morning after this case for today it's exelon corporation versus the commissioner of internal revenue mr com taxes on the sales through a like kind exchange but upheld almost ninety million dollars in penalties based on at least three fundamental errors first the tax court applied the wrong legal test to determine whether the purchase option in the subways was so likely to be exercised as to render both the option and excellence ownership illusory second it wrongly dismissed excellence reliance on its advisors opinions based on communications between w lawyer that were not improper let alone so obviously improper that exelon should have known they undermined the appraisal and third the tax court misunderstood the subways for turn conditions in concluding that clients with them would be unduly costly these three errors render the deficiency invalid and the penalties wholly misplaced at first the tax court by the wrong test to evaluate whether the purchase option was a real option the test that the i commissioner my friends on the other side suggested it's not a tax case i'm just not sure what what they had in mind about that it's as as it's very name suggested is tax crazy issue the same is the issue here it's not exactly the same issue your honor but i do think that it's this court's test it's the i think it's the most relevant precedent from this court but more to the point i think it's also right because the test in these cases should look to whether the option is essentially illusory so th excellence ownership interest is also effectively illusory and so if the option is really a false option and there's no question that just take the texas example c p s will repurchase at the end of this sublease all right well then we didn't have an ownership interest but if it's only reasonably likely which is the standard the tax court applied that's what an option is i mean and you know we could ask what reasonably likely means i mean if there's a forty percent chance that c p s would repurchase at the end of the lease is that reasonably likely i suppose so about sixty percent i suppose so as well but if there's a forty to sixty percent chance that c p s won't exercise the purchase option at the end of the exxon plainly has an ownership interest in the plates because there's a forty to sixty percent chance that they're going to end up with one hundred percent ownership after the subways term has expired so i do think that this court even though it's a different context essentially has it right in m w gear that you should be looking for something that is either economically compelled were very close to it i mean you know if you want to say you know if the test is not reasonably likely but overwhelmingly likely i think that gets at what the test should get but as the tax court applied it the purest of all options which is you know you know it's about fifty percent that the party will exercise its option about fifty percent they won't that would be reasonably likely and that would  us of our risks of ownership in a way that makes absolutely no sense it's a comment i like to ask you about the definitions of capacity factor in availability factor so my problem here is that in your brief at page forty six the way that you really availability by definition well your honor i think the way to understand that is to say that that definition in the context of return condition would be best understood by people in the industry as an availability factor i think if you just sort of peel that out and look at it in the abstract we're compare it to what stone and webster was using in a very different context i can understand why you might say yeah the sexy looks more like but i think the people in the industry and this is what the amicus brief says and this is what if there'd been any testimony on this the testimony would reveal that people in the industry would look at that contextually and they would say of course it's an availability factor or maybe an adjusted availability factor is what it probably was because we've never expect to see a capacity factor in a return condition because the return condition by its very nature is something that the operator can or the suddenly see can control and everybody in the industry understands that capacity factor is outside the control of the operator can stop predicts depreciation you can sell predicts market factors i mean even though those guesses right mean you can still make presumably one would want to before making an investment it exactly your honor and which is but there's two different context right there's stone and webster when they're evaluating the original investment still loyal when they're trying to assess the value of the plants based on discounted cash flow of course they're going to look at capacity factor and those are going to be based on guesstimates and if this definition appeared in that context you know i still think it would be ambiguous in the industry  to have evidence but it might well be understood as capacity factor but as a return condition it just doesn't make any sense and i don't think the tax court understood it correctly because the tax court thought that that return condition estimated annual capacity was something you could sort of throw money at and you could get the plant sort of up to snuff and capacity factor doesn't work that way i mean availability factor does but you can you know by spending more money on maintenance or repairing some boiler that's broken you can get the plant sort of up to snuff but if the market has shifted for example you know the people who were negotiating this contract could not have anticipated fracking and what that would to the cost of natural gas and what that would do to the capacity factors for coal fired plants based on factors entirely out of the plant operators control and so again i understand the question i understand why looking at it in the abstract would say x i don't know i mean that looks as much like capacity factors availability factor but i think and this is where i think the amicus brief is coming from and this is what the testimony i believe would reveal if there'd been any is that the people in the industry looking at that would say no that's that that's a little ambiguous but it must mean adjusted availability factor because otherwise it doesn't make any sense i think you also get that sense if you look at you know the the report and this is on appendix this page one sixty five and one sixty six i think is the most relevant pages with the way it's looking at this and trying to estimate estimate the discounted cash flow they have you know separate lines for availability adjusted availability and capacity factor and they nakedly an unambiguous lee have this wine for capacity factor and the reason i pick these pages is because this is thirty one years out which is when the sub weeks expires  they have numbers like fifty eight point seven percent and then if you look at the next page those numbers are down to forty nine point six percent and so if if the techs were right that capacity factor and estimated annual near eighty two percent in that it just seems that when so much right on these turns and it's a condition and at least it's almost like you're saying well in the industry everybody understands that sometimes green means green but in this particular context it meant red  wouldn't one be precise about language when this much money is at stake in the deal you know as with almost any contract i've ever seen after the fact when issues arisen could you be more precise about it absolutely but i think i would sort of turn that around and say when this much money the four hundred twenty three million dollars efficiency and ninety million dollars in penalties rides on it why would you get evidence about this why would you not me just put this in context i mean the tax court says on pages one forty three of his opinion and then one seventy one of the opinion that excellent must have known this would have been obvious tax law with a remote to pull multiple exelon witnesses none of whom were asked about this topic and on page one forty three the tax court says c p s in the context the texas spruce lease also must have known this well there was a c p s witness and he wasn't asked about this not by the s and not by the tax court judge who was not shy about asking witnesses about other questions and so i get that like in the context of a transaction of this size it would be better if this were written more clearly i mean i wish it had but in the context of these deficiencies i think the taxpayers at least intitled to be able to put on some evidence and you know and have the relevant witnesses at least testify to what this meant in context did you seek rehearing on this basis we did not seek rehearing on this basis so if the jets got it so wrong why didn't you try or why didn't your client try to get the judge to look at it the way you're now looking at i think your honor we considered the possibility i think there were a variety of factors including timing and the concerned that you know we're talking about the one nine hundred ninety nine tax year and i think we were just concerned that just totally misapplied term as we've been discussing here you would normally give that judge a chance to look at it that way you think you got it wrong well and i just say what you often would i think that also any i'm talking as a trial judge you like together second by i can understand your perspective your honor i also think in fairness though we do think there are these other fundamental errors such that i think even if we could correct this one error we still think the tax cut was applying the wrong legal standard we still think that he made a you know an equally egregious mistake in faulting the exelon for the possibility that winston and strawn crossed some line in its communications with the  and at least as i read the tax court opinion you know the sort of the critical elements of its findings it's both deficiencies and penalties turns on this return condition it does turn on the standard because it's clearly applying a reasonable likelihood standard and the third thing it turn on is this perception that there was something nefarious between winston strong and the lawyer and there too there just is a complete absence of evidence on this before we get to the penalties i'm just having a  real problem with the notion of reversing a tax court finding a fact that exelon had no in dish of ownership after thirteen days of trial forgetting all of this terminology argument everything else he found as a fact that he didn't have any indicia of ownership no responsibility to maintain the property you funded the the option price you pay them eighty eight million dollars in one case to to to to do this deal upfront the chances of the fault by the less no because one of them was a municipality san antonio and the other one was prohibited by the georgia law from declaring bankruptcy so there was no risk really no risk it at all and that so forgetting about all this terminology how do you get around  that those findings of fact based on a clearly erroneous standard well you're on a couple of points one is i don't think in the end that's what the tax court rested its decision on it made observations about some of those factors but when it comes down to what the decision rests on i think it really does rest on the winston and strawn opinion and his understanding of the return conditions and i do think it's important to understand how critical the purchase option issue is because it really does undermine the other things that you've referred to because if there is let's say there's a fifty percent chance that the purchase option repurchase option is not going to be exercised if that were recognized i don't see how you reached the conclusion that we had no risk because that means that there's a fifty percent chance that at the end of the sublease we're going to own we're going to own these properties outright and the circumstances in which c p s would not exercise the sublease repurchase option is precisely when the plant is substantially below the fair market value of the plant is substantially below the repurchase price and so if this plant at the end of thirty years is only worth two hundred million dollars then c p s is going to walk away from it we're going to be stuck with it and at the end of the day we're going to lost like one hundred million dollars on this investment and how that's not a real risk and there's nothing to do with bankruptcy i mean you know i think bankruptcy risk even if it's unlikely it's still a risk and that's the hallmark of ownership you know and i don't it doesn't make a lot of sense to me to say i have to contract with somebody who's likely to go into bankruptcy before you recognize the risk that i could be stuck holding the bag if my counterparty goes into bankruptcy but you're contracting with two entities that basically will never go into bankruptcy for the reasons i mentioned with having to get around the fact that that exxon represented to its own board that it was scheduled to receive the fixed price option at the end of their lease term i don't think they were told that your honor we dress in that in the meeting it does that's a quote what i think what you're reading from is the cash flow estimate that was part of the package that went to the board and if you're talking about cash flow i think you're absolutely right there were two times when they could possibly get cash flow and it was at the time that they got eighty percent of the purchase price back as a prepayment of the lease and the second time is with the repurchase option but that same package later and it had something that made it crystal clear that it was an option and that it wasn't guaranteed so i think if you read that whole package you would not come to that conclusion possibly go wrong here some of the investments with were with ai gee what could possibly go wrong with that the real risks here that exelon took but the most dramatic of them is that it could be stop owning this property at the end  reality where the property was worth substantially less than the market value at the time and i would just underscore that you know it's never true in some of these other cases where you have you know a tobacco company buying a waste treatment plant in holland like this is a case where if exxon ended up with a texas power plant it would know what to do with it and this is a sector of the economy where a valuation thirty years out almost can't be locked in in a way that eliminates risk and this whole case starting when my client thought they were going to sell their fossil fuel assets for two billion dollars and ended up within a matter of months selling them for four billion dollars so the idea that thirty years out you could predict absolutely that the fair market value of these properties would be greater than the purchase place price option such that it was essentially locked in that c p s would end up with these properties i think it's just a impact on the value of cool for plans it absolutely would your i mean you know not to put too fine a point on it but if the last presidential election had gone the other way the value of a coal fired plant would be substantially less than it is given what has happened with coal regulation as a result of the election that just happened which is just underscores why it really is fanciful that to think that the fair market value of this is locked in in a way that of course we would the s would exercise the option and to maybe use the other thirty seconds of my extra minute on it just on the penalties issue i mean i do think whatever you determine on the deficiency i think the penalties requires an even greater finding because it requires a finding for which there's no evidence if you look at one seventy one of the tax court opinion there's no evidence to support the idea that exelon would have obviously interpreted the return condition the way the tax court did there's no evidence that exelon would understood that winston and strawn crossed the line with the deloitte and we also think that the tax court with respect applied even if you think that the tax court applied a better standard based on subsequent federal circuit decisions mean morning your honour's ticket christianson for the united states may it please the court selling leaseback transactions the exelon engaged on engaged in this case are like all the other tax shelters that the courts have almost unanimously rejected in other cases the other lie low and silo cases that specifically have been unanimously found to not muster that are passed muster u nder the substance over form dr and by every circuit court that has addressed and consider those transactions i do want to discuss for a moment the return conditions this was one of the basis of the tax court's decision it certainly was not the only evidence before the tax court that led it to conclude that the lessees were reasonably likely to exercise their purchase options but with respect to the return conditions the tax court simply did not misunderstand what they required and that the return condition for estimated annual capacity did in fact refer to the plant's capacity factor the court need only look at the plain language of the return condition itself to arrive at that conclusion could you respond to mr comments point about the text quite not pressing on this issue and asking questions about it and he says that there was some ambiguity and if this was that important to the tax quite the tax court would have been pressing on this issue during the trial and it did not the evidence actually includes substantial testimony from excellent experts regarding capacity factor include in the evidence exists and only its reports regarding the declining capacity factor and so i think what the tax court did is it relied on that testimony from excellence own experts with respect to what the meaning of capacity factor is and the way its own reports to reach its conclusions i don't know that there were was a lot of back and forth questioning from the tax court on this particular issue but there was substantial evidence regarding the meaning of capacity factor and what that meant for example again the return condition refers for estimated annual capacity refers expressly to actual generation and there's no dispute between the parties both exelon and the amicus agree that measuring actual generation is is a measurement of the plant's capacity factor as opposed to availability factor which instead measures how often a plant is capable of running was that was that the definition on which you the  to the normal claim capacity of at least eighty two percent and so just looking at the plain language of the return condition it's a it's expressed reference to the actual operation of the plant and there's no dispute that capacity factor measures actual generation and again these definitions for all of the return conditions were lifted from the stone and webster engineering report which included which defined capacity factor using the exact same terminology and also there was a separate definition for equivalent of a lability which use the exact same terminology that's used in the return conditions for the second return condition which is that energy output so the so the definitions included in the return conditions were lifted from stone and webster's own engineering report if the court is looking to what the people in the industry understood capacity factor to mean the court need go no further than stone and webster's own engineering report which defined those terms and would it up and i had friendlies to include that given that it doesn't off projections about market and things that would be difficult to predict it does include i agree capacity factor can be impacted by market forces a moment ago i referred to testimony from  experts which which relates to this topic because the capacity factor certainly is not unrelated to the physical condition of the plant in fact capacity factor can be managed the plant owner at least according to excellence experts dr myers one of exxon's experts explained that the declining capacity factor which meant that the actual hours well it could become more obsolete in the future i think that could have been part of the declining capacity factor and the point was that if if the plant owner does not continue to replace components of the plant that become obsolete then the capacity factor will continue to decline but the the owner does have control over the capacity factor in that the owner as parts of the plant become obsolete the owner can invest and replace those those components of the plant to make the plant more competitive and that is precisely what john reed another one of excellence experts explained in his expert report he stated and i'm going to quote this is the supplemental appendix page three ninety five he states that the plant's capacity factor can also be affected by the ability or lack thereof to retrofit existing equipment to remain competitive i e avoid technological obs that is what the tax court was focused on that meg in c p s would be required to make significant investment to retrofit and upgrade the plants as they became obsolete and by doing so and i want to quote just to be sure that this is indeed what the tax court understood on page one seventy one of the court's opinion the court stated the petitioner as a sophisticated power plant operator must appreciated that it would be very expensive for c p s to sufficiently upgrade the plant to meet the capacity requirements so the court repeatedly refers to this concept of obsolescence and the river and the requirement that the lessees in order to maintain a sufficiently high capacity factor would have to upgrade components of the plan as they became obsolete so that somewhere along the line one of them did actually open a new plant i don't remember where that was and they'd been may have been in georgia but you know alongside the other one other sort of these proximity to the same customer base but of course that customer base was obviously growing substantially and that's that's where i get confused about when we talk about capacity factors it's based on demand how much you're actually operate what's what it would do you really could customer demand i guess  right and as as the plant owner you know prevents a plant from becoming obsolete and retrofits parts that have become obsolete that makes the plant more competitive so that it will actually be called on more to deliver energy more frequently and that and that's one of the tax court's findings in this regard or supported by at salons own expert testimony and by the stone webster report which defines what capacity factor means and of course the subways return risk but they're also hearing that it's highly unlikely so why then is it supposed to be glaringly obvious to exxon let me just in response to that that exelon itself actually registered these transactions as tax shelters and at the time the definition of tax shelter meant to refer to a transaction that the significant purpose of which is the a vision of federal income tax so tax exelon itself registered these transactions house and i want to put out any gain that i've made in the house into another house so i don't have to pay tax on it people did that right there's nothing wrong with minimizing a tax break right i agree with that your honor and i think that these transactions cross the line the and yes silo is sell and lease out and lie low as lease and lease out when there's not when you talk about tax evasion isn't there a difference between that and where you do for  not yes if there were at their literal it at the end of that and it's not it's not really an invasion there are times when you can defer when a tax becomes you when you have to realize that obviously for if a company buys another company and pays for it with to recognize the income from the sale of its plants and in one thousand nine hundred nine you know unless the transactions actually did confer transfer genuine ownership in the out of state plants to excellent but on their accounting advice that it's highly unlikely that the tax i mean i understand everything you're saying understand that your position is that the silo transaction was you know fraudulent from the beginning i get that's your position but if they're being advised by their as a tax court found that exelon was also aware that winston was providing the lloyd and stone and webster with with the conclusions it wanted to see in order to support his tax opinions in fact that was again planned from the start when pricewaterhouse coopers explain and that the tax receipt would be you know addressed by obtaining opinions from experts know how ok how is exxon supposed to know that a and b you know these were sophisticated players they knew what they they knew what exxon wanted to do they already knew what the criteria where this is that the law firm telling the client it's hired to do the the work you know how hard to get the report you know well this is what we're looking for tell me if this ma that it's not necessarily saying you know that you must find the we want you to be dishonest in your conclusions so there are two things how do you how do you think exxon knew and then i'm skeptical that you think that w so we've cited the e mail exchange in the record where that occurred and exelon actually suggested a phone call between all of them so that they could make sure they were all on the same page so exelon was aware that those conclusions are being provided to deploy and that and then in turn when someone strong relied on those very conclusions to issue a favorable tax opinion well where do you start there's a certain when in fact when they're obviously made a big effort to say well that was a big effort to evade taxes and i call it more of a deferment but the fact that experts agree with each other and double check and that sort of  thing is that said some kind of an implication of fraud or is that more like the good business practices in order to coordinate and to find out it's where there may be some mistakes here and there are those three experts in all of them combining  it's kind of substantial i think that the tac court found was that that that interfet interfered with the integrity and indeed the independence of detroit as as the appraiser and so delay to reach these conclusions  what evidence is there in the record that the taxpayer knew about this communication which is that fades twenty so they start page twenty two it's so so it's page three sixty two the e mail from winston and strawn that was attaching proposed conclusions for the appraisal that winston and strawn emailed to stone and webster first which was then shared with exelon exelon concluded that most of the appraisal conclusions actually pertain to the lawyer and for them to the lawyer and then they had a conference and discussed it so that they were all on the same page that's what the e mail shows us just how the conclusions were transferred from winston to to this exchange as well and also the transcript there's testimony as a court found that that there was substantial back and forth and feedback and that winston and strawn provided regular feedback to the lloyd throughout the process including reviewing drafts of the appraisals and what the court found was that all of that combined together was an attempt to obtain certain results and not merely an attempt you know if they crossed that bridge it was an attempt to obtain certain results the court found as opposed to would as opposed to  you know what facts might be legally significant so it was a finding by the court that that winsome that crossed that line in interfering with the independence of dilutes appraisal and i would i would note that the burden to establish reasonable cause and good faith again is on the taxpayer the evidence that is in the record supports the court's finding that that winston crossed the line in attempting to obtain certain tax results and if you look at winston's propose conclusions with the final conclusions and dilutes report they are remarkably the same and almost verbatim as the court pointed out in its opinion so not only did winston provide the questions but it also provided the the silo and lyla transactions and had never once found that the exercise of the purchase option was not or it was not economically compelled so the federal circuit concluded that those appraisals were m correct legal standard to it to be applied the reasonably likelihood mean something more than just more likely than not but instead it adopted that standard as applied by the federal circuit and second circuit which used other similar language to describe that standard such as being where a prudent investor would reasonably expect that outcome and so our position is that the reasonable likelihood let me begin by answering your question the penalties in the deficiency have been paid in full now my friend starts his presentation here as they've started their briefs and everywhere else with trying to compare this to all the other side of the law the transactions well they're not like all the at least two critical ways one this is the only one of these that we're aware of that is involves a like kind exchange and that means it's an effort at deferral of taxes it's not this effort where somebody comes into your office and says hey do we have a deal for you we're going to transfer some benefits and you can evade some taxes by getting a deduction from somebody else this really is a different dynamic this all started with a very real transaction in which we made more money than we thought we would we were trying in good faith t advantage of ten thirty one of the tax code i think there's anything to furious about that so that's one way it's very different the second way it's very different is if you look at all these other circuit cases one thing you'll notice b b and t consolidated evidence wells fargo those cases don't involve penalt this case even though i would say that it's the least and not true is that these transactions because it starts out it's different and starts out with an effort to execute a like kind exchange it's the one where they are seeking penalties and i think the penalties are really out of here and i'll get back to it as to what the record says about the return conditions there's no citation of page one seventy one in the appendix of the opinion as to what we knew and you don't have to search for this whole record that texts were tells you page one forty two although the parties did not submit any evidence regarding the amount c p s would be required to invest in the spruce station to meet the return skinner if that's the key thing to the both the deficiency and the penalties you need some evidence you can't impose a four hundred million dollar deficiency and ninety million dollars in penalties on no evidence at all the rest of the stuff is ambiguous actual actual doesn't solve it you can have actual capacity or actual availability obsolescence doesn't solve it because obsol plant can become obsolete because of market conditions you can put all the nice retrofits you want but if the coal plant is not going to have a high availability to past the factor rather in a market where coal prices are high and natural gas prices are low a disk to finish on the penalty issue one other finding of the tax court that should be lost in this is a page sixteen he finds that excellent needed expert advice so to say that we needed expert advice to execute this transaction but we can't rely on it because something as subtle as the winston and strawn exchanges when the only testimony on this record is from hughes at page one thirty three of the opinion where our expert says that the weight complied with the relevant professional standards i just don't think you can impose penalties on us for that and just to finish there's one case that we did not cite but i found the preparation for argument that is directly relevant to this point so i'll just give you the citation it's the d h l case from the ninth circuit it's two eighty five third twelve ten and it's case where the tax court was reversed on penalties for d h l providing too much advice to its accounting firm and that was case where d h l was making the communications directly so this case where it's winston strong i think is off for sure do you disagree that the supplemental appendix pages that mr kristof this cited to show that your client knew about this interference between your legs interference between winston and lloyd well i agree that they knew about the communications but i think the relevant question is did they know that those communications were improper and there's no evidence for that and indeed so just again i thought to be as clear as i can i don't contest that exelon knew those communications happened but i think the relevant test for penalties is whether they knew that there was something inappropriate about them such they could not reasonably rely on the appraisal thank you thank case it's taken under advisement