Document ID: s3://data.kl3m.ai/documents/govinfo/USCOURTS/USCOURTS-ca4-07-01177/USCOURTS-ca4-07-01177-0/pdf.json

Parties Involved:
BB&T Corporation
Appellant
Equipment Leasing and Finance Association
Amicus Supporting Appellant
United States of America
Appellee

Document Text:

PUBLISHED

UNITED STATES COURT OF APPEALS

FOR THE FOURTH CIRCUIT

BB&T CORPORATION, 

Plaintiff-Appellant,

v.

UNITED STATES OF AMERICA,

Defendant-Appellee.  No. 07-1177

EQUIPMENT LEASING AND FINANCE

ASSOCIATION,

Amicus Supporting Appellant. 

Appeal from the United States District Court

for the Middle District of North Carolina, at Durham.

N. Carlton Tilley, Jr., District Judge.

(1:04-cv-00941-NCT)

Argued: February 1, 2008

Decided: April 29, 2008

Before WILLIAMS, Chief Judge, WILKINSON, Circuit Judge,

and Patrick Michael DUFFY, United States District Judge

for the District of South Carolina, sitting by designation.

Affirmed by published opinion. Chief Judge Williams wrote the opinion, in which Judge Wilkinson and Judge Duffy joined. 

COUNSEL

ARGUED: William Kearns Davis, BELL, DAVIS & PITT, P.A.,

Winston-Salem, North Carolina, for Appellant. Judith Ann Hagley,

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UNITED STATES DEPARTMENT OF JUSTICE, Tax Division,

Washington, D.C., for Appellee. ON BRIEF: Alan M. Ruley, BELL,

DAVIS & PITT, P.A., Winston-Salem, North Carolina; Robinson B.

Lacy, Andrew S. Mason, Ann McLean Jordan, SULLIVAN &

CROMWELL, L.L.P., New York, New York, for Appellant. Anna

Mills Wagoner, United States Attorney, Greensboro, North Carolina;

Richard T. Morrison, Acting Assistant Attorney General, Gilbert S.

Rothenberg, Acting Deputy Assistant Attorney General, Richard Farber, UNITED STATES DEPARTMENT OF JUSTICE, Tax Division,

Washington, D.C., for Appellee. Steven E. Grob, Edward A. Groobert, Anthony Ilardi, Jill M. Wheaton, DYKEMA GOSSETT,

P.L.L.C., Bloomfield Hills, Michigan, for Amicus Supporting Appellant.

OPINION

WILLIAMS, Chief Judge:

This appeal requires us to determine the tax consequences of a

complex financial transaction. BB&T Corp. entered into a "leasein/lease-out" transaction, often called a "LILO," hoping to reduce its

tax liability, but the Internal Revenue Service ("IRS") disallowed the

deductions it claimed. After BB&T sued for a refund, the district

court granted summary judgment in favor of the Government. 

BB&T now appeals, arguing that the district court misapplied the

"substance-over-form" doctrine in determining that it could not claim

deductions for rent and interest under 26 U.S.C.A. §§ 162(a)(3) &

163(a) (West 2002 & Supp. 2007). Specifically, BB&T disputes the

district court’s conclusion that although the form of the 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. For the following reasons, we affirm.

I.

Because this is an appeal from the district court’s grant of summary

judgment in favor of the Government, we review the facts in the light

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most favorable to BB&T. Anderson v. Liberty Lobby, Inc., 477 U.S.

242, 255 (1986).

A. Background.

The parties agree that the structure of the transaction at issue

matches that of a "typical" LILO, so we begin with a brief overview

of this complex transactional form. 

In a typical LILO, a U.S. taxpayer leases property from a taxexempt entity and simultaneously leases that property back to the

owner. The tax-exempt owner’s sublease has a shorter term than the

taxpayer’s lease. Upon expiration of the shorter sublease, the owner

may exercise an option to buy back the remainder of the taxpayer’s

lease. Thus, in practical terms, the tax-exempt property owner continues to use the property during the sublease term just as it did before

the transaction and bears no risk of losing control of its asset(s). 

The taxpayer, meanwhile, receives tax benefits by deducting the

rental payments on its lease, amortizing certain transaction costs, and,

depending on its financing arrangement, deducting interest payments.

Maxim Shvedov, CRS Report for Congress: Tax Implications of

SILOs, QTEs, and Other Leasing Transactions with Tax-Exempt

Entities 8 (2004). The tax benefits can be substantial and are achieved

primarily by "[a]ccelerating the transaction-related deductions and

delaying recognition of the corresponding revenues." Id. at 3. This

delayed recognition creates a tax deferral, which, in practice, will

function as a tax reduction due to the time value of money. Id. at 2,

8.

Generally, parties aim to structure a LILO in a way that essentially

eliminates any risk of economic loss while maximizing the deductions

that the taxpayer may claim. In this respect, the parties strive to

"strike a balance between limiting their exposure to risks on one hand,

and making sure the provisions do not disqualify the transaction as a

[genuine] lease [for tax purposes] on the other. Id. at 9; see also Mark

P. Gergen, The Logic of Deterrence: Corporate Tax Shelters, 55 Tax

L. Rev. 255, 259 n.19 (2002) (noting that LILOs are often structured

so that "there is no risk to any party, other than the tax law risk"). 

BB&T CORP. v. UNITED STATES 3

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The chief tax risk associated with entering into a LILO is the possibility that the IRS will deem the transaction a sham. LILOs have been

harshly criticized as abusive tax shelters that serve only to transfer tax

benefits associated with property ownership from tax-indifferent entities, which have no use for them, to U.S. taxpayers. See David P.

Hariton, Response to "Old ‘Brine’ in New Bottles" (New Brine in Old

Bottles), 55 Tax L. Rev. 397, 402 (2002) (noting one commentator’s

characterization of LILOs as abusive tax shelters and agreeing that

LILOs "purport[ ] to create tax benefits that Congress did not intend

to confer on anyone in respect of transactions that involve no business

investment at all"). In 1996, the IRS issued proposed regulations that

largely eliminated the tax benefits associated with LILOs; these regulations became effective in 1999. Section 467 Rental Agreements, 61

Fed. Reg. 27,834 (proposed June 3, 1996); 26 C.F.R. § 1.467-1 to -5

(2007). Although the regulations did not apply to transactions entered

into before 1999, there remained a risk that the IRS would invoke

generally applicable tax law principles to disallow LILO-related

deductions. Despite the risk, many large financial institutions executed LILO transactions between 1996 and 1999.

B. The Transaction.

1. BB&T Enters into the LILO.

BB&T, a U.S. financial services company based in the Southeast,

entered into the LILO at issue in this appeal with Sodra Cell AB

("Sodra"), the business division of a Swedish cooperative recognized

as one of the world’s leading wood pulp manufacturers.1 The property

at issue in the transaction is a 22% interest in the pulp manufacturing

equipment at one of Sodra’s mills (hereinafter "the Equipment").2 As

1BB&T implemented the transaction through a trust, with Fleet

National Bank ("Fleet") acting as trustee. The parties agree that use of

the trust did not alter the tax consequences of the transaction, which

would have been the same had BB&T entered into the transaction

directly. Accordingly, we refer to both BB&T Corp. and the trust as

"BB&T" unless the context otherwise requires. 

2The remaining 78% interest in that mill’s pulp-manufacturing equipment was the subject of a similar LILO between Wachovia Bank and

Sodra. 

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explained more fully below, the transaction, which remains on-going,

involves a lease and simultaneous (but shorter-term) lease-back, followed by a series of options.

A promoter, Knight, Tallman & van Tol Capital Partners, L.L.C.

("KTV"), solicited BB&T to participate in the transaction. KTV marketed the LILO to BB&T as a "tax driven structure" that would provide significant "[t]ax savings" while eliminating economic risk

through the use of defeased accounts.3 (J.A. at 173-186.) 

Before entering into the LILO, BB&T performed an independent

evaluation of the transaction. This internal assessment described the

transaction as a "tax-driven deal" with an after-tax investment yield

"largely generated by tax benefits associated with accelerated tax

deductions" for rent. (J.A. at 187.) BB&T’s Chief Financial Officer

("CFO") conceded that "if there were no tax benefits" BB&T would

"[p]robably not" have moved forward with the LILO. (J.A. at 83.) The

CFO claimed, however, that BB&T was "intrigued by the transaction"

in part because it was "looking to grow loans and diversify [its] loan

portfolio." (J.A. at 996-97.)4

As part of the process outlined in the KTV promotion, BB&T had

the Equipment appraised. Deloitte and Touche, L.L.P. performed the

appraisal and prepared a report estimating the equipment’s useful life

and fair market value, as well as the value of the interest BB&T

would have in the equipment at different times.

Then, on June 30, 1997 (the "Closing Date"), BB&T and Sodra

executed the transaction through a series of interrelated agreements.

These agreements included, inter alia, a "Head Lease," a Sublease, a

Debt Payment Undertaking Agreement ("Debt PUA"), and an Equity

Payment Undertaking Agreement ("Equity PUA"). The Head Lease

and Sublease govern the parties’ interests in the Equipment, while the

Debt PUA and Equity PUA set forth fiscal obligations.

3A defeased account is one in which funds are escrowed at a bank and

pledged to the appropriate party. 

4

Interestingly, the transaction was not presented to BB&T’s commercial leasing subsidiary, which played no role in initiating, evaluating,

approving, or managing the transaction. 

BB&T CORP. v. UNITED STATES 5

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2. Property Interests — the Leases.

Pursuant to the Head Lease, BB&T leased the equipment from

Sodra for a 36-year term. At the same time, under the terms of the

Sublease, Sodra leased the equipment back from BB&T for a 15.5-

year period that the parties refer to as the "Basic Lease Term." In

effect, the Sublease retracted BB&T’s rights and obligations under the

Head Lease for the duration of the Basic Lease Term, but provided

BB&T a right to make an annual inspection of the Equipment.5 Sodra

therefore continues to use and possess the Equipment as it did prior

to the transaction. Between 1995 and 1997, Sodra made major

improvements to the Equipment at a cost in excess of $125 million.

After the Closing Date (between 1997 and 2001), Sodra continued to

make improvements to the Equipment at a capital cost totaling $74.6

million. 

When the Basic Lease Term expires on January 1, 2013, Sodra has

the option to buy back BB&T’s remaining interest under the Head

Lease. Sodra’s exercise of this option would terminate the transaction

in 2013, following the close of the Basic Lease Term. 

If Sodra declines this "purchase option," BB&T has options of its

own. These options include (1) requiring Sodra to extend its Sublease

an additional 13.3 years to April 18, 2026 (meaning the Sublease

would then end 7.2 years prior to the expiration of the Head Lease)

(the "renewal option"); (2) leasing the equipment to a party other than

Sodra, subject to certain requirements concerning the terms of the

replacement lease and the identity and creditworthiness of the

5The Head Lease gave BB&T the right to sole possession of the equipment (subject to an annual inspection by Sodra), the right to operate the

equipment, and the right to retain all profits generated from its use of the

equipment. The Sublease turned the tables, granting Sodra the right to

sole possession of the equipment (subject to an annual inspection by

BB&T), the right to operate the equipment, and the right to retain all

profits generated by its use of the equipment. 

Under the Head Lease, BB&T was required to maintain, service,

repair, and overhaul the equipment in accordance with certain standards,

and to bear all costs related the equipment’s use and maintenance. Under

the Sublease, however, Sodra took over these obligations. 

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replacement lessee (the "replacement lease option"); or (3) taking possession of the equipment and using it at its own expense and for its

own benefit for the remainder of the Head Lease term (the "return

option"). (J.A. at 1841.)

3. Financing Obligations.

i. Closing.

As we previously noted, supra note 1, BB&T implemented the

transaction through a trust, with Fleet National Bank ("Fleet") acting

as trustee. The closing proved relatively straightforward: ABNAMRO Bank N.V. ("ABN"), one of the world’s most secure financial

institutions, assisted with the financing by depositing $68,008,236 in

BB&T’s trust account at ABN, while BB&T contributed $18,228,895

of its own funds to the trust account.6 Acting pursuant to the Debt

PUA, Fleet immediately transferred $68,008,236 (a sum equal to that

furnished by ABN), back to a defeased account at ABN (the "Debt

PUA account"). As a result of this irrevocable transfer, those funds

became an asset solely of ABN, unreachable by Sodra, BB&T, or

their respective creditors. Of the remaining $18,228,895, Fleet used

$12,000,193 to purchase treasury bonds, which were placed in an

account at Fleet. This purchase set in motion the Equity PUA. To

complete the closing, Fleet transferred $6,228,702 to Sodra as Sodra’s

"incentive for doing the deal." (J.A. at 325.) 

On paper, however, the closing proved far more complicated. The

$68,008,236 ABN provided represented a non-recourse loan from one

of ABN’s subsidiaries, Hollandsche Bank-Unie N.V. ("HBU") (hereinafter the "HBU loan"), the proceeds of which ABN was transferring

to BB&T’s trust account on behalf of HBU. Once placed in the trust

account, the HBU loan, coupled with BB&T’s $18,228,895 investment, became BB&T’s "Advance Head Lease Payment," the first

(and, as explained below, potentially the only) rent payment due

6BB&T also paid an additional $5.53 million in gross fees in connection with the transaction, including an advisory fee to KTV and a

$220,000 payment to ABN for its role in the transaction. (J.A. at 50.)

KTV, in turn, paid BB&T a $1 million advisory fee in connection with

the transaction. 

BB&T CORP. v. UNITED STATES 7

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Sodra under the Head Lease. Only the $6,228,702 "incentive" payment actually went to Sodra because the Debt PUA obligated Sodra

to make a $68,008,236 payment to ABN, which was acting as "Debt

PUA Issuer" for the transaction, and the Equity PUA mandated a

$12,000,193 payment from Sodra to Fleet, which was serving as "Equity PUA Issuer." Accordingly, these funds were transferred to ABN

and Fleet on Sodra’s behalf, rather than paid to Sodra.

ii. Basic Lease Term (Closing Date-January 1, 2013).

The Head Lease calls for BB&T to pay rent to Sodra in two installments. The Advance Head Lease Payment represents the first installment, and a second payment of $557.8 million (the "Deferred Head

Lease Payment") is due in 2038, five years after the Head Lease

expires. BB&T thus will not make any rental payments during the

Basic Lease Term. 

Moreover, although Sodra is required to make annual rental payments during this term, Sodra does not supply any additional funds

to satisfy this obligation. Instead, ABN, in its capacity as Debt PUA

Issuer, makes the payments on Sodra’s behalf from the funds it

received at closing. BB&T does not receive any of these rental payments because BB&T assigned the right to receive rent from Sodra

to HBU as part of providing collateral for the HBU loan.7 Accordingly, ABN, acting as "Debt PUA Issuer," makes the annual payments

directly to HBU from the Debt PUA account. Through 2012, these

annual payments exactly equal the remaining principal and interest

due on the loan. Because ABN, not HBU, provided the funds for the

loan, however, ABN is actually paying itself from the $68,008,236

(the sum equal to the loan proceeds) that it received at closing. The

net result is that no funds change hands during this period; only a cir7To secure its obligation to satisfy the HBU loan, BB&T assigned to

HBU a lien on the Head Lease, Sublease, and BB&T’s right to rent payments from Sodra, as well as the right to payments under the Debt PUA.

The loan collateral specifically excludes what the transaction’s promoter

candidly termed the "real money" in the transaction, (J.A. at 175), the

approximately $12 million in government bonds placed in the Equity

PUA account. 

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cular intrabank transfer occurs. On its own books, therefore, ABN

treats the loan as an off-balance sheet transaction carrying zero risk.

In the meantime, the treasury bonds purchased by Fleet as Equity

PUA Issuer remain in an account at Fleet (the "Equity PUA

account").

iii. January 1, 2013 to the Transaction’s End.

a. Purchase Option.

If Sodra exercises its purchase option, the purchase would be

funded from the resources BB&T supplied at closing. ABN, as Debt

PUA Issuer, would fund part of the purchase price by making the

final payment under the Debt PUA on January 1, 2013, thereby also

retiring the HBU loan. Fleet, as Equity PUA Issuer, would pay the

remaining balance of the purchase price on Sodra’s behalf by dispersing the funds from the Equity PUA account to BB&T in five payments made at specified times in 2013.8

 Because Sodra would be

buying back all of BB&T’s interests and obligations under the Head

Lease, including the obligation to make the Deferred Head Lease Payment, BB&T would be relieved of the obligation to make that payment. The transaction would therefore end with Fleet’s final payment

to BB&T in 2013. 

The practical effect of this scenario would be no different than if

BB&T had invested in the treasury bonds directly, except that BB&T

paid roughly $6 million to Sodra as incentive for participating in the

transaction, as well as various transaction fees, and would have

received tax deductions for rent, interest, and amortization of

transaction-related fees had the IRS not audited its tax return.

b. BB&T’s Options.

If Sodra declines the purchase option, and BB&T elects to renew

the Sublease, ABN, as Debt PUA Issuer, will still make the final pay8The payments and maturity dates of the treasury bonds in the Equity

PUA account at Fleet are set to match the amount and timing of the funds

due BB&T under the Equity PUA. 

BB&T CORP. v. UNITED STATES 9

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ment under the Debt PUA, retiring the HBU loan. This payment will

still be considered made on Sodra’s behalf, but as a rental payment.

Sodra will also make annual rental payments each year of the

renewed sublease term, as well as additional payments at the beginning of certain years and a deferred payment at the end of the

renewed sublease. Meanwhile, the treasury bonds in the Equity PUA

account will be reinvested and will serve as collateral for (and will be

available to apply to) Sodra’s rental payments. 

The parties structured the transaction so that the rent from the

renewed sublease would grow at a predetermined rate and ultimately

equal the amount of the Deferred Head Lease Payment when it is due,

thereby allowing BB&T to fulfill that obligation without investing

additional funds. Moreover, even if interest rates are not as the parties

assumed and the sums BB&T has pledged as collateral for the

Deferred Head Lease Payment do not total $557.8 million in 2038,

Sodra has no recourse against BB&T for any deficiency. 

If BB&T does not exercise the renewal option, Fleet will deliver

the funds in the Equity PUA Account to Sodra. The last payment

under the Debt PUA will also go to Sodra, meaning that BB&T would

be responsible for the final payment to retire the HBU loan.9 BB&T

would still be required to provide collateral for the Deferred Head

Lease Payment—in the form of rents from the replacement sublease

if it exercises that option, or an alternative such as a letter of credit

or guarantee should it choose the return option—and Sodra would still

have no recourse against BB&T for any shortfall in the Deferred

Head Lease Payment.

4. Looking Ahead: BB&T and Sodra’s Options.

Sodra has professed uncertainty as to whether it will exercise its

purchase option, and BB&T maintains that as a result, any of the

options made possible by the transaction could become a reality at the

close of the Basic Lease Term. BB&T has conceded, however, that

9

If, however, BB&T failed to pay the balance of the loan, Sodra would

be required to purchase the loan from HBU. In this circumstance,

Sodra’s only recourse against BB&T is limited to the collateral BB&T

provided for the HBU loan. 

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it entered into the transaction believing that "the most likely thing is

[Sodra] would not walk away from the property," given that Sodra

had been in business for years, making the purchase option or the

renewal option the most likely scenarios. (J.A. at 85.) Of course,

because the renewal option belongs to BB&T, not Sodra (and the

renewal lease would not encompass the full Head Lease term), Sodra

could ensure uninterrupted use and control of the Equipment only by

exercising the purchase option. An expert report commissioned by the

Government predicted this result, concluding that, for a number of

reasons, including dislocation costs and cost of replacing lost manufacturing capacity, the purchase option represented the only economically viable scenario for Sodra. Deloitte & Touche’s appraisal, in

contrast, deemed Sodra unlikely to exercise the purchase option, reasoning that the purchase price exceeded the value of the Head Lease

interest Sodra would acquire (apparently without taking into account

that because the option was prefunded by BB&T, Sodra would pay

nothing for its "purchase").10

The parties dispute whether BB&T can profit from the transaction

if it does not receive the tax benefits it hoped the LILO’s "tax driven

structure" would generate. BB&T contends that, under the purchase

option, it stands to make a minimum pre-tax net profit of

$12,555,532, and under the renewal lease option, it could net a minimum pre-tax profit of $27,833,846. The Government disputes

BB&T’s methodology and has proffered an expert report concluding

that in the absence of the tax benefits generated by the transaction,

BB&T has no realistic expectation of realizing an economic gain. 

10In connection with the transaction, Sodra signed a Tax Indemnity

Agreement in which it agreed that for U.S. income tax purposes, neither

it nor any of its personnel would take a position inconsistent with the

characterization of Sodra as the owner, head lessor, and sublessee of the

Equipment. Before Sodra entered into this agreement, however, Sodra’s

tax advisors characterized the transaction as a financing arrangement that

did not affect Sodra’s interests in the Equipment, apparently anticipating

that Sodra would not surrender control of the Equipment to BB&T. (See

J.A. at 1736 (internal tax evaluation explaining, among other things, that

"[f]rom a value added tax law perspective, the transaction can be considered either based on its real meaning, that is, a financial transaction, or

based on its formal content, that is two lease relationships").) 

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There is no dispute, however, that the transaction maximizes

BB&T’s protection from loss. Sodra was required to set up a longterm Letter of Credit for the protection of BB&T in the event that

something happened to cause the transaction to unwind early. And,

the structure of the transaction ensures that BB&T has the power to

recoup the investment in government bonds from the Equity PUA

account, if it so chooses. Finally, BB&T’s obligations — the HBU

loan and the Deferred Head Lease Payment — represent non-recourse

obligations, with only proceeds and interests derived from the transaction itself pledged as collateral.

C. BB&T’s 1997 Tax Return.

In its 1997 tax return, BB&T reported rent from Sodra’s sublease

and amortization of an advisory fee as income. BB&T claimed deductions for: (1) $9,894,362 in rent paid to Sodra on the Head Lease; (2)

$2,820,925 in interest on the HBU loan, and; (3) amortization of

$137,943 in fees an expenses made in connection with the transaction.

When the IRS audited BB&T, it disregarded the reported income and

disallowed the deductions, resulting in a $9,416,592 increase in

BB&T’s taxable income for 1997.

D. Proceedings Before the District Court.

Following the audit, on October 14, 2004, BB&T filed a complaint

in the United States District Court for the Middle District of North

Carolina, seeking a refund of taxes it claimed to have overpaid.

Thereafter, BB&T and the Government filed cross-motions for summary judgment, and the district court granted summary judgment in

favor of the Government. 

With regard to the rental payment, the district court concluded that

BB&T was not entitled to a deduction because even though the form

of the transaction was a lease and immediate sublease, in substance

BB&T had not acquired a genuine leasehold interest in the equipment. Relying primarily on two cases from the United States Tax

Court, Alstores Realty Corp. v. Comm’r, 46 T.C. 363 (1966), and

Ashlock v. Comm’r, 18 T.C. 405 (1952), the district court reasoned

that "[w]here a conveyance of property is accompanied by retention

of the same interest in the property, only a future interest is con12 BB&T CORP. v. UNITED STATES

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veyed." (J.A. at 1848.)11 The district court further reasoned that the

various obligations in the transaction were offsetting and that, when

those offsetting obligations were "collapsed" against each other, all

that remained was BB&T’s payment of transaction costs in a complicated circle ending with an investment in government bonds. The

court concluded that the investment could have proceeded in an identical manner without the additional shuffling of paper. 

Concerning the interest deduction, the district court concluded that

"[w]hen the intermediate payment steps are disregarded, which must

be done in order to consider the substance of the loan transaction and

not the form selected by the parties, it becomes clear that the loan

transaction is only a circular transfer of funds in which the . . . loan

is paid from the proceeds of the loan itself." (J.A. at 1858.) Accordingly, it determined that the HBU loan did not constitute genuine

indebtedness, and BB&T was not entitled to an interest deduction. 

BB&T timely appealed, and we have jurisdiction pursuant to 28

U.S.C.A. § 1291 (West 2006).

II.

A.

We review de novo the district court’s grant of summary judgment

to the Government, applying the same standards that the district court

was required to apply. See Laber v. Harvey, 438 F.3d 404, 415 (4th

Cir. 2006) (en banc). "Summary judgment is appropriate ‘if the pleadings, depositions, answers to interrogatories, and admissions on file,

together with the affidavits, if any, show that there is no genuine issue

as to any material fact and that the moving party is entitled to a judgment as a matter of law.’" Id. (quoting Fed. R. Civ. P. 56(c) (West

1992)). We construe the evidence in the light most favorable to

BB&T, the non-moving party, and draw all reasonable inferences in

BB&T’s favor. Id.

11IRS Revenue Ruling 2002-69, though not relied on by the district

court, takes the same view. Rev. Rul. 2002-69, 2002-2 C.B. 760. 

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We begin our discussion with a few familiar rules. A taxpayer, of

course, "has the legal right to decrease the amount of what otherwise

would be his taxes, or altogether avoid them, by any means which the

law permits." Bridges v. Comm’r, 325 F.2d 180, 183 (4th Cir. 1963).

A taxpayer may not, however, claim tax benefits that Congress did

not intend to confer by setting up a sham transaction lacking any

legitimate business purpose, or by affixing labels to its transactions

that do not accurately reflect their true nature. Accordingly, under the

"economic substance doctrine," a transaction may be disregarded as

a sham for tax purposes if the taxpayer "was motivated by no business

purposes other than obtaining tax benefits" and "the transaction has

no economic substance because no reasonable possibility of a profit

exists." Rice’s Toyota World, Inc. v. Comm’r, 752 F.2d 89, 91 (4th

Cir. 1985). Similarly, the doctrine of "substance over form" recognizes that the substance of a transaction, rather than its form, governs

for tax purposes. See, e.g., W.Va. N. R.R. Co. v. Comm’r, 282 F.2d

63, 65 (4th Cir. 1960) ("It is well settled that in matters of taxation

substance rather than form prevails and that the taxability of a transaction is determined by its true nature rather than by the name which

the parties may use in describing it."). Because "an income tax deduction is a matter of legislative grace . . . the burden of clearly showing

the right to the claimed deduction is on the taxpayer." Interstate Transit Lines v. Comm’r, 319 U.S. 590, 593 (1943); see also Jack’s

Cookie Co. v. United States, 597 F.2d 395, 400 (4th Cir. 1979) (noting the "settled principle that statutes authorizing deductions from

income for federal tax purposes are to be strictly construed"). 

BB&T claims that it has demonstrated its entitlement to deductions

for rent and interest under 26 U.S.C.A. §§ 162(a)(3) & 163(a) by

showing that the transaction has economic substance and a form that

must be respected for tax purposes. Thus, according to BB&T, neither

the economic substance doctrine nor the substance-over-form doctrine

prohibits BB&T from receiving the deductions it claimed. Given the

procedural posture of this case, we take BB&T at its word that the

transaction meets the criteria for economic substance set forth in

Rice’s Toyota World.

12 Accordingly, we direct our attention to

12We recognized in Rice’s Toyota World, Inc. v. Comm’r, 752 F.2d 89

(4th Cir. 1985), that whether a particular transaction is a sham lacking

14 BB&T CORP. v. UNITED STATES

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BB&T’s argument that the form of the transaction, as evidenced by

the parties’ written agreements, accurately reflects its substance. We

first address whether BB&T has acquired a genuine leasehold interest

giving rise to a rent deduction under § 162(a)(3) before turning to the

question of whether BB&T paid "interest on indebtedness" within the

meaning of § 163(a).

B.

In applying the doctrine of substance over form, we "look[ ] to the

objective economic realities of a transaction rather than to the particular form the parties employed," Frank Lyon Co. v. United States, 435

U.S. 561, 573 (1978). As the Supreme Court has repeatedly

explained, "the simple expedient of drawing up papers" is not "controlling for tax purposes when the objective economic realities are to

the contrary." Id. (internal quotation marks omitted). Accordingly, the

parties agree that to deduct payment on the Head Lease as a "rental"

payment under § 162(a)(3), BB&T must establish that it acquired a

genuine leasehold interest in the Equipment. See 26 U.S.C.A.

§ 162(a)(3) (permitting a deduction for "rentals or other payments

required to be made as a condition to the continued use or possession,

for purposes of the trade or business, of property to which the taxpayer has not taken or is not taking title or in which he has no

equity"). 

In Frank Lyon Co., the Supreme Court provided guidance for

determining when the form of a leasing transaction should be

respected for tax purposes. In the course of analyzing a sale and leaseback arrangement, the Frank Lyon Co. Court held that

where . . . there is a genuine multiple-party transaction with

economic substance which is compelled or encouraged by

business or regulatory realities, is imbued with taxeconomic substance "is an issue of fact." Id. at 92. The district court did

not address this factual question in its summary judgment ruling.

Because we need not address this issue to resolve this appeal and the parties continue to dispute BB&T’s motives and profit potential, we too,

will leave the economic-substance question unanswered. 

BB&T CORP. v. UNITED STATES 15

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independent considerations, and is not shaped solely by taxavoidance features that have meaningless labels attached,

the Government should honor the allocation of rights and

duties effectuated by the parties. Expressed another way, so

long as the lessor retains significant and genuine attributes

of the traditional lessor status, the form of the transaction

adopted by the parties governs for tax purposes. What those

attributes are in any particular case will necessarily depend

upon its facts. 

435 U.S. at 583-84 (emphasis added).

Thus, establishing that the Head Lease is, in substance, a true lease

for tax purposes requires a demonstration that "the lessor retains significant and genuine attributes of the traditional lessor status." Frank

Lyon Co., 435 U.S. at 584. Accord Estate of Thomas v. Comm’r, 84

T.C. 412, 432 (Tax Court 1985) ("[T]he parties’ characterization of

the form of the transaction should be respected so long as the lessor

retains significant and genuine attributes of a traditional lessor."). We

are not persuaded that BB&T has made this showing with regard the

leases at issue here. 

First, each right and obligation BB&T obtained under the Head

Lease it simultaneously returned to Sodra via the Sublease for the

duration of the Basic Lease Term, leaving BB&T only a right to make

an annual inspection of the Equipment. Second, although the transaction ostensibly provides for the exchange of tens of millions of dollars

in rental payments during the Basic Lease Term, the only money that

has (and that may ever) change hands between BB&T and Sodra is

the $6,228,702 BB&T provided as Sodra’s "incentive for doing the

deal." (J.A. at 325.) Sodra has therefore not only continued to use the

Equipment just as it had before the transaction, it has done so without

paying anything to BB&T. Third, Sodra, through the purchase option,

can unwind the transaction without ever losing dominion and control

over the Equipment or having surrendered any of its own funds to

BB&T, and has no economic incentive to do otherwise.13 BB&T

13BB&T disputes the Government expert’s conclusion that the purchase option represents the only economically viable scenario for Sodra

16 BB&T CORP. v. UNITED STATES

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therefore does not expect Sodra to "walk away" from the Equipment.

(J.A. at 85.) Finally, regardless of whether Sodra bucks this expectation, the structure of the transaction insulates BB&T from any risk of

losing its initial $12,833,846 investment in the government bonds or

incurring the obligation to invest additional funds. 

In sum, the transaction does not allocate BB&T and Sodra’s rights,

obligations, and risks in a manner that resembles a traditional lease

relationship. See Alstores Realty Corp., 46 T.C. at 373 (holding that

because a "so-called space-occupancy agreement placed the two parties’ rights, obligations, and risks as they would be allocated in a typical lease arrangement[,] . . . the arrangement was a lease in substance

as well as in form"); Swift Dodge v. Comm’r, 692 F.2d 651, 653-54

(9th Cir. 1982) (recharacterizing a lease as a conditional sales contract

because the parties’ obligations, legal rights, and risks were no different than they would be in a conditional sale arrangement and "Swift

Dodge did not retain . . . significant and genuine attributes of a lessor"); Aderholt Specialty Co. v. Comm’r, 50 T.C.M. (CCH) 1101

(1985) (holding that a lease arrangement was a sale for federal tax

purposes because the transaction "divested [the lessor] of any significant and genuine attributes of traditional lessor status" and "if the benefits, obligations, and rights of the putative lessor are essentially those

of a secured seller, the substance of the arrangement must govern and

it will be deemed a sale for tax purposes" (internal quotation marks

omitted)). 

Moreover, unlike the taxpayer in Frank Lyon Co., BB&T has failed

to show any "business or regulatory realities" that "compelled or

encouraged," id. at 583, the structure of the transaction at issue here,

by relying on the appraisal report it commissioned. The report predicted

that Sodra would be unlikely to exercise its purchase option because the

purchase option price (which the report analyzed as including the obligation to make the Deferred Head Lease Payment) exceeds the anticipated

value of the remaining term of the Head Lease. This prediction plainly

does not reflect the economic reality of the transaction, however, as

BB&T supplied the funds for the purchase, and Sodra need not pay itself

the Deferred Head Lease Payment. Because the "purchase" is free to

Sodra, price cannot be obstacle. 

BB&T CORP. v. UNITED STATES 17

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nor has it established that its LILO is "imbued with tax-independent

considerations, and is not shaped solely by tax-avoidance features that

have meaningless labels attached," id. at 583-84. To the contrary,

BB&T has offered no regulatory or economic reality driving the

transaction’s simultaneous conveyance and retraction of rights and

obligations, nor has it offered any non-tax related purpose for structuring the transaction in this manner. 

In these respects, BB&T stands in sharp contrast to the lessor in

Frank Lyon Co. There, regulatory restrictions prevented the WorthenBank & Trust Company ("Worthen") from financing the construction

of a new bank and office building through a conventional mortgage.

Worthen therefore arranged "an alternative solution" — a sale and

lease-back arrangement with Frank Lyon Co. — that would "provide

[Worthen] with the use of the building, satisfy the state and federal

regulators, and attract the necessary capital." Frank Lyon Co., 435

U.S. at 564. The arrangement did not create any tax benefits that

could not have been enjoyed had the transaction taken another form,

but it did result in a situation in which neither party "was the owner

of the building in any simple sense." Id. at 581. The Supreme Court

concluded that Frank Lyon should be treated as the owner for tax purposes (and not merely a lender of money and conduit for mortgage

payments to a third party, as the government had argued) because

Frank Lyon was the only one whose capital was committed to, and

genuinely at risk in, the building. Id. at 577, 581. We are thus unpersuaded by BB&T’s insistence that the same factors causing the

Supreme Court to respect the form of the transaction at issue in Frank

Lyon Co. are also present in this appeal. Compare Coleman v.

Comm’r, 16 F.3d 821, 826 (7th Cir. 1994) (distinguishing Frank Lyon

Co. and explaining that "the existence of the benefits and burdens of

ownership" is dispositive of whether a taxpayer will be treated as the

owner of leased property for tax purposes). 

Likewise, BB&T’s argument that the district court "violated the

well-settled principle that the transaction in question must be viewed

‘as a whole,’" (Appellant’s Br. at 34 (quoting ACM P’ship v. Comm’r,

157 F.3d 231, 247 (3d Cir. 1998))), rings hollow. This principle does

not require courts to treat needless additional steps or "tax-avoidance

features that have meaningless labels attached," Frank Lyon Co., 435

U.S. at 584, as legitimate by virtue of their attachment to a substan18 BB&T CORP. v. UNITED STATES

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tive transaction, such as a purchase or sale. To the contrary, this

aspect of the substance-over-form doctrine serves to prevent taxpayers from manipulating the tax code in that way. As the Supreme Court

has explained,

the transaction must be viewed as a whole, and each step,

from the commencement of negotiations to the consummation of the sale, is relevant. A sale by one person cannot be

transformed for tax purposes into a sale by another by using

the latter as a conduit through which to pass title. To permit

the true nature of a transaction to be disguised by mere formalisms, which exist solely to alter tax liabilities, would

seriously impair the effective administration of the tax policies of Congress.

Comm’r v. Court Holding Co., 324 U.S. 331, 334 (1945); see also

Minn. Tea Co. v. Helvering, 302 U.S. 609, 613 (1938) (stating that

"[a] given result at the end of a straight path is not made a different

result because reached by following a devious path" and refusing to

accord tax effect to a "meaningless and unnecessary incident" inserted

into a transaction); Morgan Mfg. Co. v. Comm’r, 124 F.2d 602, 605

(4th Cir. 1941) (holding that a purported corporate reorganization "in

its essence was a sale" because the parties’ superficial compliance

with the applicable statutes achieved an "object [that] could have been

attained much more simply and easily" by a direct sale and "no explanation of the adoption of the more cumbersome method [was]

offered"). 

Accordingly, we, like the district court, conclude that in substance,

the transaction is a financing arrangement, not a genuine lease and

sublease. All that BB&T has done is paid Sodra approximately $6

million dollars to sign documents meeting the formal requirements of

a lease and sublease, arranged a circular transfer of funds from and

then back to ABN, and invested approximately $12 million in government bonds. Sodra, meanwhile, maintains uninterrupted possession

and control of the Equipment, and has no economic incentive to cede

control to BB&T. Because the funds BB&T provided as the Advance

Head Lease Payment do not, in substance, constitute "rental[ ] . . .

payments required to be made as a condition to the continued use or

possession" of the Equipment, BB&T is not entitled to a deduction

BB&T CORP. v. UNITED STATES 19

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under § 162(a)(3). Cf. W.Va. N. R.R. Co., 282 F.2d at 65 (upholding

disallowance of rental deduction where an increase in rent was not in

substance an ordinary and necessary business expense, but rather a

device through which a third party purchased the company’s stock);

Sun Oil Co. v. Comm’r, 562 F.2d 258, 269 (3d Cir. 1977) (concluding

that purported sale-leaseback was in substance a financing arrangement between the parties and disallowing a claim for rent deductions

under § 162(a)(3)).

C.

We next consider BB&T’s entitlement to deduct interest paid on

the HBU loan from its taxable income. Under § 163(a), "[t]here shall

be allowed as a deduction all interest paid or accrued within the taxable year on indebtedness." 26 U.S.C.A. § 163(a). "Explaining that

‘interest’ is to be given its usual, ordinary and everyday meaning, the

Supreme Court has defined the term as compensation for the use or

forbearance of money." Halle v. Comm’r, 83 F.3d 649, 652 (4th Cir.

1996) (internal quotation marks and citation omitted). Generally, the

underlying "indebtedness" is defined as "an existing, unconditional,

and legally enforceable obligation for the payment of a principal

sum." Id. at 653 (internal quotation marks omitted).14 And, in keeping

with principles of substance over form, "deductible interest can only

accrue on genuine indebtedness." Halle, 83 F.3d at 652, 655 (emphasis in original); see also Midkiff v. Comm’r, 96 T.C. 724, 735 (1991)

("‘[I]ndebtedness’ must be indebtedness in substance and not merely

in form.").

14Even if conditional, an existing, legally enforceable obligation may

constitute "indebtedness" if 

(1) the contingency on which the obligation rests is beyond the

control of the party seeking the interest deduction, (2) the

amount of the indebtedness on which the interest accrued was

fixed as of the date that the interest began to accrue, and (3) the

payor’s liability to the payee is primary and direct. 

Halle v. Comm’r, 83 F.3d 649, 653 (4th Cir. 1996). Also, "indebtedness

may be imposed on the purchaser of property when the benefits and burdens of ownership shift before payment." Id. (internal quotation marks

omitted). 

20 BB&T CORP. v. UNITED STATES

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BB&T claims that it accrued deductible interest on the HBU loan

because, pursuant to the "Loan and Security Agreement" it signed

with HBU, BB&T has a legal obligation to repay the loan. According

to BB&T, the loan therefore necessarily constitutes genuine indebtedness, and the circularity of the parties’ obligations, the non-recourse

nature of the loan, and the other features of the transaction considered

by the district court are irrelevant. We cannot accept this contention.

As an initial matter, it is difficult to see how the "interest" BB&T

paid could represent "compensation for the use or forbearance of

money." Id. at 652 (internal quotation marks omitted). At the transaction’s closing, ABN supplied the $68,008,236 for the loan on behalf

of HBU, and BB&T immediately returned $68,008,236 to ABN (as

Debt PUA Issuer). Accordingly, 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. And,

because the funds became an asset solely of ABN upon their transfer

to the Debt PUA account, BB&T could not use the money after the

transaction’s closing. 

Moreover, concluding that BB&T may claim a deduction for "interest . . . on indebtedness," 26 U.S.C. § 163(a), solely because it

signed loan documents would turn the substance-over-form doctrine

on its head. Instead, to determine whether the HBU loan constitutes

genuine indebtedness, we must "look beyond the parties’ terminology

to the substance and economic realities" of the transaction. Halle, 83

F.3d at 655 (internal quotation marks omitted). 

In so doing, we agree with the Government and the district court

that the HBU loan does not constitute genuine indebtedness. Despite

the loan documents providing that BB&T has a legal obligation to

repay $68,008,236 to HBU, the transaction does not in fact require

BB&T to pay any money to HBU. BB&T, having immediately

returned a sum equal to the amount ABN supplied in furnishing the

HBU loan to a defeased account at ABN, has relieved itself of any

further repayment obligations. Cf. Hines v. United States, 912 F.2d

736, 741 (4th Cir. 1990) (concluding that a loan transaction was a

sham where "the lease and debt payments between the three parties

. . . were structured to be offsetting" and this "circularity meant that

the transaction became self-sustaining after the payments at closing

BB&T CORP. v. UNITED STATES 21

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with virtually no further financial input necessary from any of the parties"). 

BB&T makes much of the provision in its replacement lease and

return options (two of the three alternatives BB&T could pursue in

the event Sodra declined its purchase option) calling for: (1) ABN to

make the final payment under the Debt PUA to Sodra rather than

applying it toward the final payment on the HBU loan; and (2) for

BB&T to supply the final loan payment from another source. This

provision does not, however, create an unconditional obligation for

BB&T to make further payment on the loan. As discussed above,

Sodra has no economic incentive to decline the purchase option, and

despite commissioning an appraisal report predicting that Sodra

would consider the free purchase overpriced, BB&T does not expect

Sodra to surrender control of the Equipment. Moreover, even if

BB&T were given an occasion to select one of its three options following the conclusion of the Basic Lease Term, BB&T would not be

unconditionally obligated to make any further payment toward the

loan. BB&T would have to affirmatively choose to eschew its

renewal option for one of the two options triggering that burden.15

Finally, we are unpersuaded by BB&T’s argument that the district

court should have distinguished this case from one involving a mere

"circularization of funds which d[id] not amount to a loan," Felcyn v.

United States, 691 F. Supp. 205, 212 (C.D. Cal. 1988), on the ground

that, here, unlike in Felcyn, there was an actual delivery of the loan

proceeds. A party simply does not incur genuine indebtedness by taking money out of a bank and then immediately returning it to the issu15In addition, were BB&T to make that choice, the loan is nonrecourse to BB&T. We see no economic incentive for BB&T to supply

the funds needed to fully repay the loan, given that the loan collateral

excludes what the transaction’s promoter described as the "real money"

in the transaction, (J.A. at 175), the approximately $12 million in government bonds placed in the Equity PUA account. See Odend’hal v.

Comm’r, 748 F.2d 908, 912 (4th Cir. 1984) (disallowing interest deduction based on nonrecourse loan because although, in general, "a nonrecourse loan should be treated as a true loan," this is not the case where

the "taxpayer[ ] ha[s] no economic incentive to repay the obligation[ ]"

(internal quotation marks omitted)). 

22 BB&T CORP. v. UNITED STATES

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ing bank. This principle holds true even if the bank accepts the

bookkeeping responsibility of repaying itself out of the loan proceeds

for the duration of the loan. See Bridges v. Comm’r, 39 T.C. 1064,

1077, aff’d 325 F.2d 180 (4th Cir. 1963) (concluding that a transaction "merely provided the ‘facade’ of a loan," as "there was no reason

to think that [the taxpayer] . . . would have been called upon to pay

the note out of his own funds or to put up additional collateral").

III.

In closing, we are reminded of "Abe Lincoln’s riddle . . . ‘How

many legs does a dog have if you call a tail a leg?’" Rogers v. United

States, 281 F.3d 1108, 1118 (10th Cir. 2002). "The answer is ‘four,’

because ‘calling a tail a leg does not make it one.’" Id. Here, BB&T

styled the LILO as a lease financed by a loan, but did not in substance

acquire a genuine leasehold interest or incur genuine indebtedness.

Accordingly, although we decline to resolve whether the transaction

as a whole lacks economic substance — that is, whether it has

"reached the point where the tax tail began to wag the dog," Hines,

912 F.2d at 741, we conclude that the Government was entitled to recognize that tail for what it was, not what BB&T professed it to be.

The judgment of the district court is therefore

AFFIRMED.

BB&T CORP. v. UNITED STATES 23

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