proposed that Exelon could defer the tax liability on the gains from the sale of its power plants by executing "like-kind exchanges" under § 1031 of the Tax Code, which provides: "No gain or loss shall be recognized on the exchange of property held for productive use ... or for investment if such property is exchanged solely for property of like-kind which is to be held either for productive use ... or for investment." 26 U.S.C. § 1031(a)(1) (1999).

Exelon identified two of its own fossil-fuel power plants that were good candidates for like-kind exchanges: the Collins Plant, to be sold for $930 million, $823 million of which would be taxable gain; and the Powerton Plant, to be sold for $870 million, $683 million of which would be taxable gain. It then identified three investment candidates for the exchanges: the J.K. Spruce Plant Unit No. 1 ("Spruce"), a coal-fired plant in Texas that would replace the Collins Plant; and two coal-fired plants in Georgia–Plant Robert W. Sherer Units No. One, Two, and Three ("Sherer") and Plant Hal Wansley Units No. One and Two ("Wansley"),–which together would replace the Powerton Plant.

To carry out its purported like-kind exchanges, Exelon entered into six "sale-and-leaseback" transactions. In each of the three representative transactions² Exelon leased an out-of-state power plant from a tax-exempt entity for a period longer than the plant's estimated useful life. Exelon then immediately leased the plant back to that entity for a shorter sublease term and provided to the tax-exempt entity a multimillion-dollar accommodation fee for engaging in the transaction, along with a fully-funded purchase option to terminate Exelon's residual interest at the end of the sublease.

Exelon asserted that it had acquired a genuine ownership interest in each of the plants as a result of the transactions, thus qualifying them as like-kind exchanges under § 1031, entitling it to defer tax on the $1,231,927,407 gain it realized from the sale of its power plants. Exelon also claimed $93,641,195 in deductions on its 2001 return for depreciation, interest and transaction costs as lessor of the plants.

The Commissioner disallowed the benefits claimed by Exelon, characterizing the sale-and-leaseback transactions as a variant of the traditional sale-in-lease-out ("SILO") tax shelter that the tax courts and courts of appeals had almost universally invalidated as abusive tax shelters that fail to transfer genuine ownership or leasehold interest in the underlying property. See, e.g., Wells Fargo & Co. v. United States , 641 F.3d 1319, 1321-22, 1329-30 (Fed. Cir. 2011). The Commissioner determined income deficiencies of $431,174,592 for tax year 1999 and $5,534,611 for tax year 2001, and imposed a 20% accuracy-related penalty for each year.

After a 13-day trial, the tax court, in a comprehensive 175-page opinion, agreed with the Commissioner, applying the substance over form doctrine to conclude that the transactions in question, like SILO transactions, failed to transfer to Exelon a genuine ownership interest in the out-of-state plants. As a result, Exelon was not entitled to like-kind exchange treatment or its claimed deductions. The tax court agreed with the Commissioner that in substance Exelon's transactions most closely resemble loans from Exelon to the tax-exempt entities.

II.

A. SILOs

Each of Exelon's sale-and-leaseback transactions was structured as a variant of a SILO tax shelter, which is a transaction designed to transfer tax benefits associated with property ownership from a tax-exempt entity to the taxpayer, but which in reality fails to transfer the benefits and burdens of ownership in the underlying property. See Wells Fargo , 641 F.3d at 1321. All SILOs are structured similarly. First, the tax-exempt entity leases the asset to the taxpayer under a "headlease" for a term that exceeds the useful life of the asset, thereby qualifying the lease as a "sale" for federal tax purposes. The taxpayer concurrently leases the asset back to the tax-exempt entity for a term that is less that the asset's useful life. That lease, called a "sublease," is a "net" lease, meaning that the tax-exempt entity is responsible for all expenses normally associated with ownership of the asset, and retains legal title. Id . Each "sublease" contains an option under which the tax-exempt entity can repurchase the asset at the end of the sublease term at a set price. This option is "fully funded" with funds provided by the taxpayer for that purpose at the outset of the transaction. As a result, the tax-exempt entity has no risk of losing control of the asset. Id .

The taxpayer prepays its entire "rent" under the headlease in one lump sum payment at closing. Id . Typically, this rent prepayment is funded in part with the taxpayer's own funds and in part with a nonrecourse loan, although in some instances (as in the instant case) the taxpayer funds the entire prepayment with its own funds. Most of the taxpayer's prepaid rent is deposited into restricted accounts that are nominally held by the tax-exempt entity but are pledged to secure the tax-exempt entity's rental obligations under the sublease and to fund its repurchase option at the end of the sublease term. A small percentage of the headlease rent prepayment, usually between 4% and 8% of the asset value, is paid to the tax-exempt entity as its accommodation fee for participating in the SILO transaction. Id .

The taxpayers' headlease prepayment is invested in high grade debt with the growth of the account managed to ensure that the tax-exempt entity has sufficient funds to repurchase the asset from the taxpayer at the conclusion of the sublease without adding any funds of its own. The repurchase or "exercise price" is set at the beginning of the SILO transaction and can be exercised simply by giving notice. Id .

In the unlikely event that the tax-exempt entity chooses not to exercise its repurchase option, the transaction generally provides the taxpayer with two options. First, it can elect a "return option" under which it takes immediate control of the asset or, more likely, it can exercise what is called the "service contract option" under which the tax-exempt entity is required to satisfy several conditions before continuing to use the asset or arranging for its use by a third party. Id .

A SILO transaction offers three forms of tax benefits to the taxpayer. First, it can take depreciation deductions on the asset for the remainder of its useful life. Next, it can take deductions for interest payments made from any loan used to finance the taxpayer's prepayment of rent under the headlease. And third, it can deduct certain transaction costs associated with the SILO. These benefits are partially offset by the taxpayer's receipt of income at the end of the sublease if the tax-exempt entity exercises its repurchase option, but "the deferral of tax payments during the life of the sublease has substantial economic value to the taxpayer." Id .

B. Exelon's Test Transactions

As noted, it was PwC that first pitched the idea of like-kind exchanges to Exelon. PwC's strategy was to use the cash obtained from Exelon's sale of its fossil fuel power plants to acquire "tax title" in like-kind replacement properties through the sale and leaseback transactions, in which the properties would be leased back to the original owner under "triple net" leases with an end-of-term "fixed purchase option." PwC's plan was to structure the transactions to ensure that federal tax ownership of the replacement asset would pass to Exelon, while operation risks remained with the lessee. As incentive to enter the transaction, Exelon would pass a portion of its tax-deferred benefit to the lessee in the form of an upfront cash benefit.

PwC estimated that the tax deferral allowed under § 1031 would provide an after-tax yield of 20%. PwC explained to Exelon that the transactions would be similar to maintaining a typical debt private...