Taxpayer Denied §1031 Treatment for SILO Transaction

The taxpayer in the case of Exelon Corp. et al. v. Commissioner, 147 T.C. No. 9 had a major gain that it did not want to pay current tax on—almost $1.6 billion.  The gain would occur when an acquired entity disposed of its fossil fuel power plants. 

The taxpayer was approached with a potential solution—engage in a purported §1031 exchange.  The taxpayer acquired power plants from tax exempt public utility companies as the claimed replacement property, plants which they then leased back to those entities.  Referred to as a “sale in, lease out” (SILO) transaction, it was a packaged transaction sold to the taxpayer.

The IRS complained that, in reality, the taxpayer never obtained the benefits and burdens of ownership of these plants—and so didn’t actually acquire true ownership of the plants.  Rather, this amounted to an exchange of their old power plants for secured loans to the public utilities. 

The reason the IRS viewed the matter this way was due to the nature of the leases entered into, arguing that, in fact, the public utilities that “sold” their plants to the taxpayer in the Section 1031 exchange had effectively entered into a transaction knowing full well they would have no realistic choice at the end of the lease to “buy back” the property.

The Tax Court noted that SILO transactions have not fared well in the Courts—with one major exception.  As the Court noted:

The courts considering SILO/LILO transactions have almost universally concluded that the taxpayers never obtained the benefits and burdens of ownership or attributes of a traditional lessor and, thus, were not entitled to claim various associated deductions. See ConEd II, 703 F.3d at 1381-1382 (finding that the LILO was not a genuine lease and sublease); Altria Grp., Inc. v. United States, 658 F.3d at 291 (affirming jury finding that a series of LILO and other transactions failed the substance over form inquiry); Wells Fargo, 641 F.3d at 1330 (sustaining the trial court's conclusion that the SILO transactions ran afoul of the substance over form doctrine); BB & T Corp. v. United States, 523 F.3d 461, 464 (4th Cir. 2008) ("[A]lthough the [transaction] form * * * involved a lease financed by a loan, BB & T did not actually acquire a genuine leasehold interest[.]"); John Hancock Life Ins. Co. (U.S.A.) v. Commissioner, 141 T.C. at 109-110, 145 (concluding that all LILO transactions and some SILO transactions at issue were in substance financial instruments, loans); UnionBanCal Corp. v. United States, 113 Fed. Cl. 117, 136 (2013) (concluding that the taxpayer did not obtain the requisite ownership interest to claim the deductions); AWG Leasing Tr. v. United States, 592 F. Supp. 2d 953, 981-982 (N.D. Ohio 2008) (finding that a SILO transaction involving an interest in a German waste-to-energy plant did not convey an ownership interest to the taxpayer to justify the deductions). The only notable exception is the SILO transactions analyzed in John Hancock Life Ins. Co. (U.S.A.) v. Commissioner, 141 T.C. at 111-137, where this Court concluded that because exercising the purchase option at the end of the sublease was not the only economically viable option for the original property owners and John Hancock was exposed to more than de minimis risk after the end of the sublease period, John Hancock acquired a future ownership interest in the underlying properties.

So the question to be decided was whether this SILO transaction was not one where the only economically viable option at the end of the sublease was for the tenant to exercise the option to reacquire the property.

A key factor, as the Court noted analyzing the structure:

We next consider whether petitioner acquired the benefits and burdens of ownership in the light of the options available to petitioner and CPS at the end of the Spruce sublease period. First, we decide whether CPS was reasonably expected to exercise its cancellation option at the end of the Spruce sublease period. If it was, petitioner's profit was fixed at the outset of the Spruce transaction and petitioner did not acquire any benefits and burdens of ownership with respect to the Spruce station. See John Hancock Life Ins. Co. (U.S.A.) v. Commissioner, 141 T.C. at 139-143.

One key factor is that if the tenant did not exercise its option to reacquire the property it would have to incur costs to get the plant into a specified condition—and those costs would not be insubstantial.

The Court found that the math simply argued strongly in favored of the exercise of this option:

Under the circumstances, we find it significantly more likely that CPS, should it attempt to walk away from the transaction and return the Spruce station to Exelon, would face substantial economic losses. Accordingly, we find that the range of scenarios under which CPS would decide to exercise its cancellation option is significantly broader than expected by petitioner's experts, including Prof. Myers.

We also find that both petitioner and CPS, experienced power plant operators having the benefit of professional legal and other advice, understood that the terms of the Spruce transaction were inconsistent with the Deloitte appraisal and the projected future value of the Spruce station. The parties understood that it would be very difficult, if not impossible, for CPS to return the Spruce plant at the end of a 32-year sublease in almost the same condition in which CPS received it in 2000 without significant investment. Thus, the parties understood and reasonably expected at the time of entering into the Spruce transaction that CPS would exercise the cancellation option at the end of the sublease because meeting the return conditions would be extremely burdensome. According to Prof. Myers' analysis, with the required capacity factor of 82% in 2032, more than 20% higher than projected in the Spruce appraisal, it would be economically beneficial for CPS to exercise its cancellation option.

Moreover, we note that when the City of San Antonio brought suit in court to obtain a declaratory judgment of the continued validity of certain covenants in its outstanding public securities -- thereby allowing CPS to enter into the transaction with petitioner -- in its initial draft of the petition the city represented that it intended to exercise the cancellation option. Even though this representation was subsequently deleted at the suggestion of Winston & Strawn and PwC, this Court infers an understanding among the parties that CPS would exercise the option to reacquire the Spruce plant. At the very least, it was reasonably likely at the time of the transaction that the purchase option would be exercised.

Therefore, the Court agreed with the IRS’s view that this was really a loan to the public utility secured by the plant, rather than the actual acquisition of the plant.  Since exchanging the plants for secured loans is not a valid §1031 exchange, the taxpayer must recognize the entire gain on this transaction.