IRS Examines Effects of LILO Transactions.

X is a U.S. corporation. FM is a foreign municipality that has historically owned and used certain property with a remaining useful life of 50 years and a fair market value (FMV) of $100 million. BK1 and BK2 are banks. None of the parties is related.

On Jan. 1, 1997, x and FM entered into a lease-in/lease-out (LILO) transaction under which FM leased the property to X under a "headlease" and X immediately leased the property back to FM under a "sublease." The term of the headlease is 34 years. The "primary" term of the sublease is 20 years. Moreover, the sublease may also have a"put renewal" term of 10 years.

The headlease requires X to make two rental payments to FM during its 34-year term: (1) an $89 million "prepayment" at the beginning of year 1; and (2) a "postpayment" at the end of year 34 that has a discounted present value of $8 million. For Federal income tax purposes, X and FM allocate the prepayment ratably to the first six years of the headlease and the future value of the postpayment ratably to the remaining 28 years of the headlease.

The sublease requires FM to make fixed, annual rental payments over both the primary term and (if exercised) the put renewal term. The fixed, annual payments during the put renewal term are substantially higher than those for the primary term. Nevertheless, the fixed annual payments during the put renewal term are projected (as of Jan. 1, 1997) to equal only 90% of the FMV rental amounts for that term.

At the end of the sublease primary term, FM has a "fixed-payment option" to purchase from X the headlease residual (i.e., the right to use the property beyond the sublease primary term, subject to the obligation to make the rent postpayment) for a fixed amount projected (as of Jan. 1, 1997) to equal the FMV of the headlease residual. If FM exercises the option, the transaction is terminated at that point and X is not required to make any portion of the postpayment due under the headlease. If FM does not exercise the option, X may elect to (1) use the property itself for the headlease's remaining term, (2) lease the property to another person for the headlease's remaining term or (3) compel FM to lease the property for the 10-year put renewal term of the sublease. If FM does not exercise the fixed-payment option and X exercises its put renewal option, X can require FM to purchase a letter of credit guaranteeing the put renewal rents. If FM does not obtain the letter of credit, FM must exercise the fixedpayment option.

To partially fund the $89 million headlease prepayment, X borrows $54 million from BK1 and $6 million from BK2. Both loans are nonrecourse, have fixed interest rates and provide for annual debt service payments that fully amortize the loans over the sublease's 20-year primary term. The amount and timing of the debt service payments mirror the amount and timing of the sublease payments due during the sublease's primary term.

On receiving the $89 million headlease prepayment, FM deposits $54 million into a deposit account with an affiliate of BK1 and $6 million into a deposit account with an affiliate of BK2. The deposits with the affiliates of BK1 and BK2 earn interest at the same rates as the loans from BK1 and BK2. FM directs the BK1 affiliate to pay BK1 annual amounts equal to 90% of FM's annual rent obligation under the sublease (i.e., amounts sufficient to satisfy X's debt service obligation to BK1). The parties treat these amounts as having been paid from the affiliate to FM, then from FM to X as rental payments and finally, from X to BK1 as debt service payments. In addition, FM pledges the deposit account to X as security for FM's obligations under the sublease, while X, in turn, pledges its interest in FM's pledge to BK1 as security for X's obligations under the loan from BK1. Similarly, FM directs the affiliate of BK2 to pay BK2 annual amounts equal to 10% of FM's annual rent obligation under the sublease (i.e., amounts sufficient to satisfy X's debt service obligation to BK2). The parties treat these amounts as having been paid from the affiliate to FM, from FM to X as rental payments and finally, from X to BK2 as debt service payments. Although this deposit account is not pledged, the parties understand that FM will use the account to pay the remaining 10% of the FM annual rent obligation under the sublease.

X requires FM to invest $15 million of the headlease prepayment in highly rated debt securities that will mature in an amount sufficient to fund the fixed amount due under the fixed-payment option, and to pledge these debt securities to X. Having economically defeased both its rental obligations under the sublease and its fixed payment under the fixed payment option, FM keeps the remaining portion of the headlease prepayment as its return on the transaction.

For tax purposes, X claims deductions for interest on the loans and for the allocated rents on the headlease. X includes in gross income the rents received on the sublease and, if and when exercised, the payment received on the fixed-payment option. By accounting for each element of the transaction separately, X purports to generate a stream of substantial net deductions in the early years of the transaction, followed by net income inclusions on or after the conclusion of the sublease primary term. As a result, X anticipates a substantial net after-tax return from the transaction. X also anticipates a positive pre-tax economic return from the transaction. However, this pre-tax return is insignificant in relation to the net after-tax return.

Analysis

In general, a transaction will be respected for tax purposes if it has economic substance compelled or encouraged by business or regulatory realities, is imbued with tax-independent considerations, and is not shaped solely by tax-avoidance features that have meaningless labels attached. In assessing the economic substance of a transaction, a key factor is whether the transaction has any practical economic effect other than the creation of tax losses. Courts have refused to recognize the tax consequences of a transaction that does not appreciably affect the taxpayer's beneficial interest, except to reduce tax. The presence of an insignificant pretax profit is not enough to provide a transaction with sufficient economic substance to be respected for tax purposes.

In determining whether a transaction has sufficient economic substance to be respected for tax purposes, offsetting legal obligations or circular cash flows may effectively eliminate any real economic significance of the transaction.

Viewed as a whole, the objective facts of the LILO transaction indicate that it lacks the potential for any significant economic consequences other than the creation of tax benefits. During the 20-year primary term of the sublease, X's obligation to make the property available under the sublease is completely offset by its right to use the property under the headlease; its obligation to make debt service payments on the loans from BK1 and BK2 is completely offset by its right to receive sublease rentals from FM. Moreover, X's exposure, to the risk that FM will not make the rent payments is further limited by the arrangements with the affiliates of BK1 and BK2. In the case of the loan from BK1, X's economic risk is completely eliminated through the defeasance arrangement. In the case of the smaller loan from BK2, X's economic risk (although not completely eliminated) is substantially reduced through the deposit arrangement. As a result, neither bank requires an independent source of funds to make the loans or bears significant risk of nonpayment. In short, during the sublease primary term, the offsetting and circular nature of the obligations eliminate any significant economic consequences of the transaction.

At the end of the 20-year sublease primary term, X will have either the proceeds of the fixed-payment option or a headlease residual that has a FMV approximately equal to the proceeds of the fixed-payment option. If, at the end of the 20-year sublease primary term, the headlease residual is worth more than the payment required on the fixed-payment option, FM will capture this excess value by exercising the option, leaving X with only the proceeds of the option. Conversely, if, at the end of the 20-year sublease primary term, the headlease residual is worth significantly less than the payment required on the fixed-payment option, X will put the property back to FM under the put renewal option at rents, that, while initially projected to be at only 90% of estimated FMV, are (because of the decline in the value of the property) greater than FMV. Thus, the fixed-payment option and put renewal option operate to "collar" the value of the headlease residual during the primary term, limiting much of the economic consequence of the headlease residual.

In addition, facts indicate that there is little economic consequence from X's nominal exposure to FM's credit under the fixed-payment option and, if exercised, the renewal term. At the inception of the transaction, FM was required to use a portion of the headlease prepayment to purchase highly rated debt securities that were pledged to X, ensuring FM's ability to make the payment under the fixedpayment option. If FM does not exercise the fixed-payment option and X exercises the put renewal option, X can require FM to purchase a letter of credit guaranteeing FM's obligation to make the put renewal rent payments. If FM does not obtain the letter of credit, FM must exercise the fixed-payment option. Thus, as a practical matter, the transaction is structured so that X is never subject to FM's credit.

The conclusion that X is insulated from any significant economic consequence of the headlease residual is further supported by several factors indicating that the parties expect FM to exercise the fixed-payment option. First, FM has historically used the property. Second, because the fixedpayment obligation is fully defeased, FM need not draw on other sources of capital to exercise the option. However, if FM does not exercise the fixedpayment option and X exercised the put renewal option, FM would be required to draw on other sources of capital to satisfy its put renewal rental obligations.

In sum, the LILO transaction lacks the potential for significant economic consequences other than the creation of tax benefits. During the sublease's primary term, X's obligations to provide property are completely offset by its right to use property. X's obligation to make debt service payments on the loans are completely offset by X's right to receive rent on the sublease. These cash flows are further assured by the deposit arrangements with the affiliates of BK1 and BK2. Finally, X's economic exposure to the headlease residual is rendered insignificant by the option structure and the pledge of the securities that defeases FM's option payment. Thus, the only real economic consequence of the LILO transaction during the sublease's 20-year primary term is X's pre-tax return. This pre-tax return is too insignificant, when compared to X's after-tax yield, to support a finding that the transaction has significant economic consequences other than the creation of tax benefits.

Some of the features of the LILO transaction discussed are present in transactions that the Service will respect for Federal income tax purposes. For example, an arrangement for "in-substance defeasance" of an outstanding debt was respected in Kev. Rul. 85-42. By contrast, in the LILO transaction, the deposit arrangement exists from the inception of the transaction, eliminating any need by BK1 and BK2 for an independent source of funds. Similarly, other features of the LILO transaction, such as nonrecourse financing and fixed-payment options, are respected in other contexts. However, when these and other features are viewed as a whole in the context of the LILO transaction, they indicate the transaction should not be respected for tax purposes.

As a result of the transaction lacking economic substance, X may not deduct interest or rent paid or incurred in connection with the transaction.

The IRS will scrutinize LILO transactions for lack of economic substance and/or, in appropriate cases, recharacterize transactions for Federal income tax purposes based on their substance. Use of terms such as "loan" "lease," "headlease" and "sublease" in this revenue ruling should not be interpreted to indicate the Service's acceptance of X's characterization of the LILO transaction described.

Holding

A taxpayer may not deduct, under Secs. 162 and 163, rent and interest 'paid or incurred in connection with a LILO transaction that lacks economic substance.

Rev. Rul. 99-14, IRB 1999-13