On tax day — April 15, 2011 — a federal appeals court agreed with a lower court and dealt Wells Fargo & Co. an unexpected tax blow by denying the bank $115 million in claimed deductions. The deductions were tied to transactions dating back to 1997, and involved 26 SILO (sale-in/lease-out) transactions with tax-exempt organizations.
To get an appreciation of how the tables were turned on Wells Fargo, it’s best to understand how a SILO works. Generally, it comprises two concurrent leases of an asset owned by a tax-exempt organization. In the first lease, which is known as the “head lease,” the tax-exempt organization leases the asset to a corporate taxpayer for a term that exceeds the useful life of the asset. The Internal Revenue Service treats the head lease as a sale of the asset. In the second lease, which is known as the “sublease,” the taxpayer leases the asset back to the tax-exempt organization for a term that is less than the asset’s remaining useful life.
The taxpayer prepays the entire rent on the head lease in one lump sum, and funds the prepayment in part with its own funds and in part with a nonrecourse loan. The tax-exempt organization receives a small percentage (4% to 8%) of the head lease prepayment as its “fee” for participating in the transaction. The remainder of the prepayment is placed in two restricted accounts. The “debt portion account” is used to make the sublease rental payments. This payment account contains sufficient funds to cover the organization’s payments for the life of the sublease — or equivalently, the taxpayer’s payments for the life of its nonrecourse loan.
In addition, an affiliate of the nonrecourse lender invests the “equity portion account” in high-grade debt. The growth of this account is managed so that the tax-exempt organization has sufficient funds to repurchase its asset from the taxpayer at the conclusion of the sublease. The repurchase price is established at the beginning of the transaction. If the organization chooses not to exercise its repurchase option, the taxpayer can elect either the “return option” or the “service contract option.” That’s the quick version of how a SILO works.
The Wells Fargo SILO Mentality
The Wells Fargo case looks back to transactions completed from 1997 through 2003. During that time, the bank entered into several SILO transactions with tax-exempt entities, and in 2002 Wells Fargo claimed $115 million in tax deductions based on 26 SILO transactions.
To be entitled to deductions for depreciation of assets and accrued interest, as well as transaction expenses, Wells Fargo had to show that it owned the SILO equipment. To qualify as an owner for tax purposes, the taxpayer must bear the benefits and burdens of property ownership. However, Wells Fargo did not bear such benefits and burdens and, as a result, was denied the tax benefits that accrue to the owner of property. (See Wells Fargo & Company and Subsidiaries v. United States, _F.3d_ (Fed. Cir. 2011).)
Wells Fargo had argued that it acquired the benefits and burdens of ownership because there was a possibility that it would regain possession of the leased assets at a time when they still retained some economic useful life. Its position is predicated on uncertainty regarding whether the tax-exempt organizations would exercise their options to repurchase. The trial court found that “the evidence strongly supports a conclusion that the repurchase options would almost certainly be exercised.” Agreeing with the lower court, the federal circuit court observed that “we have never held that the likelihood of a particular outcome in a business transaction must be absolutely certain before determining whether the transaction constitutes an abuse of the tax system.”
Indeed, the federal circuit court concluded that the trial court 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 organization would do nothing other than exercise the option.”
In its argument, Wells Fargo insisted that its case is governed by the Supreme Court’s decision in Frank Lyon Co. v. United States, 435 U.S. 561 (1978), in which the high court allowed tax deductions for a sale-leaseback transaction having some of the same characteristics as the SILOs. However, Frank Lyon involved a transaction between two taxable entities. Moreover, the trial court in Frank Lyon found that the lessee was “highly unlikely” to exercise its purchase option.
But the federal circuit court was not swayed, and upheld the trial court’s finding that the entities are “virtually certain” to exercise their repurchase options. The circuit court observed: “left with purely circular transactions that elevate form over substance.” To be sure, the only flow of funds between the parties was the initial lump sum given to the tax-exempt organization as consideration for its participation in the transaction.
The federal circuit court, therefore, supported the trial court’s conclusion that SILO transactions ran afoul of the substance over form doctrine. Accordingly, it upheld the judgment of the trial court with the result that Wells Fargo was denied the tax deductions it hoped would flow from its involvement in these SILO transactions.
Robert Willens, founder and principal of
Robert Willens LLC,
writes a weekly tax column for CFO.com.