TAX PRACTICE. tax notes. ConEd LILO Decision: Bad Facts, Bad Law. By Randy Clark and Mark Regante

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1 ConEd LILO Decision: Bad Facts, Bad Law By Randy Clark and Mark Regante Randy Clark is an associate and Mark Regante is a partner in the tax department of Milbank, Tweed, Hadley & Mc- Cloy LLP, New York. The Federal Circuit recently overturned a Court of Federal Claims decision regarding the Randy Clark effect a fixed price purchase option has on the characterization of a transaction for federal income tax purposes. Although the ultimate conclusion is not surprising given the government s success in challenging lease-in, lease-out transactions, the Federal Circuit s analysis has far broader implications Mark Regante than were necessary to reach its conclusion and possibly far broader than were intended. In Consolidated Edison Co. of New York v. United States, 1 the Federal Circuit reversed a determination of the Court of Federal Claims finding that a lease entered into between a Dutch utility (EZH) and a Consolidated Edison subsidiary (ConEd) was rendered illusory because of the presence, and likelihood of exercise, of a fixed price purchase option. In doing so, the court effectively adopted a new standard for analyzing the effect of a purchase option on the substance of a transaction formally characterized as a lease for federal income tax purposes. The Federal Circuit s decision setting forth this new standard, purportedly derived from its decision in Wells Fargo & Co. v. United States, 2 is internally inconsistent, ignores more than 50 years of case law and administrative practice, and will 1 No (Fed. Cir. 2013) F.3d 1319 (Fed. Cir. 2011). TAX PRACTICE tax notes create considerable uncertainty in myriad circumstances in which property is subject to a put or call option. 3 We think the standard to be gleaned from the Consolidated Edison decision is that, at least in the context of a sale-leaseback transaction involving a triple-net lease, a lessee should be viewed as the owner of property if the exercise of a purchase option by the lessee is so likely to occur that a prudent investor in the grantor s position should have reasonably expected that the holder would exercise the option. This standard rationalizes in some measure the court s stated reliance on Wells Fargo and the internal inconsistencies within the Consolidated Edison decision itself. The new standard used by the Federal Circuit in Consolidated Edison sets an extraordinarily low bar for disregarding the form of a transaction and either ignores or distorts the extensive body of case law addressing fixed price purchase options. The facts of the transaction at issue did not differ materially from a traditional lease-in, lease-out transaction. ConEd leased a percent undivided interest in a cogeneration facility from EZH for 43.2 years (the Head Lease) and simultaneously subleased the facility back to EZH for 20.1 years (the Sublease). Under the Head Lease, ConEd made a rent prepayment of approximately $120 million, funded 3 For examples of the internal inconsistencies in the Federal Circuit s decision, see: Consolidated Edison, No at 2 ( We conclude that ConEd s claimed deductions must be disallowed. This is so because there was a reasonable likelihood that the tax-indifferent entity in the LILO Transaction (the lessor of the master lease) would exercise its purchase option at the conclusion of the ConEd sublease, thus rendering the master lease illusory (emphasis added)); Consolidated Edison, No at 21 ( our key inquiry is whether EZH would exercise its purchase option (emphasis added)); Consolidated Edison, No at ( the appropriate inquiry is whether a prudent investor in the taxpayer s position would have reasonably expected that outcome (quoting Wells Fargo, 641 F.3d at ) (emphasis added)); and Consolidated Edison, No at 23 ( in our view, and consistent with Wells Fargo, therefore, the critical inquiry is whether ConEd could have reasonably expected that the tax-[indifferent] entit[y] would exercise [its] repurchase option (emphasis added)) (citing Wells Fargo, 641 F.3d at 1327). TAX NOTES, March 11,

2 COMMENTARY / TAX PRACTICE in part by an approximately $80 million nonrecourse loan. Of the approximately $40 million portion of the rent prepayment funded by ConEd, $31 million was segregated in an investment account (and invested in Treasury separate trading of registered interest and principal of securities) that was pledged to secure EZH s obligations under the Sublease (the Equity Defeasance Account). The $80 million portion of the rent prepayment financed by a nonrecourse loan to ConEd was deposited by EZH into a separate account (the Debt Defeasance Account) to be drawn on to simultaneously satisfy EZH s rent obligations under the Sublease and ConEd s obligations under the Head Lease. At the end of the Sublease term, EZH could purchase ConEd s interest in the facility for approximately $215 million (the Purchase Option). If EZH did not exercise the Purchase Option, ConEd could either require that EZH renew the Sublease for an additional 16.5 years (the Renewal Option) or take over the operation of the facility for the remainder of the Head Lease term (the Retention Option). In analyzing the effect of the various end-of-lease options, the lower court concluded that the Transaction presented three separate, viable Options, none of which was guaranteed or inevitable at the time the Transaction was consummated. 4 Therefore, the lower court concluded that the form of the transaction as a purported lease controlled and the deductions attendant to the transaction were allowed to ConEd. In its appeal to the Federal Circuit, the government offered two principal arguments for why the Head Lease was not a true lease and should not be respected. First, the government argued that if the Purchase Option were reasonably expected to be exercised, the transaction would be characterized as one without any meaningful substance. 5 Second, the government argued that even if the Purchase Option were not exercised, the ability to exercise the Renewal Option insulated ConEd from any risk from declines in the residual value of the facility. The court agreed with the government s first assertion and, therefore, did not address the second. The Federal Circuit, following its own decision in Wells Fargo, considered the key inquiry to be whether a prudent investor would have reasonably expected that EZH would exercise the Purchase Option. 6 The court recognized that the lower court did not apply the reasonable expectation standard in analyzing the facts of the transaction 4 90 Fed. Cl. 228, 340 (2009). 5 Id. at Consolidated Edison, No , at 16. when it concluded that the transaction consisted of three possible scenarios, none of which was certain to occur after the initial lease term. 7 The court then turned to the record to address whether ConEd could meet its burden of proof, again confusing the relevant standard. 8 The court ultimately concluded that because the undisputed evidence establishes that EZH was reasonably likely to exercise the purchase option, ConEd has failed to show that the substance of the transaction included a genuine leasehold interest. 9 In doing so, the court dismissed an appraisal ConEd obtained from Deloitte & Touche LLP that determined that there was no economic compulsion for EZH to exercise the Purchase Option. Notably, in reaching its conclusion, the Federal Circuit made no mention of the economic defeasance arrangements or that ConEd had numerous protections against a risk of loss and had capped its opportunity for profit. The court also neglected to consider whether the transaction lacked a business purpose or might be recharacterized as the purchase of a future possessory interest. By not incorporating these, or any other factors, into its analysis, the decision leaves the impression that, when analyzing the substance of any transaction involving optioned property, any option the holder is reasonably likely to exercise should be presumed to have been exercised. For this reason Consolidated Edison cannot be dismissed as just another case in the sale-in, lease-out/lilo line of cases. The Reasonable Expectation Standard According to the court, its decision in Wells Fargo required that a court assess whether a prudent investor in ConEd s position would have reasonably expected that EZH would exercise the purchase option. 10 The Consolidated Edison court cited language in Wells Fargo to the effect that the appropriate inquiry is whether a prudent investor in the taxpayer s position would have reasonably expected that outcome, saying this made clear that a reasonable expectation standard, rather than a certainty standard, governed the substance-overform analysis. 11 The language quoted by the court in Consolidated Edison, however, takes the court s prior statement 7 Id. at 17 (citing 90 Fed. Cl. at 306). Notably, although Wells Fargo was decided after the lower court in Consolidated Edison rendered its decision, ConEd was not given an opportunity to address the Wells Fargo standard on remand. Instead the Federal Circuit turned to its own analysis of the trial record to support its conclusion. 8 See supra, note 3. 9 Id. at Id. at Id. at TAX NOTES, March 11, 2013

3 out of context. In Wells Fargo, this reasonable expectation standard was immediately followed by the court s explanation that characterization of a transaction based on a highly probable outcome may be appropriate, particularly where the structure of the transaction is designed to discourage alternative outcomes. 12 This explanatory language suggests that a prudent investor should reasonably expect an outcome to occur when this outcome is highly probable. The Consolidated Edison court did not analyze whether any end-of-lease option was highly probable, but instead focused on whether a particular end-of-lease option was reasonably likely. Also, the court s analysis of whether the exercise of the Purchase Option was reasonably likely conflates the reasonable expectation standard actually suggested in Wells Fargo with an outcome-based standard, surely to the confusion of taxpayers attempting to plan future transactions. The explanatory language in Wells Fargo suggests that recharacterization of a transaction, based on a highly probable outcome, may be appropriate when the structure of the transaction is designed to discourage alternative outcomes. Although we do not doubt that the Consolidated Edison court, with its apparent result-oriented focus, could have found that the transaction structure discouraged alternative outcomes, the court forgoes any such analysis. Analyzing the likelihood that the Purchase Option would be exercised, the court briefly describes the consequences of a failure by EZH to exercise the Purchase Option, but none of those consequences indicates that letting ConEd exercise the Renewal Option or the Retention Option was discouraged. For example, the court notes that if ConEd exercised the Renewal Option...EZHwould potentially lose the ability to operate the facility profitably during the [period between the renewal period and the end of the Head Lease]; and under the Retention Option, EZH would risk losing the right to operate the facility profitably during the remainder of the head lease. 13 Although the court points out repeatedly that the Equity Defeasance Account and the Debt Defeasance Account could be used to pay the Purchase Option price, effectively rendering the Purchase Option costless, it ignores that the proceeds of those accounts could also be used to pay EZH s obligations if ConEd exercised the Renewal Option. The Renewal Option or the Retention Option might also be viewed as costless to the extent that the defeasance accounts were available to pay the rent during the renewal term if the Renewal Option was exercised, or to the extent that the COMMENTARY / TAX PRACTICE proceeds of the defeasance accounts would offset any loss to EZH associated with the surrender of the facility if the Retention Option was exercised. Although the court assumes that EZH could lose the ability to operate the facility profitably, this assumption ignores the possibility that EZH could earn a greater return through the Renewal Option or a return and reinvestment of the proceeds of the defeasance accounts following ConEd s exercise of the Retention Option. The court s analysis also raises real questions about the standard applied in Wells Fargo and used in Consolidated Edison. Assuming that the critical inquiry is whether a taxpayer reasonably expected that the [counterparty] would exercise their repurchase options, the proper question is: How likely does it have to be that an option will be exercised for a taxpayer to reasonably expect that the option will be exercised? In Wells Fargo, where this standard was first applied, the finder of fact described the repurchase options as virtually certain to be exercised. Certainly, a taxpayer should reasonably expect a result that is virtually certain, and this result could properly govern the substance of a transaction. The analysis in Consolidated Edison, however, asked whether the exercise of the Purchase Option was reasonably likely. For example, the court suggests in Consolidated Edison, perhaps paraphrasing the Wells Fargo standard, that the key inquiry is whether EZH would exercise its purchase option. 14 Despite concluding that the proper standard is explicitly a reasonable expectation standard rather than a certainty standard, the court does not appear to be applying an expectation standard. Instead, the court suggests that ConEd has the burden of proof to show that EZH s exercise of the purchase option is not reasonably likely 15 and concludes that the undisputed evidence establishes that EZH was reasonably likely to exercise the purchase option. 16 When the court purports to analyze the expectations of ConEd regarding the Purchase Option, it is not clear what level of likelihood the court believes ConEd should have expected. The court initially notes a statement by a ConEd executive that the exercise of the Purchase Option was more likely than not. 17 The court also relied on a description from Cornerstone, ConEd s outside adviser instrumental in structuring the transaction, that it is reasonable to assume [that EZH] will exercise the 12 Wells Fargo, 641 F.3d at (emphasis added). 13 Consolidated Edison, No , at Id. at Id. at Id. at Id. at 28. TAX NOTES, March 11,

4 COMMENTARY / TAX PRACTICE purchase option. 18 Notably, in footnote 11 of its decision, the court quotes the entire relevant passage from Cornerstone s analysis to the effect that although the Purchase Option price would equal or exceed the fair market value of the facility, certain noneconomic factors tend to shift the probability of [EZH] executing the Purchase Option. 19 This suggests that in the court s eyes, a sale and lease-back transaction, and perhaps other transactions involving purchase options, should be recharacterized if the evidence indicates that the exercise of the Purchase Option is more likely than not. Should a taxpayer reasonably expect an outcome that is merely more likely than not or that is more probable than other outcomes? Equally troubling was the Federal Circuit s conclusion that ConEd was not entitled to rehearing to determine whether it could satisfy this new standard established in Wells Fargo, and the dismissal of ConEd s argument, based on the independent appraisal it had received, that it satisfied that standard. ConEd referred to the Deloitte appraisal that it had received when it entered into the transaction to demonstrate that a prudent investor would not have reasonably expected that EZH would exercise the Purchase Option. 20 In rejecting that argument, the court criticized the Deloitte appraisal as not accounting for EZH s noneconomic incentives for exercising the option, such as the importance of the facility to EZH s business. The court, however, did not address how ConEd, the prudent investor in question, was to forecast these subjective factors more than 20 years into the future. Despite highlighting deficiencies in the Deloitte appraisal, the court offered no reason why a prudent investor in ConEd s position would not have been able to rely on the appraisal. Prior Analysis of Fixed Price Purchase Options In addition to the internal inconsistencies presented by the court s holding in Consolidated Edison, the opinion also ignores established precedent concerning the effect of a fixed price purchase option on the substance of a transaction for federal income tax purposes. For example, in Oesterreich v. Commissioner, the Ninth Circuit found that a lessor of property was divested of its equity interest in the property as a result of a purchase option granted to the lessee for nominal consideration. 21 Not only was the purchase option in that case exercisable for nominal consideration, the facts indicated that the lessee would not have agreed to the lease unless 18 Id. 19 Id. at n.11 (emphasis added). 20 Id. at 21 (emphasis added) F.2d 798, (9th Cir. 1955). it provided that title would vest in the lessee. 22 The Ninth Circuit in Oesterreich nevertheless recognized that a mere option to buy at the expiration of a lease does not divest the lessor of its equity interest in the leased property, but distinguished Oesterreich from the cases that reached this conclusion by noting that the cases that respected purchase options were evaluating a purchase option to buy the lease property for full consideration. 23 In Consolidated Edison, the exercise price of the Purchase Option exceeded the expected fair market value of the facility at the time of exercise. 24 In Northwest Acceptance Corp. v. Commissioner, the Tax Court evaluated a series of transactions involving purchase options generally reflecting an exercise price of 10 percent of the original cost of the leased property. 25 When the lessees were free to decline their right to exercise their purchase options, the presence of a more than nominal purchase option did not transfer an equity interest in the leased property to the lessee even when the exercise price encourage[ed] the lessee s purchase of the equipment at the end of the lease term. 26 This was true even when the ability of the lessee to exercise its purchase option was guaranteed, which, the court said, demonstrated no more than good business sense on the part of the taxpayer/lessor. 27 In LTV Corp. v. Commissioner, the Tax Court analyzed a lease with a fixed price purchase option equal to the estimated fair market value of the leased property at the end of the lease term. 28 When no part of the payments under the lease were applied as an offset to the option price, the Tax Court found that the option did not create (or transfer) an equity interest in the leased property to the lessee. 22 Id. at Id. at 802 (citing Benton v. Commissioner, 197 F.2d 745 (5th Cir. 1952); Indian Creek Coal & Coke Co. v. Commissioner, 23 B.T.A. 950 (1931); Haverstick v. Commissioner, 13 B.T.A. 837 (1928)). When the IRS has analyzed purchase options for nominal consideration, it has found a nominal exercise price makes these options certain or virtually certain to be exercised. See LTR ; LTR See Consolidated Edison, No , at The Federal Circuit in ConEd never challenged the conclusion in the Deloitte appraisal that the Purchase Option price exceeded the fair market value of the facility at the time the Purchase Option could be exercised T.C. 836, aff d per curiam, 500 F.2d 1222 (9th Cir. 1974). 26 Northwest Acceptance, 58 T.C. 836 at Id. at 848. The taxpayer in Northwest was a finance company that purchased lease contracts from equipment dealers. Many of the contracts provided that the dealer selling the contract or a third-party would guarantee the obligations of the applicable lessee, and some included a guarantee of the exercise of the purchase option T.C. 39 (1974) TAX NOTES, March 11, 2013

5 29 6 Cl. Ct. 441 (1985). 30 Transamerica, 7 Cl. Ct. at 448 (emphasis added) F.3d. 461, 469 (4th Cir. 2008). 32 Id. at Fed. Cl. 228, 340 (2009). 34 See Frank Lyon v. United States, 435 U.S. 561, 581 (1978) F. Supp.2d 953, 978 (N.D. Ohio 2008). COMMENTARY / TAX PRACTICE In Transamerica Corp. v. United States, the Claims Court found a lease contract to constitute a conditional sale if several factors, including a purchase option, indicated that the lease was intended to convey an equity interest in the property. 29 Regarding the likelihood of the exercise of the purchase option, the Claims Court noted that the exercise price of the purchase option, in the form of the final lease payment, was substantially below the fair market value of the leased property. The Claims Court found that the likelihood that the purchase option would not be exercised was remote, noting that an option price substantially below the value of leased property indicates that the parties were reasonably certain at the time they entered into the [transaction] that the option would in fact be exercised. 30 Combining the bargain purchase option with other negative facts, the Claims Court recharacterized the transaction, although it is noteworthy that it took a bargain purchase option, nearly certain to be exercised, for the Claims Court to expect a taxpayer to be reasonably certain of an outcome. In BB&T Corp. v. United States, a LILO transaction was recharacterized as a financing arrangement under which the exercise of a purchase option by the lessee was the only economically viable scenario for the lessee. 31 Because the lessee had no economic incentive to elect not to exercise the purchase option, the court concluded that the lessor therefore [did] not expect [the lessee] to walk away from the Equipment. 32 In stark contrast, the finder of fact in Consolidated Edison found that the transaction at issue presented three separate, viable Options...none of which was guaranteed or inevitable at the time the Transaction was consummated. 33 The Federal Circuit never analyzed whether the exercise of the Purchase Option was the only viable option for EZH, instead finding it sufficient that it was a reasonably likely scenario. The Supreme Court has discouraged this type of speculation when contrary to a clear finding of the finder of fact, as was the case in Consolidated Edison. 34 In AWG Leasing Trust v. United States, the district court recharacterized a sale-in/lease-out transaction based on the existence of a fixed price purchase option that was extremely likely to be exercised. 35 This was the case because the lessee s other end-oflease options were either economically disadvantageous or politically unpopular. 36 Notably, the court in AWG Leasing Trust proved the likelihood of a particular option by demonstrating why the lessee was discouraged from electing (or permitting) an alternative outcome. Given the explanatory language of the Consolidated Edison court s purported standard from Wells Fargo that characterization of a transaction based on a highly probable outcome may be appropriate, particularly where the structure of the transaction is designed to discourage alternative outcomes it is surprising that the court in Consolidated Edison did not focus on the costs to EZH of letting ConEd exercise the Renewal Option or the Retention Option. The Federal Circuit focused on the costless nature of the Purchase Option, while neglecting to focus on the fact that neither the Renewal Option nor the Retention Option necessarily imposed any additional cost to EZH, aside from unanalyzed theoretical periods of lost profits. Conflicting Standards and Future Planning In Rev. Proc , 37 the IRS purported to establish guidelines for a taxpayer to request a ruling that a leveraged lease would be respected as a lease for federal income tax purposes. One condition is that the lessee (and some related parties) not have a contractual right to purchase the property from the lessor at a price less than its fair market value at the time the right is exercised. The seemingly unambiguous notion in the revenue procedure that the presence of a purchase option at fair market value does not indicate that a lease should be recharacterized is now in doubt. 38 Taxpayers will need to be concerned that other factors, including noneconomic factors and future factors outside the four corners of the transaction, may tend to shift the probability that a lessee may exercise or is reasonably likely to exercise a purchase option or are such that a prudent investor could have reasonably expected that the [lessee] would exercise a purchase option. Outside the leasing context, the IRS has been more explicit in evaluating what level of likelihood that an option will be exercised is necessary for a 36 Id. at C.B The position of the IRS regarding below fair market value purchase options, stated in Rev. Rul , C.B. 39, asks whether the purchase option was virtually certain to be exercised from the outset or whether the terms of the option provide a significant indication that it will be exercised. Subsequent non-precedential guidance from the IRS reached similar conclusions. See TAM (Sept. 17, 1980) (option price below fair market value provided a significant indication that the option would be exercised); LTR (Aug. 25, 1983) ( virtually certain purchase option resulted in lease recharacterized as a sale). TAX NOTES, March 11,

6 COMMENTARY / TAX PRACTICE taxpayer to be considered the owner of property. For example, in Rev. Rul , 39 the IRS concluded that adjustable rate convertible notes were equity for federal income tax purposes when the holders of the notes had an option to convert them into stock at any time. This was the result when the face value is a figure calculated primarily to ensure conversion into stock and there was a very high probability that the notes would be converted into stock. Analyzing the deductibility of interest accruing on an investment unit in Rev. Rul , 40 the IRS specifically endorsed an economic compulsion test, stating that if the characterization of an instrument or a transaction for federal income tax purposes either depends on, or could be affected by, the existence of a person s legal right or option to elect a certain course of action, the tax consequences often depend on whether the exercise (or nonexercise) of the right or option is economically compelled based on all the facts and circumstances. 41 Treasury regulations also provide some guidance in other contexts. For example, a corporation with more than a single class of stock is not eligible to be treated as an S corporation. 42 Treasury regulations provide that, in general, an instrument, obligation, or arrangement that is not stock will not be considered stock for this purpose. 43 However, a call option will be considered a second class of stock when a corporation issues a call option that is substantially certain to be exercised and is in the money on the issue date. 44 The Tax Court has considered an argument by the IRS that a taxpayer was the owner of property because it bought a call option while the seller simultaneously held a put option. In Penn-Dixie Steel Corporation v. Commissioner, 45 the Tax Court analyzed the simultaneous acquisition of an option by one corporation, Continental, to acquire the stock of a target, Phoenix, beginning August 1, 1971, and ending July 31, 1972, and an option by the owner of Phoenix to sell stock of Phoenix to Continental beginning August 1, 1970, and ending July 31, The IRS asserted that the possibility that C.B C.B Id. (emphasis added). 42 Section 1361(b)(1)(D). 43 Reg. section (l)(4)(i). 44 Reg. section (l)(4)(iii) T.C. 837 (1978). the put or call would not be exercised was so remote that it should be ignored [and] the price set at the outset would prove to be advantageous to one party or the other. The Tax Court even recognized that Continental intended to exercise its call if the owner of Phoenix did not exercise its put. This did not convince the Tax Court, however, because the exercise of the options was not a sufficient certainty and any intention would be subject to revaluation in light of changing circumstances. 46 Therefore, Penn-Dixie suggests that even when taxpayers intend a result to occur, that result will not control the tax consequences of the transaction unless that result is sufficiently certain. Consolidated Edison has confused significantly the analysis of when an option should be presumed exercised. The Federal Circuit suggests that the exercise price has little bearing because, the court concludes, exercise may be reasonably likely because of extraneous noneconomic factors even when the option does not contain a bargain element. The only way to reconcile past precedent, Rev. Proc , historical administrative practice, and Wells Fargo is to recognize the limits on the reasonable expectation standard as the Federal Circuit applied it in Wells Fargo that is, that characterization of a transaction based on a highly probable outcome may be appropriate, particularly where the structure of the transaction is designed to discourage alternative outcomes. 47 Therefore it is not the existence of a purchase option itself that presents an evil to be prevented, but rather a transaction designed so a holder is economically compelled to elect a particular option. In that sense, the standard applied in Consolidated Edison is deficient because it looks only to whether a particular option was reasonably expected to be exercised. Instead, a subjective analysis is needed of the facts and evidence available to the grantor at the time the transaction is entered into to determine whether the transaction, as a whole, compels the holder to exercise the option. Absent objective criteria or some unifying standard, every transaction that includes a purchase option will be suspect. Why would any party bargain for the inclusion of a purchase option it had no reasonable expectation of exercising? The Consolidated Edison decision must be reconsidered. 46 Id. at Wells Fargo, 641 F.3d at TAX NOTES, March 11, 2013