Free Post Trial Brief - District Court of Federal Claims - federal

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No. 06-305 T (Judge Marian Blank Horn)

IN THE UNITED STATES COURT OF FEDERAL CLAIMS

CONSOLIDATED EDISON COMPANY OF NEW YORK, INC. & SUBSIDIARIES Plaintiff v. THE UNITED STATES, Defendant

UNITED STATES' OPENING POST-TRIAL BRIEF

NATHAN J. HOCHMAN Assistant Attorney General DAVID GUSTAFSON STEVEN I. FRAHM DAVID N. GEIER JOSEPH A. SERGI ADAM R. SMART KAREN M. GROEN Attorneys Tax Division Department of Justice Washington, D.C. 20044 (202) 616-3448 (telephone) (202) 307-0054 (facsimile)

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TABLE OF CONTENTS TABLE OF CONTENTS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ii TABLE OF AUTHORITIES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . v INTRODUCTION . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 PROCEDURAL BACKGROUND . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7 FACTUAL STATEMENT . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8 I. REGULATORY AND STATUTORY BACKGROUND . . . . . . . . . . . . . . . . . . . . . . . . . . . 8 II. DETAILED STRUCTURE OF THE EZH LILO TRANSACTION . . . . . . . . . . . . . . . . . 9 A. Transaction Cash Flows . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11 1. Lease Rent . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11 2. Debt Defeasance Account . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16 3. Equity Defeasance Account . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19 4. Sublessee Loan . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24 5. Letter of Credit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26 B. End-of-sublease options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29 1. EZH's purchase option . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29 2. CED's options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32 a. Sublease Renewal Option . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33 b. Retention Option . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 36 3. Final Basic Rent Payment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 39 III. THE PATH TO THE EZH LILO TRANSACTION . . . . . . . . . . . . . . . . . . . . . . . . . . . . 41 A. The History of CED . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 41

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B. CED'S Consideration of LILO Transactions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 48 C. Pursuit of the EZH LILO Transaction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 51 D. The Papering of the EZH LILO Transaction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 63 E. The Closing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 78 F. CED'S Pursuit of Other LILOs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 78 IV. RISK LEVEL OF THE EZH LILO TRANSACTION . . . . . . . . . . . . . . . . . . . . . . . . . . 83 ARGUMENT . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 86 I. BURDEN OF PROOF . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 86 II. PLAINTIFF IS NOT ENTITLED TO DEDUCTIONS FOR AN ADVANCE HEAD LEASE PAYMENT AND TRANSACTION COSTS IN 1997 . . . . . . . . . . . . . . . . . . . . . 88 A. The Transaction's Substance, Not Its Form, Determines Its Tax Treatment . . . 88 B. CED Failed to Acquire a Current Leasehold Interest in the EZH RoCa3 Facility . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 89 C. The Court Should Collapse Reciprocal Rights and Obligations . . . . . . . . . . . . 101 III. PLAINTIFF IS NOT ENTITLED TO AN INTEREST EXPENSE DEDUCTION RELATED TO THE PURPORTED LOAN . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 105 IV. THE TRANSACTION LACKS ECONOMIC SUBSTANCE . . . . . . . . . . . . . . . . . . . . 107 A. The Sham Transaction Doctrine and Economic Substance . . . . . . . . . . . . . . . . 107 B. Plaintiff's LILO Transaction Lacks Objective Economic Substance . . . . . . . . 113 1. Plaintiff Did Not Have a Reasonable Expectation of Profit, because the LILO Transaction Would Generate Huge Negative Cash Flows and Earnings on a Pre-Tax Basis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 114 Plaintiff Could Not Expect To Realize Economic Gains Typically Associated with Leveraged Leasing . . . . . . . . . . . . . . . . . . . . . . . . . . . 117

2.

C. Plaintiff's Asserted Business Purpose for Entering the LILO Transaction Is Not Credible . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 120 iii

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1.

Without the Tax Benefits Plaintiff would not have Entered into the EZH LILO Transaction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 121 Plaintiff's Purported Business Purpose Lacks Merit . . . . . . . . . . . . . . . 122

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CONCLUSION . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 131

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TABLE OF AUTHORITIES FEDERAL CASES ACM Partnership v. Commissioner, 157 F.3d 231 (3d Cir. 1998) . . . . . . . . . . . . . . . . . . . passim ASA Investerings Partnership v. Commissioner, 201 F.3d 505 (D.C. Cir. 2000) . . . . . . . . . . . 113 Aderholt Specialty Co. v. Commissioner, 50 T.C.M. (CCH) 1101, T.C. Memo (P-H) 1985-491 (1985) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 96 Alstores Realty Co. v. Commissioner, 46 T.C. 363 (1966) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 98 American Electric Power Co., Inc. v. United States, 326 F.3d 737 (6th Cir. 2003) . . . . . . . . . 87

American Electric Power Co., Inc. v. United States, 136 F. Supp. 2d 762 (S.D. Ohio 2001) . . 130 Ballagh v. United States, 331 F.2d 874 (Ct. Cl. 1964) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 123 Basic Inc. v. United States, 549 F.2d 740 (Ct. Cl. 1977) . . . . . . . . . . . . . . . . . . . . . . . . . . 122-123 BB&T Corp. v. United States, 2007 WL 37798 *7-8 (M.D.N.C. 2007) . . . . . . . . . . . . . . . passim Benedict v. United States, 881 F. Supp. 1532 (D. Utah 1995) . . . . . . . . . . . . . . . . . . . . . . . . . . 99 Big "D" Development Corp. v. Commissioner, 30 T.C.M. (CCH) 646 (1971) . . . . . . . . . . . . 101 Black & Decker Corp. v. United States, 436 F.3d 431 (4th Cir. 2006) . . . . . . . 109-110, 113, 118 Blue Flame Gas Co. v. Commissioner, 54 T.C. 584 (1970) . . . . . . . . . . . . . . . . . . . . . . . . . . . 101 Bridges v. Commissioner, 39 T.C. 1064 (1963) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 105, 107 Bussing v. Commissioner 88 T.C. 449 (1987) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 103 In re CM Holdings, Inc., 301 F.3d 96 (3d Cir. 2002) . . . . . . . . . . . . . . . . . . . . . . . . . . . . 110, 113 Casebeer v. Commissioner, 909 F.2d 1360 (9th Cir. 1990) . . . . . . . . . . . . . . . . . . . . . . . . . . . 108 Coleman v. Commissioner, 16 F.3d 821 (7th Cir. 1994) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 90 Coltec Industries, Inc. v. United States, 454 F.3d 1340 (Fed. Cir. 2006) . . . . . . . . . . . . . . passim

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Commissioner v. Court Holding Co., 324 U.S. 331 (1945) . . . . . . . . . . . . . . . . . . . . . . . . . . . . 108 Commissioner v. Duberstein, 363 U.S. 278 (1960) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 88 Commissioner v. Indianapolis Power & Light Co., 493 U.S. 203 (1990) . . . . . . . . . . . . . . . . . 100 Commissioner v. Tower, 327 U.S. 280 (1946) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 88 Compaq Computer Corp. v. Commissioner, 277 F.3d 778 (5th Cir. 2001) . . . . . . . . . . . . . . . . . 87 Deputy v. Du Pont, 308 U.S. 488 (1940) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 105 Dow Chemical Co. v. United States, 435 F.3d 594 (6th Cir. 2006) . . . . . . . . . . . 87, 110, 118-119 Estate of Thomas v. Commissioner, 84 T.C. 412 (1985) . . . . . . . . . . . . . . . . . . . . . . . . . . . . 91, 93 Felcyn v. United States, 691 F. Supp. 205 (C.D. Cal.1988) . . . . . . . . . . . . . . . . . . . . . . . . . . . 107 Frank Lyon Co. v. United States, 435 U.S. 561 (1978) . . . . . . . . . . . . . . . . . . . . . . . . . . . . passim Gilman v. Commissioner, 933 F.2d 143 (2d Cir. 1991) . . . . . . . . . . . . . . . . . . . . . . . . . . . 113, 118 Goldberg v. United States, 789 F.2d 1341, 1343 (9th Cir. 1986) . . . . . . . . . . . . . . . . . . . 108-109 Greenfield v. Commissioner, 44 T.C.M. (CCH) 1487 (1982) . . . . . . . . . . . . . . . . . . . . . . . . . . 101 Gregory v. Helvering, 293 U.S. 465 (1935) . . . . . . . . . . . . . . . . . . . . . . . . . . . . 87, 108-109, 123 Grodt & McKay Realty, Inc. v. Commissioner, 77 T.C. 1221 (1981) . . . . . . . . . . . . . . . . . . . . . 88 H.J. Heinz Co. & Subsidiaries v. United States, 76 Fed. Cl. 570 (Fed. Cl. 2007) . . . . . . . passim Helvering v. F. & R. Lazarus & Co., 308 U.S. 252 (1939) . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100 Helvering v. Gowran, 302 U.S. 238 (1937) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 87 IES Industries, Inc. v. United States, 253 F.3d 350 (8th Cir. 2001) . . . . . . . . . . . . . . . . . . . . . 113 INDOPCO, Inc. v. Comm'r, 503 U.S. 79, 84 (1992) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 87 International Paper Co. v. United States, 33 Fed. Cl. 384 (Ct. Cl. 1995) . . . . . . . . . . . . . . . . . 104 J. B. N. Telephone Co., Inc. v. United States, 638 F.2d 227 (10th Cir. 1981) . . . . . . . . . . . . . . . 87

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Jade Trading v. United States, 80 Fed. Cl. 11 (2007) . . . . . . . . . . . . . . . . . . . . . 87, 110, 113, 118 James v. Commissioner, 899 F.2d 905 (10th Cir. 1990) . . . . . . . . . . . . . . . . . . . . . . . . . . 110, 124 Keener v. United States, 76 Fed. Cl. 455 (Fed. Cl. 2007) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 109 Kirchman v. Commissioner, 862 F.2d 1486 (11th Cir. 1989) . . . . . . . . . . . . . . . . . . . . . . . . . 109 Knetsch v. United States, 364 U.S. 361 (1960) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 105, 113, 118 Kruesel v. United States, 63-2 U.S. Tax Cas. (CCH) ¶ 9714, 12 A.F.T.R.2d (RIA) ¶ 5701 (D. Minn. 1963) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 98 Kuper v. Commissioner, 533 F.2d 152 (5th Cir. 1976) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 123 Kwiat v. Commissioner, 64 T.C.M. (CCH) 327, T.C. Memo (RIA) 1992-433 (1992) . 95-96, 100 Lerman v. Commissioner, 939 F.2d 44 (3d Cir. 1991) . . . . . . . . . . . . . . . . . . . . . . . . . . . 109, 113 Long Term Capital Holdings v. United States, 330 F. Supp. 2d 122 (D. Conn 2004) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 113-114, 123 McCulley Ashlock v. Commissioner, 18 T.C. 405 (1952) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 98 N. Pacific Railway Co. v. United States, 378 F.2d 686 (Ct. Cl. 1967) . . . . . . . . . . . . . . . . . . . 123 National Starch & Chemical Corp. v. Commissioner, 918 F.2d 426 (3rd Cir.1990) . . . . . . . . 109 Neb. Department of Revenue v. Loewenstein, 513 U.S. 123 (1994) . . . . . . . . . . . . . . . . . . . 88, 89 Newman v. Commissioner, 902 F.2d 159 (2d Cir. 1990) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 87 Nicole Rose Corp. v. Commissioner, 320 F.3d 282 (2d Cir. 2003) . . . . . . . . . . . . . . . . . . 108, 123 Old Colony R. Co. v. Commissioner, 284 U.S. 552 (1932) . . . . . . . . . . . . . . . . . . . . . . . . . . . . 105 PACCAR, Inc. v. Commissioner, 85 T.C. 754 (1985) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 96, 104 Rexnord, Inc. v. United States, 940 F.2d 1094 (7th Cir. 1991) . . . . . . . . . . . . . . . . . . . . . . . . . . 96 Rice's Toyota World, Inc. v. Commissioner, 752 F.2d 89 (4th Cir. 1985) . . . . . . . . . 109-110, 113 Rickey v. Commissioner, 502 F.2d 748 (9th Cir. 1974) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 101

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Rogers v. United States, 281 F.3d 1108 (10th Cir. 2002) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 101 Rothschild v. United States, 407 F.2d 404 (Ct. Cl. 1969) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 87 Sacks v. Commissioner, 69 F.3d 982 (9th Cir. 1995) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 87 Saviano v. Commissioner, 765 F.2d 643 (7th Cir. 1985) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 109 Swift Dodge v. Commissioner, 692 F.2d 651 (9th Cir. 1982) . . . . . . . . . . . . . . . . . . . . . 91

TIFD III-E , Inc. v. United States, 459 F.3d 220 (2d Cir. 2006) . . . . . . . . . . . . . . . . . . 94-95, 104 United Parcel Service of America, Inc. v. Commissioner, 254 F.3d 1014 (11th Cir. 2001) . . 110 United States v. Ingalls, 399 F.2d 143 (5th Cir. 1968) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 101 Volvo Cars of N.A., Inc. v. United States, 92-2 U.S. Tax Cas. (CCH) ¶ 50,705 . . . . . . . . . . . . . 96 Waterman S.S. Corp. v. Commissioner, 430 F.2d 1185 (5th Cir. 1970) . . . . . . . . . . . . . . . . . . 123 Weller v. Commissioner, 270 F.2d 294 (3d Cir. 1959) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 108 Williams v. Commissioner, 1 F.3d 502 (7th Cir. 1993) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 98-99 Winn-Dixie Stores, Inc. v. Commissioner, 113 T.C. 254 (1999) . . . . . . . . . . . . . . . . . . . . 130-31 FEDERAL STATUTES AND REGULATORY MATERIAL Jobs and Growth and Relief Reconciliation Act of 2003 (P.L. 108-27) at § 302 . . . . . . . . . . . . . 8 64 Fed. Reg. 26845 (May 18, 1999) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8, 81 Rev. Rul. 72-543, 1972-2 C.B. 87 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 96 Rev. Rul. 99-14, 1999-1 C.B. 835, modified & superseded by Rev. Rul. 2002-69, 2002-2 C.B. 760 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8 Rev. Rul. 2002-69, 2002-2 C.B. 760 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8 CONGRESSIONAL MATERIALS H.R. Rep. No. 108-755 at 660, 662-663 (2004) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8

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06-305 T (Judge Marian Blank Horn)

IN THE UNITED STATES COURT OF FEDERAL CLAIMS

CONSOLIDATED EDISON COMPANY OF NEW YORK, INC. & SUBSIDIARIES Plaintiff, v. THE UNITED STATES, Defendant.

UNITED STATES' OPENING POST-TRIAL BRIEF

INTRODUCTION This case concerns whether Plaintiff is entitled to certain tax deductions in connection with the participation of its subsidiary, Consolidated Edison Development ("CED"), in a leasein, lease-out (LILO) tax shelter. Plaintiff, a United States taxpayer, through a CED, purported to simultaneously lease a minority interest in a power facility, the RoCa3 Facility, from its owner, N.V. Electriciteitsbedrifj Zuid-Holland ("EZH"), under a head lease and lease the property back to EZH under a sublease. After the close of the transaction, EZH (or its successors) continued to operate the RoCa3 Facility and retained all of the benefits and burdens associated with the facility's use and ownership. Nevertheless, on its federal income tax return, Plaintiff reported

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rental income and far greater tax deductions for purported rent, interest, and amortized transaction costs in connection with the EZH LILO Transaction. The Internal Revenue Service disallowed the deductions and disregarded the claimed rental income. Plaintiff then paid the resulting deficiency, and filed this suit for a tax refund.1 The specific substantive issue raised in this refund suit is whether Plaintiff is entitled to deductions for rent, interest, and transaction costs it asserts were incurred in 1997 in connection with the EZH LILO Transaction. As discussed more fully below, Plaintiff's claimed tax deductions are improper for three reasons. First, looking at the EZH LILO Transaction as a whole reveals that Plaintiff did not, in substance, acquire a present leasehold interest in the RoCa3 Facility. Second, Plaintiff did not incur genuine indebtedness in connection with the deal. Third, and alternatively, the Transaction should be disregarded under the economic substance doctrine. Plaintiff bears the burden of proof on all these issues. The general structure of the transaction is as follows: The EZH LILO Transaction was carried out by a series of agreements, whereby a trust acting for CED (a subsidiary of Plaintiff) purported to lease a minority interest in the RoCa3 Facility, located in the Netherlands, from a foreign power company, EZH, for a period of 43.2 years, and simultaneously purported to sublease it back to EZH for a period of 20.1 years. (Joint Stipulation of Fact (hereinafter "Stip.") ¶¶ 104, 113, 135). After the papers were executed, EZH continues to operate and maintain the RoCa3 Facility, just as it did prior to entering into the Transaction. (Tr. 1343 (Holzman)).

The amount directly at issue in this case is the tax impact of the LILO shelter for only two weeks ­ $328,066. The real amount is far greater. The shelter is expected to last twenty years and the amounts of tax benefits claimed in subsequent years are and will be very substantial. 2

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CED partially financed its purported upfront rental payment in the EZH LILO Transaction through a purported non-recourse loan of $81 million from a foreign bank, Hollandsche Bank-Unie N.V. ("HBU"), a subsidiary of ABN-AMRO Bank N.V. ("ABN AMRO"). (Stip. ¶¶ 117, 131). Nevertheless, the entirety of the purported non-recourse loan never left the ABN AMRO corporate umbrella, as the proceeds were first placed in an account at ABN AMRO and, after a series of successive, circular transfers, were simply used by ABN AMRO to pay down the purported non-recourse loan provided by its corporate subsidiary, HBU. (Stip. ¶¶ 126, 127, 187, 189, 198, 199). Payments from the funds in the ABN AMRO account (which served as the Debt Defeasance Account and bore the same interest rate as the purported non-recourse loan) matched exactly the scheduled repayment of the purported non-recourse loan, and thus were designed to be sufficient to satisfy all of CED's payments on the purported nonrecourse loan. (Stip. ¶¶ 118, 188, 199; Tr. 1272 (Holzman)). In other words, CED simply received the funds from HBU and caused them to be transferred them right back to HBU's parent company, who agreed to use those same funds to pay back the purported loan by HBU. The remainder of CED's supposed initial rent payment was funded by a $39 million purported equity investment, but EZH was required to use approximately $31 million of that sum to purchase zero risk U.S. Treasury STRIPS with a predetermined maturation amount that matched CED's entire expected return from the transaction. (Stip. ¶¶ 208-210; Tr. 2174-75 (DePlautt); Tr. 3738-39, 3875-76 (Bent); DX 20194, Bates 25120). These Treasury STRIPS were placed in an investment account (which served as the Equity Defeasance Account) (Stip. ¶ 213), pledged to Plaintiff (and expressly not pledged to the lending institutions involved in the transaction), and could not be withdrawn by EZH. (Stip. ¶¶ 218, 219; Tr. 1447 (Holzman)).

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EZH also allocated approximately $1.4 million of the equity investment to purchase a standby letter of credit to virtually eliminate any risk to CED of recovering its investment and expected return. (JX 330, Bates 7110 (report from pricing run reflecting letter of credit allocation); DX 20193, Bates 25093). EZH retained the remaining approximately $6 million of the equity investment as its fee for participating in the transaction. (Tr. 3706, 3718-19 (Bent); DX 20193, Bates 250872). At the end of the initial 20 year term, the operative documents provided that EZH had the option, the Sublease Purchase Option, to terminate the entire transaction for a preset purchase price, which price would be satisfied by the maturity value of the Treasury STRIPS and the remaining funds in the Debt Defeasance Account. (Stip. ¶¶ 165, 235; DX 20035, Bates 21361; DX 20195, Bates 25190). In other words, EZH could end the Transaction without cost by electing to have ABN AMRO credit to HBU the remainder of the funds securing the nonrecourse loan, and transfer back to CED the Treasury STRIPS purchased with CED's equity investment at the beginning of the transaction. EZH would keep its fee and CED would have

As explained in Stipulation ¶¶ 208 and 209 n.9, the final pricing run (conducted after the close of the transaction and never changed by Cornerstone (CED's advisor) to match the amount identified on JX 372) reflects that the amount used to purchase the Treasury STRIPS is $30,083,052.77; JX 372 indicates the amount used to purchase the Treasury STRIPS was $31,252,643.73. The difference in these amounts accounts for the difference in the projection of the Government's expert in equipment lease transactions (including the structuring, arranging and negotiation of those transactions), Mr. Paul Bent, of a $7.5 million fee to EZH at closing (DX 20193, Bates 25093), versus the approximately $6 million fee listed above. (Tr. 3707 (Bent)). In any event, the difference does not impact the mechanics of the Transaction, except to the extent it results in the computation of a different fee to EZH. With respect to the designation of expertise sought for Mr. Bent, as well as the other experts proffered by Defendant in this case (Drs. LaRue (Tr. 5045-46 (LaRue)) and Thomas (Tr. 4473-74 (Thomas)) and Mr. Ray (Tr. 4707 (Ray)), the Government sought these designations from the Court because of the nature of the assignment each expert was given in relation to this case. (Tr. 5373-74). 4

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claimed tax deductions, without other real economic effect. (Tr. 3720-23 (Bent); DX 20194, Bates 25142). At least for the first 20 years, CED's return from this transaction was essentially the result of an investment in U.S. Treasury STRIPS (wrapped in the complicated artifice of a purported lease transaction) and its tax deductions. (Tr. 3738 (Bent)). The investment in Treasury STRIPS is something that CED could have done on its own, without sinking millions in transaction costs (Stip. ¶ 106; JX 508; JX 890; JX 892; JX 934; JX 1109, Bates 16272) to generate tax benefits by creating the appearance of a lease transaction. Further, CED's return from the EZH LILO Transaction is essentially riskless. (See DX 20193, Bates 25061 (noting that the defeasance mechanisms employed in the EZH LILO Transaction virtually assured CED's return from the transaction); JX 388, Bates 8021 (noting transaction is "fully defeased"); JX 397, Bates 8123 (noting that EZH's obligations to CED are fully secured by the U.S. Treasury STRIPS and letter of credit) and Bates 8124 (noting that in the event of default by EZH, CED can simply draw on the U.S. Treasury STRIPS and letter of credit to obtain its expected return); Tr. 3736-37, 3807 (Bent)). The EZH LILO Transaction is structured for tax purposes to appear that EZH would not necessarily exercise the Sublease Purchase Option at year 20 and end the Transaction.3 (See Tr. 1978 (Muoio) (noting that the purchase option price was set above fair market value for tax purposes); JX 329, Bates 7065 (Shearman & Sterling letter discussing requirement that the purchase option price must be set above market value)). Thus, the transaction documents provided that in the event EZH did not exercise the Sublease Purchase Option, subject to certain

A tax indemnity agreement entered into by EZH specifically prohibited a formal agreement or arrangement whereby EZH would be required to exercise the Sublease Purchase Option. (Stip. ¶ 280-281; JX 9, Bates 676-77). 5

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prerequisites, CED had the right to require EZH to renew the sublease for another 16.5 years ("the Sublease Renewal Option"), or to require EZH to return the undivided lease interest to Plaintiff for the duration of the lease term ("the Retention Option"). (Stip. ¶ 169). Even assuming that EZH does not exercise the Sublease Purchase Option, CED's total return on its investment would be assured because it could exercise its renewal option, and EZH would be required to reinvest the money arising from the maturation of the original Treasury STRIPS in a similar investment vehicle that would have a maturity date towards the end of the lease term, simply deferring the riskless return for CED until the end of the 44 year lease term. (JX 397, Bates 8121 ("If the utility did not purchase the plant at year 20 the trust [for the benefit CED] would have the option to . . . require the utility to re-lease the plant for an additional 17 years at prices that would assure CED of its expected return."); JX 390 ("In either case [comparing EZH's exercise of the Sublease Purchase Option and CED's exercise of the renewal option], CED will receive sufficient funds from the EZH Sub-lessee (as rent and/or proceeds from the sale of the head lease pursuant to the [Sublease Purchase Option]) to pay-off the third party loans, recover its equity investment, and earn a return.")). While Plaintiff will claim that in such a situation it will be responsible for making a large back end rental payment in year 44, in fact, such a payment is non-recourse to Plaintiff and is made up of a series of offsets that require no additional deposit of funds and is entirely funded by Plaintiff's original equity. (Tr. 3744-47, 3920-21 (Bent); Tr. 1292-95 (Holzman); Tr. 5064-65 (LaRue); JX 130, Bates 3160; JX 555, bates 9961; DX 20193, Bates 25072-73; DX 20199, Bates 25337, n.22). Alternatively, as will be demonstrated below, the EZH LILO Transaction was entered into with the expectation and understanding that EZH would, in fact, exercise the Sublease Purchase Option and terminate the

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transaction during year 20, never reaching this back end payment. (See JX 1142, Bates 16776; JX 3904, Bates 8029 (noting that it is questionable that this back end payment will ever be made)). PROCEDURAL BACKGROUND On its consolidated U.S. Corporate Income Tax Return (Form 1120) for taxable year 1997, Plaintiff reported rent income received in the EZH LILO Transaction and it deducted rent, amortized transaction costs, and interest expense resulting from the Transaction. Specifically, Plaintiff reported amounts characterized as rental income ($399,693) and deducted amounts characterized as rental expenses ($1,072,652), amortization of transaction costs ($9,698), and interest expenses ($254,954) related to a purported property interest and indebtedness incurred in connection with the EZH LILO Transaction, for a net loss of $937,331. (Stip. ¶¶ 299-300). Upon audit of Plaintiff's 1997 federal income tax return, the Internal Revenue Service ("Service") disregarded the income, and disallowed the deductions, reported by Plaintiff from the EZH LILO Transaction. The Service's proposed adjustments in connection with the EZH LILO Transaction resulted in an increase of $937,331 in Plaintiff's taxable income for 1997. As a result of its proposed adjustments, the Service assessed against Plaintiff a deficiency for 1997 in the amount of $328,066. Plaintiff paid this amount and filed a claim for refund (Form 1120X) with the Service on December 2, 2005. The Service denied the claim, and on April 19, 2006, Plaintiff filed the instant suit seeking a refund of the amount of the deficiency. (Stip. ¶¶ 297306).

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FACTUAL STATEMENT I. REGULATORY AND STATUTORY BACKGROUND This case concerns the propriety of certain tax deductions that Plaintiff claimed as a result of its participation in a LILO tax shelter. In 1999, the Service advised taxpayers that it would disallow under the economic-substance doctrine the rent and interest-expense deductions claimed in LILOs. Rev. Rul. 99-14, 1999-1 C.B. 835, modified and superseded by Rev. Rul. 2002-69, 2002-2 C.B. 760. The Service later ruled that it also would deny those tax benefits under the substance-over-form doctrine. Rev. Rul. 2002-69, 2002-2 C.B. 760.5 Because Congress considered LILOs and related abusive shelters to be a widespread problem, it amended the Code in 2004 to prophylactically eliminate them by statute, leaving to the Service the responsibility to challenge such transactions (using common-law doctrines) entered into prior to the law's effective date. Jobs and Growth and Relief Reconciliation Act of 2003 (P.L. 108-27) at § 302. As the legislative history to those amendments provides, the amendments were "not intended to affect the scope of any other present-law tax rules or doctrines applicable to purported leasing transactions," and "[n]o inference is intended regarding the appropriate present-law tax treatment of transactions entered into prior to the effective date." H.R. Rep. No. 108-755 at 660, 662-663 (2004).

As a practical matter, taxpayers (including Plaintiff (Tr. 2035-36 (Muoio))) stopped engaging in LILOs after May 1999, when the Service adopted final Section 467 Treasury Regulations, which treat rent prepayments as loans and eliminate the tax benefits sought by parties entering into LILO Transactions. See 64 Fed. Reg. 26845 (May 18, 1999). 8

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II.

DETAILED STRUCTURE OF THE EZH LILO TRANSACTION EZH and CED (through a wholly owned subsidiary, Consolidated Edison Leasing

("CEL"), by way of a trust6) implemented the EZH LILO Transaction by executing a series of interrelated agreements. (Stip. ¶ 104). Under these agreements, EZH purported to lease a 47.47% interest in the RoCa3 Facility to CED for 43.2 years (i.e., from December 15, 1997 through February 24, 2041). (Stip. ¶ 113). CED simultaneously subleased its interest in the RoCa3 Facility back to EZH for 20.1 years (the "Sublease Basic Term"). (Stip. ¶ 135). At the end of the Sublease Basic Term (i.e., January 2, 2018), EZH can exercise the (prefunded by CED) Sublease Purchase Option to purchase CED's leasehold interest. (Stip. ¶ 165; Tr. 1326-29 (Holzman); Tr. 3047 (Mintun) (noting that one of the purposes of the defeasance accounts was to provide sufficient funds for EZH to exercise the Sublease Purchase Option); Tr. 3720-22 (Bent); JX 329, Bates 7063; JX 766, Bates 12462; DX 20193, Bates 25081-82; DX 20202, Bates 25384). If EZH does not exercise its prefunded Sublease Purchase Option, CED can, subject to fulfilling certain requirements, exercise the Sublease Renewal Option, renewing EZH's sublease until 2034 (the "Sublease Renewal Term") (Stip. ¶¶ 136, 169-78) or exercise the Retention Option, electing to have EZH return its 47.47% interest in the sublease to CED for the remainder of the lease term (i.e, through 2041). (Stip. ¶¶ 179-80).

For ease of reference this brief will treat CED as the party to the transaction unless the need to distinguish the trust and/or CEL arises in a specific instance. 9

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To this day, EZH7 owns and operates the RoCa3 Facility as if the LILO Transaction never occurred.8 As was the case prior to the Transaction, EZH has maintained possession of the RoCa3 Facility, continues to operate the facility in the normal course of its energy generation business, invests in major capital improvements to the RoCa3 Facility, remains responsible for all costs associated with its use and maintenance, and retains all of the income generated from the operation of the RoCa3 Facility. (Stip. ¶ 137; see Tr. 1343 (Holzman); JX 352, Bates 7476 (noting that the successor to EZH has worked very aggressively to improve efficiency and productivity); JX 369 and JX 876, Bates 13723 (installation of remote control systems in the Control Room); JX 370 (RoCa3 upgrade to GT brushseals)). Conversely, as long as EZH's sublease rent is "paid," CED cannot use or possess its leasehold interest in the RoCa3 Facility until 2018, and then only if EZH abandons its Sublease Purchase Option and CED complies with

In or about January 2000, EZH, through a series of mergers and stock purchases, became E.On Benelux Generation n.v., a subsidiary of E.On Energie A.G. a German energy company. (Stip. ¶¶ 69-72; JX 292; JX 293; JX 294; JX 295). However, for ease of reference, EZH and its successor entities will be referred to as EZH throughout the brief unless it is necessary to refer to the successor entity by its specific name. In an effort to claim EZH undertook significant obligations by entering into the EZH LILO Transaction, Plaintiff will likely claim that EZH is under various requirements to maintain the RoCa3 Facility in a certain manner, provide yearly officer's certificates concerning its operations, maintain other logs and reports in its business, and maintain insurance on the facility. However, a close look at these requirements reveals that they effectively impose no greater burden on EZH than it has as an owner. For example, EZH must only maintain insurance of the same type it maintains on other facilities it operates. (JX 4, Bates 417). Similarly, EZH is required to use the same maintenance practices it uses at its other facilities. (JX 4, Bates 399). Further, many of the requirements concerning maintaining of reports only apply if EZH is already maintaining such reports. (JX 4, Bates 404; Stip. ¶ 148). Finally, the annual officer's certificate (see JX 367) is essentially a one page document with minimal information, attaching EZH's annual report created for shareholders ­ a de minimis undertaking that is simply insufficient to justify Plaintiff's assertions. Simply put, EZH undertook essentially no responsibilities greater than it already held as owner of the RoCa3 Facility. (See DX 20193, Bates 25087). 10
8

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all of the requirements to exercise the Retention Option. (Stip. ¶ 180; Tr. 559-62 (Burke)). Further, CED cannot actually use or possess the RoCa3 Facility itself, because it possesses only a 47.47% leasehold interest, and the remainder of the facility (the majority share) is subject to a LILO transaction with Banc One Leasing Corp. (Stip. ¶ 58 n.2; JX 402, Bates 8143; Tr. 2867 (Mintun)). Because of the operation of the "Control Documents," which set forth the rules in the event EZH does not exercise its prefunded Sublease Purchase Option, CED, as minority leaseholder, has no power to insert itself as the operator of the RoCa3 Facility even if, for the sake of argument, EZH chose not to exercise its prefunded Sublease Purchase Option.9 (Stip. ¶¶ 266-68; JX 11, Bates 737; see also Tr. 3980 (Bent)). A. Transaction cash flows 1. Lease Rent

The Lease Agreement required CED to pay rent to EZH in two installments: $120.1 million advance rent due (the "Initial Basic Rent Payment") on the closing date, and $831.5 million deferred rent, theoretically due in 2041. (Stip. ¶ 116) For tax purposes, the $120.1 million advance rent was allocated to the first five years of the lease term, and the deferred $831.5 million rental payment was allocated to the remaining years of the transaction on an undiscounted basis, serving as the basis for Plaintiff's claimed rental deductions in each of the

Thus, CED's use of its leasehold interest in the case of exercise of the Retention Option would be limited to obtaining its share of the output of the RoCa3 Facility (offset by its paying its share of the operation and maintenance expenses associated therewith) (Tr. 2250 (DePlautt); see Tr. 1393 (Holzman)), with the specifics of these future contingencies remaining undefined in large part. (See JX 11, Bates 738, 747). Further, as explained by Defendant's expert, Mr. Bent, the combination of the Access Agreement and the Control Documents implies that CED can only require EZH to wheel an amount energy from the facility for which it already has an agreement in place to sell. (Tr. 3932-35 (Bent)). 11

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respective years. (Stip. ¶ 120; see Tr. 1360-64 (Holzman)). As shown below, CED's obligation to make the $831.5 million payment in 2041 is eliminated or offset by other rights and obligations under the operative documents, and CED will not be required to make any further investment in the transaction beyond its initial equity investment. (See infra at 39-40; DX 20193, Bates 25071-73). CED paid the $120.1 million Initial Basic Rent Payment with an $80,792,270.36 non-recourse loan from HBU (the "Lender's Commitment"), and $39,320,000.00 of its own money (the "Investor's Commitment").10 (Stip. ¶ 117). HBU is a wholly-owned subsidiary of ABN AMRO. (Stip. ¶ 131; JX 401; Tr. 1272 (Holzman)). Although the loan agreement is nominally between Wilmington Trust Company ("WTC" as trustee for CED) and HBU, the funds for the loan were furnished by ABN AMRO. (Stip. ¶ 126 (noting that the "lender's commitment" was located in an account at ABN AMRO)). ABN AMRO recognized this when early discussions concerning provision of the loan for the transaction were underway with EZH: "Thank you for inviting ABN AMRO Bank N.V. (`ABN AMRO') to act as lender and defeasance bank in a U.S. Lease Transaction . . . ." (JX 401 (emphasis added); Tr. 1273 (Holzman) (noting that he assumed Capstar, EZH's advisor, arranged for this)). Tellingly, it was ABN AMRO that was paid the fee for the loan provided by HBU. (Stip. ¶ 129; JX 43). The EZH LILO Transaction is structured so that the loan proceeds remain with ABN AMRO. (Stip. ¶¶ 126-128, DX 20194, Bates 25129-31). The parties to this transaction refer to the "loan" involved in this case as "loop debt" in an apparent reference to the circular nature of

The source of this $39,000,000.00 was actually Consolidated Edison Company of New York ("CECONY"). (Stip. ¶¶ 122-123). 12

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the movement of the funds through the ABN AMRO banking family with practically no risk to the financial entity. (See JX 401 (ABN AMRO memorandum noting that the loan would be structured in such a way that it would be accredited a 0% risk weighting for ABN AMRO's purposes); JX 943 (fax from Shearman & Sterling, counsel for CED, describing the transaction)).11 On the closing date, payments due under the various agreements were effected through a series of ownership transfers of two accounts, the WTC Account and the ABN AMRO Account. As explained in more detail below, the WTC Account is the source of funds used to obtain the Treasury STRIPS placed in the Equity Defeasance Account, and the ABN AMRO Account eventually becomes the Debt Defeasance Account. A subsidiary of CED, Consolidated Edison Leasing, transferred the Investor's Commitment to the WTC Account and then transferred its rights in the account to WTC as trustee, essentially for the benefit of CED. (Stip. ¶¶ 124, 125; JX 43). The funds for the Lender's Commitment came from an ABN AMRO Account. (Stip. ¶ 126). HBU transferred its rights to the ABN AMRO account to CED (by way of the trust). (Stip. ¶ 126). Through the trust, CED then transferred its rights to these two accounts to EZH. (Stip. ¶ 128). EZH, pursuant to the Rotte Agreement (JX 23, Bates 1067) and the Sublease Deposit, Pledge and Repledge Agreement (JX 24, Bates 1106), then in turn irrevocably transferred its rights to the ABN AMRO Account to the Rotte Foundation (JX 43, Bates 1444), a foundation

Because of the lack of risk associated with the loan and the fact that ABN AMRO treated the loan as if it stood on both sides of the deal, the representations in section 10(c) of the Participation Agreement (JX 1, Bates 42) lack any real meaning, notwithstanding that Plaintiff will refer to them in an effort to show the debt is bona fide. 13

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(i.e., trust) formed by EZH to insulate the funds deposited therein from bankruptcy. (Stip. ¶ 187; Tr. 1268 (Holzman) (noting that EZH could not remove the funds from this account)). The Rotte Foundation granted a first priority security interest in the ABN AMRO Account CED (through the trust) (Stip. ¶ 193; JX 24), and subsequently the Rotte Foundation then transferred its rights to the ABN AMRO Account to ABN AMRO. (Stip. ¶ 189; JX 43). The interest rate on the funds in the ABN AMRO Account (also referred to as the Sublease Deposit) was 7.10% compounded annually (Stip. ¶ 188), the same interest rate HBU charged on its loan to CED, using these very funds. (Stip. ¶ 118; Tr. 1272 (Holzman)). Because of these identical interest rates and because the funds in the ABN AMRO Account were only used to pay down the HBU Loan, the amount remaining in the ABN AMRO Account at any point in time would be equal to the outstanding payment owed on the HBU Loan. (Stip. ¶ 199). As the funds in the ABN AMRO Account were credited to HBU as "payments" on the HBU Loan, the loop was completed ­ all without the funds ever leaving ABN AMRO (other than the split second transfers of ownership of the ABN AMRO Account that occurred at closing). (See DX 20194, Bates 25130-31). At the same time, pursuant to the IJssell Agreement (JX 19, Bates 972), in conjunction with the Sublessee Pledge and Security Agreement (JX 20, Bates 994), and the Custody Agreement (JX 22, Bates 1041), EZH transferred to the IJssell Foundation (another trust) approximately $31 million (from CED's equity investment) to be held in a Custodial Account by Credit Suisse as custodian (which served as the Equity Defeasance Account). (Stip. ¶¶ 208-209; Tr. 3702 (Bent); DX 20194, Bates 25120). Pursuant to the Custody Agreement, Credit Suisse was required to immediately purchase Treasury STRIPS in amounts and with maturity dates

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sufficient to meet EZH's obligations under the operative documents (which in turn would provide CED's expected return from the transaction (Tr. 2174-75 (DePlautt); Tr. 3738-39 (Bent)) and place them in the Custody/Equity Defeasance Account.12 (Stip. ¶¶ 208, 210-213; DX 20194, Bates 25120). The Equity Defeasance Account was pledged to CED (and expressly not pledged to the lending institutions involved in the transaction) (Stip. ¶¶ 218, 219, 225; JX 1, Bates 126-129; JX 7, Bates 615; JX 20, Bates 994), and could not be withdrawn by the IJssell Foundation prior to satisfying its obligations under the operative documents.13 (JX 19, Bates 973; Tr. 2705 (Reed)). Only after the transfers identified above were completed, did EZH receive the remaining amounts in the WTC Account, which after allocating approximately $1.4 million dollars as the present value estimate for purchase of the required standby letters of credit (JX 330, Bates 70997100 (showing undiscounted letter of credit fee estimates), Bates 7110 (report from pricing run reflecting letter of credit allocation); JX 332, Bates 7196 (same); DX 20193, Bates 25093; DX 20194, Bates 25128), left approximately $6 million, which is referred to by the parties to the deal as the NPV (net present value) benefit to EZH and is driven by CED's tax benefits (Tr. 2971-73 (Mintun)). As described next, the cash flows were carefully structured so that CED was guaranteed the ability to repay the HBU loan through the Debt Defeasance Account and recoup its investment through the Equity Defeasance Account.14 The account and the Treasury STRIPS located therein are also referred to as the IJssell Deposit. (Stip. ¶ 214).
13 12

See infra at 19-23.

Plaintiff argues that the rent from leverage leases is typically pledged to the lender to secure the outstanding debt payments so as to convince the Court that the payment arrangement between ABN and HBU is not in any way unusual. (See, e.g., Tr. 1406-07 (Holzman)). 15

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2.

Debt Defeasance Account

Except for years 1997 through 2003 and part of 2004 (when no payments are due to be made), during the Sublease Basic Term, both CED's loan payments and EZH's rent payments (which are structured to offset each other, other than the inclusion of one free cash payment to CED15) are made out of the Debt Defeasance Account (i.e. the ABN AMRO Account). (Stip. ¶¶ 195-199; Tr. 1282-83 (Holzman)). As security for EZH's obligation to make its rent payments under the sublease, CED was granted a first priority security interest in the Debt Defeasance Account. (Stip. ¶ 193; Exhibit 24, Bates 1089-1091). CED then pledged that security interest to HBU as security for the debt service payments on the HBU loan. (Stip. ¶ 194; JX Exhibit 24, Bates 1086; Bates 1091). CED directed that all rental payments (coming from ABN AMRO

However, as Defendant's expert, Paul Bent, explained, while investors in traditional leverage lease transactions often structure the transaction such that the lessee's rental payments satisfy the outstanding debt, the funds in those instances come from the lessee's operation of the asset (or at least its operations generally), not from the funds fronted by the "loan" itself and put to the side in an account to make those payments. (See Tr. 3717-18 (Bent); see also JX 288, Bates 5637 (where management of EZH questions why the defeasance accounts must be established instead of allowing EZH unfettered use of the funds injected into the Transaction at closing)). Thus, Plaintiff's argument simply ignores what is different than a so-called "typical leverage lease" with respect to the loan repayment in the EZH LILO Transaction ­ the source of the funds used to satisfy the rental payments and HBU loan repayments. Even Ms. McCartney, chair of the board of CED, recognized the unique nature of the rental structure of the EZH LILO Transaction when she noted that (contrary to the structure of the actual Transaction) it would be "logical" that EZH's ability to make its rental payments would derive from its ability to generate revenues from the operation of the RoCa3 Facility. (Tr. 951 (McCartney)). In 2012 an additional $5,220,969.87 in "rent payment" is made by EZH directly to CED in the form of a free cash payment. (JX 330, Bates 7084; Tr. 1277-78 (Holzman); Tr. 3711 (Bent)). This payment is completely funded by the maturity of a Treasury STRIP from the Equity Defeasance Account as described in further detail infra, and is not a payment from EZH's own funds. (Tr. 1277-78 (Holzman)). This "free cash" payment is the first of the scheduled payments from the Equity Defeasance Account that provides CED with its cash return. (Tr. 3711 (Bent)). 16
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under the Rotte Agreement) be made directly to HBU, thus satisfying CED's debt service obligations. (Stip. ¶ 194A; JX 4, Bates 389-390). Because the amount initially deposited in the Debt Defeasance Account was equal to the "loan" provided by HBU; the interest rate on the account was identical to the interest rate on the HBU loan; EZH's scheduled rent payments (other than the free cash portions) under the Sublease Agreement equaled, in both timing and amount, CED's scheduled debt payments to HBU; and the periodic transfers of funds from ABN AMRO, which when made satisfied both EZH's rental obligations as well as CED's debt service obligations, the remaining balance in the Debt Defeasance Account would always be sufficient to cover the remaining debt service on the HBU loan at any given time. (See DX 20194, Bates 25132 (chart setting forth a comparison of the HBU loan and the ABN AMRO Debt Defeasance Account). The transfer from the Rotte Foundation to ABN AMRO was irrevocable. (JX 43, Bates 1432) Upon transfer, the funds in the Debt Defeasance Account became ABN AMRO's asset, pledged to HBU. (Id. (noting that the Rotte Foundation transferred to ABN AMRO all of its "rights, title and interest in and to, exclusive dominion and control over" the Debt Defeasance Account)). Neither EZH nor its creditors has any right to the money in the event of EZH's bankruptcy. (Stip. ¶ 190A; see Tr. 1268-69 (Holzman) (noting that EZH had no access to the funds in the Debt Defeasance Account)). Essentially, this circular financing arrangement from a defeased account ensures that the sublease rent and HBU loan are paid at no cost to either EZH or CED, and virtually eliminates any risk of loss on the Transaction (except tax risk). (DX 20194, Bates 25129-32, 25148, 25155-56; DX 20193, Bates 25061-64; Tr. 3736-44 (Bent); Tr. 5054-55 (LaRue)).

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If EZH elects the Sublease Purchase Option, ABN AMRO will cause HBU to credit the remaining $123,615,472 in the Debt Defeasance Account on January 2, 2018 toward CED's obligations to HBU, also in the amount of $123,615,472. (Stip. ¶¶ 234, 236; JX 24; DX 20193, Bates 25081). Thus, if the Sublease Purchase Option is elected the HBU Loan will be paid in full without cost to CED. (Stip. ¶ 236). In order to further reduce the already minimal risk that ABN AMRO would not make payment to HBU under the terms of the operative documents, the Transaction provided further steps to replace ABN AMRO as the debt defeasance holder with other more secure defeasance mechanisms. (JX 1, Bates 66-67, 113-14 ; Tr. 1329-30 (Holzman) (noting that there were steps in place in the transaction to mitigate any risk of ABN AMRO's default on its obligations)). Thus, the only way that the debt defeasance mechanism would not perform its designated function and a payment default would occur is if the parties to the transaction decided not to use the alternative debt defeasance mechanisms provided in the Transaction and ABN AMRO subsequently defaulted on its obligation to make the payments to its own subsidiary HBU. This is simply an unrealistic result. In any event, EZH also served as a backstop to these various defeasance protections. As Mr. Mintun of Capstar acknowledged, the only risk of non-payment would be a failure of the defeasance accounts ­ i.e., the failure of all available debt defeasance mechanisms (including ABN AMRO, an AA rated bank, and the permitted substitute defeasance mechanisms) and the failure of the United States government in the case of the equity defeasance­coupled with the inability of EZH to actually make payments from its own funds. (Tr. 3051 (Mintun)).

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3.

Equity Defeasance Account

As discussed above, like the HBU loan proceeds (which remain with HBU's parent, ABN AMRO), most of the equity portion of CED's advance rent (except the approximately $6 million paid to EZH as an accommodation fee and the portion allocated to purchase the letter of credit) was transferred to the IJssell Foundation and deposited with another highly accredited bank ­ Citibank ­ pursuant to the IJssell Agreement and the Custody Agreement with Credit Suisse to fund the equity portion of EZH's sublease rental payments. (Stip. ¶¶ 208-209; Tr. 1287-89 (Holzman)). Again, this account was specifically excluded as collateral for the HBU loan16 and the IJssell Foundation granted CED a security interest in the Equity Defeasance Account superior to that of EZH. (Stip. ¶¶ 218 -219, 221-223; JX 20, Bates 995; JX 21, Bates 1029-30; Tr. 1447 (Holzman)). As consideration for the transfer of funds, the IJssell Foundation agreed to undertake certain Payment Obligations of EZH, including the obligations to make payment of any equity portion of sublease basic or renewal rent, the equity portion of the Sublease Purchase Option price, any termination payments, and any free cash17 payments required to be made under the operative documents. (JX 19, Bates 971-73). The IJssell Foundation could not withdraw the

This is an important distinction from a traditional leverage lease. Since CED's equity investment is not actually at risk of seizure by HBU, Plaintiff's LILO Transaction is unlike a traditional leverage lease described by Plaintiff's expert, Dr. Ellis, in which a substantial portion of the overall investment by an equity investor may be at risk in the event of a default. (PX 10073, Bates 19999, ¶ 38). CED defined "free cash payments" as rents in excess of debt service and other obligations of the trustee. (JX 1142, Bates 16777). The free cash payments derived from the Equity Defeasance Account are the source of CED's return from the transaction (other than the tax benefits at issue here). (Tr. 3711 (Bent); DX 20193, Bates 25084). These payments are sometimes referred to as Excluded Payments. 19
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investments in the Equity Defeasance Account until all Payment Obligations are satisfied. (JX 19, Bates 971-73). Pursuant to prearranged instructions in the Custody Agreement, Credit Suisse used approximately $21 million of CED's equity investment to purchase Treasury STRIPS that are scheduled to mature, with the exception of one set to mature in 2012,18 at the end of the Sublease Basic Term. (Stip. ¶ 211). On January 2, 2012, one of the Treasury STRIPS in the Equity Defeasance Account is set to mature in the amount of $5,220,969.87. (Stip. ¶ 211-212). This date corresponds with the first equity portion of sublease basic rent (also in the amount of $5,220,969.87). (Tr. 1289-90 (Holzman); Tr. 3711 (Bent)). If, as understood by the parties to the transaction, in 2018 EZH elects to end the LILO Transaction by purchasing CED's interest under the lease, EZH can satisfy the equity portion of the purchase price (approximately $92 million), by looking to the IJssell Foundation and Credit Suisse to transfer the Treasury STRIPS (and the earnings thereon) to CED as a Payment Obligation under the IJssell Agreement.19 (Stip. ¶¶ 231-235, 237; JX 19, Bates 971-73; DX 20193, Bates 25063-64, 25081; Tr. 3721-24 (Bent)).

Again this particular Treasury STRIPS investment represents the source of funds for the "free cash" portion of EZH's rental payment in 2012. (Tr. 1278 (Holzman)). The Sublease states that EZH may use "readily available funds" (which would be equal to the value of the Treasury STRIPS) to satisfy this portion of the Sublease Purchase Option price; however, this option appears highly unlikely given that it would require several extra steps to essentially put EZH in the same position and results in no practicable effect or benefit to EZH because it would have to come up with the cash to pay the purchase price, only to then cash in the Treasury STRIPS to replace this exact amount of cash outlay. (See Tr. 1376 (Holzman) (noting that EZH could pay the amount from sources other than the Treasury STRIPS, but acknowledging that it would simply have to pay the exact same amount as the value of those maturing Treasury STRIPS)). In other words, it is a zero sum game, as EZH will be in the exact same position financially it was before it exercised the Sublease Purchase Option whichever method it chooses. 20
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The remaining Treasury STRIPS investment in the account, with a maturity date of January 2, 2018 in an amount of $7,326,950.33, is used to pay Sublease Basic Rent that is due on that date (and is another "free cash payment" to CED). (Stip. ¶ 232). If EZH does not exercise its Sublease Purchase Option, CED can extend EZH's sublease and thereby require EZH, through the IJssell Foundation, and pursuant to Section 3(c) of the IJssell Agreement, to transfer the funds generated by the Treasury STRIPS to successor equity defeasance accounts to be used to pay EZH's renewal sublease rent and other Payment Obligations, including the "Excluded Payments" / "Excluded Portions" due at the end of the lease term pursuant to the Sublessee Loan Agreement described herein.20 (JX 19, Bates 971, 973; DX 20193, Bates 25084). In other words, Section 3(c) of the IJssell Agreement required the IJssell Foundation to reinvest immediately all proceeds of the Treasury STRIPS remaining in the Equity Defeasance Account upon maturity of the Treasury STRIPS to the extent those funds were not allocated to a current payable Payment Obligation, such that those funds would be available to satisfy any remaining Payment Obligations. (JX 19, Bates 973). By way of example, in the event EZH did not exercise the Sublease Purchase Option, the funds from the four Treasury STRIPS remaining in the Equity Defeasance Account valued at $22,958,869.31 each (valued as of their respective maturity dates, April 15, June 15, September 15, and December 15, 2018) (Stip. ¶ 233) would be handled as follows: (1) The IJssell Foundation would be required to transfer to CED $37,525, 237.44 as an excluded payment under

While the technical language used to describe "Excluded Payments" is quite cumbersome and difficult to follow (see JX 1, Bates 130, 137-38), the term includes the means by which CED obtains its return on its investment in the event EZH does not elect the Sublease Purchase Option. (DX 20193, Bates 25084, 25091-92). 21

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the sublessee loan21 (JX 44, Bates 1478 (schedule of payments, set forth as a percentage which would equal this amount on January 2, 2018); JX 330, Bates 7084); (2) CED would then use $34,036,691.62 of that amount to fund the Trustee Treasury Collateral Account pursuant to Section 11(a)(x)-(xi) of the Participation Agreement (JX 1, Bates 46; JX 330, Bates 7084; DX 20193, Bates 25072; DX 20194, Bates 25121); and (3) Because Payment Obligations remain during the remainder of the lease term (the remaining equity portions of the sublease renewal rents and Excluded Payments which are comprised of (the annual "free cash" payments made to CED under the sublessee loan in 2032-2036, and 2041 (Stip. ¶¶ 173, 182; JX 44, Bates 1478-79; JX 330, Bates 7084; DX 20193, Bates 25091-92; DX 20194, Bates 25126, 25137), the IJssell Foundation would then be required to establish a successor custody account much like the initial Equity Defeasance Account, using the remaining funds from these four maturing Treasury STRIPS and acquire government obligations with maturity dates corresponding to these Payment Obligations (JX 19, Bates 971-73; DX 20193, Bates 25084; DX 20194, Bates 25120, 25137). Thus, EZH could not simply take this money and do as it pleases with it as Payment Obligations

As described in more detail infra, the Trustee Treasury Collateral serves to secure a portion of the Final Basic Rent Payment purportedly due from CED. (See DX 20193, Bates 25072). 22

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still remained under the Transaction.22 (See Tr. 3718-19 (Bent) (noting that EZH does not get any more money other than the fee it receives at closing)). By placing its equity investment in a defeased account, CED was able to ensure that it could recoup its investment in the Transaction, no matter what happened at the end of EZH's sublease ­ i.e. its free cash payments would guarantee its returns, whether those payments came in the form of the sublease purchase price, or as scheduled payments under the sublessee loan, all funded from the Equity Defeasance Account. (See JX 379, Bates 7948 and JX 380, Bates 7956 ("Cash returns on a lease-leaseback are derived from a combination of the excess rental income over the cost of the projected debt service (the "free cash flow") and the tax benefits . . . ."); see also JX 1107, Bates 16256; Tr. 1335-36 (Holzman) (noting the special equity security arrangements in place to preserve the economic return to CED); Tr. 3875-76 (Bent) (noting that CED expected to derive its return from the Equity Defeasance Account at the end of the Transaction's term)). As CED emphasized in its evaluation of the LILO, CED's equity investment would be returned to CED through EZH's exercise of its Sublease Purchase Option or CED's exercise of its Sublease Renewal Option (if EZH forgoes its Sublease Purchase Option). (JX 397, Bates 8121 ("If the utility did not purchase the plant at year 20 the trust would have the option to . . . require the utility to re-lease the plant for an additional 17 years at prices

Dr. Reed, one of Plaintiff's experts, who performed an analysis of whether one could say with virtual certainty whether the Sublease Purchase Option would be exercised, admittedly did not take into account what actually happened to the funds in the Equity Defeasance Account if EZH did not exercise the Sublease Purchase Option when making his determination. (Tr. 2705-06 (Reed)). He simply relied on representations from Plaintiff's counsel to the effect that at some point EZH could use the funds outside of the transaction if it did not exercise the Sublease Purchase Option, but had no real understanding of how or when that might actually occur. (Tr. 2703-04 (Reed)). 23

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that would assure CED of its expected return.") and 8122 ("The transactions contemplated will be structured in such a way that CED will obtain the same yields and rates of return regardless of whether the utility exercises its purchase option at year 20 or is required to re-lease the plant for an additional 17 years."). 4. Sublessee Loan

As part of the EZH LILO Transaction, EZH and CED, through the trust, entered into a Sublessee Loan Agreement, pursuant to which CED was to lend to EZH funds equal in amount and timing to the first six sublease rental payments under the sublease agreement, as well as the portion of the seventh sublease rental payment not covered by the scheduled payment from the Debt Defeasance Account in 2004. (Stip. ¶¶ 261-63; JX 44; Tr. 1282-83 (Holzman)). The purpose of this sublessee loan was to provide additional benefit to EZH, although neither Mr. Holzman from Cornerstone (CED's advisor), Mr. DePlautt (the primary contact at CED on the transaction) nor Mr. Mintun (EZH's advisor) could explain exactly how.23 (Tr. 2226 (DePlautt); Tr. 1279 (Holzman); Tr. 3044-45 (Mintun)). Essentially, as explained in connection with CED's consideration of the EZH LILO Transactions, the Sublessee Loan worked as follows: Any annual sublease rental payments due but not paid from the Debt Defeasance Account were treated as deferred rents, and were treated as a sublessee loan. (JX 396, Bates 8115; JX 722, Bates 12246; see also Tr. 1282 (Holzman)). The Sublessee Loan Agreement set forth an interest

Joint Exhibit 396 implies that the Sublessee Loan can be used in a transaction to maintain the yield to CED in the event of a change in interest rates prior to the close of the Transaction. (JX 396, Bates 8115). The sublessee loan portion of the Final Basic Rent Payment takes the place of a portion of the Lease Collateral Account portion of the final payment. (Id.). The confusion regarding the purpose of this aspect of the EZH LILO Transaction can be seen in Arthur Andersen's conflicting accounting treatments recommended for the sublessee loan. (Compare JX 555, Bates 9962 with, JX 1049, Bates 16270). 24

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Case 1:06-cv-0