Court of Federal Claims Upholds LILO Transaction

The Court of Federal Claims held that a lease-in, lease-out (LILO) transaction involving a Dutch power plant undertaken by a New York utility company was a valid business transaction that had economic substance.

Background

In the mid-1990s, the Consolidated Edison Company of New York (Con Ed), a New York electricity and natural gas utility company, was ordered by its state regulator, the New York Public Service Commission (PSC), to restructure its electricity generation operations as part of the deregulation of the electric industry in New York. Under the deregulation order, the PSC and Con Ed agreed that Con Ed would restructure as a holding company composed of unregulated subsidiaries and that it would sell off 50% of its electricity-generating plants in New York. Con Ed could invest up to 5% of its consolidated capital in unregulated subsidiaries, including subsidiaries that made investments in foreign power-generating plants and projects.

Con Ed expected to have losses due to deregulation and the resulting divestiture of assets. It also expected to have shortterm losses on some of the new projects it was investing in due to their substantial upfront costs. Therefore, according to Con Ed’s former controller, the company began looking for LILO investments to offset some of these losses. A LILO transaction is a leveraged lease arrangement designed to frontload the transaction’s financial profits into its early years without changing the overall profit expected.

Con Ed carefully evaluated many prospective investments before entering into a LILO transaction with the Dutch utility company Electriciteitsbedrijf Zuid-Holland, N.V. (EZH), involving the RoCa3 power-generating facility. In that transaction, EZH leased a 47.3% interest in the RoCa3 facility to Con Ed through one of its unregulated subsidiaries for a term of 43.2 years, and Con Ed subleased the interest back to EZH for a term of 20.1 years. Under the terms of the sublease, EZH was responsible for the operation, maintenance, repair, and upkeep of the facility. At the end of the sublease term, EZH could exercise an option to purchase Con Ed’s remaining leasehold interest, or Con Ed could exercise an option to either renew the sublease or have EZH return Con Ed’s interest in the facility. The parties also entered into a number of financing and other agreements that supported the primary lease/sublease.

For the year 1997, Con Ed reported rental income from the RoCa3 transaction of $399,693 and expenses of $1,337,294. On audit, the IRS disallowed the bulk of the loss from the transaction, increased Con Ed’s income by $937,331, and assessed a $328,066 deficiency against the company. Con Ed paid the deficiency and filed a claim for refund in the Court of Federal Claims.

The Parties’ Arguments

The IRS argued that the transaction should be disregarded because Con Ed did not acquire in substance a present leasehold interest in the RoCa3 facility since Con Ed did not enjoy the benefits and burdens of owning an interest in the RoCa3 facility and possessed at most a contingent future interest in the property similar to, but less substantial than, an option. Alternatively, the IRS claimed that the transaction should be disregarded under the economic substance doctrine because it did not have a reasonable expectation of profit outside the tax benefits and was not motivated by a valid nontax business purpose.

In response to the IRS’s arguments, Con Ed pointed to three factors to support its position that the transaction had economic substance and was a true lease. First, in entering into the transaction, it reasonably projected that it would earn a substantial pretax profit and pay substantial federal income taxes on this profit. Second, the tax benefit that arises from the transaction is deferral, not tax elimination. Third, it had structured the transaction in accordance with the applicable financial accounting standards.

The Court’s Decision

The Court of Federal Claims held that the RoCa3 transaction was a true lease that had economic substance and that Con Ed was entitled to the loss from the transaction that it claimed for 1997. In its decision, the court followed the precedent of the Supreme Court in Frank Lyon Co., 435 U.S. 561 (1978), in which the Court considered the same issues in the context of a sale and leaseback agreement. However, the Court of Federal Claims noted that it based its decision on the facts and circumstances of Con Ed’s transaction.

As the Supreme Court did in Frank Lyon, the Court of Federal Claims held that the key factor in determining whether the transaction was a true lease was whether Con Ed had acquired the benefits and burdens of owning the leasehold interest in the RoCa3 facility. According to the court, this depended on whether Con Ed had a risk of loss and an opportunity for gain in its investment in the facility. The IRS claimed that if EZH were to exercise the sublease purchase option, Con Ed’s continuing risk in the transaction would be eliminated. The IRS further claimed that it was certain when parties entered into the transaction that EZH would exercise the option, so Con Ed essentially had no risk of loss on the transaction. Con Ed countered that it was not preordained that EZH would exercise the option, and even if EZH did, Con Ed would still have a risk of loss and an opportunity for gain from the transaction.

After considering the extensive testimony in the case, the court found that the company had both a risk of loss and an opportunity for gain and that therefore the lease was a true lease. In particular, the court found that the transaction offered the chance to make a profit and the opportunity “to gain technical and regulatory expertise, establish a presence in a Western European market, and improve environmental knowledge and sensitivity.” As to risk, the court found that although Con Ed naturally had attempted to mitigate the risk of the transaction, it was subject to risks from a default by EZH on the agreement, currency and energy price fluctuations, domestic and Dutch regulatory actions, and the general risks inherent in operating and maintaining a power generation facility.

The court then looked at the economic substance of the transaction. Once again citing Frank Lyon and various other federal cases, the Court of Federal Claims stated that a transaction had economic substance if there were one or more independent, nontax business purposes for the transaction and it was not shaped solely by tax avoidance motives. In making this determination, a court is required to objectively determine if the taxpayer had a reasonable possibility of making a profit from a transaction exclusive of tax benefits and if the taxpayer had any legitimate nontax motives for entering into it. After reviewing the testimony of numerous Con Ed executives and both parties’ expert witnesses, the court determined that Con Ed could reasonably have expected to make a pretax profit from the RoCa3 transaction and that the transaction also offered a number of other significant nontax benefits for the company. Therefore, it held that the transaction had economic substance and that Con Ed was entitled to the loss it claimed from the transaction on its 1997 return.

Reflections

Although this decision may encourage anyone forced to defend a transaction against an economic substance attack, it is probably not the beginning of a wave of taxpayer wins on the issue. As the Court of Federal Claims took pains to point out, the existence of economic substance is a facts-and-circumstances determination. Although it undeniably gained a tax benefit through the RoCa3 transaction, Con Ed had a relatively strong case that the transaction was not totally tax driven. In addition, Congress passed Sec. 470 in 2004 to curtail the use of LILO transactions, so it is doubtful Con Ed would win on the issue for leases entered into after Sec. 470’s effective date (March 12, 2004).

Consolidated Edison Co. of NY, No. 06- 305T (Fed. Cl. 10/21/09)