Government Loses LILO Case

In a rare setback for the IRS in its litigation against lease-in, lease-out (LILO) tax shelters, the Court of Federal Claims held that an arrangement Consolidated Edison Co. of New York (Con Ed) had with an electric utility in the Netherlands should be respected for federal tax purposes because it had valid business purposes beyond its tax benefits.

The lengthy opinion in Consolidated Edison Co. of New York Inc. & Subsidiaries v. U.S., no. 06-305T (Fed. Cl. 10/21/09), followed a five-week trial featuring 1,600 exhibits containing more than 25,000 pages. The IRS contended, as it has successfully in a number of similar cases, that financing for the lease and leaseback arrangement was circular and that the terms ensured that payments met the respective utilities’ obligations without risk of loss. Con Ed argued, and the court agreed, however, that the transaction was in form a true lease that demonstrated a valid business purpose and possessed economic substance.

Con Ed, through a trust owned by a subsidiary, entered the 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 the 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 transaction was highly leveraged.

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.

Con Ed asserted that it reasonably projected it would earn pretax profits of at least $61 million, on which taxes were deferred but not eliminated, plus other nontax benefits.

For its analysis of economic substance, the court turned to the U.S. Supreme Court decision in Frank Lyon Co. v. U.S. (435 U.S. 561 (1978)) and the Federal Circuit’s holding in Coltec Industries Inc. v. U.S. (454 F.3d 1340 (2006)) for the principles that the transaction must when viewed objectively have a business purpose other than beneficial tax treatment, i.e., that it show a reasonable possibility of profit beyond its tax benefits. The court also emphasized that the case must be decided based on an analysis of all the facts and circumstances surrounding the transaction in question.

Reviewing the extensive testimony given and evidence presented, the Court of Federal Claims said that the benefits and burdens of ownership of a leasehold interest were demonstrated by a risk of loss of its investment and opportunity to profit. In large part, it said, the validity of the lease depended on how likely it was that EZH would exercise its option to purchase the remaining lease from Con Ed, which would eliminate the latter’s risk. The court noted what it said was credible evidence presented by Con Ed that EZH’s exercise of the option was not inevitable or preordained and that the Dutch company in fact had no incentive to do so.

Other potential business benefits besides profit included an opportunity to gain technical and regulatory expertise, establish a presence in a Western European market, and improve environmental knowledge and sensitivity, the court said. Risks for Con Ed included risk of default by EZH, costs of maintaining the facility, fluctuations in currency and cost of energy, and Dutch and U.S. regulation. Thus the transaction had economic substance, the court held.