F:\word\lease\2003.07 LILO and leasing update.doc
Date: July 07, 2003
To: Harry Short
From: David Lyon
Re: LILO AND LEASING TRANSACTIONS - UPDATE
I writing this because
the IRS is becoming increasingly aggressive in attacking various lease structures –
especially LILO transactions,
our financial exposure to LILO and other leasing transactions is very large and continues
I think the Corporation needs to adopt a more effective and realistic program of managing
the tax risk associated with leasing transactions.
My specific thoughts on recent developments and our financial exposure are as follows:
1. Recent IRS decision to litigate, rather than offer a general settlement program for LILO
Last fall the IRS offered settlement prams for COLI and two other tax shelters. Taxpayers
saw these programs and fair and used them to settle many outstanding tax shelter cases.
Out of approximately 35 outstanding COLI cases, all but five were settled through the
settlement program. Until recently, taxpayers had been hopeful that the IRS would offer a
similar settlement program for LILOs.
On May 1st, however, IRS Deputy Chief Counsel Gary Wilcox said the IRS has decided not
to offer an across-the-board settlement program for LILO transactions. Wilcox also said that
purely domestic LILOs will not be treated any better and noted that 2002-69 does not
differentiate between domestic and cross-border LILOs.
On May 9th, IRS Chief Counsel B. John Williams repeated and expanded on Gary Wilcox’s
comments. Williams believes LILOs are abusive and the IRS needs to litigate in order to
establish the courts’ position on these transactions. At the same time, however, Appeals will
issue settlement guidelines so that cases not designated for litigation will be able to settle on
a case by case basis.
2. What it means if we’re designated for litigation.
If the Tri-Met LILO transaction is designated for litigation, our only options are to go to court
or concede the issue entirely.
In addition, we’re no longer eligible to use the Fast Track Settlement program for any issues
in the 1996-97 cycle. Issues other than LILO, however, can and hopefully would be settled in
the normal Appeals process.
3. Recent court decisions
Going to court would be a very difficult route.
Our first choice would be whether to go to Tax Court or federal District Court. By my count,
the Tax Court has heard 14 tax shelter cases in the past six years and held in favor of the
IRS in every one. District courts have heard five cases, holding three times for the IRS and
twice for taxpayer.
If we lose, either in Tax Court or District Court, we could appeal to the Circuit Court. If we
were to win in Tax Court or District Court, the IRS would almost certainly appeal.
Circuit Courts have decided 16 tax shelter cases in the past six years, with 12 decisions in
favor of the IRS and four in favor of taxpayers. None of the 16 Circuit Court decisions have
been by the 7th Circuit in Chicago.
None of the recent court decisions involve LILOs. I think, however, that the IRS' overall
success in litigating other tax shelter cases is a factor in their decision to litigate LILOs.
4. Winston & Strawn’s opinion that the IRS is “unlikely to prevail”.
In December 2001, Winston & Strawn provided us with a tax opinion addressing the Tri-Met
transaction, saying that "the Service is unlikely to prevail if the adjustments are subject to
litigation". Because I’m not familiar with the specific facts of Tri-Met, I can’t say whether I
agree with their opinion.
However, it’s my understanding that a tax opinion normally assumes that a taxpayer will
continue its case until it reaches the forum that provides the best chance of winning. In other
words, Winston & Strawn probably assumes that we would appeal to the Circuit Court.
5. Our exposure to LILO transactions is $120 million, before tax.
In November 2001, I estimated our exposure to LILO transactions to be $120 million, before
tax. This was made up of approximately $20 million of interest currently payable to the IRS,
plus a $100 million mark-to-market writedown of our current investment. I’d be happy if
someone were to review my calculation of these numbers.
The exposure today is greater in terms of interest payable to the IRS and less in terms of the
mark-to-market writedown of our investment. I think the total is still approximately $120
6. Foreign sales corps and ETI transactions.
The IRS case against LILOs is based largely on the fact that they involve
circular cash flows (which usually occur when a transaction is defeased), and
end of lease options that effectively collar the residual value.
Foreign sales corporations and extra-territorial income transactions (which are basically the
same transaction) also typically involve these two features.
7. FSC/ETI transactions – the “who’s debt” issue.
In addition, FSC/ETI transactions have the “who’s debt” issue.
Although nonrecourse debt was used to finance the planes, the FSCs have no debt on their
books. Debt is placed in either a holding company in between Norlease and the FSC or on
Norlease's books directly. This qualifies as a leveraged lease for financial accounting
The reason for doing this is to maximize the tax benefits. For tax purposes, 30% of the FSC
income is excluded while the interest expense is deducted in full. If interest expense were
netted against the FSC income it would reduce the tax benefits of the transaction.
Norlease books tax benefits based on this calculation with no corresponding reserve for the
It's my understanding that Norlease sought but was unable to get a "should" opinion on this
8. FSC/ETI transactions – financial exposure.
Norlease entered into four FSC/ETI transactions in 1999 – 2000 and another one in 2001.
The IRS is currently auditing the four in 1999-2000 and I think it’s likely they will propose
I think our total financial exposure to FSC/ETI transactions is perhaps $70 million before tax.
Like LILOs, this is made up interest payable to the IRS today plus the mark-to-market
writedown of our investment.
Although the risk of losing a case involving FSC/ETI transactions is lower than the risk of
losing the LILO issue, I think we should begin reserving for a portion of the financial
9. Leveraged leases
Although leveraged leases have been used for at least 30 years, the structure has evolved. I
think that most of our leases today include end-of-term options that collar the residual value,
to a greater extent than they did 20 years ago. This reduces Norlease’s exposure to residual
Some of our recent leveraged leases are also defeased, which reduces Norlease’s exposure
to credit risk.
I don’t think the lease accounting reports that are in Corporate Tax show the residual options
and I don’t think they show whether a lease is defeased. I do, however, think the Corporation
should have a risk management policy regarding these types of lease features.
I don’t think the Corporation is adequately addressing the tax risk associated with leasing
transactions. I don’t think Norlease is willing to do this and I think the Controller’s Department
needs to step in.
This will probably have to include a large provision to cover issues that have been avoided in