Awg Leasing Trust v. U.S.

Decision Date28 May 2008
Docket NumberCase No. 1:07-CV-857.
Citation592 F.Supp.2d 953
PartiesAWG LEASING TRUST, KSP Investments, Inc. As Tax Matters Partner, Plaintiff, v. UNITED STATES of America, Defendant.
CourtU.S. District Court — Northern District of Ohio

Brian J. Lamb, David J. Hooker, James D. Robenalt, Jeffry J. Erney, Anthony J. Rospert, Frank R. Desantis, Michele Kryszak Abraham, Stephen D. Williger, Thompson Hine, Cleveland, OH, Tracy A. Hannan, Thompson Hine, Atlanta, GA, for Plaintiff.

Karen A. Smith, Matthew Von Schuch, Robert J. Kovacev, Stuart J. Bassin, U.S. Department of Justice, Washington, DC, for Defendant.

OPINION & ORDER

[Resolving Doc. No. 1]

JAMES S. GWIN, District Judge:

I. Introduction1

With this action, two large national banks dispute adjustments that the Internal Revenue Service ("IRS") made to partnership federal income tax returns for the 1999, 2000, 2001, 2002, and 2003 tax years. In those adjustments, the IRS found that the banks' partnership, the AWG Leasing Trust, mis-characterized a 1999 transaction as a $423 million purchase of a German waste-to-energy facility. The IRS says the transaction was a thinly-veiled tax dodge that attempted to skirt IRS and Congressional action directed to limiting transactions that had the purpose of transferring tax deductions for rental payments, depreciation, amortization, and interest payments from tax neutral entities. As a result, the IRS claims that the Plaintiffs owe approximately $88 million in taxes for the 1999-2003 tax years and will owe much more for subsequent years.

As will be described below, the banks say that they paid $423 million on December 7, 1999 to buy a waste-to-energy facility in Wuppertal, Germany and should be allowed to depreciate the Wuppertal plant. The banks argue that their contemporaneous lease of the facility back to the original owner under a very long-term triple-net lease and their grant of an option to repurchase the facility does not defeat their claim of ownership rights to the facility.

The banks also say that they should be allowed to deduct interest on the $368 million long-term non-recourse loans that they obtained from two German banks to finance the transaction even though the loan proceeds went to escrow-type accounts that the German entity could not access and that were committed to paying the German company's lease payments and to providing sufficient funding to complete the option exercise.

In deciding this case, the Court makes two determinations. First, the Court decides whether the 1999 transaction has economic substance apart from the tax benefits at issue. Second, the Court considers whether the banks enjoyed the benefits and burdens of ownership of the Facility when the transaction pre-funded the repurchase of the facility and also required the original owner to repurchase the facility unless it met near-impossible conditions. As will be described, the Court finds that the transaction had some minimal substance apart from the tax benefit. However, the Court finds that the Plaintiffs never obtained an ownership interest sufficient to obtain a depreciable interest in the facility. The Court further concludes that the Plaintiffs are not entitled to deductions for interest paid or accrued on the underlying transaction loans because such loans do not constitute genuine indebtedness.

For the reasons that follow, this Court SUSTAINS the IRS's determination that the Plaintiffs' asserted tax benefits relating to the AWG transaction are improper. The Court DENIES the Plaintiffs' claimed depreciation deductions under 26 U.S.C. § 168, interest expense deductions under § 163(a), and amortization of transaction costs deductions. The Court also upholds the IRS's imposition of accuracy-related penalties at the partnership level for substantial understatement of tax liability under 26 U.S.C. § 6662(a).

II. Background

This case revolves around a 1999 sale-in/lease-out ("SILO") transaction. Under some SILO transactions, a party acquires assets from a tax-exempt party under a "head lease." A SILO head lease typically involves a lease term sufficiently long to qualify as a sale under United States tax law. The acquiring party then simultaneously leases the assets back to the original owner under a longterm triple-net "sublease" with lease and option payments that exhaust almost all of the sale proceeds. The original owner also receives an option to repurchase the asset. Depending upon the transaction provisions, the exercise of the repurchase option may be nearly certain. In practical terms, the tax-exempt property owner continues to use the property as it did before the transaction and has no risk of losing control of the property. Meanwhile, the taxpayer receives tax benefits, sometimes significant tax benefits, by depreciating the assets, amortizing certain transaction costs, and deducting interest payments.

Where the original owner seems extremely likely to repurchase the facility that it originally sold, the IRS argues that a true sale has not occurred and that the owner-lessor is not entitled to claim tax benefits associated with ownership, such as deductions for depreciation. The IRS also says that where a transaction has no economic substance apart from tax benefits, the taxpayer is not entitled to deduct interest on loans used to fund the transaction or expenses associated with the transaction.

A. Historic Tax Treatment of Leveraged Lease Transactions

For some time, financial leasing has served as an important vehicle for commercial enterprise fund raising. Leasing can mitigate the capital commitment that usually accompanies asset purchases. Often, commercial leases also allow parties to transfer tax benefits in an efficient fashion. Lessees who were unable to fully utilize tax benefits (usually because of a lack of profits) could obtain lower financial cost by entering a transaction that allowed them to transfer the tax benefits associated with depreciation and interest expense deductions to lessors who could more fully use these tax benefits. In theory, the lessees obtained lower financing costs in recognition of their transfer of the tax benefit. Accounting rules that apply to leveraged leases also make them significantly more attractive.2 Concerned that financial leases unfairly undercut the federal tax system the IRS and Congress have adopted rules to ensure that the risks and indices of true ownership pass to the lessor before tax benefits can be claimed.

SILOs are a modified version of their tax-driven financial predecessors, lease-in/lease-out ("LILO") transactions. Although each transaction is factually distinct, SILOs generally differ from LILOs by having a longer-term head lease that is sufficiently long to qualify for tax purposes as a sale. In a typical LILO, the taxpayer leases property from a tax-exempt entity and simultaneously leases the same property back to the owner and gives the owner an option to repurchase the lease. In practical terms, the tax-exempt property owner continues unfettered use of the property just as before the transaction, but the taxpayer claims tax benefits. As the Fourth Circuit Court of Appeals recently noted, "LILOs have been harshly criticized as abusive tax shelters that serve only to transfer tax benefits associated with property ownership from tax-indifferent entities, which have no use for them, to U.S. taxpayers." BB & T Corp. v. United States, 523 F.3d 461, 465 (4th Cir.2008) (citing David Hariton, Response to "Old `Brine' in New Bottles" (New Brine in Old Bottles), 55 TAX L. REV. 397, 402 (2002)).

In 1996, the IRS issued proposed regulations that generally eliminated any favorable tax treatment associated with LILOs. These proposed regulations sought to reduce the tax benefits of lease-leaseback transactions by treating prepaid rent as a loan. Section 467 Rental Agreements, 61 Fed. Reg. 27,834 (June 3, 1996). On May 19, 1999, the IRS issued a final ruling under I.R.C. § 467, significantly reducing the tax benefits commonly associated with LILO structures. See Rev. Rul. 99-14, 1999-1 C.B. 835, modified and superseded by Rev. Rul. 2002-69, 2002-2 C.B. 760. In its 1999 ruling, the IRS determined that LILOs were abusive and impermissible tax shelters and announced that it would seek disallowance of rent and interest deductions on the grounds that these transactions lack economic substance. These regulations did not retroactively apply to any transactions created before May 19, 1999, but "there remained a risk that the IRS would invoke generally applicable tax law principles to disallow LILO-related deductions." BB & T Corp. v. United States, 523 F.3d 461, 465 (4th Cir.2008).

KeyCorp ("Key") and PNC Financial Services Group, Inc. ("PNC Financial") previously participated in a large number of LILO transactions. As a result of the 1999 IRS regulations, Key and PNC stopped taking part in new LILO transactions. [Joint Ex. 56, Doc. 167-7 at KSP0197639-42; Angel Tr., Doc. 178-1 at 224.]

Presumptively alerted that the IRS would challenge exotic efforts to transfer tax deductions from tax indifferent entities, one might have thought that banks would step away from similar transactions. Instead, some United States banks began to enter into sale-leaseback transactions ("SILOs") that were designed to substantially replicate lease-leaseback transactions. [Joint Ex. 56, Doc. 167-7 at KSP0197639-42; Angel Tr., Doc. 178-1 at 224.]

Having given notice that purposeless efforts to transfer tax benefits would be addressed, it was no surprise when in 2004, Congress passed the American Jobs Creation Act to explicitly eliminate all tax advantages of SILO transactions created after March 12, 2004. America Jobs Creation Act of 2004, Pub. L. No. 108-357, § 848, 118 Stat. 1418 (2004). Consequently, neither Key nor PNC participated in any new cross-border lease to service contract transactions after that date. [Angel...

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