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Editor: Paul L. Caron
Pepperdine University School of Law

Wednesday, May 28, 2008

IRS Wins AWG SILO Tax Shelter Case

AWG Leasing Trust v. United States, No. 1:07-CV-857 (N.D. OH 5/28/08):

With this action, two large national banks dispute adjustments that the Internal Revenue Service (“IRS”) made to partnership federal income tax returns for the 1999, 2000, 2001, 2002, and 2003 tax years. In those adjustments, the IRS found that the banks’ partnership, the AWG Leasing Trust, mis-characterized a 1999 transaction as a $423 million purchase of a German waste-to-energy facility. The IRS says the transaction was a thinly-veiled tax dodge that attempted to skirt IRS and Congressional action directed to limiting transactions that had the purpose of transferring tax deductions for rental payments, depreciation, amortization, and interest payments from tax neutral entities. As a result, the IRS claims that the Plaintiffs owe approximately $88 million in taxes for the 1999 - 2003 tax years and will owe much more for subsequent years.

As will be described below, the banks say that they paid $423 million on December 7, 1999 to buy a waste-to-energy facility in Wuppertal, Germany and should be allowed to depreciate the Wuppertal plant. The banks argue that their contemporaneous lease of the facility back to the original owner under a very long-term triple-net lease and their grant of an option to repurchase the facility does not defeat their claim of ownership rights to the facility.

The banks also say that they should be allowed to deduct interest on the $368 million long-term non-recourse loans that they obtained from two German banks to finance the transaction even though the loan proceeds went to escrow-type accounts that the German entity could not access and that were committed to paying the German company’s lease payments and to providing sufficient funding to complete the option exercise.

In deciding this case, the Court makes two determinations. First, the Court decides whether the 1999 transaction has economic substance apart from the tax benefits at issue. Second, the Court considers whether the banks enjoyed the benefits and burdens of ownership of the Facility when the transaction pre-funded the repurchase of the facility and also required the original owner to repurchase the facility unless it met near-impossible conditions. As will be described, the Court finds that the transaction had some minimal substance apart from the tax benefit. However, the Court finds that the Plaintiffs never obtained an ownership interest sufficient to obtain a depreciable interest in the facility. The Court further concludes that the Plaintiffs are not entitled to deductions for interest paid or accrued on the underlying transaction loans because such loans do not constitute genuine indebtedness.

For the reasons that follow, this Court SUSTAINS the IRS’s determination that the Plaintiffs’ asserted tax benefits relating to the AWG transaction are improper. The Court DENIES the Plaintiffs’ claimed depreciation deductions under § 168, interest expense deductions under § 163(a), and amortization of transaction costs deductions. The Court also upholds the IRS’s imposition of accuracy-related penalties at the partnership level for substantial understatement of tax liability under § 6662(a)

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