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Friday, August 16, 2013

The Tax Court Weighs In on LILOs and SILOs

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On August 5, in John Hancock Life Ins. Co. v. Commissioner, 141 T.C. No. 1 (8/5/13), the Tax Court ruled for the first time on the income tax consequences of lease-in-lease-out (LILO) transactions and sale-in-sale-out (SILO) transactions. The Tax Court ultimately joined a long list of courts to disallow the taxpayer’s claimed deductions related to these transactions. In fact, in all Courts of Appeals in which LILO and SILO cases have been argued, the taxpayer has lost its claimed tax benefits.

While the IRS had asserted deficiencies of over $559 million stemming from 27 challenged transactions entered into in the late 1990s, John Hancock and the IRS agreed, for the sake of expediency, to try seven test cases (three LILO transactions, four SILO transactions). A formula would then be applied to the remaining transactions to determine the amount of deficiency, if any.

 In disallowing John Hancock’s claimed deductions, the Tax Court relied primarily on substance-over-form grounds, rather than economic substance. Notably, the IRS failed to timely raise economic substance arguments in its pleadings, and, as a result, the court placed the burden of proving the economic substance doctrine applied to the test transactions on the IRS.

Economic substance analysis has two prongs: (1) the transaction must have economic substance beyond generating tax benefits (the “objective test”); and (2) the taxpayer must have a nontax business purpose for entering the transaction (the “subjective test”). In 2010, the Health Care and Education Reconciliation Act (HCERA) codified the judicial doctrine in §7701(o) as a conjunctive test – that is, a transaction will have economic substance only if a taxpayer satisfies both the objective and subjective tests.Prior to codification, several circuits treated the test as disjunctive – i.e., if the taxpayer satisfies one or the other prong, the transaction has economic substance.The codified test under §7701(o), however, only applies to transactions entered into after HCERA’s enactment on March 30, 2010. The transactions at issue in John Hancock pre-dated that cutoff, and, therefore, were governed by case law.

An appeal of the John Hancock case would lie with the First Circuit, which appears to look to both the objective and subjective tests, but which has not directly addressed whether it applies a conjunctive or disjunctive test. Nevertheless, the Tax Court examined each prong and found that the IRS failed to satisfy its burden of proof with respect to both.  Thus, John Hancock actually prevailed on the economic substance arguments.

Interestingly, the Tax Court seemed to look quite favorably upon John Hancock with respect to the subjective test, stating:

Respondent argues that the test transactions do not serve a nontax business purpose and that John Hancock’s sole motivation for entering into the test transactions was to consume tax capacity. This conclusion ignores John Hancock’s principal business function. The need to fulfill John Hancock’s insurance policy and annuity obligations contributed significantly to its investment decisions. Numerous representatives from John Hancock credibly testified at trial that John Hancock sought and continues to seek diverse investments that provide returns and cashflows to meet its short- and long-term responsibilities.

This at least raises the question of whether, if a disjunctive test were applied, John Hancock might have prevailed on the economic substance argument even without the burden having been placed on the IRS.On the other hand, the court deemed the financial models John Hancock used for purposes of the objective test “inconclusive,” and almost certainly this would not have sufficed to satisfy a conjunctive test where John Hancock bore the burden of proof.

The Tax Court’s holding, however, turned on the substance-over-form doctrine and the determination that John Hancock acquired only a future interest in the properties underlying certain test transactions. With respect to the three LILO test transactions and one of the SILO test transactions, the court concluded that the transactions were, in substance, financial arrangements. More specifically, they were loans from John Hancock to the respective counterparties. John Hancock bore no more than de minimis risk of losing its initial investment, and the counterparties were reasonably likely to exercise their purchase options.As a result, John Hancock was assured to receive a predetermined return.This analysis falls in line with several other LILO/SILO decisions where the court found the substance of the transaction did not include a genuine leasehold interest in which the taxpayer bore the benefits and burdens of a lease transaction. (See, e.g., Consol. Edison Co. of N.Y. v. United States, 703 F.3d 1367 (Fed. Cir. 2013); BB&T Corp. v. United States, 523 F.3d 461 (4th Cir. 2008)). Additionally, the Tax Court in John Hancock held that, as a result of these transactions being recast as loans, the IRS appropriately determined that John Hancock had original issue discount income.

In the remaining three SILO test transactions, the Tax Court determined that John Hancock did not acquire a present interest in the properties underlying the transactions. Rather, John Hancock was effectively insulated from all non-de minimis risk before the purchase option date. Therefore, the court found that, on the closing date of the transactions, John Hancock acquired no more than a future interest in the assets underlying the transactions.  Unlike the lessor in a traditional leveraged lease, John Hancock stood to acquire a current interest only on the purchase option dates. The Tax Court’s logic closely follows the IRS’s position in Rev. Rul. 2002-69, 2002-44 I.R.B. 760, that taxpayers may not deduct rent or interest paid or incurred in connection with LILO transactions because, regardless of pre-tax profit potential or business purpose, LILOs confer only a future interest in property, rather than a current leasehold interest.

In sum, John Hancock is noteworthy for the fact that the Tax Court, in its first opportunity to rule on LILOs and SILOs, can be added to the substantial list of courts where case law runs strongly against the taxpayer in LILO and SILO transactions. Also noteworthy is John Hancock’s success on economic substance grounds, though the extent to which that is the result of the burden being shifted to the IRS is a legitimate question. Finally, as the rationale behind the case’s outcome mostly mirrors the arguments previously used to disallow deductions associated with LILOs and SILOs, John Hancock provides little in the way of new avenues for defense of the transactions.

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