The Metro Crash and Tax: Leaseback Infrequently Asked Questions
As discussed in an earlier post, Metro said that it could not comply with the NTSB recommendation that Metro replace its 1000-series Rohr cars because of a “tax advantage lease.” This post explains tax advantage leases in more detail–not the specifics of the WMATA’s Rohr leases, which we haven’t seen, but rather sale-leasebacks (sometimes called “sale-in/lease-outs,” or “SILOs”) in general. We’ll talk about two parties: TransitCo, which, like WMATA, is a tax-exempt transit authority, and Taxpayer, which is not tax exempt and has a regular flow of income. (This post discusses domestic sale-leasebacks; there are additional tweaks for cross-border sale-leasebacks.)
So: Leaseback Infrequently Asked Questions (or, Everything You Wanted To Know About Leasebacks but Were Afraid To Ask, Because You Thought You Would Probably Get Really Bored).
What’s the main idea?
The main idea is that TransitCo, which is tax exempt and thus cannot use tax benefits, essentially sells these tax benefits to Taxpayer, a taxable party who can use them to offset income.
What tax benefits?
TransitCo is mostly selling depreciation deductions.
That is not helpful. What are depreciation deductions?
Let’s back up for a minute. Imagine you spend $100 buying baking supplies, which you then turn into cupcakes that you sell for $110. It seems inaccurate to say that you have $110 of income when overall, you are only $10 better off than you would have been if you had not baked the cupcakes at all. So to determine taxable income, you get to subtract your trade or business expenses from your gross income. In this case, you would have only $10 of taxable income.
Focus, please. What if instead you spend $100 on a cupcake machine that is expected to produce $110 of income over ten years? From an economic perspective, you should have to match your expenditures at least roughly with the income they produce. So instead of deducting all $100 up front, you should deduct a portion of the machine’s cost each year for ten years. If the machine produces the same amount of income each year, for example, you should be permitted to deduct $10 each year. At the end of ten years, the machine will be used up-it will no longer be able to produce income-and the full cost of the machine will have offset income generated by the machine. These deductions are depreciation deductions (so called because the machine “depreciates” in value).
Moreover, under current tax law, depreciation deductions are very valuable, because they do not match up with the actual reduction in value of the machine, but rather are generally extremely accelerated. This increases the present value of the depreciation deductions.
Ok, can you translate that to our scenario?
Sure. TransitCo has a bunch of equipment–rail cars, say–that cost, say, $100 (please add however many zeroes you need to make this realistic and/or interesting). Let’s say tax law permits TransitCo to deduct $10 a year for 10 years–that is, TransitCo can offset $10 of taxable income a year.
But wait–TransitCo is tax exempt. It doesn’t pay any taxes anyway.
Exactly! So TransitCo can reduce its taxable income by $10 a year, but because it already doesn’t pay tax, these deductions are worthless to TransitCo.
Taxpayer, on the other hand, does pay tax, at, say, a 40% rate. (This isn’t totally unrealistic, if we take into account not only federal taxes, which are 35% for a corporation, but also state and local taxes.) If Taxpayer has $10 of income, it has to pay $4 of tax. (Again, add as many zeroes as you like–they’re free!) So a $10 deduction is worth $4 to Taxpayer, because a $10 deduction allows Taxpayer to offset $10 of income and thus avoid $4 of tax.
So the depreciation deductions are useless in TransitCo’s hands, but are worth $4 to Taxpayer.
Hmm…worthless for TransitCo, valuable for Taxpayer. Let’s make a deal!
Right. So here’s our deal: TransitCo will “sell” the rail cars to Taxpayer. Legal title won’t change hands, but TransitCo and Taxpayer will structure things so that they can claim that for tax purposes, Taxpayer is the legal owner of the rail cars. Then Taxpayer will lease the rail cars back to TransitCo.
To be clear, the rail cars never leave TransitCo’s possession–Taxpayer has absolutely no use for rail cars. But it has a lot of use for depreciation deductions, and as the “owner” of the rail cars, it will get to take those deductions. TransitCo, for its part, gets cash up front, some of which it keeps and some of which it pays back to Taxpayer over the term of the lease as rent.
Wait, Taxpayer has rental income? That can’t be good from a tax perspective. That’s taxable, right?
Taxpayer usually borrows to fund the deal, so it has to pay interest. The interest payments are deductible, and Taxpayer uses the interest deductions to offset the rental income.
Phew. Well, that sounds good–TransitCo gets cash for depreciation deductions it can’t use, and Taxpayer gets depreciation deductions that it can use. So a lot of transit agencies did these, right?
Yep, municipalities loved these for all kinds of financing. The Federal Transit Administration approved lots of these deals, and even encouraged them as part of what they called “innovative financing techniques.”
Awesome! So everybody wins!
Well, no. When less taxes get paid, the government gets less money, so the fisc was the biggest loser here. So while municipalities might have loved the deals, the IRS didn’t. By 2005 they’d had enough, and they classified these transactions as tax shelters. In their view, nothing substantive was happening. Taxpayer didn’t really own the rail cars, because Taxpayer didn’t have any of the risks or rewards associated with ownership. It was a purely tax-motivated deal, with no business purpose or substance.
Uh-oh. What happened to the taxpayers who had already entered into the deals? Were they grandfathered or something? What happened to their depreciation deductions?
The IRS gave them a chance to settle for, as they say, pennies on the dollar. For example, it appears that in exchange for the investors in the WMATA deals terminating all their tax advantages by the end of 2008 and giving up 80% of the tax benefits they’d taken (i.e., 80% of the depreciation deductions), the IRS agreed not to investigate them or pursue civil or criminal remedies.
Is that what the recent WMATA litigation was about, with that Belgian bank?
Well, maybe indirectly. WMATA entered into sixteen deals that were apparently very similar to the one I’ve described here. As part of those deals, insurance companies, including AIG, guaranteed WMATA’s lease payments. These guarantees had to be rated very highly. If that rating fell, WMATA would be in technical default and would have to pay a termination fee.
As you may have heard, AIG has been having some problems, and the rating did indeed fall. A couple of banks settled with WMATA at little or no cost to WMATA, but the Belgian bank KBC Bank NV wanted the full termination fee. Of course, KBC was still getting lease payments, so WMATA was of the view that the bank just wanted out because it wasn’t getting the tax benefits anymore (because of the IRS’s crackdown), and that it shouldn’t get the termination fee. So WMATA took the bank to court, and the whole thing ended up settling (the terms of the settlement remain secret).
Thank you. I’ve got some more questions–like, ok, it was a tax shelter, but how the heck was Metro supposed to get money otherwise?–but I think I’ve had enough for now–I’m going to go take a nap.
No problem. Sweet dreams!