Exelon did not have tax ownership of the property it “acquired”
In June 2017, the Tax Court decided that Exelon owed approximately $526 million in tax and penalties because Exelon incorrectly claimed ownership of certain power plants for federal income tax purposes (Tax Ownership). The Seventh Circuit Court of Appeals now has issued an opinion affirming the Tax Court’s decision. For further details of the Tax Court’s decision, please see our prior Alert. The decisions in this case emphasize that Tax Ownership is held by the party that bears the economic benefits and burdens of property ownership (regardless of which party holds legal title to the property); and that the IRS is willing to take this issue on when the conclusion as to ownership carries with it significant tax dollars.
Tax deferral sought
Exelon’s predecessor, Unicom (the former parent company of Commonwealth Edison), sold power plants for about $4.8 billion in 1999, generating about $1.6 billion of gain. It sought to defer tax on this gain by qualifying for like-kind-exchange treatment under section 1031 of the Tax Code.
The like-kind-exchange rules permit deferral of federal income tax upon disposal of certain types of property, generally including real estate. Qualifying for the deferral benefit requires acquiring replacement property of like-kind to the property sold.
No tax deferral allowed
Unicom sought to defer taxation of its $1.6 billion gain, obtain cash up front, and achieve a predictable return. It entered into a number of power plant sale-leaseback transactions intended to achieve those results. However, the IRS, the Tax Court, and the Seventh Circuit Court of Appeals all agreed that tax deferral did not apply because Unicom did not obtain Tax Ownership of the replacement power plants, comparing the transactions to prior tax shelter transactions.
The Court of Appeals concluded that the taxpayer did not face any significant risk indicative of genuine ownership during the terms leases at issue. It also found that there was no reasonable expectation or likelihood that the lessees would fail to exercise their purchase options at the end of the lease terms (if the lessees did not exercises the options, Exelon could have regained ownership of the plants. The Seventh Circuit rejected the conclusions of the valuation reports the taxpayer relied upon in this regard, as the IRS and Tax Court did previously.
The Seventh Circuit also affirmed Exelon’s liability for about $87 million of tax penalties. The taxpayer had received tax opinions from a large law firm, tax advice from a one large accounting firm, and valuation appraisals from another large accounting firm. It presented a vigorous defense based on an assertion of reasonable reliance on this advice.
However, the Court of Appeals concluded that the taxpayer did not reasonably rely on tax advice for its tax deferral claims. The taxpayer’s law firm sent a list of expected valuation conclusions to the valuation firm in advance. The taxpayer forwarded the list to the valuation firm multiple times. Exelon argued to no avail that these communications did not taint the valuation reports.
The Court concluded that the pre-funded nature of the lessees’ purchase options increased the certainty of their exercise at the end of the lease terms. The court noted certain unreasonable aspects of the valuation analysis, including the “obvious inconsistency” of the physical return condition specified in the contracts and the plant capacity factors projected in the valuation report at the end of the lease terms.
Property transactions where a seller and a purchaser each have some continued interest in the property are transactions that may raise Tax Ownership issues, especially where the tax result of the transaction differ significantly. One type of transaction raising this issue is a sales-leaseback. Parties to these types of transactions should consult their tax advisors and consider how the economic benefits and burdens of ownership affect their tax results, even if the amounts of tax and penalties at stake do not approach the approximately $526 million at stake in the Exelon case.