Washington Metro and its Sale-Leasebacks--not just a drain on the federal fisc, but also a matter of life and death?

As all are undoubtedly aware, the Washington Metro experienced its worst-ever subway crash, resulting in nine deaths.  The crash involved an older model of rail car, one that the NTSB had asked the Metro system to phase out.  The system hadn't done so--and didn't plan to until 2015--, because they had entered into sale-leaseback arrangements on their assets, leaving them essentially with no option to upgrade without an infusion of cash from another source.  See Vaughn, Metro Delayed Upgrades Because of Tax Shelter, Wall St. J. (Jun 25, 2009); Henchman, D.C. Metro SILO Contract may have obligated them to run outdated railcars, Tax Foundation Tax Policy Blog (Jun 25, 2009).

Here's a couple of paragraphs from the Journal article.

Metro, the light-rail transit system of the District of Columbia that reaches into parts of Maryland and Virginia, was one of dozens of public-works agencies nationwide that entered into the leasing deals, known as sale-in, lease-out, or SILO, transactions. Under the deals, foreign banks bought railcars or other equipment from the public agencies, claimed millions in depreciation tax benefits, and then leased the equipment back to the agency.

Metro had entered into such an arrangement with 16 banks. It has unwound agreements with Bank of New York-Mellon, SunTrust Bank, Belgium's KBC Bank, Regents Bank and Norlease Inc. Metro reaped more than $100 million from the deals, which it used for capital investments, Ms. Kissal said.

In other words.  Metro entered into these sale-leaseback (SILO) transactions in respect of its assets with banks that wanted to lower their tax bills.  The municipality was acting as an accommodation party to the banks, much as foreign banks like Deutsche Bank, ABN-Amro and others have acted as accommodation parties to US corporations that want to reduce their US taxes. (See, e.g., GE's Castle Harbour deal--litigated under the name of "TIFD"--in which foreign banks arranged their financings, noted as such on the bank's books, to look like partnerships so that GE could refresh its depreciation deductions on fully depreciated equipment.  The banks were effectively paid a higher rate of interest than they would otherwise have commanded, as the fee for serving as an accommodation party in the tax shelter deal.). 

How did these deals work? Municipalities and their agencies are exempt from federal taxes so they don't get to use depreciation deductions to decrease federal income taxes.  But if a tax-exempt person (or, a person with lots of net operating losses that is therefore "tax indifferent")  "sells" its assets to a taxable bank (with a wink-wink-nod-nod) and then leases its assets back, the bank becomes the new "owner" of the assets.  The bank usually funds the "purchase" with a nonrecourse loan.  If recognized as the tax owner for federal income tax purposes, the bank can now claim depreciation deductions on the assets.  So the bank has rental income but interest deductions and depreciation deductions that result in a taxable loss in the early years of the transaction, resulting in lower taxes.  The tax-exempt person uses most of the money it receives to defease its obligations under the lease and other documents, but is left with a "profit" on the deal, amounting to a fee paid by the bank for helping it lower its tax liability--i.e., the fee amounts to a sharing of the tax benefit.

For a broad description of the world of sale-leasebacks as financings, see this GE Commercial Equipment Financing, Sales-leasebacks: Benefits and Challenges for both Healthy and Underperforming Companies, 2001.  For a description of SILO transactions between banks and municipalities, see, e.g.,  Luitjens, Sale in-Lease out (SILO) Transactions, Federal, State and Local Governments Newsletter, Jun 2004, at 3; Sandra Yip,  Credit Implications of IRS Scrutiny of LILO/SILO Transactions and proposed Accounting Guidance for U.S. Banks, Moodys, Feb. 2006 (has a good chart showing banks that entered into SILO deals).  

Congress took away the tax benefit of entering into new SILO transactions with tax-indifferent parties in the 2004 American Jobs Creation Act 2004, section 847.  After that, Treasury issued Notice 2005-13 to identify existing SILO transactions as "listed transactions" under the reportable transaction rules and to inform taxpayers that the government would challenge the purported tax benefits of taxpayers who had entered into SILO transactions prior to the 2004 Act .   The IRS developed a settlement initiative and settled with about 2/3 of the US corporations that had claimed tax benefits from SILO transactions (often for foreign rail or sewer systems).   See IRS Sees Strong Response to LILO/SILO Settlement Offer (Oct. 21, 2008).  The settlement initiative allowed banks keep 20% of the disallowed deductions if they got out of the SILO agreements by the end of 2008. The lowering of AIG's credit rating in the financial crisis last fall provided the foreign banks a useful trigger by causing a technical default by the municipalities whose obligations under the contracts were guaranteed by AIG.  See Transit Agencies in Bind Due to SILO Deals and AIG Collapse, Tax Foundation (Oct 30, 2008) (noting that the Washington Metro authority had sought an injunction in 2008 against a Belgian bank that was demanding $43 million in termination fees for the SILO deal it had financed because of the AIG collapse and technical default,, and including a list of transit agencies that entered into SILO transactions).

The Tax Foundation notes that "most of the agreements are now in a holding pattern, with transit agencies continuing to make payments and negotiating with the foreign banks that technically own the railcars purchased with public funds." DC Metro Silo contract (Jun 25, 2009).

(hat tip--Tax Prof and Concurring Opinions).

Comments

[Jack]

As usual an excellent presentation. One thing that is clear from the post is that the issue is so complex as to be nearly unintelligible to even a well educated person. Is this an example of corporate responsibility at its best? I can't figure out who the winners and losers are in this scenario,
other than those killed in the DC Metro crash.

[LindaMBeale]

The "winners" are the US or foreign corporate taxpayers (and their shareholders) who uset he deal to get tax attributes that lower their federal income tax burden ("buying" an asset with leverage and claiming depreciation and interest deductions in excess of rental income) and the US municipality who is essentially selling for a fee a tax attribute that is otherwise useless to it as a tax-exempt entity (the attribute is the ability to use depreciation deductions).

The losers are the federal fisc and the rest of American taxpayers, who have to pay more to make up for the very much lower corporate taxes.

[Aunt Deb]

This is the sort of thing I wish the media would report on. It seems to me that this story and the information in your post on UBS and American accounts in Swiss banks should get prominent coverage. But they simply don't appear, as far as I know.