Article

Note: Consolidated Edison Company of New York, Inc. (Beneficiary/Taxpayer) entered into a "lease-in, lease-out" (LILO) agreement with Electriciteitsbedrijf Zuid-Holland (Applicant) under which Applicant leased an undivided 47.47% interest in a facility to Beneficiary/Taxpayer for 43.2 years, and Beneficiary/Taxpayer subleased the same interest to Applicant for a minimum of 20.1 years. During the shorter term sublease, Applicant was required to maintain various standby letters of credit in favor of Beneficiary as security for the agreement's various maintenance, repair, and payment obligations.

When the United States Internal Revenue Service (IRS) disallowed several of the rental, interest, and transaction cost deductions claimed by Beneficiary/Taxpayer in the LILO agreement, Beneficiary/Taxpayer sued the United States to recover funds allegedly overpaid to IRS in the tax year the agreement was entered into. The United States Court of Federal Claims, Horn, J., entered judgment in favor of Beneficiary/Taxpayer.

In her opinion, the Judge cited Revenue Ruling 99-14:

A taxpayer may not deduct, under §§ 162 and 163, rent and interest paid or incurred in connection with a LILO transaction that lacks economic substance. . . . [IRS] will scrutinize LILO transactions for lack of economic substance and/or, in appropriate cases, recharacterize transactions for federal income tax purposes based on their substance.

The Judge defined "economic substance" as true ownership in a leasehold interest such that the taxpayer claiming the deduction possesses both the benefits and burdens of ownership and therefore "satisfies the substance over form test."

The Judge ruled that the LILO agreement had economic substance and that Beneficiary/Taxpayer possessed both the benefits and burdens of ownership because the standby mitigated risk between Beneficiary/Taxpayer and Applicant but did not completely eliminate the risks of the Issuer's dishonor or bankruptcy. Therefore, the relevant rental, interest, and transaction costs were ruled deductable from tax requirements and refunded to Beneficiary/ Taxpayer.

[JEB/kmw]

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