The opinion of the court was delivered by: Richard J. Holwell, District Judge
MEMORANDUM OPINION AND ORDER
This case concerns federal income tax deductions plaintiff Altria Group Inc. and its subsidiary Phillip Morris Capital Corp. ("PMCC" or "Altria," collectively with plaintiff) generated by leasing big pieces of infrastructure from tax-indifferent counterparties. These tax shelter transactions are known in the leasing industry as SILOs ("Sale-In-Lease-Out") and LILOs ("Lease-In-Lease-Out"). Following a two-week trial, the jury concluded on the facts presented to it that plaintiff's SILOs and LILOs lacked economic substance and failed to transfer tax ownership of the properties to Altria, thereby justifying disallowance by the IRS of certain deductions claimed by Altria. Several courts and another jury have reached similar conclusions in other jurisdictions. See BB&T Corp. v. United States, 523 F.3d 461 (4th Cir. 2008); AWG Leasing Trust v. United States, 592 F. Supp. 2d 953 (N.D. Ohio 2008); Fifth Third Bancorp & Subs. v. United States, 05 Civ. 350 (S.D. Ohio, April 18, 2008) (jury verdict); Wells Fargo & Co. v. United States, 91 Fed. Cl. 35 (Fed. Cl. 2010). But see Consolidated Edison Co. v. United States, 90 Fed. Cl. 228 (Fed. Cl. 2009).
The four transactions in the present case relate to Altria's acquisition of leasehold interests in the Long Island Railroad's primary maintenance facility, a Dutch wastewater treatment plant, and two power plants in Georgia and Florida. Each of the counterparties was indifferent to U.S. federal income tax, in the sense that the ability to depreciate or amortize the assets would not substantially affect the entities' tax liability. In each transaction, Altria immediately leased the asset back to its original owner using agreements with a number of unusual features, including complete defeasance (prepayment, in essence) of the lessee's rent and an owner's option to repurchase the asset. Altria then claimed depreciation, amortization, interest expense, and transaction expense deductions on its 1996 and 1997 corporate tax return based on its newly acquired assets, even though (i) its purchase money immediately was invested in securities that the nominal lessees could not access without providing substitute collateral, and (ii) the lessees could reacquire the assets without incurring any out-of-pocket costs.
From the perspective of the U.S. Treasury, these and similar transactions entered into by Altria created billions of dollars of tax-deferral benefits out of thin air. The Commissioner of Internal Revenue concluded that the transactions had no purpose, substance, or utility apart from their anticipated tax consequences and disallowed the deductions. Altria filed this suit, arguing, in substance, that because it complied with certain standards developed for traditional leveraged leasing transactions, it was entitled to the challenged deductions.
From June 23 to July 9, 2009, the Court held a jury trial to determine Altria's entitlement to the deductions. At the close of evidence, Altria moved for judgment as a matter of law, and the Court reserved decision on the motion. After the jury returned a verdict for the Government on all of Altria's claims, Altria renewed its motion and moved in the alternative for a new trial.
For the reasons that follow, the motions will be denied.
The four transactions that gave rise to the challenged deductions are seemingly complex. Each transaction, however, shares the same basic structure, which is helpfully summarized in a series of memoranda that PMCC's credit department prepared for senior Altria management at the time PMCC entered into the transactions. (See GX 107 ("Oglethorpe Mem."); GX 257 ("MTA Mem."); GX 304 ("Vallei Mem."); GX 407 ("Seminole Mem.").) The description that follows is drawn primarily from those memoranda. To simplify the discussion, several details that are irrelevant for purposes of this opinion, such as the special purpose entities and trusts through which the transactions were implemented, are omitted.
PMCC is a financial services company that focuses on investments and leveraged leasing. (Tr. 123.) In each transaction, PMCC acquired a leasehold interest in an asset that originally was owned by a governmental entity or an electrical cooperative.
The "MTA" transaction involved the Hillside Maintenance Complex in Hollis, Queens, the primary maintenance facility for the Long Island Rail Road's rail cars. As described in the transaction's credit memorandum, the facility "is a unique and essential asset to the viability of the Long Island Rail Road and the MTA." (MTA Mem., at ALT0016431.) "The modern 900,000 square foot Facility, possessing the latest advances in industrial engineering, robotics, and computer technology, is required to meet the repair and maintenance needs of the LIRR well into the twenty-first century." (Id.) The complex originally was owned by the New York Metropolitan Transportation Agency (the "MTA"), a public benefit corporation of the State of New York. (Id. at ALT0016430.) As an agency of a state government, the MTA is not subject to federal income taxation for purposes relevant to this case. See 26 U.S.C. § 115 (1994).
The "Oglethorpe" transaction involved an interest in the Rocky Mountain power plant, an 848 megawatt pumped storage hydroelectric facility. The plant, located in Floyd County, Georgia, is used to provide "peak" power to customers of the Oglethorpe Power Corp., themselves electric utilities. During periods of low electricity demand, it uses electricity from the public grid to pump water into a reservoir on top of a mountain. Then, during periods of peak demand, gravity propels water through the plant's turbines to generate electricity. As described in the Oglethorpe credit memorandum, the plant "fills a major gap for Oglethorpe which had been buying peaking capacity under contract to meet short-terms needs." (Oglethorpe Mem., at ALT 0003524.) At the time the transaction was entered into, Oglethorpe had over a billion dollars in net operating losses, thus the ability to claim deductions for wear and tear on the plant would not have had a substantial effect on its federal tax liability. (Tr. 896, 900.)
The "Seminole" transaction involved a 625 megawatt coal-fired electrical generating unit, known as "Unit 1," that is located in Palatka, Florida. The plant originally was owned by the Seminole Electrical Cooperative, Inc, an electrical cooperative similar to Oglethorpe. According to the transaction's credit memorandum, the unit "accounts for approximately 50% of Seminole's generating capacity and is indispensable for Seminole's operations." (Seminole Mem., at ALT002543.) This transaction terminated in accordance with the terms of the parties' agreement. (Tr. 1959.)
Thus, there presently is no possibility that Altria will be required to take possession of Unit 1.
The "Vallei" transaction involved a wastewater treatment facility in the Netherlands. Like other wastewater treatment facilities that have been leased to American investors, the facility at issue here accelerates the biological processing of wastewater. (Vallei Mem., at ALT0001032.) The credit memorandum opined that such facilities "represent critical assets to the efficient, safe and economical treatment of wastewater for the inhabitants of the Gelderland, Utrecht and Noord Holland provinces of The Netherlands." (Id. at ALT0001025.) The facilities originally were owned by Watershap Vallei en Eem, an independent agency of the government of the Netherlands that is responsible for the treatment of wastewater within its assigned geographic region. (Vallei Mem., at ALT0001019- ALT0001020.) As an agency of a foreign government, Vallei is not subject to U.S. federal income tax for any relevant purposes.
As noted, each of the four transactions had two principal components: a "head" lease and sublease. In the head lease, the tax indifferent entity initially leased the asset (or a percentage interest in the asset) to Altria. In three of the four transactions (Oglethorpe, Seminole, and Vallei), the head lease extended beyond the useful life of the asset and thus transferred tax ownership. (Tr. 248.) In the remaining transaction (MTA), the head lease did not extend past the asset's useful life and thus did not transfer tax ownership. (Id.) The relationship between the head lease term and an asset's appraised useful life accounts for whether a transaction was denominated a SILO ("sale in-lease out") or LILO ("lease in-lease out"), as well as whether Altria purported to acquire a depreciable or amortizable interest in the asset.*fn1
PMCC immediately leased the asset back to the tax indifferent entity through a sublease whose term was shorter than that of the head lease. Each sublease had a "basic" term that lasted for approximately the amount of time the transaction was expected to generate positive tax benefits. (See, e.g., Mulligan Demonstrative 25.) At the conclusion of the sublease, the tax-indifferent lessee had the right to repurchase the asset for an amount slightly greater than the asset's expected fair market value. (See, e.g., Mulligan Demonstrative 26.) If the lessee did not exercise this purchase option, PMCC could take possession of the facility or put the lessee to additional obligations. The nature of these obligations varied depending on the transaction.
In the MTA, Seminole, and Oglethorpe transactions, PMCC could unilaterally require the lessee to renew the lease for an additional "renewal" term. In the MTA transaction, this term lasted for twelve years (MTA Mem., at ALT0016428-29); in the Oglethorpe transaction, it lasted for sixteen years (Oglethorpe Mem., at ALT000351516); and in the Seminole transaction, it lasted for approximately fifteen years. (Seminole Mem., at ALT0025401-02.) The Vallei transaction had a slightly different structure, in which PMCC could require Vallei to enter into a service contract for the operation of the wastewater treatment facility. The governing agreements required Vallei to return the facilities under "stringent" return conditions, and, at PMCC's option, enter into a contract in which a third-party operator acceptable to PMCC would operate the facilities for an additional sixteen years. (Vallei Mem., at ALT0001022-23.)
Following the renewal or service contract term, the governing agreements contemplate a brief period during which Altria will be required to take possession or otherwise dispose of the asset. In the MTA transaction, this period lasts for 9.2 years, or approximately twenty percent of the Hillside Maintenance Complex's appraised useful life; in the Oglethorpe transaction, it lasts for thirteen years, or approximately twenty-two percent of the hydroelectric plant's appraised useful life; in the Seminole transaction, it lasts for 9.2 years, or approximately twenty percent of Unit 1's appraised useful life; and in the Vallei transaction, the period lasts for 19.73 years, or approximately thirty-four percent of the wastewater treatment facility's appraised useful life. (See, e.g., Mulligan Demonstrative 32 (collecting sources).) At trial, the Government contended that the appraisals these estimates were based on were entitled to little weight.
The following diagram, a summary of the Seminole transaction reproduced from Altria's summary judgment brief, illustrates the transactions' basic structure:
(Altria Summ. J. Mem. 15.)
During the initial and renewal lease terms, the lessees assumed significantly all of the traditional benefits and burdens of ownership, including the obligation to pay property taxes, insurance, maintenance, and regulatory costs. (See, e.g., PX 150, at OGL015401, OGL0154005-06.) Altria's claim that it acquired a depreciable interest in the assets therefore is based on the possibility that, in a given transaction, the lessee will not exercise its purchase option; the transaction will not unwind pursuant to a subsequent agreement of the parties (as in fact occurred in the Seminole transaction); the appraised useful life of the asset is reasonably accurate; and the appraised residual value of the asset is reasonably accurate. If and only if each of these conditions is met, Altria will take possession of an asset with substantial economic value during the "tail" or "residual" period of the head lease. Interestingly, the MTA, Oglethorpe, and Seminole memoranda assume, with varying degrees of certainty, that the lessee will exercise its purchase option at the conclusion of the basic lease term. (MTA Mem., at ALT0016431; Oglethorpe Mem., at ALT0003518; Seminole Mem., at ALT0025404.) And each credit memorandum assumes that the asset will have no residual value at the end of the renewal or service contract term. (MTA Mem., at ALT0016429; Oglethorpe Mem., at ALT0003516; Seminole Mem., at ALT0025402; Vallei Mem., at ALT0001023.)
B. Differences Between the Challenged Transactions and a "Traditional" Leveraged Lease
A substantial amount of evidence addressed whether the transactions were materially different from a traditional leveraged lease. In a traditional leveraged lease, the owner of an asset such as an airplane sells the asset and immediately leases it back under a long-term lease. (See, e.g., Tr. 137-30.) The original owner benefits from monetizing an illiquid asset, while the lessor benefits from rental income and the ability to depreciate the asset for tax purposes. While the tax treatment of such transactions can be difficult,*fn2 the parties generally agreed that Altria was entitled to the challenged deductions if the transactions it entered into are nothing more than examples of a "time honored leveraged lease." During trial, however, at least five differences between the transactions and such a lease were apparent.
First, the jury heard evidence from which it could have concluded that the transactions involved assets that are qualitatively different than those found in typical leveraged leasing transactions. (See, e.g., Tr. 1260-61, 1349-51.) In particular, the jury could have found that there was no viable secondary market for the assets, so that in each transaction, Altria and its counterparty effectively entered into a bilateral monopoly in which the asset's price after the transaction's closing would be determined by non-economic factors. Altria introduced some evidence to the contrary. (See, e.g., Tr. 1250-52.) But the jury was free to reject the inference that Altria sought to draw-that (for example) the secondary markets for Dutch wastewater treatment facilities and commercial aircraft are equally viable.
Second, the jury heard evidence from which it could have concluded that the transactions involved assets that were essential to the lessees. PMCC's credit memorandum, for example, generally described the leased assets as critical to the lessees' business operations. See supra § I.A. And PMCC's former president testified that the company sought to invest in assets of "strategic importance." (Tr. 1331.)
Third, the jury heard evidence from which it could have concluded that the appraisals that parties relied on to set key transactional terms, including the assets' nominal sale price, did not properly estimate the assets' expected residual value and expected useful life, and incorrectly predicted that the lessees would not exercise their purchase options at the end of the basic subleases. For example, one of Altria's appraisers testified that although the transactions involved assets worth hundreds of millions of dollars, he spent an average of one week on each appraisal. (Tr. 615.) A transactional lawyer from the MTA testified that the purpose of the appraisal was simply to support Altria's tax position. (Tr. 514-15.) Altria's counterparties generally did not receive a copy of the appraisals before the transactions closed. (Tr. 515, 621-22, 749-50.) And although PMCC's internal staff uniformly expected the lessees to exercise their purchase options, no one at PMCC or the firms that performed the appraisals ever questioned the appraisals' conclusions to the contrary. (Tr. 443.) In short, while the appraisals have the trappings of a serious inquiry into the assets' commercial value, the jury reasonably could have concluded that they were little more than window dressing designed to bolster Altria's tax position.
Fourth, because each counterparty was indifferent to U.S. federal income tax, the transactions had the effect of creating tax benefits rather than transferring a tax benefit between taxpayers that paid comparable tax rates. Logically, one would not expect this to affect whether a nominal owner acquired a depreciable interest in leased property. See Bernard Wolfman, The Supreme Court in the Lyon's Den: A Failure of Judicial Process, 66 Cornell L. Rev. 1075, 1098 (1981). The Supreme Court, however, has expressly indicated that a transaction's effect on the U.S. treasury must inform a federal court's analysis of whether a transactional form chosen selected by a taxpayer should be respected for federal tax purposes. See Frank Lyon Co. v. United States, 435 U.S. 561, 580.
Fifth, in each transaction, the lessee's rent and purchase-option price were fully "defeased." As a result, the lessee did not receive any additional liquidity aside from an amount that was directly traceable to the tax benefits created by the transactions. This unusual feature worked as follows:
At the beginning of a transaction, the lessee momentarily received a sum of money in exchange for granting a leasehold to Altria. Approximately four-fifths of this money consisted of non-recourse financing obtained by Altria. The remaining money was provided by Altria and represented Altria's "equity" investment in the asset. After paying sizeable transaction fees and setting aside an amount less than the tax benefits created by the transaction, the lessee immediately transferred the purchase money it received from Altria into two bank accounts: a "debt" defeasance account, and an "equity" defeasance account.
The debt defeasance account was established at an affiliate of the financial institution that provided the non-recourse financing and was governed by an agreement whereby the financial institution, known as the "debt payment undertaker," was required to make periodic payments out of the account's proceeds. These payments were structured so that on each date when a payment was due from PMCC to the lender, a corresponding rent payment was due from the lessee to PMCC, and a matching payment was due from the debt payment undertaker to the lessee. When a lease payment came due, the debt payment undertaker and the lending bank (the same bank) made offsetting entries on their books discharging the parties' various payment obligations. (Compare, e.g., PX 157, at OGL016813-14, with PX162, at OGL017322-23, and PX 150, at OGL015537-38; see also Tr. 218-19.)
The equity defeasance account was established at a second financial institution and was governed by a separate agreement, known as an "equity funding agreement." The funds in this account generally were invested in U.S. treasury bonds, and were used to make any sublease payments not funded by payments from the debt defeasance account. With interest, the equity account accreted to an amount sufficient to pay the lessee's purchase option price at the end of the initial lease term or the obligations to which PMCC could put the lessee. (Compare, e.g., PX 150, at OGL015420, with PX 162, at OGL17324, and PX 165, at OGL017371; see also Tr. 221-22, 226.) The lessee was prohibited from accessing the money in the defeasance accounts unless it provided substitute collateral acceptable to Altria. (See, e.g., PX 165, OGL017358-59; see also Tr. 219-23.)
Appendix A to this opinion, the wiring instructions from the Oglethorpe transaction's closing, illustrates the creation of the defeasance accounts and the essentially circular flow of purchase money through the lessee to the debt and equity payment undertakers. Note in the diagram that Utrecht-America Finance Co., the provider of non-recourse ...