The only question I have about the appeal is whether Altria really harbored the fantasy that, having failed to smoke these these shelters past the jury and then the district judge, the Second Circuit just would not be paying attention? Altria's goofy adventures -- first in getting into these shelters and then thinking that it could con the jury and the judges -- should be the best refutation that if we just let business people be business people they will make good decisions.
At any rate, let's see what the Second Circuit had to say. It is a fairly routine hokey tax shelter opinion (surely Altria anticipated it coming down this way). Early on in its lead up to the bottom-line rejection of the shelters, the Court states general propositions, concluding with this one related to the venerable principle that tax law is governed by substance rather than form (sort of like handwriting on the wall):
This principle may be summarized by the statement that "[i]n tax law, . . . substance rather than form determines tax consequences." Raymond v. United States, 355 F.3d 107, 108 (2d Cir. 2004) (internal quotation marks omitted). "In applying this doctrine of substance over form, the [Supreme] Court has looked to the objective economic realities of a transaction rather than to the particular form the parties employed." Frank Lyon Co. v. United States, 435 U.S. 561, 573 (1978). The Supreme Court "has never regarded 'the simple expedient of drawing up papers,' as controlling for tax purposes when the objective economic realities are to the contrary." Id. at 573 (citation omitted). "To permit the true nature of a transaction to be disguised by mere formalisms, which exist solely to alter tax liabilities, would seriously impair the effective administration of the tax policies of Congress." Comm'r v. Court Holding Co., 324 U.S. 331, 334 (1945).Having said that, I think we can all see where the Court of going. But there are more general principles. Since the issue ultimately turned upon tax ownership, the court refined the principle in context as follows:
Where two parties purport to transfer an interest in an asset, courts may disregard the purported transfer, for federal tax purposes, "where the transferor continues to retain many of the benefits and burdens of ownership." Bailey v. Comm'r, 912 F.2d 44, 47 (2d Cir. 1990) (citing cases); see also United States v. Regan, 937 F.2d 823, 826 (2d Cir. 1991) ("[T]he generally accepted rule [is] that for Federal income tax purposes, the owner of property must possess meaningful burdens and benefits of ownership." (internal quotation marks omitted)); BB&T Corp. v. United States, 523 F.3d 461, 472 (4th Cir. 2008) ("[A] true lease for tax purposes requires a demonstration that 'the lessor retains significant and genuine attributes of the traditional lessor status.'" (quoting Frank Lyon, 435 U.S. at 584)).The Court then squashes Altria's attempt to rely upon the Frank Lyon case. Ever since Frank Lyon came out with its goofy bottom-line holding, courts have been effectively limiting the holding to the facts, insisting that the case before it involves different facts and therefore a taxpayer favorable result is not commanded by Frank Lyon. The Second Circuit continues this tradition to mitigate the damage from Frank Lyon (which without the courts' good sense mitigation and willingness not to take the Supreme Court too seriously would be unmitigated disaster). You would think tax shelter players and their counsel would have gotten this point by now and by the time of the transactions in Altria. The Court then said:
Thus, Altria was not eligible for depreciation deductions with respect to the litigated transactions unless it obtained, in substance, a genuine ownership interest in the facilities at issue. Whether Altria obtained such an interest is determined by the substance and economic realities of the transaction that gave rise to the asserted interest. See Helvering v. F. & R. Lazarus & Co., 308 U.S. 252, 255 (1939). Because "an income tax deduction is a matter of legislative grace . . . the burden of clearly showing the right to the claimed deduction is on the taxpayer." Knight v. Comm'r, 552 U.S. 181, 192 (2008) (internal quotation marks omitted).
Here, Altria was required to prove that it had the benefits and burdens of owning or leasing the facilities at issue in the four representative transactions. See Knight, 552 U.S. at 192. Given Frank Lyon's command that this question "in any particular case will necessarily depend on its facts," 435 U.S. at 584, the district court rightly rejected Altria's attempt to supplant Frank Lyon's inclusive test with five exclusive factors drawn from a nonbinding revenue guideline, used by the IRS "for advance ruling purposes," Rev. Proc. 75-21, 1975-1 C.B. 715. See also Frank Lyon, 435 U.S. at 579 n.14 (observing that Revenue Procedure 75-21 was "not intended to be definitive").Altria's arguments as to its ownership turned upon some potential residual ownership rights it might have had in events that were unlikely to happen. Here's the snapshot of the economics:
Altria could benefit from; (7) whether it was reasonable to expect that the facility would have meaningful value at the end of the leaseback that Altria could benefit from; and (8) whether Altria had the potential to benefit from an increase in the facility's 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 270 n.4 (reprinting in full the factors the district court included in its jury instructions). The district court "emphasize[d] . . . that no single factor is determinative" and stated that "[i]n the end, the question is whether Altria retained significant and genuine attributes of traditional owner (or lessor) status."
Altria purported to lease an asset from a tax-indifferent party, immediately lease it back for a shorter period of time, and retain a future interest whose scope would be determined at the end of the sublease term. In this context, an instruction that the purchase option must be "certain or virtually certain" would have precluded the jury from considering all of the various post-sublease scenarios, which together shed light on whether Altria retained an asset with meaningful value at the end of the sublease term. See Simonson, supra, at 3-18. For example, even if the tax-indifferent entity did not exercise its unilateral, fully-funded purchase option, Altria could force the entity to renew the sublease and maintain the status quo (as it indicated it would in internal memoranda). Indeed, the Government argued that these two scenarios were the only likely ones. The purchase option was costless; the tax-exempt entity would receive no additional money by declining to exercise it; and if economic conditions made the purchase option unattractive to the tax-indifferent entity, those same conditions would make Altria unwilling to take possession or lease the property to a third party.The rest of the opinion simply addresses variations on the same theme. However, the Court did agree with the district court's characterization of the transaction as "[a] pointlessly complex transaction with a tax-indifferent counterparty that insulates the taxpayer from meaningful economic risk of loss or potential for gain cries out for [substance over form] treatment."
The other circuit courts that have reached this issue agree. In the most recent case, the Federal Circuit stated that "[w]e 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." Id. at 1325-26; see also Simonson, supra, 38 Tax Law. at 11, 14 (proposing "reasonable assurance" standard for options at end of sublease). In addition, faced with a LILO transaction similar to Altria's, the Fourth Circuit found that although the tax-indifferent entity could decline to exercise its purchase option at the end of its sublease, it "ha[d] no economic incentive to do [so]." BB&T, 523 F.3d at 473. Thus, the Fourth Circuit concluded that the taxpayer's financial appraisal for the transaction, which (like Altria's) reached the opposite conclusion, "plainly does not reflect the economic reality of the transaction." Id. at 473 n.13.
Lastly, contrary to Altria's argument, the district court's instruction did not "allow the jury to disregard Altria's residual stake in the leased assets . . . if it believed simply that there was a 'likelihood' that the lessee would exercise its purchase option." Rather, the district court listed factors the jury could (and could decline to) consider; "emphasize[d] . . . that no single factor [was] determinative"; and stated that "[i]n the end, the question is whether Altria retained significant and genuine attributes of traditional owner (or lessor) status," Altria, 694 F. Supp. 2d at 270-71. Given the wide-ranging and fact-intensive nature of the inquiry under Frank Lyon, the district court properly allowed the jury to consider the likelihood that the tax-indifferent entity would exercise its fully-funded purchase option.
The Court concludes:
In sum, we affirm the jury's finding that Altria did not obtain a genuine ownership or leasehold interest in the four facilities or incur genuine debt, and therefore Altria was not entitled to a tax refund for any of its claimed deductions. As a result, we need not review the jury's determinations that none of the four Altria transactions had economic substance. The substance over form doctrine and the economic substance doctrine are independent bases to deny a claimed tax deduction. "The IRS . . . is entitled in rejecting a taxpayer's characterization of an interest to rely on a test less favorable to the taxpayer, even [if] the interest has economic substance." TIFD III-E, Inc. v. United States, 459 F.3d 220, 231 (2d Cir. 2006) (emphasis added).So why did I ever discuss Altria in my Federal Tax Crimes blog in the first place? I want readers to consider whether they can meaningfully distinguish in terms of criminal tax enforcement (i) the Son-of-Boss transactions resulting in prosecutions for KPMG individuals, E&Y individuals and BDO Seidman individuals and deferred prosecution and massive fines for KPMG and (ii) the transactions in Altria and other such cases. Maybe none of them should have been criminally prosecuted; or maybe all of them should have been. But how do readers distinguish between those that are prosecuted and those that are not?
Addendum 5/24/12: Altria has announced that it has settled with the IRS all of its BS SILO / LILO escapades. See Altria will pay $500M to resolve IRS dispute (Bloomberg 5/22/12), here. It appears from the news release that the settlement is to pay tax and interest only. Penalties are not mentioned. That's a bit surprising because these were clearly BS shelters that should have drawn penalties. Although the IRS is not supposed to settled penalties for more tax than would otherwise have been warranted, I have to wonder whether Altria put more on the table elsewhere to avoid penalties which under today's reporting regimes are embarrassing for publicly held Corporations. The amount Altria reportedly agreed to pay was $500 million to the IRS and state tax collectors.