Bond lawyers who have issued unusual tax opinions about bond-financed equipment or property in sale-in/lease-out and lease-in/lease-out transactions will soon go under the microscope of the Internal Revenue Service, an official said this week.
At issue, according to Charles Anderson, field manager of the IRS tax-exempt bond division, is the tax-exempt status of bonds used to purchase assets owned by municipalities and leased to private entities.
The IRS plans to investigate such transactions for violations of its private use and private payment or security requirements, which could affect the tax-exempt status of the bonds. Anderson said the agency will look at four or five so-called SILO and LILO deals predating Octobers corporate tax law, which prohibited private entities from using SILOs to claim federal tax deductions but did not address issues related to tax-exempt bonds.
In a SILO or LILO deal, a tax-exempt municipality sells or leases an asset such as transportation equipment to a private entity for cash. The private firm leases the asset back to the municipality and deducts the depreciation costs and interest expenses from its federal taxes as an owner of the asset. At the end of the lease term, the asset reverts back to the municipality for a fee in excess of the propertys then-fair market value.
SILO and LILO arrangements used to be a popular way for local governments to obtain funding for infrastructure and technology projects. A SILO transaction provides a private entity with tax deductions that the municipality cannot use because it is tax-exempt. The private entity treats the arrangement as a purchase and leaseback of property for federal tax purposes.
LILOs lease-in/lease-out deals have similar features but involve put or renewal options instead of the service contract provisions common in SILO deals.
The IRS is most concerned about what happens, from the standpoint of bonds tax exemption, when tax-exempt bonds finance the acquisition of a transferred asset. Certain tax opinions provided by bond lawyers after the appearances of unexpected cash windfalls from SILO transactions have caught the agencys eye, according to Anderson.
Some of the written opinions that we have seen dont make sense to us. When bond-financed equipment is sold, why arent the bonds redeemed? he said.
If there is a problem, we will address whether the tax opinions cause a [Section] 6700 issue at some level, Anderson added, referring to the section of IRS code used to penalize participants in abusive bond transactions.
The IRS new enforcement initiative comes after Octobers corporate tax bill essentially shut down SILOs by placing limitations on the deductibility of losses from future SILO agreements. Under the law, taxpayers entering into SILO arrangements cannot claim tax benefits as the purported owners of an asset purchased or leased from a municipality because they do not acquire tax ownership of the asset. Fifteen transportation deals that were pending at the time were grandfathered into the law.
After deductions for private entities were disallowed by the corporate tax bill, the Treasury Department in February said SILO deals are designed to exploit tax law by shifting tax benefits from parties that cannot use them to parties that can.
In conjunction with the IRS, the department designated SILOs and LILOs as listed transactions and abusive tax avoidance transactions. Taxpayers who enter into SILOs must now disclose their participation to the IRS.
Additionally, promoters of SILOs must maintain lists of investors and, in certain cases, register those transactions with the IRS.
On June 29, the IRS issued internal guidance to its agents on SILOs, instructing them to deny deductions for depreciation and interest expenses, and to assert penalties when taxpayers enter into abusive SILO transactions with tax-exempt entities.
The guidance outlined two specific scenarios for which benefits would be denied and penalties assessed. Both involve sale-leaseback transactions in which the private entities do not acquire and retain significant and genuine attributes of a traditional owner, including the benefits and burdens of ownership for federal tax purposes, according to the IRS.
Leasing transactions involving tax-exempt bond-financed equipment are still legal so long as a private party does not attempt to write off interest expenses and depreciation costs. But those tax issues are beyond the scope of the tax-exempt bond enforcement programs new, narrow focus, Anderson said.
The IRS intends to look at four or five SILO and LILO deals for evidence of problems. The agencys Office of Professional Responsibility could also see several municipalities come forward via Voluntary Closing Agreement Program requests.
Anderson said the agency would scrutinize SILO and LILO deals that occurred prior to 2004, due to timing concerns. For now, we probably will look at transactions that happened before the corporate tax bill, which didnt really address the effect on Section 103, he said. Thats something wed like to take a look at.
The IRS has not yet reached any conclusions about whether or not problems exist, Anderson said. He estimated that there were dozens of SILO and LILO transactions involving bond-financed equipment outstanding, especially ones that involved transportation equipment, but said the agency does not have a definitive number. And officials will have to look at transactions in the context of what equipment was leased and how much of it was bond-financed, using private-use and private-payment tests, he added.
There is no easy answer; thats why we have to take a look and see what kind of conclusions we can make, Anderson said. I think well have a snapshot of whats going on and that will enable us to talk about some of the issues that may or may not be there.
