In an opinion that appears to close the door on lease-in, lease out (LILO) tax shelters once and for all, the Federal Circuit Court of Appeals issued a decision Wednesday reversing and remanding a case to the Court of Federal Claims, which had upheld the transaction ( Consolidated Edison Co. of New York, No. 2012-5040 (Fed. Cir. 1/9/13)). In a departure from most recent case law, the lower court had held that the LILO transaction had economic substance and allowed Consolidated Edison (Con Ed) the rental deductions and interest expense it had claimed ( Consolidated Edison Co. of New York, 90 Fed. Cl. 228 (2009)). This issue should not arise in the future because Sec. 470, which was enacted in 2004, specifically prohibits LILO transactions.
The background of the case
Con Ed, through a trust owned by a subsidiary, entered an agreement with Electriciteitsbedrijf Zuid-Holland NV (EZH) to lease from the Dutch utility a 47.47% interest in an electric generating plant in the Netherlands and then sublease it back to EZH. The lease was for 43.2 years, with a 20.1-year sublease beginning concurrently with the main lease. At the end of the sublease term, EZH could exercise an option to purchase from Con Ed its remaining lease. If it did not exercise the option, Con Ed could either renew the sublease or require EZH to return its ownership interest in the Con Ed trust. The parties also entered into a number of financing and other agreements that supported the primary lease/sublease.
On its consolidated return for 1997, Con Ed reported rental income from the transaction from which it deducted rental expenses, interest, and amortized transaction costs for a net loss of $937,331. The IRS disallowed the loss and assessed a deficiency of $328,066. Con Ed paid the deficiency and sued for a refund.
The IRS claimed the transaction lacked economic substance because Con Ed entered into it without any valid business purpose or reasonable expectation of making a profit beyond any tax benefits achieved. Con Ed did not acquire a genuine leasehold interest under the benefits-and-burdens test and did not commit or invest any risk capital in the facility, the IRS argued. As noted above, the Claims Court disagreed with the IRS and granted Con Ed’s refund claim. The government appealed.
The Appeals Court’s opinion
The Federal Circuit held that because there was undisputed evidence that EZH was reasonably likely to exercise the purchase option, Con Ed did not prove that the transaction was in substance a leasehold interest in which Con Ed would bear the benefits and burdens of the lease transaction. The appeals court did not address the economic substance issue on which the lower court had based its decision and, instead, stressed that its recent decision in Wells Fargo & Co., 641 F.3d 1319 (Fed. Cir. 2011), compelled it to apply a substance-over-form analysis to Con Ed’s case. Under that doctrine, courts must determine a transaction’s tax consequences based on the underlying substance of the transaction rather than on its legal form. On this basis, Con Ed’s deductions for rental payments under the lease were disallowed.
The court applied a similar analysis in determining that Con Ed’s deductions for interest expense from “loans” used to finance the transaction were not permitted. The loan was denoted in documents as a “loop” loan, and the court concluded that “a party simply does not incur genuine indebtedness by taking money out of a bank and then immediately returning it to the issuing bank,” quoting BB&T Corp., 523 F.3d 461 (4th Cir. 2008). Accordingly, both the rental and interest deductions were disallowed, and the case was remanded to determine whether Con Ed was owed any interest from its earlier payments.
