Tax Refund Litigation Update: Court of Federal Claims Relies on “Substance Over Form” Doctrine to Recharaterize Transaction

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A decision by the United States Court of Federal Claims originally filed under seal and reissued on October 23, 2013 evidences an important trend in the substance over form doctrine created by the courts to recharacterize transactions for tax purposes to reveal their true purpose. A copy of the opinion can be found here.

This case, Unionbancal Corporation & Subsidiaries v. United States, involved a lease-in/lease-out transaction, more commonly known as a LILO, designed to transfer tax benefits from an entity not subject to U.S. income taxation (a tax-indifferent entity) to an entity that is subject to U.S. income taxation. At issue in this case was whether the “Pond Transaction” – a leveraged lease between a subsidiary of UnionBanCal Corporation (UBC) and the City of Anaheim, California – was undertaken solely for tax benefits and not for any true economic purpose or benefit.

As of 1998, Anaheim owned the Pond, an arena located in Anaheim, California, where the Anaheim Mighty Ducks agreed to play all of its regular season hockey games until February 2023. Ogden Facility Management Corporation of Anaheim managed and operated the Pond on behalf of Anaheim and had the exclusive right to use, manage, operate, market and promote the Pond.

UBC is a financial services company that enters into direct financing and leveraged leases through its Equipment Leasing Division (ELD). UBC’s ELD proposed to Ogden that it would acquire an “equity portion of a leasehold interest” in the Pond.  Among other things, the proposal strongly suggested that UBC’s main purpose in entering the LILO transaction was to achieve the tax benefits associated with rent and interest deductions. According to Lance Markowitz, Senior Vice President of UBC and head of the ELD, UBC “would not have pursued the transaction without the tax attributes.”

On the day the Pond Transaction closed, UBC and Anaheim executed a series of interrelated agreements, including two leases pertaining to the Pond: a Head Lease Agreement and Sublease Agreement. Pursuant to Head Lease, UBC leased an undivided interest in the Pond from Anaheim and simultaneously, via the Sublease, UBC conveyed its interest in the Pond back to Anaheim. The Lease and Sublease were part of an integrated transaction. In other words, one would not have been executed without the other.

In its decision, the Claims Court stated that in a typical LILO, a U.S. Taxpayer purports to lease property from a tax-indifferent owner under a “head lease,” and then simultaneously leases that property to the owner under a sublease. Before and after the transaction, the tax-indifferent entity continues to operate the property. Nevertheless, the taxpayer claims deductions predicated under the head lease. The tax-indifferent entity receives a fee for agreeing, in effect, to transfer its “wasted” tax deductions to a tax-paying entity that can use them.

Here, the property that was leased/subleased in the LILO in question was the Pond, an arena owned by Anaheim (the tax-indifferent entity). UBC deducted the rent payments it made under this transaction under section 162(a)(3) of the Code, which permits a deduction for “rentals or other payments required to be made as a condition to the continued use or possession, for purposes of the trade or business of property.” Further, it deducted the interest it paid on the loans used to discharge its rent obligations under 163(a) of the Code, which provides a deduction for “interest paid or accrued within the taxable year on indebtedness.”

In “substance over form” doctrine cases, “it is the taxpayer’s burden to demonstrate that the form of its transaction accords with its substance.”Principal Life Ins. Co. v. United States, 70 Fed. Cl 144, 160 (2006). “[J]udicial anti-abuse doctrines prevent taxpayers from subverting the legislative purpose of the tax code.” Consol. Edison Co. of New York, Inc. v. United States, 703 F.3d 1367, 1374 (Fed. Cir. 2013). Among these doctrines is that of “substance-over-form … which … provides that the tax consequences of a transaction are determined based on the underlying substance of the transaction rather than its legal form.” Wells Fargo & Co. v. United States, 641 F.3d 1340, 1354 (Fed. Cir. 2011). To permit otherwise, the Supreme Court has held, “would seriously impair the effective administration of the tax policies of Congress.” Comm’r of Internal Revenue v. Court Holding Co., 324 U.S. 331, 334 (1945).

The Court further described a phalanx of recent cases wherein courts considering analogous LILO/SILO transactions have concluded that, despite the form of those transactions, the taxpayers, in substance, never obtained the benefits and burdens of ownership, and viewed in their totality, the circumstances of the lease/sublease transactions did not permit the taxpayers to be viewed as possessing an interest in the property upon which their deductions were based. Thus, in those cases, the courts found that the structure of the LILO/SILO in question prevented the taxpayer from obtaining a genuine ownership interest in the property. And in each instance, the key inquiry has been the same – whether the taxpayer involved bore the benefits and burdens associated with the leased asset.

A central question in each case involving analogous transactions was whether the original property holder – the “tax indifferent” entity – could be expected to exercise its purchase option at the end of the sublease. That issue has proved to be determinative because if that option was to be exercised, the transactions would become offsetting leases, leaving the property in the hands of the original owner, at least for tax purposes. Furthermore, in each case the tax indifferent entity was to maintain uninterrupted use of the subject property without any involvement of the taxpayer. In addition, via the offsetting nature of the obligations established in the transaction, the taxpayer was insulated from meaningful economic risk of loss or potential gain, and thus obtained none of the benefits or burdens associated with the leasehold interest.

In this case, the Federal Claims Court considered the issue of whether a prudent investor in UBC’s position would have reasonably expected Anaheim to exercise the purchase option and buy out UBC’s Head Lease interest. Based on the record, the Court answered this question in the affirmative stating that the LILO here was “designed to strongly discourage alternative outcomes” to exercising the Purchase Option.

In reaching its conclusion, the Claims Court also noted the strong and strategic civic ties Anaheim has to the facility in question. The property in question is a highly-visible, public arena, which was acquired with public financing and which currently houses a professional hockey team that bears the city’s name on its sweaters. The Court also noted how UBC and Anaheim internally accounted for the transaction. In short, the Claims Court concluded that “the economic effects of repurchasing the asset were so desirable, and the alternatives to repurchasing that asset so odious, as to make it more likely than not that Anaheim would exercise the Purchase Option.” The Court additionally stated that “that finding makes plain that UBC did not have the requisite ownership interest in the Pond Head Lease to support its claimed rent deductions.” Finally, the Court held that the ultimate conclusion regarding the Purchase Option would have been the same even if it were more likely than not that Anaheim would fail to exercise the Purchase Option. That was so because UBC’s investment was assured of being recouped irrespective of the residual value of the property.

On the issue of whether UBC was entitled to its interest deductions under section 163(a) of the Code, in another case the Federal Circuit recently opined that the taxpayer must incur genuine indebtedness associated with the LILO transaction. Knetsch v. United States, 364 U.S. 361, 365-66 (1960). The Federal Circuit further held that whether payment constitutes “interest” on genuine “debt” depends upon the substance not the form of the transaction. Id. In this case, the debt incurred by UBC was, in substance, decidedly not genuine, deriving from circular transactions largely with the subsidiaries of a single entity – transactions in which UBC’s loan was paid with the proceeds of the same loan.

The doctrine of “substance over form” is a judicial creation. This case represents another instance in which a court has relied upon the premise that a transaction must be designed for a real business purpose or motive in order for the courts to respect it as valid. It is undeniable that the tax benefits or burdens of a proposed course of action are always relevant; they always make a difference in the decision-making process of business executives. However, taxpayers should be careful not let tax implications be the exclusive purpose behind a transaction or they run the risk of having the transaction recharacterized by the courts.