United States: Tax Court Holds Against Taxpayer In John Hancock

The Tax Court issued its first opinion on lease-in, lease-out ("LILO")/sale-in, lease-out ("SILO") leveraged lease transactions in John Hancock Life Insurance Co v. Commissioner on August 5.1 The controversy concerned John Hancock's involvement in 27 LILO and SILO transactions between 1997 through 2001, but to resolve the matters "expeditiously,"2 the parties agreed to try seven test transactions consisting of three LILOs and four SILOs. The court held in favor of the government and denied John Hancock the tax benefits of all the transactions. In its analysis, the court discussed the decisions of other federal courts that had decided cases involving LILOs and SILOs, including Altria Grp., Inc. v. US,3 BB&T Corp. v. US,4 and Wells Fargo & Co. v. US,5 all of which were also decided against the taxpayers. In John Hancock the IRS asserted that the transactions were, in substance, loans made by the taxpayer rather than true leases or equity investments. The Tax Court found that the IRS had failed to show that the taxpayer had no realistic expectation of profit or business purpose for the relevant transactions, thus holding that the IRS failed to prove that the test transactions lacked economic substance. Nevertheless, the court found that most of the test transactions failed a substance over form analysis and recharacterized those transactions as financing transactions. For the taxpayer, this resulted in additional original issue discount ("OID") income and the loss of various deductions, including interest on non-recourse debt incurred pursuant to the transactions.

Economic Substance Analysis

The Tax Court's 244-page decision begins its analysis of the subject transactions testing for economic substance. Economic substance analysis includes both an objective and subjective test. A transaction passes the objective test if there is economic substance separate from the tax benefits of the transaction. A transaction passes the subjective test if the taxpayer shows a legitimate non-tax business purpose for entering into the transactions. For the objective test, the taxpayer presented evidence of projected cash flow from the investments. The court stated that a net present value calculation for the investments could be useful in this analysis and found that the taxpayer's reports lacked a determination and were inconclusive with respect to the net present value calculation. Nevertheless, the court found that the IRS had not met its burden of proof because it failed to show that there was no reasonable expectation of profit for the taxpayer. With regard to the subjective test, the court noted that the taxpayer had a long history of making careful investment decisions based on its principal business purpose of fulfilling its obligations as an insurance company. For each transaction, the company performed due diligence and engaged advisers to determine that each transaction would "contribute towards diversifying its investments, provide a strong yield, and match its long-term obligations."6 This convinced the Tax Court that there was a legitimate, non-tax business purpose for the SILO/LILO investments. Therefore, using the objective and subjective tests, the Tax Court was not convinced that the transactions failed the economic substance analysis.

Substance over Form

After finding for the taxpayer on the economic substance issue, the Tax Court considered whether the substance of the transactions was consistent with their form. The court cited the Supreme Court's decision in Frank Lyon for the idea that a sale-leaseback will be respected for tax purposes if the "lessor retains significant and genuine attributes of a traditional lessor."7 Accordingly, the court stated that in this case, the transactions could be respected if John Hancock could show that it had a true leasehold interest in the LILO properties and a true ownership interest in the SILO properties. In testing for substance over form, the Tax Court used an overall facts and circumstances analysis, while citing various factors that are relevant to the inquiry (but not requiring a strict factor test). Considering the LILO transactions, the court found that the true substance was a loan rather than a lease because, among other things, the terms and security provided in the deal created only a de minimis risk for the taxpayer, and the taxpayer was guaranteed a fixed return on its investments. Moreover, the purported lessees in the transactions had purchase options, and the court found that they were reasonably likely to exercise the options based on the financial realities of the deal. Therefore, the court held that the taxpayer had not shown that it acquired the benefits and burdens of a traditional lessor in the LILO transactions and recharacterized the transactions as loans. Similarly, the court found that one SILO transaction should be recharacterized as a loan because John Hancock did not acquire the benefits or burdens of ownership. As was the case in the LILO transactions, the court noted that the counterparty in the SILO was likely to exercise a purchase option while the taxpayer was insulated from the risk of loss and received a guaranteed return on its investment. In each recharacterized transaction, the taxpayer received a predetermined return on its investment without any of the appreciable downside risk or upside potential that a true owner would have. For the remaining SILOs among the tested transactions, the court found that John Hancock had an ownership interest in the relevant properties, albeit a future interest, and did not recharacterize the transactions as loans. Although there were purchase options in the SILOs, the court assumed that they would not be exercised. John Hancock was protected from risk before the purchase option, but after that period the company would acquire the risks and benefits of ownership if the option was not exercised during a period when a service contract (rather than the original lease) would control the transaction. The court noted that the allowance of the taxpayer's claimed interest deductions for non-recourse debt incurred in the transactions depended on the taxpayer acquiring the benefits and burdens of the underlying properties. Thus, the recharacterization of the LILO transactions and one SILO transaction as loans eliminated the taxpayer's relevant claims for deductions. For the remaining SILO transactions which were not recharacterized, the court found that the taxpayer did not receive a present ownership interest in the SILO properties sufficient for it to claim interest deductions with respect to the relevant non-recourse indebtedness associated with the investments. Therefore, the taxpayer's interest deductions were denied. Because most of the transactions failed the substance over form analysis and were recharacterized as financing transactions, the taxpayer had additional OID income and lost various deductions, including interest on non-recourse debt incurred pursuant to the transactions. The rejection of the LILO/SILO transactions in general is consistent with other courts' decisions, but the decision not to rely on the economic substance doctrine is a noteworthy departure from the analyses of the other federal courts that have addressed similar transactions.

Footnotes

1. John Hancock Life Insurance Co. v. Commissioner, 141 T.C. No. 1 at 126 (Aug. 5, 2013).

2. Id. at 10.

3. 658 F.3d 276 (2d. Cir. 2011).

4. 523 F.3d 461 (4th Cir. 2008).

5. 641 F.3d 1319 (Fed. Cir. 2011).

6. John Hancock Life Insurance Co. v. Commissioner, 141 T.C. No. 1 at 144.

7. Id. at 145.

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