Fixed-price purchase options may receive more attention after a decision by the US Tax Court in a case involving LILOs and SILOs.

The court said 27 lease transactions that John Hancock Life Insurance Company did during the period 1997 through 2001 were not true leases for tax purposes and denied tax deductions for rent and depreciation that the company claimed.

Some of the transactions were cross-border lease-sublease deals called LILOs (for lease-in-lease-out) where mainly European municipalities or companies leased infrastructure assets to Hancock that Hancock subleased back to them. The remaining transactions were sale-leasebacks called SILOs where, at the end of the lease, the lessee had either to buy the assets or enter into a power contract or other “service contract” to continue buying the output from the leased facility. The parties selected three LILOs and four SILOs to litigate as test cases.

The government has won all six litigated LILO cases to date. A seventh case had a 10-day trial before the US Court of Federal Claims, but that court has not yet released a decision.

The Tax Court said that all of the Hancock LILOs and one of the SILOs were “financial arrangements” rather than real leases. In the other three SILOs, it said Hancock bought only a future interest in the leased assets.

The case is John Hancock Life Insurance Company v. Commissioner. The Tax Court released its decision in the case in early August.

Starting with the LILOs, Hancock leased assets for 38 years and subleased them back for 18, but the court said the terms were otherwise virtually identical. No money changed hands in practice during the sublease term other than a payment by Hancock to the European counterparty as a fee to enter into the transaction. The upfront amount Hancock paid the counterparty was never really at risk during the sublease term since the counterparty’s obligations to Hancock were fully defeased. Hancock argued that it had credit risk on the defeasance bank. The court called this risk “de minimis.”

The court said Hancock had basically a predetermined fixed return. The European counterparties had options at the end of each sublease to buy the remaining leasehold interest Hancock held in the assets for a fixed price. The court assumed the purchase options would be exercised after concluding exercise is a “reasonable likelihood.”

This view of purchase options is in line with a decision by the US appeals court for the federal circuit last January in a LILO case involving Consolidated Edison. The court in that case said it is a problem to give a lessee a fixed-price option to purchase equipment at the end of the lease term if exercise of the option is “reasonably expected.” Many tax lawyers believe the Con Ed court used the wrong standard. Most courts to date have allowed fixed-price purchase options without disturbing true lease treatment as long as exercise is not a foregone conclusion.

The Tax Court defended the approach: “Neither the Tax Court nor the Court of Appeals for the First Circuit [where the Hancock decision may be appealed] 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.” It insisted this is consistent not only with the approach taken in the federal circuit where the Con Ed case was heard, but also in the prestigious second circuit in New York.

Turning to the SILOs, the Tax Court said that in three of the four test SILOs, Hancock acquired only a future interest in the leased assets after the leases end. Hancock had little risk during the lease term because the lessees had defeased the rent even though this was not required by the documents, and Hancock was not directly a party to the defeasance arrangements. Although Hancock had no present interest in the assets, it acquired at least a future interest because the lessees seemed more likely to enter into service contracts to buy the output at the end of the lease terms rather than buy the assets.

Hancock said the Tax Court’s approach threatens all leveraged lease transactions. The court disagreed. It said the lessor in a typical lease has credit risk that the lessee will default on rent during the lease term. Hancock had no such risk because of defeasance. There are two types of defeasance: “legal defeasance” where the bank into which the lessee deposits money to pay future rent assumes the legal obligation to pay rent and the lessee is released, and “in-substance defeasance” where the lessee remains legally obligated. The distinction made no difference in this case.

One of the SILOs did not involve any defeasance, but the court felt the purchase option in that transaction was reasonably likely to be exercised. The court said Hancock had basically made a loan to the lessee in that case.

Assuming exercise of the purchase option, Hancock had a predetermined return without regard to the asset value and no upside potential or downside risk tied to ownership.

On the positive side, the court rejected an IRS claim that the transactions lacked economic substance. Courts deny tax benefits in transactions that are entered into solely for tax reasons without any real business purpose or expectation of a return beyond the tax benefits. Congress has since written this requirement into the US tax code. The Hancock transactions preceded codification.

Hancock said it expected a pre-tax return in the LILOs of 2.54% to 4.33% if the purchase options were not exercised, and 2.83% to 3.43% if exercised. A government witness argued that Hancock has a pre-tax loss on the deals if the calculations are done correctly using present-value concepts. The court agreed the numbers should have been discounted, but was not persuaded by the government’s calculations. It also said Hancock had a clear business purpose: the need to fulfill its insurance policy and annuity obligations contributed significantly to its investment decisions.

The court called the LILOs and one of the four SILOs mere “financial arrangements” and recast them basically as loans by Hancock to the counterparties. In so doing, it not only denied the tax benefits Hancock claimed, but also required it to report the difference in what it paid and what it was expecting back as original issue discount over the life of the “loans.”