FARGO v. UNITED States
| Decision Date | 15 April 2011 |
| Docket Number | 2010-5108 |
| Parties | WELLS FARGO & COMPANY AND SUBSIDIARIES, Plaintiff-Appellant, v. UNITED STATES, Defendant-Appellee. |
| Court | U.S. Court of Appeals — Federal Circuit |
OPINION TEXT STARTS HERE
Appeal from the United States Court of Federal
Claims in case no. 06-CV-628, Judge Thomas C. Wheeler.
David Farrington Abbott, Mayer Brown, LLP, of New York, New York, argued for plaintiff-appellant. With him on the brief were Brian W. Kittle; and Stephen M. Shapiro, Joel V. Williamson, Thomas C. Durham, Timothy S. Bishop and Michael R. Emerson, of Chicago, illinois.
Cory A. Johnson, Trial Attorney, Commercial Litigation Branch, Tax Division, United States Department of Justice, of Washington, DC, argued for defendant-appellee. On the brief were John A. Dicicco, Acting Assistant Attorney General, Richard Farber and Judith A. Hagley, Attorneys.
Before Newman, Bryson, and Linn, Circuit Judges.
This case requires us to evaluate the federal income tax consequences of sale-in, lease-out ("SILO") transactions. The Court of Federal Claims denied Wells Fargo $115 million in claimed deductions for tax year 2002 stemming from its participation in 26 SILO transactions with tax-exempt entities. We affirm.
A sale-in, lease-out transaction of the sort at issue in this case consists of two concurrent leases of an asset owned by a tax-exempt entity. In the first lease, known as the "head lease," the tax-exempt entity leases the asset to the taxpayer for a lease term that exceeds the useful life of the asset. Because the asset will be returned to the tax-exempt entity only after its useful life has expired, the IRS treats the head lease as a sale of the asset. In the second lease, known as the "sublease," the taxpayer leases the asset back to the tax-exempt entity for a term that is less than the asset's remaining useful life. The sublease is a net lease, meaning that the tax-exempt entity is responsible for all expenses normally associated with ownership of the asset. The tax-exempt entity also retains legal title to the asset.
The taxpayer prepays the entire "rent" of the head lease in one lump sum. The taxpayer funds the rent prepayment in part with its own funds and in part with a nonrecourse loan. The portion of the rent prepayment funded by the taxpayer's own funds is known as the "equity portion," and the portion funded through borrowing is known as the "debt portion." The tax-exempt entity receives a small percentage of the head lease rent prepayment, usually between 4 percent and 8 percent of the asset value, as its fee for participation in the SILO transaction. The remainder of the rent prepayment, minus transaction costs, is placed in two restricted accounts, one for the equity portion and one for the debt portion. Each account is nominally held by the tax-exempt entity, but the funds are controlled by an affiliate of the taxpayer's nonrecourse lender.
The debt portion account is used to make the tax-exempt entity's sublease rental payments. Money never actually changes hands during a rental payment; the lender's affiliate simply moves funds from the tax-exempt entity's debt portion account to the lender's account in an amount sufficient to service the taxpayer's nonrecourse loan debt. The debt portion account has sufficient funds to cover the tax-exempt entity's payments for the life of the sublease or, equivalently, the taxpayer's payments for the life of its nonrecourse loan. Because of the circular nature of the debt payments, the funds in the debt portion account are known as "loop debt." The taxpayer's debt is effectively "defeased," or extinguished, meaning that dedicated funds exist for the purpose of paying off the debt. The taxpayer can therefore ignore its nonrecourse loan debt for purposes of its balance sheet.
The lender's affiliate invests the equity portion account in high-grade debt, such as government bonds. The growth of the account is managed so that the tax-exempt entity has sufficient funds to repurchase its asset from the taxpayer at the conclusion of the sublease. The repurchase price, or "exercise price," is set at the begin- ning of the SILO transaction. The tax-exempt entity can exercise its option to repurchase the asset simply by giving notice to the taxpayer. If the option is exercised, the funds in the equity portion account are transferred to the taxpayer, and a final payment of loop debt is made from the debt portion account to the taxpayer's nonrecourse lender. The debt portion account is emptied and the debt of the taxpayer to the lender is satisfied. The net result is the same as if the taxpayer had simply invested its equity portion account in high-grade debt, receiving a predictable return on that investment over the life of the sublease.
If the tax-exempt entity chooses not to exercise its repurchase option, the taxpayer generally has two choices. The taxpayer can elect either the "return option," under which the taxpayer takes control of the asset immediately, or the "service contract option," under which the taxpayer postpones taking control of the asset. Under the "service contract option," 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. Those conditions are described below. Under either option, the tax-exempt entity ultimately receives the balance of the funds in the two accounts.
SILOs offer three tax benefits to the taxpayer. First, as owner of the asset for tax purposes based on the head lease, the taxpayer may take depreciation deductions on the asset for the remainder of its useful life. See 26 U.S.C. ("I.R.C.") § 167(a). Second, the taxpayer may take deductions for interest payments made from the tax-exempt entity's debt portion account to service the taxpayer's nonrecourse loan. See I.R.C. § 163(a). Third, the taxpayer may deduct certain transaction costs associated with the SILO. If the tax-exempt entity exercises its repurchase option, these tax benefits are partially offset at the end of the sublease by taxes owed on the taxpayer's receipt of funds from the equity portion account. Even taking those taxes into account, however, the deferral of tax payments during the life of the sublease has substantial economic value to the taxpayer.
SILOs evolved in response to a long-running battle among Congress, the IRS, and enterprising taxpayers regarding the boundaries of permissible leasing of tax-exempt property to generate tax benefits. In 1981, Congress enacted "safe-harbor leasing rules" that allowed taxpayers to lease property from tax-exempt entities. Economic Recovery Tax Act, Pub. L. No. 97-34, 95 Stat. 172 (1981). The safe-harbor rules, however, were quickly repealed in 1982. Tax Equity and Fiscal Responsibility Act, Pub. L. No. 97-248, 96 Stat. 324 (1982). In 1984, Congress enacted the so-called "Pickle Rule," which provided that property leased from a tax-exempt entity would be depreciated at a slower rate than other property in order to limit the tax benefits generated by such transactions. Deficit Reduction Act, Pub. L. No. 98-369, 98 Stat. 494 (1984).
Taxpayers then began to employ creative strategies to avoid the Pickle Rule and receive greater tax benefits from the property of tax-exempt entities. One of those strategies was the use of lease-in, lease-out ("LILO") transactions. A LILO is like a SILO, except that the head lease term is shorter than the asset's remaining economically useful life, so the IRS treats it as a lease rather than a sale. The end-of-lease options are also different for LILOs if the tax-exempt entity does not exercise its repurchase option: At the taxpayer's discretion, the tax-exempt entity may be required to return the assets, renew its lease, or lease the assets to a third party. See Rev. Rul. 02-69, 2002-2 C.B. 760. Like the SILO options, each of the end-of-lease options in a LILO is structured to effectively eliminate risk of loss to the taxpayer. See BB&T Corp. v. United States, 523 F.3d 461, 464-65 (4th Cir. 2008). The Federal Transit Administration ("FTA") has at various times promoted LILO and SILO leases as a means of providing infusions of cash for financially troubled public transit agencies.
The LILO market came to an end beginning in 1999, when the Treasury Department issued new regulations requiring that prepayment of the head lease rent be treated as a loan for tax purposes. See Treas. Reg. § 1.467-4. At that point, taxpayers were "[p]resumptively alerted that the IRS would challenge exotic efforts to transfer tax deductions from tax indifferent entities." AWG Leasing Trust v. United States, 592 F. Supp. 2d 953, 959 (N.D. Ohio 2008). In 2002, the IRS clarified that LILO transactions did not satisfy the substance-over-form doctrine, discussed below. Rev. Rul. 02-69. Taxpayers then began using SILOs instead of LILOs in order to avoid the new regulations on leases by characterizing the head lease as a sale. In addition, taxpayers asserted that the term of a service contract was not subject to the Pickle Rule for determining the applicable rate of depreciation. Finally, in 2004, Congress put an end to tax benefits generated from both LILO and SILO transactions by amending the Internal Revenue Code. American Jobs Creation Act, Pub. L. No. 108-357, 118 Stat. 1418 (2004); see I.R.S. Notice 05-13, 2005-1 C.B. 630. While the amendments were prospective in effect, they were not designed to alter the general principles of tax law that apply in determining the legitimacy of transactions designed to generate tax deductions. See H.R. Rep. No. 108755, at 660 (2004) (Conf. Rep.).
From 1997 to 2003, Wells Fargo entered into several SILO transactions with tax-exempt entities. For tax year 2002, Wells Fargo claimed $115 million in deductions based on 26 SILO transactions. Seventeen of the transactions were with domestic transit agencies, and nine were with owners of qualified...
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