PUBLISHED
UNITED STATES COURT OF APPEALS
FOR THE FOURTH CIRCUIT
BB&T CORPORATION,
Plaintiff-Appellant,
v.
UNITED STATES OF AMERICA,
Defendant-Appellee. No. 07-1177
EQUIPMENT LEASING AND FINANCE
ASSOCIATION,
Amicus Supporting Appellant.
Appeal from the United States District Court
for the Middle District of North Carolina, at Durham.
N. Carlton Tilley, Jr., District Judge.
(1:04-cv-00941-NCT)
Argued: February 1, 2008
Decided: April 29, 2008
Before WILLIAMS, Chief Judge, WILKINSON, Circuit Judge,
and Patrick Michael DUFFY, United States District Judge
for the District of South Carolina, sitting by designation.
Affirmed by published opinion. Chief Judge Williams wrote the opin-
ion, in which Judge Wilkinson and Judge Duffy joined.
COUNSEL
ARGUED: William Kearns Davis, BELL, DAVIS & PITT, P.A.,
Winston-Salem, North Carolina, for Appellant. Judith Ann Hagley,
2 BB&T CORP. v. UNITED STATES
UNITED STATES DEPARTMENT OF JUSTICE, Tax Division,
Washington, D.C., for Appellee. ON BRIEF: Alan M. Ruley, BELL,
DAVIS & PITT, P.A., Winston-Salem, North Carolina; Robinson B.
Lacy, Andrew S. Mason, Ann McLean Jordan, SULLIVAN &
CROMWELL, L.L.P., New York, New York, for Appellant. Anna
Mills Wagoner, United States Attorney, Greensboro, North Carolina;
Richard T. Morrison, Acting Assistant Attorney General, Gilbert S.
Rothenberg, Acting Deputy Assistant Attorney General, Richard Far-
ber, UNITED STATES DEPARTMENT OF JUSTICE, Tax Division,
Washington, D.C., for Appellee. Steven E. Grob, Edward A. Groo-
bert, Anthony Ilardi, Jill M. Wheaton, DYKEMA GOSSETT,
P.L.L.C., Bloomfield Hills, Michigan, for Amicus Supporting Appel-
lant.
OPINION
WILLIAMS, Chief Judge:
This appeal requires us to determine the tax consequences of a
complex financial transaction. BB&T Corp. entered into a "lease-
in/lease-out" transaction, often called a "LILO," hoping to reduce its
tax liability, but the Internal Revenue Service ("IRS") disallowed the
deductions it claimed. After BB&T sued for a refund, the district
court granted summary judgment in favor of the Government.
BB&T now appeals, arguing that the district court misapplied the
"substance-over-form" doctrine in determining that it could not claim
deductions for rent and interest under 26 U.S.C.A. §§ 162(a)(3) &
163(a) (West 2002 & Supp. 2007). Specifically, BB&T disputes the
district court’s conclusion that although the form of the transaction
involved a lease financed by a loan, BB&T did not actually acquire
a genuine leasehold interest or incur genuine indebtedness as a result
of the transaction. For the following reasons, we affirm.
I.
Because this is an appeal from the district court’s grant of summary
judgment in favor of the Government, we review the facts in the light
BB&T CORP. v. UNITED STATES 3
most favorable to BB&T. Anderson v. Liberty Lobby, Inc., 477 U.S.
242, 255 (1986).
A. Background.
The parties agree that the structure of the transaction at issue
matches that of a "typical" LILO, so we begin with a brief overview
of this complex transactional form.
In a typical LILO, a U.S. taxpayer leases property from a tax-
exempt entity and simultaneously leases that property back to the
owner. The tax-exempt owner’s sublease has a shorter term than the
taxpayer’s lease. Upon expiration of the shorter sublease, the owner
may exercise an option to buy back the remainder of the taxpayer’s
lease. Thus, in practical terms, the tax-exempt property owner contin-
ues to use the property during the sublease term just as it did before
the transaction and bears no risk of losing control of its asset(s).
The taxpayer, meanwhile, receives tax benefits by deducting the
rental payments on its lease, amortizing certain transaction costs, and,
depending on its financing arrangement, deducting interest payments.
Maxim Shvedov, CRS Report for Congress: Tax Implications of
SILOs, QTEs, and Other Leasing Transactions with Tax-Exempt
Entities 8 (2004). The tax benefits can be substantial and are achieved
primarily by "[a]ccelerating the transaction-related deductions and
delaying recognition of the corresponding revenues." Id. at 3. This
delayed recognition creates a tax deferral, which, in practice, will
function as a tax reduction due to the time value of money. Id. at 2,
8.
Generally, parties aim to structure a LILO in a way that essentially
eliminates any risk of economic loss while maximizing the deductions
that the taxpayer may claim. In this respect, the parties strive to
"strike a balance between limiting their exposure to risks on one hand,
and making sure the provisions do not disqualify the transaction as a
[genuine] lease [for tax purposes] on the other. Id. at 9; see also Mark
P. Gergen, The Logic of Deterrence: Corporate Tax Shelters, 55 Tax
L. Rev. 255, 259 n.19 (2002) (noting that LILOs are often structured
so that "there is no risk to any party, other than the tax law risk").
4 BB&T CORP. v. UNITED STATES
The chief tax risk associated with entering into a LILO is the possi-
bility that the IRS will deem the transaction a sham. LILOs have been
harshly criticized as abusive tax shelters that serve only to transfer tax
benefits associated with property ownership from tax-indifferent enti-
ties, which have no use for them, to U.S. taxpayers. See David P.
Hariton, Response to "Old ‘Brine’ in New Bottles" (New Brine in Old
Bottles), 55 Tax L. Rev. 397, 402 (2002) (noting one commentator’s
characterization of LILOs as abusive tax shelters and agreeing that
LILOs "purport[ ] to create tax benefits that Congress did not intend
to confer on anyone in respect of transactions that involve no business
investment at all"). In 1996, the IRS issued proposed regulations that
largely eliminated the tax benefits associated with LILOs; these regu-
lations became effective in 1999. Section 467 Rental Agreements, 61
Fed. Reg. 27,834 (proposed June 3, 1996); 26 C.F.R. § 1.467-1 to -5
(2007). Although the regulations did not apply to transactions entered
into before 1999, there remained a risk that the IRS would invoke
generally applicable tax law principles to disallow LILO-related
deductions. Despite the risk, many large financial institutions exe-
cuted LILO transactions between 1996 and 1999.
B. The Transaction.
1. BB&T Enters into the LILO.
BB&T, a U.S. financial services company based in the Southeast,
entered into the LILO at issue in this appeal with Sodra Cell AB
("Sodra"), the business division of a Swedish cooperative recognized
as one of the world’s leading wood pulp manufacturers.1 The property
at issue in the transaction is a 22% interest in the pulp manufacturing
equipment at one of Sodra’s mills (hereinafter "the Equipment").2 As
1
BB&T implemented the transaction through a trust, with Fleet
National Bank ("Fleet") acting as trustee. The parties agree that use of
the trust did not alter the tax consequences of the transaction, which
would have been the same had BB&T entered into the transaction
directly. Accordingly, we refer to both BB&T Corp. and the trust as
"BB&T" unless the context otherwise requires.
2
The remaining 78% interest in that mill’s pulp-manufacturing equip-
ment was the subject of a similar LILO between Wachovia Bank and
Sodra.
BB&T CORP. v. UNITED STATES 5
explained more fully below, the transaction, which remains on-going,
involves a lease and simultaneous (but shorter-term) lease-back, fol-
lowed by a series of options.
A promoter, Knight, Tallman & van Tol Capital Partners, L.L.C.
("KTV"), solicited BB&T to participate in the transaction. KTV mar-
keted the LILO to BB&T as a "tax driven structure" that would pro-
vide significant "[t]ax savings" while eliminating economic risk
through the use of defeased accounts.3 (J.A. at 173-186.)
Before entering into the LILO, BB&T performed an independent
evaluation of the transaction. This internal assessment described the
transaction as a "tax-driven deal" with an after-tax investment yield
"largely generated by tax benefits associated with accelerated tax
deductions" for rent. (J.A. at 187.) BB&T’s Chief Financial Officer
("CFO") conceded that "if there were no tax benefits" BB&T would
"[p]robably not" have moved forward with the LILO. (J.A. at 83.) The
CFO claimed, however, that BB&T was "intrigued by the transaction"
in part because it was "looking to grow loans and diversify [its] loan
portfolio." (J.A. at 996-97.)4
As part of the process outlined in the KTV promotion, BB&T had
the Equipment appraised. Deloitte and Touche, L.L.P. performed the
appraisal and prepared a report estimating the equipment’s useful life
and fair market value, as well as the value of the interest BB&T
would have in the equipment at different times.
Then, on June 30, 1997 (the "Closing Date"), BB&T and Sodra
executed the transaction through a series of interrelated agreements.
These agreements included, inter alia, a "Head Lease," a Sublease, a
Debt Payment Undertaking Agreement ("Debt PUA"), and an Equity
Payment Undertaking Agreement ("Equity PUA"). The Head Lease
and Sublease govern the parties’ interests in the Equipment, while the
Debt PUA and Equity PUA set forth fiscal obligations.
3
A defeased account is one in which funds are escrowed at a bank and
pledged to the appropriate party.
4
Interestingly, the transaction was not presented to BB&T’s commer-
cial leasing subsidiary, which played no role in initiating, evaluating,
approving, or managing the transaction.
6 BB&T CORP. v. UNITED STATES
2. Property Interests — the Leases.
Pursuant to the Head Lease, BB&T leased the equipment from
Sodra for a 36-year term. At the same time, under the terms of the
Sublease, Sodra leased the equipment back from BB&T for a 15.5-
year period that the parties refer to as the "Basic Lease Term." In
effect, the Sublease retracted BB&T’s rights and obligations under the
Head Lease for the duration of the Basic Lease Term, but provided
BB&T a right to make an annual inspection of the Equipment.5 Sodra
therefore continues to use and possess the Equipment as it did prior
to the transaction. Between 1995 and 1997, Sodra made major
improvements to the Equipment at a cost in excess of $125 million.
After the Closing Date (between 1997 and 2001), Sodra continued to
make improvements to the Equipment at a capital cost totaling $74.6
million.
When the Basic Lease Term expires on January 1, 2013, Sodra has
the option to buy back BB&T’s remaining interest under the Head
Lease. Sodra’s exercise of this option would terminate the transaction
in 2013, following the close of the Basic Lease Term.
If Sodra declines this "purchase option," BB&T has options of its
own. These options include (1) requiring Sodra to extend its Sublease
an additional 13.3 years to April 18, 2026 (meaning the Sublease
would then end 7.2 years prior to the expiration of the Head Lease)
(the "renewal option"); (2) leasing the equipment to a party other than
Sodra, subject to certain requirements concerning the terms of the
replacement lease and the identity and creditworthiness of the
5
The Head Lease gave BB&T the right to sole possession of the equip-
ment (subject to an annual inspection by Sodra), the right to operate the
equipment, and the right to retain all profits generated from its use of the
equipment. The Sublease turned the tables, granting Sodra the right to
sole possession of the equipment (subject to an annual inspection by
BB&T), the right to operate the equipment, and the right to retain all
profits generated by its use of the equipment.
Under the Head Lease, BB&T was required to maintain, service,
repair, and overhaul the equipment in accordance with certain standards,
and to bear all costs related the equipment’s use and maintenance. Under
the Sublease, however, Sodra took over these obligations.
BB&T CORP. v. UNITED STATES 7
replacement lessee (the "replacement lease option"); or (3) taking pos-
session of the equipment and using it at its own expense and for its
own benefit for the remainder of the Head Lease term (the "return
option"). (J.A. at 1841.)
3. Financing Obligations.
i. Closing.
As we previously noted, supra note 1, BB&T implemented the
transaction through a trust, with Fleet National Bank ("Fleet") acting
as trustee. The closing proved relatively straightforward: ABN-
AMRO Bank N.V. ("ABN"), one of the world’s most secure financial
institutions, assisted with the financing by depositing $68,008,236 in
BB&T’s trust account at ABN, while BB&T contributed $18,228,895
of its own funds to the trust account.6 Acting pursuant to the Debt
PUA, Fleet immediately transferred $68,008,236 (a sum equal to that
furnished by ABN), back to a defeased account at ABN (the "Debt
PUA account"). As a result of this irrevocable transfer, those funds
became an asset solely of ABN, unreachable by Sodra, BB&T, or
their respective creditors. Of the remaining $18,228,895, Fleet used
$12,000,193 to purchase treasury bonds, which were placed in an
account at Fleet. This purchase set in motion the Equity PUA. To
complete the closing, Fleet transferred $6,228,702 to Sodra as Sodra’s
"incentive for doing the deal." (J.A. at 325.)
On paper, however, the closing proved far more complicated. The
$68,008,236 ABN provided represented a non-recourse loan from one
of ABN’s subsidiaries, Hollandsche Bank-Unie N.V. ("HBU") (here-
inafter the "HBU loan"), the proceeds of which ABN was transferring
to BB&T’s trust account on behalf of HBU. Once placed in the trust
account, the HBU loan, coupled with BB&T’s $18,228,895 invest-
ment, became BB&T’s "Advance Head Lease Payment," the first
(and, as explained below, potentially the only) rent payment due
6
BB&T also paid an additional $5.53 million in gross fees in connec-
tion with the transaction, including an advisory fee to KTV and a
$220,000 payment to ABN for its role in the transaction. (J.A. at 50.)
KTV, in turn, paid BB&T a $1 million advisory fee in connection with
the transaction.
8 BB&T CORP. v. UNITED STATES
Sodra under the Head Lease. Only the $6,228,702 "incentive" pay-
ment actually went to Sodra because the Debt PUA obligated Sodra
to make a $68,008,236 payment to ABN, which was acting as "Debt
PUA Issuer" for the transaction, and the Equity PUA mandated a
$12,000,193 payment from Sodra to Fleet, which was serving as "Eq-
uity PUA Issuer." Accordingly, these funds were transferred to ABN
and Fleet on Sodra’s behalf, rather than paid to Sodra.
ii. Basic Lease Term (Closing Date-January 1, 2013).
The Head Lease calls for BB&T to pay rent to Sodra in two install-
ments. The Advance Head Lease Payment represents the first install-
ment, and a second payment of $557.8 million (the "Deferred Head
Lease Payment") is due in 2038, five years after the Head Lease
expires. BB&T thus will not make any rental payments during the
Basic Lease Term.
Moreover, although Sodra is required to make annual rental pay-
ments during this term, Sodra does not supply any additional funds
to satisfy this obligation. Instead, ABN, in its capacity 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 pay-
ments because BB&T assigned the right to receive rent from Sodra
to HBU as part of providing collateral for the HBU loan.7 Accord-
ingly, 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 cir-
7
To secure its obligation to satisfy the HBU loan, BB&T assigned to
HBU a lien on the Head Lease, Sublease, and BB&T’s right to rent pay-
ments from Sodra, as well as the right to payments under the Debt PUA.
The loan collateral specifically excludes what the transaction’s promoter
candidly termed the "real money" in the transaction, (J.A. at 175), the
approximately $12 million in government bonds placed in the Equity
PUA account.
BB&T CORP. v. UNITED STATES 9
cular intrabank transfer occurs. On its own books, therefore, ABN
treats the loan as an off-balance sheet transaction carrying zero risk.
In the meantime, the treasury bonds purchased by Fleet as Equity
PUA Issuer remain in an account at Fleet (the "Equity PUA
account").
iii. January 1, 2013 to the Transaction’s End.
a. Purchase Option.
If Sodra exercises its purchase option, the purchase would be
funded from the resources BB&T supplied at closing. ABN, as Debt
PUA Issuer, would fund part of the purchase price by making the
final payment under the Debt PUA on January 1, 2013, thereby also
retiring the HBU loan. Fleet, as Equity PUA Issuer, would pay the
remaining balance of the purchase price on Sodra’s behalf by dispers-
ing the funds from the Equity PUA account to BB&T in five pay-
ments made at specified times in 2013.8 Because Sodra would be
buying back all of BB&T’s interests and obligations under the Head
Lease, including the obligation to make the Deferred Head Lease Pay-
ment, BB&T would be relieved of the obligation to make that pay-
ment. The transaction would therefore end with Fleet’s final payment
to BB&T in 2013.
The practical effect of this scenario would be no different than if
BB&T had invested in the treasury bonds directly, except that BB&T
paid roughly $6 million to Sodra as incentive for participating in the
transaction, as well as various transaction fees, and would have
received tax deductions for rent, interest, and amortization of
transaction-related fees had the IRS not audited its tax return.
b. BB&T’s Options.
If Sodra declines the purchase option, and BB&T elects to renew
the Sublease, ABN, as Debt PUA Issuer, will still make the final pay-
8
The payments and maturity dates of the treasury bonds in the Equity
PUA account at Fleet are set to match the amount and timing of the funds
due BB&T under the Equity PUA.
10 BB&T CORP. v. UNITED STATES
ment under the Debt PUA, retiring the HBU loan. This payment will
still be considered made on Sodra’s behalf, but as a rental payment.
Sodra will also make annual rental payments each year of the
renewed sublease term, as well as additional payments at the begin-
ning of certain years and a deferred payment at the end of the
renewed sublease. Meanwhile, the treasury bonds in the Equity PUA
account will be reinvested and will serve as collateral for (and will be
available to apply to) Sodra’s rental payments.
The parties structured the transaction so that the rent from the
renewed sublease would grow at a predetermined rate and ultimately
equal the amount of the Deferred Head Lease Payment when it is due,
thereby allowing BB&T to fulfill that obligation without investing
additional funds. Moreover, even if interest rates are not as the parties
assumed and the sums BB&T has pledged as collateral for the
Deferred Head Lease Payment do not total $557.8 million in 2038,
Sodra has no recourse against BB&T for any deficiency.
If BB&T does not exercise the renewal option, Fleet will deliver
the funds in the Equity PUA Account to Sodra. The last payment
under the Debt PUA will also go to Sodra, meaning that BB&T would
be responsible for the final payment to retire the HBU loan.9 BB&T
would still be required to provide collateral for the Deferred Head
Lease Payment—in the form of rents from the replacement sublease
if it exercises that option, or an alternative such as a letter of credit
or guarantee should it choose the return option—and Sodra would still
have no recourse against BB&T for any shortfall in the Deferred
Head Lease Payment.
4. Looking Ahead: BB&T and Sodra’s Options.
Sodra has professed uncertainty as to whether it will exercise its
purchase option, and BB&T maintains that as a result, any of the
options made possible by the transaction could become a reality at the
close of the Basic Lease Term. BB&T has conceded, however, that
9
If, however, BB&T failed to pay the balance of the loan, Sodra would
be required to purchase the loan from HBU. In this circumstance,
Sodra’s only recourse against BB&T is limited to the collateral BB&T
provided for the HBU loan.
BB&T CORP. v. UNITED STATES 11
it entered into the transaction believing that "the most likely thing is
[Sodra] would not walk away from the property," given that Sodra
had been in business for years, making the purchase option or the
renewal option the most likely scenarios. (J.A. at 85.) Of course,
because the renewal option belongs to BB&T, not Sodra (and the
renewal lease would not encompass the full Head Lease term), Sodra
could ensure uninterrupted use and control of the Equipment only by
exercising the purchase option. An expert report commissioned by the
Government predicted this result, concluding that, for a number of
reasons, including dislocation costs and cost of replacing lost manu-
facturing capacity, the purchase option represented the only economi-
cally viable scenario for Sodra. Deloitte & Touche’s appraisal, in
contrast, deemed Sodra unlikely to exercise the purchase option, rea-
soning that the purchase price exceeded the value of the Head Lease
interest Sodra would acquire (apparently without taking into account
that because the option was prefunded by BB&T, Sodra would pay
nothing for its "purchase").10
The parties dispute whether BB&T can profit from the transaction
if it does not receive the tax benefits it hoped the LILO’s "tax driven
structure" would generate. BB&T contends that, under the purchase
option, it stands to make a minimum pre-tax net profit of
$12,555,532, and under the renewal lease option, it could net a mini-
mum pre-tax profit of $27,833,846. The Government disputes
BB&T’s methodology and has proffered an expert report concluding
that in the absence of the tax benefits generated by the transaction,
BB&T has no realistic expectation of realizing an economic gain.
10
In connection with the transaction, Sodra signed a Tax Indemnity
Agreement in which it agreed that for U.S. income tax purposes, neither
it nor any of its personnel would take a position inconsistent with the
characterization of Sodra as the owner, head lessor, and sublessee of the
Equipment. Before 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. (See
J.A. at 1736 (internal tax evaluation explaining, among other things, that
"[f]rom a value added tax law perspective, the transaction can be consid-
ered either based on its real meaning, that is, a financial transaction, or
based on its formal content, that is two lease relationships").)
12 BB&T CORP. v. UNITED STATES
There is no dispute, however, that the transaction maximizes
BB&T’s protection from loss. Sodra was required to set up a long-
term Letter of Credit for the protection of BB&T in the event that
something happened to cause the transaction to unwind early. And,
the structure of the transaction ensures that BB&T has the power to
recoup the investment in government bonds from the Equity PUA
account, if it so chooses. Finally, BB&T’s obligations — the HBU
loan and the Deferred Head Lease Payment — represent non-recourse
obligations, with only proceeds and interests derived from the transac-
tion itself pledged as collateral.
C. BB&T’s 1997 Tax Return.
In its 1997 tax return, BB&T reported rent from Sodra’s sublease
and amortization of an advisory fee as income. BB&T claimed deduc-
tions for: (1) $9,894,362 in rent paid to Sodra on the Head Lease; (2)
$2,820,925 in interest on the HBU loan, and; (3) amortization of
$137,943 in fees an expenses made in connection with the transaction.
When the IRS audited BB&T, it disregarded the reported income and
disallowed the deductions, resulting in a $9,416,592 increase in
BB&T’s taxable income for 1997.
D. Proceedings Before the District Court.
Following the audit, on October 14, 2004, BB&T filed a complaint
in the United States District Court for the Middle District of North
Carolina, seeking a refund of taxes it claimed to have overpaid.
Thereafter, BB&T and the Government filed cross-motions for sum-
mary judgment, and the district court granted summary judgment in
favor of the Government.
With regard to the rental payment, the district court concluded that
BB&T was not entitled to a deduction because even though the form
of the transaction was a lease and immediate sublease, in substance
BB&T had not acquired a genuine leasehold interest in the equip-
ment. Relying primarily on two cases from the United States Tax
Court, Alstores Realty Corp. v. Comm’r, 46 T.C. 363 (1966), and
Ashlock v. Comm’r, 18 T.C. 405 (1952), the district court reasoned
that "[w]here a conveyance of property is accompanied by retention
of the same interest in the property, only a future interest is con-
BB&T CORP. v. UNITED STATES 13
11
veyed." (J.A. at 1848.) The district court further reasoned that the
various obligations in the transaction were offsetting and that, when
those offsetting obligations were "collapsed" against each other, all
that remained was BB&T’s payment of transaction costs in a compli-
cated circle ending with an investment in government bonds. The
court concluded that the investment could have proceeded in an iden-
tical manner without the additional shuffling of paper.
Concerning the interest deduction, the district court concluded that
"[w]hen the intermediate payment steps are disregarded, which must
be done in order to consider the substance of the loan transaction and
not the form selected by the parties, it becomes clear that the loan
transaction is only a circular transfer of funds in which the . . . loan
is paid from the proceeds of the loan itself." (J.A. at 1858.) Accord-
ingly, it determined that the HBU loan did not constitute genuine
indebtedness, and BB&T was not entitled to an interest deduction.
BB&T timely appealed, and we have jurisdiction pursuant to 28
U.S.C.A. § 1291 (West 2006).
II.
A.
We review de novo the district court’s grant of summary judgment
to the Government, applying the same standards that the district court
was required to apply. See Laber v. Harvey, 438 F.3d 404, 415 (4th
Cir. 2006) (en banc). "Summary judgment is appropriate ‘if the plead-
ings, depositions, answers to interrogatories, and admissions on file,
together with the affidavits, if any, show that there is no genuine issue
as to any material fact and that the moving party is entitled to a judg-
ment as a matter of law.’" Id. (quoting Fed. R. Civ. P. 56(c) (West
1992)). We construe the evidence in the light most favorable to
BB&T, the non-moving party, and draw all reasonable inferences in
BB&T’s favor. Id.
11
IRS Revenue Ruling 2002-69, though not relied on by the district
court, takes the same view. Rev. Rul. 2002-69, 2002-2 C.B. 760.
14 BB&T CORP. v. UNITED STATES
We begin our discussion with a few familiar rules. A taxpayer, of
course, "has the legal right to decrease the amount of what otherwise
would be his taxes, or altogether avoid them, by any means which the
law permits." Bridges v. Comm’r, 325 F.2d 180, 183 (4th Cir. 1963).
A taxpayer may not, however, claim tax benefits that Congress did
not intend to confer by setting up a sham transaction lacking any
legitimate business purpose, or by affixing labels to its transactions
that do not accurately reflect their true nature. Accordingly, under the
"economic substance doctrine," a transaction may be disregarded as
a sham for tax purposes if the taxpayer "was motivated by no business
purposes other than obtaining tax benefits" and "the transaction has
no economic substance because no reasonable possibility of a profit
exists." Rice’s Toyota World, Inc. v. Comm’r, 752 F.2d 89, 91 (4th
Cir. 1985). Similarly, the doctrine of "substance over form" recog-
nizes that the substance of a transaction, rather than its form, governs
for tax purposes. See, e.g., W.Va. N. R.R. Co. v. Comm’r, 282 F.2d
63, 65 (4th Cir. 1960) ("It is well settled that in matters of taxation
substance rather than form prevails and that the taxability of a trans-
action is determined by its true nature rather than by the name which
the parties may use in describing it."). Because "an income tax deduc-
tion is a matter of legislative grace . . . the burden of clearly showing
the right to the claimed deduction is on the taxpayer." Interstate Tran-
sit Lines v. Comm’r, 319 U.S. 590, 593 (1943); see also Jack’s
Cookie Co. v. United States, 597 F.2d 395, 400 (4th Cir. 1979) (not-
ing the "settled principle that statutes authorizing deductions from
income for federal tax purposes are to be strictly construed").
BB&T claims that it has demonstrated its entitlement to deductions
for rent and interest under 26 U.S.C.A. §§ 162(a)(3) & 163(a) by
showing that the transaction has economic substance and a form that
must be respected for tax purposes. Thus, according to BB&T, neither
the economic substance doctrine nor the substance-over-form doctrine
prohibits BB&T from receiving the deductions it claimed. Given the
procedural posture of this case, we take BB&T at its word that the
transaction meets the criteria for economic substance set forth in
Rice’s Toyota World.12 Accordingly, we direct our attention to
12
We recognized in Rice’s Toyota World, Inc. v. Comm’r, 752 F.2d 89
(4th Cir. 1985), that whether a particular transaction is a sham lacking
BB&T CORP. v. UNITED STATES 15
BB&T’s argument that the form of the transaction, as evidenced by
the parties’ written agreements, accurately reflects its substance. We
first address whether BB&T has acquired a genuine leasehold interest
giving rise to a rent deduction under § 162(a)(3) before turning to the
question of whether BB&T paid "interest on indebtedness" within the
meaning of § 163(a).
B.
In applying the doctrine of substance over form, we "look[ ] to the
objective economic realities of a transaction rather than to the particu-
lar form the parties employed," Frank Lyon Co. v. United States, 435
U.S. 561, 573 (1978). As the Supreme Court has repeatedly
explained, "the simple expedient of drawing up papers" is not "con-
trolling for tax purposes when the objective economic realities are to
the contrary." Id. (internal quotation marks omitted). Accordingly, the
parties agree that to deduct payment on the Head Lease as a "rental"
payment under § 162(a)(3), BB&T must establish that it acquired a
genuine leasehold interest in the Equipment. See 26 U.S.C.A.
§ 162(a)(3) (permitting a deduction for "rentals or other payments
required to be made as a condition to the continued use or possession,
for purposes of the trade or business, of property to which the tax-
payer has not taken or is not taking title or in which he has no
equity").
In Frank Lyon Co., the Supreme Court provided guidance for
determining when the form of a leasing transaction should be
respected for tax purposes. In the course of analyzing a sale and lease-
back arrangement, the Frank Lyon Co. Court held that
where . . . there is a genuine multiple-party transaction with
economic substance which is compelled or encouraged by
business or regulatory realities, is imbued with tax-
economic substance "is an issue of fact." Id. at 92. The district court did
not address this factual question in its summary judgment ruling.
Because we need not address this issue to resolve this appeal and the par-
ties continue to dispute BB&T’s motives and profit potential, we too,
will leave the economic-substance question unanswered.
16 BB&T CORP. v. UNITED STATES
independent considerations, and is not shaped solely by tax-
avoidance features that have meaningless labels attached,
the Government should honor the allocation of rights and
duties effectuated by the parties. Expressed another way, so
long as the lessor retains significant and genuine attributes
of the traditional lessor status, the form of the transaction
adopted by the parties governs for tax purposes. What those
attributes are in any particular case will necessarily depend
upon its facts.
435 U.S. at 583-84 (emphasis added).
Thus, establishing that the Head Lease is, in substance, a true lease
for tax purposes requires a demonstration that "the lessor retains sig-
nificant and genuine attributes of the traditional lessor status." Frank
Lyon Co., 435 U.S. at 584. Accord Estate of Thomas v. Comm’r, 84
T.C. 412, 432 (Tax Court 1985) ("[T]he parties’ characterization of
the form of the transaction should be respected so long as the lessor
retains significant and genuine attributes of a traditional lessor."). We
are not persuaded that BB&T has made this showing with regard the
leases at issue here.
First, each right and obligation BB&T obtained under the Head
Lease it simultaneously returned to Sodra via the Sublease for the
duration of the Basic Lease Term, leaving BB&T only a right to make
an annual inspection of the Equipment. Second, although the transac-
tion ostensibly provides for the exchange of tens of millions of dollars
in rental payments during the Basic Lease Term, the only money that
has (and that may ever) change hands between BB&T and Sodra is
the $6,228,702 BB&T provided as Sodra’s "incentive for doing the
deal." (J.A. at 325.) Sodra has therefore not only continued to use the
Equipment just as it had before the transaction, it has done so without
paying anything to BB&T. Third, 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.13 BB&T
13
BB&T disputes the Government expert’s conclusion that the pur-
chase option represents the only economically viable scenario for Sodra
BB&T CORP. v. UNITED STATES 17
therefore does not expect Sodra to "walk away" from the Equipment.
(J.A. at 85.) Finally, regardless of whether Sodra bucks this expecta-
tion, 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.
In sum, the transaction does not allocate BB&T and Sodra’s rights,
obligations, and risks in a manner that resembles a traditional lease
relationship. See Alstores Realty Corp., 46 T.C. at 373 (holding that
because a "so-called space-occupancy agreement placed the two par-
ties’ rights, obligations, and risks as they would be allocated in a typi-
cal lease arrangement[,] . . . the arrangement was a lease in substance
as well as in form"); Swift Dodge v. Comm’r, 692 F.2d 651, 653-54
(9th Cir. 1982) (recharacterizing a lease as a conditional sales contract
because the parties’ obligations, legal rights, and risks were no differ-
ent than they would be in a conditional sale arrangement and "Swift
Dodge did not retain . . . significant and genuine attributes of a les-
sor"); Aderholt Specialty Co. v. Comm’r, 50 T.C.M. (CCH) 1101
(1985) (holding that a lease arrangement was a sale for federal tax
purposes because the transaction "divested [the lessor] of any signifi-
cant and genuine attributes of traditional lessor status" and "if the ben-
efits, obligations, and rights of the putative lessor are essentially those
of a secured seller, the substance of the arrangement must govern and
it will be deemed a sale for tax purposes" (internal quotation marks
omitted)).
Moreover, unlike the taxpayer in Frank Lyon Co., BB&T has failed
to show any "business or regulatory realities" that "compelled or
encouraged," id. at 583, the structure of the transaction at issue here,
by relying on the appraisal report it commissioned. The report predicted
that Sodra would be unlikely to exercise its purchase option because the
purchase option price (which the report analyzed as including the obliga-
tion to make the Deferred Head Lease Payment) exceeds the anticipated
value of the remaining term of the Head Lease. This prediction plainly
does not reflect the economic reality of the transaction, however, as
BB&T supplied the funds for the purchase, and Sodra need not pay itself
the Deferred Head Lease Payment. Because the "purchase" is free to
Sodra, price cannot be obstacle.
18 BB&T CORP. v. UNITED STATES
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. 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 struc-
turing the transaction in this manner.
In these respects, BB&T stands in sharp contrast to the lessor in
Frank Lyon Co. There, regulatory restrictions prevented the Worthen-
Bank & Trust Company ("Worthen") from financing the construction
of a new bank and office building through a conventional mortgage.
Worthen therefore arranged "an alternative solution" — a sale and
lease-back arrangement with Frank Lyon Co. — that would "provide
[Worthen] with the use of the building, satisfy the state and federal
regulators, and attract the necessary capital." Frank Lyon Co., 435
U.S. at 564. The arrangement did not create any tax benefits that
could not have been enjoyed had the transaction taken another form,
but it did result in a situation in which neither party "was the owner
of the building in any simple sense." Id. at 581. The Supreme Court
concluded that Frank Lyon should be treated as the owner for tax pur-
poses (and not merely a lender of money and conduit for mortgage
payments to a third party, as the government had argued) because
Frank Lyon was the only one whose capital was committed to, and
genuinely at risk in, the building. Id. at 577, 581. We are thus unper-
suaded by BB&T’s insistence that the same factors causing the
Supreme Court to respect the form of the transaction at issue in Frank
Lyon Co. are also present in this appeal. Compare Coleman v.
Comm’r, 16 F.3d 821, 826 (7th Cir. 1994) (distinguishing Frank Lyon
Co. and explaining that "the existence of the benefits and burdens of
ownership" is dispositive of whether a taxpayer will be treated as the
owner of leased property for tax purposes).
Likewise, BB&T’s argument that the district court "violated the
well-settled principle that the transaction in question must be viewed
‘as a whole,’" (Appellant’s Br. at 34 (quoting ACM P’ship v. Comm’r,
157 F.3d 231, 247 (3d Cir. 1998))), rings hollow. This principle does
not require courts to treat needless additional steps or "tax-avoidance
features that have meaningless labels attached," Frank Lyon Co., 435
U.S. at 584, as legitimate by virtue of their attachment to a substan-
BB&T CORP. v. UNITED STATES 19
tive transaction, such as a purchase or sale. To the contrary, this
aspect of the substance-over-form doctrine serves to prevent taxpay-
ers from manipulating the tax code in that way. As the Supreme Court
has explained,
the transaction must be viewed as a whole, and each step,
from the commencement of negotiations to the consumma-
tion of the sale, is relevant. A sale by one person cannot be
transformed for tax purposes into a sale by another by using
the latter as a conduit through which to pass title. To permit
the true nature of a transaction to be disguised by mere for-
malisms, which exist solely to alter tax liabilities, would
seriously impair the effective administration of the tax poli-
cies of Congress.
Comm’r v. Court Holding Co., 324 U.S. 331, 334 (1945); see also
Minn. Tea Co. v. Helvering, 302 U.S. 609, 613 (1938) (stating that
"[a] given result at the end of a straight path is not made a different
result because reached by following a devious path" and refusing to
accord tax effect to a "meaningless and unnecessary incident" inserted
into a transaction); Morgan Mfg. Co. v. Comm’r, 124 F.2d 602, 605
(4th Cir. 1941) (holding that a purported corporate reorganization "in
its essence was a sale" because the parties’ superficial compliance
with the applicable statutes achieved an "object [that] could have been
attained much more simply and easily" by a direct sale and "no expla-
nation of the adoption of the more cumbersome method [was]
offered").
Accordingly, we, like the district court, conclude 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 govern-
ment bonds. Sodra, meanwhile, maintains uninterrupted possession
and control of the Equipment, and has no economic incentive to cede
control to BB&T. Because the funds BB&T provided as the Advance
Head Lease Payment do not, in substance, constitute "rental[ ] . . .
payments required to be made as a condition to the continued use or
possession" of the Equipment, BB&T is not entitled to a deduction
20 BB&T CORP. v. UNITED STATES
under § 162(a)(3). Cf. W.Va. N. R.R. Co., 282 F.2d at 65 (upholding
disallowance of rental deduction where an increase in rent was not in
substance an ordinary and necessary business expense, but rather a
device through which a third party purchased the company’s stock);
Sun Oil Co. v. Comm’r, 562 F.2d 258, 269 (3d Cir. 1977) (concluding
that purported sale-leaseback was in substance a financing arrange-
ment between the parties and disallowing a claim for rent deductions
under § 162(a)(3)).
C.
We next consider BB&T’s entitlement to deduct interest paid on
the HBU loan from its taxable income. Under § 163(a), "[t]here shall
be allowed as a deduction all interest paid or accrued within the tax-
able year on indebtedness." 26 U.S.C.A. § 163(a). "Explaining that
‘interest’ is to be given its usual, ordinary and everyday meaning, the
Supreme Court has defined the term as compensation for the use or
forbearance of money." Halle v. Comm’r, 83 F.3d 649, 652 (4th Cir.
1996) (internal quotation marks and citation omitted). Generally, the
underlying "indebtedness" is defined as "an existing, unconditional,
and legally enforceable obligation for the payment of a principal
sum." Id. at 653 (internal quotation marks omitted).14 And, in keeping
with principles of substance over form, "deductible interest can only
accrue on genuine indebtedness." Halle, 83 F.3d at 652, 655 (empha-
sis in original); see also Midkiff v. Comm’r, 96 T.C. 724, 735 (1991)
("‘[I]ndebtedness’ must be indebtedness in substance and not merely
in form.").
14
Even if conditional, an existing, legally enforceable obligation may
constitute "indebtedness" if
(1) the contingency on which the obligation rests is beyond the
control of the party seeking the interest deduction, (2) the
amount of the indebtedness on which the interest accrued was
fixed as of the date that the interest began to accrue, and (3) the
payor’s liability to the payee is primary and direct.
Halle v. Comm’r, 83 F.3d 649, 653 (4th Cir. 1996). Also, "indebtedness
may be imposed on the purchaser of property when the benefits and bur-
dens of ownership shift before payment." Id. (internal quotation marks
omitted).
BB&T CORP. v. UNITED STATES 21
BB&T claims that it accrued deductible interest on the HBU loan
because, pursuant to the "Loan and Security Agreement" it signed
with HBU, BB&T has a legal obligation to repay the loan. According
to BB&T, the loan therefore necessarily constitutes genuine indebted-
ness, and the circularity of the parties’ obligations, the non-recourse
nature of the loan, and the other features of the transaction considered
by the district court are irrelevant. We cannot accept this contention.
As an initial matter, it is difficult to see how the "interest" BB&T
paid could represent "compensation for the use or forbearance of
money." Id. at 652 (internal quotation marks omitted). At the transac-
tion’s closing, ABN supplied the $68,008,236 for the loan on behalf
of HBU, and BB&T immediately returned $68,008,236 to ABN (as
Debt PUA Issuer). Accordingly, ABN, which treated the loan as an
off-balance sheet transaction, did not forbear any money during the
time period in which BB&T sought to claim interest deductions. And,
because the funds became an asset solely of ABN upon their transfer
to the Debt PUA account, BB&T could not use the money after the
transaction’s closing.
Moreover, concluding that BB&T may claim a deduction for "in-
terest . . . on indebtedness," 26 U.S.C. § 163(a), solely because it
signed loan documents would turn the substance-over-form doctrine
on its head. Instead, to determine whether the HBU loan constitutes
genuine indebtedness, we must "look beyond the parties’ terminology
to the substance and economic realities" of the transaction. Halle, 83
F.3d at 655 (internal quotation marks omitted).
In so doing, we agree with the Government and the district court
that the HBU loan does not constitute genuine indebtedness. Despite
the loan documents providing that BB&T has a legal obligation to
repay $68,008,236 to HBU, the transaction does not in fact require
BB&T to pay any money to HBU. BB&T, having immediately
returned a sum equal to the amount ABN supplied in furnishing the
HBU loan to a defeased account at ABN, has relieved itself of any
further repayment obligations. Cf. Hines v. United States, 912 F.2d
736, 741 (4th Cir. 1990) (concluding that a loan transaction was a
sham where "the lease and debt payments between the three parties
. . . were structured to be offsetting" and this "circularity meant that
the transaction became self-sustaining after the payments at closing
22 BB&T CORP. v. UNITED STATES
with virtually no further financial input necessary from any of the par-
ties").
BB&T makes much of the provision in its replacement lease and
return options (two of the three alternatives BB&T could pursue in
the event Sodra declined its purchase option) calling for: (1) ABN to
make the final payment under the Debt PUA to Sodra rather than
applying it toward the final payment on the HBU loan; and (2) for
BB&T to supply the final loan payment from another source. This
provision does not, however, create an unconditional obligation for
BB&T to make further payment on the loan. As discussed above,
Sodra has no economic incentive to decline the purchase option, and
despite commissioning an appraisal report predicting that Sodra
would consider the free purchase overpriced, BB&T does not expect
Sodra to surrender control of the Equipment. Moreover, even if
BB&T were given an occasion to select one of its three options fol-
lowing the conclusion of the Basic Lease Term, BB&T would not be
unconditionally obligated to make any further payment toward the
loan. BB&T would have to affirmatively choose to eschew its
renewal option for one of the two options triggering that burden.15
Finally, we are unpersuaded by BB&T’s argument that the district
court should have distinguished this case from one involving a mere
"circularization of funds which d[id] not amount to a loan," Felcyn v.
United States, 691 F. Supp. 205, 212 (C.D. Cal. 1988), on the ground
that, here, unlike in Felcyn, there was an actual delivery of the loan
proceeds. A party simply does not incur genuine indebtedness by tak-
ing money out of a bank and then immediately returning it to the issu-
15
In addition, were BB&T to make that choice, the loan is non-
recourse to BB&T. We see no economic incentive for BB&T to supply
the funds needed to fully repay the loan, given that the loan collateral
excludes what the transaction’s promoter described as the "real money"
in the transaction, (J.A. at 175), the approximately $12 million in govern-
ment bonds placed in the Equity PUA account. See Odend’hal v.
Comm’r, 748 F.2d 908, 912 (4th Cir. 1984) (disallowing interest deduc-
tion based on nonrecourse loan because although, in general, "a nonre-
course loan should be treated as a true loan," this is not the case where
the "taxpayer[ ] ha[s] no economic incentive to repay the obligation[ ]"
(internal quotation marks omitted)).
BB&T CORP. v. UNITED STATES 23
ing bank. This principle holds true even if the bank accepts the
bookkeeping responsibility of repaying itself out of the loan proceeds
for the duration of the loan. See Bridges v. Comm’r, 39 T.C. 1064,
1077, aff’d 325 F.2d 180 (4th Cir. 1963) (concluding that a transac-
tion "merely provided the ‘facade’ of a loan," as "there was no reason
to think that [the taxpayer] . . . would have been called upon to pay
the note out of his own funds or to put up additional collateral").
III.
In closing, we are reminded of "Abe Lincoln’s riddle . . . ‘How
many legs does a dog have if you call a tail a leg?’" Rogers v. United
States, 281 F.3d 1108, 1118 (10th Cir. 2002). "The answer is ‘four,’
because ‘calling a tail a leg does not make it one.’" Id. Here, BB&T
styled the LILO as a lease financed by a loan, but did not in substance
acquire a genuine leasehold interest or incur genuine indebtedness.
Accordingly, although we decline to resolve whether the transaction
as a whole lacks economic substance — that is, whether it has
"reached the point where the tax tail began to wag the dog," Hines,
912 F.2d at 741, we conclude that the Government was entitled to rec-
ognize that tail for what it was, not what BB&T professed it to be.
The judgment of the district court is therefore
AFFIRMED.