Transportation Authority Comments on Guidance Affecting Nonprofits Linked to Prohibited Transactions

Dear Sir/Madam:

The Metropolitan Transportation Authority ("MTA"), a public benefit corporation and public authority of the State of New York, welcomes this opportunity to submit formal comments pursuant to your request for comments in Notice 2007-18, 2007-9 I.R.B. 1. MTA submitted comments by letter dated August 9,2006 (the "August Letter") pursuant to your request for comments in Notice 2006-65, 2006-31 I.R.B. 1. This letter focuses on the application of section 4965 to transactions commonly referred to as LILO and SILO transactions and the questions left open by Example 3 of Notice 2007-18.

Example 3 of Notice 2007-18.

Notice 2007-18 provides that, for purposes of section 4965(a), the amount and timing of the net income and proceeds attributable to a prohibited tax shelter transaction will be computed in a manner consistent with the substance of the transaction. For this purpose, Notice 2007-18 provides that the IRS "will look to" the listing guidance and any subsequent published guidance relating to the transaction. MTA does not claim or take such IRS position with respect to the characterization of the LILO and SILO transactions to which it is a party, and the following comments are MTA's response to the IRS position as set forth in Notice 2007-18.

Example 3 applies these principles to a typical LILO transaction entered into before the effective date of section 4965. In Example 3, X, a Non-Plan Entity, received $268M as an advance payment of head lease rent. Of this amount, $200M was borrowed by Y, the tax investor, from a lender. X deposited $200M of the advance payment with a debt payment undertaker in order to defease a portion of its obligations under the sublease. Of the remaining $68M, X deposited $54M with an equity payment undertaker and X retained $14M.

Example 3 provides that, in substance, the transaction consists of a $14M accommodation fee for X's participation in the transaction and a $54M a loan from X to Y. The remainder of the transaction is ignored. Example 3 concludes that net income and proceeds received by X on inception of the transaction are allocated to that calendar year and, because that year is before the section 4965 effective date, X will not be subject to section 4965 for amounts received in that year.

Example 3 leaves open a number of questions in respect of LILO/SILO transactions, which are discussed below.

Application to SILOs.

In Notice 2005-13, 2005-9 I.R.B. 630, the IRS listed SILOs and stated that: "In substance, the transactions described above are merely a transfer of tax benefits to X, coupled with X's investment of the Equity Collateral for a predetermined after-tax rate of return." This is consistent with the substance analysis of LILOs set forth in Example 3. Given the number of SILO transactions potentially subject to section 4965, it would be helpful for the IRS to confirm that the same section 4965 analysis as applies to LILOs also applies to SILOs.

Application of Section 4965 to Post-Closing Years.

The conclusions expressed in Example 3 are with respect to amounts received in 1999, the year in which the LILO closed; nothing is said regarding application of section 4965 to net income/proceeds in respect of subsequent years, though the implication of this silence is that, at least with respect to LILOs, the section 4965 analysis stops with the income/proceeds received at closing. Rather than have to rely on a negative implication, it would be helpful if the IRS would amplify Example 3 to provide that X's use of the $68M equity component will not give rise to additional proceeds or net income subject to section 4965.

The section 4965 tax applies to the greater of net income of the entity or proceeds received by the entity, in each case to the extent attributable to the transaction. We are concerned that, contrary to the implication of Example 3, the IRS might regard investment earnings with regard to the $54M as income and/or proceeds subject to section 4965.¹

Lessee participants in LILO and SILO transactions, like X in Example 3, typically invested the amount corresponding to the $54M in Example 3 in highly-rated securities or with a highly-rated equity payment undertaker in order to economically defease the equity portion of the rent and other payment obligations under the lease. The amount of the accommodation fee in a LILO/SILO is determined by the yield on the applicable equity defeasance instrument. The higher the yield on the equity defeasance, the greater the accommodation fee. In Example 3, the $1.4M:$54M split of the $68M equity component of the transaction is a function of the yield on the equity defeasance. If in Example 3, Y would have allowed defeasance with less than investment-grade bonds, the accommodation fee would have been greater than $14M. Because of the link between the yield on the equity defeasance and the amount of the accommodation fee, the income to X in the transaction is really only the accommodation fee. X receives no independent income from the investment of the equity defeasance that is not fully embedded in the accommodation fee. Example 3 provides that the loan amount from Y to X is $54M. A better approach would be to say that the loan amount is the full equity investment, $68M, and that this $68M loan provides a below-market implicit interest rate. The present value of the $68M below-market rate loan is, in substance, the $14M accommodation fee. In substance, the up-front accommodation fee is the only income from a LILO/SILO. Accordingly, the net income potentially subject to section 4965 is the present value of the below-market rate loan represented by the equity investment -- the accommodation fee -- less X's legal and other expenses paid in connection with entering into the transaction.²

Under the above $68M below-market rate loan approach, the net income subject to section 4965 in Example 3 is $14M, less expenses. We believe that the "proceeds" for section 4965 purposes of a LILO/SILO ought to be the gross unrestricted cash received at closing. In Example 3, the proceeds would be $14M, without reduction for any expenses. There is no restriction in the LILO/SILO documents as to X's use of the $14M of the proceeds.³ The LILO/SILO documents typically required investment of the $54M in acceptable investments. The proceeds prong of section 4965 is triggered only if proceeds are received by the entity. Because of the limitations imposed by the LILO/SILO documents, the lessee has not really received the amounts used to fund the defeasance. Accordingly, the only proceeds received by the lessee for section 4965 purposes is the accommodation fee.

Another possible interpretation of the proceeds prong is that the entire amount of the below-market rate loan, $68M in Example 3, is regarded as proceeds received by the lessee. As this amount is received at closing, which will have occurred prior to the section 4965 effective date, the $68M would not be subject to section 4965. However, we arc concerned that, contrary to the implication of Example 3, earnings on the loan proceeds could be regarded as additional proceeds subject to section 4965. Under the facts of Example 3, the use of $68M loan proceeds will generate additional proceeds, whether in the form of fare box revenues from transit cars purchased with the $14M or interest on the equity payment undertaking purchased with the $54M. For purposes of section 4965, proceeds from these transactions should be regarded as proceeds from separate transactions, not from a prohibited tax shelter transaction. The prohibited tax shelter transaction in a LILO/SILO should be the below-market loan from the equity investor. In our August Letter we explained why we believe that you should not, for purposes of section 4965, adopt an expansive definition of the term "proceeds," such as that provided by Regulations section t .148-1, which would treat investment earnings as bond proceeds for certain section 103 purposes.

We are also concerned with the possible application of section 4965 if the lessee does not exercise its purchase option in the LILO/SILO. As a purely commercial matter, a lessee may decide that it makes economic sense to not exercise its purchase option.⁴ However if there is a risk that failure to exercise the purchase option would give rise to net income or proceeds subject to section 4965, the lessee may be compelled to exercise the purchase option and thereby waive what would otherwise be a valuable economic right in order to avoid exposure to the tax. We believe that the LILO/SILO prohibited tax shelter transaction should be limited to the transaction insofar as it assumes that the purchase option is exercised. If the purchase option is not exercised, the below-market rate loan should be deemed to be repaid and a new transaction entered into. Of course that new transaction may itself constitute a prohibited tax shelter transaction, but if it is not such transaction, the section 4965 tax should not apply to any net income or proceeds with respect to such transaction.

Attached for your consideration is a redrafted Example 3 that addresses the concerns discussed above.

Example 3. In 1999, X, a calendar year Non-Plan Entity using the cash method of accounting, entered into a lease-in/lease- out transaction ("LILO") substantially similar to the transaction described in Notice 2000-15, 2000-1 C.B. 826 (describing Rev. Rul. 99-14, 1999-1 C.B. 835, superseded by Rev. Rul. 2002-69, 2002-2 C.B. 760). In 1999, X purported to lease property to Y pursuant to a "head lease," and Y purported to lease the property back to X pursuant to a "sublease" of a shorter term. In form, X received $268M as an advance payment of head lease rent. Of this amount, $200M had been, in form, financed by a nonrecourse loan obtained by Y. X deposited the $200M with a "debt payment undertaker." This served to defease both a portion of X's rent obligation under its sublease and Y's repayment obligation under the nonrecourse loan. Of the remaining $68M advance head lease rent payment, X deposited $54M with an "equity payment undertaker." This served to defease the remainder of X's rent obligation under the sublease. This amount inures to the benefit of Y and enables Y to recover its investment in the transaction and a return on that investment. X retained the remaining $14M of the advance head lease rent payment. In substance, the $68M is a below- market rate loan from Y to X and the present value of this loan, $14M, represents an accommodation fee for X's participation in the transaction.

According to the substance of the transaction, the head lease, sublease and nonrecourse debt will be ignored for Federal income tax purposes. Therefore, any net income or proceeds resulting from these elements of the transaction will not be considered net income or proceeds attributable to the LILO transaction for any year during the term of the transaction for purposes of section 4965(a).

Under X's established cash basis method of accounting, any net income and proceeds received in 1999 and attributable to the $68M loan are allocated to X's December 31, 1999, tax year for purposes of section 4965. Because the 1999 tax year is before the effective date of TIPRA, X will not be subject to any excise tax under section 4965 for the amounts received in 1999. Any income or proceeds received by X during the term of the LILO transaction in respect of the S14M accommodation fee and the $54M investment with the equity payment undertaker will not be considered net income or proceeds attributable to the LILO. If X fails to exercise its purchase option under the lease, any net income or proceeds received by X as a result of such failure shall not be treated as income or proceeds attributable to the LILO.

The analysis described above applies to sale-in/lease out ("SILO") transactions substantially similar to the transactions described in Notice 2005-13, 2005-9 I.R.B. 630.

² The equity defeasance is only an economic defeasance; it is not a legal defeasance. The lessee in a LILO/SILO remains legally obligated to make the required payments under the LILO/SILO, even upon failure of the equity defeasance. Accordingly, there may be circumstances where, as a commercial matter, the lessee in a LILO/SILO will want, or be required, to replace the original equity defeasance instrument. As interest rates will undoubtedly have changed from the closing date, the lessee may have income (or loss) on the equity defeasance. Any income of the lessee attributable to modification or replacement of the equity defeasance should be regarded as income attributable to the equity defeasance, not income from the below-market rate loan in the LILO/SILO transaction. Such income is derived from an independent transaction. Accordingly, any such income should not be subject to section 4965.

³ For LILO/SILO transactions of equipment funded with grants from the Federal Transit Administration, the Federal Transit Administration conditioned its consent to the transaction on the transit's use of the $14M for additional transit assets.

⁴ There is no legal obligation in the LILO/SILO documentation for the lessee to exercise its purchase option. We express no view on the likelihood of failure to exercise the option. We only point out that the purchase option is, in fact, an option, not a binding obligation, and without getting into the liklihood of nonexercise, all would have to concede that there is at a minimum a possibility of nonexercise.