Case 1:06-cv-00305-MBH Document 60 Filed 10/05/2007 Page 1 of 10
No. 06-305 T
(Judge Marian Blank Horn)
IN THE UNITED STATES COURT OF FEDERAL CLAIMS
CONSOLIDATED EDISON COMPANY
OF NEW YORK, INC. & SUBSIDIARIES
THE UNITED STATES,
TRIAL BRIEF OF THE UNITED STATES
During December 1997, Plaintiff (“Con Ed”) engaged in a complicated lease-in/lease-out
tax shelter commonly referred to as a LILO (the “Transaction”). The Transaction involved a
facility located in the Netherlands (“Facility”) owned and operated by EZH. Con Ed purported to
lease the Facility from EZH under a lease and simultaneously purported to sublease the Facility
back to EZH. To this day, EZH (and its successors) continue to own and operate the Facility in
its business as it always has. On its federal income tax return, Con Ed reported rental income
and far greater tax deductions for rent, interest, and amortized transaction in connection with this
Transaction. The Internal Revenue Service disallowed the deductions and disregarded the rental
income. Con Ed then paid the resulting deficiency, and filed this suit for a tax refund.1
The amount directly at issue in this case is the tax impact of the LILO shelter for only
two weeks – $328,066. The real amount is far greater. The shelter is expected to last twenty
years and the amounts of tax benefits claimed in subsequent years is and will be very substantial.
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Con Ed’s claimed tax deductions are improper for three reasons. First, looking at the
Transaction as a whole reveals that Con Ed did not in substance acquire a present leasehold
interest in EZH’s property. Second, Con Ed did not incur genuine indebtedness in connection
with the deal. Third, and alternatively, the Transaction should be disregarded under the
economic substance doctrine. Con Ed bears the burden of proof on all these issues.
The Transaction’s Substance Controls
A transaction’s substance, not its form, determines its treatment for federal income tax
purposes. Gregory v. Helvering, 293 U.S. 465 (1935). For this reason, courts have never
regarded “the simple expedient of drawing up papers” as controlling for tax purposes where, as
here, a transaction’s objective economic realities do not comport with the form in which the deal
has been cast. Commissioner v. Tower, 327 U.S. 280, 291 (1946); Commissioner v. Duberstein,
363 U.S. 278 (1960); Frank Lyon Co. v. United States, 435 U.S. 561, 573 (1978). Thus, when
the substance of a transaction differs from its form, substance controls. See Nebraska Dep’t of
Revenue v. Loewenstein, 513 U.S. 123 (1994) (recharacterizing a “sale” and “repurchase” of
municipal bonds as a secured lending transaction).
In evaluating the merits of the tax deductions here, this Court must determine whether, in
substance, EZH transferred an interest in property to Con Ed. H.J. Heinz Co. v. United States, 76
Fed. Cl. 570 (Ct. Cl. 2007); Grodt & McKay Realty, Inc. v. Commissioner, 77 T.C. 1221, 1237
(1981). This requires a comparison of the Transaction’s operative documents to any real world
substantive rights and duties of the participants that actually changed as a consequence of the
Transaction. Doing so here demonstrates that while the form of the Transaction is dizzying in its
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complexity, its substance is as follows: Both before and after the Transaction, EZH continued to
operate the Facility. Con Ed acquired no right to profit and had no exposure to loss from the
operation of the Facility. Other than Con Ed’s up-front payment of an accommodation fee and
other costs to those who facilitated the Transaction under which the tax benefits are being
claimed, monies went in an accounting circle and never truly changed hands. In essence, Con
Ed purchased the tax benefits at issue here for a fee and an investment in government securities
(or alternatively, if not a direct investment in government securities, then a loan by Con Ed to
EZH secured by the government securities). At the end of the day, other than an up-front
accommodation fee and costs paid by Con Ed for the tax benefits, no other monies truly changed
hands. It follows that EZH never conveyed to Con Ed a true leasehold interest in its property,
and Con Ed is not entitled to the tax deductions it claims.
To prevail, Con Ed must prove that it both attained and retained significant and genuine
attributes of an owner of a traditional leasehold interest in EZH’s property. Frank Lyon, 435
U.S. at 584, 98 S. Ct. at 1304. Those attributes are present only when the person purporting to
own a leasehold interest enjoys the benefits and bears the burdens normally incident to
possession of such an interest. Coleman v. Commissioner, 16 F.3d 821, 826 (7th Cir. 1994),
citing Frank Lyon, supra. See also Heinz, 76 Fed. Cl. at 582. In this case, the reciprocal nature
of Con Ed’s and EZH’s rights and duties contained in the Operative Documents, the circular flow
of funds that from the outset virtually ensured payment of the respective obligations created
thereunder, and EZH’s continued and unabated use of its Facility at no cost to itself, mean that
Con Ed had neither the benefits nor the burdens of the leasehold interest it claims.
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The controlling and persuasive case law confirms this substance over form result. In
Frank Lyon, supra, taxpayer purported to engage in a sale/leaseback of a building. The building,
however, was constructed with funds that were dedicated to the project and which consisted of
cash and proceeds of a recourse loan. The Supreme Court concluded that the taxpayer remained
the true owner of the building for tax purposes, and it relied on the fact that the taxpayer alone
was liable for the debt that financed the construction of the building, and bore the risk of loss if
the building declined in value. Frank Lyon, 435 U.S. at 581.
Following the Supreme Court’s lead in Frank Lyon, courts have focused on the existence
of both financial risk and economic risk of loss through declines in market value as indicia of
“tax” ownership. See e.g., Coleman, 16 F. 3d at 826-27 (denying depreciation deductions to a
taxpayer who purportedly acquired computer equipment with nonrecourse debt through a
sale/leaseback); Swift Dodge v. Commissioner, 692 F.2d 651, 652-54 (9th Cir. 1982) (all of the
indicia of ownership in general, and the risk of depreciation in particular, rested with the users of
the vehicles (not the taxpayer), thus the transactions were, in substance, conditional sales).
Recently, a nearly identically structured LILO transaction was disallowed in BB&T
Corporation v. United States, 2007 WL 37798 (M.D.N.C. Jan. 4, 2007) (on appeal). In 1997,
BB&T, like Con Ed here, purported to lease property from a foreign entity in a LILO transaction
and reported rent income and claimed much larger deductions for rent, interest and transaction
expenses. The district court granted the United States’ motion for summary judgment and held
that BB&T failed to prove it had acquired a genuine leasehold interest or had engaged in
purposeful borrowing. In form, BB&T had acquired a “lease” and a “loan,” but the district court,
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noting the absence of an at-risk investment, determined that the taxpayer lacked an interest in the
property. See Estate of Thomas, 84 T.C. 412 (1985).
The BB&T court held that the foreign entity, in substance, retained its same interest in the
property and continued to enjoy the same benefits and burdens of ownership it had before the
Transaction. The court further concluded that the transaction was not sustainable under
precedent upholding sale/leaseback transactions (where the taxpayers had at-risk investments in
the leased property), because BB&T’s investment was (as BB&T itself concluded in its internal
documents) protected from loss. Viewing the LILO as an integrated transaction (instead of
focusing on isolated steps), the court determined that the parties’ rights and obligations were
offsetting, including the rent and debt obligations. Collapsing those obligations, the court
concluded that BB&T and the foreign entity did not – in substance – enter into a lease and
sublease. Instead, the court held that BB&T paid transaction costs (in exchange for tax benefits)
and invested in government securities, not the leased asset.
Likewise, Con Ed did not acquire a leasehold interest in EZH’s property for tax purposes.
Con Ed bore no financial risk for the loan. The proceeds remained at all times with the lender’s
parent company, and this circular financing arrangement provided a ready source of funds to
repay the loan. In addition, Con Ed took steps to mitigate all risk in the Transaction. In short,
the repayment of the outstanding loan and the equity investment are fully defeased.
Further, as in BB&T, the Transaction features a fully funded Purchase Option that EZH
can “exercise” at the end of the Lease that minimizes the extent to which Con Ed can participate
in any possible residual benefit. Similarly, Con Ed’s Lease Renewal Option limits the extent to
which Con Ed will suffer from any decrease in market value. In effect, these two options at the
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end of the sublease act in tandem to cap the residual value of Con Ed’s purported leasehold
interest, and protect Con Ed from the risk that the value of its interest will decline. Recently, the
Second Circuit concluded that a bank lacked an equity investment in a partnership for that very
reason. TIFD III-E, Inc. v. United States, 459 F.3d 220, 223 (2d Cir. 2006); see also
International Paper Co. v. United States, 33 Fed. Cl. 384 (Ct. Cl. 1995), citing PACCAR v.
Commissioner, 85 T.C. 754 (1985) (“A sale is completed and ownership rights transfer to the
buyer when the buyer acquires the ‘benefits and burdens of ownership.’”).
EZH’s option to purchase Con Ed’s interest in the lease for a fixed price, coupled with
Con Ed’s option to force EZH to renew the sublease should conditions dictate, leave the benefits
and burdens of ownership of the lease interest exactly where they have always been – with EZH.
Unless and until both EZH and/or Con Ed decide otherwise, EZH will possess the Facility
“rent-free”, remain responsible for all costs and capital improvements associated with the
Facility’s use and maintenance, and retain all profits from operation of the Facility. Thus, the
Transaction did not result in a transfer of a current property interest from EZH to Con Ed.
Granted, if EZH fails to exercise its prefunded Purchase Option and Con Ed fails to extend the
sublease, there may come a time when Con Ed acquires an interest in the Facility, but that day
has not yet arrived. Of course, the Court is free to conclude that EZH will likely exercise the
Purchase Option if it believes its failure to do so would seriously depart from its past conduct.
Dow v. United States, 435 F.3d 594, 601-02 (6th Cir. 2006). Indeed, the facts suggest that EZH,
through its successor company, will continue its long-standing use, operation, and possession of
the Facility. EZH and its successors have been the sole owner and operator of the Facility since
it opened, and continue to maintain and upgrade the Facility in an effort to improve its
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production capabilities. As the Sixth Circuit ruled in Dow, supra, Con Ed cannot merely hold
out the prospect of a change in EZH’s historic behavior as a basis to sustain the Transaction.
The Transaction at issue is not a “genuine multi-party transaction with economic
substance . . . compelled or encouraged by business or regulatory realities.” Frank Lyon, supra at
584. On the contrary, Con Ed’s documents describe the Transaction as a tax-driven deal between
Con Ed and EZH, in which Con Ed obtained certain tax benefits, and EZH received an
accommodation fee (referred to as a Net Present Value Benefit). The circular financing
arrangement, in which Con Ed’s “debt” is paid by EZH’s “rent” and money never leaves the
control of the lender’s affiliates, is transparent and must disregarded. Once the illusion of this
“debt loop” is stripped away from the Transaction, the lease and sublease are easily collapsed; all
that is left is Con Ed’s payment of transaction costs and its investment in government securities
which accounts for the entirety of Con Ed’s pretax profits.
Con Ed Is Not Entitled to an Interest Expense Deduction
Section 163(a) of the Internal Revenue Code generally allows taxpayers a deduction for
all interest paid or accrued within the taxable year on indebtedness. Interest refers to
compensation for the use or forbearance of money. Int’l Paper Co, 33 Fed. Cl. at 384, citing
Deputy v. DuPont, 308 U.S. 488, 498 (1940). In order to claim a deduction, however, the debt
on which the interest is paid must be genuine. Knetsch v. United States, 364 U.S. 361 (1960).2
Con Ed’s nonrecourse loan lacks substance, and should not be treated as a genuine debt.
The funds used to make the loan were “loaned” to Con Ed (nonrecourse) by the lender; Con Ed
Similarly, the disallowance of the purported “rent” paid by Con Ed would also be
disallowed under §162(a)(3) of the Internal Revenue Code (26 U.S.C.), which requires that
deductible rent be paid for the “use or possession” of property.
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in turn “paid” the funds to EZH; EZH then “paid” the funds to the lender’s parent. The parent
then “paid” these funds to its subsidiary (the lender) to satisfy both EZH’s rent obligations under
the lease and Con Ed’s obligations under the loan agreement (debt defeasance). Thus, no funds
left the lender’s corporate umbrella, and no portion of this purported borrowing was ever
invested in the Facility, or put to any other purposeful use by either Con Ed or EZH.
In examining an identical financing structure in BB&T, the court concluded that the
interest expense deduction was not valid, because the purported loan was in substance only a
circular transfer of funds in which the loan was repaid from the proceeds of the loan itself, none
of which was put to any substantive, purposive use. 2007 WL 37798, at *11-12.
III. The Transaction Lacks Economic Substance
The Economic Substance Doctrine requires disregarding transactions for tax purposes
that lack economic reality, even if they comply with the literal terms of the Internal Revenue
Code. Coltec Industries, Inc. v. United States, 454 F.3d 1340 (Fed. Cir. 2006). Con Ed bears the
burden of proving that the LILO Transaction has economic substance. Id. This Court, in
Rothschild v. United States, 407 F.2d 404, 411 (Ct. Cl. 1969), has described this burden as
“unusually heavy.” Coltec, 454 F.3d at 1355; Heinz, 76 Fed. Cl. at 584 ( “A taxpayer must prove
that its transaction was both purposeful and substantive--if proof in either regard is lacking, the
transaction is a sham.”). In short, the Federal Circuit adopted a disjunctive test, under which the
lack of either an objective or a subjective business purpose would be grounds to disregard a
transaction. Coltec, 454 F.3d at 1355-56. Thus, the transaction will be disregarded if a plaintiff
is unable to prove that (1) the transaction has a reasonable expectation of profit existing outside
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of the tax benefits and (2) the transaction was motivated by a business purpose other than
obtaining tax benefits. Id.
Con Ed did not have a reasonable opportunity for a pretax profit. When transaction
costs, and the time value of money are considered, this Transaction produces a substantial pretax
loss. See ACM Partnership v. Commissioner, 157 F.3d 231, 259 (3d Cir 1998); Dow, 435 F.3d at
600-01. In addition, the Court must determine whether the cash flows on which Con Ed relies
should be considered at all. In cases such as this, the relevant inquiry is whether the transaction
that generated the disputed tax deductions – not a piece of the transaction – has economic
substance. Coltec, 454 F.3d at 1356-57. For this reason, the economic substance of leasing
transactions often turns on whether the taxpayer reasonably expected to earn a profit from the
residual value of the leased property after the lease expires. Gilman v. Commissioner, 933 F.2d
143, 149 (1991). No such potential exists here, because any profit Con Ed can reasonably
expect is simply the risk-free return generated from the purchase of government securities. In
fact, Con Ed did not even value the residual interest.
Quite apart from its inability to generate a meaningful profit, absent tax benefits in
dispute, Con Ed also lacks a genuine non-tax business purpose for entering into the Transaction.
The facts belie Con Ed’s claim that it entered into the Transaction to gain entry into the
Netherlands power industry. First, Con Ed’s own employees will testify that it never considered
any nontax driven investments in this country. Second, Con Ed eliminated the Netherlands
during its country screening process prior to the transaction and confirmed this in a second
country screening process conducted after the transaction. Moreover, Con Ed never even visited
the Facility until the audit started, almost eight years after the closing of the Transaction. This
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reveals that the Transaction was purely a tax driven deal to Con Ed. Con Ed also asserts that
another non-tax business purpose for the Transaction was to achieve leveraged lease accounting.
As a matter of law this stated reason is not sufficient to satisfy the subjective aspect of the
economic substance test because the benefits of leveraged lease accounting are largely dependent
on the tax deductions in dispute. An accounting benefit from a transaction that lacks economic
substance cannot imbue the transaction generating the tax benefit with economic substance for
tax purposes. American Electric Power, Inc. v. United States, 136 F. Supp. 2d 762, 791-92 (S.D.
Ohio), aff’d 326 F. 3d 737 (6th Cir. 2003), quoting Winn-Dixie Stores, Inc. v. Commissioner, 113
T.C. 254, 287 (1999), aff’d 254 F. 3d 1313 (11th Cir. 2001) (“If a legitimate business purpose for
the use of the tax savings were sufficient to breathe substance into a transaction whose only
purpose was to reduce taxes, [then] every sham tax shelter device might succeed.”).
s/ David N. Geier
DAVID N. GEIER
Attorney of Record
U.S. Department of Justice, Tax Division
Post Office Box 26
Washington, D.C. 20044
Telephone: (202) 616-3448
Facsimile: (202) 307-0054
RICHARD T. MORRISON
Assistant Attorney General
STEVEN I. FRAHM
Chief, Court of Federal Claims Section
Assistant Chief, Court of Federal Claims Section
October 5, 2007
s/ Steven I. Frahm