The Tax Court properly sustained the IRS’s determination that like-kind exchanges with sale and lease-back transactions were loans. Applying the substance-over-form doctrine, the court had held that the taxpayer had failed to acquire a genuine ownership interest in the plants and, therefore, was not entitled to like-kind-exchange treatment, or to its claimed tax deductions. The Appeals Court agreed while holding that a “reasonable expectation or likelihood” standard rather than an economic compulsion or certainty standard governed the characterization of a tax transaction under the substance over-form doctrine. In addition, the record definitively revealed that all of the parties to the transactions fully intended and expected the sublessees to exercise their purchase options at the end of the sublease terms. As a result, the taxpayer bore none of the burdens or indicia of ownership such that it was entitled to the benefit of a like-kind exchange.
The transactions were recharacterized as loans because the taxpayer funded the transactions entirely with its own funds and received the funds back with interest in two payments: the first six months after the closing date and the second at the end of the sublease term in the form of the option cancellation payment. In addition, the taxpayer’s return on investment was predetermined and it did not have an upside potential or much of a downside risk. The transactions were similar to traditional sale/leaseback (SILO) and lease-in/lease-out (LILO) transactions because they created a circular flow of money accompanied by a transfer of tax benefits from a tax-exempt to a taxable entity. In addition, the terms of the transaction ensured that only six months into the deal, the taxpayer was in the same cash position as if it had taken out a loan to finance the transaction.
Moreover, the taxpayer did not have any obligation regarding the maintenance, operation or insurance of the leased property during the sublease term or the remainder of the headlease. Under the terms of the sublease, the municipal utility accepted all of the risks associated with the operation of the power plant during the sublease term. Further, the taxpayer’s due diligence did not indicate any ownership rights because the taxpayer did not follow up on any of the red flags raised in the engineering reports.
In addition, the taxpayer did not face any significant risks indicating genuine ownership during the sublease term. The risk of the municipal utility’s going bankrupt during the first six months of the transaction was commercially impossible. The municipal utility had also obtained sufficient credit enhancements to secure the risk of rent nonpayment or early sublease termination. Also, it was reasonably likely at the time of the transaction that the purchase option would be exercised. The parties understood and reasonably expected at the time of the transaction that the municipal utility would exercise the cancellation option at the end of the sublease because meeting the return conditions would be extremely burdensome.
Because the transactions were really loans, the taxpayer exchanged its power plants for an interest in financial instruments. Since such an exchange was not “like kind,” the taxpayer was required to include in income the gain it received on the sale of the power plants. Moreover, since the transactions were not leases, the taxpayer was not entitled to deduct depreciation or interest or to amortize the transaction costs. The transaction costs were required to be included as an additional loan to the tax-exempt public utilities. Further, the taxpayer was not entitled to include “rent” in income because the transaction was a loan; therefore, there was no rental income. However, the taxpayer received original issue discount income because the tax-exempt utilities reasonably expected that the options at the end of the sublease would be exercised, the option price was fixed and the funds for payment were set aside (defeased) as of the closing date.
The taxpayer was liable for a negligence penalty for disregard of rules or regulations. The taxpayer failed to show reasonable cause and good faith sufficient to meet the exception for those penalties. The taxpayer did not reasonably rely on a tax professional because its law firm’s tax opinions were based on unreasonable assumptions and arrived at unreasonable conclusions in light of how the transactions were actually structured. Moreover, the taxpayer, a sophisticated power plant operator, knew or should have known that the law firm’s tax opinion was flawed. Further, the original issue discount (OID) income should be included in the penalty calculation because nothing in Code Sec. 6662 nor any other provision of the Code provides that an underpayment should be reduced because a taxpayer did not anticipate that the IRS would make a certain argument in litigating a tax case or because the IRS was inconsistent in its prior litigation strategy.
Affirming the Tax Court 147 TC – No. 9, Dec. 60,697.
Exelon Corporation, CA-7
Code Sec. 1001
CCH Reference – 2018FED ¶29,225.1022
Code Sec. 1031
CCH Reference – 2018FED ¶29,608.1103
Code Sec. 6662
CCH Reference – 2018FED ¶39,651G.15
Code Sec. 6664
CCH Reference – 2018FED ¶39,661.654
Tax Research Consultant
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