In a lengthy opinion, the Tax Court voided the claimed tax benefits of an intricate sale-leaseback transaction involving foreign partners presumed immune from U.S. tax, and upheld an IRS income assessment of $87 million and a disallowance of $50 million in depreciation deductions. Andentech, LLC et al v CIR, T.C. Memo 2002-97.
Andentech (A), a Wyoming LLC, was formed by two Belgian citizens with $200,000 in borrowed funds. A purchased (subject to existing leases) 40 IBM mainframe computers from Comdisco (C), a large publicly traded computer leasing company, for $122 million. Consideration consisted of $15 million in cash (borrowed from UBS, a Swiss Bank) and $107 million in notes. Simultaneously, A leased the computers back to C. One month later, A sold a portion of rents due from C to Nationsbank for $87 million, which accelerated an $87 million portion of A’s note to C. This recognition event resulted in $87 million of current income to A, which flowed through to A’s Belgian partners, who claimed a treaty exemption.
Shortly thereafter, in a transaction intended to qualify under IRC § 351, the Belgian partners relinquished their interest in A in exchange for preferred stock (with a liquidating preference) in RD Leasing (RDL), a subsidiary of Norwest Equipment Finance Inc. (NEFI), itself a subsidiary of Norwest, a bank holding company traded on the NYSE. The change in ownership of A resulted in an acceleration of A’s senior $15 million note to UBS. NEFI then contributed $15 million in cash to RDL for RDL common stock and the UBS note was extinguished. On its 1993 return, A reported income of $87 million, all of which was allocated to (presumed) treaty-exempt Belgians. In 1994, A claimed $50 million in depreciation deductions.
The Tax Court, upholding the assessments, (i) disregarded A, finding that the Belgians, having received preferred stock in NEFI, were never at risk of losing their $200,000 investment, which was “comparably minimal” in comparison to the nonrecourse funds borrowed by A; (ii) (alternatively) disregarded the participation of the Belgians under the step-transaction doctrine; and (iii) found the sale-leaseback transaction a “sham,” fueled entirely by a desire to achieve tax benefits, with no economic substance and no profit potential.
The court was clearly concerned that the transaction “stripped” $87 million in rental income to treaty-exempt non-U.S. persons, and generated more than $50 million in depreciation deductions (utilized by Norwest on its consolidated return) with no offsetting rental income. A, moreover, seeking only to maximize deductions, had never “bargained” with C over the purchase price of the computers. This failure to negotiate demonstrated the lack of a business purpose other than obtaining tax benefits.
The court was also troubled by other factors, including (i) the failure of C to notify A (the “owner”), pursuant to the sales contract, that one end-user had exercised an option to purchase one of the computers; (ii) the large amount of nonrecourse debt, which indicated a lack of “economic substance”; (iii) “overvalued” residuals assumed by A, which cast into doubt the profit motive; and (iv) the insertion of other “entities” solely for “tax-avoidance” reasons.
While a treaty should not “shield” the taxpayer from the step-transaction doctrine, neither should a court substitute its judgment for that of Congress, which granted certain non-U.S. persons a treaty exemption. Assuming, arguendo, that an appeals court found the requisite profit potential, would reversal be warranted? If so, perhaps Comdisco and Norwest erred not in seeking tax benefits clearly accorded by treaty, but rather by pursuing them without the quid pro quo of imbuing the transaction with real risk of economic loss. Perhaps a sale-leaseback structured in part to obtain tax benefits but also evidencing economic risk and real profit potential would have survived Tax Court scrutiny. As the court emphasized, tax benefits alone do not evidence a business purpose.