Thursday, April 21, 2011

Federal Circuit Upholds Denial Of Claimed Tax Breaks From SILO Transactions

Wells Fargo & Company and Subsidiaries v. U.S. (CA FC 04/15/2011) 107 AFTR 2d ¶2011–734

The Court of Appeals for the Federal Circuit, affirming the Court of Federal Claims, has denied a corporation's claimed tax breaks from participation in 26 sale-in, lease-out (SILO) transactions, on the ground that the transactions lacked economic substance.

Observation: This case involved years before there was a legislative and administrative crackdown on SILOs. For example, effective generally for leases entered into after Mar. 12, 2004, the American Jobs Creation Act cracked down on SILO and other types of leasing transactions involving tax exempts by suspending tax-exempt use losses. Also, IRS designated SILOs as abusive tax shelter transactions in Notice 2005-13, 2005-1 CB 630.

Background. Before the crackdowns noted above, SILOs were used as tax shelters. A tax-exempt entity such as a public transit agency would transfer tax benefits for a fee to a U.S. taxpayer. The transactions involved depreciable assets such as rail cars, locomotives, or buses in the transit leases, or telecommunications equipment. The objective was for the taxpayer to take advantage of significant tax deductions acquired from tax-exempt entities to offset taxable income and thereby reduce its overall tax liability.

Facts. Wells Fargo claimed $115,174,203 in depreciation, interest and transaction cost deductions for the tax year 2002. The deductions stemmed from Wells Fargo's participation in 26 leveraged lease transactions, 17 with domestic transit agencies, and nine involving qualified technological equipment (“QTE”). Although the tax treatment of all 26 transactions was at issue in the case, the parties limited their trial presentation to five agreed transactions, allowing the Court's ruling on these five to guide the resolution of the remainder. Of the five trial transactions, four involved public transit agencies, and one was a QTE lease involving cellular telecommunications equipment.

Lower court rulings. The Court of Federal Claims found that Wells Fargo was not entitled to the claimed tax deductions on the five trial transactions. The SILO transactions did not grant to Wells Fargo the burdens and benefits of property ownership. The transactions lacked economic substance, and were intended only to reduce Wells Fargo's federal taxes by millions of dollars.

According to the Court, the SILO transactions essentially amounted to Wells Fargo's purchase of tax benefits for a fee from a tax-exempt entity that couldn't use the deductions. The transactions were designed to minimize risk and assure a desired outcome to Wells Fargo, regardless of how the value of the property might have fluctuated during the term of the transactions. The Court stressed that nothing of any substance changed in the tax-exempt entity's operation and ownership of the assets. The only money that changed hands was Wells Fargo's up-front fee to the tax-exempt entity, and Wells Fargo's payments to those who participated in or created the intricate agreements.

Failed arguments on appeal. Wells Fargo argued that the Court of Federal Claims (1) employed an inappropriate methodology to determine that Wells Fargo lacked the benefits and burdens of ownership in the assets that were the subject of the SILO transactions; (2) used the wrong test to measure its pretax profit; and (3) misapplied the “nontax business purpose” test.

The Federal Circuit stressed that, in order to be entitled to deductions for depreciation of assets and associated interest and transaction expenses, Wells Fargo had to show that it owned the SILO equipment. Ownership for tax purposes is not determined by legal title. Instead, in order to qualify as an “owner” for tax purposes, the taxpayer must bear the benefits and burdens of property ownership. In this case, the parties agreed that the clearest indicator of ownership is the allocation of risk associated with the value of the leased assets.

Wells Fargo argued that it acquired the benefits and burdens of ownership in the leased assets because there was a possibility that it would regain possession of the leased assets at a time when they still retained some economically useful life. Its argument was predicated on uncertainty regarding whether the tax-exempt entities would exercise their options to repurchase the assets. The Court of Federal Claims noted that for tax purposes, Wells Fargo required the tax-exempt entities to state that at the time of closing that they had not made any determination whether they would exercise their repurchase options. However, the Court of Federal Claims found on the evidence that the repurchase options would almost certainly be exercised to terminate the transactions.

The Federal Circuit found that the extensive witness testimony and documentation relied upon by the Court of Federal Claims supported its conclusions. The Appeals Court said that the Court of Federal Claims was justified in concluding that, from the inception of the transactions, the economic effects of the alternatives were so onerous and detrimental that a rational tax-exempt entity would exercise the options.

As a result, what was left were purely circular transactions that elevate form over substance. The only flow of funds between the parties to the transaction was the initial lump sum given to the tax-exempt entity as compensation for its participation in the transaction. From the tax-exempt entity's point of view, the transaction effectively ended as soon as it began. The benefits to Wells Fargo continued to flow throughout the term of the sublease, however, in the form of deferred tax payments. The third-party lender and its affiliate were also compensated for their participation, as were the creators and promoters of the transactions. These transactions were win-win situations for all of the parties involved because free money—in the form of previously unavailable tax benefits utilized by Wells Fargo—was divided among all parties.

Bottom line. The Federal Circuit sustained the Court of Federal Claim's conclusion that the SILO transactions at issue ran afoul of the substance-over-form doctrine and therefore were abusive tax shelters. Based on well-grounded factual findings, the Court of Federal Claims permissibly found that the claimed tax deductions were for depreciation on property Wells Fargo never expected to own or operate, interest on debt that existed only on a balance sheet, and write-offs for the costs of transactions that amounted to nothing more than tax deduction arbitrage. It therefore upheld the judgment of the Court of Federal Claims.

Observation: Most courts that have examined SILOs or the similar LILO (lease-in, lease-out) transactions have concluded that the taxpayer who participated in the transaction was not entitled to any of the claimed tax benefits. However, one case went against IRS. That case, also decided by the Court of Federal Claims, held that a LILO transaction entered into by Consolidated Edison of New York (Con Ed) didn't lack economic substance. See Consolidated Edison Company of New York, Inc. v. U.S. (Ct Fed Claims 10/21/2009) 104 AFTR 2d 2009-6966.

References: For SILO transactions, see FTC 2d/FIN ¶L-6329; United States Tax Reporter ¶4704; TG ¶16811.

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