Tax Litigation Blog

Lease-In/Lease-Out ("LILO") -BB&T Corporation v. United States

During my days working with the Office of Chief Counsel, I was fortunate to be involved in tax shelter litigation. In one of those meetings in Washington, D.C. a former deputy chief counsel uttered the phrase “not all LILO’s are bad”. Reason - LILO’s are factually intense. Surprise! A LILO case was decided through a motion for summary judgment – BB&T Corporation v. United States, 2007 TNT 4-19 (M.D. N.C. 2007).

BB&T, a financial service company, participated in a LILO transaction ("Transaction") with Sodra Cell AB ("Sodra"), a Swedish company, a world-wide manufacturer of wood pulp. The Transaction at issue involved the lease and sublease of the pulp manufacturing equipment (the "Equipment") at one of Sodra's pulp-manufacturing facilities.

During my days working with the Office of Chief Counsel, I was fortunate to be involved in tax shelter litigation. In one of those meetings in Washington, D.C. a former deputy chief counsel uttered the phrase “not all LILO’s are bad”. Reason - LILO’s are factually intense. Surprise! A LILO case was decided through a motion for summary judgment – BB&T Corporation v. United States, 2007 TNT 4-19 (M.D. N.C. 2007).

BB&T, a financial service company, participated in a LILO transaction ("Transaction") with Sodra Cell AB ("Sodra"), a Swedish company, a world-wide manufacturer of wood pulp. The Transaction at issue involved the lease and sublease of the pulp manufacturing equipment (the "Equipment") at one of Sodra's pulp-manufacturing facilities.

On June 30, 1997, Sodra and BB&T, through a trust, entered into the Transaction by executing a series of agreements. The Transaction consisted of a "Head Lease" in which BB&T acquired an undivided interest in the Equipment for a period of 36 years ending June 30, 2033 and an immediate shorter term sublease (the "Lease") of the undivided interest in the Equipment back to Sodra for a term of 15.5 years.

The Head Lease required BB&T to pay rent to Sodra in two installments. The first installment (the "initial Head Lease Payment"), approximately $86.2 million, was due on the closing date and was allocated to the first five years of the Head Lease term. The second installment (the "Deferred Head Lease Payment") of approximately $557.8 million was due in 2038, five years after the expiration of the Head Lease term, and was allocated to the last 31.5 years of the Head Lease term.

At Closing:

  • BB&T paid the Initial Head Lease Payment with $18,228,895 of its own funds plus $68,008,236 from a non-recourse loan from Hollandsche Bank-Unie N.V. ("HBU"). HBU was a wholly owned subsidiary of ABNAMBRO Bank N.V. ("ABN").
  • On June 30, 1997, ABN, on behalf of HBU, transferred $68,008,236 (the funds representing the HBU loan) into BB&T's Trust (the "Trust") account at ABN.  BB&T transferred $18,228,895 into the Trust account at ABN. Thus, at closing a total of $86,237,131 was deposited into the Trust account at ABN either by BB&T or on BB&T's behalf.
  • Sodra was required to pay $68,008,236 to ABN as "Debt PUA Issuer" under the Debt Payment Undertaking Agreement ("Debt PUA"). Under the Debt PUA, BN was obligated to make certain payments to BB&T on Sodra's behalf.
  • Sodra was required to pay $12,000,193 to Fleet National Bank ("Fleet") as the "Equity PUA Issuer" under the Equity Payment Undertaking Agreement ("Equity PUA"). Under the Equity PUA, Fleet was required to use the $12,000,193 to purchase certain government securities.

Sodra's Debt PUA and Equity PUA payments were made at closing as follows: (1) the Trust, on Sodra's behalf, made the $68,008,236 payment that Sodra was required to make to ABN as Debt PUA Issuer using proceeds of BB&T's first installment payment and (2), the Trust, on Sodra's behalf, made the $12,000,193 payment Sodra was required to make to the Equity PUA Issuer also using proceeds of BB&T's first installment payment. In sum, $86,237,131 was deposited into the Trust account at ABN either by BB&T or on BB&T's behalf. Of the total deposited by BB&T, $80,008,429 was paid on Sodra's behalf to the Equity PUA the Debt PUA, leaving a balance of $6,228,702, which the Trust transferred to Sodra's account at ABN. BB&T has described this $6 million payment as Sodra's "incentive for doing the deal."

Pursuant to the Lease, Sodra was required to make annual rent payments to BB&T. Sodra's rent payments were equal to BB&T's scheduled loan payments to HBU, in both amount and timing, through January 1, 2012. In addition, BB&T's scheduled debt payments to HBU on the HBU loan, and Sodra's annual rent payments to BB&T, were equal to the scheduled payments required by the Debt PUA, which obligated ABN to pay Sodra's rent during the Head Lease term directly to HBU, until January 1, 2012. The interest rate on the funds that Sodra paid to the Debt PUA Issuer was equal to the interest rate on the HBU loan. Thus, the Debt PUA payments from ABN to its subsidiary HBU satisfied both Sodra's rental obligations to BB&T under the sublease and BB&T's obligations to HBU under the loan agreement. Finally, the Debt PUA obligated ABN to make a final payment of $11,542,500 in 2013, either to or for the benefit of Sodra, depending on which of the options at the end of the Lease are exercised by the parties.

Net effect: Sodra received a $6 million dollar payment and continued to use the property the same before/after the transaction; ABN received $6,228,702 for its participation and Fleet was holding on to $12,000,193 which has been invested in government securities for someone’s benefit; and BB&T received the rental/lease and interest deductions, while having to report rental income.

HOLDING:

The Court stated that the parties agreed that the applicable doctrine was substance over form and cited to Frank Lyon Co. v. United States, 435 U.S. 561, 572 - 73 (1978). The Court then found that if BB&T wanted the rental deductions the facts had to establish that it had an interest in the property. Citing and analyzing the facts in Alstores Realty Corp. v. Comm'r, 46 T.C. 363, 371 (1966), the Court found that Sodra's use and possession of the Equipment was unaltered by the Transaction (but for BB&T's annual right of inspection). In particular, Sodra used, maintained, and serviced the Equipment as it did before the Transaction and even made significant investments in and improvements to the Equipment. In addition, Sodra was entitled to all of the profits generated from the use of the Equipment during the term of the Lease. Moreover, although the form of the transaction required Sodra to make rent payments to BB&T, those payments were in fact made by the Debt PUA, were funded in full by BB&T's Initial Head Lease Payment, and did not require Sodra to invest any of its own funds. Thus, the Court found that only a future interest in the property was conveyed to BB&T.

BB&T asserted that it bore an unlimited risk of loss in the vent certain options were not exercised. The Court found the Transaction was structured so that there was no risk to BB&T's initial (and only) cash outlay. Of the $18,228,895 million that BB&T initially transferred into the Trust account at ABN, $12,000,193 was paid to the Equity PUA to purchase certain government securities. The remainder of BB&T's equity investment, $6,228,702, was transferred to Sodra's account at ABN as Sodra's "incentive for doing the deal." In the event Sodra exercised the purchase option, the funds in the Equity PUA would be returned to BB&T through the payment of the purchase price. In the event Sodra did not exercise the purchase option and BB&T enforced the Sublease Renewal provision, the funds in the Equity PUA would be returned to BB&T through the Sublease Renewal rents. Moreover, BB&T's own internal documents noted that Sodra's Letter of Credit requirement added to BB&T's security that its initial investment, and anticipated after- tax yield, would be protected from the loss at all times.

The Court finally held that when the intermediate payment steps were disregarded, which must be done in order to consider the substance of the loan transaction and not the form selected by the parties, it became clear that the loan transaction was only a circular transfer of funds in which the HBU loan was paid from the proceeds of the loan itself. There was no money lent to BB&T in a substantive sense, and the HBU loan did not reflect genuine indebtedness.  The Court stated:

"For interest to accrue there must be an underlying indebtedness requiring an "unconditional and legally enforceable obligation for the payment of money." Autenreith v. Comm'r, 115 F.2d 856, 858 (3d Cir.1940), aff'g 41 B.T.A. 319 (1940). In this case, although the loan documents -- the form selected by the parties -- may provide that BB&T had a legal obligation to repay the loan, the transaction in fact -- the substance -- did not actually require BB&T to pay any money to HBU. Through the circular nature of the transaction, BB&T's purported principal and interest payments were actually paid from the proceeds of the loan itself. In fact, after the closing in June 1997, BB&T was not required to provide any additional funds over the life of the loan. As such, BB&T's purported interest payments could not be what Congress intended to allow as an income tax deduction. "

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