Read the Tax Court’s opinion [PDF 1.04 MB]
The following is the Tax Court’s very brief summary of today’s 244-page opinion.
The taxpayer is primarily engaged in the business of selling life insurance policies, annuities, long-term care insurance, and other retirement services. To fulfill its contractual obligations under these services, the taxpayer invests the premiums it receives.
In 1979, the taxpayer began investing in leveraged leases (i.e., a lease in which the equity investor borrows money from a third-party lender to finance a portion of the purchase price of the asset involved and leases the asset to its ultimate user).
In 1997, the taxpayer began investing in lease-in-lease-out (LILO) transactions and in 1999 began investing in sale-in-lease-out (SILO) transactions. The taxpayer participated in 19 LILO transactions and eight SILO transactions between 1997 and 2001.
- LILO transactions - With respect to the LILO transactions, the taxpayer: (1) claimed deductions for rental expenses for the prepaid rent paid to the tax-indifferent entities and interest expenses related to the repayment of the nonrecourse loans; and (2) amortized transaction costs related to the LILO transactions.
- SILO transactions - With respect to the SILO transactions, the taxpayer claimed deductions for depreciation and interest expenses and amortized the related transaction costs.
The IRS disallowed these deductions for the years at issue and determined that the taxpayer had OID (original issue discount) income with respect to the LILO and SILO transactions.
Issues before the Tax Court
The parties agreed to litigate three LILO transactions and four SILO transactions and use them as test transactions for the remaining LILO and SILO transactions at issue.
A transaction will be respected for federal income tax purposes if it has economic substance and the substance of the transaction is consistent with its form.
The taxpayer argued that the LILO and SILO test transactions had economic substance because the taxpayer derived a pre-tax profit from each transaction and entered into the transactions with the primary purpose of making a profit.
The taxpayer also argued that the substance of each LILO and SILO transaction was consistent with its form because the taxpayer held a true leasehold interest in each of the LILO assets and obtained an ownership interest in each of the SILO assets.
The IRS countered and argued that the LILO and SILO test transactions lacked economic substance and that the substance of the transactions was not consistent with their form. Specifically, the IRS asserted that:
- The taxpayer failed to acquire a substantive leasehold interest in the LILO assets and failed to acquire a substantive ownership interest in the SILO assets.
- The true substance of the LILO and SILO transactions was a loan from the taxpayer to the tax-indifferent entities.
Alternatively, the IRS argued that with respect to the LILO and SILO transactions, at most the taxpayer acquired a future interest in the LILO and SILO assets.
Summary of Tax Court’s holdings
Among the conclusions reached, the Tax Court held:
- That the IRS failed to prove that the three LILO and four SILO test transactions lack economic substance.
- That the substance of the three LILO test transactions was not consistent with their form.
- That the LILO test transactions resembled financial arrangements, and that the taxpayer therefore was denied its claimed rental expense, interest expense, and transaction cost deductions with respect to them.
- That the substance of three of the SILO test transactions was consistent with their form but that the taxpayer did not acquire a present interest in the SILO test transaction properties and was therefore denied its claimed depreciation and interest expense deductions.
- That the substance of the fourth SILO test transaction was not consistent with its form and that this SILO test transaction resembled a financial arrangement; therefore, the taxpayer was denied its claimed depreciation expense, interest expense, and transaction cost deductions with respect to that transaction.
- That the taxpayer had OID income with respect to the three LILO test transactions and the fourth SILO test transaction but not with respect to the first three SILO test transactions, in which it failed to acquire a present interest.