Tax Indemnity Claims

Tax Indemnity Claims

July 10, 2010

Tax indemnity claims were upheld against a lessee.

The case holds lessons for lenders.

Most US airlines have used lease financing when buying new aircraft. They cannot use the depreciation deductions on the aircraft or interest deductions on borrowed money to buy them.

Therefore, a tax equity investor buys the aircraft, paying around 20% of the purchase price out of its pocket and borrowing the rest from a bank. It claims the depreciation and interest deductions and leases the aircraft to the airline for a reduced rent that reflects a sharing of the tax benefits.

Delta Air Lines defaulted on three such aircraft leases with Northwestern Mutual Life, AT&T Credit and the DFO Partnership when the airline went bankrupt in 2005.

The lenders in the transactions foreclosed on the aircraft, the leases were set aside in bankruptcy and the aircraft were sold with approval of the bankruptcy court. The new owners entered into new leases with Delta. The bankruptcy trustee approved a formula for compensating the tax equity investors in the old leases.

Delta had promised the tax equity investors in separate tax indemnity agreements signed in connection with the original leases that it would compensate them for any recapture of depreciation deductions on the aircraft in the event of a foreclosure and sale. It also promised in the leases themselves to pay an amount called the “stipulated loss value” of the aircraft in the event the leases terminated early. The stipulated loss value was supposed to repay the remaining debt outstanding at termination and enable the tax equity investors to reach their expected returns.

The tax indemnity agreements were written so that Delta would not have to pay both a tax indemnity and stipulated loss value. Each of them had slightly different wording. For example, one said that Delta did not have to pay a tax indemnity after any event that “required” it to pay stipulated loss value. Another said Delta did not have to pay a tax indemnity where it pays stipulated loss value “or an amount determined by reference thereto.”

The bankruptcy relieved Delta from having to pay stipulated loss value, but not from the tax indemnity obligations.

Nevertheless, Delta persuaded the bankruptcy court that the way the tax indemnity agreements were worded meant its obligation to indemnify the tax equity investors for loss of depreciation was never triggered. It said the event was one for which the documents “required” it to pay stipulated loss value (even though it may not have done so in fact). It had paid an amount that was “determined by reference to” stipulated loss value.

The tax equity investors won on appeal. A federal appeals court in New York said the contracts should be read to give effect to what the parties intended. They clearly intended that a tax indemnity would be paid unless the investors were compensated for the same loss through stipulated loss value.

The case is Northwestern Mutual Life Insurance Co. v. Delta Air Lines. The 2d circuit court of appeals released the decision on June 22.

Lenders have not traditionally paid attention to what the tax indemnity agreement says as it has been viewed as a document solely between the lessee and the tax equity investor. Lenders may want to make sure in the future that tax indemnity claims cannot be asserted after a lessee bankruptcy unless the lenders have received full repayment of the debt.

Keith Martin