Filed: Aug. 05, 2013
Latest Update: Nov. 14, 2018
Summary: REPORTS OF THE UNITED STATES TAX COURT JOHN HANCOCK LIFE INSURANCE COMPANY (U.S.A.), AS SUC- CESSOR IN INTEREST TO JOHN HANCOCK LIFE INSURANCE COMPANY (F.K.A. JOHN HANCOCK MUTUAL LIFE INSURANCE COMPANY) AND SUBSIDIARIES, ET AL.,1 PETITIONERS v. COM- MISSIONER OF INTERNAL REVENUE, RESPONDENT Docket Nos. 6404–09, 7083–10, Filed August 5, 2013. 7084–10. JH is primarily in the business of selling life insurance poli- cies, annuities, long-term care insurance, and other retire- ment services. To fulf
Summary: REPORTS OF THE UNITED STATES TAX COURT JOHN HANCOCK LIFE INSURANCE COMPANY (U.S.A.), AS SUC- CESSOR IN INTEREST TO JOHN HANCOCK LIFE INSURANCE COMPANY (F.K.A. JOHN HANCOCK MUTUAL LIFE INSURANCE COMPANY) AND SUBSIDIARIES, ET AL.,1 PETITIONERS v. COM- MISSIONER OF INTERNAL REVENUE, RESPONDENT Docket Nos. 6404–09, 7083–10, Filed August 5, 2013. 7084–10. JH is primarily in the business of selling life insurance poli- cies, annuities, long-term care insurance, and other retire- ment services. To fulfi..
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REPORTS
OF THE
UNITED STATES TAX COURT
JOHN HANCOCK LIFE INSURANCE COMPANY (U.S.A.), AS SUC-
CESSOR IN INTEREST TO JOHN HANCOCK LIFE INSURANCE
COMPANY (F.K.A. JOHN HANCOCK MUTUAL LIFE INSURANCE
COMPANY) AND SUBSIDIARIES, ET AL.,1 PETITIONERS v. COM-
MISSIONER OF INTERNAL REVENUE, RESPONDENT
Docket Nos. 6404–09, 7083–10, Filed August 5, 2013.
7084–10.
JH is primarily in the business of selling life insurance poli-
cies, annuities, long-term care insurance, and other retire-
ment services. To fulfill its contractual obligations under
these services JH invests the premiums it receives. In 1979
JH began investing in leveraged leases. A leveraged lease is
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 JH began investing in lease-in-lease-out (LILO) trans-
actions and in 1999 began investing in sale-in-lease-out
(SILO) transactions. JH participated in 19 LILO transactions
and 8 SILO transactions between 1997 and 2001. With
respect to the LILO transactions, JH 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. JH also amortized transaction costs related
1 Cases of the following petitioners are consolidated herewith: The Manu-
facturers Investment Corporation and Subsidiaries, as Successor in Inter-
est to John Hancock Financial Services, Inc., and Subsidiaries, docket No.
7083–10; and John Hancock Life Insurance Company (U.S.A.) and Subsidi-
aries, as Successor in Interest to John Hancock Life Insurance Company
(f.k.a. John Hancock Mutual Life), docket No. 7084–10.
1
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2 141 UNITED STATES TAX COURT REPORTS (1)
to the LILO transactions. With respect to the SILO trans-
actions, JH claimed deductions for depreciation and interest
expenses and amortized the related transaction costs. R dis-
allowed these deductions for the years at issue and deter-
mined that JH had OID income with respect to the LILO and
SILO transactions. 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. P argues that
the LILO and SILO test transactions have economic sub-
stance because JH derived a pretax profit from each trans-
action and entered into the transactions with the primary
purpose of making a profit. P also argues that the substance
of each LILO and SILO transaction is consistent with its form
because JH held a true leasehold interest in each of the LILO
assets and obtained an ownership interest in each of the SILO
assets. R argues that the LILO and SILO test transactions
lack economic substance and the substance of the transactions
is not consistent with their form. Specifically, R argues that
JH failed to acquire a substantive leasehold interest in the
LILO assets and failed to acquire a substantive ownership
interest in the SILO assets. Thus, R argues the true sub-
stance of the LILO and SILO transactions is a loan from JH
to the tax-indifferent entities. R argues in the alternative with
respect to the LILO and SILO transactions that at most P
acquired a future interest in the LILO and SILO assets. The
parties also dispute the location of JH’s principal place of
business. Held: JH’s principal place of business is Boston,
Massachusetts. Held, further, R failed to prove that the three
LILO and four SILO test transactions lack economic sub-
stance. Held, further, the substance of the three LILO test
transactions is not consistent with their form. The LILO test
transactions resemble financial arrangements, and JH is
therefore denied its claimed rental expense, interest expense,
and transaction cost deductions with respect to them. Held,
further, the substance of three of the SILO test transactions
is consistent with their form; however, JH did not acquire a
present interest in the SILO test transaction properties and
is therefore denied its claimed depreciation and interest
expense deductions. Held, further, the substance of the fourth
SILO test transaction is not consistent with its form. That
SILO test transaction resembles a financial arrangement, and
JH is therefore denied its claimed depreciation expense,
interest expense, and transaction cost deductions with respect
to that transaction. Held, further, JH 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
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(1) JOHN HANCOCK LIFE INS. CO. (U.S.A.) v. COMM’R 3
SILO test transactions, in which it failed to acquire a present
interest.
Arthur L. Bailey, Jean A. Pawlow, James W. Johnson,
Kevin J. Cloherty, Alexis A. Maclvor, Thomas K. Spencer, and
Nathaniel J. Dorfman, for petitioners.
Daniel A. Rosen, Lyle B. Press, Steven N. Balahtsis, Allison
Ickovic, and Abigail F. Dunnigan, for respondent.
CONTENTS
FINDINGS OF FACT ............................................................................. 8
Background .......................................................................................... 8
I. John Hancock’s History ............................................................ 8
II. Investment Process and Review ............................................. 9
III. Leasing .................................................................................... 10
IV. LILO and SILO Transactions ................................................ 10
A. Basic Structure ..................................................................... 10
B. History ................................................................................... 15
C. Due Diligence ........................................................................ 17
D. The Hoosier Transaction ...................................................... 18
The LILO Test Transactions .............................................................. 19
I. OBB LILO .................................................................................. 20
A. Lease and Sublease .............................................................. 20
1. The Asset ............................................................................ 20
2. Terms .................................................................................. 21
3. Rent and Financing ........................................................... 21
a. Initial Lease .................................................................... 21
b. Sublease and Defeasance ............................................... 21
4. Property Rights and Obligations ...................................... 22
5. Default ................................................................................ 23
B. End of Sublease Term .......................................................... 23
1. OBB’s Purchase Option ..................................................... 23
2. John Hancock’s Options .................................................... 24
a. Renewal Option .............................................................. 24
b. Replacement Option ....................................................... 25
c. Retention Option ............................................................ 25
II. SNCB 2 and SNCB 5 Lot 1 LILO Transactions .................... 25
A. Lease and Sublease .............................................................. 25
1. The Assets .......................................................................... 25
2. Terms .................................................................................. 26
3. Rent and Financing ........................................................... 27
a. Initial Lease .................................................................... 27
b. Sublease and Defeasance ............................................... 27
4. Property and Default Rights and Obligations ................. 28
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4 141 UNITED STATES TAX COURT REPORTS (1)
B. End of Sublease Term .......................................................... 28
The SILO Test Transactions .............................................................. 28
I. TIWAG ....................................................................................... 29
A. Lease and Sublease .............................................................. 29
1. The Assets .......................................................................... 29
2. Terms .................................................................................. 29
3. Rent and Financing ........................................................... 30
a. Initial Lease .................................................................... 30
b. Sublease and Defeasance ............................................... 30
4. Property Rights and Obligations ...................................... 32
5. Default ................................................................................ 33
B. End of Sublease Term .......................................................... 33
1. TIWAG’s Purchase Option ................................................ 33
2. John Hancock’s Options .................................................... 33
II. Two Dortmund Transactions .................................................. 35
A. Lease and Sublease .............................................................. 35
1. The Asset ............................................................................ 35
2. Terms .................................................................................. 36
3. Rent and Financing ........................................................... 37
a. Initial Lease .................................................................... 37
b. Sublease and Defeasance ............................................... 37
4. Property and Default Rights and Obligations ................. 38
B. End of Sublease Term .......................................................... 38
III. SNCB SILO ............................................................................. 39
A. Grant and Subgrant ............................................................. 39
1. The Asset ............................................................................ 39
2. Terms .................................................................................. 40
3. Rent and Financing ........................................................... 40
a. Grant ............................................................................... 40
b. Subgrant and Defeasance .............................................. 40
4. Property and Default Rights and Obligations ................. 42
B. End of Subgrant Term ......................................................... 42
Tax Returns, Notices of Deficiency, and Trial .................................. 43
I. Procedural History .................................................................... 43
A. Notice of Deficiency (Docket No. 6404–09) ......................... 43
B. Notice of Deficiency (Docket No. 7084–10) ......................... 44
C. Notice of Deficiency (Docket No. 7083–10) ......................... 45
D. Pretrial Motions .................................................................... 47
II. Trial .......................................................................................... 48
A. Petitioners’ Expert Witnesses (Alphabetical Order) .......... 48
1. Mr. John Dolan .................................................................. 48
2. Dr. Paul Doralt .................................................................. 48
3. Mr. Hans Haider ................................................................ 49
4. Dr. Friedrich Hey .............................................................. 49
5. Dr. Friedrich Popp ............................................................. 49
6. Dr. Thomas Schu¨rrle ......................................................... 49
7. Dr. Norbert Stoeck ............................................................. 50
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(1) JOHN HANCOCK LIFE INS. CO. (U.S.A.) v. COMM’R 5
8.
Dr. Frederik Vandendriessche .......................................... 50
B. Respondent’s Expert Witnesses (Alphabetical Order) ....... 50
1. Dr. Ignaas Behaeghe ......................................................... 50
2. Dr. Stefan Diemer ............................................................. 51
3. Dr. Matthias Heisse .......................................................... 51
4. Dr. Thomas Lys ................................................................. 51
5. Dr. F.H. Rolf Seringhaus .................................................. 52
6. Mag. Alexander Stolitzka .................................................. 52
7. Dr. Vukan Vuchic .............................................................. 52
8. Dr. Peter Wundsam ........................................................... 53
OPINION ................................................................................................. 53
Burden of Proof ................................................................................... 53
Principal Place of Business ................................................................ 53
Leveraged Lease Transactions ........................................................... 54
I. Frank Lyon ................................................................................ 54
A. Economic Substance ............................................................. 56
B. Substance Over Form ........................................................... 57
II. LILO and SILO Litigation ...................................................... 58
A. BB&T ..................................................................................... 60
B. AWG ....................................................................................... 62
C. Wells Fargo ........................................................................... 66
D. Altria ..................................................................................... 70
E. Consolidated Edison ............................................................. 74
The Test Transactions ........................................................................ 77
I. Economic Substance .................................................................. 78
A. Objective Inquiry .................................................................. 79
B. Subjective Inquiry ................................................................. 88
II. Substance Over Form .............................................................. 89
A. OBB and SNCB LILO Transactions ................................... 91
1. OBB Purchase Option Decision ........................................ 95
a. Financial Considerations ............................................... 99
b. Retention Option ............................................................ 100
c. Renewal and Replacement Options .............................. 100
2. SNCB Purchase Option Decision ...................................... 105
3. Conclusion .......................................................................... 109
B. SILO Test Transactions ....................................................... 110
1. TIWAG and Dortmund Transactions ............................... 111
a. Sublease Term ................................................................ 111
b. Purchase Options ........................................................... 114
i. TIWAG Transaction .................................................... 114
ii. Dortmund Transactions ............................................. 123
c. Service Contract Benefits and Burdens ........................ 132
d. Future Interest ............................................................... 135
2. SNCB .................................................................................. 137
a. Purchase Option Decision .............................................. 138
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6 141 UNITED STATES TAX COURT REPORTS (1)
b. Subgrant Term ............................................................... 143
c. Conclusion ....................................................................... 145
Interest Deductions ............................................................................. 145
Original Issue Discount ...................................................................... 147
Transaction Expenses ......................................................................... 149
Conclusion ............................................................................................ 149
HAINES, Judge: These cases are consolidated for purposes
of trial, briefing, and opinion. Respondent determined the fol-
lowing deficiencies in petitioners’ Federal income tax for
1994 2 and 1997–2001 (years at issue): 3
Year Deficiency
1994 ...................................................................... $8,860,564
1997 ...................................................................... 65,746,621
1998 ...................................................................... 173,497,367
1999 ...................................................................... 59,899,141
2000 ...................................................................... 108,046,947
2001 ...................................................................... 143,516,079
These deficiencies stem from 27 leveraged lease trans-
actions (leveraged leases) that petitioners participated in
between 1997 and 2001. For purposes of resolving this action
expeditiously, the parties agreed to try seven of the leveraged
leases (test transactions) and apply a formula to determine
the deficiency, if any, with respect to the remaining lever-
aged leases. The test transactions comprise three lease-in-
lease-out (LILO) transactions and four sales-in-lease-out
(SILO) transactions. 4
The test transactions were identified at trial and are
referred to herein by the lease counterparty to each trans-
action. The counterparties for the LILO test transactions are:
2 Petitioners’ 1994 deficiency arises from the denial of a claimed NOL
carryback.
3 All section references are to the Internal Revenue Code (Code), as
amended and in effect for the years at issue, and all Rule references are
to the Tax Court Rules of Practice and Procedure, unless otherwise indi-
cated. Amounts are rounded to the nearest dollar.
4 Petitioners have referred to the SILO transactions as ‘‘service contract’’
transactions throughout the pleadings and at trial and have emphasized
this distinction from a LILO. For simplicity and without prejudice, we
refer to these transactions as SILO transactions.
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(1) JOHN HANCOCK LIFE INS. CO. (U.S.A.) v. COMM’R 7
(1) Osterreichische Bundesbahnen (OBB), a Government-
owned Austrian corporation that operates the Austrian Fed-
eral railway system, and (2) Socie´te´ Nationale des Chemins
de Fer Belges (SNCB), a Belgian company that owns and
operates the national rail system of Belgium. 5 The counter-
parties for the SILO test transactions are: (1) Tiwag-Tiroler
Wasserkraft AG (TIWAG), an Austrian corporation that is
owned by the Austrian Province of Tyrol and is in the busi-
ness of generating, transmitting, and distributing electrical
power to commercial and residential consumers in Tyrol; (2)
the City of Dortmund, Germany (Dortmund); 6 and (3) SNCB.
The issues for decision are: (1) whether the principal place
of business for petitioner in docket No. 7083–10 was in
Massachusetts or Michigan; (2) whether the test transactions
lacked economic substance resulting in disallowance of peti-
tioners’ claimed deductions for rent, depreciation, interest,
and transaction expenses; (3) whether under the substance
over form doctrine, the substance of the test transactions was
a purchase of a future interest, inconsistent with its form,
resulting in disallowance of petitioners’ claimed deductions
for rent, depreciation, interest, and transaction expenses; or
(4) alternatively, whether under the substance over form doc-
trine, the substance of the test transactions was a financing
arrangement, inconsistent with its form, resulting in genera-
tion of original issue discount (OID) income and the disallow-
ance of petitioners’ claimed deductions for rent, depreciation,
and interest expenses.
5 SNCBis the counterparty to two LILO test transactions. At trial and
on brief these LILO transactions were referred to as SNCB 2 and SNCB
5 lot 1. For purposes of this Opinion, we refer to them individually in the
same manner and collectively as the SNCB LILO transactions.
6 Dortmund is the counterparty to two SILO test transactions, referred
to at trial and on brief as the Dortmund 1 and Dortmund 2 transactions.
The assets subject to the Dortmund 1 transaction are Halls 1, 2, and 3A
of the Westfalenhallen Dortmund Trade Fair, Event, and Congress Center
Complex and the associated facility sites. The assets subject to the Dort-
mund 2 transaction are Halls 4–8 of the Westfalenhallen Dortmund Trade
Fair, Event, and Congress Center Complex and the associated facility
sites. In all other material respects, Dortmund 1 and Dortmund 2 are iden-
tical. Therefore, for purposes of this Opinion, we refer to them individually
as Dortmund 1 and Dortmund 2, and collectively as the Dortmund trans-
actions.
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8 141 UNITED STATES TAX COURT REPORTS (1)
FINDINGS OF FACT
Some of the facts have been stipulated and are so found.
The stipulations of fact, together with those attached exhibits
which were found relevant and admissible, are incorporated
herein by this reference. At the time they filed their peti-
tions, the principal place of business of petitioners in docket
Nos. 6404–09 and 7084–10 was in Massachusetts. There is a
dispute among the parties as to whether the principal place
of business of petitioner in docket No. 7083–10 was in
Massachusetts or Michigan.
Background
I. John Hancock’s History
John Hancock Mutual Life Insurance Co. (JH Mutual) was
incorporated in Massachusetts in 1862. In February 2000 JH
Mutual converted from a mutual life insurance company to
a publicly traded company. At that time it was renamed
John Hancock Life Insurance Co. (JHLIC) and became a
wholly owned subsidiary of John Hancock Financial Services,
Inc. (JHFS). In April 2004 Manulife Financial Corp., a
Canadian company (Manulife), acquired JHFS and all of its
subsidiary corporations. Pursuant to a restructuring, on
December 31, 2009, John Hancock Life Insurance Co.
(U.S.A.) (JHUSA) succeeded JHLIC. A subsidiary of
Manulife, the Manufacturer’s Investment Co., a Michigan
general business corporation (MIC), succeeded JHFS. Unless
otherwise indicated, for purposes of this Opinion we refer to
JH Mutual, JHLIC, JHFS, JHUSA, MIC, and their subsidi-
aries collectively as John Hancock.
Throughout its history John Hancock’s primary business
has been the sale of life insurance policies, annuities, long-
term care insurance, and other retirement services. To fulfill
its contractual obligations under these services, John Han-
cock invests the premiums it receives. Because of the varying
lengths of John Hancock’s contractual obligations to its
policyholders, it seeks to invest in opportunities that match
its long- and short-term cashflow needs and provide an
appropriate return or yield for its assessed risk levels.
John Hancock’s financial needs require it to invest in a
diversified set of domestic and international assets. Between
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(1) JOHN HANCOCK LIFE INS. CO. (U.S.A.) v. COMM’R 9
1997 and 2001 John Hancock invested between $6.8 and $10
billion annually and managed a portfolio of investments val-
ued between $38.9 and $46.6 billion.
II. Investment Process and Review
Between 1997 and 2001 John Hancock’s committee of
finance oversaw its investments. The committee of finance
comprised members of John Hancock’s board of directors as
well as its chairman, vice chairman, and president. Com-
mittee of finance approval was required for all investments
of a designated size.
John Hancock’s bond and corporate finance group managed
the day-to-day responsibilities with respect to a significant
portion of the company’s investments, including bond port-
folios, private equity, and alternative asset investments. The
bond and corporate finance group was divided into teams.
For instance, the ‘‘industrial’’ team was charged with man-
aging investments in transportation, timber, industrial
equipment, mining, metal and communications assets. The
‘‘energy’’ team managed investments in power plants, power
companies, and other energy assets. The ‘‘international’’ team
managed cross-border investments. The work of each team
was connected to the ‘‘portfolio management’’ department,
which determined the types of investments and yields that
John Hancock needed to support its contractual obligations
to its policyholders. The division of responsibility within the
bond and corporate finance group allowed each team to spe-
cialize and develop an expertise in its designated industries.
Each of John Hancock’s investments went through a thor-
ough review process. Typically, a bond and corporate finance
group team was charged with drafting an investment rec-
ommendation, known within John Hancock as a ‘‘yellow
report’’. A yellow report analyzes a proposed investment in
numerous ways, including an analysis of the expected return,
risk profile, collateral support, credit rating of the relevant
parties to the transaction, term of the transaction, and any
special aspects of the investment. The yellow report was used
as an approval request for many of John Hancock’s invest-
ments.
John Hancock’s bond investment committee reviewed the
yellow reports. The bond investment committee held
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10 141 UNITED STATES TAX COURT REPORTS (1)
bimonthly meetings and comprised leaders from each of the
bond and corporate finance group’s industry teams. At each
bond investment committee meeting, the credit analyst
responsible for analyzing the investment featured in the yel-
low report presented the opportunity, discussed the risks and
rewards of the investment, and fielded questions from the
committee. After review and consideration, the bond invest-
ment committee’s members voted to approve or deny an
investment. If an investment was approved, it moved to the
committee of finance for further review and approval.
Generally, a committee of finance meeting was held once
a month. However, in certain circumstances the bond invest-
ment committee was granted ‘‘between meeting authority’’ to
enter into an investment normally requiring further
approval. ‘‘Between meeting authority’’ was necessary in
cases where John Hancock has to proceed with a time-sen-
sitive investment.
III. Leasing
In 1979 John Hancock formed a leasing company. Leasing
transactions were attractive to John Hancock because they
offered a higher after-tax return than traditional invest-
ments. A leveraged lease is 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. John Hancock partici-
pated in leveraged leases as both equity investor and lender.
A variety of assets were involved, including aircraft, medical
equipment, tractors, irrigation systems, barges, trailers,
grain silos, natural gas compressors, manufacturing equip-
ment, automobiles, and railcars.
IV. LILO and SILO Transactions
A. Basic Structure
John Hancock participated in 19 LILO transactions and 8
SILO transactions between 1997 and 2001. LILO and SILO
transactions are types of leveraged leases. In a typical LILO
transaction, a U.S. taxpayer, acting through a grantor trust, 7
7 The grantor trust is generally disregarded for Federal income tax pur-
poses.
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(1) JOHN HANCOCK LIFE INS. CO. (U.S.A.) v. COMM’R 11
leases assets from a foreign or domestic tax-exempt entity
and simultaneously leases that property back to the lessee. 8
The U.S. taxpayer prepays the initial lease’s rent, which is
funded through a nonrecourse loan from a third-party lender
and an equity contribution from the U.S. taxpayer. The
equity ordinarily ranges from 10% to 20% of the value of the
initial lease. Because the loan funding the debt portion of the
investment is nonrecourse, the U.S. taxpayer is entitled to
favorable accounting treatment on its financial statements
pursuant to Statement of Financial Accounting Standards
No. 13 (FAS 13). 9
The sublease has a shorter term than the initial lease. At
the end of the sublease term the tax-exempt entity has the
option to purchase the remainder of the U.S. taxpayer’s
leasehold interest in the initial lease. If the tax-exempt
entity chooses not to exercise this purchase option, the U.S.
taxpayer may elect to: (1) compel the tax-exempt entity to
renew the sublease; (2) take possession of the asset; or (3)
enter into a replacement sublease with a third party. Most
LILO and SILO transactions impose requirements upon a
tax-exempt entity that chooses not to exercise its purchase
option, such as refinancing the U.S. taxpayer’s nonrecourse
loan. If the tax-exempt entity cannot meet these require-
ments, it must ordinarily exercise the purchase option.
A typical SILO transaction is similar, except that the term
of the initial lease extends beyond the remaining useful life
of the asset. Therefore, the U.S. taxpayer takes the position
that the initial lease is a sale for U.S. Federal tax purposes.
Also, if the tax-exempt entity chooses not to purchase the
asset at the end of the sublease term, the U.S. taxpayer’s
options differ slightly. The U.S. taxpayer may (1) compel the
lessee to arrange for a service contract for the asset for a pre-
determined term or (2) take possession of the asset.
8 Each
lessee counterparty to the test transactions is a foreign entity.
These foreign entities are so called tax-indifferent entities because they are
not subject to U.S. taxation. For convenience we shall refer to these enti-
ties as tax-exempt entities.
9 FAS 13 addresses lease accounting for lessors and lessees taking part
in leveraged leases. FAS 13 enables earlier recognition of income relative
to other transactions with similar cashflows. Additionally, FAS 13 allows
nonrecourse debt used in a leveraged lease to be excluded from the liabil-
ities side of a balance sheet.
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12 141 UNITED STATES TAX COURT REPORTS (1)
‘‘Defeasance’’ is a common characteristic in most LILO and
SILO transactions. Defeasance is a way to minimize risk.
The form of the defeasance in a particular LILO or SILO
transaction will vary, but it is ordinarily accomplished
through one or more deposits with third-party financial
institutions, known as payment undertakers. In most LILO
and SILO transactions the U.S. taxpayer will require a debt
payment undertaking agreement (DPUA) as part of the
transaction, and often will require an equity payment under-
taking agreement (EPUA) as well. In a DPUA, the tax-
exempt entity deposits a portion of prepaid rent received
from the U.S. taxpayer funded by the nonrecourse loan with
the debt payment undertaker (DPU), sometimes related to
the lender, and in return the DPU agrees to make rent pay-
ments on behalf of the tax-exempt entity under the sublease.
The timing and amount of the tax-exempt entity’s rent under
the sublease usually matches the U.S. taxpayer’s debt service
payments on the nonrecourse loan. As a result, the DPU will
often pay the lender directly and neither the U.S. taxpayer
nor the tax-exempt entity makes any out-of-pocket payments
during the initial lease term.
In an EPUA, the tax-exempt entity deposits a portion of
the U.S. taxpayer’s equity investment with an equity pay-
ment undertaker (EPU). This deposit is designed to pay the
tax-exempt entity’s equity portion of rent payments, to grow
to cover the sublease termination value in case of a sublessee
default, and to fund the tax-exempt entity’s purchase option
at the end of the initial lease. As a result, the tax-exempt
entity is not forced to incur any additional out-of-pocket
expenses if it chooses to exercise its purchase option.
In addition to a DPUA and an EPUA, the U.S. taxpayer
in a LILO or SILO transaction may require additional protec-
tion, such as a pledge of the amounts deposited pursuant to
the DPUA or EPUA, or residual value insurance. If an
amount deposited with a payment undertaker is not pledged
to the U.S. taxpayer, the tax-exempt entity may have the
right to withdraw the deposit for its own use if it replaces
the deposit with approved substitute collateral, such as a
letter of credit. The tax-exempt entity retains the portion of
the equity contribution that is not deposited pursuant to an
EPUA. This amount is known as the tax-exempt entity’s ‘‘net
present value benefit’’ from the transaction.
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(1) JOHN HANCOCK LIFE INS. CO. (U.S.A.) v. COMM’R 13
The following graphics display the closing day and sub-
lease lease term cashflows 10 and the operating structure of
a basic single-lender LILO with debt and equity defeasance
during the sublease lease term. For purposes of this graphic,
the U.S. taxpayer’s grantor trust is the lessor and the tax-
exempt entity is the lessee during the sublease lease term.
The tax-exempt entity receives a fee for entering into the
transaction with the grantor trust. The equity contribution
(minus the fee) will then be invested by the equity payment
undertaker and will be used to pay a portion of the sublease
rent payments and fund the purchase option at the end of
the sublease term. The debt contribution will be invested by
the debt payment undertaker and will be used to pay a por-
tion of the sublease rent payments and eventually returned
to the lender as debt service payments on the nonrecourse
loan. Typically the lender and the debt payment undertaker
are related parties, and often the equity payment undertaker
is also related to the lender.
10 The graphic ignores transaction expenses that the U.S. taxpayer ordi-
narily pays on the closing date.
v:\files\photos\230211A.eps
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14 141 UNITED STATES TAX COURT REPORTS (1)
The dashed lines represent the theoretical flow of cash from
the payment undertakers to the tax-exempt entity, the tax-
exempt entity to the grantor trust, and the grantor trust to
the U.S. taxpayer and the lender. However, because the
timing and amount of the lessee’s sublease rent payments
and the lessor’s debt service payments match exactly, the
debt payment undertaker often pays the lender directly,
satisfying both the sublease rent and the debt service pay-
ment. Similarly, the equity payment undertaker’s sublease
rent ends up in the hands of the U.S. taxpayer as a return
of equity.
v:\files\photos\230211B.eps
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(1) JOHN HANCOCK LIFE INS. CO. (U.S.A.) v. COMM’R 15
Above is a combination of the closing day cashflows and the
sublease term cashflows. Together the two cashflows create
what is known as loop debt.
B. History
In 1975 the Internal Revenue Service (IRS) issued guide-
lines for advance ruling purposes in determining whether
leveraged lease transactions may be treated as leases for
Federal tax purposes. Rev. Proc. 75–21, 1975–1 C.B. 715. In
1981 Congress enacted safe harbor leasing rules for sale and
leaseback transactions that allowed taxpayers to lease prop-
erty from tax-exempt entities. Economic Recovery Tax Act of
1981, Pub. L. No. 97–34, 95 Stat. 172. These safe harbor
rules were repealed in 1982 because of adverse public reac-
tion and reduced tax revenues. Tax Equity and Fiscal
Responsibility Act of 1982, Pub. L. No. 97–248, 96 Stat. 324.
In 1984 Congress enacted what has become known as the
‘‘Pickle rule’’, which subjected property leased to a tax-
exempt entity to unfavorable depreciation rules. Deficit
Reduction Act of 1984, Pub. L. No. 98–369, 98 Stat. 494.
John Hancock began investing in LILO transactions in
1997. LILO transactions were designed to work around the
Pickle rule because the taxable party leased the property
involved, rather than purchasing it, and then immediately
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16 141 UNITED STATES TAX COURT REPORTS (1)
subleased the property back to the tax-exempt entity. LILO
transactions became popular means of raising funds for tax-
exempt entities. In fact, the Federal Transit Administration
(FTA) promoted and approved LILO and SILO transactions
between 1997 and 2001 as a means of providing cash infu-
sions for financially troubled public transit agencies.
In 1999 John Hancock and other similar investors ceased
to invest in LILO transactions because of a change to the
regulations under section 467, requiring that prepayment of
the initial lease rent be treated as a loan for tax purposes.
See sec. 1.467–4, Income Tax Regs. 11 In 2002 the IRS issued
Rev. Rul. 2002–69, 2002–2 C.B. 760, which determined that
a LILO transaction is more properly characterized as a
future interest in property and a taxpayer may not deduct
rent or interest paid or incurred in connection with such a
transaction. The IRS further stated that it would disallow
tax benefits claimed in connection with LILO transactions on
other grounds, including the substance over form and eco-
nomic substance doctrines. Id.
Unable to continue investing in LILO transactions, John
Hancock and other similar investors began investing in SILO
transactions. SILO transactions also avoided the pitfalls of
the Pickle rule because the service contract was arguably not
included in the lease term as long as it complied with section
7701(e). As a result, SILO transactions were designed to
allow the lessor to claim depreciation deductions over a
shorter term, increasing the transaction’s tax value.
In 2004 Congress enacted the American Jobs Creation Act
of 2004, Pub. L. No. 108–357, 118 Stat. 1418, eliminating the
benefits associated with LILO and SILO transactions. This
legislation was prospective in effect and was not designed to
alter the general principles of tax law that apply to deter-
mine the legitimacy of transactions designed to generate tax
deductions. See H.R. Conf. Rept. No. 108–755, at 660 (2004),
2004 U.S.C.C.A.N. 1341, 1720–1721.
11 The IRS proposed regulations that largely eliminated the tax benefits
associated with LILO transactions in 1996; these regulations became effec-
tive in 1999.
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(1) JOHN HANCOCK LIFE INS. CO. (U.S.A.) v. COMM’R 17
C. Due Diligence
John Hancock learned of opportunities to invest in LILO or
SILO transactions from promoters such as D’Accord Finan-
cial Services and Citigroup. A promoter acted as an adviser
to the counterparties in these transactions, drafted offering
memoranda, and solicited offers or bids from potential inves-
tors. After receiving an offering memorandum, John Hancock
would prepare an offer that was contingent on participation
of the lenders at agreeable terms, completion of internal and
external due diligence, and the receipt of approved expert
opinions and reports. If John Hancock was chosen to partici-
pate in the transaction, it engaged experts and attorneys to
help negotiate a term sheet. John Hancock set limitations for
its total investments in LILO and SILO transactions between
1997 and 2001 that were based on its ‘‘tax capacity’’, which
was determined on the basis of its ability to offset its taxable
income with losses.
As part of John Hancock’s internal assessment of a LILO
or SILO transaction, the bond and corporate finance group
drafted a yellow report. Each transaction had to receive the
approval of John Hancock’s bond investment committee and
committee of finance. John Hancock generally chose to
participate in LILO and SILO transactions where its spe-
cialty groups had a familiarity with the assets involved.
Team members of the bond and corporate finance group per-
formed site visits and inspected many of the subject assets
of the leveraged leases.
John Hancock also engaged a team of independent special-
ists and consultants as part of its due diligence process.
These specialists and consultants were relied upon to provide
appraisals, accounting advice, insurance advice, legal opin-
ions, engineering opinions, and market analysis with respect
to the relevant industries. John Hancock also relied upon a
financial modeling tool within the leasing industry known as
the ABC reports. Among other things, the ABC reports pro-
jected John Hancock’s pretax and after-tax financial con-
sequences for each transaction. The ABC reports provided
alternative simulations based on the assumption that the
counterparty to each LILO or SILO transaction exercised its
purchase option and on the assumption that the counterparty
did not exercise its purchase option.
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18 141 UNITED STATES TAX COURT REPORTS (1)
As part of John Hancock’s internal risk assessment, John
Hancock gave each LILO and SILO transaction a credit
rating based on the credit ratings of the counterparties, the
relevant defeasance, and the external specialty reports and
opinions. John Hancock’s internal credit rating for each LILO
transaction was AA1, one grade below John Hancock’s
highest credit rating of AAA. John Hancock’s internal credit
rating for each SILO transactions was AA3, a grade slightly
lower than AA1. John Hancock categorized its investments in
LILO and SILO transactions as bonds.
The securities valuation office of the National Association
of Insurance Commissioners (NAIC) evaluates and rates
investments held by insurance companies. Its highest rating
is NAIC 1, which is given to transactions that require the
least amount of regulatory capital. Each of John Hancock’s
LILO and SILO transactions was rated NAIC 1.
D. The Hoosier Transaction
In 2008 the financial sector experienced a credit crisis.
This crisis resulted in widespread credit downgrades of
financial institutions throughout the world, including down-
grades to the credit ratings of some of the payment under-
takers and insurance entities involved in John Hancock’s
LILO and SILO transactions. In one such case, John Han-
cock was forced to litigate with an Indiana cooperative, Hoo-
sier Energy, over a SILO transaction involving a coal-fired
power plant. Hoosier Energy Rural Elec. Coop., Inc. v. John
Hancock Life Ins. Co., 588 F. Supp. 2d 919 (S.D. Ind. 2008),
aff ’d, 582 F.3d 721 (7th Cir. 2009).
In 2002 John Hancock entered into a SILO transaction
with Hoosier in which John Hancock leased a coal-fired
power plant for 63 years and subleased it back to Hoosier for
30 years. John Hancock’s equity investment in the trans-
action was $56,772,812. John Hancock also spent
$12,830,640 in transaction expenses. As part of John Han-
cock’s security package, Hoosier obtained a credit default
swap from Ambac Assurance Corp. (Ambac). In 2008 Ambac’s
credit rating was downgraded, and John Hancock exercised
its right upon a credit downgrade under the transaction
documents to require Hoosier to replace Ambac. When Hoo-
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(1) JOHN HANCOCK LIFE INS. CO. (U.S.A.) v. COMM’R 19
sier was unable to replace Ambac within the specified period,
John Hancock tried to enforce its default rights.
Hoosier sought injunctive relief to prevent John Hancock
from enforcing its default rights while it continued to look for
a replacement for Ambac. The District Court for the
Southern District of Indiana granted Hoosier’s request for
injunctive relief, and the Court of Appeals for the Seventh
Circuit affirmed, giving Hoosier approximately 31⁄2 months to
find a replacement. During this period, John Hancock and
Hoosier settled their dispute. In this settlement, Hoosier
agreed to pay John Hancock $68 million.
The LILO Test Transactions
In connection with each of the test transactions John Han-
cock entered into numerous agreements covering thousands
of pages and conferring various rights and obligations upon
the parties involved. 12 The general rights and obligations
created as part of each test transaction are similar. However,
the details of those rights and obligations vary from trans-
action to transaction. In each case, a ‘‘participation agree-
ment’’ governs the interaction of the agreements to the trans-
action and provides, among other things, a general frame-
work for the transaction’s structure. Each transaction
includes numerous agreements, including an initial lease and
sublease, known as the ‘‘head lease’’ and the ‘‘lease’’ in some
cases. For simplicity and consistency, we refer to the head
lease in each transaction as the initial lease and the lease as
the sublease. 13 Our reference to the transaction in this way
is for convenience and is not dispositive of the status of a
12 John
Hancock did not directly participate in any of the test trans-
actions. Rather, John Hancock established a grantor trust through which
it participated. These grantor trusts are generally disregarded for Federal
income tax purposes and thus do not affect our analysis. Therefore, they
are disregarded for purposes of this Opinion.
13 Each test transaction includes a tax indemnity agreement. The tax in-
demnity agreements provide that the lessee counterparty will indemnify
John Hancock should John Hancock lose its rights to claim the expected
tax benefits from the test transactions because of certain enumerated rea-
sons. Unlike the taxpayer in Historic Boardwalk Hall, LLC v. Commis-
sioner, 694 F.3d 425 (3d Cir. 2012), rev’g
136 T.C. 1 (2011), John Hancock
is not protected if its tax benefits are reduced as a result of an IRS chal-
lenge.
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20 141 UNITED STATES TAX COURT REPORTS (1)
transaction or the determination of the benefits and burdens
of ownership. The basic structures and relevant details of
each of the LILO test transactions are described below.
I. OBB LILO
A. Lease and Sublease
1. The Asset
The OBB transaction closed on June 18, 1998. The asset
subject to the OBB transaction is the Vienna Kledering Mar-
shalling Yard (VK marshalling yard), which opened in 1996.
Its primary function is ‘‘shunting’’, or the splitting up of
freight cars from incoming trains, sorting them, and
attaching them to outbound trains headed to their final des-
tinations in Europe. The VK marshalling yard has the
capacity to process over 6,100 freight cars daily and is one
of the largest marshalling yards in eastern Europe.
Deloitte & Touche (Deloitte) appraised the VK marshalling
yard for the OBB transaction at a fair market value, as of
the closing date, of $352,711,000. This value served as the
basis for determining John Hancock’s investment in the ini-
tial lease. John Hancock and OBB did not further negotiate
this investment amount. The appraisal further determined
that as of the closing date, the VK marshalling yard had a
remaining economic useful life of approximately 48 years.
The appraisal used both the cost method of valuation and the
discounted cashflow method in reaching its fair market value
determination but based its conclusion on the cost method
because of a lack of reliable data with respect to expected
revenues and expenses from the VK marshalling yard.
Deloitte also estimated the residual value of John Hancock’s
remaining leasehold interest in the VK marshalling yard at
the end of the sublease term to be $105,107,878. The
appraisal relied upon the discounted cashflow method to
reach this residual value determination, stating that the cost
approach was inapplicable and that the residual value of
John Hancock’s remaining leasehold interest would depend
upon the cashflows the VK marshalling yard would generate
during the remainder of the initial lease term.
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(1) JOHN HANCOCK LIFE INS. CO. (U.S.A.) v. COMM’R 21
2. Terms
On the closing date, OBB leased the VK marshalling yard
to John Hancock for a term of approximately 38 years.
Simultaneously, John Hancock subleased the VK marshalling
yard back to OBB for a term of approximately 18 years. At
the end of the sublease term OBB was given the option of
purchasing John Hancock’s leasehold interest in the VK mar-
shaling yard.
3. Rent and Financing
a. Initial Lease
The initial lease required John Hancock to make an up-
front payment to OBB of $309,375,024 and a deferred rent
payment of $2,295,340,042 on November 12, 2041, five years
after the end of the initial lease term. To fund the up front
payment, John Hancock contributed $65,980,517 and bor-
rowed $243,394,507 from Creditanstalt AG (Credit AG) on a
nonrecourse basis. John Hancock also paid $8,817,775 of
transaction expenses.
b. Sublease and Defeasance
Pursuant to the sublease, OBB agreed to pay rent to John
Hancock. In order to fund the sublease rent payments OBB
entered into a number of defeasance agreements. Pursuant to
a DPUA, on the closing date OBB deposited the $243,394,507
John Hancock borrowed from Credit AG and paid to OBB as
an up front rent payment with CA-Leasing GmbH (CA
Leasing), an affiliate of Credit AG. In return, CA Leasing
agreed to make a series of payments on behalf of OBB which
exactly match John Hancock’s debt service payments to
Credit AG in amounts and timing. As a result, pursuant to
the transaction documents, CA Leasing pays Credit AG
directly to satisfy John Hancock’s debt service and OBB’s
sublease rent.
Credit AG guaranteed CA Leasing’s payments under the
DPUA. The DPUA and guaranty do not eliminate OBB’s
legal obligation to pay rent under the sublease. In certain cir-
cumstances, OBB is entitled to replace the DPUA with sub-
stitute collateral, including a qualified letter of credit.
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22 141 UNITED STATES TAX COURT REPORTS (1)
On June 19, 1998, one day after the closing date, OBB
entered into a swap agreement with Merrill Lynch Capital
Services, Inc. (Merrill Lynch). Pursuant to this agreement,
OBB paid Merrill Lynch $45,380,000 from John Hancock’s
$65,980,517 of equity contribution in exchange for Merrill
Lynch’s agreement to make payments to OBB in accordance
with a specified schedule, including payments to fund OBB’s
purchase option if exercised. Further, an affiliate of Merrill
Lynch guaranteed Merrill Lynch’s obligations pursuant to
the swap agreement. OBB pledged a first-priority security
interest in the swap agreement to John Hancock as collateral
for its obligations under the sublease. OBB retained the
excess of the up front rent payment from John Hancock to
OBB pursuant to the initial lease over the amounts OBB
deposited with CA Leasing and Merrill Lynch under the
DPUA and swap agreement, respectively. This amount is
OBB’s cash takeaway from the transaction, or what the par-
ties refer to as OBB’s ‘‘net present value benefit’’.
On the closing date, OBB also provided John Hancock with
a letter of credit issued from Bank Austria Aktiengesellschaft
(Bank Austria). Under the letter of credit, Bank Austria is
required to pay John Hancock a specified amount in the
event OBB defaults on its obligations pursuant to the sub-
lease. This potential payment eliminated any of John Han-
cock’s risk of exposure that was not covered under the DPUA
and the swap agreement. The DPUA, swap agreement,
guaranties, pledge, and letter of credit were all required in
the OBB transaction under the participation agreement. As
a result of the structure in place, the OBB LILO transaction
is fully defeased.
4. Property Rights and Obligations
The initial lease grants John Hancock the right to ‘‘posses-
sion, use and quiet enjoyment’’ of the VK marshalling yard.
The initial lease is a net lease, meaning that it requires John
Hancock to insure, maintain, and repair the VK marshalling
yard. John Hancock may satisfy these requirements through
its participation in the sublease. John Hancock’s participa-
tion in the sublease is required under the participation
agreement.
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(1) JOHN HANCOCK LIFE INS. CO. (U.S.A.) v. COMM’R 23
OBB’s rights and obligations under the sublease with
respect to possession and use of the VK marshalling yard are
nearly identical to John Hancock’s rights and obligations
under the initial lease, including the right to ‘‘quiet enjoy-
ment’’ of the VK marshalling yard. The sublease grants OBB
the right to modify the VK marshalling yard, subject to cer-
tain restrictions. OBB is further restricted, with certain
exceptions, from subleasing the VK marshalling yard or cre-
ating or permitting a lien on the VK marshalling yard. John
Hancock has the right to visit and inspect the VK marshal-
ling yard.
5. Default
If John Hancock defaults on its obligations under the ini-
tial lease, OBB may require John Hancock to return the VK
marshalling yard, terminate the lease, and demand liq-
uidated damages. In the ‘‘Event of Loss’’, the lease termi-
nates and John Hancock is required to pay a stipulated value
to OBB. An ‘‘Event of Loss’’ is defined to include, among
other things, actual loss of the VK marshalling yard due to
damage or governmental seizure.
John Hancock’s rights against OBB in the case of a lessee
default under the sublease are similar. John Hancock is enti-
tled to collect on the ‘‘Termination Value’’ of the sublease,
take possession of the VK marshalling yard, sell the VK mar-
shalling yard, and terminate the sublease. The sublease
termination value is predetermined and is designed to pro-
vide John Hancock with a return on its equity investment.
In the case of an ‘‘Event of Loss’’ under the sublease, which
is the equivalent to the event of loss under the initial lease,
the initial lease ends and OBB must pay John Hancock the
termination value. Additionally, all rents are due from OBB
to John Hancock, and OBB must pay John Hancock an addi-
tional amount to offset the stipulated value John Hancock is
required to pay OBB under the initial lease.
B. End of Sublease Term
1. OBB’s Purchase Option
At the end of the sublease term OBB has the option to pur-
chase John Hancock’s leasehold interest in the VK marshal-
ling yard for $153,817,825, payable in predetermined install-
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24 141 UNITED STATES TAX COURT REPORTS (1)
ments. The payments due to OBB from CA Leasing and Mer-
rill Lynch match exactly the purchase option price and
timing. If OBB exercises its purchase option, all agreements
executed pursuant to the OBB LILO transaction will termi-
nate and John Hancock will no longer be required to pay
OBB the deferred rent payment under the initial lease.
2. John Hancock’s Options
If OBB does not exercise its purchase option, John Han-
cock may choose among three alternatives. John Hancock
may elect to: (1) renew the sublease; (2) replace OBB and
lease the VK marshalling yard to another lessee; or (3) take
possession of the VK marshalling yard. In all three scenarios
John Hancock must provide OBB with acceptable collateral
to secure John Hancock’s obligations to pay the deferred rent
payment under the initial lease.
a. Renewal Option
The renewal option extends John Hancock’s sublease with
OBB for approximately 13 years and includes a set of
prenegotiated rent payments during the renewal term
totaling $642,175,362. These rent payments have two compo-
nents. First, the current portion of renewal rent is equal to
$213,241,461 and is payable throughout the renewal term.
The remainder, or $428,933,901, is deferred and payable at
the end of the renewal term. Combined, these rent payments
ensure John Hancock’s return on its equity investment. At
the end of the renewal term John Hancock would take
possession of the VK marshalling yard for the remainder of
the initial lease term.
If John Hancock elects to renew the sublease, OBB must
arrange for either an extension of the nonrecourse loan from
Credit AG to John Hancock or for another lender to replace
Credit AG as the lender under substantially the same terms
as the original loan. If OBB is unable to do so, it must pur-
chase up to 49% of the principal outstanding on the loan
from Credit AG and attempt to again extend the remaining
loan or find a replacement lender. If OBB is still unable to
extend the loan or find a replacement lender, it again has the
option of choosing to exercise the purchase option.
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(1) JOHN HANCOCK LIFE INS. CO. (U.S.A.) v. COMM’R 25
If OBB elects the renewal option, it must also arrange for
collateral substantially identical to the swap agreement and
letter of credit to secure the equity portion of rent during the
renewal term. OBB may also be required to provide collateral
to secure the debt portion of rent during the renewal term
if the replacement lender deems it necessary for the loan
extension.
b. Replacement Option
Under the replacement option, OBB must cooperate with
John Hancock in the negotiation, execution, and delivery of
a replacement lease. However, John Hancock bears the costs
incurred in connection with the replacement lease. The
replacement lease does not have to mirror the renewal lease.
John Hancock, and not OBB, must arrange for a loan exten-
sion for its nonrecourse loan from Credit AG or find a
replacement lender. If John Hancock is unable to do so, it
must purchase the remaining principal of the loan from
Credit AG. Further, if John Hancock is unable to find a
replacement lessee within 30 days of the end of the sublease
term, it will be deemed to have selected the renewal option.
c. Retention Option
Under the retention option, John Hancock must arrange
for payments in satisfaction of the principal of its non-
recourse loan from Credit AG. If John Hancock is unable to
do so within 30 days of the end of the sublease term, it will
be deemed to have selected the renewal option.
II. SNCB 2 and SNCB 5 Lot 1 LILO Transactions
A. Lease and Sublease
1. The Assets
The SNCB 2 and SNCB 5 lot 1 transactions closed on Sep-
tember 29 and December 15, 1997, respectively. The
Kingdom of Belgium owns 99.9% of SNCB, which was reorga-
nized as a limited liability company under Belgian public law
in 1991. 14 SNCB operates and maintains domestic and inter-
14 In
2005 SNCB again reorganized with SNCB being renamed SNCB
Holding. Under the reorganization SNCB formed two subsidiaries, SNCB
Continued
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26 141 UNITED STATES TAX COURT REPORTS (1)
national passenger trains and freight rolling stock in Bel-
gium. The asset subject to the SNCB 2 transaction is the
Thalys highspeed trainset (Thalys trainset), which consists of
two power units and eight passenger cars, holds approxi-
mately 400 people, and is used for highspeed international
travel. The assets subject to the SNCB 5 lot 1 transaction are
eight electric motive units (EMUs). The EMUs are three-car
trainsets consisting of a driving car and two trailer cars and
are used predominantly for intercity service.
Deloitte appraised the Thalys trainset at a fair market
value of $34,267,200 on the closing date of the SNCB 2
transaction. Deloitte separately appraised the EMUs at a fair
market value of $61,371,200 on the closing date of the SNCB
5 lot 1 transaction. As in the OBB transaction, these values
served as the basis for determining John Hancock’s invest-
ments in the transactions, and the parties did not further
negotiate the investment amounts. Deloitte concluded that as
of the closing dates of the SNCB 2 and SNCB 5 lot 1 trans-
actions, the Thalys trainset and the EMUs had remaining
economic useful lives of 42 and 45 years, respectively. The
appraisals used both the cost method and the discounted
cashflow method in their fair market value determinations
but chose to rely on the cost method because of a lack of reli-
able data with respect to expected revenues and expenses in
connection with the assets. Deloitte also appraised John
Hancock’s remaining leasehold interests in the Thalys
trainset and EMUs at the end of the subleases, estimating
the residual values to be $7,774,387 and $14,483,603, respec-
tively.
2. Terms
As part of the SNCB 2 transaction John Hancock leased
the Thalys trainset from SNCB for a term of approximately
34 years. Simultaneously, John Hancock subleased the
Thalys trainset back to SNCB for a term of approximately 15
years. In the SNCB 5 lot 1 transaction John Hancock leased
the EMUs from SNCB for a term of approximately 34 years.
Simultaneously, John Hancock subleased the EMUs back to
SNCB for a term of approximately 16 years. SNCB has the
and Infrabel, both public limited liability companies. For purposes of this
analysis, we refer to SNCB Holding and its subsidiaries as SNCB.
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(1) JOHN HANCOCK LIFE INS. CO. (U.S.A.) v. COMM’R 27
option of purchasing John Hancock’s leasehold interests in
the Thalys trainset and EMUs at the end of each trans-
action’s sublease term.
3. Rent and Financing
a. Initial Lease
Similar to the OBB transaction, the initial lease in each of
the SNCB LILO transactions required John Hancock to make
an up-front rent payment on the closing date and a deferred
rent payment five years after the end of each initial lease
term. John Hancock contributed $6,314,390 and $12,164,454
to the SNCB 2 and SNCB 5 lot 1 transactions, respectively,
and borrowed $23,957,351 and $42,725,648 to fund the
remainder of the up-front payments on a nonrecourse basis
from Eurofima European Co. for the Financing of Railroad
Rolling Stock (Eurofima). John Hancock also paid transaction
expenses of $733,318 and $797,826 as part of the SNCB 2
and SNCB 5 lot 1 transactions, respectively.
b. Sublease and Defeasance
Pursuant to the subleases, SNCB agreed to pay rent to
John Hancock. Similar to the OBB LILO, in order to fund its
sublease rent payments SNCB entered into a number of
defeasance agreements. The debt defeasance in each trans-
action is accomplished through a prepaid currency swap
whereby SNCB and Eurofima agreed to swap specified
amounts of U.S. dollars for Belgian francs on specified dates.
Similar to the DPUA in the OBB transaction, the payments
due from Eurofima to SNCB exactly match John Hancock’s
debt service payments to Eurofima in amount and timing.
The equity defeasance in each SNCB LILO transaction is
governed by a pledged collateral account agreement (PCAA)
with Merrill Lynch. Pursuant to the PCAAs, SNCB deposited
a specified amount with Merrill Lynch to secure the equity
portion of sublease rent, sublease termination value, and the
amount required for SNCB’s purchase options. John Hancock
was granted a first-priority security interest in each of the
PCAAs. SNCB’s net present value benefit in the SNCB LILO
transactions is the difference between John Hancock’s up-
front payments under the initial leases and the respective
amounts deposited and paid pursuant to the currency swaps
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28 141 UNITED STATES TAX COURT REPORTS (1)
and PCAAs. As a result of the structure in place, the SNCB
LILO transactions are fully defeased.
4. Property and Default Rights and Obligations
John Hancock’s and SNCB’s property and default rights
and obligations pursuant to the initial leases and subleases
of the SNCB LILO transactions are substantially similar to
those conferred under the initial lease and sublease of the
OBB transaction. The most significant difference between the
OBB transaction and the SNCB LILO transactions is that in
each of the SNCB LILO transactions the counterparty,
SNCB, has limited right under the subleases to replace the
subject assets.
B. End of Sublease Term
According to the appraisals, the fixed purchase option price
in each of the SNCB LILO transactions is greater than the
expected fair market values of the respective assets on the
purchase option dates. If SNCB exercises its purchase
options with respect to the SNCB LILO transactions, all
agreements executed pursuant to the transactions would
terminate and John Hancock would no longer be required to
pay the deferred rent payments under the initial leases.
If SNCB does not exercise its purchase options, John Han-
cock may renew the subleases, replace SNCB with a different
lessee, or take possession of the assets. The rights and
obligations conferred upon John Hancock under each option
are substantially similar to those described with respect to
the OBB transaction.
The SILO Test Transactions
Several characteristics distinguish John Hancock’s SILO
transactions from its LILO transactions. First, because the
length of the initial lease exceeds the estimated economic
useful life of the asset, John Hancock treated each SILO
transaction as a sale for U.S. Federal tax purposes. Next, a
service contract option replaces the renewal and replacement
leases if the lessee forgoes its purchase option. And finally,
pursuant to section 467 the sublease rent payments are
treated as a loan from the lessee counterparty to the U.S.
taxpayer (section 467 loan). Section 467 imputes a loan and
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(1) JOHN HANCOCK LIFE INS. CO. (U.S.A.) v. COMM’R 29
adds an interest component to a lease in certain cases where
the allocation of rent payments does not match the dates
when actual payments are due. In the case of John Hancock’s
SILO transactions, the lessee counterparties prepay their
sublease rent payments, creating a section 467 loan from the
lessee counterparty to John Hancock.
I. TIWAG
A. Lease and Sublease
1. The Assets
The TIWAG transaction closed on December 21, 2001.
TIWAG is a regional energy utility in the Province of Tyrol,
Austria. The asset subject to the TIWAG transaction is a
21.6% undivided interest in the Sellrain-Silz hydropower
facility (Sellrain-Silz). Sellrain-Silz is a pumped storage,
hydroelectric generating facility. The water powering the
facility comes from an area covering 139 square kilometers
in the northern Stubai Alps. Sellrain-Silz is an important
component in TIWAG’s power supply. According to the most
recent public data, in 2008 Sellrain-Silz produced 21% of
TIWAG’s total power generation and 4% of TIWAG’s total
power sold.
Deloitte appraised the 21.6% undivided interest in
Sellrain-Silz as of the closing date of the TIWAG transaction
at a fair market value of $323,136,000, with a remaining eco-
nomic useful life of 75 years. This appraised fair market
value served as the basis for determining John Hancock’s
investment in the transaction, and the parties did not fur-
ther negotiate the investment amount. Further, Deloitte esti-
mated that as of the end of the sublease and service contract
terms the fair market value of the 21.6% undivided interest
in Sellrain-Silz would be $648,210,816 and $778,757,760,
respectively. Deloitte used the discounted cashflow method in
its fair market value determinations.
2. Terms
On the closing date John Hancock leased the 21.6% undi-
vided interest in Sellrain-Silz from TIWAG for a term of
approximately 94 years. Simultaneously, John Hancock sub-
leased the 21.6% undivided interest in Sellrain-Silz to
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30 141 UNITED STATES TAX COURT REPORTS (1)
TIWAG for a term of approximately 35 years. Because the
term of the initial lease exceeded its estimated remaining
economic useful life, the parties treated it as a sale for U.S.
tax purposes. TIWAG has the option of purchasing John
Hancock’s leasehold interest in Sellrain-Silz at the end of the
sublease term.
3. Rent and Financing
a. Initial Lease
On the closing date John Hancock paid TIWAG $323 mil-
lion pursuant to the initial lease. To fund this payment, John
Hancock contributed $49,427,050 in equity and borrowed a
total of $273,572,950 from two lenders on a nonrecourse
basis: $246,215,655 from Mercantile Leasing Co. (Mercantile)
(series A loan) and $27,357,295 from Bank fu¨r Tiroler und
Vorarlberg (BTV) (series B loan). John Hancock paid
$4,037,500 of transaction expenses.
b. Sublease and Defeasance
Pursuant to the sublease, TIWAG agreed to pay rent to
John Hancock. The sublease required many of these pay-
ments to be made before the period to which they were allo-
cated. The prepayment of rent is treated as a loan from
TIWAG to John Hancock under section 467. At the end of the
sublease term the section 467 loan balance is expected to be
$636,037,102. In order to fund the sublease rent payments,
TIWAG entered into a number of defeasance agreements.
Unlike John Hancock’s LILO transactions, the SILO trans-
actions do not require full defeasance. Rather, the trans-
action documents only require the proceeds of the series A
loan to be set aside pursuant to a DPUA. In the TIWAG
transaction, pursuant to the series A DPUA, TIWAG paid
$246,215,655 to Barclays Bank PLC (Barclays) on the closing
date. In return, Barclays agreed to make a series of pay-
ments on behalf of TIWAG which exactly match John Han-
cock’s debt service payments to Mercantile under the series
A loan. As a result, the transaction documents allow for pay-
ments directly from Barclays to the series A lender, Mer-
cantile, to satisfy John Hancock’s series A debt service and
a portion of TIWAG’s sublease rent. The series A DPUA is
a three-party agreement that includes John Hancock, pro-
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(1) JOHN HANCOCK LIFE INS. CO. (U.S.A.) v. COMM’R 31
viding John Hancock with a priority interest in the deposit
in the event TIWAG defaults on its sublease rent obligations.
Barclays is an affiliate of the series A lender, Mercantile.
However, Mercantile did not guarantee Barclay’s payments
under the series A DPUA. TIWAG remains legally respon-
sible for all rent and other obligations under the sublease. In
certain circumstances TIWAG may replace the series A
DPUA with substitute collateral, including a qualified letter
of credit.
In addition to the series A DPUA, TIWAG entered into a
series B DPUA and an EPUA on the closing date. TIWAG’s
series B DPUA and EPUA were arranged and agreed upon
outside of the SILO transaction. The documents governing
the TIWAG transaction do not require these agreements.
John Hancock is not a party to either agreement, and neither
is pledged to John Hancock.
Pursuant to the series B DPUA, TIWAG deposited
$29,585,454 with Dexia Credit Local (Dexia). In return Dexia
agreed to make a series of payments on behalf of TIWAG
which exactly match John Hancock’s debt service payments
to BTV under the series B loan. The payments from the
series A DPUA and the series B DPUA exactly satisfy
TIWAG’s debt portion of sublease rent. 15 Dexia is not an
affiliate of BTV, the series B lender.
Pursuant to the EPUA, TIWAG deposited $23.1 million
with UBS AG (UBS). In return UBS agreed to make a series
of payments on behalf of TIWAG pursuant to a specified
schedule covering the equity portion of sublease rent and
funding a portion of TIWAG’s purchase option if exercised.
TIWAG’s net present value benefit in the transaction is
approximately $24.1 million, equaling the difference between
John Hancock’s investment in the initial leases, $323 million,
and the amounts paid to Barclays, Dexia, and UBS pursuant
to the series A DPUA, series B DPUA, and EPUA.
Although the series B DPUA and the EPUA were not
required pursuant to the TIWAG transaction documents,
John Hancock knew of TIWAG’s intention to enter into such
agreements because the defeasance agreements allowed
15 Throughout the sublease term, TIWAG’s sublease rent payments ex-
ceed John Hancock’s debt service payments by approximately $10 million.
This $10 million is known as the ‘‘equity portion’’ of sublease rent.
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32 141 UNITED STATES TAX COURT REPORTS (1)
TIWAG to receive beneficial accounting treatment under
European accounting principles (European GAAP). Even if
TIWAG decided not to enter into a series B DPUA and EPUA
on the closing date, the transaction documents required such
agreements or other similar qualifying collateral upon the
occurrence of certain trigger events such as a credit down-
grade or majority ownership change in TIWAG. As a pre-
caution John Hancock preapproved a ‘‘form’’ of the series B
DPUA and the EPUA as well as Dexia and UBS as qualified
payment undertakers. The ‘‘form’’ series B DPUA and EPUA
are identical to TIWAG’s actual agreements absent the
information specific to the timing and participating parties.
4. Property Rights and Obligations
The initial lease grants John Hancock the right to use,
operate, maintain or possess the 21.6% undivided interest in
Sellrain-Silz. During the initial lease term TIWAG cannot
sell, dispose of, or create a security interest in the property
without John Hancock’s consent. The initial lease also
restricts TIWAG’s rights to consolidate or merge with
another company or spin off, convey, transfer, or lease
substantially all of its assets to another party.
TIWAG’s rights and obligations under the sublease with
respect to possession and use of the 21.6% undivided interest
in Sellrain-Silz are nearly identical to John Hancock’s rights
and obligations under the initial lease. The sublease is a net
lease, meaning that TIWAG is responsible for maintenance,
insurance, and operational costs. During the sublease term
TIWAG generally cannot create or permit any lien on the
21.6% undivided interest in Sellrain-Silz. John Hancock has
the right to visit and inspect Sellrain-Silz twice a year.
On the closing date John Hancock and TIWAG also
entered into an ‘‘Agreement of Servitude’’ pursuant to which
TIWAG granted John Hancock a right-of-way to specified
land parcels at Sellrain-Silz (ROW agreement). The ROW
agreement provides John Hancock access to the road that
leads from the public road to the upper dam of Sellrain-Silz.
This right-of-way was registered with the land registry at the
district court in Silz, Austria. Upon the occurrence of a
‘‘Trigger Event’’, John Hancock has the right to purchase cer-
tain parcels of land related to Sellrain-Silz. A trigger event
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(1) JOHN HANCOCK LIFE INS. CO. (U.S.A.) v. COMM’R 33
includes, among other things, TIWAG’s selling or imposing a
mortgage or pledge on specified land connected with Sellrain-
Silz.
5. Default
Neither John Hancock nor TIWAG has the right to declare
the initial lease in default and pursue remedies. However,
under the sublease, John Hancock has certain remedies
against TIWAG in the case of a ‘‘Lessee Event of Default’’.
In such a case, John Hancock is entitled to collect on the
‘‘Termination Value’’ of the sublease. John Hancock may also
take possession of, sell, or sublease the 21.6% undivided
interest in Sellrain-Silz. Just as in John Hancock’s LILO
transactions, termination value is predetermined on the
closing date and ensures John Hancock’s return on its equity
investment. TIWAG must also pay John Hancock the termi-
nation value in the case of a ‘‘Lease Event of Loss’’, which
includes actual loss or seizure of Sellrain-Silz.
B. End of Sublease Term
1. TIWAG’s Purchase Option
At the end of the sublease term TIWAG has the option of
purchasing John Hancock’s leasehold interest in Sellrain-Silz
for $795,135,940. If TIWAG exercises the purchase option,
John Hancock must pay TIWAG the amount due under the
section 467 loan, and all agreements executed pursuant to
the TIWAG transaction would terminate. The section 467
loan balance exactly matches the first installment of the pur-
chase option. Therefore, if TIWAG exercises its purchase
option, these amounts offset each other. The remaining
installments of the purchase option price are financed
through TIWAG’s EPUA, meaning that if TIWAG exercises
the purchase option, it does not have to contribute or borrow
any additional cash.
2. John Hancock’s Options
If TIWAG does not exercise its purchase option, John Han-
cock has two choices. First, it may elect to require TIWAG
to arrange for a service contract between John Hancock and
one or more power purchasers. Second, it may elect to take
possession of the 21.6% undivided interest in Sellrain-Silz. In
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34 141 UNITED STATES TAX COURT REPORTS (1)
either case, TIWAG must ensure at its own expense that
Sellrain-Silz is in satisfactory condition in accordance with
all regulatory and other requirements.
Similar to the LILO test transactions, neither party has
advanced a compelling reason John Hancock would select the
retention option in any of the SILO test transactions. There-
fore, as the parties have, we focus our discussion for each
SILO test transaction on the service contract option.
Under the service contract option, TIWAG must procure
one or more ‘‘Qualified Bidders’’ to enter into one or more
power purchase agreements with John Hancock and arrange
for an operator of the 21.6% undivided interest in Sellrain-
Silz during the service contract term. TIWAG must also find
a bank to refinance the section 467 loan. A qualified bidder
cannot be the operator or be related to the operator of
Sellrain-Silz. TIWAG may be the power purchaser or the
operator but not both. The power purchase agreements must
match the service contract term which is prearranged on the
closing date to be approximately 25 years.
Any power purchaser must agree to make a series of pre-
determined payments throughout this term, known as the
‘‘Capacity Charges’’. These payments total $1,316,013,696. A
power purchaser is also required to pay for John Hancock’s
fixed and variable cost of operating the 21.6% undivided
interest in Sellrain-Silz. The capacity charges are set at
amounts that reflect the future fair market value of the asset
and cover John Hancock’s cost of servicing the refinanced
section 467 loan while paying John Hancock a specified
return. If John Hancock fails to make the required capacity
available to the service purchaser for any reason, including
force majeure, the capacity charges will be reduced in a
manner consistent with the service contract. The power pur-
chase agreements do not require credit support to secure the
power purchaser’s payments during the service contract
term. However, if at any point during the service contract
term a power purchaser’s credit rating were to fall below A
or A2 under S&P’s and Moody’s credit rating systems,
respectively, that power purchaser would be required to pro-
cure credit support in the form of a letter of credit or guar-
anty from a bank or guarantor with the requisite credit
rating.
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(1) JOHN HANCOCK LIFE INS. CO. (U.S.A.) v. COMM’R 35
John Hancock may also request that TIWAG acquire
residual value insurance to protect a portion of the value of
the 21.6% undivided interest in Sellrain-Silz at the end of
the service contract term. The amount of the residual value
insurance is the lesser of: (1) $205,422,256 or (2) 35% of the
appraised fair market value of the 21.6% undivided interest
in Sellrain-Silz at the end of the service contract term as
determined at or near the purchase option date. From the
end of the service contract term to the end of the initial lease
John Hancock would take possession of the 21.6% undivided
interest in Sellrain-Silz to use as it pleases.
If TIWAG fails to find qualified bidders to enter into the
power purchase agreements or fails to procure a bank to
refinance the section 467 loan, it may cure this failure
through the exercise of its purchase option. If TIWAG is able
to satisfy all the required conditions and a power purchase
agreement is in place, it will receive the proceeds of the sec-
tion 467 loan from John Hancock as well as the balance of
the EPUA.
II. Two Dortmund Transactions
A. Lease and Sublease
1. The Asset
The Dortmund transactions closed on December 20, 2001.
The assets subject to the Dortmund transactions are halls 1,
2, 3A, and 4–8 of the Westfalenhallen Dortmund Trade Fair,
Event, and Congress Center Complex (trade fair facility).
Dortmund is in the State of North Rhine-Westphalia, Ger-
many. Westfalenhallen Dortmund GmbH (Westfalenhallen),
a German limited liability company, operates the trade fair
facility through its subsidiaries, and Dortmund is the sole
owner of Westfalenhallen. The trade fair facility presents
more than 30 national and international trade fairs each
year. In 2000, the year before John Hancock entered into the
Dortmund transactions, more than 7,000 exhibitors and more
than 1 million visitors came to Dortmund for events hosted
in the trade fair facility. In 2004 Dortmund constructed hall
3B as an addition to the trade fair facility, which is not and
was never made part of the Dortmund transactions. John
Hancock and Dortmund executed servitude consent agree-
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36 141 UNITED STATES TAX COURT REPORTS (1)
ments so that the new hall would not adversely affect John
Hancock’s interest in the trade fair facility.
Deloitte appraised the trade fair facility. As of the closing
date of the Dortmund transactions, the appraisals 16 con-
cluded that the halls subject to the transactions had the fol-
lowing fair market values and remaining economic useful
lives:
Fair market Remaining useful
Hall value life in years
1 $31,661,000 60
2 10,295,000 55
3A 4,588,000 55
4 23,249,000 60
5 13,910,000 55
6 22,330,000 62
7 17,835,000 62
8 15,160,000 68
The appraisals were used to determine John Hancock’s
investment in the transactions, and the parties did not fur-
ther negotiate the investment amounts. According to the
appraisals, as of the purchase option date the expected fair
market value of the trade fair facility was determined to be
$242,882,556. The methodology used in the appraisals attrib-
uted 80% of the fair market value determinations to the dis-
counted cashflow method and 20% to the cost method.
2. Terms
On the closing date John Hancock leased the trade fair
facility from Dortmund for a term of 99 years. Simulta-
neously, John Hancock subleased the trade fair facility to
Dortmund for a term of approximately 30 years. This
arrangement required multiple agreements to incorporate
the entire trade fair facility. In each transaction, an initial
lease and sublease govern the parties’ rights and obligations
with respect to the halls. With respect to the facility sites
associated with each hall, the parties entered into a ‘‘Facility
Site Lease Agreement’’ for each transaction. Unless other-
wise stated, there are no material rights and obligations con-
16 Deloitte issued one appraisal for halls 1, 2, and 3A of the trade fair
facility and a second appraisal for halls 4–8.
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(1) JOHN HANCOCK LIFE INS. CO. (U.S.A.) v. COMM’R 37
ferred, pursuant to each facility site lease, that distinguish
the Dortmund transactions from John Hancock’s other SILO
test transactions for purposes of this Opinion. Dortmund has
the option of purchasing John Hancock’s leasehold interests
in the trade fair facility at the end of the sublease term.
3. Rent and Financing
a. Initial Lease
On the closing date of the Dortmund transactions John
Hancock made payments to Dortmund of $46,544,000 and
$92,484,000 pursuant to the initial lease agreements and
facility lease agreements of the Dortmund 1 and Dortmund
2 transactions, respectively. To fund these payments, John
Hancock contributed $7,379,928 for the Dortmund 1 trans-
action and $14,652,452 for the Dortmund 2 transaction. John
Hancock also borrowed approximately 90% of the debt from
Mercantile, equal to $35,247,665 and $70,048,393 for the
respective transactions (series A loans). The remaining 10%
was borrowed from Westdeutsche Landesbank Girozentrale
(series B loans). John Hancock also paid transaction
expenses of $1,373,048 and $2,728,730 as part of the Dort-
mund 1 and Dortmund 2 transactions, respectively.
b. Sublease and Defeasance
Pursuant to the sublease agreements, Dortmund agreed to
pay rent to John Hancock. As in the TIWAG transaction, the
sublease agreements require that many of these payments be
made before the period to which they are allocated, resulting
in section 467 loans to John Hancock in each transaction. On
the purchase option date, the total balance of the section 467
loans is expected to be approximately $221,835,000. In order
to fund the sublease rent payments Dortmund entered into
a number of defeasance agreements.
On the closing date Dortmund entered into a series A
DPUA with Barclays for each of the Dortmund transactions.
The series A DPUAs are substantially similar to the series
A DPUA in the TIWAG transaction. With respect to the
series B loan and equity, just as in the TIWAG transaction,
the Dortmund transactions do not require Dortmund to enter
into a series B DPUA or an EPUA. John Hancock is not a
party to a series B DPUA or EPUA, and John Hancock is not
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38 141 UNITED STATES TAX COURT REPORTS (1)
the beneficiary of a pledge of a series B DPUA or EPUA.
Nonetheless, Dortmund defeased the series B loans and
equity in agreements executed outside of the Dortmund
transactions. Dortmund’s net present value benefit in each
transaction is equal to its up-front payments under the ini-
tial leases less the amount that was deposited pursuant to
the series A DPUAs, series B DPUAs, and EPUAs.
Dortmund entered into a series B DPUA with Hypo-und
Vereinsbank AG for each of the Dortmund transactions.
Dortmund also entered into numerous EPUAs with Bank
Austria. As in the TIWAG transaction, the series B DPUAs
and EPUAs entitle Dortmund to beneficial accounting treat-
ment under European GAAP. John Hancock knew that Dort-
mund intended on entering into such agreements because
John Hancock preapproved a ‘‘form’’ of the EPUAs as well as
Bank Austria as the EPUA undertaker. The EPUAs were
required under the participation agreement upon the occur-
rence of certain trigger events. There are no trigger events
that would require Dortmund to enter into the series B
DPUAs. Nonetheless, John Hancock approved a ‘‘form’’ for
the series B DPUAs.
4. Property and Default Rights and Obligations
John Hancock and Dortmund’s property and default rights
and obligations, pursuant to the Dortmund transactions’ ini-
tial leases, facility site leases, and sublease agreements, are
substantially similar to those conferred under the initial
lease and sublease in the TIWAG transaction.
B. End of Sublease Term
Dortmund has a purchase option at the end of each trans-
action’s sublease term which is designed in a manner con-
sistent with the TIWAG transaction. If Dortmund does not
exercise its purchase options, John Hancock must choose
between requiring Dortmund to arrange for a service con-
tract or take possession of the trade fair facility itself.
Under the service contract option Dortmund must procure
one or more service purchasers for the trade fair facility. The
service purchasers must agree to pay service fees that consist
of: (1) the annual capacity availability charges that are
designed to cover John Hancock’s debt service on the
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(1) JOHN HANCOCK LIFE INS. CO. (U.S.A.) v. COMM’R 39
refinanced section 467 loan and ensure a predetermined eco-
nomic return on its investment and (2) the trade fair facility
operating and maintenance expenses. Dortmund may remain
the operator of the trade fair facility or must find a qualified
replacement operator. Unlike the TIWAG transaction, Dort-
mund may be both the service purchaser and the operator.
If John Hancock fails to make the trade fair capacity and
management services available to the service purchasers for
any reason, including force majeure, the capacity availability
charges will be reduced in a manner consistent with the
service contract. The service contract does not require credit
support to secure a service purchaser’s payments during the
service contract term. However, if at any point during the
service contract term a service purchaser’s credit rating were
to fall below BBB+ or Baa1 under S&P’s and Moody’s credit
rating systems, respectively, the service purchaser is
required to procure acceptable credit support. In all other
ways, the design, structure, and economics of John Hancock’s
service contract options and retention options in the Dort-
mund transactions are substantially similar to those of the
TIWAG transaction.
III. SNCB SILO
A. Grant and Subgrant
1. The Asset
The SNCB SILO closed on November 14, 2001. The asset
subject to the SNCB SILO is a 50% undivided interest in the
high-speed rail line that runs from the Belgian-French
border to Lembeek, Belgium, and the railway station known
as ‘‘Brussels South’’ that is dedicated to that high-speed line
(together the HSL). The HSL is integrated with the main
east-west rail line in Belgium. SNCB considers the HSL to
be its ‘‘crown jewel’’ as it enables high-speed rail services
between the United Kingdom, France, the Netherlands, and
Germany.
Deloitte appraised the HSL and concluded that as of the
closing date, a 50% undivided interest in the HSL had a fair
market value of $426,900,500 and a remaining economic use-
ful life of 78 years. This value served as the basis for deter-
mining John Hancock’s investment in the SNCB SILO, and
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40 141 UNITED STATES TAX COURT REPORTS (1)
the parties did not further negotiate the investment amount.
Deloitte further appraised the 50% undivided interest in
HSL as of the purchase option date at $890,941,344. The
appraisal used the discounted cashflow method in its fair
market value determinations.
2. Terms
On the closing date John Hancock entered into a grant of
rights agreement with SNCB with respect to the 50% undi-
vided interest in HSL for a term of approximately 99 years
(grant). Simultaneously, John Hancock and SNCB entered
into a subgrant of rights agreement for a term of approxi-
mately 29 years (subgrant) whereby John Hancock granted a
set of nearly identical rights in the 50% undivided interest
in HSL back to SNCB. 17 SNCB has the option of purchasing
John Hancock’s interest in the HSL at the end of the
subgrant term.
3. Rent and Financing
a. Grant
On the closing date John Hancock paid $426,900,500 to
SNCB pursuant to the grant. To fund this payment John
Hancock contributed $61,177,535 in equity and borrowed a
total of $365,722,965 from two lenders on a nonrecourse
basis, $329,150,668 from Mercantile (series A loan) and
$36,572,297 from Barclays (series B loan). John Hancock also
paid $3,799,414 of transaction expenses.
b. Subgrant and Defeasance
Pursuant to the subgrant SNCB agreed to make subgrant
rent payments to John Hancock in the amounts and on the
dates specified in the sublease agreement. The sublease
requires that many of these payments be made before the
period to which they are allocated. As in John Hancock’s
other SILO test transactions, this prepayment creates a sec-
tion 467 loan. At the end of the sublease term the section 467
17 For
purposes of this analysis, there are no material differences be-
tween the function of the grant of rights and the subgrant used in the
SNCB SILO and the leases and subleases used in John Hancock’s other
SILO test transactions.
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(1) JOHN HANCOCK LIFE INS. CO. (U.S.A.) v. COMM’R 41
loan balance is expected to be $780,056,766. In order to fund
the subgrant rent payments SNCB entered into a number of
defeasance agreements.
On the closing date, SNCB entered into a series A DPUA
with Barclays. The series A DPUA is substantially similar to
those in John Hancock’s other SILO test transactions. Also
as in John Hancock’s other SILO test transactions, the SNCB
SILO transaction does not require SNCB to enter into a
series B DPUA or an EPUA. John Hancock is not a party to
a series B DPUA or an EPUA, and John Hancock is not the
beneficiary of a pledge of a series B DPUA or EPUA.
On November 19, 2001, SNCB entered into a currency
swap transaction (CST) with Bank of America, NA (BofA).
Pursuant to the currency swap transaction, SNCB agreed to
pay BofA U.S.-dollar-denominated payments on certain speci-
fied dates in exchange for euro-denominated payments. The
payments made to SNCB under the currency swap trans-
action match the debt service payments on the series B loan.
Unlike the currency swap transactions in the SNCB LILO
transactions, SNCB did not prepay this currency swap.
Also on November 19, 2001, SNCB entered into a USD
Credit Linked Deposit Agreement with UBS (CLDA). Similar
to the EPUAs in John Hancock’s other SILO test trans-
actions, SNCB placed a deposit with UBS in exchange for a
series of payments exactly matching the timing and amount
of the equity subgrant payments and the purchase option
price. SNCB may not freely terminate the CLDA. 18 However,
the CLDA permits SNCB to direct the payments due from
UBS to the recipient of its choosing. As in John Hancock’s
other SILO test transactions, the CLDA entitled SNCB to
beneficial accounting treatment under European GAAP, and
John Hancock knew that SNCB intended on executing such
an agreement. SNCB calculated its net present value benefit
from the transaction as the difference between the
$426,900,500 received from John Hancock pursuant to the
grant and the amounts paid upon the execution of the series
A DPUA, the CLDA, and the CST.
18 Petitioners
argue that SNCB may terminate the CLDA at any time to
free up cash for its general business purposes. To support this argument,
petitioners rely solely on the testimony of an SNCB executive. This testi-
mony is not consistent with the terms of the CLDA.
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42 141 UNITED STATES TAX COURT REPORTS (1)
4. Property and Default Rights and Obligations
For purposes of this analysis the property and default
rights and obligations of John Hancock and SNCB, with
respect to the grant and subgrant, are substantially similar
to those conferred under the initial leases and subleases in
John Hancock’s other SILO test transactions. The primary
difference in the SNCB SILO transaction is that HSL is part
of the Belgian public domain. Consequently, the parties
included provisions in the transaction documents providing
that if HSL ceases to be an asset in the public domain, the
parties intend for all of the transaction documents to survive
and the rights and obligations of the parties to constitute an
independent contractual relationship.
B. End of Subgrant Term
SNCB has a purchase option at the end of the subgrant
term under substantially the same terms and conditions as
in John Hancock’s other SILO test transactions. Further, as
in those transactions, if SNCB does not exercise its purchase
option, John Hancock must choose between requiring SNCB
to arrange for a service contract or taking possession of the
50% undivided interest in HSL.
Under the service contract option SNCB must procure a
‘‘Service Purchaser’’ under the service contract, which cannot
be SNCB, and arrange for the section 467 loan to be
refinanced. John Hancock must find an operator for the 50%
undivided interest in HSL; but if it cannot find a suitable
operator, SNCB is required to assume the position. Under
the service contract the service purchaser must agree to pay
John Hancock: (1) the base service fees, which are designed
to cover John Hancock’s debt service on the refinanced sec-
tion 467 loan and ensure a predetermined economic return
on its investment and (2) the monthly additional fees that
cover the fixed and variable costs of operating the 50% undi-
vided interest in HSL.
The service purchaser has the right to terminate the
service contract if John Hancock fails to make the asset
available for the negotiated services for any reason, except
for force majeure, and fails to cure within 60 days of notifica-
tion. In the case of force majeure, the service purchaser may
terminate the service contract if John Hancock fails to cure
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(1) JOHN HANCOCK LIFE INS. CO. (U.S.A.) v. COMM’R 43
within 180 days. In all other ways, the design, structure, and
economics of John Hancock’s service contract option and
retention option are substantially similar to those of John
Hancock’s other SILO test transactions.
Tax Returns, Notices of Deficiency, and Trial
I. Procedural History
John Hancock filed a consolidated Federal income tax
return for each of the years at issue.
A. Notice of Deficiency (Docket No. 6404–09)
On December 17, 2008, respondent issued a notice of defi-
ciency to John Hancock which determined Federal income
tax deficiencies for 1994, 1997, and 1998 of $8,860,564,
$65,746,621, and $173,497,367, respectively, based upon the
disallowance of various deductions and adjustments to gross
income from John Hancock’s LILO transactions and the
denial of a capital loss carry back to 1994. On March 16,
2009, John Hancock filed the petition with this Court at
docket No. 6404–09, disputing the 1994, 1997, and 1998
determined deficiencies.
The notice of deficiency for docket No. 6404–09 included
three of the test transactions litigated in these cases, the
OBB LILO and the two SNCB LILOs. 19 With respect to the
OBB LILO, respondent determined that the LILO trans-
action was in substance the purchase of a future interest by
John Hancock and therefore denied John Hancock’s deduc-
tions of $66,899,067 for a rental expense, $15,946,722 for an
interest expense, and $298,054 for amortized transaction
costs for 1998. Additionally, respondent reduced John Han-
cock’s taxable rental income by $19,169,206 for 1998. Alter-
natively, respondent determined that in substance the OBB
LILO transaction was a financing arrangement and therefore
increased John Hancock’s taxable income by $1,040,159 for
OID income for 1998. Under this alternative argument,
respondent concedes John Hancock’s deduction for amortized
transaction costs.
With respect to the two SNCB LILOs, respondent deter-
mined that the LILO transactions were in substance pur-
19 The notice of deficiency combined the two SNCB LILO transactions.
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44 141 UNITED STATES TAX COURT REPORTS (1)
chases of future interests by John Hancock and therefore
denied John Hancock’s deductions of $6,849,494 and
$39,408,434 for rental expenses, $1,737,691 and $10,030,464
for interest expenses, and $23,787 and $127,220 for amor-
tized transaction costs for 1997 and 1998, respectively.
Additionally, respondent reduced John Hancock’s taxable
rental income by $2,265,498 and $13,298,535 for 1997 and
1998, respectively. Alternatively, respondent determined that
in substance the two SNCB LILO transactions were a
financing arrangement and therefore increased John Han-
cock’s taxable income by $229,736 and $1,929,488 for OID
income for 1997 and 1998, respectively. Under this alter-
native argument, respondent concedes John Hancock’s deduc-
tion for amortized transaction costs. 20
B. Notice of Deficiency (Docket No. 7084–10)
On December 24, 2009, respondent issued a notice of defi-
ciency to John Hancock which determined a Federal income
tax deficiency for 1999 of $59,899,141 based upon the dis-
allowance of various deductions and adjustments to gross
income from John Hancock’s LILO transactions. On March
23, 2010, John Hancock filed the petition with this Court at
docket No. 7084–10, disputing the 1999 determined defi-
ciency.
The notice of deficiency for docket No. 7084–10 included
three of the test transactions litigated in these cases, the
OBB LILO and the two SNCB LILOs. 21 With respect to the
OBB LILO, respondent determined that the LILO trans-
action was in substance the purchase of a future interest by
John Hancock and therefore denied John Hancock’s deduc-
tions of $124,785,824 for a rental expense, $29,516,300 for an
interest expense, and $555,956 for amortized transaction
costs for 1999. Additionally, respondent reduced John Han-
cock’s taxable rental income by $35,739,244 for 1999. Alter-
natively, respondent determined that in substance the OBB
LILO transaction was a financing arrangement and therefore
increased John Hancock’s taxable income by $4,746,135 for
OID for 1999. Under this alternative argument, respondent
20 Respondent made similar determinations and denied similar deduc-
tions for the six other LILO transactions listed in the notice of deficiency.
21 The notice of deficiency combined the two SNCB LILO transactions.
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(1) JOHN HANCOCK LIFE INS. CO. (U.S.A.) v. COMM’R 45
concedes John Hancock’s deduction for amortized transaction
costs.
With respect to the two SNCB LILO transactions,
respondent determined that the LILO transactions were in
substance the purchase of a future interest by John Hancock
and therefore denied John Hancock’s deductions of
$39,408,436 for a rental expense, $9,787,937 for an interest
expense, and $127,220 for amortized transaction costs for
1999. Additionally, respondent reduced John Hancock’s tax-
able rental income by $13,298,535 for 1999. Alternatively,
respondent determined that in substance the two SNCB
LILO transactions were financing arrangements and there-
fore increased John Hancock’s taxable income by $2,055,293
for OID income for 1999. Under this alternative argument,
respondent concedes John Hancock’s deductions for amor-
tized transaction costs. 22
C. Notice of Deficiency (Docket No. 7083–10)
On December 24, 2009, respondent issued a notice of defi-
ciency to John Hancock which determined Federal income
tax deficiencies for 2000 and 2001 of $108,046,947 and
$143,516,079, respectively, based upon the disallowance of
various deductions and adjustments to gross income from
John Hancock’s LILO and SILO transactions and the denial
of worthless stock losses for 2000. 23 On March 23, 2010,
John Hancock filed the petition with this Court at docket No.
7083–10, disputing the 2000 and 2001 determined defi-
ciencies.
The notice of deficiency for the case at docket No. 7083–
10 included all seven of the test transactions litigated in
these cases, the OBB LILO, the two SNCB LILOs, 24 the
TIWAG SILO, the two Dortmund SILOs, 25 and the SNCB
SILO. With respect to the OBB LILO, respondent determined
that the LILO transaction was in substance the purchase of
a future interest by John Hancock and therefore denied John
22 Respondent made similar determinations and denied similar deduc-
tions for the six other LILO transactions listed in the notice of deficiency.
23 The parties filed a stipulation of settled issues with the Court on June
7, 2011, resolving the worthless stock loss issue for 2000.
24 The notice of deficiency combined the two SNCB LILO transactions.
25 The notice of deficiency combined the two Dortmund SILO trans-
actions.
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46 141 UNITED STATES TAX COURT REPORTS (1)
Hancock’s deductions of $124,785,824 and $124,785,724 for
rental expenses, $29,073,071 and $28,598,273 for interest
expenses, and $555,956 and $555,956 for amortized trans-
action costs for 2000 and 2001, respectively. Additionally,
respondent reduced John Hancock’s taxable rental income by
$35,739,244 and $35,739,244 for 2000 and 2001, respectively.
Alternatively, respondent determined that in substance the
OBB LILO transaction was a financing arrangement and
therefore increased John Hancock’s taxable income by
$4,044,640 and $5,361,948 for OID income for 2000 and
2001, respectively. Under this alternative argument,
respondent concedes John Hancock’s deduction for amortized
transaction costs.
With respect to the two SNCB LILO transactions,
respondent determined that the LILO transactions were in
substance purchases of future interests by John Hancock and
therefore denied John Hancock’s deductions of $39,408,436
and $38,940,891 for rental expenses, $9,527,327 and
$9,068,703 for interest expenses, and $127,220 and $127,220
for amortized transaction costs for 2000 and 2001, respec-
tively. Additionally, respondent reduced John Hancock’s tax-
able rental income by $13,298,535 and $13,297,807 for 2000
and 2001, respectively. Alternatively, respondent determined
that in substance the two SNCB LILO transactions were a
financing arrangement and therefore increased John Han-
cock’s taxable income by $2,189,343 and $2,332,181 for OID
income for 2000 and 2001, respectively. Under this alter-
native argument, respondent concedes John Hancock’s deduc-
tions for amortized transaction costs.
With respect to the TIWAG SILO, respondent determined
that John Hancock had not acquired the benefits and bur-
dens of ownership of the property subject to the SILO trans-
action and therefore denied John Hancock’s deductions of
$807,500 for a depreciation expense, $535,234 for an interest
expense, and $2,802 for amortized transaction costs for 2001.
Additionally, respondent determined that in substance John
Hancock made a loan to TIWAG and failed to report interest
income on that loan. Therefore, respondent increased John
Hancock’s taxable income by $78,302 for OID income for
2001.
With respect to the two Dortmund SILO transactions,
respondent determined that John Hancock had not acquired
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(1) JOHN HANCOCK LIFE INS. CO. (U.S.A.) v. COMM’R 47
the benefits and burdens of ownership of the property subject
to the SILO transactions and therefore denied John Han-
cock’s deductions of $115,170 for depreciation expenses,
$240,614 for interest expenses, and $21,259 for amortized
transaction costs for 2001. Additionally, respondent deter-
mined that in substance John Hancock made a loan to Dort-
mund and failed to report interest income on that loan.
Therefore, respondent increased John Hancock’s taxable
income by $24,985 for OID income for 2001.
With respect to the SNCB SILO, respondent determined
that John Hancock had not acquired the benefits and bur-
dens of ownership of the property subject to the SILO trans-
action and therefore denied John Hancock’s deductions of
$5,032,552 for a depreciation expense, $2,594,278 for an
interest expense, and $15,898 for amortized transaction costs
for 2001. Additionally, respondent determined that in sub-
stance John Hancock made a loan to SNCB and failed to
report interest income on that loan. Therefore, respondent
increased John Hancock’s taxable income by $627,439 for
OID income for 2001. 26
D. Pretrial Motions
Respondent failed to timely raise the economic substance
theory in the pleadings, instead raising the issue for the first
time in his pretrial memorandum, dated September 16, 2011.
Petitioners filed a motion in limine for exclusion of respond-
ent’s argument based on the economic substance theory on
September 23, 2011, and respondent filed an objection to
petitioners’ motion on October 6, 2011. On October 11, 2011,
the parties presented oral arguments to the Court with
respect to petitioners’ motion. By order of the Court dated
October 12, 2011, we denied petitioners’ motion in limine for
exclusion of the economic substance theory but placed the
burden of proof with respect to the economic substance
theory on respondent.
26 Respondent made similar determinations and denied similar deduc-
tions for the six other LILO transactions and one other SILO transaction
listed in the notice of deficiency.
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48 141 UNITED STATES TAX COURT REPORTS (1)
II. Trial
The Court held a five-week special trial session in Boston,
Massachusetts. The record in these cases includes the testi-
mony of 53 witnesses, over 3,600 exhibits, over 4,000 pages
of trial transcripts, and over 1,000 pages of briefing. Both
parties rely heavily on expert opinions to support their argu-
ments. The parties’ expert witnesses, their qualifications,
and their Court-recognized expertises are listed below. We
evaluate expert opinions in the light of all of the evidence in
the record, and we are not bound by the opinion of any
expert witness. Helvering v. Nat’l Grocery Co., 304 U.S. 282,
295 (1938); Shepherd v. Commissioner, 115 T.C. 376 (2000),
aff ’d, 283 F.3d 1258 (11th Cir. 2002). We may reject, in
whole or in part, any expert opinion. Estate of Davis v.
Commissioner, 110 T.C. 530, 538 (1998).
A. Petitioners’ Expert Witnesses (Alphabetical Order)
1. Mr. John Dolan
The Court recognized Mr. Dolan as an expert in the field
of European railways and railway assets. Mr. Dolan is a
chartered civil engineer, a member of the Institution of Civil
Engineers, and a holder of the title European engineer. He
is also a chartered member of the Institute of Logistics and
Transport. Mr. Dolan has worked in the European railway
industry since 1972 and currently works as a consultant for
InterFleet Technology Ltd. where he advises on a range of
railway safety, infrastructure, and operational issues. He
previously worked in advisory roles for Haliburton, Her Maj-
esty’s Railway Inspectorate, and British Rail.
2. Dr. Paul Doralt
The Court recognized Dr. Doralt as an expert in the field
of Austrian tax law. Dr. Doralt is admitted to the Austrian
Chamber of Accountants as a certified tax adviser and to the
Austrian bar as an attorney. He is currently a partner at
Dorda Brugger Jordis GmbH, with his practice focus in tax
law. Mr. Doralt is a board member of the International Tax
Committee of the International Bar Association.
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(1) JOHN HANCOCK LIFE INS. CO. (U.S.A.) v. COMM’R 49
3. Mr. Hans Haider
The Court recognized Mr. Haider as an expert in the field
of Austrian and European electricity. Mr. Haider is currently
the managing partner of Hans Haider Consulting. He has
over 40 years of experience, having served as a member of
the management board of Siemens AG Austria and chairman
of the management board and CEO of Verbund AG, Austria’s
largest utility. He has previously served as president of the
Austrian National Committee to the World Energy Counsel
and president of the European Union of the Electricity
Industry. Mr. Haider is currently a member of Ernst &
Young’s Energy Advisory Board.
4. Dr. Friedrich Hey
The Court recognized Dr. Hey as an expert in the field of
German tax law. Dr. Hey received a doctorate in law from
the University of Hamburg/Germany and is admitted as a
certified tax adviser and a German attorney. He is currently
a partner at Debevoise & Plimpton LLP (Debevoise &
Plimpton) and the chair of the German American Lawyers
Association. Dr. Hey’s work has been published numerous
times, and he has been recognized as a leading German tax
expert by publications such as Chambers, Legal 500 EMEA,
PLC Which Lawyer?, and Who’s Who Legal.
5. Dr. Friedrich Popp
The Court recognized Dr. Popp as an expert in the field of
Austrian corporate law and creditor rights law. Dr. Popp
received a doctorate in law from the University of Vienna/
Austria with a thesis in civil law. He is currently an asso-
ciate at Debevoise & Plimpton. Dr. Popp has published
numerous articles in various journals and is a frequent
contributor to the Austrian Journal of Banking and Financial
Research.
6. Dr. Thomas Schu¨rrle
The Court recognized Dr. Schu¨rrle as an expert in the field
of German administrative and public law. Dr. Schu¨rrle
received a doctorate in law from the University of Heidel-
berg. He is currently the managing partner of the Frankfurt
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50 141 UNITED STATES TAX COURT REPORTS (1)
office of Debevoise & Plimpton. His experience has focused
on advising municipalities and companies on the financial,
economic, and regulatory aspects of cross-border leasing. Dr.
Schu¨rrle teaches a law class at the Institute of Law and
Finance at the Johann-Wolfgang-Goethe-University in
Frankfurt.
7. Dr. Norbert Stoeck
The Court recognized Dr. Stoeck as an expert in the field
of trade fair industry including the ownership and operation
of trade fairs in Germany. Dr. Stoeck received a Ph.D. in
marketing from the University of Rostock. Since 1983 he has
worked at Roland Berger Strategy Consultants and currently
serves as the head of the ‘‘International Trade Shows,
Tourism and Mega-Events’’ practice group. In this role Dr.
Stoeck has managed over 100 trade fair projects internation-
ally and advised on countless others including trade fairs in
German municipalities. He has written numerous books and
articles discussing the management of trade fairs, trade fair
strategies, and all other aspects of the trade fair industry.
8. Dr. Frederik Vandendriessche
The Court recognized Dr. Vandendriessche as an expert in
the field of Belgian administrative and public law. Dr.
Vandendriessche received a doctorate in law at the Univer-
sity of Ghent with a focus in public and private legal entities.
He is currently a partner in the Brussels office of Stibbe
where he focuses his practice in administrative law. Dr.
Vandendriessche is a professor of public law at the Univer-
sity of Ghent and the University of Antwerp. He has written
a wide range of articles about public law that have been pub-
lished in Belgian journals and magazines.
B. Respondent’s Expert Witnesses (Alphabetical Order)
1. Dr. Ignaas Behaeghe
The Court recognized Dr. Behaeghe as an expert in Bel-
gian law. Dr. Behaeghe received a doctorate in law and eco-
nomic sciences from the University of Antwerp and a mas-
ter’s in tax law from the Fiscale Hogeschool in Brussels. He
is currently an equity partner at Eversheds Brussels.
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2. Dr. Stefan Diemer
The Court recognized Dr. Diemer as an expert in the field
of German tax law. Dr. Diemer received his doctorate in law
from the University of Regensburg. He is currently a partner
at Heisse Kursawe Eversheds and practices in the area of
corporate and tax law. Dr. Diemer is a certified tax lawyer
and is a member of the International Transaction Support
Team of Eversheds, a unit specializing in international trans-
actions. The JUVE Handbuch 2009/2010 lists Dr. Diemer as
a frequently recommended lawyer in the field of corporate
law.
3. Dr. Matthias Heisse
The Court recognized Dr. Heisse as an expert in the field
of German law, except for German criminal law. Dr. Heisse
received his doctorate in law from the University of Munich.
He is currently the managing partner of Heisse Kursawe
Eversheds and focuses his practice in mergers and acquisi-
tions, corporate, and tax law. Dr. Heisse lectures on cor-
porate law topics at the University of Turin, the University
of Munich, and the University of Augsburg. He is recognized
in numerous publications such as Chambers Europe, Legal
500 Europe, and the JUVE Handbook 2010/2011 as a leading
attorney in the field of corporate law.
4. Dr. Thomas Lys
The Court recognized Dr. Lys as an expert in the field of
financial economics. Dr. Lys received his Ph.D. in accounting
and finance from the University of Rochester. He presently
holds the Eric L. Kohler chair in accounting and professor of
accounting and information management at the North-
western University Kellogg School of Professional Manage-
ment. Dr. Lys teaches classes in financial reporting, security
analysis, and mergers and acquisitions. Dr. Lys’ research has
been published in prominent academic journals including the
Journal of Accounting and Economics, the Journal of Finan-
cial Economics, the Journal of Business, and the Accounting
Review. Dr. Lys has previously testified for the Government
in other Federal leasing cases.
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52 141 UNITED STATES TAX COURT REPORTS (1)
5. Dr. F.H. Rolf Seringhaus
The Court recognized Dr. Seringhaus as an expert in the
field of trade fair exhibiting and marketing. Dr. Seringhaus
earned his doctorate in administrative studies from York
University. He is a professor emeritus in global marketing at
the Wilfred Laurier University School of Business and
Economics. Dr. Seringhaus has worked in academics since
1981 teaching courses and researching international mar-
keting. He has written countless journal articles discussing
topics such as international trade fairs and marketing, as
well as three books on global marketing management.
6. Mag. Alexander Stolitzka
The Court recognized Mag. Stolitzka as an expert in the
field of Austrian law. Mag. Stolitzka received a doctorate in
law from Vienna University. He is currently the managing
partner of Eversheds Austria, focusing his practice in real
estate, insurance, and corporate law. He is also a member of
the board of directors of Eversheds International, Ltd.,
London. Mag. Stolitzka is a member of the German Chamber
of Commerce in Austria and is also a legal adviser to the
Swiss embassy in Vienna.
7. Dr. Vukan Vuchic
The Court recognized Dr. Vuchic as an expert in the field
of transportation systems. Dr. Vuchic received a Ph.D. in
civil engineering and transportation from the University of
California at Berkeley. He is an emeritus professor of
transportation systems engineering at the University of
Pennsylvania where he taught and performed research in
various areas of transportation from 1967–2010. Dr. Vuchic
has written over 150 papers and reports discussing rail sys-
tems and has lectured at approximately 90 universities. He
has also published three books on urban public transpor-
tation systems and another book on relationship of transpor-
tation and cities. Dr. Vuchic is also the recipient of numerous
honors and awards from transportation organizations around
the world for his contributions to the field of transportation
systems.
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(1) JOHN HANCOCK LIFE INS. CO. (U.S.A.) v. COMM’R 53
8. Dr. Peter Wundsam
The Court recognized Dr. Wundsam as an expert in the
field of Austrian taxation and accounting. Dr. Wundsam is a
partner at Moore Stephens in Vienna and has been working
as an auditor and tax consultant for 15 years. He is a cer-
tified public accountant and certified tax adviser in Austria.
He is also a member of the executive board of the Chamber
of Accountants and a member of the committee on commer-
cial law and auditing within the Austrian Chamber of
Accountants. Further, Dr. Windsam is the head of the
working committee public sector of the Austrian Institute of
Auditors and an editor of the publication Public Sector Bul-
letin.
OPINION
Burden of Proof
The burden is upon petitioners to prove that respondent’s
determinations in the notices of deficiency are incorrect. See
Rule 142(a)(1). However, in respect of any new matter,
respondent bears the burden of proof. Id. Respondent failed
to timely raise his economic substance argument in the
pleadings. As a result, on October 12, 2011, the Court issued
an order placing the burden in these cases on respondent to
prove that the economic substance doctrine applies to the
leveraged leases. Petitioners do not argue that the burden of
proof shifts to respondent pursuant to section 7491(a) for any
other issue or year, nor have they shown that the threshold
requirements of section 7491(a) have been met for any of the
other determinations at issue. Accordingly, the burden
remains on petitioners with respect to all other issues to
prove that respondent’s determinations of deficiencies in
income tax are incorrect.
Principal Place of Business
In the case at docket No. 7083–10 the parties disagree as
to whether an appeal would come before the U.S. Court of
Appeals for the First or Sixth Circuit. In the case of a cor-
poration seeking redetermination of a tax liability, section
7482(b)(1)(B) provides that a decision of the Tax Court ‘‘may
be reviewed by the United States court of appeals for the cir-
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54 141 UNITED STATES TAX COURT REPORTS (1)
cuit in which is located * * * the principal place of business
or principal office or agency of the corporation’’. This deter-
mination is made as of the time the petition is filed. Thus,
the crux of the parties’ dispute is the location of MIC’s ‘‘prin-
cipal place of business’’.
The Supreme Court has recently determined that a cor-
poration’s ‘‘principal place of business’’ is ‘‘best read as refer-
ring to the place where a corporation’s officers direct, control,
and coordinate the corporation’s activities.’’ Hertz Corp. v.
Friend, 559 U.S. 77, 92–93 (2010). This is often referred to
as the ‘‘nerve center’’ test, and it normally refers to where a
corporation maintains its headquarters, provided that the
headquarters is the actual center of direction, control, and
coordination. Id. Respondent argues that MIC’s principal
place of business is and always has been in Michigan because
MIC was incorporated there and has represented in cor-
respondence to the IRS and the Michigan Department of
Consumer & Industry Services that its principal place of
business is in Michigan. Petitioners argue, on the other
hand, that MIC’s principal place of business is in Massachu-
setts because six of its nine corporate officers 27 and all three
of its directors work in Massachusetts, its corporate books
and records are kept in Massachusetts, and its significant
business decisions have been and continue to be made in
Massachusetts. Further, MIC does not maintain offices in
Michigan.
It is clear to us that MIC’s ‘‘nerve center’’ is in Massachu-
setts. Respondent has not presented any evidence to dispute
that MIC’s office in Massachusetts is the center of its direc-
tion, control, and coordination. Therefore, we conclude that
Massachusetts was MIC’s principal place of business when
its petition was filed.
Leveraged Lease Transactions
I. Frank Lyon
The seminal case for leveraged lease transactions is Frank
Lyon Co. v. United States, 435 U.S. 561 (1978), where the
Supreme Court set forth the circumstances under which the
27 The remaining three officers work in Toronto, Canada.
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(1) JOHN HANCOCK LIFE INS. CO. (U.S.A.) v. COMM’R 55
Commissioner must respect such a transaction for Federal
tax purposes. The Supreme Court stated:
[W]here * * * there is a genuine multiple-party transaction with eco-
nomic substance which is compelled or encouraged by business or regu-
latory realities, that is imbued with tax-independent considerations, and
that is not shaped solely by tax-avoidance features * * * [to which]
meaningless labels [are] attached, the Government should honor the
allocation of rights and duties effectuated by the parties. Expressed
another way, so long as the lessor retains significant and genuine
attributes of the traditional lessor status, the form of the transaction
adopted by the parties governs for tax purposes. What those attributes
are in any particular case will necessarily depend upon its facts. * * *
[Id. at 583–584; fn. ref. omitted.]
In Frank Lyon, Worthen Bank (Worthen) sought to con-
struct a new bank building. State and Federal regulations
prohibited Worthen from financing the construction through
conventional methods. As a result, Worthen was forced to
find alternative financing, and eventually came to an agree-
ment with the taxpayer, Frank Lyon Co. (Frank Lyon).
Pursuant to this agreement, Frank Lyon purchased the
building from Worthen during its construction for a total of
$7,640,000, and leased it back to Worthen for an initial term
of 25 years. Frank Lyon invested $500,000 and financed the
remainder with a third-party lender. A mortgage secured the
loan on the building, as well as Frank Lyon’s promise to
assume personal responsibility for the loan’s repayment and
an assignment to the lender of the rental payments under
the lease.
Worthen retained options to repurchase the building at the
end of the 11th, 15th, 20th, and 25th years of the initial
lease. Alternatively, Worthen could opt to renew the lease for
eight additional five-year terms. Worthen’s rent payments
equaled the amounts of Frank Lyon’s debt service in amount
and timing. Further, the prices of Worthen’s purchase
options matched Frank Lyon’s then-outstanding loan bal-
ance, plus Frank Lyon’s initial $500,000 investment, with 6%
compounded interest. The lease was a net lease with
Worthen remaining obligated to pay taxes, insurance, and
utilities.
The Supreme Court held that the form of a sale-leaseback
transaction will be respected for Federal tax purposes as long
as the taxpayer retains significant and genuine attributes of
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56 141 UNITED STATES TAX COURT REPORTS (1)
a traditional lessor. Id. at 584. An important inquiry is
‘‘whose capital was committed to the * * * [property] * * *
[and therefore, who is] entitled to claim depreciation for the
consumption of that capital.’’ Id. at 581. Frank Lyon was
liable as principal for the repayment of the $7,640,000 loan,
had invested $500,000 in the transaction, and its return on
the transaction was guaranteed only if Worthen exercised its
extension options, which was speculative.
The Supreme Court also determined the following factors,
among others, to favor Frank Lyon: (1) Worthen’s rent and
purchase option prices were reasonable; (2) Frank Lyon
assumed the credit risk of Worthen’s defaulting on its rent
payments; (3) there was a real possibility that Worthen could
walk away from the transaction at the end of the initial
lease; (4) the transaction was negotiated in good faith
between independent parties; and (5) Worthen and Frank
Lyon paid the same tax rates, making the transaction tax
neutral for the fisc. Accordingly, the Supreme Court held for
Frank Lyon, concluding that ‘‘a sale-and-leaseback, in and of
itself, does not necessarily operate to deny a taxpayer’s claim
for deductions.’’ Frank Lyon, 435 U.S. at 584.
A. Economic Substance
After the Supreme Court issued its opinion in Frank Lyon,
several Courts of Appeals reduced the Supreme Court’s eco-
nomic substance formulation to a two-part test: (1) whether
the transaction had economic substance beyond tax benefits
(objective test); and (2) whether the taxpayer had shown a
nontax business purpose for entering the disputed trans-
action (subjective test). See, e.g., ACM P’ship v. Commis-
sioner, 157 F.3d 231, 247–248 (3d Cir. 1998), aff ’g in part,
rev’g in part T.C. Memo. 1997–115; Bail Bonds by Marvin
Nelson, Inc. v. Commissioner, 820 F.2d 1543, 1549 (9th Cir.
1987), aff ’g T.C. Memo. 1986–23; Rice’s Toyota World, Inc. v.
Commissioner, 752 F.2d 89, 91–92 (4th Cir. 1985), aff ’g in
part, rev’g in part 81 T.C. 184 (1983). However, the various
Courts of Appeals disagree as to the appropriate relationship
between the objective and subjective tests. 28
28 Congress codified the economic substance doctrine in the Code by the
Health Care and Education Reconciliation Act of 2010, Pub. L. No. 111–
152, sec. 1409, 124 Stat. at 1067. See also H.R. Rept. No. 111–443 (I), at
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(1) JOHN HANCOCK LIFE INS. CO. (U.S.A.) v. COMM’R 57
The Court of Appeals for the Fourth Circuit has adopted
a disjunctive approach, treating a transaction as having eco-
nomic substance if the transaction has either a business pur-
pose or economic substance. See, e.g., Rice’s Toyota World,
Inc. v. Commissioner, 752 F.2d at 91–92. The Courts of
Appeals for the Ninth and Eleventh Circuits view the objec-
tive and subjective prongs as elements of one comprehensive
inquiry. See, e.g., Sacks v. Commissioner, 69 F.3d 982, 988
(9th Cir. 1995), rev’g T.C. Memo. 1992–596; Kirchman v.
Commissioner, 862 F.2d 1486, 1492 (11th Cir. 1989), aff ’g
Glass v. Commissioner, 87 T.C. 1087 (1986). Finally, the
Court of Appeals for the Federal Circuit adheres to a multi-
factor test which provides that a lack of economic substance
may be sufficient to invalidate a transaction regardless of
whether the taxpayer has motives other than tax avoidance.
Coltec Indus., Inc. v. United States, 454 F.3d 1340, 1355
(Fed. Cir. 2006).
B. Substance Over Form
Courts use substance over form and its related judicial doc-
trines to determine the true nature of a transaction disguised
by formalisms that exist solely to alter tax liabilities. See
United States v. R.F. Ball Constr. Co., 355 U.S. 587 (1958);
Commissioner v. Court Holding Co., 324 U.S. 331 (1945);
Stewart v. Commissioner, 714 F.2d 977, 987–988 (9th Cir.
1983), aff ’g T.C. Memo. 1982–209; Rose v. Commissioner,
T.C. Memo. 1973–207. In such instances, the substance of a
transaction, rather than its form, will be given effect. We
generally respect the form of a transaction, however, and will
apply the substance over form principles only when war-
ranted. See Gregory v. Helvering, 293 U.S. 465 (1935); Blue-
berry Land Co. v. Commissioner, 361 F.2d 93, 100–101 (5th
Cir. 1966), aff ’g 42 T.C. 1137 (1964).
In Frank Lyon, 435 U.S. at 584, the Supreme Court held
that the form of a sale-leaseback transaction will be
respected for Federal tax purposes as long as the lessor
retains significant and genuine attributes of a traditional
291–299 (2010), 2010 U.S.C.C.A.N. 123, 222–231 (discussing the reasons
for codification of the economic substance doctrine). This codified doctrine
does not apply to these cases because it is effective only for transactions
entered into after March 30, 2010.
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58 141 UNITED STATES TAX COURT REPORTS (1)
lessor. The substance over form doctrine requires viewing the
transaction as a whole. Commissioner v. Court Holding Co.,
324 U.S. at 334. A ‘‘critical fact,’’ however, is whether the
taxpayer has undertaken ‘‘substantial financial risk’’ of loss
of its investment on the basis of the value of the underlying
property. Coleman v. Commissioner, 16 F.3d 821, 826 (7th
Cir. 1994), aff ’g T.C. Memo. 1987–195 and T.C. Memo. 1990–
99.
II. LILO and SILO Litigation
In the cases at bar, petitioners assert that the LILO and
SILO leveraged leases are genuine multiple-party trans-
actions, with economic substance, that were compelled or
encouraged by business realities and were not designed as a
scheme to avoid payment of taxes. As such, petitioners
assert, the LILO and SILO leveraged leases should be
respected for Federal tax purposes because they satisfy the
requirements set out by the Supreme Court in Frank Lyon
Co.
Respondent contends that the LILO and SILO leveraged
leases are ‘‘prepackaged, promoted tax products’’ that ‘‘create
tax benefits for John Hancock out of thin air, and share that
value with the counterparties, promoters, and advisors’’.
Therefore, respondent argues that the leveraged leases
should not be respected for Federal tax purposes because
John Hancock did not acquire the benefits and burdens of
ownership with respect to the SILO transactions or a true
leasehold interest with respect to the LILO transactions and
thus the transactions lack economic substance.
Taxpayers have lost their fight for claimed tax benefits in
SILO and LILO transactions in all Courts of Appeals in
which they have appeared. The Courts of Appeals for the
Second and Fourth Circuits have ruled against taxpayers in
Altria Grp., Inc. v. United States, 658 F.3d 276 (2d Cir. 2011)
(denying the taxpayer’s motion for judgment as a matter of
law and a new trial after a jury verdict disallowed the tax
benefits derived from three SILO transactions and a LILO
transaction), aff ’g 694 F. Supp. 2d 259 (S.D.N.Y. 2010), and
BB&T Corp. v. United States, 523 F.3d 461 (4th Cir. 2008)
(disallowing the tax benefits derived from a LILO trans-
action), aff ’g 2007 WL 37798 (M.D.N.C. 2007), respectively.
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(1) JOHN HANCOCK LIFE INS. CO. (U.S.A.) v. COMM’R 59
Likewise, the Court of Appeals for the Federal Circuit has
ruled against taxpayers in Wells Fargo & Co. v. United
States, 641 F.3d 1319 (Fed. Cir. 2011) (disallowing the tax
benefits derived from 26 SILO transactions), aff ’g 91 Fed. Cl.
35 (2010), and Consol. Edison Co. of N.Y., Inc. & Subs. v.
United States, 703 F.3d 1367,
2013 WL 93110 (Fed. Cir.
2013) (disallowing tax benefits derived from a LILO trans-
action because the taxpayer never acquired the benefits and
burdens of ownership), rev’g 90 Fed. Cl. 228 (2009). In AWG
Leasing Trust v. United States, 592 F. Supp. 2d 953 (N.D.
Ohio 2008), the District Court for the Northern District of
Ohio disallowed the tax benefits derived from a SILO trans-
action. AWG was not appealed. 29
The Tax Court has never ruled upon the income tax con-
sequences of a LILO or SILO transaction. As an aid to our
evaluation of the present cases, we will review the LILO and
SILO cases already decided, in chronological order by the
date they were decided. We begin with BB&T, in which the
Court of Appeals for the Fourth Circuit established the basis
for a substance over form inquiry with respect to LILO trans-
actions. We next review AWG, in which the District Court for
the Northern District of Ohio was the first court to review
a SILO transaction, applying both a substance over form
inquiry and a two-part economic substance inquiry. Finally,
we review three decisions from the Courts of Appeals for the
Second Circuit 30 and the Federal Circuit, 31 which determine
whether the substance of each transaction is consistent with
its form, among other inquiries, and set forth the standard
29 Additionally, in Fifth Third Bancorp v. United States, No. 05–350
(S.D. Ohio Apr. 18, 2008), a jury verdict without a related published opin-
ion disallowed the taxpayer’s claimed tax benefits derived from a LILO
transaction. Further, beginning on March 12, 2012, the Court of Federal
Claims held a 10-day trial in Unionbancal Co. & Subs. v. United States,
No. 1:06-cv-00587 (Fed. Cl. filed Aug. 14, 2006), to determine whether to
uphold assessed deficiencies resulting from two LILO transactions. To
date, no opinion has been issued and no decision has been rendered in that
case.
30 Altria Grp., Inc. v. United States, 658 F.3d 276 (2d Cir. 2011), aff ’g
694 F. Supp 2d. 259 (S.D.N.Y. 2010).
31 Wells Fargo & Co. v. United States, 641 F.3d 1319 (Fed. Cir. 2011),
aff ’g 91 Fed. Cl. 35 (2010), and Consol. Edison Co. of N.Y., Inc. & Subs.
v. United States, 703 F.3d 1367 (Fed. Cir. 2013), rev’g
90 Fed. Cl. 228
(2009).
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60 141 UNITED STATES TAX COURT REPORTS (1)
by which to judge whether a purchase option is likely to be
exercised in a LILO or SILO transaction.
A. BB&T
In the first case of its kind, the Court of Appeals for the
Fourth Circuit affirmed a District Court’s decision to grant
summary judgment to the Government, disallowing the tax-
payer’s claimed deductions in connection with a LILO trans-
action. BB&T, 523 F.3d 461. The taxpayer, BB&T Corp.
(BB&T), was a domestic financial service company. In the
LILO transaction, BB&T leased pulp manufacturing equip-
ment from Sodra Cell AB (Sodra), a Swedish manufacturer
of wood pulp, for a term of 36 years and subleased the equip-
ment back to Sodra for a term of 15.5 years.
BB&T’s LILO transaction was very similar to the typical
LILO transaction described above in section IV.A of our
findings of fact and depicted in the associated graphic. The
rights and obligations conferred in the initial lease and sub-
lease were nearly identical, with Sodra continuing to use and
possess the equipment as it did before the transaction. The
transaction was fully defeased, resulting in a series of book-
keeping entries in satisfaction of Sodra’s sublease rent pay-
ments and BB&T’s debt service which matched in amount
and timing. The defeasance transactions also prefunded
Sodra’s purchase option at the end of the sublease. As in
John Hancock’s LILO transactions, if Sodra were to decide
not to exercise its purchase option, BB&T would have the
choice of: (1) renewing the sublease; (2) replacing Sodra; or
(3) retaining the equipment. Finally, Sodra was required to
procure a long-term letter of credit for the benefit of BB&T
in the event that the transaction was unwound early.
BB&T argued to the District Court that it had acquired a
legitimate leasehold interest in the equipment. The argu-
ment was predicated upon certain new obligations imposed
on Sodra as part of the sublease, including Sodra’s obligation
to maintain and operate the equipment consistently with cer-
tain standards, hold a specified amount of insurance, and file
certain reports not previously required. The court disagreed,
holding that ‘‘[i]n substance, Sodra’s use and possession of
the [e]quipment was unaltered by the transaction’’. The court
held that nothing in the record indicated that any alterations
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(1) JOHN HANCOCK LIFE INS. CO. (U.S.A.) v. COMM’R 61
to Sodra’s rights and obligations with respect to the equip-
ment were unique to the initial lease, nor was there any evi-
dence that such obligations were not the responsibility of
Sodra before the LILO transaction.
The District Court further held that even if Sodra were to
choose not to exercise its purchase option, the defeasance
structures and obligations imposed on the parties ensured
that BB&T bore no real risk of loss. Despite construing the
evidence in the light most favorable to BB&T, the court
granted the Government’s motion for summary judgment,
disregarded the reciprocal and offsetting obligations of the
LILO transaction, and concluded that BB&T acquired no
more than a future interest in the equipment.
On appeal, the Court of Appeals for the Fourth Circuit
affirmed the trial court’s decision. Applying the doctrine of
substance over form, the Court of Appeals determined that
in order for BB&T to deduct payment on the initial lease as
a rent payment under section 162(a)(3), it had to establish
that it acquired a genuine leasehold interest in the equip-
ment, i.e., that the initial lease was, in substance, a true
lease for tax purposes.
In determining whether the transaction allocated BB&T’s
and Sodra’s rights, obligations, and risks in a manner that
resembles a traditional lease relationship, the court found
that (1) BB&T and Sodra exchanged nearly identical rights
and obligations in the initial lease and sublease, leaving
BB&T only a right to make an annual inspection of the
equipment; (2) though the transaction provided for the
exchange of tens of millions of dollars in rent payments,
there was a lack of actual cashflow during the term of the
transaction aside from the money BB&T provided Sodra as
incentive for the transaction; (3) Sodra, through its purchase
option, could unwind the transaction without ever losing
dominion and control over the equipment or having surren-
dered any of its own funds to BB&T and had no economic
incentive to do otherwise; thus, BB&T did not expect Sodra
to walk away from the cashless purchase option at the end
of the sublease; and (4) the structure insulated BB&T from
any risk of losing its initial investment. BB&T, 523 F.3d at
473.
Moreover, the court held that unlike the transaction in
Frank Lyon, the LILO transaction ‘‘failed to show any ‘busi-
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62 141 UNITED STATES TAX COURT REPORTS (1)
ness or regulatory realities’ that ‘compelled or encouraged
* * * the structure of the transaction at issue here, nor has
it established that the LILO is ‘imbued with tax-independent
considerations, and is not shaped solely by tax avoidance fea-
tures that have meaningless labels attached’ ’’. Id. Thus, the
court held in substance the transaction was a financing
arrangement, not a genuine lease and sublease.
The court did not analyze BB&T’s LILO transaction for
economic substance. The court noted that whether a par-
ticular transaction lacks economic substance is a question of
fact. Id. at 472. As a result, because the case arose out of a
motion for summary judgment, the District Court and the
Court of Appeals were required to view the facts in a light
most favorable to BB&T, and both courts assumed the LILO
transaction had economic substance.
B. AWG
In AWG, 592 F. Supp. 2d 953, the District Court for the
Northern District of Ohio was the first court to review a
SILO transaction. In the transaction at issue, KeyCorp (Key)
and PNC Financial Services Group, Inc. (PNC), two financial
institutions, entered into a grantor trust (Key/PNC). Key/
PNC leased a waste-to-energy disposal and treatment plant
(facility) in Wuppertal, Germany, from Abfallwirtschafts-
gesellschaft mbH Wuppertal (AWG) for a term of 75 years
and subleased the facility back to AWG for a term of 24
years. A consortium of German municipalities owned AWG,
and they were also some of the facility’s most important cus-
tomers. Like John Hancock’s SILO transactions, because the
initial lease exceeded the expected economic useful life of the
leased asset, it was treated as a sale for U.S. Federal tax
purposes.
The sublease was a net lease, with AWG retaining nearly
identical rights and obligations with respect to the facility as
it had before the SILO transaction. Key/PNC through an
equity contribution provided approximately 13% of the pre-
paid rent to AWG as required by the initial lease. Similar to
John Hancock’s SILO transactions, the remainder of the
transaction was financed through two nonrecourse loans, a
series A loan accounting for 90% of the debt and a series B
loan accounting for the remaining 10%. Unlike John Han-
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cock’s SILO transactions, Key/PNC required that the trans-
action feature full defeasance, with AWG obligated to enter
into separate DPUAs for the series A and series B loans, as
well as an EPUA. These defeasance agreements ensured the
payment of AWG’s rental obligation under the sublease,
which matched Key/PNC’s debt service in amount and
timing, and funded AWG’s purchase option. The series A
DPUA was pledged as collateral for repayment of Key/PNC’s
loans.
The structure of AWG’s purchase option was similar to
those of the lessee counterparties in John Hancock’s SILO
transactions. However, unlike John Hancock’s SILO trans-
actions, if AWG chose not to exercise its purchase option,
Key/PNC was not given options. Rather, the transaction
required AWG to enter into a service contract to purchase
solid waste disposal services from Key/PNC for a specified
term. As in John Hancock’s SILO transactions, the service
contract option required the lessee counterparty, AWG, to
arrange for a refinancing of Key/PNC’s nonrecourse debt.
In order to determine whether Key/PNC was entitled to
the claimed tax deductions, the District Court analyzed the
economic substance of the transaction following Dow Chem.
Co. v. United States, 435 F.3d 594, 599 (6th Cir. 2006), which
treats a transaction as having economic substance only if the
transaction has genuine economic effects other than tax
benefits and the taxpayer is truly motivated by profit to
participate in the transaction.
Starting with the assumption that AWG would exercise its
purchase option, the evidence showed that Key/PNC would
receive approximately $78 million on its $55 million equity
investment during the sublease term. The court held that
this 3.4% return was consistent with the type of return
banks ordinarily receive from leveraged lease transactions.
Further, the court held that although it was unlikely that
AWG would choose the service contract option, if it did so
Key/PNC had the potential to earn between 5% and 8% on
its equity investment, depending on the facility’s business
production. Accordingly, the District Court held that the
transaction had genuine economic effects other than tax
benefits. The court also held that Key/PNC had a profit
motive, relying on the small chance that the transaction
could earn between 5% and 8%.
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64 141 UNITED STATES TAX COURT REPORTS (1)
Having concluded that the SILO transaction had economic
substance, the District Court turned to the substance over
form test. Citing Frank Lyon, 453 U.S. 561, the District
Court held that in order for Key/PNC to prevail on its claim
that the substance of the transaction was consistent with its
form, thus entitling Key/PNC to tax depreciation and
amortization deductions, Key/PNC had to prove that it both
obtained and kept significant and genuine characteristics of
ownership of the facility. ‘‘Such genuine attributes of owner-
ship are generally found only where the alleged owner bears
both the burdens and enjoys the benefits of asset ownership.’’
AWG, 592 F. Supp. 2d at 981.
Several facts were pivotal to the court’s decision. First, the
court held that AWG’s rights and obligations with respect to
the facility remained virtually the same before and after the
SILO transaction. Notably, under German law, legal title to
the facility remained with AWG, entitling AWG to deprecia-
tion deductions on the facility for German tax purposes.
Next, the court pointed to the circular nature of the SILO
transaction’s payment structure, holding that the offsetting
payments strongly indicated that the transaction had little
substantive purpose. Third, the court held that Key/PNC did
not assume the substantive credit, residual value, or remar-
keting risk that is typical of a lessor in a leveraged lease.
Aside from its other protections, the court noted that the
SILO transaction included a guaranty from the municipal
members of AWG, backed by the German Federal Govern-
ment, to the benefit of Key/PNC.
Finally, the District Court emphasized that AWG was
‘‘highly likely’’ or ‘‘nearly certain’’ 32 to exercise its purchase
option. If AWG did not exercise the purchase option, it was
required to refinance Key/PNC’s nonrecourse debt of $383
million. On the purchase option date, the appraisal estimated
32 The
District Court also used terms such as ‘‘compelled to’’ and ‘‘vir-
tually certain’’ to determine whether AWG would exercise its purchase op-
tion. AWG Leasing Trust v. United States, 592 F. Supp. 2d 953, 986 (N.D.
Ohio 2008). Later, Courts of Appeals have discussed in depth the standard
to be used to determine whether a party in a SILO or LILO transaction
will exercise its purchase option. See Wells Fargo, 641 F.3d at 1325–1330;
Consol. Edison, 703 F.3d at 1379. The District Court in AWG lacked the
benefit of the Court of Appeals for the Federal Circuit’s in-depth analysis
of the issue and creation of a reasonable likelihood standard.
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the fair market value of the facility to be $390 million.
Accordingly, initial refinancing would require a loan-to-value
ratio of over 98%. A provision in the service contract required
a $50 million payment from AWG, reducing the amount
required to be borrowed to $333 million. Nonetheless, this
loan-to-value ratio of approximately 85% was still well above
the typical ratio for a German loan, of no greater than 67%.
The District Court concluded that exercise of the purchase
option was the only viable choice for AWG.
The court also took into consideration the tax consequence
to AWG of nonexercise under German law. As is the case in
John Hancock’s SILO transactions, although the initial lease
is treated as a sale for U.S. Federal tax purposes, under Ger-
man law AWG remained the owner of the facility. If AWG
were to elect the service contract option, it would receive the
cash balance from the DPUAs and EPUA, or approximately
$521 million. The District Court held that this receipt of
cash, combined with AWG’s relinquishment of the facility,
would likely be treated as a taxable sale under German law.
The transaction’s original appraisal failed to consider this
possibility and its impact on AWG’s purchase option decision.
Several other unique facts were important in the District
Court’s decision. For instance, the court seemed skeptical
about the accuracy of the appraisal, pointing to the large
discrepancy between the facility’s original appraised fair
market value of $250 million and the $450 million appraisal
used to build the transaction. The court also noted that no
representative from AWG testified at trial to provide evi-
dence of any reason for AWG to participate in the SILO
transaction outside of its net present value benefit. In sum,
the court concluded that
the AWG transaction is a financing arrangement designed in significant
measure to increase tax deductions available to * * * [Key/PNC]. The
AWG transaction * * * is not a genuine sale and leaseback. Essentially
all that * * * [Key/PNC] did was to pay AWG a $28.5 million accommo-
dation fee to sign paperwork meeting the formal requirements of a sale
and leaseback and to arrange a circular and largely meaningless flow of
cash from and then back to * * * [the German lenders]. AWG, mean-
while, continues to have undisturbed and uninterrupted possession and
control of the Facility, continues to claim the tax benefits of ownership
of the Facility under German law, and has no economic or political moti-
vation to give up control of the plant to * * * [Key/PNC] at any time.
Because * * * [Key/PNC] never became the true owners of the Facility,
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66 141 UNITED STATES TAX COURT REPORTS (1)
they are not entitled to deductions for the depreciation or amortization
of expenses associated with the asset. [AWG, 592 F. Supp. 2d at 990.]
C. Wells Fargo
In Wells Fargo, 641 F.3d 1319, the Court of Appeals for the
Federal Circuit affirmed the Court of Federal Claims’ deci-
sion to disallow the taxpayer’s claimed tax benefits arising
from 26 SILO transactions. The parties agreed to try a set
of test transactions, four of which involved transportation
assets with domestic transit agencies as the counterparties
(transit agency transactions) and a fifth involving qualified
technological equipment with a foreign counterparty. The les-
see counterparties and the assets of the Wells Fargo test
transactions were as follows:
(1) New Jersey Transit Corporation—45 light rail vehicles
and 650 buses;
(2) State of California Department of Transportation
(Caltrans)—6 locomotives and 12 intercity passenger rail
cars;
(3) Metropolitan Transit Authority of Harris County, Texas
(Houston Metro)—45 commuter buses and 241 transit buses;
(4) Washington Metropolitan Area Transit Authority
(WMATA)—42 subway cars; and
(5) Belgacom Mobile, S.A., a Belgian entity (Belgacom)—2
lots of GSM cellular communications equipment.
Wells Fargo & Co. (Wells Fargo) is a diversified financial
services company. It operates a leasing company, maintains
a fairly significant leasing portfolio, and invests in leases
involving a variety of assets. Wells Fargo conducted exten-
sive due diligence before entering into its SILO transactions,
including credit approvals and tax capacity analyses. It also
relied upon the work of qualified appraisers, accountants,
and lawyers who reviewed and provided support for their
SILO transactions.
In each of the transit agency transactions Wells Fargo,
through a grantor trust, made an initial equity contribution
of approximately 15% to 20% of the prepaid rent made to the
lessee counterparty and borrowed the remainder on a non-
recourse basis. Unlike John Hancock’s SILO transactions,
Wells Fargo did not divide its borrowing into series A and
series B loans. A promoter secured the appraisals that deter-
mined the value of each transaction. The rights and obliga-
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tions transferred to Wells Fargo under the initial lease in
each of the transactions were substantially similar to those
transferred back to the lessee counterparties in the respec-
tive subleases. The lessee counterparties’ rent payments
under the subleases exactly matched Wells Fargo’s debt
service payments in amount and timing. Further, unlike
John Hancock’s SILO transactions, which did not require
series B debt or equity defeasance, each of Wells Fargo’s
transactions required full debt and equity defeasance.
Wells Fargo’s SILO transactions featured purchase options
for the lessee counterparties at the end of the sublease
terms. The purchase options were prefunded through the
defeasance transactions. If a lessee counterparty were to
decide not to exercise its purchase option, Wells Fargo would
have the choice of either taking possession of the transpor-
tation equipment or requiring the lessee to arrange for a
service contract.
The service contract option imposed certain obligations on
the lessee counterparty. These obligations included: (1)
finding an acceptable operator for the transportation equip-
ment and negotiating an operating agreement; (2) arranging
for the refinancing of Wells Fargo’s nonrecourse loan; (3) in
the Caltrans and WMATA transactions, obtaining and paying
for a letter of credit for the benefit of the refinancing lender;
(4) in the Caltrans, WMATA, and Houston Metro trans-
actions, procuring and paying for residual value insurance
for the benefit of Wells Fargo; (5) satisfying the equipment’s
physical return conditions; and (6) if Wells Fargo requires,
entering into new defeasance agreements to secure amounts
owed to Wells Fargo under the service contracts.
The trial court analyzed Wells Fargo’s test transactions
under both the substance over form and economic substance
doctrines. In each test transaction, the court concluded that
Wells Fargo was not entitled to its claimed deductions. Ana-
lyzing whether the benefits and burdens of ownership had
passed to Wells Fargo, the court compared each Wells Fargo
test transaction with the transaction in Frank Lyon, finding:
The loan proceeds were not invested in the property or equipment, or
retained by either the tax-exempt entity or Wells Fargo. Moreover, the
debt and equity undertaking payment arrangements eliminated the need
for the tax-exempt entity to actually pay rent under the lease-backs, or
for Wells Fargo to actually make any debt service payments. The ‘‘rent’’
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68 141 UNITED STATES TAX COURT REPORTS (1)
and ‘‘debt’’ payments in each SILO simply are accounted for as offsetting
entries within the lender group. The debt will be completely paid with-
out Wells Fargo having to supply any funds, whether the * * * [pur-
chase options] are exercised or not. In contrast, in Frank Lyon, the tax-
payer alone was liable for repayment of recourse debt, ‘‘to which it
exposed its very business well-being.’’ * * * The taxpayer also was
dependent upon the lessee for payment of rent to service the debt. [Wells
Fargo, 91 Fed. Cl. at 77.]
The court also found that Wells Fargo’s return on its invest-
ment was guaranteed in each of the SILO transactions,
regardless of any decline in the value of the leased assets.
The court distinguished Wells Fargo’s test transactions
‘‘from Frank Lyon, where the lessee had renewal options, but
the exercise of the options was at the lessee’s unconstrained
choice, and the taxpayer did not have the ability to impose
a renewal upon the lessee.’’ Id. at 78. The court concluded
that despite convincing evidence that the service contract
and return options were viable, ‘‘[t]he near certain exercise
of * * * [the purchase options] at the end of the lease-back
period renders moot what might or might not happen after
the * * * [purchaser option] date passes.’’ Id. at 74.
Finally, the court determined that Wells Fargo’s trans-
actions lacked economic substance because on a net present
value basis each SILO is ‘‘a losing proposition without the
tax benefits.’’ Id. at 82. The court also held that there was
no nontax business purpose to the SILO transactions and
that the transactions were not the product of ‘‘any negotia-
tions or commercial realities’’.
On appeal, Wells Fargo challenged the Court of Federal
Claims’ decision with respect to both the application of the
substance over form doctrine and the court’s determination
that there was no economic substance. The Court of Appeals
for the Federal Circuit focused its analysis on the substance
over form inquiry (i.e., whether Wells Fargo acquired the
benefits and burdens of ownership in the leased assets) and
the question of whether the lessee counterparties would exer-
cise their purchase options at the end of the lease term.
Wells Fargo, 641 F.3d at 1325–1330.
Wells Fargo argued that (at the time the transactions were
entered into) it could not know for certain whether the lessee
counterparties would exercise their purchase options. The
court stated: ‘‘We have never held that the likelihood of a
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particular outcome in a business transaction must be
absolutely certain before determining whether the trans-
action constitutes an abuse of the tax system. The appro-
priate inquiry is whether a prudent investor in the tax-
payer’s position would have reasonably expected * * * [the
counterparties to exercise their purchase option]’’, not
whether the taxpayer was certain of such an outcome. Id. at
1325–1326.
Wells Fargo challenged the testimony of Dr. Lys, the
Government’s expert on financial economics, and defended its
own appraisers’ analyses. The court identified the discount
rate that the lessee counterparties would apply in calculating
the net present value of its purchase option decision as the
‘‘crux of the disagreement’’ between Dr. Lys’ analysis and
those of Wells Fargo’s appraisers. The appraisers analyses
used the weighted average cost of capital (WACC) in the
transit industry as the appropriate discount rate. Dr. Lys, on
the other hand, used a lower discount rate in the same way
as he has done for John Hancock’s transactions, equal to the
rate at which the lessee counterparty could borrow funds.
Using the borrowing rate, Dr. Lys projected that (1) the fair
market values of the leased assets on the sublease purchase
options dates and (2) the cost of the payments to Wells Fargo
under the service contracts were higher than their appraised
values. As a result, Dr. Lys concluded that the service con-
tract provided the lessee counterparties with less financial
benefit than if they simply decided to exercise the purchase
option. Wells Fargo argued that Dr. Lys’ deviation from the
use of the WACC rate was inappropriate and produced inac-
curate results.
The court adopted Dr. Lys’ approach, citing the trial court’s
acceptance of his methodology. The court declined to pass
judgment on whether a different discount rate was more
appropriate. Rather, the court held that the discount rate
was a ‘‘distinctly factual matter’’ and that Wells Fargo had
failed to prove that the trial court’s acceptance of Dr. Lys’
methodology was clear error. Further, the court concluded
that the trial court’s conclusion that the lessee counterparties
would exercise their purchase options did not depend on Dr.
Lys’ analysis. Citing witness testimony and documentary evi-
dence, the court held that the trial court’s findings of fact
provided ample evidence that there were substantial difficul-
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70 141 UNITED STATES TAX COURT REPORTS (1)
ties for the lessee counterparties to comply with the service
contract option and that Wells Fargo reasonably expected the
purchase options to be exercised. Any testimony or evidence
to the contrary was ‘‘not enough to call into question’’ the
trial court’s conclusions. Therefore, the benefits and burdens
of ownership did not pass to Wells Fargo and Wells Fargo’s
SILO transactions could not be respected for Federal tax pur-
poses under the substance over form doctrine.
D. Altria
In Altria, 658 F.3d 276, the Court of Appeals for the
Second Circuit affirmed a District Court’s decision to deny
the taxpayer judgment as a matter of law following an
unfavorable jury verdict. At issue in Altria were three SILO
transactions and a LILO transaction. The taxpayer, Altria
Group, Inc. (Altria), is a financial services company. The les-
see counterparties and subject assets of Altria’s test trans-
actions were as follows:
(1) New York Metropolitan Transportation Agency
(MTA)—a rail car maintenance facility;
(2) Oglethorpe Power Corp. (Oglethorpe)—a pumped stor-
age hydroelectric facility;
(3) Seminole Electrical Cooperative, Inc. (Seminole)—a
coal-fired electrical generating plant; and
(4) Watershap Vallei en Eem (Vallei), an independent
agency of the Government of the Netherlands—a wastewater
treatment facility. Oglethorpe, Seminole and Vallei were
SILO transactions, and MTA was a LILO transaction.
Each of Altria’s transactions featured full defeasance, a les-
see purchase option, and a renewal option or service contract
option at the end of the sublease term. Additionally, in each
of the transactions at issue: (1) there was no viable sec-
ondary market for the subject assets; (2) the assets were
essential to the lessee counterparties’ businesses; (3) the
appraisals did not properly estimate the assets’ expected
residual value and useful lives; (4) the transactions shifted
tax benefits from a nontaxable to a taxable entity, rather
then transferring benefits among taxable entities; and (5) the
defeasance accounts created a circular flow of money.
Altria’s motion for judgment as a matter of law argued
that the jury gave undue weight to evidence that had no
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bearing on the interests Altria acquired in the transactions,
that the trial court’s jury instructions were misleading, and
that Altria proved that the transactions were reasonably
expected to generate a non-tax-based profit. Notably, Altria
argued that the jury was not instructed to consider the
proper factors in determining whether Altria acquired the
benefits and burdens of a traditional lessor.
The jury instructions asked the jury to consider ‘‘all the
relevant facts and circumstances’’, including the following
eight nonexclusive factors: (1) whether ‘‘meaningful’’ control
over the assets was transferred; (2) whether the equity
investment in the facility was ‘‘meaningful’’; (3) cashflows
between the parties; (4) whether the transaction was moti-
vated by ‘‘legitimate business purposes, or solely by a desire
to create tax benefits’’; (5) regulatory realities; (6) whether
the assets had expected useful lives beyond the leaseback
that Altria could benefit from; (7) whether it was reasonable
to expect that the assets would have meaningful value at the
end of the leaseback which would benefit Altria; and (8)
whether Altria had the potential to benefit from an increase
in the assets’ value and suffer a loss of its equity investment
in the facility as a result of a decrease in the facility’s value.
Altria, 694 F. Supp. 2d at 271. For factors (6)–(8), the Dis-
trict Court asked the jury to consider the ‘‘likelihood’’ that
the lessee counterparty would exercise its purchase option.
Altria argued that these factors were inappropriate, that
the controlling factors with respect to the benefits and bur-
dens of ownership analysis should come from a series of post-
Frank Lyon Tax Court decisions, and that the jury should
have been instructed to evaluate the factors in those cases as
the exclusive determinative indicia of ownership. The District
Court disagreed, holding that
[t]o say * * * that the Tax Court’s decisions identify the exclusive cri-
teria for determining which taxpayer is entitled to a depreciation deduc-
tion would be to ignore the essential holding of Frank Lyon, that
whether a taxpayer possesses a depreciable interest in a leased asset
must be determined through a fact-intensive analysis focused on the
‘‘substance and economic realities’’ of the challenged transaction. * * *
[Id. at 275.]
Altria further argued that even if the all-encompassing
approach of Frank Lyon is proper, several of the specific fac-
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72 141 UNITED STATES TAX COURT REPORTS (1)
tors the court presented to the jury were inappropriate. The
District Court focused its discussion on two particular fac-
tors. First, Altria argued that the court erred in instructing
the jury to determine the ‘‘likelihood’’ that the lessee counter-
parties would exercise their purchase options, rather than
instructing the jury to determine whether the purchase
options were ‘‘certain’’ or ‘‘nearly certain’’ to be exercised. The
District Court held that Altria’s argument was merely one of
semantics, since the ‘‘likelihood’’ of exercise includes the
possibility of a determination that it was ‘‘certain’’ or ‘‘nearly
certain’’. It stated that no Court of Appeals supports Altria’s
proposed standard and none has addressed exactly ‘‘how
likely’’ the exercise of an option must be to support a conclu-
sion that the taxpayer did not acquire a depreciable interest.
Finally, and most importantly, the District Court held that
Altria’s proposed instruction misunderstood the Govern-
ment’s argument, i.e., that it was the cumulative effect of
each of the transactions’ possible scenarios, and not just the
purchase options, that determines whether the benefits and
burdens have passed.
Second, Altria argued that the District Court should have
instructed the jury to disregard present value in its residual
interest analysis. The District Court disagreed, finding that
the present value analysis ‘‘properly sought to illuminate the
transactions’ ‘substance and economic realities’, * * *
particularly the relative importance of the residual values
nominally Altria stood to receive’’. Altria, 694 F. Supp. 2d at
280 (quoting Frank Lyon, 435 U.S. at 582).
Altria also argued against the use of a present value anal-
ysis as part of the second prong of the economic substance
test, whether Altria acted with a bona fide business purpose.
Citing rule 401 of the Federal Rules of Evidence, which pro-
vides that ‘‘relevant evidence’’ is ‘‘evidence having any tend-
ency to make the existence of any fact that is of consequence
to the determination of the action more probable or less prob-
able’’, the District Court held that the Government’s present
value analysis easily satisfied this test, and a reasonable
factfinder might conclude that it is ‘‘less probable’’ that an
investor had a reasonable business purpose for a transaction
with a negative net present value. Id. at 284–285. Altria also
argued that the use of a present value analysis in the busi-
ness purpose test was inconsistent with one of the District
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(1) JOHN HANCOCK LIFE INS. CO. (U.S.A.) v. COMM’R 73
Court’s other jury instructions, which was to ignore present
value in determining whether the transactions had ‘‘economic
effect’’, the first prong of the economic substance test. The
District Court dismissed this argument, holding that it was
dependent on a ‘‘false dichotomy’’ and that realizing trans-
actional profit on a cash-in-cash-out basis is not the only
legitimate objective a business may pursue.
On appeal, the Court of Appeals for the Second Circuit
addressed three arguments with respect to substance over
form. Altria, 658 F.3d at 286. First, Altria challenged the
District Court’s decision that it was appropriate for the jury
to evaluate the ‘‘likelihood’’ that the lessee counterparties
would exercise their purchase options, again arguing that the
jury should have been instructed to evaluate whether exer-
cise was ‘‘certain’’ or ‘‘nearly certain’’. The Court of Appeals
affirmed the District Court’s position, holding that the pur-
chase option is just one factor in determining ownership and
that the likelihood of the purchase options’ being exercised is
not determinative of the analysis. Further, the court held
that neither the Supreme Court nor the Court of Appeals for
the Second Circuit has ever concluded that the true sub-
stance of a transaction is limited to events that are ‘‘certain’’
or ‘‘virtually certain’’ to occur.
Altria argued that the jury instructions failed to provide
any guidance on what levels of equity investment or residual
value are ‘‘meaningful’’ in the leasing context, leaving the
jury without a proper standard to work with. Altria
requested an instruction stating that a 6% equity investment
and an expected residual value of 10% to 20% would satisfy
this threshold. The court dismissed this argument, holding
that a precise numerical test would encourage taxpayers to
change the form and not the substance of their transactions.
Citing Frank Lyon, the court said that the existence of a
depreciable interest in an asset depends on the particular
facts of the case.
Finally, Altria argued that two of the factors included in
the jury instructions’ nonexclusive list were ‘‘neutral’’ and
therefore not relevant to determining traditional lessor
status. The first factor was control over the asset, which
Altria noted is present in all leveraged leases. The court
rejected this argument, holding that Frank Lyon specifically
requires such an analysis. The second factor was cashflows,
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74 141 UNITED STATES TAX COURT REPORTS (1)
which the court likewise rejected, citing the relevance of cir-
cular cashflows to the courts in Wells Fargo, BB&T, and
AWG. Accordingly, the court affirmed the jury’s findings that
Altria did not obtain the benefits and burdens of ownership
with respect to its transactions.
E. Consolidated Edison
In Consol. Edison, 703 F.3d 1367, the Court of Appeals for
the Federal Circuit reversed the Court of Federal Claims’
decision holding that the taxpayer was entitled to its claimed
deductions from a LILO transaction. The taxpayer, Consoli-
dated Edison Co. of New York, Inc., and its subsidiaries
(ConEd), is a publicly held utility company that generates,
transmits, and sells electricity to New York City and sur-
rounding areas. ConEd, through a grantor trust, leased a
47.47% undivided interest in a gas-fired, combined cycle
cogeneration facility (RoCa3) in the Netherlands from
Electriciteitsbedrijf Zuid-Holland, N.V. (EZH), for a term of
approximately 43 years and subleased RoCa3 back to EZH
for a term of approximately 20 years. ConEd was interested
in international LILO transactions that diversified its assets
and developed strategic alliances abroad. ConEd evaluated
prospective transactions in a very deliberate manner, con-
ducted extensive due diligence, and chose to invest in RoCa3
after rejecting many other proposed opportunities.
The initial lease required ConEd to prepay rent of
$120,112,270, which was funded through an equity contribu-
tion of $39,320,000, or approximately 33% of the upfront pay-
ment, and a nonrecourse loan of $80,792,270. On the initial
lease termination date, ConEd was required to make a
second rent payment to EZH of $831,525,734. Under the sub-
lease, EZH was required to make periodic rent payments to
ConEd. At the end of the sublease, EZH has the option of
purchasing ConEd’s leasehold interest in RoCa3.
The transaction featured both equity and debt defeasance
to ensure EZH’s rent payments under the sublease and
ConEd’s debt service, which matched in timing and amount.
The defeasance transactions also funded EZH’s purchase
option, allowing EZH to exercise its option without contrib-
uting any additional equity or borrowing any additional
amounts. ConEd was granted a first-priority security interest
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(1) JOHN HANCOCK LIFE INS. CO. (U.S.A.) v. COMM’R 75
in both the debt and equity defeasance accounts. As further
security for ConEd’s interests in the LILO transaction, EZH
was required to maintain one or more letters of credit in
favor of and for the benefit of ConEd.
If EZH did not exercise its purchase option at the end of
the sublease, ConEd could either compel EZH to renew the
sublease for an additional 16.5 years or choose the retention
option, which would force EZH to deliver possession of RoCa3
to ConEd. Under the renewal option, EZH had to maintain
defeasance accounts or other similar arrangements to secure
its ongoing rent payments. Further, under the renewal
option ConEd had to fund two deposits, or provide acceptable
substitute collateral, to secure the final rent payment under
the initial lease. If the retention option was elected, ConEd
had to prepay its nonrecourse loan. If ConEd was unable to
do so and timely notified EZH, the renewal option was
deemed to have been elected.
The Court of Federal Claims, to which a refund suit was
brought, determined that the transaction could not be
ignored under the substance over form doctrine and further
concluded that the transaction had economic substance. The
court concluded that there was no certainty that EZH would
exercise the sublease purchase option. Thus it followed that
the transaction, although insulated to minimize risk, was not
without risk and that the transaction presented three sepa-
rate viable options (i.e., the retention, renewal, and sublease
purchase options) that could be exercised at the end of the
sublease term, none of which was guaranteed or inevitable at
the time the transaction was consummated. The United
States appealed the Court of Federal Claims’ ruling and chal-
lenged it under the substance over form doctrine. 33
The Government argued that as of the closing date the
sublease purchase option was reasonably expected to be exer-
cised and thus the transaction should be characterized as one
without any meaningful substance. The Court of Appeals for
the Federal Circuit, following its prior decision in Wells
Fargo, agreed with the Government and found the trans-
action should be disregarded for Federal tax purposes under
the substance over form doctrine.
33 On appeal, the Government did not challenge the Court of Federal
Claims’ ruling under the economic substance doctrine.
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76 141 UNITED STATES TAX COURT REPORTS (1)
The issue as framed by the Court of Appeals was
whether EZH would exercise its purchase option at the end of the
[s]ublease * * * [t]erm. If the [s]ublease [p]urchase [o]ption were exer-
cised, the transaction would merely become a transaction in which
ConEd leased the RoCa3 Plant from EZH and leased it back for the
same identical period. Such a transaction lacks substance. This would
particularly be so here because EZH would maintain uninterrupted use
of the RoCa3 Plant without any involvement on ConEd’s part and ConEd
would not experience any benefits or burdens associated with its lease-
hold interest. [Consol. Edison, 703 F.3d at 1375–1376.]
The Court of Appeals reiterated that the standard for
determining whether the purchase option would be exercised
was a reasonable likelihood standard. In evaluating whether
the LILO transaction had to be recharacterized, the Court of
Appeals assessed whether a prudent investor in ConEd’s
position would have reasonably expected EZH to exercise its
purchase option. ConEd had the burden of proving that
EZH’s exercise of the purchase option was not reasonably
likely. The Court of Appeals determined on the basis of the
record that ConEd had failed to meet its burden.
The record demonstrated that ConEd, shortly before the
closing date of the transaction, expected that EZH would
exercise the sublease purchase option. Brian DePlautt, the
vice president of the ConEd subsidiary responsible for the
RoCa3 transaction, admitted that ConEd believed that EZH
planned, before the closing date of the transaction, to exer-
cise the option. Mr. DePlautt, when asked by ConEd’s
accountants before the transaction whether he thought EZH’s
exercise of the purchase option was ‘‘reasonably assured’’,
responded: ‘‘Yes, among the reasons are (a) * * * [the
RoCa3] facility is a newly built key asset for * * * [EZH],
[and] (b) * * * [EZH] has preplanned for purchase and done
* * * [its] economic analysis on the assumption that the
plant will be purchased.’’ Id. at 1378. Additionally, in a
November 26, 1997, memo, ConEd acknowledged a Trans-
action Structure Description document from Cornerstone, the
LILO promoter, which indicated that it was reasonable to
assume that EZH would exercise the purchase option. Id.
ConEd relied on an appraisal it obtained from Deloitte to
demonstrate that a prudent investor would not have reason-
ably expected that EZH would exercise the purchase option.
The appraisal primarily relied on Deloitte’s view that there
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(1) JOHN HANCOCK LIFE INS. CO. (U.S.A.) v. COMM’R 77
was no economic compulsion to exercise the purchase option
because the option price would exceed the projected value of
the property. The Court of Appeals found the appraisal
unconvincing as Deloitte had failed to consider several non-
economic factors and the costs to EZH that would result from
ConEd’s exercise of the renewal or retention options if EZH
declined to exercise the purchase option. Moreover, Deloitte
failed to consider the fact that the purchase option required
no out-of-pocket funds, as the money EZH would require to
exercise the purchase option was set aside in the two defea-
sance accounts.
Having found that the undisputed evidence established
that EZH was reasonably likely to exercise the purchase
option, the Court of Appeals found that ConEd had failed to
show that the substance of the transaction included a gen-
uine leasehold interest in which ConEd would bear the bene-
fits and burdens of a lease transaction. Therefore, the court
held that the LILO transaction did not constitute a true
lease and ConEd’s rent deductions were disallowed under
section 162(a)(3).
The Test Transactions
Respondent argues that John Hancock’s LILO and SILO
transactions lack economic substance and that the substance
of each transaction is not consistent with its form. Specifi-
cally, respondent argues that John Hancock failed to acquire
substantive leasehold interests in the LILO properties and
failed to acquire substantive ownership interests in the SILO
properties. Thus, respondent argues the true substance of
these LILO and SILO transactions is a loan from John Han-
cock to the counterparties and, consequently, John Hancock’s
equity contributions in these LILO and SILO transactions
should be recharacterized as loans, consistent with their sub-
stance. As a result, John Hancock would not be entitled to
its claimed deductions. 34 In addition, respondent argues that
if we recharacterize the LILO and SILO transactions as
loans, the LILO and SILO transactions would create OID
34 John Hancock claimed deductions for rent, depreciation, and interest
expense with respect to the various LILO and SILO transactions.
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78 141 UNITED STATES TAX COURT REPORTS (1)
income for John Hancock upon which John Hancock would be
subject to Federal income tax.
Petitioners, on the other hand, argue that the LILO and
SILO transactions had economic substance because John
Hancock expected to derive a pretax profit from each trans-
action and entered into each transaction with the primary
purpose of making a profit. Additionally, petitioners argue
that the substance of each LILO and SILO transaction is
consistent with its form and thus the form of each trans-
action should be respected for Federal tax purposes. Specifi-
cally, petitioners argue that John Hancock held a true lease-
hold interest in each of the LILO properties and obtained an
ownership interest in each of the SILO properties. As a
result, petitioners argue that John Hancock should be enti-
tled to its claimed deductions for the years at issue.
In order to conclude that John Hancock is entitled to its
claimed deductions, we must determine both that the test
transactions have economic substance and that the substance
of each test transaction is consistent with its form. There is
no clear formula by which to answer these questions, nor do
we attempt to create one. We begin our inquiry with the eco-
nomic substance doctrine.
I. Economic Substance
These cases are appealable to the Court of Appeals for the
First Circuit absent stipulation otherwise. In Dewees v.
Commissioner, 870 F.2d 21 (1st Cir. 1989), aff ’g Glass v.
Commissioner, 87 T.C. 1087 (1986), the Court of Appeals for
the First Circuit discussed the economic substance doctrine
as part of its consideration of whether the taxpayers were
entitled to claimed ordinary losses in a silver straddle trans-
action. The parties argued a number of theories including
that the transaction was a sham and/or lacked economic sub-
stance. Although ultimately the court did not apply the eco-
nomic substance doctrine to reach its result, 35 the court per-
mitted an analysis of both the objective and subjective fea-
35 ‘‘We need not choose among these three different conceptual ways of
addressing the problem. That is because all three roads lead to Rome.’’
Dewees v. Commissioner, 870 F.2d 21, 36 (1st Cir. 1989), aff ’g Glass v.
Commissioner, 87 T.C. 1087 (1986).
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(1) JOHN HANCOCK LIFE INS. CO. (U.S.A.) v. COMM’R 79
tures of a transaction, without a rigid two-part test requiring
a subjective analysis. Id. at 34–35.
A. Objective Inquiry
Under the objective test, a transaction has economic sub-
stance and will be respected for Federal tax purposes where
the transaction offers a reasonable opportunity for profit
independent of tax savings. Gefen v. Commissioner, 87 T.C.
1471, 1490 (1986). However, the mere presence of potential
profit does not automatically impart substance where a
commonsense examination of the transaction and the record
in toto reflect a lack of economic substance. Sala v. United
States, 613 F.3d 1249, 1254 (10th Cir. 2010); Keeler v.
Commissioner, 243 F.3d 1212, 1219 (10th Cir. 2001), aff ’g
Leema Enters., Inc. v. Commissioner, T.C. Memo. 1999–18;
see also Blum v. Commissioner, T.C. Memo. 2012–16.
John Hancock entered into a complex series of financial
arrangements with various lessee counterparties and various
other parties in order to effect the test transactions. In addi-
tion to the transaction documents and extensive testimony,
there are also numerous diagrams, charts, and tables sub-
mitted by both parties describing the test transactions. The
parties agree generally to the overall cashflows stemming
from the test transactions although there are a few discrep-
ancies regarding the dollar values. Where the parties dis-
agree is whether such cashflow projections as of the closing
date give John Hancock a pretax economic return sufficient
to pass the objective inquiry of the economic substance doc-
trine.
Petitioners argue that the test transactions satisfy the
objective inquiry of the economic substance doctrine because
each test transaction projected a positive, cash-on-cash
pretax yield, and after-tax yield on the closing dates. Peti-
tioners, relying on the ABC reports, argue that if the pur-
chase options are not exercised, John Hancock’s expected
pretax returns from the test transactions as of the closing
dates ranged between 2.54% and 4.33%. If the purchase
options are exercised, John Hancock’s expected pretax
returns ranged from 2.83% to 3.43%.
Respondent does not contest the projections in the ABC
report. Instead, respondent argues that petitioners’ projec-
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80 141 UNITED STATES TAX COURT REPORTS (1)
tions do not provide an appropriate measure of the test
transactions’ expected profitability and that petitioners’ cal-
culations must be discounted to determine the value of John
Hancock’s investments. After discounting petitioners’ calcula-
tions respondent argues that the test transactions return
pretax losses without tax benefits. Respondent relies on the
expert report of Dr. Lys to support his argument.
Because Dr. Lys’ calculations of the pretax economic bene-
fits of all test transactions are similar, we use Dr. Lys’
TIWAG calculations to demonstrate his methodology and
respondent’s argument. Dr. Lys begins by comparing the pay-
ments John Hancock made into the TIWAG SILO transaction
with the amount of money John Hancock took out of the
TIWAG SILO transaction through the purchase option date.
Dr. Lys surmised that John Hancock made cash payments of
$327.1 million to enter into the TIWAG SILO transaction.
These payments included $47.2 million in equity investment,
$273.6 in borrowed funds, and $6.3 million in transaction
fees paid to third parties. 36 Thus John Hancock’s total cash
outlay for the TIWAG SILO transaction was $53.5 million
($47.2 million equity investment plus $6.3 million in trans-
action fees). The total purchase price to enter into the trans-
action was $320.8 million ($47.2 million equity investment
plus $273.6 million in debt invested into the transaction).
Next Dr. Lys noted that the $320.8 million purchase price
was distributed among the SILO transaction participants. At
the inception of the transaction TIWAG obtained $24.1 mil-
lion as an inducement fee. The $273.6 million in loans was
placed into a debt defeasance account and the remaining
$23.1 million was placed in an equity defeasance account. By
the purchase option date, assuming exercise of the purchase
options, the original loans of $273.6 million would be fully
repaid with interest to John Hancock’s lenders and John
Hancock would receive the $23.1 million that was paid into
the equity defeasance accounts, plus accrued interest. Dr.
Lys then discounted these cashflows back to the closing date
to determine John Hancock’s pretax return.
36 Dr. Lys’ values for the TIWAG SILO transaction vary from those stat-
ed in the facts and used in the ABC report. For purposes of this Opinion,
these discrepancies are not material.
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(1) JOHN HANCOCK LIFE INS. CO. (U.S.A.) v. COMM’R 81
Dr. Lys’ calculations of the pretax returns on the TIWAG
SILO transaction, and all of the test transactions, rely on net
present value determinations, which were calculated in two
steps. First, Dr. Lys used a discount rate to accumulate John
Hancock’s expected returns from the TIWAG SILO trans-
action through its purchase option date. Next, he discounted
these expected returns back to the closing date in 2001 using
the same rate he used to accumulate the expected returns.
The result is a net gain of zero and the actual cash taken out
of the TIWAG SILO transaction by John Hancock, TIWAG,
and the lenders as of the purchase option date is $320.8 mil-
lion, the same amount put in. 37 Because John Hancock
incurred transaction fees as part of the transaction and paid
an inducement fee to TIWAG, Dr. Lys concludes that on a
net present value basis John Hancock’s expected pretax
return is negative.
Therefore, Dr. Lys argues that absent tax benefits, the
transaction does not create any economic benefits. The
present value of the benefits obtained by TIWAG and the
present value of the benefits obtained by John Hancock
exactly add up to the present value of the investment made
by John Hancock in December 2001, before transaction fees
(i.e., $47.2 million). Thus, Dr. Lys argues that the TIWAG
SILO transaction actually results in a pretax cash loss of
$30.4 million to John Hancock (consisting of the transaction
fees of $6.3 million and the inducement fee of $24.1 million).
37 As a result of Dr. Lys’ methodology, the interest income John Hancock
and its lenders received was irrelevant and did not factor into his calcula-
tions. As Dr. Lys stated in his expert report: ‘‘The interest received by the
lender and by the U.S. Taxpayer represents the costs of having to wait for
repayment of their original investment * * *. The Amounts that the lend-
er and U.S. Taxpayer will eventually receive are equivalent in PV terms
to the amounts they originally provided to the SILO structure at its close
in 2001.’’ Dr. Lys is essentially saying that the discount rate he will use
to calculate the net present value will be the same as the rate at which
an interest is earned, or the same rate he used to accumulate the expected
returns.
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82 141 UNITED STATES TAX COURT REPORTS (1)
Next, Dr. Lys found that the U.S. tax benefits to John
Hancock from entering into the TIWAG SILO transaction up
to the purchase option date equal $63.9 million, more than
offsetting the pretax cash loss of $30.4 million he deter-
mined. Additionally, Dr. Lys found that the U.S. tax benefits
to John Hancock through the service contract period (if the
purchase option is not exercised) equal $79.8 million, once
again more than offsetting the pretax cash loss of $30.4 mil-
lion he determined. Overall, Dr. Lys concludes that the
TIWAG SILO transaction is value-destroying to John Han-
cock absent tax benefits.
v:\files\photos\Hancock.eps
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(1) JOHN HANCOCK LIFE INS. CO. (U.S.A.) v. COMM’R 83
Dr. Lys’ calculation of John Hancock’s pretax returns dif-
fers significantly from petitioners’ calculations in the ABC
reports because petitioners’ calculations do not take into
account a net present value analysis. According to the
TIWAG ABC report, John Hancock invested $49,427,050 in
the TIWAG SILO transaction. John Hancock also borrowed
$273,572,950 to fund the $323 million purchase. Lastly John
Hancock paid $4,037,500 in transaction fees associated with
the SILO transaction. Thus according to the ABC report,
John Hancock invested a total of $53,464,550 in the TIWAG
transaction. Over the course of the initial lease John Han-
cock would receive $1,155,889,616 in rent payments and
other fees such as capacity charges from TIWAG or a third-
party power purchaser. From these payments, $1,139,737,359
would be paid to John Hancock’s lender in satisfaction of its
$273,572,950 loan. John Hancock would also receive
$205,422,256 in residual value from the asset, leaving John
Hancock with a $168,109,693 pretax cash return over the life
of the lease. The ABC report assumed Federal tax payments
of $63,041,236 on the income received by John Hancock,
leaving John Hancock with an after-tax cash return of
$105,068,727 over the life of the lease or an average cashflow
of $1,751,145 per year. The cashflow results in a pretax cash
internal rate of return of 2.54%.
The ABC reports also calculated John Hancock’s pretax
cash internal rate of return when the lessee counterparty
exercised its purchase option. For the TIWAG transaction
according to the ABC report, John Hancock invested a total
of $53,464,550. Over the course of the sublease John Hancock
would receive $150,124,081 of rent payments, and make a
total of $466,223,022 in debt service payments. John Han-
cock would also receive $795,135,940 upon the exercise of the
purchase option at the end of the sublease term. As a result,
John Hancock would be left with a pretax cashflow of
$115,324,288 over the course of the sublease term. John
Hancock would make Federal tax payments of $43,246,608,
leaving it with an after-tax cashflow of $72,077,680 over the
life of the sublease or an average cashflow of $2,057,729.16
per year. The cashflow results in a pretax cash internal rate
of return of 3.40%.
Respondent cites multiple cases to support his assertion
that any calculation of a transaction’s pretax profit must
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84 141 UNITED STATES TAX COURT REPORTS (1)
include a net present value analysis. Notably, in ACM P’ship
v. Commissioner, 157 F.3d at 259, the taxpayer argued that
the Tax Court’s profitability analysis was flawed because it
used a net present value analysis to adjust certain expected
income determinations. The Court of Appeals for the Third
Circuit held valid the analysis and reasoned that ‘‘[i]n trans-
actions that are designed to yield deferred rather than imme-
diate returns, present value adjustments are * * * an appro-
priate means of assessing the transaction’s actual and antici-
pated economic effects.’’ Id. Respondent also cites Wells
Fargo, where the court applied a net present value analysis
in holding that the transactions at issue lacked economic
substance. 38
Generally, we will not second-guess a taxpayer’s judgment
even if a theoretical investor could have found a more profit-
able investment. Estate of Thomas v. Commissioner, 84 T.C.
412, 440 n.52 (1985); Greenbaum v. Commissioner, T.C.
Memo. 1987–222. However, we agree with ACM P’ship that
analyzing the net present value of a transaction as part of
the economic substance inquiry may be useful for trans-
actions with deferred benefits. The extent to which such an
analysis is useful depends on the facts and circumstances.
Where the returns on a tax-advantaged investment are
immediate, a net present value analysis will be of limited aid
in determining the tax validity of a transaction. Blum v.
Commissioner, T.C. Memo. 2012–16.
Having found that a net present value analysis may be
useful in these cases, we turn to respondent’s argument that
the ABC reports do not provide reliable pretax economic
returns and thus that Dr. Lys’ net present value calculations
should control. We disagree. If, as Dr. Lys opined, the proper
test of profitability requires an investor to accumulate a
return on an investment and discount the return back at the
38 Other
courts have declined to do the same in the context of a LILO
or SILO transaction. In Consol. Edison, the Court of Federal Claims de-
clined to apply a present value analysis, holding that no specific minimum
pretax profit is required to recognize the economic substance of a leasing
transaction and the use of a present value analysis ‘‘must depend on the
specific and unique characteristics and conditions of the individual trans-
action under review.’’ Further, in AWG, the taxpayers’ nondiscounted
pretax returns of 2.5% to 3.5% were sufficient to establish economic sub-
stance.
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(1) JOHN HANCOCK LIFE INS. CO. (U.S.A.) v. COMM’R 85
same rate and over the same period, any investment with
transaction costs would always produce a pretax loss. In fact,
Dr. Lys stated at trial that the actual pretax cashflows from
the test transactions were ‘‘irrelevant’’.
At trial petitioners presented Dr. Lys with a simple
example to illustrate this point.
Q: So my simple example is: Assume that you walk into your stock-
broker and you have $101,000 in your pocket.
A: Uh-huh.
Q: And you buy a $100,000 bond—
A: 101 or—
Q: A $100,000 bond, because there are going to be some transaction
costs.
A: Okay.
Q: The broker is going to charge you $1,000 for that transaction.
A: That’s correct.
Q: Using your methodology, assume my bond is 4 percent—you would
calculate the present value today of that bond at maturity, you would
take the $100,000 and accumulate it forward at 4 percent, and then you
would discount it back at 4 percent. Am I right?
A: Correct.
Q: So on a present-value basis, the value of my investment is [$]100,000.
A: That’s correct.
Q: But I have [$]101,000 invested.
A: That’s correct.
Q: Is that a value-destroying investment?
A: Yeah. But may I specify, Your Honor? But I get a service. What the
broker did is—I had a problem. I had $100,000 today, and I didn’t want
to have $100,000 today, I wanted to have $100,000 tomorrow, or when-
ever that period is. The $1,000 transaction fee is something that I volun-
tarily paid for getting $100,000 tomorrow.
Under Dr. Lys’ methodology he does not have to analyze the
actual pretax cashflows stemming from the test transactions,
cashflows which were projected in the ABC reports and avail-
able to Dr. Lys.
At trial Dr. Lys was asked whether in order to make a
present value calculation for the test transactions he would
have to know the unpresented valued numbers, i.e., the
cashflows stemming from the transactions. Dr. Lys
responded: ‘‘No, I don’t. No, I don’t. If you put something into
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86 141 UNITED STATES TAX COURT REPORTS (1)
a bank account and you got something in the future and it’s
a fair deal, you’re going to get exactly what you paid into it,
unless something evaporates.’’ Further at trial, Dr. Lys was
asked whether he took a look at the ABC reports and at the
actual pretax cashflows to perform his present value anal-
ysis. Dr. Lys responded: ‘‘I think we did. We computed the
cashflows to actually determine what would be the
compounding rate necessary to earn that future value. So
yes, we did that. But it’s irrelevant. Absent transaction fees,
the compounding rate and the discount rate have to be the
same, because you are incurring the same risk.’’
However, Dr. Lys does not present us with any projected
cashflows in his expert report, and he does not show us how
his calculations are based on these projected cashflows. Also,
Dr. Lys uses dollar values significantly different from those
listed in the ABC report.
Dr. Lys’ present value calculations are not based on pro-
jected pretax cashflows; his methodology simply uses a dis-
count rate to accumulate expected returns forward and then
discounts these expected returns back using the same rate
used to accumulate the expected returns. Though the Court
does not consider itself an expert in project finance or
economics, the Court recognizes that there are reasons for
entering into transactions, that taxpayers may want to gen-
erate income over a period of time with varying degrees of
risks and with varying times for payouts. An economic anal-
ysis of such transactions requires a detailed approach. Cal-
culations should be based on all relevant knowledge,
including projected cashflows, as cashflows will vary as will
risk. Thus, we find Dr. Lys’ position untenable. Neither Dr.
Lys nor respondent has provided a logical explanation to sup-
port a real world application of his method and calculations.
As a result, the record does not include a credible net present
value calculation. We also question Dr. Lys’ decision to forgo
an analysis of any income streams or potential for profit from
nonexercise of the purchase options. As will be discussed
later in this Opinion, it is not a foregone conclusion that the
lessee counterparties will exercise their purchase options.
Dr. Lys also argued that John Hancock’s pretax returns
would be negative without discounting. According to Dr. Lys,
John Hancock’s calculations neglected to include a cost of
borrowing on its equity contributions. Dr. Lys believed that
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(1) JOHN HANCOCK LIFE INS. CO. (U.S.A.) v. COMM’R 87
including this cost of borrowing is appropriate because John
Hancock’s debt-to-equity ratio from 1999–2001 was consist-
ently above 93%. According to Dr. Lys’ calculations with
respect to the TIWAG SILO transaction, on the closing date
John Hancock makes a $53.5 million investment in the
transaction. By 2037, upon the exercise of TIWAG’s purchase
option, John Hancock will have received $168.8 million. Thus
John Hancock appears to receive a nominal pretax profit of
$115.3 million over 36 years. However, Dr. Lys assumes that
John Hancock must borrow 93 cents on every dollar it spends
on the TIWAG SILO transaction because Dr. Lys did not see
any evidence that John Hancock raised separate capital from
outside investors to fund its equity investment and trans-
action fees cost. We note that neither respondent nor Dr. Lys
has submitted any evidence or made any showing of proof
that John Hancock did in fact borrow an additional $49.8
million as part of the TIWAG SILO transaction. 39 Dr. Lys
then creates two tables in which he attributes a 6.81% bor-
rowing cost and a 7.04% borrowing cost to $49.8 million of
John Hancock’s equity investment and transaction fee cost
($53.5 million × 93%). According to Dr. Lys’ calculations,
John Hancock’s investment in the TIWAG SILO transaction,
even without a net present value analysis, will generate
either a $5.8 million loss or a $9.9 million loss.
End of sublease term At 6.81% At 7.04%
Net cash to John Hancock $168.8M $168.8M
Equity investment (47.2M) (47.2M)
Transaction fees (6.3M) (6.3M)
Interest paid on funds borrowed for
equity investment and fees (121.1M) (125.2M)
Nominal accounting profits (5.8M) (9.9M)
This conclusion, however, ignores John Hancock’s funda-
mental business. John Hancock derives its revenue primarily
from insurance premium payments. With each premium
John Hancock assumes a potential liability. These liabilities
39 Respondent in his opening and reply briefs cites Mortensen v. Commis-
sioner, T.C. Memo. 1984–600, for the proposition that this borrowing rate
must be used in the calculation of John Hancock’s cashflows and profits
from the test transactions. However, in Mortensen the taxpayer actually
borrowed funds used to invest in a series of spot silver transactions. The
Court did not impose a hypothetical cost of borrowing.
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88 141 UNITED STATES TAX COURT REPORTS (1)
were reported on John Hancock’s balance sheets under the
liabilities section as aggregate reserve for life policies and
contracts. These liabilities are not linked to traditional debt.
Dr. Lys used the overall liability total from John Hancock’s
balance sheets to come up with his theory that John Hancock
must be borrowing 93 cents on every dollar it spent. He did
not separate out the liabilities and see which liabilities are
connected to traditional debt. At trial petitioners asked Dr.
Lys: ‘‘Did you make any inquiry to see what type of liabilities
John Hancock has?’’ Dr. Lys responded with a simple ‘‘No.’’
Petitioners were able to show that approximately 1.2%, not
93%, of John Hancock’s liabilities on its balance sheets were
from traditional debt, i.e., actual borrowings. Additionally,
petitioners were able to show that John Hancock had not
incurred additional debt for the years 1998 through 2001.
Finally, petitioners were able to show that John Hancock had
collected almost $7 billion in premiums in 2001 and that
these retained earnings could have been used to pay John
Hancock’s equity contribution to the test transactions and
the corresponding transaction fees. On the basis of the evi-
dence presented by petitioners and Dr. Lys’ testimony, we
find that Dr. Lys’ cost of borrowing argument is wholly
unreliable and misleading.
Respondent has failed to demonstrate that John Hancock
had no realistic expectation of profit when it entered into the
test transactions. Though John Hancock’s ABC reports lack
a net present value analysis and are therefore inconclusive,
respondent bore the burden of proof on this issue.
Respondent has failed to meet his burden of proof, and we
are therefore not persuaded that the test transactions fail
the objective economic substance inquiry.
B. Subjective Inquiry
The subjective inquiry of the economic substance doctrine
focuses on whether the taxpayer has shown that it had a
business purpose for engaging in a transaction other than
tax avoidance. Bail Bonds by Marvin Nelson, Inc. v. Commis-
sioner, 820 F.2d at 1549. We examine whether the taxpayer
was induced to commit capital for reasons relating only to
tax considerations or whether a nontax or legitimate profit
motive was involved. Shriver v. Commissioner, 899 F.2d 724,
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(1) JOHN HANCOCK LIFE INS. CO. (U.S.A.) v. COMM’R 89
726 (8th Cir. 1990), aff ’g T.C. Memo. 1987–627; see also
Andantech LLC v. Commissioner, T.C. Memo. 2002–97, aff ’d
in part, remanded in part, 331 F.3d 972 (D.C. Cir. 2003).
Respondent argues that the test transactions do not serve
a nontax business purpose and that John Hancock’s sole
motivation for entering into the test transactions was to con-
sume tax capacity. This conclusion ignores John Hancock’s
principal business function. The need to fulfill John Han-
cock’s insurance policy and annuity obligations contributed
significantly to its investment decisions. Numerous rep-
resentatives from John Hancock credibly testified at trial
that John Hancock sought and continues to seek diverse
investments that provide returns and cashflows to meet its
short- and long-term responsibilities. John Hancock refers to
this investment objective as ‘‘asset/liability duration
matching’’.
John Hancock has a long history of investing in leveraged
lease transactions. The assets subject to the test transactions
were long-lived assets with which John Hancock was
familiar. John Hancock’s bond and corporate finance group
performed significant due diligence in choosing its invest-
ments and had special expertise and experience in the rel-
evant industries. Further, John Hancock engaged multiple
consultants and advisers to better understand the assets
involved. In each case, John Hancock determined that the
test transactions would contribute towards diversifying its
investments, provide a strong yield, and match its long-term
obligations. Accordingly, we are not persuaded that the test
transactions fail the subjective economic substance inquiry.
Respondent has failed to meet his burden of proving that
the test transactions fail either the objective or subjective
test under the economic substance doctrine. Therefore, we do
not find that the test transactions lack economic substance.
II. Substance Over Form
Having found that the test transactions do not lack eco-
nomic substance, we must now determine whether the sub-
stance of each test transaction is consistent with its form.
The Supreme Court, in determining whether the transaction
in Frank Lyon satisfied the substance over form test, held
that the form of a sale-leaseback transaction will be
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90 141 UNITED STATES TAX COURT REPORTS (1)
respected for Federal tax purposes as long as the lessor
retains significant and genuine attributes of a traditional
lessor. Frank Lyon, 435 U.S. at 584. Stated differently, the
form of the test transactions will be respected for Federal tax
purposes if John Hancock holds a true leasehold interest in
each LILO property and obtained an ownership interest in
each SILO property.
As previously discussed, this is a case of first impression
for this Court, and thus we have not had the opportunity to
apply a substance over form test to a LILO or SILO trans-
action. However, we have previously applied the substance
over form test to leveraged leases. In Levy v. Commissioner,
91 T.C 838, 860 (1988), the taxpayers entered into a sale-
leaseback transaction involving computer equipment. In
determining whether the substance of the transaction was
consistent with its form, we held that ‘‘[w]hether the benefits
and burdens of ownership passed is a question of fact which
must be ascertained from the intentions of the parties as evi-
denced by the written agreements read in light of all of the
relevant facts and circumstances.’’ Id. We considered several
factors as part of our facts and circumstance test, including:
(1) the taxpayer’s equity interest in the property as a
percentage of the purchase price; (2) the existence of a useful
life of the property in excess of the leaseback term; (3)
renewal rental at the end of the leaseback term set at fair
market rent; (4) whether the residual value of the equipment
plus the cashflow generated by the rental of the equipment
allows the investors to recoup at least the initial cash invest-
ment; (5) the expectation of a ‘‘turnaround’’ point which
would result in the investors’ realizing income in excess of
deductions in the later years; (6) net tax benefits during the
leaseback term less than the initial cash investment; (7) the
potential for realizing a profit or loss on the sale or re-lease
of the equipment; (8) the use of a net lease; (9) the absence
of significant positive net cashflow during the lease term;
and (10) the fact that the rental income stream during the
initial lease term is tailored to or matches interest and debt
payments that are due. See id.; Torres v. Commissioner, 88
T.C. 702, 721 (1987); Gefen v. Commissioner, 87 T.C. at
1490–1495; Mukerji v. Commissioner, 87 T.C. 926, 967–968
(1986); Estate of Thomas v. Commissioner, 84 T.C. at 433–
438. We have yet to make a determination as to which of the
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(1) JOHN HANCOCK LIFE INS. CO. (U.S.A.) v. COMM’R 91
above factors are relevant to our facts and circumstances
inquiry into the substance of the LILO and SILO test trans-
actions.
Petitioners argue that Levy and the Tax Court cases before
it set forth a strict factor test, and that we must adhere to
this test to determine the substance of the test transactions.
We disagree. This Court in Levy relied on a facts and cir-
cumstances test to make its decision and simply considered
several factors in evaluating the facts and circumstances of
the transaction. This Court, as in Levy and the Tax Court
cases before it, will continue to evaluate the overall facts and
circumstances of a transaction in determining whether the
substance of the transaction is consistent with its form. We
find no authority for a strict factor test, nor do we create
such authority.
A. OBB and SNCB LILO Transactions
Respondent argues that in substance the OBB and SNCB
LILO transactions are nothing more than financing arrange-
ments. Petitioners argue that John Hancock entered into
leases with OBB and SNCB as demonstrated by the
numerous agreements signed by the parties, including the
initial lease agreements, and thus the substance of the LILO
transactions is consistent with their form. To establish that
the initial lease is, in substance, a true lease for Federal tax
purposes, petitioners must prove that ‘‘the lessor retains
significant and genuine attributes of the traditional lessor
status’’. Frank Lyon, 435 U.S. at 584. We are not persuaded
that petitioners have done so.
First, we look at John Hancock’s and the lessee counter-
parties’ rights and obligations under the initial lease and
sublease documents. In the OBB transaction John Hancock
leased the VK marshalling yard from OBB for 38 years.
Simultaneously, John Hancock subleased the VK marshalling
yard back to OBB for 18 years. OBB’s rights and obligations
under the sublease with respect to possession and use of the
VK marshalling yard are virtually identical to John Han-
cock’s rights and obligations under the initial lease, including
the right to quiet enjoyment of the VK marshalling yard,
leaving John Hancock with only the right to visit and inspect
the VK marshalling yard. The structures of the OBB and
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92 141 UNITED STATES TAX COURT REPORTS (1)
SNCB LILO transactions are substantially similar; thus we
find the same to be true in the SNCB LILO transactions.
Second, though the transaction documents called for large
rent payments during the sublease term, the only money to
actually change hands between John Hancock and OBB
during the sublease term was John Hancock’s payment of
$20,600,517 to OBB as a fee to enter into the LILO trans-
action. Petitioners claim that John Hancock will have paid
$309,375,024 in rent to OBB. We disagree. The $243,394,507
of nonrecourse debt borrowed from Credit AG by John Han-
cock was deposited directly with CA Leasing, a related party
to Credit AG, as part of the DPUA. Moreover, since the
service payments on the nonrecourse loan and the sublease
rent payments matched exactly in time and amount, CA
Leasing directly paid Credit AG in satisfaction of the debt
service payments and a portion of the sublease rent pay-
ments. Similarly, John Hancock’s equity contribution of
$65,980,517 minus the $20,600,517 paid to OBB was depos-
ited directly with Merrill Lynch under the EPUA. These
amounts will be returned to John Hancock in satisfaction of
the portion of the sublease rent payments and through the
exercise of the purchase option. Therefore, OBB continued to
use the VK marshalling yard just as it had before entering
into the LILO transaction without making any payments to
John Hancock. Similar to the OBB transaction, the only
money to change hands in the SNCB LILO transactions was
the payments to SNCB for entering into the transactions.
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(1) JOHN HANCOCK LIFE INS. CO. (U.S.A.) v. COMM’R 93
Third, we find that John Hancock’s equity investments in
the OBB and SNCB LILO transactions were never at real
risk during the sublease terms. The transactions were fully
defeased and employed 100% loop debt. This structure
secured OBB’s and SNCB’s sublease rent payments, as well
as John Hancock’s debt service payments. Further, OBB and
SNCB pledged first security priority interests in the defea-
sance accounts to John Hancock, removing any realistic risk
of John Hancock’s becoming an unsecured creditor. The OBB
transaction provided additional protections, including the
lender’s guaranty of the DPU’s obligations and a letter of
credit ensuring John Hancock’s predetermined return in the
event of a sublease default.
Petitioners argue that even with such defeasance, John
Hancock faces the risk of credit downgrades throughout the
sublease terms. The two examples petitioners rely upon are
the credit downgrades of Ambac in the Hoosier SILO trans-
action and Merrill Lynch, the equity payment undertaker, in
the OBB LILO transaction. In Hoosier Energy, 588 F. Supp.
2d 919, when the credit default provider Ambac’s credit
rating was downgraded, John Hancock tried to enforce its
default rights. Hoosier then sought injunctive relief, and the
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94 141 UNITED STATES TAX COURT REPORTS (1)
parties eventually settled by unwinding the SILO trans-
action. An executive of John Hancock testified at the trial in
these cases that the company lost money on its investment
in the Hoosier SILO transaction; however, no documentation
was provided to prove that fact. Petitioners argue that ‘‘this
loss of investment is the calling sign of risk’’. However, there
was no evidence that Hoosier failed to make a sublease rent
payment or that Ambac failed to meet its obligations as the
credit default provider.
In the OBB LILO transaction, Merrill Lynch’s credit was
downgraded and John Hancock entered into a forbearance
agreement rather than pursue its default remedies. John
Hancock’s willingness to enter into the forbearance agree-
ment is evidence it understood that the chances of losing its
investment were remote. Because OBB had an AAA rating
and because OBB is the party ultimately responsible for the
sublease payments, John Hancock had sufficient security
that it was willing to forbear on OBB’s obligation to post
collateral. Despite the credit crisis, John Hancock has not
lost any portion of its equity investments in the test trans-
actions and has not faced any real threat of such a loss.
Petitioners argue it is impossible to guarantee the strength
of a financial instrument with any long-term duration. A
transaction is not devoid of substance ‘‘merely because it does
not involve excessive risk.’’ IES Indus., Inc. v. United States,
253 F.3d 350, 355 (8th Cir. 2001). However, de minimis risk
does not necessarily give substance to a transaction that is
otherwise without risk. ASA Investerings P’ship v. Commis-
sioner, 201 F.3d 505, 514–515 (D.C. Cir. 2000), aff ’g T.C.
Memo. 1998–305.
There is no such thing as a risk-free investment. Nonethe-
less, during the sublease terms John Hancock does not
assume any more than a de minimis risk. The defeasance
accounts, pledges, and other collateral secure the sublease
rent payments, termination values, and debt service pay-
ments for John Hancock. As a result, if the purchase options
are exercised, John Hancock will receive a predetermined
return without regard to the value of the VK marshalling
yard, the Thalys trainset, or the EMUs and will have no
upside potential or downside risk tied to ownership of the
leasehold interests because of the triple-net leases. Thus, if
our inquiry was to end here, John Hancock would not be
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(1) JOHN HANCOCK LIFE INS. CO. (U.S.A.) v. COMM’R 95
entitled to the rent and amortization deductions claimed for
the LILO transactions.
However, the parties dispute whether the purchase options
will be exercised at the end of the lease terms guaranteeing
John Hancock’s return on its LILO investments. 40
1. OBB Purchase Option Decision
Petitioners argue that as of the closing date it was uncer-
tain whether OBB would exercise its purchase option. Peti-
tioners contend that to conclude in respondent’s favor on this
issue we must determine that exercise of the purchase option
was ‘‘inevitable’’. See Estate of Thomas v. Commissioner, 84
T.C. at 434. Respondent, on the other hand, argues that as
of the closing date OBB’s only financially viable choice was
to exercise its purchase option.
Both respondent and petitioners throughout their briefs
have used the terms ‘‘compelled’’, ‘‘financially compelled’’, and
‘‘economically compelled’’ in discussing whether the purchase
option will be exercised. The courts that have analyzed SILO
and LILO cases have adopted varying standards in deter-
mining whether a party to a SILO or LILO transaction will
exercise its purchase option. In AWG, the District Court used
the terms ‘‘certain’’, ‘‘compelled’’, and ‘‘likely’’ interchangeably
in discussing the exercise of a purchase option. AWG, 592 F.
Supp. 2d at 985. In Altria, the Court of Appeals for the
Second Circuit, affirmed the District Court’s jury instruction
to ‘‘ ‘consider . . . the likelihood that the lessee would exer-
cise its purchase option’ in determining whether Altria
retained genuine ownership or leasehold interests in the
leased assets.’’ Altria, 658 F.3d at 286. Finally, in both Wells
Fargo and Consol. Edison, the Court of Appeals for the Fed-
eral Circuit rejected a ‘‘certainty’’ standard (i.e., whether the
taxpayer is certain as of the closing date of the transaction
that the lessee counterparty will exercise their purchase
40 The
purchase option decision is a critical issue in determining risk of
loss. See Consol. Edison, 703 F.3d at 1375–1376 (‘‘In this case, as in Wells
Fargo, our key inquiry is whether EZH would exercise its purchase option
at the end of the Sublease Basic Term.’’); Wells Fargo, 641 F.3d at 1327
(‘‘[T]he critical inquiry is whether Wells Fargo could have reasonably ex-
pected that the tax-exempt entities would exercise their repurchase op-
tions.’’); AWG, 592 F. Supp. 2d at 981–982 (‘‘[M]ost importantly, it is near-
ly certain that AWG will exercise the Fixed Purchase Option[.]’’).
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96 141 UNITED STATES TAX COURT REPORTS (1)
option) instead adopting a ‘‘reasonable likelihood’’ standard
(i.e., whether the taxpayer believes at the closing date of the
transaction that the lessee counterparty is reasonably likely
to exercise their purchase option). Consol. Edison, 703 F.3d.
at 1379; Wells Fargo, 641 F.3d at 1329. 41
Neither the Tax Court nor the Court of Appeals for the
First Circuit has ever set an ‘‘inevitable’’ or similar threshold
for determining whether a lessee will exercise a purchase
option, and we decline to adopt such a standard here. In
Estate of Thomas v. Commissioner, 84 T.C. at 434, we evalu-
ated a lessee purchase option at fair market value, and held
that ‘‘[c]ases which hold that equity is being transferred to
a lessee in instances where exercise of an option to purchase
is inevitable because the option price is nominal or small are
simply not in point here.’’ Accordingly, although we con-
cluded in Estate of Thomas that the ‘‘inevitable’’ exercise of
41 The
Court of Appeals for the Federal Circuit in creating a reasonable
likelihood standard stated the standard in a number of different ways. See
Consol. Edison, 703 F.3d at 1369 (‘‘[W]e conclude that ConEd’s claimed de-
ductions must be disallowed. This is so because there was a reasonable
likelihood that the tax-indifferent entity in the LILO Transaction (the les-
sor of the master lease) would exercise its purchase option at the conclu-
sion of the ConEd sublease, thus rendering the master lease illusory.’’
(Emphasis added.)); id. at 1375–1376 (‘‘[O]ur key inquiry is whether EZH
would exercise its purchase option at the end of the Sublease Basic Term.’’
(Emphasis added.)); id. at 1376 (‘‘ ‘We have never held that the likelihood
of a particular outcome in a business transaction must be absolutely cer-
tain before determining whether the transaction constitutes an abuse of
the tax system. The appropriate inquiry is whether a prudent investor in
the taxpayer’s position would have reasonably expected that outcome. Char-
acterization of a tax transaction based on a highly probable outcome may
be appropriate, particularly where the structure of the transaction is de-
signed to strongly discourage alternative outcomes.’ ’’ (Emphasis added.)
(quoting Wells Fargo, 641 F.3d at 1325–1326)); id. at 1376 (‘‘In our view,
and consistent with Wells Fargo, therefore, the ‘critical inquiry’ is whether
ConEd ‘could have reasonably expected that the tax-[indifferent] entit[y]
would exercise [its] repurchase option[ ].’ ’’ (Emphasis added.) (quoting
Wells Fargo, 641 F.3d at 1327)). Though the Court of Appeals for the Fed-
eral Circuit used varying language to state its reasonable likelihood stand-
ard, we find this distinction in language a distinction without a difference.
Thus, under the reasonable likelihood standard we would look to see
whether John Hancock on the closing date of the test transaction reason-
ably expected the lessee counterparties to execute their purchase options.
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(1) JOHN HANCOCK LIFE INS. CO. (U.S.A.) v. COMM’R 97
a purchase option crosses a threshold, we certainly did not
find that it creates one. 42
Moreover we find petitioners’ inevitable standard to be
similar to both a compulsion and certainty standard. The
Courts of Appeals for the Second and Federal Circuits have
specifically rejected a certainty standard in favor of a
‘‘reasonable likelihood’’ standard. As was stated in Wells
Fargo, 641 F.3d at 1325–1326: ‘‘We have never held that the
likelihood of a particular outcome in a business transaction
must be absolutely certain before determining whether the
transaction constitutes an abuse of the tax system.’’ Con-
sistent with the Courts of Appeals for the Second and Fed-
eral Circuits, we must determine, in the light of all of the
facts and circumstances known on the closing dates of the
transactions, whether John Hancock’s lessee counterparties
were reasonably likely to exercise their purchase options.
Petitioners and respondent introduced evidence and expert
testimony with respect to the legal, political, industrial, tech-
nical, and financial considerations that would affect the pur-
chase option decision. According to respondent’s expert in the
field of Austrian law, Mag. Stolitzka, OBB’s nonexercise of
the purchase option could face considerable legal obstacles.
Mag. Stolitzka testified to the principle under Austrian law
that requires OBB to manage its railway systems in a
manner consistent with that of a ‘‘prudent businessman’’.
Under this standard OBB would not risk the possibility that
it would be required to help finance the replacement loan.
Mag. Stolitzka also opined that if OBB forgoes its purchase
option, it would likely violate its obligation under Austrian
law to operate the VK marshalling yard as part of its public
duty. If John Hancock could not get the required permits and
licenses to operate the VK marshalling yard and the facility
ceased operating, there could be considerable damages. In
sum, Mag. Stolitzka’s position is that OBB cannot legally ful-
fill its public duty if it relinquishes control over the VK mar-
42 We find the same to be true for the other cases petitioners cited as
the basis for an ‘‘inevitable’’ or similar standard. See Oesterreich v. Com-
missioner, 226 F.2d 798, 803 (9th Cir. 1955) (finding ‘‘virtually no ques-
tion’’ that a $10 purchase price would be exercised); Belz Inv. Co. v. Com-
missioner, 72 T.C. 1209, 1229 (1979) (asking whether exercise of the pur-
chase option was a ‘‘‘foregone’ conclusion’’), aff ’d, 661 F.2d 76 (6th Cir.
1981).
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98 141 UNITED STATES TAX COURT REPORTS (1)
shalling yard, and it will not risk the chance that the facility
will not be operated for the public good. Mag. Stolitzka also
expressed concerns that nonexercise of the purchase option
could create unwanted consequences to OBB under Austrian
employment and environmental law.
Petitioners’ expert in the field of Austrian corporate law
and creditor rights law, Dr. Popp, disagreed with Mag.
Stolitzka, opining that under current Austrian law OBB
would be free to choose whether to exercise its purchase
option. According to Dr. Popp, the VK marshalling yard is
considered part of the railway infrastructure. As such, he
opined that European union law requires that any operator
of the VK marshalling yard grant access to its shunting serv-
ices on a nondiscriminatory basis and for fees that are equal
to the cost of operations. Therefore, Dr. Popp concluded that
whether or not the VK marshalling yard is in the possession
of OBB, its operation for the public good cannot be altered.
Dr. Popp also addressed Mag. Stolitzka’s concerns
regarding the loan extension and the permit and license
requirements. With respect to the loan extension under the
renewal lease, Dr. Popp opined that any conclusion regarding
whether OBB would violate any required standard of care is
speculative. In his opinion, the law allows for OBB’s manage-
ment to make risky decisions, and the decision to help
finance the loan extension, if necessary, is one it will be per-
mitted to make if it decides it is in OBB’s best interests.
Next, with respect to Mag. Stolitzka’s argument that John
Hancock will not have the necessary permits and licenses to
operate the VK marshalling yard, Dr. Popp concluded that
not only is John Hancock not barred from applying for the
required permits and licenses, a process that takes about six
months, but it may also operate the VK marshalling yard
through a third party that already has the required docu-
mentation.
Apart from any legal considerations, respondent argues
that OBB will be compelled to exercise its purchase option
because the VK marshalling yard is an integral part of the
Austrian railway system. According to Dr. Vuchic, respond-
ent’s expert in the field of transportation systems, the oper-
ations of the VK marshalling yard are fully integrated with
its rail network operations, and it is not realistic to consider
the possibility of alternative uses for the facility or the land
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(1) JOHN HANCOCK LIFE INS. CO. (U.S.A.) v. COMM’R 99
it occupies. Mr. Dolan, petitioners’ expert in the field of Euro-
pean railways and railway assets, disagreed with Dr. Vuchic.
According to Mr. Dolan, there is no aspect of the VK mar-
shalling yard that will compel OBB to exercise its purchase
option. More specifically, Mr. Dolan reiterated Dr. Popp’s
position that the VK marshalling yard cannot legally be
removed from its essential role in the Austrian railway
system and also concluded that there are no technical, polit-
ical or social concerns that would prevent its privatization.
Petitioners’ experts have convinced us that any legal, polit-
ical, industrial, or technical objections to the nonexercise of
the purchase options can be overcome, and thus are not
determinative of whether OBB is reasonably likely to exer-
cise its purchase option. Consequently, our determination of
whether the purchase option is reasonably likely to be exer-
cised by OBB will rest primarily upon a financial analysis.
a. Financial Considerations
OBB’s ‘‘management board’’ will decide whether OBB
elects its purchase option in 2016. None of the members of
OBB’s management board on the closing date are currently
serving on the management board. As of the date of trial,
OBB had not decided whether to exercise its purchase
option. 43
According to the appraisal, on the purchase option date the
fair market value of John Hancock’s remaining leasehold
interest in the VK marshalling yard is expected to be
$105,107,878. The fixed price purchase option, or OBB’s cost
to exercise its option, would be $148,760,020. 44 Therefore,
according to the appraisal, independent of any other consid-
erations, the expected purchase option disadvantage would
be $43,736,164.
However, OBB’s purchase option decision is not a choice
between the purchase option price and the estimated fair
market value of the remaining leasehold interest. It is a
43 We must evaluate whether on the closing date of the transaction it
was reasonably likely that OBB would exercise its purchase option.
44 This amount represents the present value of the installment payments
of the purchase option price of $153,817,825, using a discount rate of 7.5%.
The discount rate (i.e., the cost of capital) is an adjustment to a deter-
mined value to take into account the rate of inflation, the time value of
money, and any attendant risk.
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100 141 UNITED STATES TAX COURT REPORTS (1)
choice between the cost to OBB of exercising its purchase
option and its expected costs of not exercising its purchase
option. In determining its expected costs of not exercising its
purchase option, OBB must analyze the likelihood and con-
sequences of John Hancock’s choosing between the renewal
lease, the replacement lease, and the retention option.
Under the renewal lease John Hancock can guarantee
itself the predetermined rent payments during the renewal
term as well as collateral to secure the rent payments. On
the other hand under the replacement lease OBB must help
John Hancock procure a new lease, presumably at fair
market value, but without the benefit of collateral. Therefore,
if OBB forgoes its purchase option, John Hancock will likely
choose between: (1) the present value of the predetermined
renewal lease rent payments, taking into account the secu-
rity provided from the required collateral and (2) the present
value of the expected fair market rents during the replace-
ment term, taking into account the risks of being an
unsecured creditor.
b. Retention Option
Neither party provides any reason John Hancock would
choose the retention option in the LILO test transactions.
Although petitioners have presented evidence that John Han-
cock would be capable of owning and operating the assets
involved in the LILO test transactions if it were to select the
retention option, they have not presented any evidence indi-
cating that John Hancock would want to undertake such
tasks. Therefore, as the parties have, we focus our discussion
and analysis on the renewal and replacement options.
c. Renewal and Replacement Options
According to the appraisal the present value of the
expected fair market rents during the replacement term and
any associated costs exceed the present value of the rent pay-
ments under the renewal lease. As a result the appraisal con-
cluded that if OBB forgoes its purchase option, John Hancock
would select the replacement lease. The appraisal also deter-
mined that the replacement lease was financially advan-
tageous to OBB when compared to the purchase option.
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(1) JOHN HANCOCK LIFE INS. CO. (U.S.A.) v. COMM’R 101
Therefore, the appraisal concluded that OBB would not be
compelled to exercise its purchase option.
Respondent disagrees with the appraisal and argues that
when comparing the purchase options to the renewal and
replacement leases, exercise of the purchase options is finan-
cially advantageous to OBB. Respondent supports his conclu-
sions with a comprehensive analysis of the OBB transaction
by his expert in the field of financial economics, Dr. Lys.
Respondent’s financial analysis starts with the funda-
mental assumption that on the closing date, June 18, 1998,
the VK marshalling yard was not leased to John Hancock.
Petitioners argue that this assumption ignores the legal
realities. That may be so, but respondent’s analysis is a
financial analysis, not a legal analysis. Respondent argues
that this assumption was appropriate because the marshal-
ling yard never changed hands. According to Dr. Lys’ anal-
ysis, from a financial perspective OBB was always in posses-
sion of the VK marshalling yard and the amounts deposited
in the DPUA and the swap agreement always belonged to
John Hancock. Therefore, Dr. Lys described OBB’s purchase
option as the equivalent of a ‘‘European put option’’, 45
enabling OBB to put a leasehold interest in the VK marshal-
ling yard to John Hancock on the purchase option date. If,
however, OBB elects its purchase option, both parties always
retain what always belonged to them, making the purchase
option ‘‘cashless’’ for OBB. The following table summarizes
Dr. Lys’ analysis of the purchase option and the renewal
lease from OBB’s financial perspective:
Purchase Renewal PO
option (PO) lease advantage
End of sublease term:
DPUA -0- $19,100,000 ($19,100,000)
Swap agreement -0- 130,500,000 (130,500,000)
Renewal lease term:
Renewal lease rent -0- (129,400,000) 129,400,000
Initial lease tail period:
Residual value $61,500,000 -0- 61,500,000
Total 61,500,000 20,200,000 41,300,000
45 A European option is one that can be exercised only on its expiration
date. New Phoenix Sunrise Corp. v. Commissioner, 132 T.C. 161, 167
(2009), aff ’d, 408 Fed. Appx. 908 (6th Cir. 2008).
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102 141 UNITED STATES TAX COURT REPORTS (1)
Because the purchase option was fully funded through the
DPUA and the swap agreement, Dr. Lys’ analysis found no
cost or benefit from the deposits to OBB at the end of the
sublease term. Further, under the purchase option OBB
avoids the costs of the renewal lease rent. Absent from both
the purchase option column and the renewal lease column is
the net cashflow that OBB could realize during the renewal
lease term. This amount should be the same whether OBB
operates the VK marshalling yard after exercising the pur-
chase option or under the terms of the renewal lease. There-
fore, the only benefit to OBB from the purchase option is
that it would capture the present value of John Hancock’s
leasehold interest in the VK marshalling yard during the
period between the end of the renewal term and the end of
the initial lease, which respondent estimated to be
$61,500,000. Because OBB is a tax-exempt entity, this
$61,500,000 value is the result of converting the appraisal’s
after-tax cashflow determinations to pretax cashflows and
discounting those cashflows using a pretax weighted average
cost of capital (WACC) rate of 15%, as opposed to the after-
tax WACC of 10% used in the appraisal. 46
Under the renewal lease column, respondent argues that
OBB would receive $149,600,000 on the purchase option
date, equal to the balances of the DPUA and the swap agree-
ment. However, the renewal lease requires OBB to make
additional rent payments during the renewal lease term. The
deferred portion of these rent payments is due at the end of
the renewal term in 2029 and equals $428,933,900. This
amount is the present value of John Hancock’s deferred rent
obligation under the initial lease of $2,295,340,042 that is
due in 2041, applying a WACC rate of 15%. Therefore, these
obligations offset and do not affect OBB’s purchase option
decision. 47 The present value of OBB’s remaining obliga-
46 WACCis the expected rate of return for a company on the basis of
the average portion of debt and equity in the company’s capital structure,
the current required return on equity (i.e., cost of equity), and the com-
pany’s cost of debt.
47 If OBB exercises its purchase option, John Hancock is contractually
relieved of its obligation to make the deferred rent payment. Therefore,
John Hancock’s deferred rent payment to OBB has a net value of zero in
both the purchase option and the renewal lease and is not included in ei-
ther column of Dr. Lys’ analysis.
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(1) JOHN HANCOCK LIFE INS. CO. (U.S.A.) v. COMM’R 103
tions, as shown in Dr. Lys’ analysis, is $129,400,000. The
result is a positive spread to OBB of $20,200,000. Because
OBB would relinquish control of the VK marshalling yard at
the end of the renewal term, it would not be able to capture
the residual value of John Hancock’s remaining leasehold
interest. This analysis produced an advantage to the pur-
chase option of $41,300,000.
Dr. Lys’ analysis is similar when weighing the costs and
benefits of the purchase option against the replacement
lease, with one significant difference. Respondent argues that
if the replacement lease is attractive to John Hancock, i.e.,
the anticipated fair market rents are expected to exceed the
rents required under the renewal lease, OBB would choose to
exercise the purchase option and enter into its own replace-
ment lease, capturing the benefits of this expected value for
itself. The following table summarizes Dr. Lys’ analysis:
PO plus Replacement PO
lease lease advantage
End of sublease term:
DPUA and swap -0- $149,600,000 ($149,600,000)
Cost to find a lessee ($7,000,000) -0- (7,000,000)
Replacement lease term:
Replacement lease rent 112,300,000 -0- 112,300,000
Initial lease tail period:
Residual value 61,500,000 -0- 61,500,000
Total 166,800,000 149,600,000 17,200,000
Under the purchase option column, OBB forgoes the pro-
ceeds of the DPUA and the swap agreement and retains the
asset. As the lessor to a replacement lease OBB must incur
the costs of finding a lessee but also captures the present
value benefit of the replacement lease rents, which Dr. Lys
estimated on a pretax basis to be $112,300,000 using a dis-
count rate equal to a replacement lessee’s expected borrowing
rate. Also, OBB would capture the present value of the VK
marshalling yard’s residual value at the end of the replace-
ment lease term. If, on the other hand, OBB does not exer-
cise its purchase option and John Hancock selects the
replacement option, OBB would receive the balances of the
DPUA and the swap agreement. However, OBB would forgo
the benefits of the rent payments during the replacement
lease term as well as the residual. Therefore, respondent con-
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104 141 UNITED STATES TAX COURT REPORTS (1)
cludes that the purchase option is $17,200,000 more advan-
tageous to OBB than the replacement option. 48 Under both
the renewal and replacement option analyses, respondent
concludes that a similar result would be reached under
almost any fair market value of the VK marshalling yard on
the purchase option date.
Petitioners, bearing the burden of proof, made several
attempts to attack the validity of respondent’s analysis and
the conclusions it reached. First, petitioners attacked the
credibility of Dr. Lys, arguing he is not an appraiser. The
Court recognized Dr. Lys as an expert in the field of financial
economics and thus finds the subject matter well within his
expertise. Petitioners also attacked the choice of discount
rate used in the discounted cashflow method as inappro-
priate. We do not find respondent’s choice of discount rate to
be inappropriate in determining the residual values of John
Hancock’s leasehold interests.
Petitioners also argue that respondent’s use of the dis-
counted cashflow method is inappropriate because the
appraisal determined that the cost method was the proper
method for determining the fair market value of the VK mar-
shalling yard on the closing date. Although petitioners rely
on the appraisal, which used the cost method to determine
fair market value on the closing date, it determined that the
discounted cashflow method is the most reliable valuation
method in calculating the residual value and applied the dis-
counted cashflow method in determining the expected value
of John Hancock’s leasehold interest in the VK marshalling
yard from the end of the sublease to the end of the initial
lease.
Petitioners also rely on the appraisal to conclude that non-
exercise of the purchase option is financially advantageous to
OBB. Respondent has convinced us that he has the more
sound analysis and approach. Thus, we find that at the
48 Again,
Dr. Lys treated John Hancock’s deferred rent obligation as a
neutral factor in OBB’s decision. Under the replacement lease, OBB will
not be able to capture the revenue from the VK marshalling yard during
the renewal lease term, offsetting any benefit from John Hancock’s de-
ferred rent payment in 2041. However, if John Hancock determines the re-
placement lease to be more beneficial than the renewal lease, the present
value of the revenue OBB expects to have lost will exceed the present
value of John Hancock’s deferred rent payment.
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(1) JOHN HANCOCK LIFE INS. CO. (U.S.A.) v. COMM’R 105
inception of the OBB LILO transactions, it was reasonably
likely that OBB would exercise its purchase option.
2. SNCB Purchase Option Decision
Petitioners and respondent also introduced evidence and
expert testimony with respect to the legal, political, indus-
trial, technical and financial considerations that affect the
SNCB purchase option decision. Respondent’s expert in the
field of Belgian law, Dr. Behaeghe, expressed concerns that
there may be legal obstacles preventing SNCB from forgoing
its purchase options because the Thalys trainset and the
EMUs are part of the ‘‘public domain’’ under Belgian law. As
part of the public domain, he believed, they are subject to the
‘‘principle of untransferability’’, and SNCB would be prohib-
ited from surrendering possession of the assets unless the
Belgian Government or the Belgian minister responsible for
SNCB decided to ‘‘disaffect’’ them from public use. 49
Dr. Vandendriessche, petitioners’ expert in the field of Bel-
gian administrative and public law, disagreed with Dr.
Behaeghe. According to Dr. Vandendriessche, the Belgian
supreme court has two requirements for an asset to be
considered part of the public domain. First, the asset must
be designated for the use of all, without any distinction
between persons via explicit or implicit decisions. Second, the
asset must be ‘‘affected’’, meaning that the competent Bel-
gian authority must have designated the asset for public use.
With respect to the Thalys trainset, Dr. Vandendriessche
opined that Belgian law provides that only the domestic
transport of rail passengers is considered a public service.
Therefore, the Thalys trainset is not a public domain asset
49 Respondent
also introduced the testimony of a representative of SNCB
to support his argument that the purchase options will be exercised. Ac-
cording to that representative, as of the date of trial he believed that
SNCB will ‘‘most probably’’ exercise its purchase option in the SNCB 2
transaction because it needs the Thalys trainset and the asset is in good
condition. The representative also testified that SNCB is likely to exercise
its purchase option in the SNCB 5 lot 1 transaction because SNCB will
need the EMUs for at least six or seven years after the purchase option
date. However, we must determine whether SNCB was reasonably likely
to exercise its purchase options on the closing date of the transactions;
thus, testimony regarding the representatives’ beliefs as of the date of trial
do not inform our decision.
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106 141 UNITED STATES TAX COURT REPORTS (1)
because it is used for international travel. The EMUs, on the
other hand, are used for domestic transportation. However,
according to Dr. Vandendriessche, no Belgian authority has
affected them as an asset for public use. Therefore, Dr.
Vandendriessche concluded that neither the Thalys trainset
nor the EMUs are public domain assets. Finally, Dr.
Vandendriessche opined that even if the Thalys trainset and
EMUs were public domain assets, there is no reason why the
Belgian Government or the Belgian minister responsible for
SNCB would not disaffect the assets if it was in SNCB’s best
interests, removing any restrictions of transfer.
Respondent next argues that the Thalys trainset and the
EMUs are integral parts of SNCB’s rail fleet and that it is
extremely unlikely that SNCB would be willing to give them
up. Respondent’s argument is based on the opinion of Dr.
Vuchic, who concluded that the assets have unique
characteristics that SNCB will not risk losing. Mr. Dolan’s
testimony rebutted Dr. Vuchic. According to Mr. Dolan, there
are no technical, political, or social concerns that would pre-
vent SNCB from forgoing its purchase options.
Petitioners’ experts have convinced us that any legal, polit-
ical, industrial, or technical objections to the nonexercise of
the SNCB purchase options can be overcome and thus are
not determinative of whether SNCB is reasonably likely to
exercise its purchase options. Consequently, our determina-
tion of whether the purchase option will be exercised by
SNCB will rest primarily upon a financial analysis.
Respondent, on the basis of the analysis of his expert wit-
ness Dr. Lys, argues that SNCB is reasonably likely to exer-
cise its purchase options. Petitioners disagree, relying on the
appraisals to argue that SNCB is not reasonably likely to
exercise its purchase options. According to the appraisals, the
present value of the estimated fair market rents that would
be expected under the replacement leases will exceed the
present value of the predetermined rent payments under the
renewal lease. Therefore, as in the OBB transaction, the
appraisals concluded that SNCB can anticipate that John
Hancock would select the replacement lease in each SNCB
LILO transaction if SNCB forgoes its purchase options. The
appraisals next determined that the replacement leases
would be financially advantageous to SNCB when compared
to the purchase options. Accordingly, the appraisals con-
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(1) JOHN HANCOCK LIFE INS. CO. (U.S.A.) v. COMM’R 107
cluded that SNCB will likely decide not to exercise its pur-
chase options.
Dr. Lys’ analyses for the SNCB LILO transactions are
substantially similar to his analysis for the OBB LILO trans-
action. Because the two SNCB LILO transactions have
nearly identical structures and since Dr. Lys reached the
same conclusions in both, we will limit our review to his
analysis of the SNCB 2 transaction. The following table
summarizes Dr. Lys’ comparison of the purchase option
against the renewal lease:
Purchase
Purchase Renewal option
option lease advantage
End of sublease term:
Swap agreement -0- $3,400,000 ($3,400,000)
PCAA -0- 9,100,000 (9,100,000)
Taxes --- (400,000) 400,000
Renewal lease term:
Renewal lease rent -0- (11,500,000) 11,500,000
Initial lease tail period:
Residual value $4,500,000 -0- 4,500,000
Total 4,500,000 600,000 3,900,000
Under the purchase option column, Dr. Lys’ conclusions
are fundamentally the same as his conclusions for the OBB
transaction. The only difference of note is the method used
to calculate residual value. Because Dr. Lys and the
appraisal treat SNCB as a taxable entity, 50 Dr. Lys’ residual
value calculation does not have to convert an after-tax value
into a pretax value. Accordingly, the $4,500,000 residual
value in the purchase option column is simply the present
value of the appraisal’s estimated after-tax cashflows during
the period between the end of the renewal lease and the end
of the initial lease, using the appraisal’s after-tax WACC rate
of 11%.
Under the renewal lease column, the only difference
between SNCB’s LILO transactions and the OBB analysis is
Dr. Lys’ inclusion for taxes. According to Dr. Lys, the $1 mil-
50 It
is not clear whether under its reorganization SNCB transferred
ownership of HSL, under Belgian law, to a tax-exempt subsidiary. How-
ever, because the appraisal applies a tax against SNCB’s income in its dis-
counted cashflow analysis, Dr. Lys does the same.
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108 141 UNITED STATES TAX COURT REPORTS (1)
lion spread between the proceeds of the defeasance accounts
and the amounts SNCB would have to pay pursuant to the
renewal lease should be taxed as income. Applying the
appraisal’s 40% tax rate, Dr. Lys assessed a $400,000 tax to
SNCB under the renewal lease. The overall result of Dr. Lys’
analysis is a $3,900,000 advantage to the purchase option.
Dr. Lys reached a similar result when substituting the
replacement lease for the renewal lease. The following table
summarizes his calculations:
Purchase Purchase
option Replacement option
plus lease lease advantage
End of sublease term:
Swap and PCAA -0- $7,500,000 ($7,500,000)
Cost to find a lessee ($200,000) -0- (200,000)
Replacement lease
term:
Replacement lease
rent 7,900,000 -0- 7,900,000
Initial lease tail period:
Residual value 4,500,000 -0- 4,500,000
Total 12,200,000 7,500,000 4,700,000
Again, Dr. Lys’ analysis is fundamentally similar to his
OBB analysis. The only significant difference is his deter-
mination of the amount of proceeds SNCB can expect to
receive from the swap agreement and the PCAA in the
replacement lease column. According to Dr. Lys, SNCB will
be subject to a tax on those amounts. 51 Therefore, if the
appraisal’s 40% tax rate is applicable, SNCB’s expected after-
tax cashflow is $7,500,000 ($12,500,000 – ($12,500,000 ×
40%)). The overall result of this analysis is a purchase option
advantage of $4,700,000.
Under both the renewal and replacement lease analyses
Dr. Lys concluded that a similar result would be reached
assuming almost any residual value of the Thalys trainset on
the purchase option date. Dr. Lys also performed additional
analyses assuming SNCB to be a tax-exempt entity, and his
conclusions did not change.
51 Respondent’s expert in Belgian law, Dr. Behaeghe, concurred with this
conclusion.
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(1) JOHN HANCOCK LIFE INS. CO. (U.S.A.) v. COMM’R 109
Petitioners, bearing the burden of proof, made arguments
similar to those made with respect to the OBB purchase
option decision to attack respondent’s analysis and the
conclusions it reached. We have already found Dr. Lys to be
an expert in the field of financial economics and thus found
that the subject matter is well within his expertise. We also
have found that respondent’s choice of discount rate in deter-
mining the residual values of the leasehold interests is
appropriate.
Petitioners also argue that respondent’s analysis failed to
account for possible tax assets or tax losses by SNCB that
would offset any taxes due under Belgian law from nonexer-
cise of the purchase option. While this is true, SNCB’s tax
position will also affect the residual value of John Hancock’s
remaining leasehold interest on the purchase option date.
Respondent’s calculations consistently apply a 40% tax rate
on both the nonexercise of the purchase option and the
residual value calculation. As we discuss in greater detail in
our analysis of the SILO test transactions, respondent’s
approach is not necessarily a reliable one. Nonetheless, peti-
tioners have failed to present an alternative analysis with a
realistic combination of effective tax rates to be applied to
the residual value calculation and the proceeds of the defea-
sance accounts, respectively.
Finally, petitioners rely on the appraisal to conclude that
nonexercise of the purchase option is financially advan-
tageous to SNCB. Respondent has convinced us that he has
the more sound analysis and approach. Thus, we find that on
the closing dates of the SNCB LILO transactions, it was
reasonably likely that SNCB would exercise its purchase
options.
3. Conclusion
The lack of risk during the sublease terms, combined with
our finding that OBB and SNCB will likely exercise their
purchase options, insulates John Hancock from any risk of
losing its initial investment in the OBB and SNCB trans-
actions. Moreover, the structure of the transactions guaran-
teed John Hancock’s return on its investments was fixed
from each transaction’s respective closing date. Therefore,
given that OBB and SNCB kept control of their respective
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110 141 UNITED STATES TAX COURT REPORTS (1)
assets during the sublease term, never paid any money for
use of those assets, and were reasonably likely to unwind the
transactions through the exercise of their purchase options,
we hold that John Hancock did not acquire the benefits and
burdens of a traditional lessor in the OBB and SNCB LILO
transactions. Instead, the transactions more closely resemble
financial arrangements. Specifically, the transactions
resemble loans from John Hancock to OBB and SNCB for the
duration of the sublease terms. As a result, John Hancock
will receive a predetermined return without regard to the
value of the relevant assets and will have no upside potential
or downside risk tied to ownership of the leasehold interests.
Thus, we find that the substance of the LILO transactions is
not consistent with its form. Accordingly, we sustain
respondent’s determinations denying John Hancock’s claimed
rental expense deductions with respect to the LILO trans-
actions.
B. SILO Test Transactions
There are several critical facts that distinguish the SILO
test transactions from the LILO test transactions. First,
during the sublease terms, the transaction documents do not
require defeasance with respect to the equity or series B
debt, nor did John Hancock acquire a security interest in any
of the defeasance agreements executed outside of the trans-
action documents. 52 Next, the SILO test transactions are
distinguishable from the LILO test transactions because of
the structure of the purchase options. In the SILO test trans-
actions, the lessee will evaluate its purchase option against
a service contract, rather than a renewal or replacement
lease. 53 This evaluation will present unique considerations.
Of particular importance is the foreign tax consequences to
the lessee if it decides not to exercise its purchase option.
Because the term of the initial lease in each SILO test trans-
action exceeds the useful life of the subject asset, nonexercise
of the purchase option results in a sale of the asset from the
52 We do not specifically address respondent’s argument that John Han-
cock required the equity and series B debt defeasance agreements in the
SILO test transactions but conspired to keep them out of the transaction
documents. The evidence does not support an allegation of this magnitude.
53 As discussed earlier, neither party has set forth a reasonable argu-
ment for exercise of the retention option.
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(1) JOHN HANCOCK LIFE INS. CO. (U.S.A.) v. COMM’R 111
lessee to John Hancock for foreign tax purposes. There was
considerable expert testimony at trial regarding the potential
tax consequences of such a sale and the impact of those
potential taxes on the purchase option decisions. As with the
LILO transactions, we must similarly determine whether
John Hancock acquired the benefits and burdens of owner-
ship of the subject assets. One of our many considerations is
whether John Hancock’s investment was subject to more
than a de minimis risk of loss. As will be explained later, the
TIWAG and Dortmund SILO transactions differ in structure
from the SNCB SILO transaction; thus we will begin by ana-
lyzing the TIWAG and Dortmund SILO transactions together
and provide a separate analysis for the SNCB SILO trans-
action.
1. TIWAG and Dortmund Transactions
a. Sublease Term
Petitioners argue that we cannot consider the equity or
series B debt defeasance agreements in the TIWAG and
Dortmund transactions because John Hancock did not
require such agreements as part of the transaction. We dis-
agree. First, John Hancock expected TIWAG and Dortmund
to enter into such agreements because of the favorable
accounting treatment to which they were entitled under
European GAAP. Additionally, the transactions were
designed to fund these agreements without affecting
TIWAG’s or Dortmund’s expected net present value benefit.
We are permitted to consider side transactions that are
material to the substance of the transactions at issue. See
ASA Investerings P’ship v. Commissioner, 201 F.3d at 513 (In
evaluating whether for Federal tax purposes a partnership
had been formed between the taxpayer and a foreign
counterparty, the court considered side agreements executed
outside the alleged partnership between the foreign
counterparty and various banks. The taxpayer was not a
party to and did not require such agreements. However,
these agreements affected the foreign counterparty’s risk of
loss in the alleged partnership and were therefore relevant
to the analysis.).
We find that John Hancock’s lack of a pledge or guaranty
with respect to the equity or series B debt is more critical to
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112 141 UNITED STATES TAX COURT REPORTS (1)
our inquiry. When compared to the LILO test transactions,
this distinction increases John Hancock’s risk of loss, albeit
only ever so slightly. However, we find that this increased
risk, on its own, is not enough to carry petitioners’ burden,
for several reasons. For one, the equity and series B payment
undertakers had strong credit, and John Hancock
preapproved their inclusion in ‘‘form’’ equity and series B
debt PUAs. Additionally, the equity and series B debt
accounted for less than 30% of each transaction’s value. John
Hancock was a party to a series A DPUA in each of the
TIWAG and Dortmund transactions, providing it with protec-
tion equivalent to a pledge or guaranty with respect to the
series A debt service payments and most of the sublease rent
payments. Accordingly, we find that John Hancock’s lack of
a pledge or guaranty with respect to the equity and series B
defeasance does not materially alter John Hancock’s risk. As
was the case in the LILO test transactions, John Hancock’s
risk of loss during the sublease terms of the TIWAG and
Dortmund transactions is de minimis.
Petitioners also argue that the initial lease and sublease
materially alter the parties’ rights and obligations with
respect to the 21.6% undivided interest in Sellrain-Silz and
create risks which are indicative of ownership. To support
this argument, petitioners list a series of 16 clauses through-
out the transaction documents. We list each of these clauses
below and find that none of them creates risk to John Han-
cock during the sublease term. These clauses fall into two
categories: (1) insignificant rights and obligations; and (2)
rights and obligations that insulate John Hancock from risk
rather than expose it to risk.
Beginning with the clauses we find to be insignificant, the
initial lease requires TIWAG to post insignia on the physical
structure of the 21.6% undivided interest in Sellrain-Silz to
indicate that the asset was leased to John Hancock.
Additionally, the sublease grants John Hancock the right to
visit and inspect the asset not more than twice a year. We
find these clauses to be immaterial to the analysis. They
speak to the form of the transaction, not its substance.
The remaining 14 provisions petitioners cite are as follows:
(1) TIWAG generally may not consolidate or merge with
another party, or spin off, convey, transfer or lease substan-
tially all of its assets;
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(1) JOHN HANCOCK LIFE INS. CO. (U.S.A.) v. COMM’R 113
(2) TIWAG cannot sell, dispose of, or create a security
interest in the 21.6% interest in Sellrain-Silz without John
Hancock’s consent;
(3) TIWAG must register notice decrees with the local land
registry;
(4) the ROW agreement grants John Hancock a right of
way to specified land parcels;
(5) TIWAG agreed not to take action to terminate the ROW
agreement;
(6) upon the occurrence of a trigger event, John Hancock
has the right to exercise an option to purchase an interest in
certain facility parcels;
(7) with certain exceptions, TIWAG cannot create or permit
any lien on the 21.6% undivided interest in Sellrain-Silz;
(8) TIWAG must operate, use, maintain and repair the
21.6% undivided interest in Sellrain-Silz in accordance with
specified standards;
(9) TIWAG must replace parts with parts that meet speci-
fied standards;
(10) TIWAG must maintain records of daily operation and
of maintenance, repairs, and improvements;
(11) TIWAG is permitted to make optional improvements,
but only if the modification does not adversely affect the
21.6% undivided interest in Sellrain-Silz;
(12) TIWAG’s ability to sublease is restricted;
(13) TIWAG must purchase insurance in accordance with
specified standards; and
(14) John Hancock has the option of declaring a lessee
event of default under the sublease, but TIWAG cannot
declare an event of default under the initial lease.
None of the above-listed provisions creates risk to John
Hancock during the sublease term. In fact, most of these
provisions do nothing more than protect John Hancock’s
interests. With respect to some of these provisions, we have
no evidence that TIWAG’s use and rights with respect to the
21.6% undivided interest in Sellrain-Silz were altered after
the closing date. For instance, there is no evidence that
before the closing date TIWAG was not already maintaining
suitable records and adhering to the specified standards
required with respect to any insurance, repairs, and oper-
ations. Finally, we put little credence in the fact that John
Hancock has the option of declaring a lessee event of default
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114 141 UNITED STATES TAX COURT REPORTS (1)
under the sublease, but TIWAG cannot declare an event of
default under the initial lease. Not only is this an example
of John Hancock’s insulation from risk, but we have already
determined that the most likely cause of a lessee default
under the sublease, failure to pay sublease rent, is nearly
impossible because of the defeasance agreements.
b. Purchase Options
We look to the purchase options for additional evidence
that John Hancock acquired the benefits and burdens of
ownership in a way that is substantively distinguishable
from the LILO test transactions. Respondent argues, and we
agree, that the exercise of the purchase options guarantees
John Hancock’s return on its investment and insulates John
Hancock’s investment from more than a de minimis risk of
loss. Thus we must determine whether the various purchase
options are reasonably likely to be exercised. Respondent
relies on the analyses of Dr. Lys to argue that the purchase
options are, and have always been, TIWAG’s and Dortmund’s
only financially viable choices. As we will discuss in much
greater detail, unlike those of the LILO test transactions, Dr.
Lys’ analyses of the TIWAG and Dortmund transactions fail
to withstand scrutiny.
i. TIWAG Transaction
Petitioners, relying on the appraisal, argue that it was
financially disadvantageous for TIWAG to exercise its pur-
chase option. 54 The appraisal analyzes TIWAG’s purchase
option decision as of the closing date of the transaction.
According to the appraisal, on the purchase option date the
fair market value of the 21.6% undivided interest in Sellrain-
Silz is expected to be $648,210,816. The fixed purchase
option price, or TIWAG’s cost to exercise its option, is
$795,135,940. On the other hand, assuming John Hancock
would choose the service contract option, TIWAG’s cost of
nonexercise has two components: (1) the fair market value of
the asset that TIWAG will no longer possess, or $648,210,816
54 As
of the date of trial TIWAG had not decided whether to exercise its
purchase option. TIWAG’s competent corporate body closer to the purchase
option date will probably make the decision with the approval of its super-
visory board.
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(1) JOHN HANCOCK LIFE INS. CO. (U.S.A.) v. COMM’R 115
and (2) the costs to arrange a service contract, refinance the
section 467 loan, and obtain residual value insurance. The
appraisal estimated these additional costs at $7,108,992,
making TIWAG’s total cost of not exercising the purchase
option $655,319,808. Accordingly, the appraisal concluded
that TIWAG would not be compelled to exercise its purchase
option because the advantage of not exercising is
$139,816,132 ($795,135,940 – $655,319,808).
Respondent disagrees with the appraisal and relies on the
expert testimony of Dr. Lys to rebut the appraisal’s conclu-
sions. Dr. Lys identified what he claimed to be two signifi-
cant errors in the appraisal’s analysis. First, he opined that
the appraisal failed to account for the Austrian tax con-
sequences to TIWAG if it chooses not to exercise the pur-
chase option. Although U.S. tax law treats the initial lease
as a sale, under Austrian tax law TIWAG is not treated as
selling the 21.6% undivided interest in Sellrain-Silz on the
closing date. However, if TIWAG forgoes its purchase option
and relinquishes possession of the asset, Austrian tax law
will treat such an event as a sale from TIWAG to John Han-
cock. TIWAG’s amount realized in such a sale would be the
purchase option price of $795,135,940 funded from the pro-
ceeds of TIWAG’s EPUA and John Hancock’s repayment of
the section 467 loan. Because this would be a taxable event
to TIWAG, Dr. Lys believed that TIWAG would not net
$795,135,940 as the appraisal concluded. Rather, TIWAG
would receive $795,135,940 less the tax liability pursuant to
Austrian tax law. Applying a 40% tax rate to TIWAG’s
amount realized, Dr. Lys subtracted a tax due of
$318,054,376 ($795,135,940 × 40%), leaving TIWAG with a
total after-tax cashflow from not exercising its purchase
option of approximately $477,081,564. 55
Next, Dr. Lys opined that the appraisal used an inappro-
priately high discount rate of 7% in calculating the present
value of the capacity charges TIWAG would have to pay to
John Hancock if TIWAG becomes the power purchaser
during the service contract term. Dr. Lys believed that
55 Dr Lys’ analysis and calculations are based on an amount realized of
$790,700,000, rather than TIWAG’s expected amount realized of
$795,135,940. It is not clear where this difference comes from. For consist-
ency, we have adjusted Dr. Lys’ calculations to conform with TIWAG’s ex-
pected amount realized. This change is not material to the analysis.
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116 141 UNITED STATES TAX COURT REPORTS (1)
because these payments are due to John Hancock regardless
of TIWAG’s operating performance, they are more like debt
payments and should be discounted at TIWAG’s cost of debt.
Consequently, Dr. Lys applied a discount rate of 4.32%,
resulting in a present value of the capacity charges on the
purchase option date of approximately $497,800,000.
Dr. Lys proceeded to give his own analysis of TIWAG’s
purchase option decision. Respondent adopts Dr. Lys’ anal-
ysis and argues that the exercise of the purchase option was
financially advantageous to TIWAG. Dr. Lys’ financial anal-
ysis started with the fundamental assumption that on the
closing date the 21.6% undivided interest in Sellrain-Silz was
not transferred to John Hancock. Dr. Lys described TIWAG’s
purchase option as the equivalent of a European put option
enabling TIWAG to put the 21.6% interest in Sellrain-Silz to
John Hancock on the purchase option date. The following
table summarizes Dr. Lys’ comparative analysis of the pur-
chase option and the service contract from TIWAG’s economic
perspective:
Purchase
Purchase Service option
option contract advantage
End of sublease term:
Sec. 467 loan and EPUA -0- $477,081,564 ($477,081,564)
Costs to refinance debt -0- (2,900,000) 2,900,000
Residual value insurance -0- (7,400,000) 7,400,000
Service contract term:
Capacity charge expense -0- (497,800,000) 497,800,000
Initial lease tail period:
Residual value $143,800,000 -0- 143,800,000
Total 143,800,000 (31,018,436) 174,818,436
Beginning with the purchase option, because Dr. Lys
assumed that nothing was sold on the closing date, his posi-
tion is that TIWAG always owns the 21.6% undivided
interest in Sellrain-Silz. Similarly, the section 467 loan bal-
ance and the proceeds of the EPUA always belong to John
Hancock. As a result, if TIWAG elects the purchase option,
both parties retain what always belonged to them, making
the purchase option ‘‘cashless’’ for TIWAG. Next, if TIWAG
elects the purchase option, it will avoid the costs of refi-
nancing the section 467 loan, arranging for residual value
insurance, and paying capacity charges as the power pur-
chaser. At the end of the service contract term the purchase
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(1) JOHN HANCOCK LIFE INS. CO. (U.S.A.) v. COMM’R 117
option allows TIWAG to capture the residual value of the
21.6% undivided interest in Sellrain-Silz which Dr. Lys
determined to be $143.8 million. 56
In contrast, under the service contract option Dr. Lys’ posi-
tion is that TIWAG will receive the after-tax balance of the
section 467 loan and the proceeds of the EPUA. As part of
the service contract requirements TIWAG must incur the
costs to refinance the section 467 loan, arrange for residual
value insurance, and pay the capacity charges if it chooses to
be the power purchaser. In forgoing the purchase option
TIWAG would not be able to capture the residual value of
the asset, leaving it with zero value after the service contract
term. The end result, according to Dr. Lys, is a $178,818,436
advantage to TIWAG under the purchase option. Dr. Lys con-
cluded that a similar result would be reached no matter the
fair market value of the 21.6% undivided interest in Sellrain-
Silz on the purchase option date.
Dr. Lys’ service contract analysis assumed that TIWAG
would choose to be the power purchaser under the service
contract rather than procuring a third party. Missing from
both the purchase option and service contract columns are
TIWAG’s power sales revenue and fixed and variable costs to
operate Sellrain-Silz. These items are not included in the
table because they are the same whether TIWAG owns the
asset under the purchase option or acts as the power pur-
chaser under the service contract. On the other hand, if
TIWAG were to procure a third-party power purchaser to
enter into the service contract, TIWAG would not have to pay
the capacity charges and thus the negative $497.8 million
would be removed from the service contract column. This
would be true whether TIWAG exercises its purchase option
and enters into its own service contract or procures a third-
party power purchaser for a service contract with John Han-
cock. Additionally, TIWAG would not benefit from the power
sales revenue. To reflect this adjustment the $497.8 million
in power sales revenue would have to be added back to the
purchase option column. Consequently, the results are the
56 According to Dr. Lys, $143,800,000 is the present value of the 21.6%
undivided interest in Sellrain-Silz as of the purchase option date, deter-
mined by discounting the residual value of the asset at the end of the serv-
ice contract, as determined by the appraisal, using the appraisal’s WACC
rate of 7%.
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118 141 UNITED STATES TAX COURT REPORTS (1)
same whether TIWAG acts as the power purchaser under the
service contract or procures a third-party power purchaser.
To counter Dr. Lys’ analysis, petitioners begin by arguing
that the purchase option is not cashless to TIWAG because
the EPUA was not required as part of the SILO transaction
and is not pledged to John Hancock. Petitioners argue that
TIWAG can terminate the EPUA at any time and use the
proceeds for any other purpose. The transaction documents
do not support petitioners’ argument. The EPUA is irrev-
ocable and nonrefundable. TIWAG is merely entitled to direct
the payments due from UBS on specified dates to any party
of its choosing.
The crux of petitioners’ dispute with Dr. Lys’ analysis cen-
ters around his assumption that TIWAG will incur a signifi-
cant Austrian tax liability if it chooses not to exercise its pur-
chase option. As discussed above, under Austrian tax law
TIWAG’s nonexercise of its purchase option would be treated
as a sale of the 21.6% undivided interest in Sellrain-Silz from
TIWAG to John Hancock. According to Dr. Lys, TIWAG’s tax-
able gain from this sale would equal the difference between
its amount realized, measured as the purchase option price,
and TIWAG’s book value in the 21.6% undivided interest in
Sellrain-Silz, which he assumed to be zero. The resulting tax
liability shifted TIWAG’s purchase option from a financially
disadvantageous choice to TIWAG’s only viable financial
option.
Under Austrian tax law as of the closing date, the parties
agree that TIWAG’s taxable gain on the sale of the 21.6%
undivided interest in Sellrain-Silz would be a measure of the
difference between the fixed purchase option price,
$795,135,940, and TIWAG’s book value in the asset. There-
fore, unless TIWAG’s book value in the asset is zero on the
purchase option date, it will not be taxed on its entire
amount realized as Dr. Lys assumed. Dr. Lys recognized this
potential flaw in his calculations, stating that he had not
seen any projections of the book value of the 21.6% undivided
interest in Sellrain-Silz on the purchase option date, and he
reserved the right to supplement his analysis if reliable
information about TIWAG’s expected book value were to
become available. Despite not having this information, Dr.
Lys proceeded with his analysis, assuming that given the age
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(1) JOHN HANCOCK LIFE INS. CO. (U.S.A.) v. COMM’R 119
of the asset its book value would be very low on the purchase
option date.
To rebut Dr. Lys’ calculations, petitioners presented the
testimony of Dr. Doralt, an expert in the field of Austrian tax
law, who opined that on the closing date TIWAG could expect
the possibility of loss carryforwards to offset any capital gain
from the sale of the 21.6% undivided interest in Sellrain-Silz.
Further, Dr. Lys ignored the possibility of capital improve-
ments throughout the sublease term, which would increase
TIWAG’s book value in the 21.6% undivided interest in
Sellrain-Silz. 57 These possibilities are reasonable, and we
expect that the TIWAG would engage in any necessary tax
planning should the need arise.
Petitioners also challenge Dr. Lys’ use of a 40% income tax
rate because Austrian corporations are currently taxed at a
flat income tax rate of 25% and before 2005 that rate was
34%. Dr. Lys acknowledged this discrepancy. However, he
stated that the appraisal used a 40% income tax rate to
determine the residual values of the asset as part of the dis-
counted cashflow method and that as long as the tax rate
used for both calculations is consistent, the methodology is
correct. Petitioners have not presented alternative discounted
cashflow calculations for the residual values using an income
tax rate of 25% or 34%. 58
Finally, petitioners argue that Dr. Lys’ financial analysis is
predicated on the erroneous assumption that nothing was
sold on the closing date and that if Dr. Lys started with the
opposite assumption (i.e., that the parties entered into the
lease transactions, that TIWAG received the equity invest-
ment, and that TIWAG must pay a purchase option price to
recover ownership of the asset) the computations would prove
the opposite. According to petitioners, if TIWAG exercises its
57 If TIWAG uses tax loss carryforwards to reduce or eliminate any gain
from the sale of the 21.6% undivided interest in Sellrain-Silz, it will not
have those carryforwards for future years, eliminating a tax asset. How-
ever, TIWAG could have expiring tax loss carryovers in the year of sale
or may not have another chance to use the tax carryovers before their expi-
ration. Accordingly, the impact of tax loss carryforwards is speculative.
58 Respondent’s expert in the field of Austrian taxation and accounting,
Dr. Wundsam, agreed with petitioners on this point, stating that Austrian
tax law is always changing and that any opinion on the Austrian tax con-
sequences of the transaction in 2037 is speculative.
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120 141 UNITED STATES TAX COURT REPORTS (1)
purchase option it will pay $795,135,940 for an asset with a
fair market value of $648,210,816. Additionally, in exercising
its purchase option, TIWAG avoids the costs of refinancing
the section 467 loan and the cost of procuring residual value
insurance. Under the discounted cashflow method the
appraisal accounted for power sales revenue and expenses in
determining the fair market value of the 21.6% undivided
interest in Sellrain-Silz on the purchase option date. There-
fore, to avoid double counting, no further adjustments are
necessary for power sales revenue, expenses, or residual
value.
Under the service contract option, TIWAG would retain the
proceeds it already owned from the section 467 loan and the
EPUA and would not receive any benefit from the asset.
Assuming TIWAG chooses to be the power purchaser, it must
pay the capacity charges. 59 However, those charges would be
offset through power sales revenue. TIWAG must also incur
the costs of refinancing the section 467 loan and procuring
residual value insurance. The following table summarizes
petitioners’ analysis:
Purchase
Purchase Service option
option contract advantage
End of lease term:
Purchase price ($795,135,940) -0- ($795,135,940)
Fair market value 648,210,816 -0- 648,210,816
Costs to refinance debt -0- ($2,900,000) (2,900,000)
Residual value insurance -0- (7,400,000) (7,400,000)
Service contract term:
Capacity charge expense -0- (497,800,000) 497,800,000
Power sales -0- 497,800,000 (497,800,000)
Initial lease tail period:
Residual value -0- -0- -0-
Total (146,925,124) (10,300,000) (136,625,124)
Petitioners reach a far different result from Dr. Lys, con-
cluding that the purchase option is economically disadvanta-
geous to TIWAG. This difference, however, is not just the
result of beginning their analysis with a different assumption
about whether there was a sale on the closing date. Rather,
petitioners’ conclusion also differs from respondent’s because
59 Petitioners’ analysis does not dispute Dr. Lys’ adjustment to the dis-
count rate in calculating the present value of the capacity charges during
the service contract term.
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(1) JOHN HANCOCK LIFE INS. CO. (U.S.A.) v. COMM’R 121
petitioners’ calculations do not account for any Austrian tax
liability to TIWAG. To illustrate this point, if the 40% tax
rate Dr. Lys used in his analysis is applied to petitioners’ cal-
culations, TIWAG would incur a $318,054,376 ($795,135,940
× 40%) tax liability. This tax liability would be a negative in
the service contract column of petitioners’ analysis, resulting
in a final purchase option advantage to TIWAG of
$181,429,252. 60
To further illustrate how this affects TIWAG’s purchase
option decision, we refer back to Dr. Lys’ conclusion that
TIWAG’s advantage under the purchase option is
$174,818,436. This conclusion was based on an estimated
Austrian income tax liability of $318,054,376. Using Dr. Lys’
analysis as the baseline, if, after considering the asset’s book
value on the purchase option date and using all other
methods available to TIWAG to reduce or eliminate its tax-
able income, TIWAG’s Austrian tax liability is reduced to
$136,625,124 ($318,054,376 – $174,818,436), the purchase
option advantage would be zero.
However, a reduction in TIWAG’s annual effective Aus-
trian income tax rate will also affect the purchase option
column in Dr. Lys’ analysis. As discussed above, Dr. Lys
determined the present value of the 21.6% undivided interest
in Sellrain-Silz at the end of the service contract term to be
$143.8 million. This calculation was the result of discounting
the appraisal’s residual value determination which was cal-
culated under the discounted cashflow method and included
the imposition of an annual income tax rate of 40%. If, on the
other hand, a lower effective tax rate is used in the dis-
counted cashflow analysis, because of tax-reducing strategies
consistent with petitioners’ position on the nonexercise of the
purchase option the result would be a higher estimated
residual value. 61 If the residual value as calculated in Dr.
60 Subtracting $318,054,376 from the service contract column results in
a total under the service contract column of negative $328,354,376. This
results in a purchase option advantage of $181,429,252 ($328,354,376 –
$146,925,124).
61 The appraisal’s failure to account for the possibility that the annual
effective tax rate on income derived from the 21.6% undivided interest in
Sellrain-Silz may be less than 40% also affects the reliability of its dis-
counted cashflow method analyses used to determine the estimated fair
Continued
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122 141 UNITED STATES TAX COURT REPORTS (1)
Lys’ analysis was understated, the purchase option is more
valuable.
This tax rate adjustment for purposes of the discounted
cashflow analysis is also applicable when analyzing TIWAG’s
purchase option decision from petitioners’ perspective.
According to petitioners’ calculation, on the purchase option
date TIWAG will pay $795,135,940 for an asset with a fair
market value of $648,210,816. Petitioners’ calculation did not
apply a tax to the proceeds of the section 467 loan and the
EPUA. However, it relied on the appraisal’s fair market
value determination on the purchase option date, which was
calculated using a 40% tax under the discounted cashflow
method. If the effective tax rate used under the discounted
cashflow method is lowered, the estimated value of the 21.6%
undivided interest in Sellrain-Silz on the purchase option
date would be higher than $648,210,816, resulting in a fixed-
price purchase option that is more attractive to TIWAG.
From a financial perspective, TIWAG’s purchase option
decision will depend on the Austrian tax laws and TIWAG’s
ability to generate and use tax assets on the purchase option
date and during the period after the service contract term.
Further, the decision will also depend upon the expected
book value and residual value of the 21.6% undivided
interest in Sellrain-Silz on the purchase option date. There
was no way on the closing date for TIWAG to foresee its Aus-
trian tax consequences from nonexercise of the purchase
option with any certainty. Similarly, there was no way for
TIWAG to foresee with any degree of certainty what its effec-
tive tax rate was going to be in any given year during the
tail period of the service contract term. As a result, the
appraisal’s, Dr. Lys’, and petitioners’ purchase option anal-
yses all produce unreliable results. Therefore, we find the
evidence with respect to whether TIWAG was reasonably
likely to exercise its purchase option as of the closing date
to be inconclusive.
Respondent also argues that it is reasonably likely that the
purchase option will be exercised because of TIWAG’s obliga-
tion to refinance the section 467 loan under the service con-
tract option. Petitioners’ expert Mr. Haider opined that this
obligation would not hinder TIWAG’s decision and that the
market value of the asset on the closing date and the purchase option date.
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(1) JOHN HANCOCK LIFE INS. CO. (U.S.A.) v. COMM’R 123
cost to TIWAG of posting additional collateral if necessary
could be far less than the cost of a disadvantageous purchase
option. We agree with Mr. Haider, and we find that respond-
ent’s position on this point ignores the business realities.
Next, respondent argues that TIWAG could face significant
complications under Austrian law that would prevent it from
forgoing the purchase option. Petitioners’ expert in the field
of Austrian corporate law and creditor rights law, Dr. Popp,
successfully rebutted each of respondent’s concerns, and we
do not find them to be obstacles preventing nonexercise of
the purchase option. Therefore, we find that no additional
considerations prove that TIWAG’s purchase option was
reasonably likely to be exercised. 62
Petitioners have presented enough evidence to counter
respondent’s claim that the exercise of the purchase option
was TIWAG’s only viable financial option. As a result, we
cannot say whether on the closing date of the transaction it
was reasonably likely that TIWAG would exercise its pur-
chase option.
ii. Dortmund Transactions
Petitioners, relying on the appraisal, argue that it was
financially disadvantageous for Dortmund to exercise its pur-
chase option. 63 According to the appraisal, on the purchase
option date the fair market value of the trade fair facility
was expected to be $242,882,656. 64 The fixed price purchase
options, or Dortmund’s cost to exercise its options, is
62 For each test transaction, respondent has presented documents that
he claims prove that the lessee counterparties always intended to exercise
their purchase options. We find this evidence to be unavailing. In each
case, the evidence presented was given little context and was subject to
different interpretations. Further, at trial we heard the testimony of a rep-
resentative from each of the lessee counterparties with respect to the pur-
chase options. These representatives credibly testified that as of the clos-
ing date the lessee counterparties did not know whether they would exer-
cise their purchase options. Further, each representative testified that the
purchase option would be a business decision made at a time much closer
to the purchase option date.
63 The Dortmund city council will decide whether Dortmund exercises its
purchase options. At the date of trial Dortmund’s city council had not
made those decisions.
64 Excluding hall 3B.
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124 141 UNITED STATES TAX COURT REPORTS (1)
$283,934,629. 65 On the other hand, assuming John Hancock
would choose the service contract, Dortmund’s cost of non-
exercise has two components: (1) the fair market value of the
trade fair facility that Dortmund will no longer possess, or
$242,882,656; and (2) the costs to arrange a service contract,
refinance the section 467 loan, and obtain residual value
insurance. The appraisals estimated these additional costs at
$9,115,027, making Dortmund’s total cost of not exercising
its purchase options $251,997,683. Accordingly, the
appraisals concluded that Dortmund will likely not exercise
its purchase options because the advantage of not exercising
is $31,936,946 ($283,934,629 – $251,997,683).
Respondent disagrees with the appraisal and once again
relied on the expert testimony of Dr. Lys to rebut the
appraisal’s conclusions. As in the TIWAG transactions, Dr.
Lys opined that the appraisal’s methodologies were flawed
because they failed to account for the German tax con-
sequences to Dortmund of not exercising the purchase option
and because the discount rate used to determine the present
value of the capacity availability charges under the service
contract was inappropriate. Dr. Lys described Dortmund’s
options as European put options and again began his finan-
cial analysis with the assumption that nothing was sold on
the closing date.
To correct the perceived tax rate errors in the appraisals,
Dr. Lys used a 38% income tax rate to reduce Dortmund’s
proceeds from the section 467 loan and the EPUAs under the
service contract from $283,934,629 to $176,039,470. 66 Dr.
Lys used a 38% income tax rate because it was the German
corporate income tax rate on the closing date. The appraisals
did not apply a tax rate in their discounted cashflow anal-
yses. In fact, the appraisals state that ‘‘a pretax analysis has
been used since buy/sell decisions of exhibition industry
participants and published market yield requirements reflect
a pretax basis’’.
For the same reasons as for the TIWAG transaction, Dr.
Lys used the borrowing rate to compute the present value of
65 These
values take into account both Dortmund SILO transactions.
66 The
numbers used in Dr. Lys’ analysis for the proceeds of the sec. 467
loan and the EPUAs are slightly different. These differences are not mate-
rial to the analysis.
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(1) JOHN HANCOCK LIFE INS. CO. (U.S.A.) v. COMM’R 125
Dortmund’s capacity availability charges under the service
contract on the purchase option date. Additionally, Dr. Lys
determined the present value of the trade fair facility’s
residual value at the end of the service contract using the
appraisals’ pretax discount rate of 10.5%. The following table
summarizes Dr. Lys’ analysis, 67 assuming that Dortmund
acts as the service purchaser under the service contract: 68
Purchase
Purchase Service option
option contract advantage
End of lease term:
Sec. 467 loan and EPUA -0- $176,039,470 ($176,039,470)
Costs to refinance debt and
arrange for residual
value insurance -0- (9,115,027) 9,115,027
Service contract term:
Capacity availability charges -0- (173,100,000) 173,100,000
Initial lease tail period:
Residual value $42,300,000 -0- 42,300,000
Total 42,300,000 (6,175,557) 48,475,557
Under Dr. Lys’ analysis, the purchase option advantage is
$48,475,557. However, his conclusion again depends on
whether, and to what extent, Dortmund will be taxed on the
proceeds of the section 467 loan and the EPUAs pursuant to
German tax law. To illustrate this point, Dr. Lys estimated
a total German income tax for Dortmund of $107,895,159
($283,934,629 × 38%). If Dortmund actually owed
$48,475,557 less in German income tax liability than under
Dr. Lys’ analysis, there would be no economic advantage in
Dortmund’s exercising its purchase option.
Both parties presented expert reports with respect to the
German tax consequences to Dortmund under the service
contract option. Respondent’s expert in the field of German
tax law, Dr. Diemer, opined that Dortmund would be subject
to capital gains tax under the German corporate income tax
and trade income tax to the extent that its amount realized
from the sale exceeded the trade fair facility’s book value on
the purchase option date. As in the TIWAG transaction, Dr.
67 Dr.
Lys’ analysis used lower costs than the appraisals for Dortmund
to refinance the sec. 467 loan and obtain residual value insurance. We
have adopted the appraisals’ estimates of these costs.
68 As with TIWAG, the results are the same if Dortmund procures a
third-party power purchaser.
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126 141 UNITED STATES TAX COURT REPORTS (1)
Lys’ analysis assumed a book value of zero. Dr. Diemer fur-
ther opined that under the service contract the capacity
availability charges would be tax deductible to Dortmund
during the service contract term. As a caveat to Dr. Diemer’s
report, he stated that the changing nature of the German
corporate tax laws makes it impossible to opine with cer-
tainty on the tax consequences of a transaction occurring in
2032. Therefore, his analysis was based on current law.
Petitioners’ expert in the field of German tax law, Dr. Hey,
agreed with Dr. Diemer that any determination with respect
to the German tax consequences of a transaction in 2032 is
speculative. However, he presented the potential for a much
different impact on Dortmund under the service contract,
concluding that taxes would likely not be a material factor in
Dortmund’s decisions. Beginning with the trade income tax,
Dr. Hey explained that it is the equivalent of a municipal
income tax. Therefore, Dortmund would pay any trade
income tax imposed as a result of the sale of the
trade fair facility to itself. Further, Dr. Hey explained
that the trade income tax is deductible for German Federal
corporate income tax purposes. Therefore, the only
effect of the trade income tax would be to reduce Dortmund’s
effective corporate income tax rate.
Next, Dr. Hey opined on a number of scenarios where
Dortmund could reduce or eliminate any corporate tax
liability resulting from a sale. First, pointing to section 6b of
the German income tax code, Dr. Hey opined that ‘‘roll-over’’
relief would be available to defer any gain. Dr. Hey described
‘‘roll-over’’ relief as a mechanism similar to like-kind
exchanges under section 1031, where Dortmund would be
able to roll over the book value of the trade fair facility to
newly acquired land or buildings provided that such assets
are acquired in the current or preceding year, or will be
acquired in the following four to six years. Dr. Hey stated
that the replacement property does not need to serve the
same function as the trade fair facility and that it is reason-
able to assume that a city like Dortmund would have other
potential investments that would allow it to use this
strategy.
Dr. Hey also stated that under German tax law capital
gains may be offset against ordinary losses. There is no way
to know with certainty what Dortmund’s tax position will be
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(1) JOHN HANCOCK LIFE INS. CO. (U.S.A.) v. COMM’R 127
in 2032, but he surmised that Dortmund could be in a loss
position from its commercial activities, a common occurrence
for municipalities. Additionally, he noted that under current
law losses may be carried forward indefinitely and carried
back one year, with certain limitations.
We find Dr. Hey’s testimony to be credible, and respondent
failed to provide an effective rebuttal. As a result, although
we cannot be certain what Dortmund’s tax liability would be
from nonexercise of its purchase options, it is likely to be less
than Dr. Lys’ calculations.
Neither Dr. Hey nor respondent’s expert in the field of
German tax law, Dr. Diemer, posited that Dortmund was a
tax-exempt entity. Therefore, when evaluating Dortmund’s
purchase option decisions, we must account for an annual tax
throughout the service contract term when calculating the
residual value of the trade fair facility under the discounted
cashflow method. The appraisals did not account for such a
tax, stating that ‘‘a pretax analysis has been used since buy/
sell decisions of exhibition industry participants and pub-
lished market yield requirements reflect a pretax basis’’. We
do not challenge this conclusion. Rather, we feel it does not
apply to our inquiry. Here, we must view Dortmund’s tax
consequences consistently in evaluating its purchase option
decisions. Therefore, even though we do not know what Dort-
mund’s expected annual tax consequences were on the
closing date, the exclusion of taxes from the discounted
cashflow analysis ignores a potential cost, making it likely
that the residual value was overstated.
Dr. Lys relied on the appraisal’s pretax residual value
determinations in his calculation. Dr. Lys used this value as
the basis for determining, as of the purchase option date, the
expected present value of the trade fair facility’s residual
value at the end of the service contract. However, despite
using the appraisals’ pretax calculations for the residual, Dr.
Lys used an after-tax calculation to determine the proceeds
Dortmund would receive from the sale of the trade fair
facility to John Hancock for German tax purposes. As in the
TIWAG transaction, Dr. Lys calculated Dortmund’s taxable
income as the difference between Dortmund’s purchase
option prices and Dortmund’s book value in the trade fair
facility, which he assumed to be zero. The result is a tax rate
inconsistency.
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128 141 UNITED STATES TAX COURT REPORTS (1)
When we apply a consistent tax approach to Dr. Lys’ cal-
culations, the result is a likely decrease in the value of the
purchase option and a likely increase in the value of the
service contract option. To illustrate this impact, we refer
back to Dr. Lys’ analysis, which concluded that Dortmund
could expect its purchase options to yield a $48,475,557
advantage over its service contract options. This conclusion
reflects the least likely of scenarios, where no tax is
applicable in calculating the residual and the maximum tax
is applicable in calculating Dortmund’s tax liability. In
reality, the answer is probably somewhere in the middle, as
a tax of some kind will likely be appropriate in calculating
the residual and Dortmund can reasonably expect to offset
some portion of its tax liability from nonexercise of the pur-
chase option. In the range of possibilities, we find that there
are many reasonable outcomes where the combined mag-
nitude of a decrease in the residual value and a decrease in
Dortmund’s tax liability could exceed $48,475,555. As a
result, we find that petitioners have presented enough evi-
dence to counter respondent’s claim that on the closing dates
the exercise of the purchase options was the only viable
financial option and thus reasonably likely.
Respondent also argues that several other factors could
prevent Dortmund from forgoing its purchase options,
including legal considerations. Dr. Heisse, respondent’s
expert in the field of German law, except for German
criminal law, offered several possible legal obstacles to the
privatization of the trade fair facility. Dr. Heisse opined that
under section 107, the municipality act for North Rhine-
Westphalia (GO NRW), Dortmund is not allowed to grant a
third party the permanent right to use a facility required for
its public duties unless it gets permission from the proper
authorities and secures an alternative facility. According to
Dr. Heisse, Dortmund needs the trade fair facility to main-
tain its public duties of providing social and educational
resources to its citizens.
Dr. Heisse brought to our attention a recent decision of
Germany’s highest administrative court which held that
under article 28 of GO NRW, the city of Offenbach could not
privatize a historic Christmas market, which had been oper-
ating since 1979, because a German municipality is obligated
to protect the communal togetherness of its residents and to
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(1) JOHN HANCOCK LIFE INS. CO. (U.S.A.) v. COMM’R 129
safeguard long-established municipal-run institutions
(Christmas market case). The German court referred to trade
fairs as an example of another type of asset that a munici-
pality must safeguard. In the Christmas market case the
owner of a snack stall at the Christmas market challenged
Offenbach’s decision to privatize the Christmas market. The
stall owner argued that article 28 requires Offenbach to man-
age the Christmas market. Dr. Heisse opined that this case
established a law preventing the privatization of long-estab-
lished municipal-run institutions and would apply to the
trade fair facility on the purchase option date because it will
have been in existence for 85 years. The Christmas market
case was decided in 2009, eight years after the closing date.
In addition to Dortmund’s social and communal duties to
its citizens, Dr. Heisse also opined that Dortmund would face
budget law obstacles if it relinquished control over the trade
fair facility to John Hancock. Under section 75 of the GO
NRW, a municipality must use its financial means as effi-
ciently and diligently as possible. If Dortmund has to shift all
of its employment contracts related to the trade fair facility
to other city resources, it would be required to terminate
many of its employees, which would require significant sever-
ance payments. Dr. Heisse opined that these severance pay-
ments could violate section 75 of the GO NRW.
Petitioners’ expert in the field of German administrative
and public law, Dr. Schu¨rrle, disagreed with many of Dr.
Heisse’s conclusions. According to Dr. Schu¨rrle, the German
basic law provides a municipality with the constitutional
right to regulate any matters affecting the local community
at its own discretion. Although there are some mandatory
tasks imposed on a municipality, the operation of a trade fair
is a voluntary task. Therefore, a municipality is free to exer-
cise its voluntary tasks as it pleases as long as it exercises
the proper discretion. Dr. Schu¨rrle disagreed with Dr.
Heisse’s interpretation of section 107 of the GO NRW
because, in his opinion, the section does not obligate munici-
palities to perform certain activities to promote the social
and educational needs of its citizens. Rather, it merely
describes certain activities which are not legally deemed to
be business activities of the municipality.
Dr. Schu¨rrle’s interpretation of the Christmas market case
is consistent with his explanation of a municipality’s right to
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130 141 UNITED STATES TAX COURT REPORTS (1)
discretion. Dr. Schu¨rrle opined that the Christmas market
case did not hold that a municipality could not privatize a
long-established municipal-run institution but rather that
the municipality must use the appropriate level of discretion
in making such a decision and Offenbach failed to do so. For
instance, if Offenbach did not have the financial means to
continue to operate the Christmas market and instead chose
to allocate its resources towards other public services it
deemed to be more critical, the proper discretion would have
been used and the German court would not have required
Offenbach to maintain the Christmas market.
Finally, with respect to Dr. Heisse’s employment and
budget law concerns, Dr. Schu¨rrle opined that the German
civil code prohibits the termination of employees for the sole
reason of a transfer. Therefore, the likelihood that Dortmund
employees would object to a transfer to a different position
within the city government and expose Dortmund to signifi-
cant financial risk was small. Dr. Schu¨rrle concluded that
there are no legal obstacles to Dortmund’s nonexercise of its
purchase option. We find that neither the Christmas market
case nor any other legal consideration would prevent Dort-
mund from forgoing its purchase options.
Respondent next argues that Dortmund is unlikely to allow
the trade fair facility to fall out of its possession because of
its importance to the local economy. Respondent offered the
analysis of Dr. Seringhaus as an expert in international mar-
keting and the trade fair industry. 69 The operation of the
trade fair facility generates a direct loss to Dortmund
annually. However, Dr. Seringhaus stated that the trade fair
facility generates 140 million euro of direct and indirect
benefits to Dortmund each year. Because the trade fair
facility creates nearly 2000 jobs and approximately 124,000
hotel lodgings annually, it also has a significant impact on
local restaurants and retail stores. Dr. Seringhaus also
stated that nearly all German trade fairs are publicly owned.
We do not question the accuracy of this data. However,
respondent has not presented any evidence to show that the
69 However, following voir dire, the Court limited the scope of Dr.
Seringhaus’ report, recognizing him as an expert only in the field of trade
fair exhibiting and marketing.
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(1) JOHN HANCOCK LIFE INS. CO. (U.S.A.) v. COMM’R 131
privatization of the trade fair facility would negatively affect
these benefits.
Petitioners’ expert in the field of trade fair industry
including the ownership and operation of trade fairs in Ger-
many, Dr. Stoeck, reached contrary conclusions. First, Dr.
Stoeck pointed to several examples of privatized German
trade fairs and private companies available and able to
operate a trade fair. Further, he noted that zoning laws
would require that a private company operate the trade fair
facility in the same manner it has always been operated and
Dortmund would not have to fear a change in the manner of
use of the trade fair facility. Because a private company
could not alter the use of the trade fair facility, a transfer of
control would not necessarily affect the indirect benefits the
trade fair facility generates for Dortmund and the commu-
nity. Therefore, whether Dortmund or John Hancock owns
the trade fair facility, it is reasonable to anticipate that the
economic impact Dr. Seringhaus described would not be
significantly altered. Further, it is also reasonable to assume
that Dortmund may be motivated to privatize the trade fair
facility. On its own, operation of the trade fair facility gen-
erates an annual loss. It is possible that Dortmund will see
nonexercise of its purchase options as an opportunity to pre-
serve the benefits of the trade fair to the community, while
at the same time avoiding its annual loss in operations.
Finally, respondent argues that Dortmund would not forgo
its purchase options because of its interests in hall 3B, which
was built after the closing dates and was not included in the
Dortmund transactions. Nothing in the facts indicates that
this is a real concern. We are confident that Dortmund and
John Hancock could find a way to make it work. For
instance, in the TIWAG transaction John Hancock acquired
an undivided interest in Sellrain-Silz. In anticipation of the
possibility that they may have to share the facility, John
Hancock and TIWAG entered into facility operation, access,
and support agreements, all of which protected the parties’
rights and made a shared management arrangement feasible.
Hall 3B by itself does not make exercise of the purchase
options reasonably likely.
As with the TIWAG transaction, we cannot determine on
the facts and circumstances presented to the Court that the
TIWAG and Dortmund purchase options were reasonably
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132 141 UNITED STATES TAX COURT REPORTS (1)
likely to be exercised at the closing dates. Thus for purposes
of our analysis, we assume the purchase options will not be
exercised. As a result, we must next determine whether John
Hancock bore more than a de minimis risk of loss in the
service contract term.
c. Service Contract Benefits and Burdens
Respondent argues that even if the purchase options in the
TIWAG and Dortmund transactions are not exercised, John
Hancock is ensured its expected return on the closing date
under the service contract option. We use the facts of the
TIWAG transactions to illustrate respondent’s argument, but
the result is equally applicable to the Dortmund trans-
actions.
Respondent argues that in the TIWAG transaction the
capacity charge payments, combined with the expected
residual value of the 21.6% undivided interest in Sellrain-
Silz at the end of the service contract term, guarantees the
safety of John Hancock’s equity investment. Beginning with
residual value, on or before the purchase option date John
Hancock may request that TIWAG acquire residual value
insurance to ensure the expected fair market value of the
21.6% undivided interest in Sellrain-Silz at the end of the
service contract term. Respondent argues that this residual
value insurance removes John Hancock’s residual value risk,
ensuring its predetermined rate of return. Petitioners argue
that we should ignore the residual value insurance because
no such agreement is currently in place, and we do not know
whether such an agreement would be available or prohibi-
tively expensive. We find that petitioners’ argument lacks
merit. It is not unreasonable to assume that TIWAG will be
able to procure residual value insurance if requested. In fact,
according to the appraisal’s purchase option analysis,
TIWAG’s cost to arrange a service contract, refinance the sec-
tion 467 loan, and obtain residual value insurance is
expected to be $7,108,992. We see no reason John Hancock
would not make such a request of TIWAG. Therefore,
assuming that the insurance provider would not default on
its obligations, the residual value insurance will provide
security with respect to a portion of the expected residual
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(1) JOHN HANCOCK LIFE INS. CO. (U.S.A.) v. COMM’R 133
value of the 21.6% undivided interest in Sellrain-Silz at the
end of the service contract term.
Given the residual value insurance, the following descrip-
tion summarizes respondent’s position. John Hancock
invested approximately $53 million in equity and transaction
expenses in the TIWAG transaction. Throughout the sub-
lease and service contract terms, John Hancock is entitled to
the sublease rent payments and the capacity charges, respec-
tively. John Hancock is also responsible for its debt service
on the series A and B loans during the sublease term and on
the refinanced loan during the service contract term. John
Hancock’s equity portion of sublease rent is approximately
$10 million, meaning that to break even on its equity invest-
ment, John Hancock must recoup $43 million ($53 million –
$10 million) from the equity portion of capacity charges,
expected to be approximately $6 million, and the residual
value of the 21.6% undivided interest in Sellrain-Silz at the
end of the service contract term. 70 With the residual value
insurance, John Hancock is ensured to receive the lesser of:
(1) $205,422,256 or (2) 35% of the appraised fair market
value of the 21.6% undivided interest in Sellrain-Silz at the
end of the service contract term as determined by a new
appraisal at or near the purchase option date. Therefore, if
we assume that (1) the new appraisal is consistent with
Deloitte’s appraisal and expects the asset to be worth
$778,757,760 at the end of the service contract term and (2)
John Hancock receives the capacity charges, the result is a
pretax profit to John Hancock of over $741 million
($778,757,760 + $6 million – $43 million). Further, even if
the residual value of the 21.6% undivided interest in
Sellrain-Silz is zero at the end of the service contract term,
the result is a pretax profit to John Hancock of over $168
million ($205,422,256 + $6 million – $43 million). 71
Despite the residual value insurance, respondent’s
‘‘guaranteed return’’ argument is flawed because it ignores
70 This does not consider the time value of money. In reality, even at an
inflationary rate of return John Hancock will need to recoup more than its
equity investment to break even on the transaction.
71 If the new appraisal expects the 21.6% undivided interest in Sellrain-
Silz to be worth $778,757,760 at the end of the service contract term, then
the insured residual will be the lesser of: (1) 35% of this value, or
$272,566,216 and (2) $205,422,256.
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134 141 UNITED STATES TAX COURT REPORTS (1)
John Hancock’s economic risks during the service contract
term. Under the power purchase agreement, the power pur-
chaser must make the capacity charge payments to John
Hancock. These payments total $1,316,013,696. There are no
guaranties that John Hancock will receive any or all of these
payments. Taking a closer look at the service contract option,
TIWAG must procure a qualified bidder to act as the power
purchaser in a power purchase agreement with John Han-
cock. If TIWAG is able to do so and John Hancock enters into
a power purchase agreement, TIWAG no longer has any
obligations pursuant to the sublease. At that time, all the
risk of the power purchase agreement falls on John Hancock.
The power purchase agreement does not require any credit
support. Rather, it provides that credit support will be nec-
essary only if the power purchaser’s credit rating falls below
A or A2 under S&P’s and Moody’s credit rating systems,
respectively. Additionally, the power purchase agreement
does not guarantee payment of the capacity charges in all
circumstances. The power purchaser is obligated to pay the
capacity charges only if and to the extent John Hancock
makes the required capacity available. If the required
capacity is not made available for any reason, including force
majeure, the capacity charge would be reduced accordingly.
If we relate these risks back to the earlier example under
respondent’s assumption, we find that John Hancock’s min-
imum expected pretax profit of approximately $168 million
depends on receiving capacity charge payments of
$1,316,013,696, none of which are guaranteed. This risk is
indicative of ownership.
In addition to risk, under the service contract option John
Hancock has the opportunity to capture the benefits of
ownership in the 21.6% undivided interest in Sellrain-Silz.
The power purchase agreement provides that if the power
purchaser does not use all of the required capacity, John
Hancock will have the right to sell such capacity to other
power purchasers. Thus, if the power purchaser declines to
take generated power or the 21.6% undivided interest in
Sellrain-Silz produces more electricity than required under
the power purchase agreement, John Hancock can benefit
from such excess. There is no expectation that either of these
events will take place. Nonetheless, they are an example of
John Hancock’s upside. Another example of John Hancock’s
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(1) JOHN HANCOCK LIFE INS. CO. (U.S.A.) v. COMM’R 135
potential for gain is the residual value of the 21.6% undi-
vided interest in Sellrain-Silz at the end of the service con-
tract term. If the fair market value of the asset at the end
of the service contract term exceeds its expected residual
value, the entire benefit will belong to John Hancock.
Nothing in the transaction documents caps this potential
benefit. Therefore, during the service contract term John
Hancock enjoys the benefits and burdens of ownership with
respect to the 21.6% undivided interest in Sellrain-Silz.
The Dortmund transactions are substantially similar to the
TIWAG transaction. The service contracts do not require
credit support to secure the service purchaser’s payments of
the capacity availability charges during the service contract
term and require such credit support only if the service pur-
chaser’s credit rating falls below BBB+ or Baa1 under S&P’s
and Moody’s credit rating systems, respectively. Further,
John Hancock is entitled to the capacity availability charges
only if it provides the required services to the service pur-
chaser, even in the case of force majeure. This risk, even
when considering the residual value insurance, exceeds the
value of John Hancock’s expected residual interest from the
trade fair facility. On the benefits side, as in the TIWAG
transaction John Hancock is in position to capture any
increase in value of the asset at the end of the service con-
tract term. Therefore, during the service contract term of the
Dortmund transactions, John Hancock will enjoy the benefits
and burdens of ownership in the trade fair facility.
d. Future Interest
We have found that John Hancock will possess the benefits
and burdens of ownership with respect to its interests in the
subject assets of the TIWAG and Dortmund transactions
during their respective service contract terms, which will
begin at the end of the sublease terms if the purchase
options are not exercised. We must now determine whether
these benefits and burdens create a future, rather than a
present, interest in the subject assets. Petitioners will not be
entitled to their claimed deductions unless they prove that
John Hancock held a current interest in the subject assets
during the years at issue.
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136 141 UNITED STATES TAX COURT REPORTS (1)
The defeasance agreements were designed to insulate John
Hancock from any non-de-minimis risk during the sublease
term. Further, if the purchase options are exercised, John
Hancock will receive its expected return from the trans-
actions. Respondent argues that under these circumstances,
on their respective closing dates John Hancock acquired no
more than a future interest in the subject assets of the
TIWAG and Dortmund transactions. Respondent contends
that this future interest cannot become a current interest
unless and until the lessee counterparty chooses not to exer-
cise its purchase option. Therefore, respondent argues that
John Hancock should not be entitled to its claimed tax
deductions during the sublease term.
In BB&T, 2007 WL 37798, the District Court reached a
similar conclusion, determining that the taxpayer acquired
no more than a future leasehold interest in the subject asset.
Further, the court held that this future interest could become
a current interest only during the tail period following the
renewal lease term. The court concluded that the parties’
use, rights, and obligations with respect to the subject asset
were not materially altered during the sublease term and the
taxpayer’s initial cash outlay was never at risk because its
return was guaranteed through either the purchase option or
sublease renewal rents. Id. at *7. The Court of Appeals for
the Fourth Circuit agreed, holding that the lease and sub-
lease provided for offsetting rights and obligations, and the
structure of the transaction insulated the taxpayer from any
risk, regardless of whether the lessee counterparty exercised
its purchase option. BB&T, 523 F.3d at 473.
Here, petitioners argue that respondent’s future interest
theory fails in both law and fact. Petitioners contend that
under the principles of Frank Lyon a triple net lease is a fea-
ture typical of most commercial lease transactions and any
offsetting obligations between the lease and sublease must be
viewed as a neutral factor in the future interest analysis. As
we have previously discussed, this Court has found a triple
net lease in a leverage-lease transaction, on its own, to be a
neutral factor in determining whether a taxpayer has
acquired a leasehold interest. However, when a triple net
lease or similar arrangement is combined with other mecha-
nisms to eliminate all non-de-minimis risk from a trans-
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(1) JOHN HANCOCK LIFE INS. CO. (U.S.A.) v. COMM’R 137
action, we must consider the totality of the circumstances in
determining the transaction’s substance.
Whether or not TIWAG or Dortmund exercises its pur-
chase option, and here we assume they do not, the TIWAG
and Dortmund transactions are nothing more than the
acquisition of a future leasehold interest because they
insulate John Hancock from all non-de-minimis risk before
the purchase option date. On the closing date of the TIWAG
transaction, John Hancock acquired no more than a future
interest in the 21.6% undivided interest in Sellrain-Silz.
Similarly, on the closing dates of the Dortmund transactions,
John Hancock acquired no more than a future interest in the
trade fair facility.
Petitioners argue that such a determination threatens the
very existence of leveraged leasing, which has long been
considered a legitimate form of financing. We find peti-
tioners’ argument to be unavailing. The circumstances here
are very different from those of a traditional leveraged lease,
and certainly far different from the transaction in Frank
Lyon. In Frank Lyon, 435 U.S. at 583, the Supreme Court
specifically found that the taxpayer assumed the risk that
the lessee might default or fail. Nothing in the TIWAG and
Dortmund initial lease and sublease agreements materially
alters the parties’ rights and obligations in a way that cre-
ates such risk to John Hancock. Therefore, unlike a lessor in
a traditional leveraged lease, John Hancock stands to acquire
a current interest in the subject assets, with the benefits and
burdens that come with such an interest, only on each trans-
action’s purchase option date. Therefore, we find that John
Hancock is not entitled to the depreciation deductions
claimed with respect to the TIWAG and Dortmund SILO
transactions during the years at issue.
2. SNCB
The SNCB SILO transaction has two unique features that
distinguish it from the TIWAG and Dortmund transactions.
First, SNCB did not enter into a series B DPUA or similar
agreement. With respect to the series B debt, SNCB entered
into the CST, which is no more than a currency swap.
Respondent argues that SNCB’s calculation of its net present
value benefit, which included the CST, shows that SNCB
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138 141 UNITED STATES TAX COURT REPORTS (1)
deposited euro-denominated payments received from BofA
pursuant to the CST in a separate transaction substantially
similar to the series B DPUAs in the other SILO test trans-
actions. Respondent further relies on various communica-
tions that are not specific to this transaction to establish the
existence of this alleged series B DPUA. The record does not
support respondent’s argument. SNCB did not deposit the
euro-denominated payments received pursuant to the CST in
a series B DPUA or other similar arrangement. Further,
unlike the currency swaps in the SNCB LILO transactions,
SNCB did not prepay the CST. As a result, the proceeds of
the series B loan were always available for SNCB’s general
business purposes.
Next, the SNCB SILO transaction is distinguishable from
the TIWAG and Dortmund transactions because HSL is
expected to yield value to the service provider during the
service contract term in excess of the base service fees (i.e.,
the nonaccess and additional access fees). SNCB can capture
this value only if it exercises its purchase option. Therefore,
this distinction makes SNCB’s purchase option significantly
more attractive.
a. Purchase Option Decision
We begin our analysis of whether John Hancock acquired
the benefits and burdens of ownership of the HSL with an
examination of whether SNCB was reasonably likely to exer-
cise its purchase option. Unlike with the TIWAG and Dort-
mund SILOs where we began with an analysis of whether
John Hancock faced a risk of loss on its equity investment
during the sublease terms, we begin with the purchase
option decision because the purchase option decision is vital
to determining whether John Hancock’s equity investment in
the HSL during the subgrant term was exposed to a risk of
loss.
Similar to the TIWAG and Dortmund transactions, peti-
tioners, relying on the appraisal, argue that it would be
financially disadvantageous for SNCB to exercise its pur-
chase option. 72 According to the appraisal on the purchase
72 SNCB’s management committee will decide whether to exercise its
purchase option, and this decision will likely require the approval of its
board of directors. As of the date of trial SNCB had not decided whether
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(1) JOHN HANCOCK LIFE INS. CO. (U.S.A.) v. COMM’R 139
option date the fair market value of the 50% undivided
interest in HSL is expected to be $890,941,344. The fixed
price purchase option, or SNCB’s cost to exercise its option,
is $945,627,477. On the other hand, assuming John Hancock
would choose the service contract, SNCB’s costs of nonexer-
cise has two components: (1) the fair market value of the
50% undivided interest in HSL that SNCB will no longer
possess, or $890,941,344 and (2) the costs to arrange a
service contract, refinance the section 467 loan, and pay any
local tax indemnities under Belgian law, estimated in the
appraisal to total $21,771,925. Therefore, the appraisal con-
cluded that SNCB will likely not exercise its purchase option
because the advantage of not exercising is $32,914,208
($945,627,477 – $890,941,344 – $21,771,925).
Respondent disagrees with the appraisal and relies on the
expert testimony of Dr. Lys to rebut the appraisal’s conclu-
sions. Because SNCB cannot be the service purchaser under
the service contract, Dr. Lys’ analysis of SNCB’s purchase
option decision compares the costs and benefits of SNCB’s
exercising its purchase option and entering into its own
service contract with a third-party service purchaser against
the costs and benefits of relinquishing possession and use of
HSL under the service contract option. In many ways, Dr.
Lys’ analysis is similar to his analyses for the TIWAG and
Dortmund transactions. He again sought to correct perceived
errors in the appraisal, first applying a 40% tax rate, the
rate used in the appraisal’s discounted cashflow analysis, to
account for the Belgian tax consequences of SNCB’s receipt
of $945,627,477 73 from the section 467 loan and EPUA under
the service contract option. Next, he calculated the present
value of the base service fees under the service contract
using SNCB’s borrowing rate. Additionally, his analysis
again began with the assumption that nothing was sold on
the closing date and that SNCB’s purchase option is the
equivalent of a European put option.
to exercise its purchase option.
73 Dr Lys’ analysis and calculations are based on an amount realized of
$942 million, rather than SNCB’s expected amount realized of
$945,627,477. It is not clear where this difference comes from. For consist-
ency, we have adjusted Dr. Lys’ calculations to conform with SNCB’s ex-
pected amount realized. This change is not material to the analysis.
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140 141 UNITED STATES TAX COURT REPORTS (1)
The primary difference between SNCB’s purchase option
decision and those of TIWAG and Dortmund is that HSL is
expected to yield value to the service provider during the
service contract term in excess of the base service fees. As
seen in Dr. Lys’ analysis, SNCB can capture this value only
if it exercises its purchase option. In using the discounted
cashflow method to determine the fair market value of the
50% undivided interest in HSL on the purchase option date,
the appraisal considered four sources of revenue: (1) capacity
use payments, representing the annual payments a service
purchaser would be required to expend if it constructed a
similar asset with borrowed funds; (2) operating expenses
due under the service contract; (3) non-access-fee revenue,
including additional revenue that could be generated from
the installation and operation of fiber optic cables; and (4)
additional access-fee revenue comprising the additional rev-
enue an owner could achieve through the increased use of
the asset. SNCB will capture the benefits of these revenue
sources during the service contract term only if it exercises
its purchase option. Accordingly, Dr. Lys included the
present value of these benefits as of the purchase option date
in the purchase option column of his analysis, which
indicates as follows: 74
Purchase
option Purchase
plus service Service option
contract contract advantage
End of lease term:
Sec. 467 loan and EPUA -0- $567,376,486 ($567,376,486)
Costs to refinance debt -0- (2,200,000) 2,200,000
Service contract term:
Base service fees $683,800,000 -0- 683,800,000
Nonaccess and additional
access fees 238,500,000 -0- 238,500,000
Initial lease tail period:
Residual value 122,000,000 -0- 122,000,000
Total 1,044,300,000 565,176,486 479,123,514
Under Dr. Lys’ analysis, SNCB’s tax liability from nonexer-
cise of its purchase option would be $378,250,991
74 Unlike
the appraisal, Dr. Lys does not count the costs to arrange for
a service contract and local tax indemnities under Belgian law as costs to
SNCB under the service contract. Dr. Lys excludes these costs because
SNCB will incur them in both columns of his analysis, making them neu-
tral factors.
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(1) JOHN HANCOCK LIFE INS. CO. (U.S.A.) v. COMM’R 141
($945,627,477 × 40%) and its after-tax proceeds from the sec-
tion 467 loan and the EPUA would be $567,376,486
($945,627,477 – $378,250,991). The result is a total purchase
option advantage to SNCB of $479,123,514.
Petitioners argue that Dr. Lys’ conclusion is inaccurate and
that SNCB may not pay any taxes to Belgium resulting from
the nonexercise of the purchase option. 75 This argument,
however, even if correct, is not enough to change the overall
result. Even if we assume that SNCB will not pay any taxes
on the proceeds of the section 467 loan and the EPUA, a pur-
chase option advantage remains under Dr. Lys’ analysis of
$100,872,523 ($479,123,514 – $378,250,991). Further, this
result does not account for the possibility that the tail period
residual value in Dr. Lys’ analysis of $122,000,000 is under-
stated because it was calculated using a 40% tax rate under
the discounted cashflow method.
Petitioners do not specifically dispute Dr. Lys’ conclusions,
other than his application of a tax against the proceeds of the
section 467 loan and the EPUA. Rather, petitioners argue
that their alternative analysis under the TIWAG transaction
would be equally applicable to SNCB. This analysis begins
with the assumption that the 50% undivided interest in HSL
was sold to John Hancock on the closing date and summa-
rizes SNCB’s purchase option decision as follows:
Purchase
option Purchase
plus service Service option
contract contract advantage
End of lease term:
Purchase price ($945,627,477) -0- ($945,627,477)
Fair market value 890,941,344 -0- 890,941,344
Costs to refinance debt -0- ($2,200,000) 2,200,000
Service contract term:
Base service fees -0- -0- -0-
Initial lease tail period:
Residual value -0- -0- -0-
Total (54,686,133) (2,200,000) (52,486,133)
75 As discussed earlier, it is not clear whether under its reorganization
SNCB transferred ownership of HSL under Belgian law to a tax-exempt
subsidiary. Additionally, Dr. Lys’ analysis does not consider the book value
of the 50% undivided interest in HSL on the purchase option date or the
possibility that SNCB will have losses or loss carryovers that could reduce
or eliminate SNCB’s Belgian tax liability under the service contract option.
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142 141 UNITED STATES TAX COURT REPORTS (1)
According to petitioners, if SNCB exercises its purchase
option it will pay $945,627,477 for an asset with a fair
market value of $890,941,344 and it will avoid the costs to
refinance the section 467 loan. Under the discounted
cashflow method, the appraisal accounted for base service
fees, expenses, nonaccess fees, and additional access fees in
determining the fair market value of the 50% undivided
interest in HSL on the purchase option date. Therefore, to
avoid double counting, no further adjustments are necessary
for those items.
Under the service contract, SNCB would retain the pro-
ceeds it already owned from the section 467 loan and the
EPUA and would not receive any benefit from the residual
of the 50% undivided interest in HSL. Because SNCB cannot
be the service purchaser, it would not pay the base service
fees and expenses and would not benefit from the nonaccess
fees and additional access fees. The result, according to peti-
tioners, is a purchase option disadvantage of $52,486,133.
As in TIWAG, petitioners’ calculation does not apply a tax
to the proceeds of the section 467 loan and the EPUA. How-
ever, it relied on the appraisal’s estimated fair market value
determination on the purchase option date that was cal-
culated using a 40% tax under the discounted cashflow
method. If, consistent with petitioners’ approach to the tax
consequences of not exercising the purchase option, the
proper tax rate to be used in the appraisal’s discounted
cashflow analysis is lower than 40%, then the estimated fair
market value of the 50% undivided interest in HSL would be
higher, and the purchase option would become more attrac-
tive. Neither party has advanced alternative calculations to
measure this impact.
That said, we find that Dr. Lys’ analysis also provides
inconclusive results. 76 It is unclear how the Belgian tax con-
sequences on the purchase option date will affect SNCB’s
purchase option decision. Similarly, it is unclear what the
proper effective tax rate is for purposes of determining the
fair market value of the 50% undivided interest in HSL on
the purchase option date. Nonetheless, Dr. Lys’ analysis pro-
vides us with a framework through which we may evaluate
a range of potential results.
76 We find the same to be true of the appraisal and petitioners’ analysis.
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(1) JOHN HANCOCK LIFE INS. CO. (U.S.A.) v. COMM’R 143
In evaluating all the possibilities, we do not find there to
be a realistic scenario where the purchase option is not
advantageous to SNCB. First, petitioners have not disputed
Dr. Lys’ inclusion of the nonaccess and additional access fees
as a benefit to SNCB under the purchase option. These bene-
fits create an advantage to the purchase option that cannot
be overcome through any reasonable discussion of tax con-
sequences. More specifically, petitioners’ argument would
require us to find the most unlikely of scenarios to be real-
istic. For the purchase option to be financially disadvanta-
geous, SNCB would have to face little or no tax on the pro-
ceeds of the section 467 loan and the EPUA under the
service contract option. Additionally, at the same time, for
purposes of its residual value calculations SNCB would have
to expect to pay an effective tax rate of approximately 40%
during the service contract term. This is a tale of two
extremes, and it is wholly unrealistic. Therefore, though we
find the precise numbers in Dr. Lys’ analysis to be unreli-
able, his result cannot be disputed. As of the closing date,
SNCB was reasonably likely to exercise its purchase option.
b. Subgrant Term
Having concluded that the SNCB SILO purchase option is
reasonably likely to be exercised, we must now determine
whether John Hancock’s equity investment was at risk
during the subgrant term. Petitioners argue that the lack of
defeasance with respect to the series B debt places John
Hancock’s equity investment at risk during the subgrant
term and that such risk of loss is evidence of John Hancock’s
acquiring the benefits and burdens of ownership of the HSL.
We find that the lack of defeasance with respect to the series
B debt does not place John Hancock’s equity investment at
risk during the subgrant term. During the subgrant term
SNCB must pay John Hancock rent totaling $483,249,874
and John Hancock must make debt service payments totaling
$470,442,859 to the lenders. SNCB’s rent payments have
three components. The first component is attributable to the
series A debt, and Barclays will make payments totaling
$423,398,573 during the subgrant term to satisfy this compo-
nent under the series A DPUA. The second component is the
equity portion of subgrant rent. This amount is the excess of
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144 141 UNITED STATES TAX COURT REPORTS (1)
the $483,249,874 of subgrant rent payments John Hancock is
scheduled to receive during the subgrant term over its total
debt service payments of $470,442,859. To satisfy the equity
portion of subgrant rent, UBS will make payments totaling
$12,807,015 during the subgrant term pursuant to the
CLDA. Therefore, the series A DPUA and the CLDA combine
to account for $436,205,588 of SNCB’s subgrant rent pay-
ments, leaving $47,044,286 ($483,249,874 – $436,205,588) as
the third component of subgrant rent. This amount is attrib-
utable to the series B debt. SNCB’s payment or nonpayment
of this portion of subgrant rent does not affect John Han-
cock’s series B loan debt service obligation. Accordingly, if
SNCB defaults on its obligation to pay the series B debt por-
tion of subgrant rent, John Hancock would have to contribute
an additional $47,044,286 of equity throughout the subgrant
term to meet its series B debt service obligations.
The impact of this contribution is illustrated as follows.
Including transaction costs, John Hancock invested
$64,976,950 on the closing date. If all parties to the trans-
action meet their obligations, the equity portion of subgrant
rent, or $12,807,015, will reduce the amount John Hancock
needs to recoup from its investment to break even. Therefore,
at the end of the subgrant term John Hancock expects that
it will need to recoup an additional $52,169,935 ($64,976,950
– $12,807,015) from the transaction to break even. However,
if SNCB defaults on its obligations with respect to the por-
tion of subgrant rent that is attributable to the series B debt
($47,044,285), John Hancock would have to make additional
contributions to satisfy its series B debt service obligations.
In such a case, rather than having to recoup an additional
$52,169,935 from the transaction to break even, John Han-
cock would have to recoup $99,214,220 ($52,169,935 +
$47,044,285).
The purchase option price is $945,627,477, far greater than
the $99,214,220 that would be needed to recover John Han-
cock’s investment. Therefore, even if John Hancock is
required to contribute an additional $47,044,285 to service its
series B debt, it will still earn a profit of $846,413,257. We
can take this one step further through the use of a present
value calculation. As of the closing date, the present value of
the purchase option price was approximately $115,274,638.
We calculated this value using the after-tax WACC of 7.5%
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(1) JOHN HANCOCK LIFE INS. CO. (U.S.A.) v. COMM’R 145
used in the appraisal and Dr. Lys’ analysis over a 29.1-year
period. 77 Therefore, without discounting the equity portion of
subgrant rent or John Hancock’s additional contributions to
service the series B debt as it comes due, the result would
be a profit to John Hancock of $16,060,418 ($115,274,638 –
$99,214,220).
The above calculation proves, without a need to assess the
likelihood that SNCB would default on its subgrant rent
obligations attributable to the series B debt, that John Han-
cock does not have any meaningful risk in the SNCB SILO
transaction.
c. Conclusion
The risk of loss during the sublease term, even assuming
SNCB defaults on its subgrant rent obligations attributable
to the series B debt, combined with SNCB’s likely exercise of
their purchase options, insulates John Hancock from any risk
of losing its initial investment in the SNCB SILO trans-
action. Moreover, the structure of the transaction guaranteed
that John Hancock’s return on its investment was fixed on
the closing date of the transaction. Therefore, given that
SNCB kept control of the HSL, we find that John Hancock
did not acquire the benefits and burdens of ownership in the
HSL. The transaction resembles a financial arrangement.
Specifically, the transaction resembles a loan from John Han-
cock to SNCB for the duration of the subgrant term. As a
result, John Hancock will receive a predetermined return
without regard to the relevant value of the asset and will
have no upside potential or downside risk tied to ownership
of the HSL. Thus, we find that the substance of the SNCB
SILO transaction is not consistent with its form. Accordingly,
we deny John Hancock’s depreciation deductions with respect
to the SNCB SILO transaction.
Interest Deductions
Section 163(a) provides: ‘‘There shall be allowed as a
deduction all interest paid or accrued within the taxable year
on indebtedness.’’ Indebtedness is an existing, unconditional,
and legally enforceable obligation for the payment of a prin-
77 The subgrant term is slightly longer. It begins on November 14, 2001,
and ends on January 2, 2031.
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146 141 UNITED STATES TAX COURT REPORTS (1)
cipal sum. E.g., Landry v. Commissioner, 86 T.C. 1284, 1308
(1986). Interest is ‘‘compensation for the use or forbearance
of money.’’ Deputy v. du Pont, 308 U.S. 488, 498 (1940). It
is well settled that the indebtedness referred to in section
163(a) must be genuine, and economic realities govern over
the form in which a transaction is cast. Knetsch v. United
States, 364 U.S. 361, 365–366 (1960). In particular, the fact
that a purported borrower may sign a loan document that
provides it has a legal obligation to repay a loan cannot alone
give the debt substance. See Wells Fargo, 641 F.3d at 1321,
1330; BB&T, 523 F.3d at 476; Goldstein v. Commissioner,
364 F.2d 734, 740–742 (2d Cir. 1966) (‘‘Section 163(a) does
not ‘intend’ that taxpayers should be permitted deductions
for interest paid on debts that were entered into solely in
order to obtain a deduction.’’), aff ’g 44 T.C. 284 (1965).
Respondent argues that John Hancock’s nonrecourse loans
in the test transactions are not genuine debt because John
Hancock did not ‘‘use’’ the loans to acquire genuine interests
in the subject assets. Respondent cites Altria, 694 F. Supp.
2d at 281–282, where the trial court held: ‘‘[A]lthough the
taxpayer is legally obligated to repay the debt, its use of the
debt is so far beyond the intent of the Code that it cannot
support the deduction.’’
In determining whether the nonrecourse loans in John
Hancock’s test transactions qualify as genuine indebtedness
under section 163(a), we must view the substance of each
transaction as a whole, not in separate parts or step by step.
See Commissioner v. Court Holding Co., 324 U.S. at 334. In
other words, we will not respect the substance of the non-
recourse loans unless John Hancock used the proceeds of
those loans to acquire real capital. Petitioners do not dispute
this analysis, stating in brief that ‘‘[t]he Court’s decision on
whether John Hancock acquired the benefits and burdens of
the leased properties is determinative of whether the loans
are genuine for [F]ederal income tax purposes.’’ See Peti-
tioners’ Reply Brief p. 214.
For the reasons previously discussed, John Hancock did
not acquire a genuine interest in the subject assets of the
LILO test transactions and the SNCB SILO transaction.
Accordingly, we find that John Hancock’s nonrecourse loans
with respect to the LILO test transactions and the SNCB
SILO transaction are not genuine indebtedness for the pur-
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(1) JOHN HANCOCK LIFE INS. CO. (U.S.A.) v. COMM’R 147
poses of section 163(a), and John Hancock is not entitled to
the interest deductions it claimed with respect to those loans.
In the case of the SNCB SILO transaction, petitioners con-
cede that the lack of defeasance in the series B debt is irrele-
vant to our determination.
With respect to the TIWAG and Dortmund SILO trans-
actions, we have determined that on the respective closing
dates John Hancock acquired no more than a future interest
in the subject assets. If the lessee counterparties do not exer-
cise their purchase options, the original loans must be paid
in full and the section 467 loan must be refinanced. There-
fore, the series A and B debt in each transaction will no
longer be in existence if and when John Hancock acquires a
current interest in the subject assets. Accordingly, petitioners
are also not entitled to their claimed interest deductions from
the TIWAG and Dortmund SILO transactions.
Original Issue Discount
OID income results when a debt instrument is issued for
less than its face value. See United States. v. Midland-Ross
Corp., 381 U.S. 54 (1965); Capital One Fin. Corp. v. Commis-
sioner, 133 T.C. 136, 162 (2009), aff ’d,
659 F.3d 316 (4th Cir.
2011); Gaffney v. Commissioner, T.C. Memo. 1997–249. The
holder of a debt instrument with OID generally accrues and
includes in gross income, as interest, the OID over the life
of the obligation, even though the interest may not be
received until the maturity of the instrument. Sec.
1272(a)(1).
With respect to the LILO test transactions and the SNCB
SILO transaction, respondent argues that John Hancock’s
equity contributions must be recast as loans from John Han-
cock to the respective lessee counterparties. Under these
deemed loans, respondent contends that each lessee
counterparty agreed to repay John Hancock through the
equity portion of sublease rent and the purchase option price.
Respondent argues that these arrangements are akin to debt
instruments creating guaranteed and fixed returns to John
Hancock and should be treated as such for Federal tax pur-
poses.
Petitioners argue that John Hancock’s equity contributions
should not be recharacterized as loans because they do not
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148 141 UNITED STATES TAX COURT REPORTS (1)
represent unconditional and legally enforceable obligations
for the payment of principal sums. Rather, petitioners argue
that the alleged repayments are speculative and the trans-
action documents do not create fixed obligations. We dis-
agree. As discussed above, the lessee counterparties are
reasonably likely to exercise their fixed-price purchase
options in the LILO test transactions and the SNCB SILO
transaction. Additionally, each transaction features full
defeasance. As a result, the purchase option price and the
equity portions of sublease rent represent fixed obligations
due from the lessee counterparties to John Hancock. There-
fore, we find respondent’s recast of the equity contributions
in the LILO test transactions and the SNCB SILO trans-
action to be appropriate, and the OID rules must apply
accordingly.
With respect to the TIWAG and Dortmund transactions,
we agree with petitioners that the alleged repayments are
speculative. On the closing dates of the TIWAG and Dort-
mund transactions, John Hancock paid an amount equal to
its equity contributions and transaction costs for the right on
the purchase option dates to either: (1) its expected return
under the purchase options or (2) a current interest in the
subject asset with a service contract in place. As we have dis-
cussed, under each service contract John Hancock is exposed
to the risk of losing its equity contribution. Therefore,
respondent’s OID argument is inapplicable to the TIWAG
and Dortmund SILO transactions.
Next, we must provide the parties with guidance with
respect to the Rule 155 calculation of John Hancock’s OID
income from the LILO test transactions and the SNCB SILO
transaction. The amount of OID income with respect to a
debt instrument is the excess of the stated redemption price
at maturity (SRPM) over the issue price of the debt
instrument. Sec. 1273(a)(1). The SRPM includes all amounts
payable at maturity. Sec. 1273(a)(2). In order to compute the
amount of OID and the portion of OID allocable to a par-
ticular period, the SRPM and the time of maturity must be
known. Capital One Fin. Corp. v. Commissioner, 130 T.C.
147. In determining the issue price, a payment from the
lender to the borrower in a lending transaction is treated as
an amount lent. Sec. 1.1273–2(g)(3), Income Tax Regs.
Additionally, if the lender makes a payment to a third party,
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(1) JOHN HANCOCK LIFE INS. CO. (U.S.A.) v. COMM’R 149
that payment is treated in appropriate circumstances as an
additional amount lent to the borrower. Sec. 1.1273–2(g)(4),
Income Tax Regs.
In the case of the LILO test transactions and the SNCB
SILO transaction, the issue price for the Rule 155 calculation
is the amount deemed to have been lent from John Hancock
to the lessee counterparty and includes the up-front payment
under the initial leases. Pursuant to section 1.1273–2(g)(3)
and (4), Income Tax Regs., this amount also includes John
Hancock’s transaction costs (excluding costs associated with
debt that was not genuine) and all amounts representing the
net present value benefit to the respective lessee counterpar-
ties. The SRPM in each transaction is the amount that will
have been repaid to John Hancock on the maturity date,
equal to the equity portion of rent payments during the sub-
lease term and the purchase option price.
Transaction Expenses
Ordinary and necessary expenses paid or incurred in car-
rying on any trade or business are generally deductible. Sec.
162. In the TIWAG and Dortmund transactions, John Han-
cock incurred legitimate transaction costs as part of its
acquisition of a future interest in the subject assets. How-
ever, any transaction costs with respect to the series A and
B debt in each transactions are not deductible, as we have
found that they were not genuine indebtedness.
In the LILO test transactions and the SNCB SILO trans-
action, we have found that John Hancock’s equity invest-
ments are better characterized as loans from John Hancock
to the lessee counterparties. Pursuant to section 1.1273–
2(g)(4), Income Tax Regs., John Hancock’s transaction costs
must be included as an additional amount lent to the bor-
rowers. As such, John Hancock’s transaction costs associated
with the LILO test transactions and the SNCB SILO trans-
action are not deductible.
Conclusion
The facts and circumstances of each of the test trans-
actions are different, and we have given each independent
consideration. In doing so, we have found that in each case
the substance of the transaction is not consistent with its
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150 141 UNITED STATES TAX COURT REPORTS (1)
form. Specifically, with respect to the LILO test transactions
and the SNCB SILO transaction, we have found that the
lack of non-de-minimis risk to John Hancock during the sub-
lease terms, combined with the reasonable likelihood of the
purchase options’ being exercised, ensured from the closing
dates that John Hancock would receive its expected return
on its equity investments. This guaranteed return is not
indicative of a leasehold or ownership interest. Rather, it is
reflective of what is better described as a very intricate loan
from John Hancock to the lessee counterparties. Con-
sequently, we have also found respondent’s determination of
OID income to John Hancock to be appropriate.
The TIWAG and Dortmund transactions are slightly dif-
ferent. If TIWAG and Dortmund exercise their purchase
options, John Hancock will receive its expected return on its
equity investments. This is ensured because of the lack of
non-de-minimis risk to John Hancock during the sublease
terms. However, on the facts and circumstance before us, we
cannot determine that TIWAG or Dortmund is reasonably
likely to exercise its purchase option, and we have deter-
mined that John Hancock’s equity investment would be at
risk under each transaction’s service contract option. There-
fore, as of the closing dates of the TIWAG and Dortmund
transactions and throughout the years at issue, John Han-
cock’s equity investments were free from risk of loss. This
lack of risk can only change if and when one of the lessee
counterparties forgoes its purchase option. If that happens,
as of the relevant purchase option date John Hancock will
have a current interest in the subject asset and will be enti-
tled to all the deductions associated with that interest.
Unless and until that happens, however, the TIWAG and
Dortmund transactions will have created no more than a
future interest to John Hancock, an interest that does not
entitle John Hancock to most of its claimed deductions.
The Court, in reaching its holdings, has considered all
arguments made, and, to the extent not mentioned, concludes
that they are moot, irrelevant, or without merit.
To reflect the foregoing,
Decisions will be entered pursuant to Rule 155.
f
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