In a recent case out of the Seventh Circuit, a large corporate taxpayer lost a involving three like-kind transactions under IRC 1031. Applying the substance over form doctrine, the Court upheld the imposedtax liability of approximately $437,000,000 and accuracy related penalties under IRC 6662(a) of approximately $87,000,000.1 In this case, Exelon Corporation (“Exelon”) sold two fossil fuel power plants and replaced them with three complex lease arrangements in the form of “sale-in lease-out” (“SILO”) (as referenced by the Court, but more analogous to a lease-in lease-out transaction (“LILO”)). The intention was to result in technical ownership of the underlying parcels due to the nature of the long-term net lease.2 The procedural posture of this case was an appeal to the Seventh Circuit from a Tax Court determination of liability in the amounts mentioned above. The Seventh Circuit upheld the Tax Court ruling.
In short, the replacement property was essentially reclassified into a low-risk loan, not qualifying as like-kind property. The result was a failure to qualify for like-kind exchange treatment under IRC 1031.
The transaction was concocted and subsequently undertaken with the assistance of multiple parties including PricewaterhouseCoopers (“PwC”), Deloitte & Touche, LLP (“Deloitte”), Winston & Strawn, LLP (“Winston”). PwC engineered the plan, Winston acted as legal counsel and provided the opinion, and Deloitte prepared the appraisal.
After selling two of its fossil fuel plants, Exelon identified and purchased, among other properties,he three replacement properties consisting of the Spruce Plant, to be acquired from City Public Service (“CPS”) in San Antonio, and theScherer and Wansley properties, to be acquired from the Municipal Electric Authority of Georgia (“MEAG”).
The structure of the transaction was as follows:
- Exelon sells it two of its fossil fuel plant locations;
- Exelon enters into a long-term lease agreements for the Spruce, Scherer, and Wansley properties with all rent paid up front (the “Headlease”) 3;
- Headlease proceeds are placed in collateral accounts invested in government securities to pay rent obligations for the entire lease term in fulljust six months later;
- Exelon subleases on a shorter term back to CPS and MEAG with fixed and fully-funded buy-out options and termination options for the Headleases with all rent due six months later (in the event of an early termination, unaccrued rent would be paid back to MEAG/CPS); and4
- MEAG and CPS entered into back-to-back credit swaps to secure payment of loss values or purchase option prices when required.
In the unlikely event the properties would not be repurchased at the end of the sublease terms, there were certain return-condition provisions in place relating to the operation and condition of the plants and payment of damages for diminution in value.
The subleases provided that if the subleased properties were not purchased at the end of the sublease terms, then the properties would be returned. The subleases further specified the conditions in which the properties would need to be in the event of a return. Particularly, there were measures of the capacity factor which were ratios specifying how many hours per year the plants could operate.
|Estimated Capacity Factor at End of Sublease Term Per Deloitte Estimate||Required Capacity Factor for Return|
In short, the improvements to meet the return conditions specified in the subleases would be so costly that the buy-out was effectively guaranteed.
Arguments of Exelon on Appeal
Exelon’s issues on appeal were as follows:
- Whether the wrong legal standard was used to render the options and ownership by Exelon as illusory;
- Whether the Tax Court wrongly dismissed reliance on by Exelon on its advisors based on communications between Winston and Deloitte arguably tainting the appraisals; and
- Whether the Tax Court misunderstood the terms of the return conditions under the subleases.
Application of Legal Standard
The Tax Court applied a reasonably likely standard with respect to the virtual certainty of the transaction outcomes. As a result of this application, since it was virtually certain MEAG and CPS would Part of Exelon’s position in the transaction was that there was uncertainty on what could happen. Given the nature of the transaction structure, such as the valuations, the credit swaps, and the leases, the Tax Court was of the opinion that matters were pretty well set in stone. It was reasonably likely things would go as planned. In the similar Wells Fargo case, the Federal Circuit Court found that that the purchase options were “virtually certain” to be exercised.5
Exelon subsequently argued misapplication of the standard as well as a misunderstanding of the return conditions. The Court disposed of these arguments as well.
The analysis on this issue of tainted reliance by the taxpayer on the tax opinion gives me some pause. I am usually of the mindset that two heads (or more) are better than one. The Tax Court took sincere issue with Winston and Deloitte speaking so closely and then Deloitte drafting conclusions in its appraisals that virtually mirrored Winston’s letter. The Court imputed some knowledge and responsibility on Exelon, that in the eyes of the author seems arguably misplaced. Particularly, the Court in performing its reasonable cause analysis stated that Exelon did not rely in good faith on the Winston tax opinions and that Exelon “knew or should have known” that Winston’s conclusions were flawed. The bad facts here are Walter Hahn and Robert Hanley of Exelon were on emails between Winston and Deloitte discussing the “requested conclusions.”
While Exelon had internal tax, treasury, and accounting staff, the Court specifically acknowledged that Exelon had no in-house expertise on like-kind exchanges, the very heart of the tax dispute. While I understand the position of the Tax Court and the Seventh Circuit, the taxpayer likely went out of its way, paid dearly, and engaged several independent groups.6
Onerous Return Conditions Affirming Certainty of Results
Exelon made as its final argument that the Tax Court erred in its understanding of the return conditions under the subleases and thus it in its application of the reasonably likely standard (discussed prior). Exelon argued that the Tax Court confused the terms “availability factor” and “capacity factor.” The Court disposed of these arguments referencing usage of similar language in the subleases and Deloitte’s analysis. In response to Exelon’s argument that industry does not typically use these measures, the Court noted this was not a typical deal and was intended to achieve planned results. The Court also criticized Exelon on being consistent itself with its own language if it wanted to argue definitions.
So, Why Did Exelon Engage in the SILO/LILO Transaction?
Thinking through the results of this transaction to the taxpayer, I was at first unable to arrive at the same conclusions as the Court regarding why Exelon would want to enter into the transaction. The current state of the relinquished properties in the hands of Exelon seemingly had little depreciable basis relative to value (hence, the like-kind exchange) and based on the facts presented would not acquire any new depreciable basis. After analyzing the numbers, PwC reasoned that Exelon could end up in a similar cash position with this structure as with a traditional like-kind exchange. The structure did allow Exelon to sell its operating fossil fuel plants and move out of the fossil fuel business. However, in the SILO structure, Exelon would operate as a de-facto lender instead of a plant operator. Another interesting item is that Exelon was likely converting capital gain income to ordinary income, which in a C-corporation can present planning opportunities. For those interested, there was also an issue of original issue discount income though that was not addressed in this article.
At its core, the case is merely a complicated like-kind exchange gone bust. Some pitfalls are illustrated for taxpayers seeking penalty abatement due to both the Tax Court and the Seventh Circuit taking a dim view of coordination among the advisors. Also, in case it was missed above, this case resulted in a nine digit tax liability.7 For now, it seems Exelon made a deposit with the IRS.8
- Exelon Corp. v. Comm’r, 122 AFTR 2d 2018-6138 (also worth noting is that this case was a test case for three transactions at issue and and that the taxpayer and IRS agreed to dispose of six transactions in dispute). The numbers contained in this article relate only to the three transactions, and do not include any accounting of any additional liabilities from the other three cases.
- For consistency with the reading of the case, the term SILO will be used to describe the transaction structure in this article.
- MEAG and CPS were also paid an accommodation fee as part of the transaction
- As a matter of substance, prior to the transaction MEAG and CPS owned plants, operated them, bore the risk of operations and loss relating to the plants. After the transactions by the net-lease nature of the contractual agreements, MEAG and CPS still owned plants, operated them, bore the risk of operations and loss relating to the plants.
- Wells Fargo v. Comm’r, 641 F.3d 1319 (Fed. Cir. 2011).
- The taxpayer hired two of the big four accounting firms and a separate law firm.
- Considering the other three cases disposed of by this opinion, this could result in an aggregate three comma liability for Exelon.
- From the 2017 Annual Report