Wells Fargo & Co. claimed $115,174,203 in depreciation, interest, and transaction cost deductions for 2002. These deductions stemmed from the financial-services company’s participation in 26 “leveraged lease” transactions — specifically “sale-in lease-out” or SILO transactions.
SILOs are set up to suggest that a “sale” of property has taken place, that the property has been “leased back” to the original owner, and that a “loan” has been created to finance the transaction. With one exception, several courts have considered the tax treatment of SILOs, and their close relative LILOs (lease-in, lease-out), and have concluded that the taxpayer is not entitled to any of the claimed tax benefits.
Indeed, with regard to the Wells Fargo case that concluded on January 8, the court found that the company is not entitled to claim tax deductions. That’s because the SILO transactions did not afford Wells Fargo the “burdens and benefits” of property ownership, the transactions lacked “economic substance,” and the deals intended only to reduce the company’s federal taxes. (See Wells Fargo & Company and Subsidiaries v. United States, _F.3d_ (Fed. Cl. 2010).)
In a typical SILO, the taxpayer purports to lease capital assets from a tax-exempt entity under an agreement called a “head lease.” The length of the head lease is longer than the remaining economic useful life of the assets so the taxpayer can assert that the head lease should be treated as a sale for tax purposes. The tax-exempt entity concurrently enters into an agreement, called a “sublease,” in which it claims to lease the assets back from the taxpayer for a shorter period than the head lease.
As payment or “rent,” the taxpayer makes a single payment to the tax-exempt entity at closing that pays for the head lease. The funds for the head lease rent come from two sources: the proceeds of a nonrecourse loan, called the “debt funds,” and a cash payment from the taxpayer, called the “equity funds.”
“Wells Fargo did not have any funds at risk…. The debt will be completely paid without Wells Fargo having to supply any funds.” — Robert Willens
The tax-exempt entity does not retain the head-lease payment; rather, the debt funds are paid to an affiliate of the lender (the “debt-payment undertaker”) as part of a debt-defeasance arrangement. The debt-payment undertaker is obligated to make the tax-exempt entity’s rental payments. The rental payments, in turn, are made to the lender to satisfy the taxpayer’s debt-service obligations on the nonrecourse loan. These obligations are set to match, in both timing and amount, the tax-exempt entity’s rental payments. As a result, the debt funds flow in a circle, beginning and ending with the lender.
The equity funds are paid to the “equity-payment undertaker” as part of an equity-defeasance arrangement. Then the remaining portion of the equity funds is retained by the tax-exempt entity as its “incentive fee” for its participation in the transaction.
At the end of the sublease, the funds held by the equity-payment undertaker provide the amount due from the tax-exempt entity. Therefore, the tax-exempt entity does not need to use any of its own funds to exercise the purchase option. If the tax-exempt entity does not exercise the purchase option, the taxpayer can select one of two options:
• It can require the tax-exempt entity to transfer the assets to the taxpayer or
• It can require the tax-exempt entity to arrange a “service contract” for the operation of the assets.
These choices, the court observed, “strongly encourage” the tax-exempt entity to exercise the purchase option.
Benefits and Burdens of Ownership
A taxpayer’s claim of property ownership will not be respected unless the taxpayer acquires both the benefits and burdens of ownership. Here, Wells Fargo did not have any funds at risk; that is, the debt and equity undertaking payment arrangements eliminated the need for the tax-exempt entity to pay rent or for Wells Fargo to make any debt-service payments. The debt will be completely paid without Wells Fargo having to supply any funds, whether the purchase options are exercised or not.
Moreover, Wells Fargo will recover its initial investment plus the interest earned on the equity collateral, regardless of any decline in value of the SILO equipment. This case, therefore, is different from Frank Lyon Company v. United States, 435 US 561 (1978), in which the lessee had renewal options, but the exercise of those options was at the lessee’s choice and the taxpayer/lessor did not have the ability to impose a renewal upon the lessee.
In the Frank Lyon Co. case, the taxpayer was “gambling” that the rents it may obtain after the lease-back would be sufficient to recoup its investment. That is not the situation with Wells Fargo, which is not gambling at all. The minimum return is fixed from the outset, and Wells Fargo can force the tax-exempt entities to “stay in the game” to recoup its initial investment.
In the Wells Fargo case, the tax-exempt entities all retained legal title and the right to exclusive possession, use, and “quiet enjoyment” of the property throughout the lease-back term. The tax-exempt entities remained responsible for all maintenance and insurance, retained the right to all profits, and were responsible for all losses resulting from the operation of the equipment. In the transactions, the court has identified only a “circular flow of funds” between the lender’s affiliated entities, and no payments at all between the lessor and the lessee, except, of course, for the incentive fee to the lessee at closing. In summary, the court had no trouble concluding that Wells Fargo did not become the “owner” of the equipment and, therefore, is not entitled to the depreciation deductions in question.
No Genuine Debt
The court concluded that Wells Fargo cannot claim an interest expense deduction from the nonrecourse debt. That’s because all of the loan proceeds were immediately returned to an affiliate of the lender. The lenders did not relinquish the use of the money, and neither Wells Fargo nor the tax-exempt entities ever had use of the funds. In short, there was indebtedness “in form” but not “in substance,” and Section 163(a) of the tax code only allows a deduction for interest paid or accrued during the taxable year “on indebtedness.”
Economic Substance Lacking
Under the economic substance doctrine, Wells Fargo must prove that the transactions had:
(1) objective economic substance and (2) a nontax business purpose (“subjective” economic substance). The transactions had neither and, therefore, must be disregarded for tax purposes.
In evaluating objective economic substance, a determination must be made whether the transaction provided a “reasonable possibility of profit, exclusive of tax benefits.” But here, the nontax economic benefit to Wells Fargo is the return of its investment from the equity-defeasance arrangements, plus the interest earned on those funds. The net present value of these investment proceeds is less than the total cost to Wells Fargo of participating in the transactions.
Accordingly, on a net present value basis, each SILO is, objectively, a “losing proposition” and, therefore, the SILO transactions do not exhibit objective economic substance. Moreover, the transactions lacked subjective economic substance because there was no nontax business purpose: without the tax benefits, and without Wells Fargo’s “capacity” to use the tax benefits, it would not have entered into the SILO transactions. Accordingly, Wells Fargo’s refund claim was denied and, for good measure, the court, in no uncertain terms, condemned Wells Fargo for having the temerity to engage in such an abusive transaction.
Contributor Robert Willens, founder and principal of Robert Willens LLC, writes a weekly tax column for CFO.com.