DYK, Circuit Judge.
In its tax return for the year 1997, Consolidated Edison Company of New York, Inc. and its subsidiaries (“ConEd”) claimed multiple deductions pertaining to a lease-in/lease-out (“LILO”) tax shelter transaction. The Internal Revenue Service (“IRS”) disallowed these claimed deductions and assessed ConEd a deficiency in the amount of $328,066. ConEd paid the deficiency and filed a refund claim with the IRS; when this claim was denied, ConEd filed suit in the Court of Federal Claims (the “Claims Court”). The Claims Court awarded ConEd a full refund, and the United States appealed.
Applying the substance-over-form doctrine under our decision in
Wells Fargo & Co. v. United States,
641 F.3d 1319 (Fed.Cir.2011), we conclude that ConEd’s claimed deductions must be disallowed. This is so because there was a reasonable likelihood that the tax-indifferent entity in the LILO Transaction (the lessor of the master lease) would exercise its purchase option at the conclusion of the ConEd sublease, thus rendering the master lease illusory. Accordingly, we reverse and remand to the Claims Court for the limited purpose of determining only the refund of previously paid interest ConEd may be entitled to receive.
Background
I
This case requires the court to determine the tax consequences of a LILO
transaction, which is one of many “creative strategies” used by taxpayers to “receive greater tax benefits from the property of tax-exempt entities.”
Wells Fargo,
641 F.3d at 1322. Though the LILO Transaction at issue in this case is complex, it has a structure typical of LILOs.
The LILO Transaction is between ConEd and N.V. Electriciteitsbedrijf Zuid-Holland (“EZH”), a Dutch utility. EZH is a so-called tax-indifferent entity because it is not subject to U.S. taxation. The transaction centered around the lease and sublease of a gas-fired, combined cycle cogen-eration plant (the “RoCa3 plant”) located in the Netherlands. EZH’s RoCa3 plant opened for commercial operation in 1996 and delivers heat, electricity, and carbon dioxide to its customers.
ConEd’s avowed purpose in entering into the LILO Transaction was to achieve tax avoidance benefits associated with rent and interest deductions. For example, ConEd’s former Chief Financial Officer, Joan Frielich, admitted that achieving “front-loaded earnings” was one of the main reasons that ConEd entered into the transaction, and that the “transaction would not have had the front-loaded earnings without the tax benefits.” J.A. 2717-18. She also admitted that, without the tax benefits, the return on investment associated with the LILO Transaction would have been insufficient to “make[ ] the project acceptable.” J.A. 2718. A “Leasing White Paper,” which was presented to ConEd’s board prior to the transaction’s closing date, also emphasizes the LILO Transaction’s “[fjront [ljoaded [ejarnings” and “[gjood to [excellent [investment [yjields” resulting in part from the tax deductions. J.A. 17,123, 13,469. ConEd’s Project Briefing Memorandum, dated October 23, 1997, listed the benefits of the transaction as including (i) tax deductions for the allocated initial rent payment to EZH; and (ii) tax deductions for the interest paid on the loan financing the transaction.
II
EZH and ConEd formally completed the LILO Transaction on December 15, 1997 (the “Closing Date”), by entering into several agreements. In the master lease agreement governing the LILO Transaction (the “Head Lease Agreement”), EZH conveyed to ConEd a lease interest of an undivided 47.47%
in the RoCa3 plant for a lease term of 43.2 years (the “Head Lease Term”), commencing on December 15, 1997 and ending on February 24, 2041 (the “Head Lease Termination Date”). Simultaneously, ConEd conveyed back the property to EZH. ConEd entered into a sublease agreement with EZH (the “Sublease Agreement”) in which EZH sub
leased ConEd’s undivided interest in the RoCa3 plant from ConEd for a term of 20.1 years. This initial term of the sublease (the “Sublease Basic Term”) was set to end on January 2, 2018.
Under the Head Lease Agreement, ConEd was obligated to make an immediate Initial Basic Rent Payment of $120,112,270.36. ConEd satisfied this obligation by making an initial equity payment of $39,320,000.00 and borrowing the remaining $80,792,270.36 as a nonrecourse loan, at 7.10% interest, from Hollandsche Bank-Unie (the “HBU Loan”). The equity payment and the HBU Loan satisfied ConEd’s initial obligations to EZH under the master lease.
EZH was immediately entitled to the equity payment but, on the day following the Closing Date, the transaction required EZH to transfer approximately $31 million of ConEd’s equity payment to Credit Suisse First Boston to create an Equity Defeasance Account.
The funds in this account were invested in zero-coupon U.S. government Treasury bonds known as STRIPS, and EZH pledged its interest in the account to ConEd to secure EZH’s payment obligations under the sublease.
The account holding the proceeds of the ConEd HBU Loan was called the Debt Defeasance Account, and was held by ABN AMRO Bank N.V. (“ABN”) (the parent company of HBU at the time of the closing). In general, EZH was to make annual withdrawals from the Debt Defeasance Account (satisfying ConEd’s obligations to EZH under the Head Lease Agreement), and at the same time was to make payments in identical amounts to HBU to pay down ConEd’s HBU loan (satisfying EZH’s sublease rent obligation to ConEd under the sublease). At any given time, the amount remaining in the Debt Defea-sance Account was to equal ConEd’s remaining principal and interest payment obligations under the HBU Loan.
The Debt Defeasance Account was structured to earn 7.10% interest, which was the same interest rate as that associated with the HBU Loan. The effect was such that the HBU Loan proceeds were deposited in the
Debt Defeasance Account, and the principal and interest on the loan were paid from those proceeds, together with the interest those proceeds earned in the account.
Under the Sublease Agreement, EZH was required to “maintain, overhaul, inspect, test, repair, and service the [RoCa3 plant] at its own expense during the Sublease Basic Term on a basis comparable to EZH’s maintenance of similar facilities that it owns, leases[,] or operates.”
Consol. Edison Co. of N.Y., Inc. v. United States (ConEd),
90 Fed.Cl. 228, 241 (2009). As described above, ConEd paid EZH an “accommodation fee” of approximately $6.7 million in exchange for EZH’s willingness to enter into the transaction.
The transaction was structured so that EZH could reacquire its original interest in the RoCa3 Plant at the end of the Sublease Basic Term. A Sublease Purchase Option allowed EZH to purchase ConEd’s remaining interest in the Head Lease Term for $215,450,949.20 in 2018. If EZH declined to exercise the Sublease Purchase Option, ConEd had the opportunity to exercise one of two options. It could exercise the Sublease Renewal Option, under which EZH would be required to renew the sublease for an additional renewal term of 16.5 years. At the end of the sublease renewal term, ConEd would operate the plant or find a new sublessee for the remaining term of the head lease (the “Shirt-Tail Period”). In the alternative, ConEd could exercise the Sublease Retention Option, under which EZH would return the remaining interest in the Head Lease Term to ConEd, allowing ConEd to take over the RoCa3 Plant’s operations for the remainder of the Head Lease Term.
Ill
A LILO tax shelter is designed to accelerate losses to the taxpayer and defer gains, so as to take advantage of the time value of money by delaying tax payments. The structure of the LILO Transaction facilitated several upfront deductions that allowed ConEd to pay lower taxes in 1997 (and in later years) than it otherwise would have. Because a large entity such as ConEd reports annual income in the hundreds of millions of dollars, additional deductions offset part of that income and produce substantial tax savings. A tax-indifferent entity such as EZH, unlike ConEd, does not pay U.S. income taxes, and therefore cannot offset its income with such deductions. Meanwhile, the LILO Transaction allows EZH to benefit from the accommodation fee and, at the same time, maintain uninhibited operation of the RoCa3 Plant.
The deductions ConEd claimed for tax year 1997 were as follows. First, ConEd deducted rent it paid to EZH in the amount of $1,072,652.
Such rental deductions are allowed under the Internal Revenue Code where those payments are “required to be made as a condition to the continued use or possession, for purposes of the [taxpaying] trade or business, of property.” I.R.C. § 162(a)(3). Second, ConEd deducted interest payments associated with the HBU Loan in the amount of $254,944. Interest deductions are allowed for “all interest paid or accrued within the taxable year on indebtedness.” I.R.C. § 163(a). Although the tax impact at issue
in this case — specifically, the impact resulting from these deductions for tax year 1997 — was only $828,066, the projected tax savings from ConEd’s use of these deductions in subsequent years of the transaction was substantial. For example, the projected tax savings to ConEd during each tax year from 1998 through 2001 was over $7 million per year.
IV
The government’s primary contention is that EZH was reasonably likely to exercise the Sublease Purchase Option, and that, as a result, the purported master lease (or head lease) should not be treated as a true lease, and the tax deductions that would flow from a true lease were not available to ConEd. The government argues that the interest deductions associated with the HBU Loan were likewise not available.
The government points out that in the event that EZH exercised the Sublease Purchase Option the transaction would be completed at no risk to ConEd. In general, the head lease payments ConEd made would be recovered through the sublease payments made by EZH. The proceeds ConEd obtained from EZH’s exercise of the Sublease Purchase Option would include the amounts remaining in the Debt Defeasance account and would ensure that the remaining HBU Loan would be paid in full at no future cost to ConEd. ConEd, meanwhile, would receive most of the equity contribution in the Equity Defeasance Account back as part of the option purchase price (reduced by the fees necessary to create the transaction). ConEd would receive a return on its equity investment in the U.S. government Treasury STRIPS invested through the Equity Defeasance Account. ConEd would not need to assume any risks associated with operating the RoCaB Plant, since EZH would continue to manage and operate the RoCa3 Plant as it had before. All of ConEd’s future obligations under the head lease would be extinguished.
So too, ConEd would bear no risk associated with the HBU Loan. At the relevant time, HBU was a subsidiary of ABN, which managed the Debt Defeasance Account that held the loan’s proceeds. As discussed above, the approximately $81 million in loan proceeds were designed to flow in a loop from HBU to ConEd to EZH and back to HBU. Moreover, ConEd’s risk on the loan would be eliminated because EZH purchased a letter of credit for approximately $1,412,594.12 to secure its obligations to ConEd under the sublease. ConEd’s tax advisor described the HBU Loan as containing “100% loop debt,” and ABN treated the loan as being “off balance sheet.” J.A. 23,858, 17,140. Throughout the transaction, ABN had “irrevocable” control of the funds. J.A. 10,-432,10,444.
V
The IRS assessed the deficiency against ConEd for 1997. ConEd paid the deficiency and sued for a refund in the Claims Court. The Claims Court, after a trial, determined that the transaction could not be ignored under the substance-over-form doctrine. It concluded that ConEd had “established ... that the RoCa3 [LILO] Transaction was a unique LILO transaction, which provided tax and bookkeeping advantages to the plaintiff; was, in form, a true lease; ... and, therefore, should be respected as qualifying for the tax deductions claimed.”
ConEd,
90 Fed.Cl. at 340.
The Claims Court also “conclude[d] that there is no certainty that EZH will exercise the Sublease Purchase Option.”
Id.
at 295. It followed that the transaction, “although insulated to minimize risk, was not without risk” and that “[t]he RoCa3 [LILO] Transaction presented three separate, viable Options [i.e., the Retention, Renewal, and Sublease Purchase Options]
that could be exercised at the end of the Sublease Basic Term, none of which was guaranteed or inevitable at the time the Transaction was consummated.”
Id.
at 340. Thus, the Claims Court concluded that ConEd’s claimed interest and rent deductions were “allowable.”
Id.
at 341. The full judgment for ConEd was in the amount of $5,977,220.09, which consisted of a full refund of the deficiency related to the LILO ($328,066.00), a refund of ConEd’s overpayment of previously-paid assessed interest ($3,226,868.90), and reimbursement for a preexisting credit balance ($2,422,285.19).
The United States timely appealed the Claims Court’s ruling and challenges its ruling under the substance-overform doctrine.
We have jurisdiction under 28 U.S.C. § 1295(a)(3). “We review the characterization of transactions for tax purposes de novo, based on underlying findings of fact, which we review for clear error.”
Wells Fargo,
641 F.3d at 1325 (citing
Stobie Creek Invs., LLC v. United States,
608 F.3d 1366, 1375 (Fed.Cir.2010)).
DISCUSSION
As we stated in
Coltec,
judicial anti-abuse doctrines “prevent taxpayers from subverting the legislative purpose of the tax code.”
Coltec Indus., Inc. v. United States,
454 F.3d 1340, 1354 (Fed.Cir.2006). One such doctrine is the substance-over-form doctrine. Under this doctrine, courts determine “the tax consequences of a transaction ... based on the underlying substance of the transaction rather than its legal form.”
Wells Fargo,
641 F.3d at 1325 (citing
Griffiths v. Helvering,
308 U.S. 355, 357, 60 S.Ct. 277, 84 L.Ed. 319 (1939)). “The major purpose of the substance-over-form doctrine is to recharac-terize transactions in accordance with their true nature.”
Southgate Master Fund, L.L.C. ex rel. Montgomery Capital Advisors, LLC v. United States,
659 F.3d 466, 491-92 (5th Cir.2011) (internal quotation marks omitted).
This substance-over-form doctrine, like the economic substance doctrine, “is merely a judicial tool for effectuating the underlying Congressional purpose that, despite literal compliance with the statute, tax benefits not be afforded based on transactions lacking ... substance.”
Coltec,
454 F.3d at 1354. The Supreme Court recognized the substance-over-form doctrine in
Frank Lyon Co. v. United States,
where it noted that “[t]he Court has never regarded ‘the simple expedient of drawing up papers’ as controlling for tax purposes when the economic realities [of the transaction] are to the contrary.” 435 U.S. 561, 573, 98 S.Ct. 1291, 55 L.Ed.2d 550 (1978) (quoting
Comm’r. v. Tower,
327 U.S. 280, 291, 66 S.Ct. 532, 90 L.Ed. 670 (1946)).
The government urges that we should reverse the Claims Court’s refusal to apply the substance-over-form doctrine here for two reasons. First, if the Sublease Purchase Option were reasonably expected to be exercised, the transaction would be re-characterized as one without any meaningful substance. Second, the government urges that, even if the Sublease Purchase Option were not exercised, ConEd would not bear any residual value risk associated with the transaction because “ConEd has the ability to exercise its sublease-renewal option, and thereby recoup its investment through EZH’s continuing, pre-determined rent obligations, the payment of which is secured by the Treasury STRIPS held in the Equity Defeasance Account and a letter of credit.” Appellant’s Br. 53-54. Be
cause ConEd would not bear any risk, the government argues, the transaction should be ignored as lacking substance. Since we agree with the government’s first theory, we do not address the second.
Both LILO and related sale-in/ lease-out (“SILO”) transactions have been utilized by taxpayers in attempts to avoid taxes. A SILO transaction is identical to a LILO transaction except that the head lease term is longer than the useful life of the facility, so that the IRS ignores the lease arrangement and “treats the head lease as a sale of the asset.”
Wells Fargo,
641 F.3d at 1321. The result, as with a LILO transaction, is that the taxpayer is not entitled to deductions premised on treating the transaction as a genuine lease and sublease.
Before Congress amended the Internal Revenue Code and put an end to the tax benefits associated with LILO and SILO transactions in 2004,
see id.
at 1323 (citing American Jobs Creation Act of 2004, Pub.L. No. 108-357, 118 Stat. 1418), the LILO and SILO transactions were not uncommon, nor was litigation concerning the tax consequences of such transactions. Taxpayers have not been successful in these cases. Every circuit (including our own) that has considered LILOs or SILOs has held that such transactions do not pass the substance-over-form test.
See Altria Grp., Inc. v. United States,
658 F.3d 276 (2d Cir.2011) (affirming a jury’s determination that a series of LILO and other transactions did not withstand the substance-over-form inquiry);
Wells Fargo,
641 F.3d 1319;
BB & T Corp. v. United States,
523 F.3d 461, 464 (4th Cir.2008) (affirming district court’s conclusion that “although the form of [a LILO] transaction involved a lease financed by a loan, BB & T did not actually acquire a genuine leasehold interest or incur genuine indebtedness as a result of the transaction”).
In addressing the issues here we are obligated to follow this court’s prior decision in
Wells Fargo.
The transactions at issue in
Wells Fargo
were SILO transactions involving leases and subleases of various public transit vehicles. The transactions, like those in
BB & T, Altria,
and this case, contained purchase options as well as options similar to the renewal and retention options here.
See Wells Fargo,
641 F.3d at 1323-24. The Claims Court found that “Wells Fargo expected the tax exempt entities to exercise their options to repurchase their assets because ‘the economic effects of the alternatives were so onerous and detrimental that a rational tax-exempt entity would do nothing other than exercise the options.’”
Id.
at 1324. The Claims Court had recharacterized the transactions as ones that “ ‘essentially amounted] to Wells Fargo’s purchase of tax benefits for a fee from a tax-exempt entity that cannot use the deductions,”’ and disregarded the transactions under the substance-overform doctrine.
Id.
(alteration in original). We held that the Claims Court did not clearly err in “finding that the tax-exempt entities [we]re virtually certain to exercise their repurchase options.”
Id.
at 1330. Thus, applying the appropriate test under the substance-over-form doctrine, which asks “whether Wells Fargo could have reasonably expected that the tax-exempt entities would exercise their repurchase options,”
id.
at 1327, we easily concluded that the court was “left with purely circular transactions that elevate[d] form over substance.”
Id.
at 1330. Specifically, “the claimed tax deductions [we]re for depreciation on property that Wells Fargo never expected to own or operate, interest on debt that existed only on a balance sheet, and write-offs for the costs of transactions that amounted to nothing more than tax deduction arbitrage.”
Id.
In this case, as in
Wells Fargo,
our key inquiry is whether EZH would exercise its
purchase option at the end of the Sublease Basic Term. If the Sublease Purchase Option were exercised, the transaction would merely become a transaction in which ConEd leased the RoCa3 Plant from EZH and leased it back for the same identical period. Such a transaction lacks substance. This would particularly be so here because EZH would maintain uninterrupted use of the RoCa3 Plant without any involvement on ConEd’s part and ConEd would not experience any benefits or burdens associated with its leasehold interest.
ConEd argues that, unlike in
Wells Fargo,
the Claims Court (applying the proper standard) here made factual findings in ConEd’s favor with respect to the likelihood that the tax-indifferent entity would exercise the purchase option. ConEd argues that these findings were not clearly erroneous, and that this distinguishes this case from
Wells Fargo.
ConEd’s argument rests on three erroneous premises.
A
First, ConEd mistakenly argues that, under
Wells Fargo,
the purchase option is significant only if it is “certain” to be exercised. While the district court found that the options at issue in
Wells Fargo
were virtually certain to be exercised and we held on appeal that this finding was not clearly erroneous,
see
641 F.3d at 1329, we made clear that the relevant standard was reasonable likelihood. In evaluating whether the LILO Transaction in this case must be recharacterized,
Wells Fargo
requires that we assess whether a prudent investor in ConEd’s position would have reasonably expected that EZH would exercise the purchase option. As we stated in
Wells Fargo:
We have never held that the likelihood of a particular outcome in a business transaction must be absolutely certain before determining whether the transaction constitutes an abuse of the tax system.
The appropriate inquiry is whether a prudent investor in the taxpayer’s position would have reasonably expected that outcome.
Characterization of a tax transaction based on a highly probable outcome may be appropriate, particularly where the structure of the transaction is designed to strongly discourage alternative outcomes.
641 F.3d at 1325-26 (emphasis added). This language makes clear that a “reasonable expectation” standard, rather than a “certainty” standard, governs the rechar-acterization of transactions under the substance-over-form doctrine. In our view, and consistent with
Wells Fargo,
therefore, the “critical inquiry” is whether ConEd “could have reasonably expected that the tax-[indifferent] entit[y] would exercise [its] repurchase option[].”
Id.
at 1327.
B
Second, ConEd is mistaken in arguing that the Claims Court here applied the correct
Wells Fargo
standard. ConEd argues that the Claims Court applied the
Wells Fargo
standard and found that “EZH is not ‘likely’ to exercise its purchase option.” Appellee’s Br. 41. This is simply not an accurate characterization of the Claims Court’s findings, and it is based on quoting a portion of the Claims Court’s opinion that merely describes ConEd’s evidence.
When the Claims Court made factual findings it assumed (erroneously) that
the applicable standard was whether EZH was “certain” to exercise the option. The Claims Court specifically concluded that because “the Sublease Purchase Option was not certain to be exercised by EZH, ... [ConEd] had the benefit of potential profit and burdens of possible lost monies....”
ConEd,
90 Fed.Cl. at 304. Similarly, it noted that ConEd’s investment was subject to market risk “[b]e-cause the Sublease Purchase Option is not certain to be exercised,”
id.
at 298; that the LILO Transaction “consisted of three possible scenarios, none of which was certain to occur after the initial lease term,”
id.
at 306; and that there was “no guarantee” that the Sublease Purchase Option would be exercised as of “December 1997, when the Transaction was consummated.”
Id.
The Claims Court applied the wrong standard — understandably because, at the time that it rendered its decision, the Claims Court here did not have the benefit of our
Wells Fargo
decision.
C
Finally, ConEd mistakenly argues that even if “reasonable likelihood” is the correct standard, and was misapplied by the Claims Court, a remand is required for the Claims Court to decide this case under the correct standard. This argument rests on ConEd’s view that the record could support a finding that EZH was not reasonably likely to exercise the option. We disagree with ConEd’s assessment of the evidence. ConEd has the burden of proof to show that EZH’s exercise of the purchase option is not reasonably likely.
See United States v. Janis,
428 U.S. 433, 440-41, 96 S.Ct. 3021, 49 L.Ed.2d 1046 (1976) (“In a refund suit the taxpayer bears the burden of proving the amount he is entitled to recover.”);
Helvering v. Taylor,
293 U.S. 507, 515, 55 S.Ct. 287, 79 L.Ed. 623 (1935) (“Unquestionably the burden of proof is on the taxpayer to show that the Commissioner’s determination is invalid.”);
Coltec,
454 F.3d at 1355 (“[I]t is the taxpayer who bears the burden of proving that the transaction has economic substance.”);
Charron v. United States,
200 F.3d 785, 792 (Fed.Cir.1999) (“Since the [plaintiffs] were seeking refunds of taxes they had paid, they have the burden of proving they are entitled to the amount
sought.”)- And in this case, ConEd has not met this burden.
The record demonstrates that ConEd’s own contemporaneous statements made shortly before the Closing Date reveal ConEd’s expectation that EZH would exercise the purchase option. Brian De-Plautt, the Vice President of the ConEd subsidiary responsible for the RoCa3 transaction, admitted that ConEd believed that EZH preplanned to exercise the option before the closing date of the transaction. Responding to an inquiry from ConEd’s accountant, PriceWaterhouse, on November 21,1997, asking whether EZH’s exercise of the purchase option was “reasonably assured,” DePlautt responded:
Yes, among the reasons are (a) [the RoCa3] facility is a newly built key asset for [EZH], [and] (b) [EZH] has preplanned for purchase and done [its] economic analysis on the assumption that the plant will be purchased.
J.A. 25,776, 25,779. By that DePlautt meant that exercise of the purchase option would “more likely than not” occur (i.e., exercise was “over 50 percent” probable), and he admitted that he believed going into the transaction “that EZH had preplanned for the exercise of the purchase option.” J.A. 4140, 4238. Additionally, in a November 26, 1997, memo, ConEd acknowledged a Transaction Structure Description document from Cornerstone, the LILO promoter, which indicated that “ ‘it is reasonable to assume ... that [EZH] will exercise the purchase option.’ ”
J.A. 16,032. Finally, in ConEd’s own internal analyses of the transaction, ConEd admitted that it “assume[d] no economic benefit” from the Shirh-Tail period following the Sublease Renewal Option,
see
J.A. 16,615, suggesting that it did not fully consider situations that could arise where EZH declined the Sublease Purchase Option. Although ConEd asserted at oral argument before our court that DePlautt’s admissions only constituted the subjective views of one executive at the time the documents were written, and that ConEd changed its prediction prior to the Closing Date, the evidence ConEd cites for this proposition merely indicates that ConEd, in its financial accounting of the transaction, booked the transaction over the entire 44-year term of the head lease. This is hardly a surprise. ConEd was required to account for the transaction in this manner if it wished to take the claimed deductions. This accounting treatment does not negate the uncontradicted evidence that ConEd reasonably expected the purchase option to be exercised.
ConEd also failed to establish that a reasonable company in ConEd’s position would not have expected that EZH was
reasonably likely to exercise the option. ConEd relies on an appraisal it obtained from Deloitte & Touche (the “Deloitte Report”) to demonstrate that a prudent investor would not have reasonably expected that EZH would exercise the Sublease Purchase Option. But the Deloitte Report is primarily based on the notion that, in Deloitte’s view, there was no “economic compulsion” to exercise the Sublease Purchase Option because the Sublease Option Price would exceed the projected value of the property. J.A. 10,572.
Deloitte’s analysis is insufficient to establish that EZH was not reasonably likely to exercise the purchase option. It is uncontested that several factors would bear on the likelihood of exercise such as (1) non-economic factors; and (2) the costs to EZH that would result from ConEd’s exercise of the renewal or retention options if EZH declined to exercise the Sublease Purchase Option. Under either the renewal or retention option EZH faced substantial risks and the potential for adverse financial impacts, just as in ConEd’s view ConEd faced residual risks if either option were exercised. If ConEd exercised the Renewal Option, for example, EZH would potentially lose the ability to operate the plant profitably during the Shiri>-Tail Period; and under the Retention Option, EZH would risk losing the right to operate the plant profitably during the remainder of the head lease. As ConEd admits, “EZH can be replaced as the operator of RoCa3” at the end of the sublease. Appellee’s Br. 48.
At the same time, the Sublease Purchase Option required no out-of-pocket funds, as the money EZH would require to exercise the Sublease Purchase Options was set aside in the two defeasance accounts. Cf
. BB&T,
523 F.3d at 473 n. 13 (“BB & T supplied the funds for the purchase [option].... Because the ‘purchase’ is free to [the tax-indifferent entity], price cannot be [an] obstacle.”). As of 2018, the Debt Defeasance Account would still have a balance of $116,252,521.63, which EZH could apply to the Sublease Purchase Option payment. Meanwhile, EZH would be entitled to apply the amounts in the Equity Defeasance Account to the Sublease Purchase Option price using matured treasury STRIPS. All but one of the zero-coupon U.S. Government treasury STRIPS in the Equity Defeasance Account are set to mature in 2017 or 2018,
and the total value of these bonds at maturity is $99,199,000.00. The appropriate amounts that EZH would be entitled to in 2018 thus amounted to just over $215,451,000.00, the cost of the Sublease Purchase Option, rendering the option effectively costless to EZH.
Deloitte failed to address these considerations. Though Deloitte’s Report contained boilerplate references suggesting that Deloitte considered “other identifiable factor[s]” as well as the costs that EZH would accrue if it were to decline the Sublease Purchase Option, J.A. 10,572, there were no calculations cited in the Deloitte Report that analyzed the non-economic and other considerations described above.
More importantly, the author of the De-loitte report, Ellsworth, admitted at his
deposition that Deloitte failed to consider the consequences to EZH of not exercising the purchase option. The following exchange occurred:
Q. Mr. Ellsworth, did you consider in drafting your report the consequences to EZH of not exercising the purchase option?
A. That subject was not something that we were asked to provide an opinion on as part of the appraisal report.
J.A. 3768. Ellsworth also admitted that Deloitte failed to consider the source of the purchase option funding in assessing the likelihood that EZH would exercise the purchase option. Finally, Deloitte admitted that it produced on “the order of magnitude” of 100 appraisal reports of LILO transactions and never once found that there was “economic compulsion” to exercise a purchase option, further underscoring the boilerplate nature of its analyses. J.A. 3795-96. ConEd also cites the Kelly expert report as independent evidence that EZH was not reasonably likely to exercise the Sublease Purchase Option, but the Kelly report merely relied on the Deloitte Report’s analysis.
At oral argument, ConEd confirmed that Deloitte did not consider either the non-economic factors relevant to EZH’s exercise of the purchase option or the consequences that EZH would face if it were not to have exercised the Sublease Purchase Option. ConEd also admitted that the Kelly expert report did not consider these factors. ConEd’s other experts lend no support to its position. Though ConEd argues that Reed’s testimony suggests that exercise of the option was impossible to predict, for example, he merely testified that there was “uncertainty associated with whether the option will or will not be exercised” and that it was “impossible to determine [the purchase option’s exercise]
with virtual certainty
as of December 15, 1997.”
J.A. 4657;
ConEd,
90 Fed.Cl. at 285 (emphasis added). Thus ConEd presented no evidence that exercise of the purchase option was not reasonably likely by a prudent investor.
To the extent that ConEd argues that the government’s experts made concessions that the likelihood of EZH’s exercise of the purchase option was speculative, it is clear that their “concessions” were merely admissions of the obvious: that the future exercise of the purchase option could not be guaranteed with complete certainty. Samuel Ray, a consultant in equipment leasing and financing, merely stated that he did not “know for certain” if EZH was going to exercise the option, while making his opinion clear in his expert report that “it is reasonable that EZH will exercise the Sublease Purchase Option at the end of the Sublease Bas[ic] Term.” J.A. 6866, 29,506. David W. LaRue, a professor retained by the government, admitted that there is “[a]
certain
amount of speculation” associated with EZH’s exercise of the purchase option, but also testified that he “conclu[ded] that it was highly likely that EZH would exercise the fixed purchase option.”
J.A. 7179 (emphasis added); Trial Tr. 5087. The government’s
evidence, therefore, would not support a finding that exercise of the option was not reasonably likely.
Because the undisputed evidence establishes that EZH was reasonably likely to exercise the purchase option, ConEd has failed to show that the substance of the transaction included a genuine leasehold interest in which ConEd would bear the benefits and burdens of a lease transaction. Therefore, the LILO Transaction does not constitute a true lease and ConEd’s rent deductions were properly disallowed under § 162(a)(8) of the Internal Revenue Code.
Finally, we must also consider whether ConEd is entitled to its interest deductions associated with the HBU Loan under § 163(a) of the Internal Revenue Code. To achieve such deductions, the taxpayer must incur
“genuine
indebtedness” associated with the LILO Transaction.
See BB&T,
523 F.3d at 475 (internal quotation mark omitted). In this case, it is clear that the loan is not genuine. As noted above, ConEd undertook approximately $81 million in debt from HBU, EZH withdraws from this account to satisfy ConEd’s Initial Head Lease Payment obligation, and EZH pays back into this account (with payments that are equal in amount) in order satisfy its sublease obligations. The loan proceeds effectively remain in the account to satisfy ConEd’s loan obligation to HBU. Interest payments associated with genuine indebtedness are viewed as “compensation for the use or forbearance of money.”
Deputy v. du Pont,
308 U.S. 488, 498, 60 S.Ct. 363, 84 L.Ed. 416 (1940). Here, the funds from ConEd’s HBU Loan flowed from ABN (to fulfill the head lease obligation) and then back to ABN (to fulfill the sublease obligation) in a loop. The facts that ConEd’s tax advisor referred to the transaction as having “100% loop debt,” J.A. 23,353, and that ABN treated the transaction as “off balance sheet,”
id.
17,140, are unsurprising given that the money from the transaction would never leave ABN’s hands under the Sublease Purchase Option. As in
BB & T,
“ABN, which treated the loan as an off-balance sheet transaction, did not forbear any money during the time period in which BB & T sought to claim interest deductions.” 523 F.3d at 476;
see also Altria,
658 F.3d at 290-91 (“The evidence ... reasonably supported the jury’s finding that the nonrecourse debt Altria incurred was not genuine. The lender never forbore use of the purportedly loaned funds and Altria never obtained use of those funds.”). Following the Fourth Circuit, we agree that “[a] party simply does not incur genuine indebtedness by taking money out of a bank and then immediately returning it to the issuing bank.”
BB & T,
523 F.3d at 477. ConEd is not entitled to its interest deductions under § 163(a).
Conclusion
For the foregoing reasons, we reverse the judgment of the Claims Court in which it upheld ConEd’s claimed deductions with respect to the LILO Transaction, and remand to the Claims Court so that it may properly recalculate ConEd’s refund in light of this decision.
REVERSED AND REMANDED