A lease-leaseback transaction did not subject the tax equity investor to taxes in New Jersey.

Altria, a tobacco company, agreed to lease 483 buses from New Jersey Transit in September 2002 for a term of 37 years, and then sublease them back to NJ Transit for 12.25 years with an option for the transit agency to buy the remaining leasehold interest after the subleases ended for a fixed price that was expected to exceed the fair market value at time of exercise. If the transit agency failed to exercise the purchase option, then it had to find someone else interested in using the buses or continue to operate them. The buses had useful lives of 25 years.

Altria prepaid $318 million to lease the buses from NJ Transit. It borrowed 80% of the purchase price on a non-recourse basis from a bank. NJ Transit deposited most of the $318 million in a defeasance account from which it made the rental payments under the sublease. The rents went directly to the bank to pay off the loan.

Altria booked a $0 residual value on its books.

NJ Transit treated the transaction as a “capital lease” on its books, suggesting it retained ownership of the buses and the arrangement was just a financing.

The IRS disallowed the depreciation that Altria claimed on the buses. Altria had reported the transaction as a sale-leaseback. It said it should be viewed as having bought the buses because the lease to it of 37 years ran well beyond the useful lives of the buses. The IRS said that what Altria did in reality was make a loan and try to buy tax deductions.

The IRS alerted the New Jersey tax department to its action.

The loss of tax deductions at the federal level had the effect of increasing Altria’s taxes in New Jersey, since the starting point for the state tax calculation is federal taxable income. The state then figures out how much of that income was earned in New Jersey. It does this by applying a three-factor formula: the share of property, payroll and sales that Altria has in New Jersey as a percentage of the company’s total property, payroll and sales. New Jersey gave double weighting to the sales factor in the tax years at issue.

Altria filed an amended return to remove the buses and sublease rents from the property and sales calculations, since the IRS said it did not own the buses for tax purposes.

New Jersey rejected the refund claim.

The state tax court said in late February that Altria is correct since the buses remained owned for tax purposes by NJ Transit. The case is General Foods Credit Investors #3 Corporation v. Director, Division of Taxation.