IRS: Federal, State and Local Governments Customer Assistance

SALE IN - LEASE OUT (SILO) TRANSACTIONS BY MARLYCE LUITJENS, FSLG SPECIALIST (MIDWEST)

Your government entity may be approached about entering into a leasing transaction known as a “SILO” arrangement that may offer up-front cash benefits to enter into a long-term lease of your infrastructure. Although the up-front cash benefit is enticing and may help alleviate budget shortfalls, you should know that the Internal Revenue Service disallows depreciation and interest expense deductions claimed by taxpayers entering into SILOs. Lease-in lease-out (LILO) transactions that have many features found in the SILO transactions are “listed transactions,” meaning that they are abusive tax avoidance transactions.

To help you to understand how these transactions work, and why you should carefully evaluate participating in them, we are providing some background information.

What Is a SILO?

A SILO is a “sale-in/lease-out” arrangement between a for-profit corporation and a tax-exempt entity (Domestic or Foreign), such as a municipality or other state or local governmental unit. The objective of the transaction is to provide the for-profit corporation with tax deductions that the governmental unit cannot use because it is tax-exempt and an up-front benefit to the tax-exempt entity for entering the transaction. The SILO transaction generally includes an investor (a U.S. corporation), a tax-exempt entity (e.g. municipality), a grantor trust (an entity set up for the benefit of the investor), one or more foreign lenders, deposit taker(s) and financial advisors/arrangers (promoters) that assist the investor and/or the tax-exempt entity.

In a typical SILO transaction, the tax-exempt entity leases its property, such as a highway, subway, bridge, or water plant, to a U.S. corporation. The U.S. corporation treats the arrangement as a purchase of the property for Federal tax purposes. The U.S. corporation simultaneously leases the property back to the government entity for a shorter period of time. Although the parties structure the transaction in the same form as in a LILO transaction, since the length of the lease exceeds the useful life of the property, the transaction is treated as a sale and leaseback for tax purposes. The SILO employs the same fundamental contractual arrangements as the LILO arrangement, but typically involves a service contract provision instead of the put or renewal option found in LILOs. Please note that the service contract provision serves the same function as the put option, that is, it guarantees a fixed return to the corporation. The property generates tax deductions, mainly depreciation and interest expense, for the U.S. corporation. There are other SILOs that may be referred to as QTE (qualified technological equipment) leases.

Example of a SILO Transaction

A municipality leases its wastewater treatment plant (the “plant”) to a U.S. corporation for a 99year lease period and receives an immediate lease payment of $100 million for the property that will cover the 99-year lease term. This 99-year term is normally longer than the useful life of the plant or a nominal cost to renew the lease is granted to the investor such that the total term will be longer than the life of the asset. The municipality immediately leases the plant back from the corporation for a period of 30 years; this 30-year period usually ends at the first date on which the tax-exempt entity may exercise its buyout option. The transaction results in no change in the municipality's use or operation of, or beneficial interest in, the plant. The municipality retains the legal title to the plant and all ownership responsibilities, continues to operate the plant, delivers services, sets the user fee rates, collects the user fees, makes upgrade and expansion decisions and pays for such changes. The U.S. corporation treats the lease as a purchase for Federal tax purposes and deducts the interest expense and depreciation expense from its gross rental income. Generally, deductions exceed the rental income and offset other income of the investor.

At the onset of the contractual arrangement, the municipality receives the $100 million purported purchase price from the corporation. The funds for the $100 million are provided by an equity investment by the U.S. corporation (approximately 15-20% of the $100 million) and the remainder as a nonrecourse borrowing by the Trust. However, the municipality has an immediate right to an unrestricted use of only $3 million of the $100 million payment received from the corporation. The $3 million is in essence an accommodation fee received by the municipality for entering into the long-term lease transaction with the U.S. corporation that provides the corporation the Federal income tax benefits of the interest expense deduction and the depreciation expense deduction at the corporate tax rate of 35 percent over the term of the lease. A portion of the remaining $97 million is invested in U.S. Federal government-backed securities or other highly rated securities by the municipality. The municipality takes the majority of the $97 million in an amount equal to the nonrecourse loan amount and deposits it into a deposit account held at an affiliate of the foreign lender or by the foreign lender itself. These two accounts are pledged as security for the municipality’s obligations to the U.S. corporation and to the foreign lender, respectively.

The $97 million deposit amount defeases both the municipality’s rent obligations under the leaseback and the buyout option. The deposit account pledged to the foreign lender represents substantially all the funds necessary for the municipality to pay rent due under the leaseback, and the securities pledged to the U.S. corporation allow the municipality to exercise its buyout option at the end of the leaseback term. Thus, without any further cost or expenditure, the municipality may use the plant for the entire leaseback term and reacquire all rights to the plant at the end of the term.

Upon the expiration of the leaseback term, the municipality has the option to purchase the plant back from the U.S. corporation for a predetermined price. Typically, the highly-rated securities pledged to the U.S. corporation by the municipality will mature on the buyout date in the amount needed to fund the buyout price. If the municipality does not exercise the buyout option, the corporation has several alternatives: (1) Take possession of the plant, (2) Require the municipality to locate a third party to enter into a service contract, or (3) Compel the tax-exempt entity to enter into the service contract. Under alternative (2), if the municipality fails to locate a third party, the municipality will be in default unless it enters into the service contract. The result of all of these arrangements for the disposition of the plant, at the end of the leaseback term, is that the municipality will exercise the buyout option because all the funds needed by the taxexempt entity to exercise that option are available to that entity through the purchase of the highly-rated securities (known as the equity defeasance). In addition, given the nature of property such as a wastewater treatment plant, it is unlikely that the municipality will allow the property to be operated by a private corporation because of practical considerations, such as immunity from liability and employment agreements, and other political constraints.

SILO and LILO Transactions- Legal Considerations

The Internal Revenue Service is taking steps to combat abusive tax shelters and transactions. Tax shelters that are determined to be abusive are identified as “listed transactions.” Listed transactions require disclosure by participating corporations, individuals, partnerships, and trusts, in accordance with Treasury Regulations 1.6011-4T. You can view this list at www.irs.gov. Link to Businesses, Corporations, Abusive Tax Shelters and Transactions, and Listed Abusive Tax Shelters and Transactions for the following revenue ruling and coordinated issue paper:

Revenue Ruling 2002-69 -Lease In / Lease Out or LILO Transactions Coordinated Issue Paper -Losses Claimed and Income to be Reported from Lease In / Lease Out Transactions

For a more in-depth analysis of the LILO transaction, the Coordinated Issue Paper, “Losses Claimed and Income to be Reported from Lease In/Lease Out Transactions”, provides citations, regulations, and court cases regarding LILO transactions and can be viewed at the web site indicated above. For your reference and further information on LILOs, the web site also contains Revenue Ruling 2002-69 -Lease In / Lease Out or LILO Transactions.

Pending Administration proposals and Congressional legislation address SILO transactions and contain provisions intended to statutorily restrict these arrangements or the tax benefits available from them. If your government entity is considering an agreement of this type, you should be aware of these legislative developments.