Altria Group, Inc. v. US

• Decision Date: 16 March 2010
• Docket Number: No. 1:06-cv-09430-RJH-FM.,1:06-cv-09430-RJH-FM.
• Citation: 694 F. Supp.2d 259
• Parties: ALTRIA GROUP, INC., Plaintiff, v. UNITED STATES of America, Defendant.
• Court: U.S. District Court — Southern District of New York

694 F. Supp.2d 259

ALTRIA GROUP, INC., Plaintiff, v. UNITED STATES of America, Defendant.

No. 1:06-cv-09430-RJH-FM.

United States District Court, S.D. New York.

March 16, 2010.

Dan K. Webb, Julie A. Bauer, Winston & Strawn, LLP, Chicago, IL, Lewis S. Wiener, Victoria O'Connor, Clifford E. Muller, Daniel H. Schlueter, David A. Roby, Jerome B. Libin, Kent L. Jones, Mary E. Monahan, Sutherland Asbill & Brennan, LLP, Washington, DC, for Plaintiff.

David J. Kennedy, Lawrence Heath Fogelman, Robert William Yalen, U.S. Attorney's Office, New York, NY, for Defendant.

MEMORANDUM OPINION AND ORDER

RICHARD J. HOLWELL, District Judge:

This case concerns federal income tax deductions plaintiff Altria Group Inc. and its subsidiary Phillip Morris Capital Corp. ("PMCC" or "Altria," collectively with plaintiff) generated by leasing big pieces of infrastructure from tax-indifferent counterparties. These tax shelter transactions are known in the leasing industry as SILOs ("Sale-In-Lease-Out") and LILOs ("Lease-In-Lease-Out"). Following a two-week trial, the jury concluded on the facts presented to it that plaintiff's SILOs and LILOs lacked economic substance and failed to transfer tax ownership of the properties to Altria, thereby justifying disallowance by the IRS of certain deductions claimed by Altria. Several courts and another jury have reached similar conclusions in other jurisdictions. See BB & T Corp. v. United States, 523 F.3d 461 (4th Cir.2008); AWG Leasing Trust v. United States, 592 F.Supp.2d 953 (N.D.Ohio 2008); Fifth Third Bancorp & Subs. v. United States, 05 Civ. 350 (S.D. Ohio, April 18, 2008) (jury verdict); Wells Fargo & Co. v. United States, 91 Fed.Cl. 35 (Fed.Cl.2010). But see Consolidated Edison Co. v. United States, 90 Fed.Cl. 228 (Fed.Cl.2009).

The four transactions in the present case relate to Altria's acquisition of leasehold interests in the Long Island Railroad's primary maintenance facility, a Dutch wastewater treatment plant, and two power plants in Georgia and Florida. Each of the counterparties was indifferent to U.S. federal income tax, in the sense that the ability to depreciate or amortize the assets would not substantially affect the entities' tax liability. In each transaction, Altria immediately leased the asset back to its original owner using agreements with a number of unusual features, including complete defeasance (prepayment, in essence) of the lessee's rent and an owner's option to repurchase the asset. Altria then claimed depreciation, amortization, interest expense, and transaction expense deductions on its 1996 and 1997 corporate tax return based on its newly acquired assets, even though (i) its purchase money immediately was invested in securities that the nominal lessees could not access without providing substitute collateral, and (ii) the lessees could reacquire the assets without incurring any out-of-pocket costs.

From the perspective of the U.S. Treasury, these and similar transactions entered into by Altria created billions of dollars of tax-deferral benefits out of thin air. The Commissioner of Internal Revenue concluded that the transactions had no purpose, substance, or utility apart from their anticipated tax consequences and disallowed the deductions. Altria filed this suit, arguing, in substance, that because it complied with certain standards developed for traditional leveraged leasing transactions, it was entitled to the challenged deductions.

From June 23 to July 9, 2009, the Court held a jury trial to determine Altria's entitlement to the deductions. At the close of evidence, Altria moved for judgment as a matter of law, and the Court reserved decision on the motion. After the jury returned a verdict for the Government on all of Altria's claims, Altria renewed its motion and moved in the alternative for a new trial.

For the reasons that follow, the motions will be denied.

I. Background

A. The Transactions

The four transactions that gave rise to the challenged deductions are seemingly complex. Each transaction, however, shares the same basic structure, which is helpfully summarized in a series of memoranda that PMCC's credit department prepared for senior Altria management at the time PMCC entered into the transactions. (See GX 107 ("Oglethorpe Mem."); GX 257 ("MTA Mem."); GX 304 ("Vallei Mem."); GX 407 ("Seminole Mem.").) The description that follows is drawn primarily from those memoranda. To simplify the discussion, several details that are irrelevant for purposes of this opinion, such as the special purpose entities and trusts through which the transactions were implemented, are omitted.

PMCC is a financial services company that focuses on investments and leveraged leasing. (Tr. 123.) In each transaction, PMCC acquired a leasehold interest in an asset that originally was owned by a governmental entity or an electrical cooperative.

The "MTA" transaction involved the Hillside Maintenance Complex in Hollis, Queens, the primary maintenance facility for the Long Island Rail Road's rail cars. As described in the transaction's credit memorandum, the facility "is a unique and essential asset to the viability of the Long Island Rail Road and the MTA." (MTA Mem., at ALT0016431.) "The modern 900,000 square foot Facility, possessing the latest advances in industrial engineering, robotics, and computer technology, is required to meet the repair and maintenance needs of the LIRR well into the twenty-first century." (Id.) The complex originally was owned by the New York Metropolitan Transportation Agency (the "MTA"), a public benefit corporation of the State of New York. (Id. at ALT0016430.) As an agency of a state government, the MTA is not subject to federal income taxation for purposes relevant to this case. See 26 U.S.C. § 115 (1994).

The "Oglethorpe" transaction involved an interest in the Rocky Mountain power plant, an 848 megawatt pumped storage hydroelectric facility. The plant, located in Floyd County, Georgia, is used to provide "peak" power to customers of the Oglethorpe Power Corp., themselves electric utilities. During periods of low electricity demand, it uses electricity from the public grid to pump water into a reservoir on top of a mountain. Then, during periods of peak demand, gravity propels water through the plant's turbines to generate electricity. As described in the Oglethorpe credit memorandum, the plant "fills a major gap for Oglethorpe which had been buying peaking capacity under contract to meet short-terms needs." (Oglethorpe Mem., at ALT 0003524.) At the time the transaction was entered into, Oglethorpe had over a billion dollars in net operating losses, thus the ability to claim deductions for wear and tear on the plant would not have had a substantial effect on its federal tax liability. (Tr. 896, 900.)

The "Seminole" transaction involved a 625 megawatt coal-fired electrical generating unit, known as "Unit 1," that is located in Palatka, Florida. The plant originally was owned by the Seminole Electrical Cooperative, Inc., an electrical cooperative similar to Oglethorpe. According to the transaction's credit memorandum, the unit "accounts for approximately 50% of Seminole's generating capacity and is indispensable for Seminole's operations." (Seminole Mem., at ALT002543.) This transaction terminated in accordance with the terms of the parties' agreement. (Tr. 1959.) Thus, there presently is no possibility that Altria will be required to take possession of Unit 1.

The "Vallei" transaction involved a wastewater treatment facility in the Netherlands. Like other wastewater treatment facilities that have been leased to American investors, the facility at issue here accelerates the biological processing of wastewater. (Vallei Mem., at ALT0001032.) The credit memorandum opined that such facilities "represent critical assets to the efficient, safe and economical treatment of wastewater for the inhabitants of the Gelderland, Utrecht and Noord Holland provinces of The Netherlands." (Id. at ALT0001025.) The facilities originally were owned by Watershap Vallei en Eem, an independent agency of the government of the Netherlands that is responsible for the treatment of wastewater within its assigned geographic region. (Vallei Mem., at ALT0001019-ALT0001020.) As an agency of a foreign government, Vallei is not subject to U.S. federal income tax for any relevant purposes.

As noted, each of the four transactions had two principal components: a "head" lease and sublease. In the head lease, the tax indifferent entity initially leased the asset (or a percentage interest in the asset) to Altria. In three of the four transactions (Oglethorpe, Seminole, and Vallei), the head lease extended beyond the useful life of the asset and thus transferred tax ownership. (Tr. 248.) In the remaining transaction (MTA), the head lease did not extend past the asset's useful life and thus did not transfer tax ownership. (Id.) The relationship between the head lease term and an asset's appraised useful life accounts for whether a transaction was denominated a SILO ("sale in-lease out") or LILO ("lease in-lease out"), as well as whether Altria purported to acquire a depreciable or amortizable interest in the asset.¹

PMCC immediately leased the asset back to the tax indifferent entity through a sublease whose term was shorter than that of the head lease. Each sublease had a "basic" term that lasted for approximately the amount of time the transaction was expected to generate positive tax benefits. (See, e.g., Mulligan Demonstrative 25.) At the conclusion of the sublease, the tax-indifferent lessee had the right to repurchase the asset for an amount slightly greater than the asset's expected fair market value. (See, e.g., Mulligan Demonstrative 26.) If the lessee did not exercise this purchase option, PMCC could take possession of the facility or put the lessee to additional obligations. The nature of these obligations varied depending on the transaction.

In the...