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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. First, it can elect a "return op- had assisted other clients to implement Tax Court had treated its transaction tion" under which it takes immediate SILO transactions, including as part of like tax shelters that lacked economic control ofthe asset or, more likely, it can its "Like-Kind Exchange Program:' substance, whereas Exelon had only ob- exercise what is called the "service con- Exelon spared no expense in hiring tainedtax benefits under Section 1031, tract option" under which the tom-exempt experts to assist it in the transaction. which are benefits conferred by Con- entity is required to satisfy se~>eral con- Winston & Strawn ("Winston") was hired gress. The Seventh Circuit responded ditionsbefore continuing to use the asset as legal counsel and to provide a tax that the Tax Court had focused on the or arranging for its use by a third party. opinion; local counsel was hired in the substance ofthe underlying SILO trays- A SILO transaction offers three forms states where the power plants were lo- actions rather than their form in order of tax benefits to the taxpayer: cated; and regulatory counsel was also to determine whether or not Exelon had 1. It can take deduct depreciation on hired. Exelon also hired an engineering acquired the benefits and burdens of the asset for the remainder of its use- firm, Stone &Webster, to confirm the ownership ofthe plants. To be entitled fullife. operating status of the plants, and it to the benefits of a like-kind exchange, 2. It can deduct interest payments made hired Deloitte to provide an appraisal Exelon had to acquire a genuine own- from any loan used to finance the of the value and useful life ofthe plants ership interest in the replacement plants. taxpayer's prepayment of rent under being acquired. The Seventh Circuit concluded that Y}1 P. ~lP.a[j~P.~,SP.. Exelon also took steps to make sure the net leases of the plants under the 3. It can deduct certain transaction costs that the plants would he properly op- SILO transaction allocated all of the associated with the SILO. erated. The operators had to either have costs and risks associated with the plants ~ese benefit. are partiall}~ offset by a suitable credit rating (at the time, only to the sublessees (avd not t~ Exelon). the taxpayer's rereipl of inc~.uii~e ~l Ilir. (;eiiei dl Fl~~li i~ ;;alisficd ibis r~yuirt- Whrn this limited risk was combine end of the sublease if the tax-exempt ment) or obtain a guarantee of its ubli- with the clefeasauce slruclure aid cir- entity exercises its repurchase option, gations from someone with such a rating. cular cash flows, the Seventh Circuit but "the deferral of tax payments during In the end, Exelon entered into back- reached the "inescapable conclusion" the life of the sublease has substantial to-back ereditswaps with an insurance that Exelon did not face any significant economic value to the taxpayer:' company,Ambac Credit Products, LLC, risk indicative or genuine ownership of The Exelon transaction had the added to make Exelon whole in the event the the plants. Exelon's argument that it wrinkle that it involved a like-kind ex- plants did not continue to operate. faced risk from a potential bankruptcy change. PwC proposed that the SILO In its opinion, the Seventh Circuit of the underlying lessees was rejected would be used to transfer tax ownership first noted that a taxpayer can arrange as contrary to the facts and Exelon's own of the power plants to Exelon as replace- its affairs to decrease the amount of tax conclusions that the risk of bankruptcy mentproperty for alike-kind exchange which would otherwise be owed. How- was very low in this case. while ensuring that all operational risk ever, ataxpayer cannot claim tax benefits Exelon also argued that it faced real not conferred by Congress by setting risk at the end of the subleases that the up sham transactions that lack any le- sublessee may not exercise its option at ~ 122 AFTR2d 2018-6138(CA -7, 2018), aff'g 147 TC 230 (2016). gitimatebusiness purpose or by affixing the end ofthe initial lease term. The Tax 2 Coltec Indus., Inc., 454 Fad 1340, 1353 (CA-F.C, labels that do not accurately reflect the Court had concluded that it was rea- zoo6). transactions' true nature. sonab]}' likely that the options would 3 Wells Fargo, 641 F.3d 1319, 1325 CA-F.C., 2011). As a result, judicial anti-abuse doc- be exercised, while Exelon claimed that 4 Frank Lyon Co., 435 U.S. 561, 573(1978) (internal quotations omitted). trines have developed to "prevent tax- the option should not be treated as likely

R EAL ESTATE JANUARY 2019 •JOURNAL OF TAXATION Q 3~ to he exercised unless tl~e lessee was eco- Exelon's final argument on the merits by Deloitte for the plants at the end of iiuiiiically wiripellecl lu du so. The Sev- was that the Tax Court had erred in its the subleases, which made exercise of entl~ Circuit rejected the "standard" understanding of the end-of-lease c~n- the purchase ~pti~ns m~rc likely, Tlic proposed by Exelon> holding that a rea- ditions which related to tl~e likelihood Tax Court found that Exelon must have sonable expectation or likelihood was that the option would be exercised. ~x- appreciated that it would be very ex- required and not ec~n~mic compulsion. eluii wi~leiitletl dial llie Tax Cuurl liatl ~eiisive fur ll~e sublessees w sufficiently Exelon next argued that the Tax confused the terms "availability factor" upgrade the plants to meet the return Court erred in its application of the with "capacity factor;' but the Seventh capacity requirements. Thus> the court reasonably likely standard. The Seventh Circuit disagreed, finding that the sub- concluded that Exelon must have un- Circuit again disagreed, accepting the lesseeswere not worried about the return derstood that Winston's tax opinions, expert opinion furnished at trial by conditions because they always intended based on the Deloitte appraisals, were the IRS and rejecting the conclusions to exercise the purchase options; there flawed. that Deloitte had reached. The Tax was never any incentive for them not to Exelon contended that the Tax Court Court also rejected Deloitte's appraisals do so. The record clearly showed the had erred in its conclusion that Exelon because it found that Winston had in- sublessee's intent, which established that must have understood that the tax opin- terfered with the integrity and inde- the Uenefits and burdens of ownership ionwas flawed, repeating its prior con- pendence of the appraisal process by were not borne by Exelon. tention that the Tax Court was wrong providing Deloitte with the wording The Seventh Circuit then turned to in concluding that the options were rea- of the conclusions it expected to see the penalties which had been approved sonablylikely to beexercised. The Sev- in the final appraisal reports. The Sev- by the Tax Court. Exelon argued that it enth Circuit disagreed, stating that enth Circuit rejected Exelon's argument had relied on the advice of competent Exelon was a sophisticated operator and, that Winston was merely providing and independent professionals. The Sev- as such, knew or should have known the existing guidance and tests on the enth Circuit noted, however, that mere that it was reasonably likely, or even issue of what is considered to be a lease. reliance on counsel is not sufficient to highly likely, that the options would be Winston provided Deloitte a detailed relieve the taxpayer from penalties. In exercised. The Seventh Circuit also found list of specific conclusions that Winston 1lmerican Boat Co., LLC,6 the Seventh that the record was replete with evidence needed in order to issue the necessary Circuit had stated: that Exelon knew that Winston was sup- tax opinion. Deloittes conclusions mir- To constitute reasonable cause, the plying Deloitte with the conclusions roredthose in Winston's letter almost reliance must have been reasonable that resulted in the favorable legal opin- in light of word for word. the circumstances. This is ion. a fact-specific determination with The Seventh Circuit also concluded many variables, but the question that there was a more fundamental prob- "turns on `the quality and objectivity lem with Exelon's position that the set of the professional advice obtained"' Discussion purchase option prices far exceeded the [Internal quotations and citations Exelon was probably surprised—to tl~e fair market value ofthe plants at the end omitted.] tune of around a billion dollars when ofthe subleases. Even if we were to accept interest is taken into account—by the that position, it does not lead to Exelon's To establish the defense, the taxpayer, courts' decisions in this case. Exelon be- conclusion that "no reasonable person at a minimum, must show that the advice lieved that ithad re-invested the proceeds would overpay" that much. was "(1) based on all relevant facts and from the sale of its fossil fuel plants into To be sure, no reasonable entity circumstances, meaning the taapa}'er other power plants, which investment would overpay if it was paying with its must not withhold pertinent informa- qualified as tl~e acquisition of replace- own move}'. But here, the sublessees tion[;] and (2) not based on unreasonable ment property in a like-kind exchange. could exercise the purchase options factual or legal assumptions, including The transaction had been carefully struc- without pa}'ing a single cent oftheir own those the taxpayer knows or has reason tured so that Exelon did not need to op- money. Thus, Exelon's argument does to know are untrue:' The taxpa}'er's ed- erate the properties and to provide not reflect the economic reality of the ucation,sophistication, business expe- economic assurance against loss, as well transactions. "Because the purchase is rience, and purpose for entering the as funds for the sublessees to purchase free to [tl~e sublessees], price cannot be questioned transaction are also relevant the property at the appropriate time. [an] obstacle"5 And, because the sub- factors to be considered. lessees do not retain any of the mone}' The Tax Court had found that Exelon 5 BB&T Corp., 523 F.3d 461, 473 n.13(CA -4, 2008). set aside for the purchase option if they did not rely in good faith on Winston's 6 583 F.3d 471, 481 (CA-7, 2009 (citing Reg. do not exercise it, they have no economic tax opinions because Exelon "knew or 1.6664-4(b)(1)). incentive not to do so. Indeed,exercising should have known" that Winston's con- ~ AWG Leasing Trust, 592 F. Supp.2d 953 (DC Ohio, 2008); TIFD II I, Inc., 604 Fed. Appx. 69 the options leaves the sublessees in pre- clusionswere flawed in light ~f the "~h- (CA-2, 2015), rev"g El F. Supp3d 1A2;(DC Ccnn., cisely the same position as if the}' had vious inconsistency" of the physical 2014), 666 F.3d 836, rev'g 660 F. Supp.2d 367 not entered the transactions, except mil- return (DC Conn., 2009), on remand from X159 Fad condition specified in the con- 220 (CA-Z, 2006), rev"g and remanding 342 lions of dollars richer. tracts and the capacit~~ factors projected F.Supp.2d 94(DC Conn., 2004).

32 Q JOURNAL Of TAXATION • JANUARY 2019 REAL ESTATE The disallowance ofthe claimed tax ben- elon relied on the opinions of Win- there is a higher degree of certainty efits> not to mention the penalties, must stonand Deloitte to avoid penalties; that a purchase will occur in the fu- have been quite a shock to Exelon. both companies had been engaged ture. Ifthere had been no defeasance Several key points should be derived to facilitate the transaction. Tl~e trust account in this transaction, it from this saga: courts' decisions concerning penalties is far less certain that the court would 1. Taxpayers have to be careful about might have been completely different have ruled against Exelon. involvement in any transaction for if Exelon, in addition to retaining . Finally, although this case is only _which there is an acronym! Exelon's Winston, had asked a law firm that tangenti~ll~ elated to Section 1031,______position was likely doomed as soon was totally uninvolved in the trans- it does have some bearing. The de- as the replacement property was la- belled a SILO> because the courts have been very adverse to any mar- keted transaction that provides tax benefits. `There are numerous exam- ples of this trend, including Boss> Son-of-Boss, STARS> LILOs,SILOS, DAD, and CARDS. If a transaction action to provide an opinion. This cisions point out that replacement can be labelled and sold to multiple would have been an added cost, but property in a like-kind exchange taxpayers, it is most likely that a court in light of the fact that the penalties must be an ownership interest in will approach it with skepticism. alone will cost Exelon around $100 the replacement property; acquisi- 2. When considering a transaction that million, Exelon should have consid- tion of a financial interest without provides substantial tax benefits, be ered getting an additional opinion the benefits and burdens of owner- sure to carefully consider potential to support its position. Presumabl}' ship ofthe property is not sufficient. application ofthe judicial doctrines, Exelon did not want to have to pay A related question under Section including particularly whether the for a second opinion, Uut this may 1031 involves the acquisition of substance of the transaction is the be a situation where the taxpayer was leasehold interests which have a long same as its form. There have been penny wise but pound foolish. term; taxpayers who acquire lease- multiple decisions where the courts 4. This transaction also shows the im- hold interests must make certain have looked through alleged owner- portance ofmaking investments that that the substance of such interests ship of property and concluded that are not overly protected. A lot of the is neither a loan nor a property in- the alleged ownership was in fact a factual problems in this case arose terest recharacterized as a loan under loan.'A careful review of the upside because Exelon wanted to make sure Section 467. Section 1031 requires and downside potential of an invest- that the sublessees would benefit eco- that both the relinquished and re- meiit is required if there are tax ben- nomically frutti exercisiii~ ll7eii o~- placcil~ciit properti~s arc property efits to be achieved. tions; Exelon did not want to hold interests that will be characterized 3. 7-hi~ derision shows the iml~nrtance the assets forever. A defeasance trust as such: a property interest that lacks of a "second opinion" in connection is used to make sure there is money benefits and burdens of ownership with tax-favor tblc trtnstctioils. Lx- ~vail~hlr, hot it nLgn ,~nggc,~t, thnt i,~ not ,,nttic,i~nt.•

R EAL ESTATE JANUARY 2019 •JOURNAL Of TAXATION Q 33