Furthermore, based on past performance of other EZH units, it can be expected that EZH will operate and maintain ROC3 [sic] in a prudent and conservative manner, and if it does, the result will be a reliable, efficient plant that meets its projected design life.
The defendant, however, attempts to discredit the Duke Engineering, due diligence Report, asserting that Duke Engineering's conclusion that the plant had a useful life of 55 years at the time of its appraisal, prior to the transaction closing, was based on the assumption that the plant would operate at a “base-load” level, although Capstar Partners, EZH's financial advisor in the RoCa3 Transaction, had projected that the Facility would operate at a “mid-load” level. The defendant asserts that this changed assumption, had it been made, would have indicated that there would be an “increase in the wear and tear on the facility, and all things being equal, diminish the useful life of the facility.”
In fact, the Duke Engineering Report's load level assumption stated that the operation of the RoCa3 Facility would be at “ ‘base-load’ manner whenever possible.
” (emphasis added). Luis C. Gonzalez, a Duke Engineering engineer, who headed the Duke Engineering due diligence effort, testified as to the difference between load levels:
A. A base loaded plant is one that is designed to operate essentially continuously at full load throughout the year, 24 hours a day, seven days a week, until there is an outage, a typical maintenance outage once a year, whenever the utility typically schedules an outage, but it is a plant designed to run continuously.
Q. How does a base load plant compare to an intermediate or a peaking load plant?
A. Well, a peaking plant is a plant that is designed to come on usually a few hours a day during, for example, a hot afternoon in Washington, when there's a peak power surge and there's a requirement to supplement the base load, so it is designed to come on and then operate a few hours, go off again, maybe come on every day, and then be taken offline every day.
A mid load or—so there's no exact definition, but a mid load plant would be somewhere in-between, that is, a plant that generally runs not full-time, all the time, but also not every day, might come on and run for a whole week at a time, maybe at night, you might cut back on the output from 100 percent to 50 percent, but stay online over the overnight hours. So it is a slight difference between the three types of products.
Q. And you indicated it was Duke Engineering's assumption that the RoCa3—or understanding that the RoCa3 would operate as a base load facility?
*283 The plaintiff correctly points out that the Capstar document referencing that the plant would operate at the “mid-load” level was a document created prior to the filing of the final documents, whereas the final Duke Engineering document and other documents pertinent to finalizing the Transaction, contain references which indicate that the Facility would be operated at a base-load level. Moreover, Mr. Gonzalez testified on redirect examination, as to the difference between a base-load facility and a middle-load or mid-load facility:
Q. If RoCa3 had been operated as a middle load facility, as opposed to a base load facility, would that have necessarily changed the 55–year useful life?
A. Not necessarily. We might have, depending on the—if we knew the regime that it was being operated under, recommended slightly higher or more frequent maintenance intervals, but the conclusion easily could have been the same.
The defendant also asserts that on the date of the closing, there was a “flurry of communication” between Duke Engineering and Cornerstone regarding language to be included in Duke Engineering's Final Report with respect to the Facility's useful life. Duke's Engineering's decision not to include some proposed language regarding useful life, proper maintenance, and replacement of parts, was a judgment that Duke Engineering made in finalizing its Report. Mr. Gonzalez testified at trial that Duke Engineering also would have been comfortable with the proposed statements in its Final Report. Duke Engineering's decision not to include the proposed language in the Final Report does not indicate that the plaintiff improperly disregarded relevant information about the quality of the Facility. Indeed, Duke Engineering concluded in its executive summary that: “Certain major components can not be expected to last for 55 years and will need to be replaced and/or repaired (Exhibit 1A). These repairs and replacements have been taken into account in the projection of availability.”
Also, as part of plaintiff's due diligence efforts, Tauw Milieu, a company which performs due diligence reviews for financial clients, multinational industries and real estate companies, was engaged first by EZH and then also by CED, to complete environmental due diligence on the RoCa3 Facility prior to the Transaction closing. The Tauw team conducted on-site inspections, held interviews and reviewed environmental regulations in The Netherlands and documents they received from EZH. The final Report titled “EZH—RoCa 3 Power Station: Due Diligence Environmental, Safety and Health Report,” dated January 14, 1998, was submitted in draft form to Cornerstone, for use by plaintiff, prior to the December 15, 1997 closing date of the Transaction.
As Mr. Hans Nieuwenhuis, a representative of Tauw, testified at trial:
Environmental due diligence is the investigation into the environmental status of a certain facility. And it is very often related to transactions. And that means that the prospective buyer wants to be informed about environmental risks associated with the asset he or she wants to acquire, so it is often related to transactions.... And it takes into account, for instance, soil and ground water, air emissions, noise, odor, wastewater, storage of hazardous substances....
The Tauw environmental due diligence Report of the RoCa3 Facility, including its gas turbine, heat recovery steam generator, carbon dioxide boiler, steam turbine, two generators, a cooling water station, a cooling water channel and a primary distribution network, concluded:
Based upon our investigation of the Facility's permits, contracts, liability issues, and site assessment, our conclusion is that the Facility's overall environmental condition is very good. Based upon the historical research, review of documents supplied by EZH and the on-site visual inspection of the property, no direct evidence was found of significant contamination problems affecting or having affected the site.
Provided that proper operating, maintenance, and upgrade procedures, and all appropriate regulatory requirements are followed, the Facility does not appear to present any significant environmental concerns resulting from on-going operations.
*284 Further, the Report concluded that “EZH is in possession of all the required permits for the RoCa3 Facility, with the exception of the EMA [Environmental Management Act] permit for the pump building....” As to the environmental site assessment, “[n]o major non-compliances were encountered,” although certain minor non-compliances were encountered (minor non-compliances defined as “requiring administrative actions ... or minor investments.”). Tauw concluded that “[t]he Facility can be described as a state of the art power station. The Facility employs best available technology to minimize environmental impact, is well managed and is in good condition. Due to the above qualification, Tauw is of the opinion that the Facility doesn't present any significant environmental concern.” The Report further found, with respect to the environmental site assessment, that “[n]o major future issues were encountered,” although certain minor non-compliance or future issues were encountered. Tauw also found in its Report that it was unlikely that any administrative, civil or criminal liability would result from the operation of the RoCa3 Facility. As to the health and safety assessment, Tauw stated that “[n]o major non-compliances were found,” and listed minor non-compliances, concluding that, “costs to be made by the RoCa3 for Health and Safety are mainly costs of personnel.” The Report stated that “EZH shows a positive attitude towards matters of health and safety. A lot of attention is paid to the safety and working conditions of all employees.”
Attempting to discredit the environmental due diligence Report prepared by Tauw, the defendant asked Mr. Nieuwenhuis, as a representative of Tauw, why no one from Tauw spoke to anyone from the plaintiff until after all of its due diligence trips had been performed. In the same sentence, defendant conceded that other due diligence contributors, such as Deloitte and Duke Energy, would be “commonly” retained before an investor was identified. The defendant does not assert any further problems with Tauw's credible, environmental due diligence Report.
In fact, EZH contacted Tauw about conducting the environmental due diligence in September 1997, the same month in which the plaintiff submitted its initial proposal to EZH. Phillip S. Mintun, of Capstar Partners, EZH's financial advisor on the Transaction, testified that:
A. [T]here was some, you know, up front due diligence that we wanted to get moving, so that, you know, once we took the transaction to market, that the work that Tauw would ultimately do for the investors would have advanced to a certain level.
Q. In your experience, was it unusual to engage some of these consultants prior to identifying the—
A. No, that's standard practice in any, you know, leasing or partnership energy transaction certainly.
Q. And I think you may have touched on this yesterday, but just in case you didn't, why is this done? Why do you engage some of these consultants so early in the process?
A. It is really a timing issue. Well, I guess, timing and also to make sure that, you know, there are—if there are any unusual things that aren't apparent, that these consultants bring to the table, that we understand them and can, you know, can explore them and understand them, so that we can present them best when we bring the transaction to the market.
Q. Are these consultants ultimately engaged by the investor?
Q. In your experience, has one of the consultants that you engaged as lessee advisor, has the investor ever selected a different advisor later on?
A. There have been circumstances when, for example, an investor will engage an additional engineer, for example, with whom they have an existing relationship to sort of review the work that's being done by these consultants. That's not unusual. Obviously, when we look at engaging consultants, we want to make sure that at the end of the day, they have a reputation and work experience that investors will find acceptable, since they ultimately will be engaged by the investors.
*285 Plaintiff also presented the expert report and testimony of John J. Reed, the chairman, President and Chief Executive Officer of a management consulting and advisory firm specializing in the energy industry, and a consultant to buyers and sellers of major energy assets. Mr. Reed testified that he had been involved with more than 25 power plant sales, and involved extensively in utility mergers and acquisitions. At trial, he was qualified as an expert for the plaintiff in “the purchase, sale, and valuation of power plants and in the economic and financial factors relating to such transactions.” His report and opinion relate particularly to the economic reasons for the decisions following the expiration of the Sublease Basic Term. He concluded that a decision by EZH on whether or not to exercise the Sublease Purchase Option would rest on the fair market value of the plaintiff's remaining Lease Interest in January 2018, as compared to the Sublease Purchase Price. According to Mr. Reed, because of certain factors, valuations of the Lease Interest in the Facility might vary markedly between 1997 and 2018, and “it would have been nearly impossible to determine with virtual certainty on December 15, 1997, whether EZH would be economically compelled to exercise the Sublease Purchase Option.” Among the factors affecting revenues and costs, for example, could be the demand for energy, the cost and market prices of fuel, ancillary services, heat, carbon dioxide, natural gas, equipment and parts and labor. Among the factors affecting market competitiveness of the RoCa3 Facility would be the relative efficiency of the plant and plant outages. Factors affecting the financing requirements and cost of capital of buying CEL Trust's remaining Lease Interest, would include credit standing, required return on equity, and forecasted inflation.
Mr. Reed concluded that it was foreseeable that there would be relevant changes between 1997 and 2018, for example, in discount rates, inflation, market changes, and technological evolution. Moreover, he also concluded that there also would be changes in the Dutch utility industry, some of which were already underway at the time of the 1997 Transaction, with attendant impacts on the utility generating assets. Therefore, Mr. Reed concluded that, “it would have been impossible based on any realistic assessment of the Lease Interest's future value, as performed in late 1997, to conclude that exercising the Sublease Purchase Option would be virtually certain.” He also stated, “you cannot tell with 98 or 99 percent certainty that they will exercise the option.”
In addition to concluding that the exercise of the Sublease Purchase Option by EZH cannot be deemed as certain, Mr. Reed concluded that there also is a possibility that CEL Trust would not exercise the Sublease Renewal Option, which would result in the plaintiff operating the Facility or entering a new sublease, with a new sublessee, at market rates. In any event, if EZH does not exercise the Sublease Purchase Option, Mr. Reed concluded that for the Shirt–Tail Period, following the Sublease Renewal Term, Con Ed would be burdened with “very real potential risks” and with “benefits.” Mr. Reed also indicated at trial that the presence of defeasance funds does not affect his conclusion that the exercise of the Sublease Purchase Option, “is not reasonably certain,” although in his expert report he used slightly different words to indicate it was not “virtually” certain. With respect to the Defeasance Accounts, Mr. Reed stated:
The existence of a defeasance account has a similar effect on all three scenarios, that is, the scenario in which the purchase option is elected, the scenario in which the sublease renewal option is elected, or the scenario in which the retention option is elected.
Because these defeasance account funds are available similarly in all three scenarios for purposes of EZH, they do not have an impact in differentiating the likelihood of any one of those three scenarios occurring. My point is that the defeasance accounts are not earmarked for a single purpose.
They are in fact available under all three scenarios for the economic use of EZH and, therefore, don't enter into the equation with regard to one option over the other option being selected.
*286 Another of plaintiff's experts, Dr. David M. Ellis, a former finance professor and consultant in the field of economics, was qualified as an expert in the areas of “finance, analysis, and returns of complex financial transactions, including leases, and the analysis and valuation of securities.” He testified on the economics of leveraged leasing and the role of taxes in such transactions. Dr. Ellis testified that, generally, based on his experience and on learned treatises he had reviewed, investment decisions are made on an after-tax basis and that the government's experts did not follow this approach in their analyses. In his expert report, Dr. Ellis concluded, “[i]t is customary and appropriate to use after-tax returns when making investment decisions,” in order to figure out the maximum “total real return after taxes.”
In his expert report, Dr. Ellis addressed possible risks to the plaintiff in the event of premature termination prior to the end of the Sublease Basic Term.
Other events that can trigger termination of the Transaction and the application of the amounts in the Sublease Deposit and IJssel Deposit include EZH breaking lease covenants, casualty events, defaults, or Con Edison N.Y. acquiring a competitor to EZH. However, if the Transaction terminates prior to the Sublease Basic Term, then the amount in the Sublease Deposit and the IJssel Deposit may not be sufficient for the Sublessee to meet its obligations, and the Sublessor will be exposed to risk of loss. This can be seen by comparing the sum of the Sublease Deposit and the IJssel Deposit with: either the Sublease Termination Values, the Sublease Special Termination Values, or the Sublease Special Termination Values.
Dr. Ellis also noted in his rebuttal that since the IJssel Deposits are all invested in Treasury STRIPS:
as zero coupon instruments they will only
be worth their face value (the amount needed to make the necessary obligations) at maturity—on any
date prior to maturity they will be worth less than face value and therefore be insufficient to make the required payments. (emphasis in original).
He also concluded:
Note that in every one of the termination cases and in every year there is a shortfall. In other words, both the Sublessee and the Sublessor are exposed to risk: the Sublessee from having to come up with large amounts of foreign currency and the Sublessor from the risk that early termination due to Sublessee default leaves insufficient funds available to meet the Sublessee's obligations to the Sublessor.
Responding to the defendant's expert's comments, that the defeasance provisions, by way of the Sublease Deposit and the IJssel Deposit, “virtually eliminat[e] any risk to Con Ed of recovering its equity investment in the Facility and in the Transaction,” Dr. Ellis, in his rebuttal report, rejected that concept and indicated that the risk was eliminated,
if and only if the Sublease Purchase or Sublease Renewal Option is exercised and the Transaction runs smoothly from start to finish with no interruption or problem. If neither the Sublease Purchase Option nor the Sublease Renewal Option is exercised, Con Edison N.Y. will be exposed to variations in cash flows due to market forces in rents and due to residual value risk.
Dr. Ellis also concluded that, although the defeasance accounts can be a benefit to the sublessor,
[e]ven the loan defeasance account is not entirely riskless, as Messrs. Bent, LaRue, Ray and Thomas would have us believe. The amounts in the [Sublease Deposit] account are not invested in zero coupon Treasuries, as is the case with the IJssel Deposit: rather, they are placed in an interest bearing account at ABN AMRO Therefore, there is still credit risk present, namely the credit risk of ABN AMRO.
Recent events have highlighted that the nature of the risk is very real: last week a large German bank, Landesbank Sachsen Girozentrale, was placed in receivership by the German authorities. The bank has participated in many cross-border transactions in a variety of roles, including as *287 deposit provider; it is also a provider of letters of credit. Many of those transactions may now be in jeopardy as a result of the failure of Sachsen.
Finally, there is still credit risk associated with EZH, a municipal utility operating in the southern part of the Netherlands.... Electric Utilities are not exempt from default risk: in the nearly ten years since the start of the Transaction, defaults by such companies have occurred every year.
Further, regarding the risks and uncertainties for plaintiff, Dr. Ellis indicated that:
A. While a lot of the cash flows and so on in the lease are predetermined, there is considerable uncertainty as to what some of the cash flows and returns are going to be. In particular, at the end of the lease, there is considerable uncertainty as to what the residual value of the asset is going to be at the time that it is returned to the equity investor.
Q. How can that affect return?
A. That is crucial. That's the final, if you will, the final item in the calculation. You cannot calculate the return until you know what the residual value is. You can come up with an expected residual value at the time you enter into the transaction, but you don't know for certain what that is going to be. And until you get all the way to the end of the lease and see what the realized residual value is.
After reviewing the benefits to the plaintiff, Dr. Ellis offered the following regarding some of the risks inherent in the RoCa3 Transaction:
A. Well, it [an equity investor] certainly faces payment risk from the sublessee, the uncertainty that all the payments will be made in a timely fashion. It also is potentially exposed to interest rate risk, it is certainly exposed to residual value risk as we mentioned earlier, as I discussed earlier, the uncertainty about what the residual value would be at the end of the lease. And it is exposed to what can best be described as risk of the asset itself, that during the life of the lease, it may be subject to obsolescence as new technology comes on and renders what you thought was a state of the art piece of equipment second rate. There is also the risk, as we mentioned earlier, about the insurance, it is possible that insurance may not always be available, and there are multiple risks associated with the asset itself.
Q. Taking the last one, what would be an asset risk that an investor would face?
A. Risk of loss, fire, flood, act of war, technological obsolescence, loss of insurance.
Consistent with other witnesses offered by both the plaintiff and the defendant, Dr. Ellis testified as to the demonstrable risks associated with the Shirt–Tail Period, after the Sublease Renewal Term, and similarly with the Retention Option Period. Dr. Ellis offered the following thoughts if Con Ed were to operate the RoCa3 Facility beginning in 2018 under the Retention Option, or in 2034, under the Sublease Renewal Option. He addressed the potential for both possible loss and profitability:
Q. And could you please give us some sense of any risk that Con Ed Development would face from 2018 through 2041 if the retention option is exercised?
A. The risk of being a power generator, it will have the risks of uncertain cost of the natural gas input to generate the electricity, uncertainty over the cost at which it will be able to sell the electricity, ongoing uncertainty as to—the time the transaction was done, it would have no idea what would be involved at that point as far as keeping the, by then, a well-used asset in good operational maintenance, whether there might have been additional regulatory impositions as far as environmental or whatever. So ongoing costs associated with operating and maintaining the asset.
Q. Did you ever form any opinions about doing business in The Netherlands?
A. Yes. We actually had a process that we had to go through to look at risk premium for doing business in a particular country. And following our process, it was actually less risky than the U.S. We certainly didn't recommend a negative risk premium for The Netherlands, but it is certainly a country that you could be very comfortable with the political and regulatory and court system.
Former Chief Executive Officer of CEI Eugene McGrath similarly indicated that, through Con Ed's unregulated subsidiaries, “[b]asically we were trying to take our knowledge and expertise and go out and compete in this world. And to the extent we were successful, we would be able to grow those businesses.”
Mr. McGrath defined his deliberate growth philosophy and how it differed from that of some other utilities during the early period of deregulation, when utilities were restructuring their businesses:
A. Because at the end of the day ... I felt, personally, a responsibility ... for the energy supply for New York, for New York City. And I wanted to be sure, at the end of the day, we didn't do anything in this restructuring that jeopardized that. I also, as chairman of the company, was interested in continuing to have the ability to grow our company.
So we watched carefully to ... try to make sure that nothing prevented those two things.
Q. Were you familiar with the activities of other utilities were pursuing at this time?
A. Yes. Other utilities had gone pretty far afield. Sometime utilities, you know, bought horse farms in Argentina or airlines or—... bought power plants—bought utility properties in Australia, Great Britain. So there was a whole—timberlands. There was a whole slew of activities going on.
Q. What, if any, lessons did you learn from your monitoring the activities of other utilities?
A. Stay close to your knitting.
Mr. McGrath described Con Ed's development activities in the United States, in states other than New York, as well as outside the United States, including in England, Guatemala, China, The Netherlands and Australia. Mr. McGrath detailed how “making this investment in Holland would help Con Edison in its strategies” for development and entry into the European electricity market:
A. Well, it was consistent with what I said at the shareholder meeting there, that we were staying close to what we knew. That we were expanding outside our service territory. One of the issues we had, you know, being—being in the same small service territory, small in geographic area, is we don't—didn't know how the rest of the world dealt with regulation and how governments interacted around the world. And they're different all over the world. So part of what we needed to know and what we learned, for example, in Australia was very interesting, and also in the United Kingdom. We learned how things are done differently in different areas. And China was different from everybody else. But we needed to learn that to, first off, to learn how to work in those various areas. And Europe we were looking at also. But, also, to learn what's good and what's bad about regulation and what we might learn from how others did it and see if we could influence changes, changes here.
Mr. McGrath also testified regarding screening criteria for the target market, including:
Q. The first item is political stability.
Q. Can you comment on the relevance of that, please?
A. We were looking around the world, going to look around the world. And we *315 wanted to make sure that we were considering doing business only in those countries that we considered politically stable.
Q. Can you relate that, if at all, to the EZH investment made?
A. Well, Europe would be considered politically stable. The Netherlands, politically stable. As opposed to, at this point in time, there were rebellions in Africa and things like that where—areas we probably wouldn't want to be in.
As to the goal that investment transactions take place in “developed countries,” with “stable economies” and “stable political environments,” Mr. McGrath explained: “[w]e didn't want to add additional risk of the plant being taken over or burned down or disallowed or something.” Unlike participants in many of the other LILO transactions taking place around the world during the same time period as the RoCa3 Transaction, Con Ed, through the development company, sought to partner with an established facility, in a stable country, in an industry in which it had extensive expertise and could gain additional expertise and business benefits.
Likewise, Kevin Burke testified that following deregulation, there was a competitive market and a lot of opportunities. He stated:
A. I think there were significant business growth opportunities. The demand for electricity in the world was continuing to grow. There were, you know, some countries that would have prevalence being able to fund the power plants that needed to be developed. And we were also looking at technical services because as the utilities around the world grew significantly, they came to Con Edison on occasion and were looking for advice on how to run densely populated, you know, electricity systems in densely populated urban areas, so there were a lot of opportunities. And a lot of the opportunities came out of the proceedings that were going on elsewhere in the world and the country, similar to the competitive opportunities proceeding.
He also commented:
A. Con Edison Development was trying to grow its business. If it grew its business successfully, then the earnings for Con Edison Development and CEI would grow. And one way of growing the earnings is to make investments, but also make investments that hopefully will lead you to other investments. And we were trying—that's part of what we were trying to do at this point in time, because at this point in time, CED was a new company that was trying to get its name out there.
Q. Okay. And hopefully, you just mentioned, hopefully leading to new projects, I believe you said that?
A. Leading to other projects, that's correct.
Q. So you believe that's a benefit of the EZH transaction.
A. I believe that was a benefit of the EZH transaction and other transactions, too.
Q. Okay. And do you know if Con Edison was looking for any potential opportunities in The Netherlands, other than lease transactions?
A. I don't know if we were looking for other transactions in The Netherlands, but we were looking for other transactions in other parts of the world and being active in the area would help develop those transactions.
With respect to the development company's reasons for pursuing international investments, Ms. McCartney testified that:
A. For many reasons, a lot of utilities were investing internationally. And, frankly, we had to—we would be asked by the financial analysts and the rating agencies, you know, what we were doing on the unregulated front. And there was an expectation, I think, that we invest internationally, as others had. And it was exciting to us. It was the way we wanted to replace our lost income from the plants.
Q. And could you explain why CED was interested in Europe, as you've mentioned previously?
A. Well, Europe was undergoing the kind of regulatory change that was happening in the United States. So there were going to be opportunities for power plants and *316 transmission lines and energy trading that had not existed before.
Ms. McCartney also stated:
A. And the energy markets in Europe were opening up. So output from this plant could conceivably be sold into a power pool the way we do in New England and New York and New Jersey and Maryland. So it was our entrée into the European energy market. It was the first project that we did in Europe.
Q. And how did CED learn about other countries from this project?
A. Well, we learned about the energy market in The Netherlands. That was our primary learning.
Similarly, Mr. DePlautt testified that his personal opinion regarding lease-leaseback transactions was that these transactions presented “a terrific opportunity to learn, to get into a country, learn about the country's energy market, get paid for doing it, earn money while you are doing it, and potentially participate in a terrific overseas investment market.” He also testified that the development company sought to “concentrate on assets familiar to Con Edison,” “[b]ecause there would be a potential business benefit from addressing assets that we were familiar with and had knowledge of. We wouldn't be able to bring—corporate wouldn't necessarily be able to bring, you know, any corporate competencies to or familiarity to assets that were not familiar to Con Ed, you know, airplanes.”
Moreover, Charles Muoio indicated:
Over the time I spent in corporate planning, we continued my study and their study of what was going on domestically and internationally. And I had concluded and convinced other people within the group that the competitive advantage that we had as a utility going out into the unregulated market was in our understanding of infrastructure in large metropolitan areas, so we wanted to focus in on infrastructure projects, both domestically and internationally as a way of having a competitive advantage.
Yet an additional goal of the plaintiff through the Transaction was to share knowledge and gain expertise as a result of involvement with a state of the art electricity-generating plant, the RoCa3 Facility. Former Chairman McGrath also testified that in investing in leasing transactions, the development company was “focusing on small to medium-sized independent power and cogeneration projects.” He described the RoCa3 Facility investment as one in “a state-of-the-art power plant.” He testified:
A. Well, it was the latest state of the art in turbine technology and blade materials. It was a good example of environmentally friendly, efficient cogeneration use. And also the fact that they used and harvested the CO2 from the combustion process. These were interesting—very interesting state-of-the-art kinds of things.
Mr. McGrath offered an “assessment of the EZH transaction,” as follows:
A. Well, it was one of a group of projects that were part of the initial foray into the competitive world. It—it was good for us to be involved in the state-of-the-art plant. It was important to us that this plant work properly because, you know, if we're about, at this point in time, conveying our reputation as experts in this business to the world, we didn't want to be associated with something that didn't work right. It had the environmental aspect that had the efficient cogeneration aspects that was state of the art. It used equipment that we were familiar with and we wanted to continue to advance. When you buy, for example, a General Electric gas turbine, it comes with a certain set of blades that are made of a certain material, ceramic material or metal. But over time they improve those. We're dealing with very high temperatures, 2—to 3,000–degree temperatures. And any little change can improve efficiency. So we had a whole fleet of these back home, here, too. So it's a whole picture.
Mr. Muoio also indicated that some of the equipment in the RoCa3 Facility was equipment used in the Con Ed domestic system.
Similarly, Ms. McCartney testified that the development company looked for projects that would be “[c]onsistent with its mission of *317 gaining experience in infrastructure projects.” She explained:
A. Okay. We were just starting out. And we wanted to get to be an investor in international infrastructure projects. We had never really branched out, outside of the US. So we wanted to gain experience and be successful at that outside the US.
According to her testimony, one of the criteria for screening projects in the Gramercy Development 1997 Business Plan was to gain experience in infrastructure projects, “[a]ppropriate technology and/or expertise to provide the products and service.” Ms. McCartney continued:
A. We wanted to use, to the extent we were capable, state-of-the-art technology. So that in our technical services area, for example, we wanted to be able to share the things that Con Edison were doing that were fairly cutting edge.
Ms. McCartney went on to explain that the development company “decided to focus on a strategy of business as being related to core competencies,” because:
A. [T]his was a time when utilities all over the country were investing in a lot of different things, a lot of unregulated things as—as deregulation was coming about. And we saw some utilities investing in things outside their core competencies, like insurance companies or shopping centers, real estate. And we had guidance, really, from Gene McGrath that we wanted to stick to things that we knew. And that was the energy business.
The environmental benefits to be derived by Con Ed as a result of involvement with the RoCa3 plant were not in terms of direct decreases of environmental impacts domestically, such as emissions or discharges; rather, Con Ed indicated that it was seeking to improve its environmental image and to gain expertise to further its ability to conduct company business in a more environmentally friendly fashion. Mr. McGrath testified:
A. Remember, we were in—I was in this process, and the company was in this process of improving our environmental performance and becoming a much stronger, better, environmentally friendly. And we had come a long way, did a lot of work over the years and had made a lot of progress on this.
And this [the RoCa3 project] was an example of an environmentally good project to be associated with.
Mr. McGrath further testified:
A. Remember, we were attempting to achieve environmental excellence throughout the company. So this was more or less a mantra in the company, that we applied to—attempted to apply to all that we were doing.
Aside from the general goal of environmental consciousness, by way of explanation, Mr. McGrath testified that Con Ed was “under federal probation, the environmental program,” which shareholders in the community were aware of, because:
A. Following the Gramercy steam explosion in 1989, there was a release of asbestos, and there were several fatalities from the explosion. And that asbestos release became a major problem, major issue for the company and demonstrated that our program was not anywhere near where it needed to be. And the courts imposed a probation on—assigned a monitor and put our program on probation, which was lifted years later, after we had turned the program around and made it a good environmental program.
Q. As chairman, how would you characterize your personal commitment to the environmental track record of Consolidated Edison under your tenure?
A. Well, the explosion happened just the year before I became chairman. And it was very high on my agenda. It was—it was survival of the company to make sure we—because we couldn't operate in New York City without a good environmental program. We just wouldn't be allowed to operate. So it was a very important issue for the company.
Therefore, Mr. McGrath indicated the development company included environmental excellence as one of its screening criteria for new projects. The RoCa3 Transaction met that criteria. According to Mr. McGrath:
*318 A. And it [the EZH Facility] also had a good environmental benefit for us. Remember this is a point where we're trying to improve our environmental performance in actuality and also our reputation to the public, our environmental program. And this was a good use of energy. Efficient. And it had a byproduct that was good. And it also was part of this expansion into the world. And it put us on the map, if you will, as a company that's interested in doing work around the world. So, you know, for a lot of good reasons.
Mr. McGrath described the benefits of a combined cycle cogeneration plant, such as the EZH Facility:
A. Well, implicit in a gas fired, combined cycle power plant is an environmental message. Because gas—gas is a pure fuel. A lot of coal was burned in Europe. So that's an environmental benefit. Combined cycle is very efficient. Thermal output is a very efficient output. So, yes, environmental is implicit in that.
As an aside, Mr. McGrath noted that the exhaust gases from the boiler were sent to hothouses where the RoCa3 Facility grew tulips.
Mr. Burke also testified, regarding the environmental benefits to Con Ed, as a result of investment in the RoCa3 Facility:
A. Well, if you think of a typical, you know, power plant, most of the electricity in the United States and a good bit in Europe is generated by, you know, burning coal in large boilers, you will wind up with significant air emissions. In this case, this project was burning natural gas in a combined cycle unit which has a higher efficiency, just from the nature of the combined cycle unit. And on top of that, you take the wasted heat and instead of either putting it in a local body of water or into the air, you wind up using that waste heat to heat a number of greenhouses. And on top of that, you take the carbon dioxide and use that carbon dioxide to enter the greenhouses, too, it helps whatever was growing in the greenhouses grow. So instead of increasing the air or water emissions, the design reduced that dramatically. And that was something that we were concerned about. We would be interested in what's the environmental impact of a project because we have—we're called Consolidated Edison because we consolidated from a lot of different companies. And some companies had projects that they sold before they were even consolidated into the entity that became Con Edison that we're paying to clean up for. So the environmental impacts can be significant and also the reputation of the company. So you would rather be associated with a clean plant than associated with a dirty plant.
Mr. Burke further stated:
A. You know, also Con Ed also has been interested for a long time in doing what it can to help clean up the environment. We stopped burning coal shortly before I got to the company, so it was prior to 1973. And what this indicated was that this plant had a very clean environmental design and operation and should be able to operate very well and not have a significant impact on the environment.
According to Mr. Burke, among the beneficial aspects of the RoCa3 Facility, “[w]hat was a little atypical about it [the power plant] was that it also provided thermal energy, a little bit different but very similar to what we do with our steam system where we send steam out through pipes in the streets of Manhattan to buildings.”
Similarly, Ms. McCartney discussed the goal of the development company to “[a]chieve environmental excellence,”
A. Con Edison was in the process of polishing its image with respect to the environment, because we had had an unfortunate experience a few years before, so that we wanted to make sure that our investments in other countries were consistent with what we were trying to do in the United States, which was achieve excellence in the environmental area.
Ms. McCartney asserted that, if an opportunity did not pass the environmental screening criteria, the development company would not have pursued that investment. Ms. McCartney also referred to a portion of the 1997 annual report of CED, distributed to *319 shareholders to emphasize multiple benefits, including environmental benefits, that were factors in the decision to enter the RoCa3 Transaction:
A. Based in Manhattan's Financial District, Con Edison Development aims to become a leading investor in energy infrastructure projects, including independent power, transmission and distribution systems. The company is poised to benefit from growth in the global market for energy systems and from the trends towards privatization and restructuring that are shaping regulated energy industries in other nations. Initially, Con Edison Development is focusing on small to medium sized independent power and cogeneration projects. In December 1997, Con Edison Development provided capital to a state-of-the-art power plant near Rotterdam in The Netherlands. This plant, recently constructed, uses a unique combined-cycle process to capture the carbon dioxide contained in the plant's exhaust gas. The carbon dioxide is then sold to local greenhouses where it is used to promote the growth of plants, including Holland's famous tulips. This and other design elements make the plant one of the most innovative and environmentally-friendly electric generation facilities in the world.
The subjective views and intent of Con Ed corporate management for entering into the RoCa3 Transaction, while relevant to establishing the non-tax business purpose of the plaintiff, are insufficient on their own to establish the validity of the RoCa3 Transaction for tax purposes. Coltec Indus., Inc. v. United States, 454 F.3d at 1359. The defendant argues that the RoCa3 Transaction lacked objective economic substance for federal income tax purposes and, therefore, that plaintiff's claimed deductions must be disallowed. The Coltec
court's guidance on the objective nature of the test for determining economic substance of a transaction is worth repeating:
the economic substance of a transaction must be viewed objectively rather than subjectively. The Supreme Court cases and our predecessor court's cases have repeatedly looked to the objective economic reality of the transaction in applying the economic substance doctrine. While the taxpayer's subjective motivation may be pertinent to the existence of a tax avoidance purpose, all courts have looked to the objective reality of the transaction is [sic] assessing its economic substance. See, e.g.,
Black & Decker [v. United States], 436 F.3d at 441–42 (noting that economic substance inquiry requires an “objective
determination of whether a reasonable
possibility of profit from the transaction
existed”) (internal quotation marks omitted, first two emphases added); Dow Chem. Co. [v. United States], 435 F.3d at 599; In re CM Holdings, Inc. [United States v.], 301 F.3d [96,] 103 [ (3d Cir.2002) ] (stating that the objective economic substance inquiry is “whether the transaction affected the taxpayer's financial position in any way”); United Parcel Serv. of Am., Inc. [v. Comm'r], 254 F.3d [1014,] 1018 [ (11th Cir.2001) ]; Rice's Toyota World, Inc. v. Comm'r of Internal Revenue, 752 F.2d 89, 94 (4th Cir.1985). Coltec Indus., Inc. v. United States, 454 F.3d at 1355–56 (emphasis in original; footnote omitted). The Coltec
court quoted from Rothschild v. United States, 186 Ct.Cl. 709, 407 F.2d at 411–12, describing the “historic economic substance analysis,” Coltec Indus., Inc. v. United States, 454 F.3d at 1356 n. 16, as whether the transaction has realistic financial benefit, and finding that in a transaction which had “neither a possibility nor an opportunity of profit to the taxpayer separate and apart from the tax deduction,” the deduction of interest payments should be denied. Rothschild v. United States, 186 Ct.Cl. at 721, 724, 407 F.2d at 411, 412.
A significant consideration in determining economic substance is whether the transaction, at the time it was entered into, possessed a reasonable opportunity for economic profit. See
Coltec Indus., Inc. v. United States, 454 F.3d at 1360. In an economic substance, SILO case, the United States District Court for the Northern District of Ohio wrote:
The relevant inquiry for the Court is not whether the taxpayer's predictions regarding the pretax profits are ultimately proven true, but rather whether the projections of cash flow and residual value are reasonable *320 at the time at which the taxpayer enters into the transaction. See, e.g.,
Levy [v. Comm'r], 91 T.C. at 858; Torres [v. Comm'r], 88 T.C. at 719. The taxpayer generally must only show a reasonably expected, minimal pre-tax profit in order to prove that a transaction has economic substance and is not required to show that its transaction will yield a higher pre-tax return than all other possible investment opportunities.
AWG Leasing Trust v. United States, 592 F.Supp.2d at 980; see also
Hines v. United States, 912 F.2d at 741 (holding that the transaction at issue possessed economic substance because of an expected pretax profit, but denying the deduction because the court found that the sole motive of the plaintiff in entering the transaction was to gain tax benefits, “without any other business purpose”).
As discussed above, CED, through CEL Trust, together with EZH, entered into a complex series of financial arrangements in order to effect the RoCa3 Transaction at issue in this case. In addition to the Transaction documents and extensive testimony, there also are numerous diagrams, charts and tables submitted by both parties describing the Transaction. The record establishes how EZH and CED, directly or through CEL Trust, executed a series of agreements, imposing rights and obligations on the parties to the Transaction. In substance, they agree, although there are a few, relatively minor discrepancies regarding dollar values.
Under the Lease Agreement, CEL Trust, as the lessee, is required to pay rent to EZH, the lessor, in two installments. The first installment (the Initial Basic Rent Payment) of $120,112,270.36 was due on the closing date of December 15, 1997, and consisted of CEL Trust's commitment of $39,320,000.00 (Investor's Contribution) and HBU's commitment of $80,792,270.36 (Lender's Contribution). HBU's commitment was in the form of a nonrecourse loan in the amount of $80,792,270.36 at 7.10% interest to CEL Trust, that was to mature on January 2, 2027. The Lease Agreement allocates the Initial Basic Rent Payment to the rent due on the periods ending January 2, 1998, January 2, 1999, January 2, 2000, January 2, 2001, January 2, 2002, and part of the rental payment due for the rental period ending January 2, 2003. The second installment of rent (the Final Basic Rent Payment) is allocated to the remaining rent periods, including a payment in 2003. To effect the contribution from CEL Trust, on December 15, 1997, Con Ed was to wire $39,320,000.00 to the WTC on behalf of CEL, thereby funding the WTC Account, ROCA Facility Trust No. 2. HBU had on deposit its commitment of $80,792,270.36 to the Initial Basic Rent Payment in the ABN AMRO Account. HBU transferred and assigned its rights in the ABN AMRO Account to CEL Trust. CEL Trust made the Initial Basic Rent Payment by transferring and assigning to EZH both the WTC Account and the ABN AMRO Account.
The Final Basic Rent Payment, in the amount of approximately $831,525,734.00, is due on the Lease Termination Date, February 24, 2041. As noted, the Final Basic Rent Payment is allocated to the remaining rent periods of the Lease Term, including part of 2003 through 2041. If EZH exercises the Sublease Purchase Option, CEL Trust's obligation to pay the Final Basic Rent Payment will be terminated and EZH will pay the Sublease Purchase Option Price of $215,450,949.20, and assume all of CEL Trust's obligations under the Lease. However, if EZH does not exercise the Sublease Purchase Option, and CEL Trust exercises either the Sublease Renewal Option or the Retention Option, CEL Trust will be responsible for the Final Basic Rent Payment on February 24, 2041. The Final Basic Rent Payment is to be financed in a number of different ways, discussed above.
The Sublease Agreement, together with Appendix A of the Participation Agreement, establishes that CEL Trust subleases the undivided 47.47% interest in the RoCa3 Facility for a period of 20.1 years to EZH. Under the Sublease Agreement, EZH, the Sublessee, is to pay CEL Trust, the Sublessor, Sublease Rents on an annual basis for the 20.1 year term of the Sublease. The Sublease Rents are set at the following amounts: $0.00 due on December 15, 1997; $424,960.41 due on January 2, 1998; *321 $8,999,161.52 due on each January 2 from January 2, 1999 to January 2, 2007; $8,964,978.83 due on January 2, 2008; $7,358,487.86 due on January 2, 2009; $7,362,962.76 due on January 2, 2010; $7,362,950.30 due on January 2, 2011; and $7,362,950.33 due on each January 2 from 2012 to 2018. Under the Lease and Sublease Agreements, CEL Trust's obligation to pay Lease Rent and EZH's obligation to pay Sublease Rent are absolute and unconditional.
The Sublessee Loan Agreement provides that CEL Trust shall lend to EZH the amounts set forth on Schedule A of the Sublessee Loan Agreement, which is, on each stated date, an amount equal to the product of the value of the undivided 47.47% interest multiplied by the applicable percentage under the “Loans” caption on Schedule A, at an interest of 7.43% per annum. This was established because EZH deferred the Sublease Basic Rent Payments from 1998 through a portion of 2004. These deferred rental payments created the principal of the Sublessee Loan, the balance of which accrues interest at a fixed rate of 7.43%. The amounts borrowed by EZH pursuant to the Sublessee Loan Agreement were equal in amount and timing to the Sublease Basic Rent owed to CEL Trust from 1998–2003, and was equal to a portion of the Sublease Basic Rent paid by EZH to CEL Trust in 2004, with the following amounts due: $424,960.41, due on January 2, 1998; $8,999,161.52, due on each January 2, from January 2, 1999 to January 2, 2003; and $669,041.51, due on January 2, 2004. Under the Sublessee Loan Agreement, EZH is required to repay the Sublessee Loan, and the Sublessee Loan cannot be prepaid except as stated in the Operative Documents.
Pursuant to the Participation Agreement, two Security Agreements, referred to as defeasance deposits, were entered into in order to secure EZH's payment obligations under the Sublease and other Operative Documents: the Sublease Deposit (Debt Defeasance Deposit) and the IJssel Deposit (Equity Defeasance Deposit). On December 12, 1997, EZH established the Rotte Foundation to purchase debt instruments, make deposits and grant security interests in its assets to third parties, to secure EZH's payment obligations under the Sublease and other Operative Documents. The Rotte Foundation's payment obligations were limited to the Sublease Deposit. The managing Board of the Rotte Foundation consists of three members, an EZH employee and two trust companies, who appoint the members of the Board. In order to ensure continuity if a Sublease Event of Default were to occur and were to continue, CEL Trust may appoint an additional member to the Board. On the closing date, December 15, 1997, EZH paid the Rotte Foundation the “Sublease Deposit Amount” of $80,792,270.36 by transferring and assigning its rights in the ABN AMRO Account at an interest rate of 7.10%, compounded annually, or 6.98%, compounded semi-annually. In 1997, EZH was a Dutch company for which the functional currency was the Dutch Guilder. The Sublease Agreement, Sublease Deposit, Pledge and Repledge Agreement, and the Rotte Agreement provided that all payments due under the terms of those agreements were to be paid in United States dollars. As security for EZH's rental payment or other payment obligations under the Sublease, the Rotte Foundation granted to CEL Trust a first priority right of pledge in the Sublease Deposit. As security for its obligation to repay the Secured Amounts owed by CEL Trust to HBU, pursuant to the Loan Agreement and Loan Certificates, not in excess of the amount of Sublease Rent required to be paid pursuant to the terms of the Sublease Agreement, CEL Trust repledged the first priority right of pledge to HBU.
CEL Trust assigned to HBU a Lien of the Loan Agreement, including on the Lease Agreement, the Sublease Agreement, all rents, profits, revenues and other income from the property subjected to the Lien of the Loan Agreement, and CEL Trust's right to receive rent from EZH, in order to secure payment on the amounts due under the Loan Certificates issued under the Loan and Security Agreement. Moreover, so long as the Lien of the Loan Agreement had not been discharged, EZH was to pay its Sublease Rent payment obligations directly to HBU. The Sublease Deposit was to be used, to the *322 extent available, to pay EZH's annual rent obligations to CEL Trust during the Sublease Basic Term, and the scheduled payments made from the Sublease Deposit were calculated to be equal in amount to EZH's Sublease Basic Rent payments for the years 2005 through 2018. In 2004, the Sublease Deposit payments, if and when made, together with the proceeds from the Sublessee Loan, satisfied a portion of EZH's annual rent obligations to CEL Trust during the Sublease Basic Term.
The scheduled withdrawals from the Sublease Deposit were as follows: on each January 2, from January 2, 1998 to January 2, 2003: $0.00; on January 2, 2004: $8,330,120.01; on each January 2, from January 2, 2005 to January 2, 2007: $8,999,161.52; on January 2, 2008: $8,964,978.83; on January 2, 2009: $7,358,487.86; on January 2, 2010: $7,362,962.76; on January 2, 2011: $7,362,950.30; on each January 2 from January 2, 2012 to January 2, 2018: $7,362,950.33; on each January 2, from January 2, 2019 to January 2, 2026: $18,225,000.00; and on January 2, 2027: $14,546,488.00.
ABN AMRO agreed to make certain payments to HBU so long as the Sublease Deposit Pledge and Repledge Agreement exists with respect to the Sublease Deposit, or so long as the Lien of the Loan has not been discharged. If ABN AMRO makes those payment obligations, the remaining payments that ABN AMRO agreed to make at any time will equal the remaining principal and interest payments due on the HBU Loan.
EZH remains liable for all Sublease Obligations, notwithstanding the provisions of the Rotte Agreement. Moreover, if ABN AMRO's rating falls below A2 by Moody's or A by Standard and Poor's, EZH may replace the Sublease Deposit with Acceptable Substitute Credit Protection, at its own option and expense. EZH then would be required to provide CEL Trust and HBU a first priority security interest in such security. Under the terms of the Participation Agreement, EZH would need to arrange for one or more lenders to purchase the Loan Certificates from HBU for a purchase price of at least the principal remaining and any outstanding interest thereon, pursuant to the terms of that provision. ABN AMRO may not use the Sublease Deposit to set off any amounts or obligations owed to ABN AMRO by HBU, the Rotte Foundation, CEL Trust, or EZH. Likewise, HBU may not use any part of the Sublease Deposit as a setoff against EZH or the Rotte Foundation. Upon termination of the Rotte Agreement, the Rotte Foundation shall transfer all securities held in the Sublease Deposit to EZH, or pay EZH an amount equal to the fair market value of those securities.
On December 12, 1997, EZH also established the IJssel Foundation, to purchase debt instruments, make deposits, and grant security interests in its assets to third parties to secure certain of EZH's payment obligations under the Sublease and other Operative Documents. The IJssel's Foundation's managing Board consists of three members, an EZH employee and two trust companies who appoint the members of the Board. In order to ensure continuity, if a Sublease Event of Default were to occur, and were to continue, CEL Trust may appoint an additional member to the Board. To secure its payment obligations under the Sublease and other Operative Documents, EZH transferred to the IJssel Foundation (also referred to as “Stichting IJssel”), on the day after the closing, December 16, 1997: $31,252,643.73, to be deposited and credited to the “Account,” held by Credit Suisse First Boston, and used to purchase United States Government Obligations. The United States Government Obligations were United States Treasury Securities, including Treasury STRIPS. Treasury STRIPS are zero-coupon Treasury bonds with a face value payable at maturity. STRIPS are purchased at a discount from the face value at maturity and promise a fixed-rate of return for the life of the security, called the yield to maturity, i.e., the inherent interest rate. After the purchase and delivery of the United States Government Obligations, the IJssel Deposit contains fixed-rate zero coupon, United States Government Obligations, purchased by Credit Suisse First Boston as Custodian, for each amount of the Equity Portion of the Sublease Basic Rent, if made, and the Equity Portion of the Purchase Option Price, if paid,*323 with a maturity date prior to the date such amount is due, and with a value at maturity at least equal to such amount. The Treasury STRIPS were expected to mature at the following maturity dates and in the following amounts: November 15, 2011: $5,221,000.00; August 15, 2017: $7,363,000.00; February 15, 2018, May 15, 2018, August 15, 2018, and November 15, 2018: $22,959,000.00.
As stated above, in 1997, EZH was a Dutch company for which the functional currency was the Dutch Guilder, and the Sublease Agreement, Sublease Deposit, Pledge and Repledge Agreement, and the IJssel Agreement provided that all payments under the terms of those Agreements are due to be paid in United States dollars. EZH remains liable for all Payment Obligations, notwithstanding Stichting IJssel's agreement to make payments under the IJssel Agreement. As security for prompt payment of the Secured Obligations, Stichting IJssel granted a first priority security interest in the Credit Suisse First Boston Account, the United States Government Obligations, and any earnings thereon (referred to as the “IJssel Collateral”) to EZH and CEL Trust. Wilmington Trust Company on behalf of CEL Trust, as Trustee, was granted a first priority right of pledge in the IJssel Collateral as security for prompt payment when due of all Trustee Secured Obligations. CEL was granted a second priority right of pledge in the IJssel Collateral, as security for prompt payment when due of all EZH and the IJssel's obligations to CEL under the operative documents, subordinated only to CEL Trust's first priority right of pledge in the Collateral. EZH was granted a third priority right of pledge in the IJssel Collateral, subordinated to CEL Trust and CEL's respective rights in the IJssel Collateral, as security for the prompt payment when due of all of the Sublessee Secured Obligations (i.e., all of the IJssel Foundation's obligations to return all monies and securities in the IJssel Deposit, upon termination of the IJssel Agreement). EZH may terminate the IJssel Agreement, and all funds may be transferred to EZH, but not prior to the termination of the Sublease and the Payment Obligation as defined in the IJssel Agreement.
EZH also was required to maintain one or more Letters of Credit in favor of CEL Trust and CEL, for the benefit of CEL Trust and CEL, to secure obligations of EZH to CEL Trust and CEL under the operative documents, including for security in the event of a Sublessee Event of Default. EZH caused such Letters of Credit to be issued.
The various calculations of investments and credits differ depending on which Option is exercised in 2018. Although not certain to occur, as discussed above, if EZH elects the Sublease Purchase Option, the Sublease Purchase Option Price is set at 143.63396613% of the appraised value of the undivided 47.47% interest, at the time of the end of the Sublease Basic Term, appraised at approximately $205 million by Deloitte. The Sublease Purchase Option Price equals $215,450,949.20. If EZH elects the Sublease Purchase Option in 2018, the Sublease Purchase Option Price of $215,450,949.20 can be paid (i) in cash or (ii) $123,615,472.00 in cash, plus the remaining United States Government Obligations from the IJssel Deposit, valued at their respective maturity dates. Under the Sublease Purchase Option, CEL Trust also will receive $7,326,950.33 as the Sublease Basic Rent Payment on January 2, 2018. The IJssel Deposit includes bonds with a maturity value of $7,326,950.33, which mature on January 2, 2018, and which EZH can use to pay the Sublease Basic Rent due on that date. EZH will assume CEL Trust's obligations under the Lease, including the obligation to make the Final Basic Rent Payment, and CEL Trust will transfer the Sublessee Loan to EZH, in accordance with its terms. Moreover, under the Sublease Purchase Option, CEL Trust will make arrangements to pay the remaining balance of the HBU Loan, equal to $123,615,472.00, and HBU will release the Lien on the Lease. EZH may withdraw $123,615,472.00 from the Sublease Deposit under the Sublease Deposit Pledge and Repledge Agreement on January 2, 2018, assuming that ABN AMRO complied with the terms of that agreement. The total amount receivable by CEL Trust, under the Sublease Purchase Option, after the release of the Lien on the Lease, will be $99,162,427.53.00, which is equal to the final Sublease Basic Rent Payment (taken from the IJssel *324 Deposit) and the remaining STRIPS from the IJssel Deposit. The scheduled balance of the Sublease Deposit as of January 2, 2018, plus the value of the United States Government Obligations remaining in the IJssel Deposit together would equal the Sublease Purchase Option Price. If EZH exercises the Sublease Purchase Option, ABN AMRO will pay the balance of the Sublease Deposit to HBU. That payment will be credited toward EZH's payment of the Sublease Purchase Option Price to CEL Trust and, in turn, shall be credited toward CEL Trust's payment of its obligations under the HBU Loan. If ABN AMRO has made all the payments it is required to make under the Sublease Deposit to HBU, the HBU Loan will be paid in full. Under the Sublease Purchase Option, CEL Trust will be relieved of the responsibility to make the Final Basic Rent Payment and EZH will owe the Final Basic Rent Payment to itself.
If, however, the Sublease Renewal Option becomes operative, EZH will be required to make the Final Sublease Basic Rent Payment on January 2, 2018 of $7,362,950.33 and will then pay annual rents to CEL Trust, as follows: $18,225,000.00 on each January 2 from January 2, 2019 through January 2, 2034, and $8,251,875.00 on June 15, 2034. EZH also will be obligated to make payments to CEL Trust under the Sublessee Loan, as follows: $37,525,237.00 on January 2, 2018; $9,649,098.00 on January 2, 2032; $12,062,039.00 on January 2, 2033; $9,720,944.00 on January 2, 2034; $5,238,696.00 on June 15, 2034; $5,319,460.00 on January 2, 2035; $1,155,324.00 on January 2, 2036; $93,128,382.00 on January 2, 2041; and $414,931,341.00 on February 24, 2041.
In the event of a reset of the interest rate on the Loan Certificate or its purchase by another lender or the Sublessee, EZH will be obligated to arrange for a reset of the interest rate on the Loan Certificates or its purchase by another lender or the Sublessee. EZH also will be required to maintain an acceptable Letter of Credit, in favor of CEL and CEL Trust, securing its obligations under the Sublease Renewal Option, and EZH will be responsible for paying the fees associated with the maintenance of that Letter of Credit. The schedule of investments and withdrawals will remain in effect for the Sublease Deposit, and EZH will be permitted to make withdrawals of $7,362,950.33 on January 2, 2018 and $18,225,000.00 on each January 2 from 2019 to 2026, and then $14,546,488.08 in 2027, at which point the Sublease Deposit will be exhausted. Additionally, the Loan and Security Agreement provides that CEL Trust will have continuing nonrecourse debt service payments to make in the amounts of $7,362,950.33 on January 2, 2018, $18,225,000.00 on each January 2, from 2019 to 2026, and payment of $14,546,488.00 on January 2, 2027. CEL Trust also will be required to make the Final Basic Rent Payment of $831,525,734.00 on February 24, 2041. If CEL Trust elects the Sublease Renewal Option, the Lease Agreement provides that CEL shall fund two deposits, the Lease Collateral Deposit and the Trustee Treasury Collateral, to provide collateral for the Final Basic Rent Payment, unless CEL or CEL Trust provides Acceptable Substitute Collateral. As Acceptable Substitute Collateral, CEL or CEL Trust may provide (1) a Letter of Credit, and (2) a first priority security interest in either cash or United States backed securities, or (3) any other collateral that is acceptable to EZH in its sole discretion.
Unless CEL or CEL Trust elects to use Acceptable Substitute Collateral, CEL will make deposits in the Lease Collateral Deposit, with an AA/Aa2 rated financial institution, which will bear a fixed rate of interest and will be available to make scheduled payments. The Lease Collateral Deposit will be pledged to EZH to secure the Final Basic Rent Payment owed it on February 24, 2041. The deposits will equal $3,678,511.92 on January 2, 2027 and $18,225,000.00 on each January 2 from 2028 to and including 2034, and then $8,251,875.00 on June 15, 2034, at which point the Lease Collateral Deposit is scheduled to have a balance of $176,210,292.09. Additionally, unless CEL or CEL Trust elects to use Acceptable Substitute Collateral, CEL will purchase United States Government Obligations on specific dates set forth in the Participation Agreement, with maturity amounts also set forth in the Participation Agreement, with the maturity dates close to, *325 but not later than, the Lease Termination Date, and will then deposit those United States Government Securities in a custodial account established by CEL, on behalf of CEL Trust, with a security interest in EZH's favor, as security for a portion of CEL Trust's obligation to make the Final Basic Rent Payment. The total amount of the final payment due pursuant to the Sublessee Loan Agreement ($414,931,341.00), plus the amount of the Trustee Treasury Collateral ($141,671,596.40) and the Lease Collateral Deposit would total $831,525,734.00 as of February 24, 2041, assuming that (i) CEL funds the Lease Collateral Deposit and the Trustee Treasury Collateral, and (ii) that CEL is able to earn an interest rate of 6.86% on the Lease Collateral Deposit from June 15, 2034 until February 24, 2041. The payment of the Final Basic Rent Payment of approximately $831,525,734.00 is a recourse liability to CEL Trust, to the extent of $141,671,596.40. This amount would be satisfied by the creation of the Trustee Treasury Collateral, or the Acceptable Substitute Collateral. CEL has a recourse liability to EZH for the remaining portion of the $831,525,734.00 to the extent of amounts, if any, CEL receives from the CEL Trust after the Sublease Basic Termination Date. At the end of the Sublease Renewal Term, CEL Trust may sublease the Facility to another party, to EZH, or it may take possession of the Facility itself, and have it operated at its own expense and for its own benefit for the remainder of the Lease Term (the Shirt–Tail Period).
In the event that CEL Trust exercises the Retention Option in 2018, EZH will return the Sublessee's Lease Interest to CEL Trust on January 2, 2018, and CEL Trust shall make arrangements acceptable to HBU for the payment of the principal amount of all Loan Certificates. If, however, CEL Trust fails to make such arrangements and HBU provides notice of this failure, CEL Trust will be deemed to have elected the Sublease Renewal Option. Under the Retention Option, EZH will be required to maintain an acceptable Letter of Credit in favor of CEL and CEL Trust, securing its obligations under the Sublessee Loan, and will be responsible for paying maintenance fees on the Letter of Credit. The Sublease Deposit, Pledge and Repledge Agreement will be terminated and the Sublease Deposit will come due, permitting EZH withdrawals of $7,362,950.33 on January 2, 2018 and $116,252,521.63 for the balance, at which point the Sublease Deposit will be exhausted. Under the Retention Option, CEL may fund the Trustee Treasury Collateral or the Incremental Collateral Pledge as security for the Final Basic Rent Payment. Alternatively, CEL or CEL Trust may provide Acceptable Substitute Collateral in the form of either (1) a Letter of Credit and (2) a first priority security interest in either cash or United States Government-backed securities, or (3) any other collateral that is acceptable to EZH in its sole discretion. If CEL chooses to fund the Trustee Treasury Collateral, the account would consist of United States Treasury obligations to be purchased on January 2, 2018, with maturities as close to, but not later than, the Lease Termination Date, with a maturity amount of $141,671,496.40. The amount that CEL will need to pay for the necessary collateral on January 2, 2018 will depend on the interest rates prevailing at that time. If CEL chooses to fund the Incremental Collateral Pledge, CEL will enter into a custody arrangement to hold, on behalf of EZH, either United States Government Obligations or other corporate bonds with ratings of at least Aa2 and AA. These deposits will bear a fixed rate of interest determined as of the date funded and will be available to make maturity payments in 2041 in an amount not less than the dollar amount equal to (i) the excess of the Final Basic Rent Payment over (ii) the sum of the Lease Collateral Deposit and Trustee Treasury Collateral maturity at February 24, 2041 and the scheduled payment of the Sublessee Loan, also on the Lease Expiration Date. This deposit will be pledged to EZH to secure the incremental shortfall on the Final Basic Rent Payment owed to it on February 24, 2041.
Under the Retention Option, CEL Trust is entitled to the final Sublease Basic Rent Payment on January 2, 2018. CEL Trust also is entitled to payments from EZH on the Sublessee Loan, as follows: $37,525,237.00 on January 2, 2018; $9,649,098.00 on January 2, *326 2032; $12,062,039.00 on January 2, 2033; $9,720,944.00 on January 2, 2034; $5,238,696.00 on June 15, 2034; $5,319,460.00 on January 2, 2035; $1,155,324.00 on January 2, 2036; $93,128,382.00 on January 2, 2041; and $414,931,341.00 on February 24, 2041.
Moreover, EZH is entitled to the Final Basic Rent Payment of $831,525,734.00 on February 24, 2041. The total amount of the final payment due pursuant to the Sublessee Loan Agreement ($414,931,341.00), plus the amount of the Lease Collateral Deposit and Trustee Treasury Collateral and the projected value of the Incremental Collateral Pledge, will total $831,525,734.00 as of February 24, 2041, assuming that (i) CEL elects to fund the Incremental Collateral Pledge and the Trustee Treasury Collateral, and (ii) that CEL is able to earn an interest rate of 6.86% on the Incremental Collateral Pledge from the date funded until February 24, 2041. The payment of the Final Basic Rent Payment is a recourse liability of CEL Trust to the extent of $141,671,596.40. This amount would be satisfied by the creation of the Trustee Treasury Collateral if CEL, on behalf of CEL Trust, chooses to create that account. In addition, CEL has a recourse liability to EZH for the remaining portion of the $831,525,734.00 Final Basic Rent Payment, to the extent of amounts, if any, CEL receives from CEL Trust after the Sublease Basic Termination Date.
Objectively, the plaintiff expected a pretax profit under each of the possible Options structured in the Transaction. Admittedly, the potential for profit was greater under some Options than others, however, profit was a realistic, strategic goal on the plaintiff's part when it entered into the RoCa3 Transaction in 1997. In Emershaw v. Commissioner of Internal Revenue, the Tax Court stated:
In order to produce a pretax profit, [plaintiff] must realize shared rent and residual value in excess of ... the amount of its negative cash flow from the sale and leaseback transaction.
Emershaw v. Comm'r, T.C.Memo. 1990–246, 59 T.C.M. (CCH) 621, 625 (1990), aff'd,
949 F.2d 841 (6th Cir.1991), reh'g denied
While no specific minimum pretax profit has been established for recognizing the economic substance of a leasing transaction, a pretax profit of 3.4% or “more than 3%” has been accepted as sufficient to imbue a transaction with economic substance. See, e.g.,
AWG Leasing Trust v. United States, 592 F.Supp.2d at 980. In the present case, both the plaintiff's leasing expert, Dr. Ellis, and the defendant's leasing experts, Mr. Bent and Mr. Ray, confirmed that pretax yields falling between 2% and 4% of the transaction's value are not uncommon for leasing deals. The court in AWG
noted that the banks involved in the AWG transaction “typically receive internal rates of return between 2.5% and 3.5%.” Id. In AWG Leasing Trust,
even though, as noted earlier, the court held that the transaction would not be respected for tax purposes because the transaction had no valid business purpose other than to gain tax advantages, the court, nonetheless, found that the transaction in that case possessed economic substance because it would run a pretax rate of return of 3.4%, even if the purchase option was exercised. The AWG
court indicated that a 3.4% pretax profit was sufficient to show that the transaction had some “ ‘practicable economic effects other than the creation of income tax losses.’ ” Id. (quoting Rose v. Comm'r, 868 F.2d 851, 853 (6th Cir.1989)).
The formula the plaintiff used to calculate the plaintiff's pretax profits compares CEL Trust's equity investment, plus the direct costs of financing, to the cash flow from rent and residual value. The plaintiff, with the help of outside experts, projected, that if EZH were to exercise the Sublease Purchase Option, the pretax yield, at a minimum, would be 4.44%, which is above the amount cases have previously acknowledged as sufficient pretax profit. The plaintiff asserts that, absent the occurrence of a “Premature Termination,” the plaintiff was projected to earn a minimum of approximately $61 million, which would be in addition to the recovery of its initial $43 million equity investment in the RoCa3 Facility. Based on the pricing runs generated by Cornerstone in advance of the Transaction, even if EZH exercises the Sublease Purchase Option in 2018, CEL *327 Trust would expect to earn a pretax cash flow profit of $60,974,397.00, and $39,633,358.00 after-tax cash flow profit.
The profit expected from the RoCa3 Transaction is calculated with respect to the various rights and obligations of the parties. If EZH elects to exercise the Sublease Purchase Option, the Sublease Purchase Option Price of $215,450,949.20 will be due to be paid to CEL Trust on January 2, 2018. The scheduled balance of the Sublease Deposit as of January 2, 2018, plus the value of the remaining Treasury STRIPS in the IJssel Deposit would equal the Sublease Purchase Price of $215,450,949.20. This amount can be paid either (i) in cash, or (ii) with $123,615,472.00 in cash, plus the delivery of the remaining STRIPS from the IJssel Deposit, valued at their maturity dates, and totaling $91,835,477.24 in 2018. Additionally, EZH will be required to pay $7,326,950.33 as a Final Sublease Basic Rent Payment, which is equal to one of the Treasury STRIPS, in addition to those used to pay the Sublease Purchase Option Price, which matures on January 2, 2018. This is in addition to the $5,220,969.87 that CEL Trust will have received on January 2, 2012, the earlier maturity date of one of the STRIPS in the IJssel Deposit. If EZH exercises the Sublease Purchase Option, ABN AMRO will pay the balance of the Sublease Deposit to HBU. That payment will be credited toward EZH's payment of the Sublease Purchase Option Price to CEL Trust and, in turn, will be credited toward CEL Trust's payment of its obligations under the HBU Loan. If ABN AMRO has made all the payments it is required to make under the Sublease Deposit to HBU, the HBU Loan will be paid in full. HBU then will release its Lien of the Loan. CEL Trust then will receive the final Sublease Basic Rent Payment ($7,326,950.33), plus the subsequent payments from the IJssel Deposit (totaling $91,835,477.24). The total amount receivable by CEL, from CEL Trust, will, therefore, equal $99,162,427.57 plus the $5,220,969.87 from the first Treasury STRIPS, with a maturity date of January 2, 2012. After subtracting CEL Trust's initial equity investment of $43 million, CEL Trust should receive a pretax profit of $60,974,397.00.
According to testimony in the record, the development company's consultant, Cornerstone, generated pricing runs which did not assume that only the Sublease Purchase Option would be exercised by EZH. Cornerstone also projected that, if CEL Trust exercises the Sublease Renewal Option, it can expect to earn a pretax profit of approximately $101,538,462.00, which could be higher or lower depending on the residual value left to CEL Trust at the end of the Sublease Renewal Term in 2034 and the cost to CEL Trust of operating the RoCa3 Facility at the end of the Sublease Renewal Term for the Shirt–Tail Period from 2034–2041. Projections for the Shirt–Tail Period were considered unknown, given possible intervening occurrences, at the time of the Transaction. Even residual value was hard to project in 1997 and, therefore, was not included in the calculations. During the Shirt–Tail Period, plaintiff can either operate the RoCa3 Facility itself or sublease it to another party.
If CEL Trust exercises the Retention Option, the potential to earn a pretax profit would be even greater, as would the risk of loss, and both would depend on the performance of the RoCa3 Facility during the Retention Option Period. The plaintiff also would have to pay a proportional share of expenses. Under the Retention Option, EZH would be required to return the undivided 47.47% interest to CEL Trust from 2018 through 2041, and make the Final Sublease Basic Rent Payment due on January 2, 2018. During that period, plaintiff would be exposed to a large variety of risks and opportunities with respect to operations of the RoCa3 Facility. The Retention Option requires prepayment of the nonrecourse loan, and failure to prepay the loan results in the Sublease Renewal Option being deemed exercised.
The defendant argues that the plaintiff, reasonably, could not have expected to achieve any net economic benefit from the cash flows of the RoCa3 Transaction, based on its expert's (Dr. LaRue's) analysis of the cash flow pricing run materials. The defendant maintains that, on a discounted cash flow basis, “the RoCa3 LILO was incapable of generating any economic profit to CED *328 absent the tax benefits.” Dr. LaRue, who similarly arrived at the 4.44% pretax profit figure, then applied a discount interest rate to the equation of 6.183% to arrive at a cash flow of less than “zero.”
In his report, Dr. LaRue admits that the discount rate he applied was a theoretical rate, and that there is no such thing as a risk free investment. Defendant relies on language in ACM Partnership v. Commissioner of Internal Revenue, 157 F.3d at 259, to argue that, in transactions designed to yield deferred, not immediate, profits, present value adjustments are the method by which to calculate a transaction's actual and anticipated profits.
The plaintiff rejects the defendant's assertion that a discount rate should be applied to the pretax profit projection. The plaintiff argues that the opportunity to make a higher profit with other investments that would be more profitable is not evidence that the activity in question is not profitable. Moreover, evidence presented throughout the course of the trial, including the testimony at trial, and exhibits entered into the record, demonstrate that the plaintiff had numerous business objectives in mind when it entered the RoCa3 Transaction, so that a discount rate, which considers only profitability in monetary terms, is not the only, or necessarily the best, measure of the transaction.
The case on which the defendant relies, ACM Partnership v. Commissioner of Internal Revenue, 157 F.3d at 236, does not direct the use of a discount rate in profit calculations, but acknowledges that some courts have allowed the use of a discount rate in appropriate circumstances. In ACM Partnership v. Commissioner of Internal Revenue,
the court stated:
We reject ACM's contention that Estate of Thomas [Thomas v. Comm'r, 84 T.C. 412, 1985 WL 15324], which construed Treasury Regulations under I.R.C. § 183, precludes present value adjustments in the prospect-for profit analysis under the judicially created economic substance doctrine. In transactions that are designed to yield deferred rather than immediate returns, present value adjustments are, as the courts have recognized, an appropriate means of assessing the transactions' actual and anticipated economic effects. See, e.g.,
Hilton v. Commissioner, 671 F.2d 316, 317 (9th Cir.1982) (affirming economic substance determination based on the present value analysis of taxpayer's investments);
Citizens & Southern Corp. v. Commissioner, 91 T.C. 463, 498, 1988 WL 90987 (1988) (noting that value of an acquired asset may be determined based on future income likely to be generated that [sic] by that asset discounted to present value), aff'd,
919 F.2d 1492 (11th Cir.1990); Gianaris v. Commissioner, 64 T.C.M. (CCH) 1229, 1234 (1992) (“[W]e have consistently discounted ... income streams produced by [an investment] in determining whether the taxpayer had a profit objective.”) (citations omitted).
We find no basis in the law for precluding a tax court's reliance on a present value adjustment where such an adjustment, under the surrounding circumstances, will serve as an accurate gauge of the reasonably expected economic consequences of the transaction.
at 259 (footnotes in opinion omitted). Even the ACM
court did not direct use of a “present value adjustment”; the court simply did not “preclude” its use. Id. at 259. Moreover, the only clear conclusion to be drawn from the statement by the court in ACM Partnership v. Commissioner,
is that, as is true with respect to all aspects of an evaluation of the economic substance sufficiency of a LILO transaction for tax deduction *329 purposes, the analysis must depend on the specific and unique characteristics and conditions of the individual transaction under review.
The defendant also argues that the plaintiff had no reasonable expectation of profit aside from tax benefits and no expectation of a residual value. The defendant contends that, “the Sublease Purchase Option is the designed outcome” in the RoCa3 Transaction. The court has already addressed this assertion and has found that exercise of the Sublease Purchase Option was not pre-ordained when the plaintiff entered into the RoCa3 Transaction. The plaintiff analyzed and understood the Transaction as including the residual value or possible projected benefits of the RoCa3 Transaction during the Sublease Renewal Option or Retention Option. At trial, the plaintiff agreed that some of the pre-Transaction analyses included an assumption of a zero residual value, as is not uncommon in leveraged and simple leases. Documents in the record indicate that, for RoCa3 Transaction analysis purposes, pricing runs were considered a “base case” analysis, and assumed no additional revenue for the seven year residual period at the end of the Sublease Renewal Term. However, the Deloitte appraisal analyzed and included a discussion of the residual value of the Facility and estimated pretax cash flows during the Shirt–Tail Period, including the possibility for the greatest pretax profit during the Retention Option Period.
Of the “particularly significant” factors to be considered when determining whether a transaction possesses economic substance, apart from tax benefits, an inquiry into “the reasonableness of the income and residual value projections,” has been recognized as a “particularly significant” factor, in Levy v. Commissioner of Internal Revenue, 91 T.C. at 856 (citing Rice's Toyota World, Inc. v. Comm'r, 81 T.C. 184, 204–207, 1983 WL 14860 (1983)). As part of the analytical process, in which plaintiff engaged prior to closing the Transaction in 1997, the plaintiff estimated residual value in the future in a conservative fashion, and identified profit potential under each option. The year 2018 was far enough in the future from when the Transaction was finalized, in a changing regulatory environment in the United States and The Netherlands, such that all eventualities were possible.
In their briefs, and in subsequent filings with the court, the parties have discussed or noted a number of federal court decisions concerning LILO and SILO transactions, originating in different jurisdictions. Although not binding on this court and in each case distinguishable, they are of interest. These cases include: Hoosier Energy Rural Electric Cooperative, Inc. v. John Hancock Life Insurance Company, 588 F.Supp.2d 919 (S.D.Ind.2008), stay denied,
No. 108–1560, 2008 WL 5092964 (S.D.Ind. Nov.26, 2008), order superseded,
2008 WL 5216027 (S.D.Ind. Dec.11, 2008), aff'd,
582 F.3d 721 (7th Cir.2009); BB & T Corporation v. United States, No. 1:04–0941, 2007 WL 37798 (M.D.N.C. Jan. 4, 2007), aff'd,
523 F.3d 461 (4th Cir.2008); AWG Leasing Trust v. United States, 592 F.Supp.2d 953 (N.D.Ohio 2008); Fifth Third Bancorp & Subsidiaries v. United States,
No. 05–350 (S.D.Ohio Apr. 18, 2008) (jury verdict); and Altria Group, Inc. v. United States,
No. 06–9430 (S.D.N.Y. Jul. 9, 2009) (jury verdict). Each of these cases was ultimately decided against the taxpayer, however, as indicated throughout this opinion, considerations of economic substance are factually specific to the transaction involved.
In BB & T Corporation v. United States, 523 F.3d 461 (4th Cir.2008), the United States Court of Appeals for the Fourth Circuit affirmed the decision of the United States District Court for the Middle District of North Carolina. The District Court granted summary judgment in favor of the government. No trial was held. The court reviewed the LILO transaction, entered into between BB & T, a United States “financial services company based in the Southeast,” with Sodra Cell AB (Sodra), a “Swedish cooperative recognized as one of the world's leading wood pulp manufacturers.” Id. at 465. The District Court concluded, and the Fourth Circuit affirmed, that BB & T “did not actually acquire a genuine leasehold interest or incur genuine indebtedness as a result of the transaction....” Id. at 464. The BB & T
court found that the transaction *330 lacked economic substance, as the taxpayer failed to show any “ ‘business or regulatory realities' that ‘compelled or encouraged,’... the structure of the transaction.” Id. at 473 (quoting Frank Lyon Co. v. United States, 435 U.S. at 583, 98 S.Ct. 1291). The court also found in BB & T
: “... nor has it [BB & T] established that its LILO is ‘imbued with tax-independent considerations, and is not shaped solely by tax-avoidance features that have meaningless labels attached.’ ” Id. at 473 (quoting Frank Lyon Co. v. United States, 435 U.S. at 583, 98 S.Ct. 1291).
The facts presented in the BB & T
case are unique, as are the facts presented in the Con Ed
litigation. The taxpayer, BB & T, was approached about entering a LILO transaction with Sodra. Before entering the transaction, BB & T “performed an independent evaluation of the transaction,” during which the CFO of BB & T specifically determined that it was a “ ‘tax-driven deal’ with an after-tax investment yield ‘largely generated by tax benefits associated with accelerated tax deductions' of rent.” BB & T Corp. v. United States, 523 F.3d at 465. Moreover, the CFO of BB & T noted that “ ‘if there were no tax benefits,’ BB & T would ‘[p]robably not’ have moved forward with the LILO” transaction, although the CFO of BB & T stated that he was “ ‘intrigued by the transaction,’ ” in part, because it was “ ‘looking to grow loans and diversify [its] loan portfolio.’ ” Id. at 465–66.
In brief, on the closing date of the LILO transaction at issue in the BB & T
case, BB & T and Sodra executed a series of interrelated agreements, including a “ ‘Head Lease,’ a Sublease, a Debt Payment Undertaking Agreement (‘Debt PUA’), and an Equity Payment Undertaking Agreement (‘Equity PUA’).” Id. at 466. The structure of the BB & T
transaction was established such that, under the Head Lease, BB & T leased the equipment from Sodra for a period of 36 years and, under the Sublease, Sodra subleased the equipment back to BB & T for a period of 15.5 years. Id. The 15.5 year period was referred to as the Basic Lease Term, during which Sodra continued to use, maintain and improve the equipment. Id. At the end of the Basic Lease Term in 2013, Sodra has the option to buy back BB & T's remaining interest in the Head Lease, thereby terminating the transaction. Id. Under the terms of the agreements between BB & T and Sodra, if Sodra does not exercise the purchase option, BB & T may (1) require Sodra to extend the Sublease an additional 13.3 years, after which BB & T would possess the remaining interest for a period of 7.2 years; (2) lease the equipment to a third party, subject to certain requirements; or (3) take possession of the equipment and use it “at its own expense and for its own benefit” for the remainder of the Head Lease. Id. at 466–67. BB & T implemented the transaction through a trust and financed the transaction with its own funds and a nonrecourse loan. Id. at 467. A sum of $6,228,702.00 was transferred from the trustee of the trust to Sodra, as Sodra's “incentive for doing the deal.” Id. BB & T was required to make two lease payments, an “Advance Head Lease Payment,” which came from BB & T's upfront investment and a nonrecourse loan placed in a trust account. Id. A second, Deferred Head Lease Payment, was set to be due in 2038, at the expiration of the Head Lease, and is to be paid, depending on future events and which option is exercised at the end of the basic lease term. At closing, pursuant to the Debt PUA, Fleet National Bank (Fleet) immediately transferred $68,008,236, the same amount contributed by ABN AMRO, into a defeased account, the “Debt PUA account,” the funds of which “became an asset solely of ABN AMRO, unreachable by Sodra, BB & T, or other respective creditors.” Id. The trustee in the transaction purchased Treasury bonds at the transaction closing, to be held by the Equity PUA, and to be used to partially fund the purchase price on Sodra's purchase option, if Sodra elects to exercise its purchase option. Id. at 468. The remainder of the purchase price is to be funded by the final payment under the Debt PUA, which also will retire the HBU loan. Id.
although Sodra is required to make annual rental payments during this term, Sodra does not supply any additional funds to satisfy this obligation. Instead, ABN [ABN AMRO Bank, N.V.], in its capacity *331 as Debt PUA Issuer, makes the payments on Sodra's behalf from the funds it received at closing. BB & T does not receive any of these rental payments because BB & T assigned the right to receive rent from Sodra to HBU [Hollandsche Bank–Unie N.V.] as part of providing collateral for the HBU loan. Accordingly, ABN, acting as “Debt PUA Issuer” makes the annual payments directly to HBU from the Debt PUA account. Through 2012, these annual payments exactly equal the remaining principal and interest due on the loan. Because ABN, not HBU, provided the funds for the loan, however, ABN is actually paying itself from the $68,008,236 (the sum equal to the loan proceeds) that it received at closing. The net result is that no funds change hands during this period; only a circular intrabank transfer occurs. On its own books, therefore, ABN treats the loan as an off-balance sheet transaction carrying zero risk.
at 467–68 (footnote omitted). In sum, the court concluded that “[t]he net result was that no funds change hands during this period; only a circular intrabank transfer occurs,” Id. at 468, and that “the transaction is a financing arrangement, not a genuine lease and sublease.” Id. at 475.
If Sodra exercises the purchase option, the purchase price will be funded from resources supplied by BB & T at closing. BB & T also will be relieved from having to make the Deferred Head Lease Payment. Id. at 469. In addition, the court discussed BB & T's options in the event that Sodra does not exercise the purchase option, and found that BB & T's Deferred Head Lease Payment either would be fully funded, or would be without risk due to Sodra's lack of recourse against BB & T for any deficiency. Id. at 468–69. The court also found that “BB & T, therefore, does not expect Sodra to ‘walk away’ from the Equipment .... [and] regardless of whether Sodra bucks this expectation, the structure of the transaction insulates BB & T from any risk of losing its initial $12,833,846 investment in the government bonds or incurring the obligation to invest additional funds.” Id. at 473. Significantly, as noted above, “[b]efore Sodra entered into this agreement, however, Sodra's tax advisors characterized the transaction as a financing arrangement that did not affect Sodra's interests in the Equipment, apparently anticipating that Sodra would not surrender control of the Equipment to BB & T.” Id. at 469 n. 10. Moreover, as stated in the court's opinion, “BB & T has conceded, however, that it entered into the transaction believing that ‘the most likely thing is [Sodra] would not walk away from the property.’ ” Id. at 469. With respect to the “financing arrangement,” and particularly the loan in the BB & T
case, the court based its conclusions on the fact that “Sodra has no economic incentive to decline the purchase option,” and that “BB & T does not expect Sodra to surrender control of the Equipment.” Id. at 476.
The Fourth Circuit, therefore, concluded that:
in substance, the transaction is a financing arrangement, not a genuine lease and sublease. All that BB & T has done is paid Sodra approximately $6 million dollars to sign documents meeting the formal requirements of a lease and sublease, arranged a circular transfer of funds from and then back to ABN, and invested approximately $12 million in government bonds. Sodra, meanwhile, maintains uninterrupted possession and control of the Equipment, and has no economic incentive to cede control to BB & T.
Id. at 475.
The BB & T
court found that BB & T failed to incur the rights, obligations and risks that resemble a traditional lease relationship, because Sodra's exercise of the purchase option was expected by the framers of the transaction, and considered virtually certain. Therefore, the court concluded that risks did not exist for BB & T, even if Sodra failed to exercise its purchase option. In the case currently before this court, however, as discussed above, no such definite result was foreseen or foreseeable in 1997 when the RoCa3 Transaction was formulated. Based on the facts of the case before the court, EZH is not certain to exercise the Sublease Purchase Option, and if EZH does not exercise the Sublease Purchase Option, both the *332 residual value risk and potential profit are present for the plaintiff.
The BB & T
court also found that,
unlike the taxpayer in Frank Lyon Co.,
BB & T has failed to show any “business or regulatory realities” that “compelled or encouraged,” [Frank Lyon Co. v. United States, 435 U.S. at 583, 98 S.Ct. 1291], the structure of the transaction at issue here, nor has it established that its LILO is “imbued with tax-independent considerations, and is not shaped solely by tax avoidance features that have meaningless labels attached,” id. at 583–84, 98 S.Ct. 1291.... To the contrary, BB & T has offered no regulatory or economic reality driving the transaction's simultaneous conveyance and retraction of rights and obligations, nor has it offered any non-tax related purpose for structuring the transaction in this manner.
BB & T Corp. v. United States, 523 F.3d at 473–74.
Unlike the BB & T
case, the plaintiff in the case currently before this court, after a lengthy trial, as opposed to summary proceedings on a motion in BB & T
, was able to prove that the form of the transaction created a genuine ownership interest in a leasehold, which possessed economic substance, with “tax-independent considerations,” Frank Lyon Co. v. United States, 435 U.S. at 584, 98 S.Ct. 1291, based on other “business” and/or “regulatory realities.” Id. at 583, 98 S.Ct. 1291. Furthermore, in BB & T
, the court “decline[d] to resolve whether this transaction as a whole lacked economic substance,” BB & T Corp. v. United States, 523 F.3d at 477, but, instead, decided the case based on its findings that the form of the BB & T “transaction is a financing arrangement, and not a genuine lease and sublease.” Id. at 475, 479.
Unlike the BB & T
plaintiff, the Con Ed
plaintiff involved in the current RoCa3 Transaction has established a number of non-tax, business reasons for entering the RoCa3 Transaction, including making a pretax profit; obtaining favorable accounting benefits under FAS 13, with front-loaded and near term earnings; having the potential opportunity to take possession of, and operate the RoCa3 Facility, and derive profits from the operation of the Facility if the Sublease Renewal Option or Retention Option comes into effect; entering the Western European, including the Dutch, utility markets in a deregulated environment; learning about and sharing technology in its own utility “core competency”; gaining expertise and goodwill from an environmentally friendly energy company and, thereby, improving its own, somewhat tarnished, environmental image. These were all substantial and valuable business purposes that the Con Ed
plaintiff sought to derive from the RoCa3 Transaction. Because BB & T was a financial services provider entering a transaction with a wood pulp manufacturer, it could not have had any intention or objective reality to benefit from the transaction in ways similar to those in which Con Ed, an energy company, could hope to benefit from the RoCa3 Transaction, which was a transaction between two energy-producing companies.
In the case currently before the court, there also is sufficient testimony and documentary evidence to persuade this court that the choice of Options is not predestined and that Con Ed could take control of and ably manage the RoCa3 Facility during the Shirt–Tail Period under the Sublease Renewal Option or during the Retention Period, EZH, or a subsequent owner of EZH, would not have to fear diminution of the Facility in the hands of Con Ed, another major utility, so as to be forced into exercising the Sublease Purchase Option, in order to preserve its asset for the remainder of its useful life.
The case of AWG Leasing Trust v. United States, 592 F.Supp.2d 953, involved a sale-in/lease-out (SILO) transaction, entered into in 1999, and was decided by the United States District Court for the Northern District of Ohio after a trial. The court described *333 SILO transactions as “a modified version of their tax-driven financial predecessors, lease-in/lease-out (‘LILO’) transactions.” Id. at 959. The IRS disallowed tax deductions for rental payments, depreciation, amortization and interest payments on nonrecourse loans the Trust had obtained from two German banks. Id. In the AWG
case, Abfallwirtschaftgesellschaft mbH Wuppertal (AWG Wuppertal) was the municipal owner of a waste-to-energy facility in Germany, which made its revenue from the operation of the facility. Id. at 960. AWG Leasing Trust (the Trust) consisted of two United States banks, Key Global Finance (KSP) and PNC Financial Services Group, Inc. (PNC). Id.
at 961. KSP and PNC invested in the Trust through a Delaware business Trust called AWG Leasing Trust. Id. at 965.
The AWG transaction was structured with a Head Lease Agreement, by which the Trust plaintiffs obtained the facility from the prior owners for a period of 75 years, in exchange for $423 million at closing, and a lease-back agreement. Id. at 966–67. The Trust argued it should be allowed depreciation on the Wuppertal plant and interest on the nonrecourse loans obtained to finance the transaction between AWG Wuppertal and the Trust. In a footnote, the court wrote, “[d]espite the fact that the Head Lease has a term of 75 years, the Facility's estimated remaining useful life was only valued at 46 years.” Id. at 967 n. 8. The court also noted that the Head Lease “contains a provision stating that if the actual economic useful life of the Facility is ever deemed to be longer than 75 years, then the term of the Head Lease is automatically extended to be 125% of the new expected useful life of the Facility.” Id. The Head Lease was to be treated as a sale as of the closing date under United States federal income tax law, but was not recorded as a proper sale under German law. Moreover, AWG Wuppertal continued to take depreciation deductions for tax purposes under German tax law. Id. at 967.
Pursuant to the lease-back agreement, the Trust leased the facility back to AWG Wuppertal until January 1, 2024 in exchange for annual rent payments (the Initial Leaseback Period), under which AWG Wuppertal remains responsible for the costs of operating the facility, including taxes, insurance and maintenance expenses, and pursuant to which AWG Wuppertal was entitled to sole possession and operation of the facility and to the profits generated from the facility during the Initial Leaseback Period. Id. Nonrecourse loans and a relatively small contribution from the plaintiffs funded the closing of the deal. Id. at 967–68. Moreover, AWG Wuppertal was required to put the money it obtained from the loans into Debt Payment Undertaking Accounts (Debt PUAs), which act as Defeasance Accounts, created to pay AWG Wuppertal's obligations under the sublease and to apply those payments to plaintiffs' debts that are incurred under the transaction. Id. at 969.
At the end of the Initial Leaseback Period in 2024, AWG Wuppertal can exercise one of two options: the Fixed Purchase Option, or the Service Contract Option. Id. at 970–73. The Fixed Purchase Option entitles AWG Wuppertal to regain the Trust's interest in the facility for a price of $521 million, which would be funded by the Debt PUAs and the Equity PUA. Id. The proceeds of the loans, therefore, will return to the lenders, and neither AWG Wuppertal nor the Trust will have to provide cash to repay the loans. Id. at 970–71. If AWG Wuppertal does not exercise the Fixed Purchase Option, AWG Wuppertal and the Trust, or its designee, must enter into a waste disposal service contract at the end of the Leaseback Term. This is the Service Contract Option, under which AWG Wuppertal agrees to purchase solid waste disposal services from a third party provider, chosen by the plaintiffs, from January 1, 2024 until September 23, 2036. Id. at 971. To do this, AWG Wuppertal must first arrange nonrecourse refinancing of the nonrecourse debt that will be outstanding in 2024, and pay a number of charges, including borrowing costs associated with the nonrecourse loan and Operation Agreement Loans. Id. at 971–72. During the Service Contract Term, AWG Wuppertal also must pay a periodic service fee to the Trust or its designee. If AWG Wuppertal exercises the Service Contract Option, then it also gets a second option to repurchase the facility by terminating the Head Lease and, at the end of the *334 Service Contract in 2036, paying the Trust money equivalent to the fair market value of the facility. Id. at 972. The court found that although the AWG SILO transaction did have “some economic substance apart from tax benefits,” and is expected to make a small, but guaranteed, pretax profit with a small chance of a large profit, if AWG Wuppertal exercises the Service Contract Option, “the transaction's stated form as a ‘sale’ is not consistent with its economic reality.” Id. at 976. The AWG
court concluded that AWG Wuppertal's Fixed Purchase Option “nearly certain[ly]” will be exercised and that the plaintiffs were virtually certain of this outcome when they closed the transaction. Id. at 981–82. The court based its conclusion on its finding that the Fixed Purchase Option is the only economically feasible and economically dominant option for AWG Wuppertal. Id. As a result, the AWG
court stated that:
the AWG transaction does not allocate the rights, responsibilities, and risks between AWG and the Plaintiffs in a way that resembles a traditional sale. Further, as in the BB & T
case, the Plaintiffs here have “failed to show any ‘business or regulatory realities' that ‘compelled or encouraged’ the structure of the transaction at issue here, nor has it established that its [SILO] is ‘imbued with tax-independent considerations, and is not shaped solely by tax avoidance features that have meaningless labels attached.’ ” BB & T Corp. v. United States, 523 F.3d 461, 473 (4th Cir.2008) (other citations omitted).
Id. at 990.
The court further pointed out that under German tax law, the AWG transaction was not a sale of ownership in the facility. Id. at 972–73. The court was concerned that not only does AWG Wuppertal continue to list the plant as an asset on its financial statements, it also receives depreciation deductions for German taxes, and that the Trust was aware of the German tax treatment:
In fact, AWG Wuppertal represented to the German tax authorities that:
the head lease and the sublease are entered into simultaneously, so that possession, uses and obligations will at no time—not even for one legal second—be transferred to the U.S. Trust, if [AWG] exercises the [Fixed Purchase Option].
Id. at 973.
court found that, “[a]fter examining the totality of the circumstances that existed in [December] 1999, the Court concludes that the Plaintiffs could have reasonably expected to make a small but guaranteed, pre-tax profit that is sufficient to show that the transaction had some ‘practicable economic effects other than the creation of income tax losses,’ ” and is, therefore, “not an economic sham.” Id.
at 980, 981 (citation omitted). The court concluded, however, that no substantive benefits or burdens of ownership were exchanged between the parties during the initial lease-back period, no significant cash flows occurred between the parties during the initial leaseback period, the plaintiffs incurred minimal risk during the Head Lease period, and “most importantly, it is nearly certain” that the Fixed Price Purchase Option will be exercised, “thus ensuring that the plaintiffs never actually acquire[d] economic ownership of the facility.” Id. at 981–82. The court, therefore, disallowed the deductions the plaintiff claimed.
case can be distinguished on the facts from the case currently before the court. First, the AWG
case is focused on a SILO transaction, which generates a different, primary focus, with the finding that no sale occurred. The plaintiffs in the AWG
case intended to structure the transaction so it would not be a sale under German law, although it purported to be a sale for United States tax purposes. Id. at 973, 983. This became a critical consideration for the court on the issue of ownership and as part of its analysis of the financing arrangements. Id. at 993. Second, the court determined that it was a near certainty that AWG Wuppertal will exercise the Fixed Purchase Option in 2024, and determined that its analysis of near certainty was the most important reason for the court's conclusion that “the AWG transaction does not allocate the rights, responsibilities, and risks between AWG and the Plaintiffs in a way that resembles a traditional sale.” Id. at 990. The AWG
court also noted that the transaction had a guaranty from the municipal members of AWG Wuppertal, *335 backed by the German federal government, id. at 984, and the AWG court analyzed both the German tax law consequences and the German political climate as dictating against a decision to exercise the Service Contract Option, but instead to exercise the Fixed Purchase Option. Id. at 988–90. The AWG
court further found that the underlying debt from nonrecourse loans was not genuine and that the Trust was not entitled to deduct interest expenses on that debt, pursuant to 26 U.S.C. § 163(a), in that “[t]he underlying loans do not constitute genuine indebtedness because the Plaintiffs, at no point in time, will be required to use their own funds to repay the debt to the German banks.” Id. at 994.
An additional significant distinction between the AWG and Con Ed
cases is that the AWG
transaction closed on December 7, 1999, which was after Revenue Ruling 99–14, 1999–1 C.B. 835, was published on March 29, 1999, and the final regulation, 64 Fed.Reg. 26845, pursuant to 26 U.S.C. § 467, was published on May 18, 1999. Unlike the Con Ed
plaintiff, AWG Trust undertook the transaction with knowledge of the final, published IRS position, which more directly discredited the proposed AWG transaction. The Judge in AWG acknowledged that the ruling and regulations “significantly reduc[ed] the tax benefits commonly associated with LILO structures.” Id. at 959.
The defendant's assertion that AWG
and BB & T
are “nearly identical” to the current case is not correct. Each tax case, and each LILO or SILO case, must undergo a very fact specific analysis. The Con Ed
case is unlike the BB & T
case, which found that “Sodra, through the purchase option, can unwind the transaction without ever losing dominion and control over the Equipment or having surrendered any of its own funds to BB & T, and has no economic incentive to do otherwise.” BB & T v. United States, 523 F.3d at 473. The Con Ed
case also is unlike the AWG
case, in which the court found the exercise of the right to repurchase its asset at the end of the initial sublease period “extremely likely,” AWG Leasing Trust v. United States, 592 F.Supp.2d at 979; “nearly certain,” id. at 985; “highly likely,” “will” be exercised, id. at 981–82, and that “the parties intended this result when they closed the AWG deal on December 7, 1999,” id. at 985, having “included requirements in the 1999 Transaction that make a decision by AWG to enter the Service Contract near impossible.” Id. at 981. Each case individually presents distinguishing factual circumstances, such that a blanket disallowance of deductions taken in all LILO—or SILO-type cases would be contrary to the intent of the statutes, regulations and case precedent. Although it certainly would be easier for a court to follow the earlier opinions and to disallow the tax benefits claimed by plaintiff, the parties have presented volumes of exhibits and testimony, including expert testimony, unique to the RoCa3 Transaction. After reviewing all this information, unlike in AWG
and BB & T
, exercise of the Sublease Purchase Option in the RoCa3 Transaction was not all but certain. Based on the testimony and documents presented in the case before this court, basing a ruling on prognostication is too speculative. Although in 2018, it may turn out that there are some advantages for EZH to exercise the Sublease Purchase Option, in an uncertain and changing economic, energy resource, and regulatory environment, nothing can be pre-determined with certainty. Even if EZH exercises the Sublease Purchase Option, some profit, together with benefits derived from numerous other business purposes, are achievable through the RoCa3 Transaction. Moreover, additional profit potential and risk exist for plaintiff if EZH chooses not to exercise the Sublease Purchase Option in 2018.
The case of Hoosier Energy Rural Electric Cooperative, Inc. v. John Hancock Life Insurance Company, 582 F.3d 721 (7th Cir.2009), affirmed the prior decision of the United States District Court for the Southern District of Indiana, 588 F.Supp.2d 919 (S.D.Ind.2008), which was decided on a motion for preliminary injunction, seeking to enjoin John Hancock Life Insurance Company, and several other companies, from demanding a payment based on a deemed default. The most recent decision in the case was issued by the United States Court of Appeals for the Seventh Circuit and, like the decisions in AWG
and BB & T
, is not binding *336 on this court. Moreover, the posture of the case, the facts presented and the disposition in the Hoosier Energy
case are sufficiently dissimilar from the current case so that the Hoosier Energy
case has little, if any, bearing on the case currently before this court. Perhaps the only lesson to be learned from the Hoosier Energy
case is the acknowledgment of some risk to those involved in LILO or SILO transactions, in the event the banks involved fail and the monetary protections, which are part of the transactions, are implicated.
The District Court in Hoosier Energy
granted a preliminary injunction. The Seventh Circuit, reviewing the District Court action, stated that its appellate review “is deferential at the preliminary injunction stage, and we lack an adequate basis on which to disagree with the district court's assessment.” Hoosier Energy Rural Elec. Coop., Inc. v. John Hancock Life Ins. Co., 582 F.3d at 726. The only question for the Seventh Circuit was “whether Hoosier Energy has a plausible theory on the merits ... to justify exposing John Hancock to financial risks until the district court can decide the merits,” which it answered in the affirmative. Id. at 726; see also
The plaintiff, Hoosier Energy, is a cooperative made up of rural electric cooperative members, and is the owner of an energy plant, which does not earn significant profits. Hoosier Energy Rural Elec. Coop., Inc. v. John Hancock Life Ins. Co., 588 F.Supp.2d at 922. The defendant, John Hancock, was an investor in a SILO transaction. Id.
The action arose from the fact that after the credit crisis in 2008, Hoosier Energy was unable to find a suitable credit substitute for Ambac Credit Products, Inc., which controlled funds in the payment cycle and guarantees, given Ambac's declining credit rating. The defendant, John Hancock, “pulled the plug” on the transaction and requested an early termination payment from Hoosier Energy in the amount of approximately $120 million. Id. at 924–26. The plaintiff then sought “a preliminary injunction to enjoin defendants ... from making any demand or any payment pursuant to any assertion that a default has occurred and enjoining John Hancock from asserting that a default has occurred.” Id. at 922.
By way of introduction to the case, the District Court, with obvious distaste for the type of business transaction, but only a limited record, stated:
This case provides a case study of some of the worst aspects of modern finance. The case arises from an elaborate transaction that combines the sometimes toxic intricacies of credit default swaps and investment derivatives with a blatantly abusive tax shelter. Investment bankers and lawyers have made more than $12 million in fees for putting together the paper transaction known as a “sale in-lease out” or “SILO” transaction of an electrical generating plant. Although all parties have been making all payments required under the contracts, the transaction is now in crisis because credit rating agencies have downgraded the credit ratings of one of the parties.
Id. at 921.
The District Court granted the injunction, based on Hoosier showing “a reasonable likelihood of success on the merits on two independent theories for relief: the essential illegality of the Merom SILO transaction, and temporary commercial impracticability.” Id. at 927–28. Despite acknowledging repeatedly that, due to the injunctive nature of the case, the court's “findings of fact and conclusions of law are tentative because they are the result of an expedited process,” id. at 921–22, the court again reiterated its negative, first impression, of the deal:
This deal was an attempt to create an appearance of a sale but without any real economic substance.