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ower own: i e- i n xc ~n es. an. s 0 o ix i n xe on RICHARD M. LIPTON When structuring transactions to achieve substantial tax benefits,carefully consider the potential application of judicial doctrines such as substance ~verform. In ~xelon,' the Seventh Circuit turned structure. It sold all of its fossil-fuel offthe lights on ~xelnn's attempt to use power plants for X4.8 billion, ever ~2. SILO transactions with taa-c~cmpt cn- billion more than expected. Using ~L.JS tities to obtain the benefits ofa like-kind billion of the proceeds to update its nu- excliaii~,e. The ~oui't ~oil~ludtd that tltt cl~ar fleet, ~x~loi~ was ]eft with ap~r~x- substance ofthe transactions that ~~elon imately $2.45 billion to invest. It w as had entered into were loans, not pur- also left with a significant taa bill. It thus cl~ases of real property, and as a result began looking for a strategy that could the like-kind exchanges were not effec- reduce or defer the tax on the gain. tive. Exelon was advised in this quest by PwG which suggested that Eaelon use alike-kind exchange to reduce its taxable Background gain from the sale or power plants. Ex- In 1999, after deregulation ofthe energy elon identified two of its own fossil-fuel industry in Illinois, Exelon, an Illinois- power plants that were good candidates based energy company, decided to sell for like-kind exchanges: the Collins its fossil-fuel power plants, intending Plant, to be sold for $930 million, $823 to use the proceeds to finance improve- million of which would be taxable gain; ments to its nuclear plants and infra- and the Powerton Plant, to be sold for RICHARD M. LIPTON is a partner in the Chicago office of the law firm of Baker McKenzie, and is a past chair of the ABA Tax Section. He is a regular contributor to Txs JouxuaL as well as co-editor of the Shop Talk column. Copyright O 20]8, Richard M. Lipton. J ANUARY 2018 t JOURNAL OF TAXATION Q 29 $870 million, $683 million of which derlying property to Exelon> so that the each transaction, and thus E~:elon did would be taxable gain. It then identified like-kind exchanges were ineffective. not acquire any benefits or burdens of three investment candidates fir the ex- The TRS also asserted an accurary-related ownership. The curt rejected Rxel~n;s changes: penalty for the years at issue. The defi- reliance on the properties' residual values • The J.K. Spruce Plant Unit No. 1 ciencies totaled almost $440 million to establish genuine ownership. ("Spruce"), a coalfired plat in without interest, and the 20°ro penalty The Tax Court also sustained the Texas that would replace the added significantly to the total tax bill. penalties that were proposed by the IRS. Collins Plant. After a 13-day trial, the Tax Court • Two coal-fired plants in Georgia— agreed with the IRS, applying the sub- Plant Robert W. Sherer Units No. stauce-over-form doctrine to conclude Seventh Circuit Decision One, Two, and Three ("Sherer") that the transactions in question, like The Seventh Circuit started its opinion and Plant Hal WanSley iJnits Nn. SiT,n tran.sar.tinns, failed to transfer to with a hriefcliscussirni nfa CTi,n tran,~- One and Two ("Wansley")—which Exelon a genuine ownership interest in action, which is a transaction designed together would replace the Power- the out-of-state plants. As a result, Exelon to transfer tax benefits associated with ton Plant. was not entitled to like-kind exchange property ownership from atax-exempt To carry out its purported like-kind treatment or its claimed deductions. The entity to a taxable one. All SILOS are exchanges, Exelon entered into six "sale- Tax Court agreed with the IRS that, in structured similarly. First, the tax-exempt entity leases the asset to the taxpayer under a "headlease" for a term that ex- ceedsthe useful life of the asset, thereb}' qualifying tl~e lease as a "sale" for federal tax purposes. The taxpayer concurrently leases the asset hack to the tax-exempt entity for a term that is less that the assets useful life. That lease, called a "sublease;' is a "net" lease, meaning that the tax-ex- and-leaseback" transactions. In each of substance, Exelon's transactions most emptentity is responsible for all expenses the three representative transactions, closely resemble loans from Exelon to normally associated with ownership of Exelon leased an out-of-state power the tax-exempt entities. the asset, and retains legal title. plant from atax-exempt entity fora pe- To reach this conclusion, the court Each "sublease" contains an option riod longer than the plant's estimated first anal}'zed the parties' rights and ob- under which the tax-exempt entity can useful life. Exelon then immediately ligations during the sublease term for repurchase tl~e asset at the end of the leased the plant back to that entity for each transaction. In doing so, it con- sublease term at a set price. This option a shorter sublease term and provided cludedthat Exelon "did not face an}~ sig- is "fully funded" with funds provided to the tax-exempt entity a multimillion- nificant risks indicative of genuine by the taxpayer for that purpose at the dollar accommodation fee for engaging ownership" during that period. In par- outset of the transaction. As a result, in the transaction, along with a fully ticular, the court found that the trans- the tax-exempt entity has no risk oflos- funded purchase option to terminate actions' "circular flow of money" ing control of the asset. Exelon's residual interest at the eild of precluded Exelon from having any real The taxpayer prepays its entire "rent" the sublease. investment in the plants, despite using under the headlease in one lump-sum Exelon asserted that it had acquired its own funds(as opposed to borrowed payment at closing. Typically, this rent a genuine ownership interest in each of funds in a traditional SILO)to finance prepayment is funded in part with the the plants as a result of the transactions, the headlease pa}~ments. In addition, taxpayer's own funds and in part with thus qualifying them as like-kind ex- the court found that each sublease al- a nonrecourse loan, although in some changes under Section 1031, entitling located all costs and risks associated instances (as in the instant case) the tax- it to defer tax on the $1,231,927,407 with the plants to the sublessees, and payerfunds the entire prepayment with gain it realized from the sale of its power that each transaction's defeasance struc- its own funds. Most of the taxpayer's plants. Exelon also claimed $93,641,195 tureleft Exelon able to "fully recover its prepaid rent is deposited into restricted in deductions on its 2001 return for de- investment" in the unlikely event of ei- accounts that are nominally held by the preciation> interest, and transaction ther alessee bankruptcy or an early ter- tax-exempt entit}'but are pledged to se- costs as lessor of the plants. mination of the sublease. cure the tax-exempt entity's rental ob- The IRS disallowed the like-kind ex- Next, the court reviewed the parties' ligationsunder the sublease and to fund changesbecause they involved sale-in, options at the end ofthe sublease terms its repurchase option at the end of the lease nut (SiT,(~) arrangements with the and found that there was a "reasonable sublease term. A small percentage ofthe owners of the power plants. According likelihood" that the lessees would each headlease rent prepayment, usually be- to the IRS, these transactions did not exercise its purchase option, meaning tween 4%and 8% of the asset value, is transfer genuine ownership of the un- Exelon's profit was fixed at the onset of paid to the tax-exempt entity as its ac- 3O O JOURNAL OF TAXATION • JANUARY 2019 REAL ESTATE commodation fee for participating in relating to the power plants would re- payers from subverting the legislative the SILO transaction. main with underlying lessees. purpose ofthe tax code:'2 One such doc- The taxpayers' headlease prepayment PwC explained to Exelon that the trine, the substance-over-farm doctrine is invested in high-grade debt with the transactions would be similar to main- applied by the Tax Court> "provides that growth ofthe account managed to ensure taining atypical debt private placement, the tax consequences of a transaction that the tax-exempt entity has sufficient and that the fundamental risks for Exelon are determined based on the underlying funds to repurchase the asset from the would be the credit of the lessee and the substance of the transaction rather than taxpayer at-the ~on~lusion ofthe sublease federal.tax .risk that the IRS would not its legal form:°3 In applying this doctrine, without adding any funds of its own. respect the form ofthe transaction. PwC the Supreme Court has "looked to the The repurchase or "exercise price" is set explained that the credit risk would be objective economic realities of a trans- at the beginning ofthe SILO transaction addressed through the transactions'"de- action rather than the particular form and can be exercised simply by giving feasance strategy;' and the tax risk would the parties employed;' and "has never notice. be mitigated by obtaining an appraisal regarded the simple expedient of drawing In the unlikely event that the tax-ex- and other expert opinions to support up papers as controlling for tax purposes empt entity chooses not to exercise its the conclusion that the fixed purchase when the objective economic realities repurchase option, the transaction gen- option was not "practically compelled:' are to the contrary"° erally provides the taxpayer with two Prior to making its pitch to Exelon> PwC Exelon contended on appeal that the options.

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