UNITED STATES TAX COURT

167

ALS

147 T.C. No. 9

UNITED STATES TAX COURT

EXELON CORPORATION, AS SUCCESSOR BY MERGER TO UNICOM

CORPORATION AND SUBSIDIARIES, Petitioner v.

COMMISSIONER OF INTERNAL REVENUE, Respondent

EXELON CORPORATION AND SUBSIDIARIES, Petitioner v.

COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket Nos. 29183-13, 29184-13.

Filed September 19, 2016.

P, a corporation engaged in the production, transmission, and

distribution of electricity to residential, commercial, and industrial

customers in Northern Illinois, sold its fossil fuel power plants in

1999 for $4.813 billion. Seeking to manage the taxable gain of $1.6

billion resulting from the sale, P pursued a series of like-kind

exchanges employing sale-leaseback strategies between P and

unrelated third parties C and M, each of the latter a tax-exempt public

utility. P fully funded the transactions using the proceeds from the

sale of its own power plants. In the transactions, C or M would lease

a power plant to P for a term exceeding the plant's useful life,

receiving in turn a lump-sum payment of cash, and P would sublease

the power plant back to C or M. Part of the amount paid to C or M

would be returned to P as a prepayment of the sublease, another part

would be set aside for investment and to secure a cancellation option

SERVED Sep 19 2016

-2allowing C and M to purchase back their power plants at the end of

the sublease periods, and the remainder would be retained by C and

M and used for their own needs. Since exercising the cancellation

options was expected to be the only economically viable option, the

parties to the transactions anticipated that at the end of the sublease

periods C and M would exercise their cancellation options and regain

ownership of the power stations leased to P. The primary tax benefits

that P expected to derive were from the deferral of income tax under

I.R.C. sec. 1031 and various deductions related to the replacement

properties. P identified appropriate replacement properties,

conducted due diligence, and closed the transactions within the

timeframes provided for in I.R.C. sec. 1031.

IIeld: The agreements between P and C and M are not true leases

but rather properly characterized as loans since the transactions did

not transfer the benefits and burdens of ownership to P. The

substance of the transactions is not consistent with their form.

IleM, further, P did not satisfy the requirements of I.R.C. sec. 1031

for the 1999 tax year since P exchanged power plants for an interest

in financial instruments.

IIeM, further, P is not entitled to depreciation deductions claimed

for 2001 with respect to its transactions with C and M.

IleM, further, P may not deduct interest or include rental income

with respect to the transactions with C and M for the 2001 tax year

since the transactions are not lease agreements for Federal tax

purposes under I.R.C. sec. 467.

IleM, further, P must include in income for the 2001 tax year

original issue discount income arising out of P's equity contribution,

which is to be repaid with interest through the cancellation options in

P's agreements with C and M.

-3Held, further, P is not entitled to deduct transaction costs related to

its transactions with C and M for its 2001 tax year and must instead

include them as an additional amount lent to C and M.

I]eld, further, P is liable for accuracy-related penalties under I.R.C.

sec. 6662 for the 1999 and 2001 tax years on the grounds of

negligence or disregard of rules or regulations. P did not show

reasonable cause and good faith under I.R.C. sec. 6664(c) to meet the

exception for those penalties.

David F. Abbott, Joel V. Williamson, Erin G. Gladney, Kristin M.

Mikolaitis, Andrew W. Steigleder, Michelle A. Spiegel, and Michael D. Educate,

for petitioner.¹

Matthew I. Root, Elizabeth P. Flores, Steven N. Balahtsis, Abigail F.

Dunnigan, Lisa M. Goldberg, Casey R. Kroma, and Michael T. Shelton, for

respondent.

¹Natasha Goldvug represented petitioner at trial. On October 28, 2015, she

filed a motion to withdraw as counsel for petitioner, which the Court granted on

October 29, 2015.

-4LARO, Judge: These cases are consolidated for purposes of trial, briefing,

and opinion. Respondent determined the following deficiencies and penalties in

petitioner's2 Federal income tax in timely issued notices of deficiency:

Year

Deficiency

Penalty

sec. 6662(a)

1999

2001

$431,174,592

5,534,611

$86,234,918

1,106,922

Petitioner timely filed petitions with the Court seeking redetermination of

these deficiencies and penalties.

The deficiencies at issue arise out of petitioner's participation in six

transactions that respondent labeled sale-in/lease-out (SILO) transactions in an

alleged like-kind exchange under section 1031.3 The transactions are as follows:

Counterparty

Transaction name

City Public Service

Municipal Electric Authority of Ga.

Municipal Electric Authority of Ga.

Spruce

Scherer 1, Scherer 2, Scherer 3

Wansley 1, Wansley 2

2In this Opinion, references to petitioner include both Exelon Corp. and

Exelon Corp. as successor to Unicom Corp., which merged with Exelon Corp. on

October 20, 2000, and thereafter went out of existence.

3Unless otherwise indicated, section references are to the Internal Revenue

Code (Code) as applicable for the years in issue. Rule references are to the Tax

Court Rules of Practice and Procedure. Dollar amounts are rounded to the nearest

dollar.

-5The parties have agreed, with the Court's approval, to reduce the number of

transactions to be tried to three "test transactions": Spruce, Scherer 1 (Scherer),

and Wansley 1 (Wansley), and to apply the Court's methodology in this Opinion

to the remaining transactions.4

The parties have resolved two issues by filing stipulations of settled issues

with the Court. The parties have agreed that petitioner is entitled to the benefits of

interest netting as provided in section 6621(d) for 1999, the amount of which will

be determined after the parties submit Rule 155 computations. The parties have

also agreed that petitioner is not subject to the penalty under section 6662 for the

2001 tax year for an underpayment due to a substantial understatement of income

tax, although petitioner still may be subject to the section 6662 penalty for 2001

on account of negligence or disregard of rules or regulations.

We decide the following issues:

1. whether the substance of the test transactions is consistent with their

form. We hold that it is not;

2. whether petitioner has satisfied the requirements of section 1031. We

hold that it has not;

40ur rulings in this Opinion with respect to Wansley 1 will be determinative

for Wansley 2. Our rulings with respect to Scherer 1 will be determinative for

Scherer 2 and Scherer 3.

-63. whether petitioner is entitled to depreciation deductions claimed for 2001

with respect to the test transactions. We hold that it is not;

4. whether petitioner must include in income in 2001 original issue

discount income related to the test transactions. We hold that it must;

5. whether petitioner is entitled to deduct amortized transaction costs

related to test transactions for its 2001 tax year. We hold that it is not; and

6. whether petitioner is liable for penalties under section 6662 for the 1999

and 2001 tax years. We hold that it is.

FINDINGS OF FACT

Some of the facts have been stipulated. The stipulations of fact and the

facts drawn from stipulated exhibits are incorporated herein, and we find those

facts accordingly. At the time of filing the petitions, Exelon, the primary

petitioner, had its principal place of business in Chicago, Illinois. The parties

agree that these cases are appealable to the Court of Appeals for the Seventh

Circuit.

Background

I.

Exelon and Its Subsidiaries

Commonwealth Edison Co. (ComEd) was organized in Illinois on October

17, 1913, as a result of the merger of Cosmopolitan Electric Co. into ComEd.

-7Unicom Corp. (Unicom) was created in January 1994 as a holding company for

ComEd. Unicom Investment, Inc. (UII), was created on April 23, 1999, as a

wholly owned subsidiary of Unicom.

Exelon Corp. (Exelon), petitioner in these cases and the successor by

merger to Unicom and its consolidated subsidiaries (Unicom Group), was

incorporated in February 1999. Exelon became the parent corporation of PECO

Energy Co. (PECO) and Unicom through merger on October 20, 2000. As a result

of the merger of Exelon and Unicom, Unicom went out of existence. After the

merger, Exelon wholly owned PECO and owned more than 99% of ComEd.

Both Unicom and Exelon used the calendar year as their tax year. Both

companies were accrual basis taxpayers during all relevant periods.

II.

Unicom's Decision To Sell Fossil Fuel Power Generation Assets

A.

ComEd's Power Generation Business in 1999

In 1999 ComEd engaged in the production, transmission, and distribution of

electricity to residential, commercial, and industrial customers in Northern Illinois.

ComEd operated in Chicago, Illinois, under a nonexclusive electric franchise

ordinance. ComEd received approximately one-third of its ultimate revenues from

customers in Chicago.

-8In addition, ComEd operated its electric business outside of Chicago in 395

municipalities under nonexclusive franchises that were received under certificates

of convenience and necessity granted by the Illinois Commerce Commission

(ICC). ComEd owned and operated a full spectrum of assets necessary to produce

and deliver electricity to its customers, including power generation plants (both

fossil fueled and nuclear fueled), the high-voltage transmission system which

transported the electricity from the generators to the service areas, and the lowvoltage distribution system needed to provide the electricity to end users.

B.

Deregulation of the Electric Industry and Unicom

The 1990s marked a shift in the regulatory framework for the electric

industry. Before 1996 most electric utility companies were vertically integrated

conglomerates which, similarly to ComEd, owned a full spectrum of assets for

production and delivery of electricity to the customers. By April 1996 the Federal

Energy Regulatory Commission (FERC) had issued final rules requiring

nondiscriminatory access to the transmission grid controlled by vertically

integrated utilities.

These rules opened the market to smaller utilities and power generators and

provided an opportunity for the formation of "wholesale" energy companies.

Instead of investing in their own transmission capacity, smaller energy producers

-9could now use the transmission system already in place regardless of who owned it

to deliver power to their customers.

Many States pursued their own restructuring strategies for electric industry

deregulation, some of them requiring separation of power generation from sales to

final customers. On December 16, 1997, Illinois enacted the Electric Service

Customer Choice and Rate Relief Law, codified at 220 Ill. Comp. Stat. Ann. 5/16101 to -130 (West 2013). Unlike other States, Illinois did not enact deregulation

legislation requiring divestiture of power generation and allowed electric utilities a

choice of how they wished to pursue the transition.

These regulatory changes resulted in the transformation of the power

industry by the early 2000s from a number of separate vertically integrated utilities

to a network of businesses where the various elements of the supply chain were

being operated separately and interacted through market-based contracts and

power exchanges.

To face the challenges of the changing market, Unicom decided to evaluate

its operations in Illinois, including its nuclear and fossil fuel power plants.

Although Unicom management believed the company was well positioned to

succeed in the new market structure, the study revealed that Unicom would have

to make significant changes to its operation model in order to stay competitive

- 10 long term. Unicom and ComEd considered multiple options, including continued

operation with accelerated depreciation, indefinite suspension from operation, a

sale of assets to a third party, and retirement or closure of assets. Unicom needed

of cash to maintain and expand its nuclear generation facilities and distribution

system. After determining that operation of fossil fuel power plants would bring

less value than immediate sale, Unicom decided in July 1998 that it was time to

divest itself entirely of its fossil-fueled power generation business. At that time

Unicom estimated it would receive approximately $2.5 billion from the sale.

C.

Unicom's Sale of the Fossil Fuel Power Plants

Unicom started looking for an appropriate buyer for its fossil fuel power

plants in 1999. One prospective buyer offered Unicom $3 billion for the plants.

Unicom's management, however, believed that the company could get a better

deal. Eventually, Edison Mission offered Unicom $4.8 billion for the fossil fuel

power plants, almost twice the initial estimate.

The $4.8 billion offer would enable ComEd to upgrade its nuclear plants

and make the necessary investments in its distribution system. On March 22,

1999, ComEd entered into an asset sale agreement with Edison Mission (EME

agreement). To effect the sale, ComEd transferred its interests in the fossil fuel

power plants to UII pursuant to an agreement dated May 11, 1999, subject to the

- 11 EME agreement. UII agreed to pay ComEd $4.813 billion for the assets, in the

form of a demand note in the amount of $2.35 billion and the difference in

interest-bearing term notes.

After receipt of the assets, UII would immediately transfer the assets to

Edison Mission and receive $4.813 billion in cash. Immediately after receipt of

the cash, UII would pay the $2.35 billion aggregate principal due to ComEd under

the demand note. UII would pay the amount due under the demand note with

interest-bearing term notes. Upon the notes' maturity, UII would pay the principal

amount of the notes. Edison Mission acted through its subsidiary, Midwest

Generation. Deloitte & Touche LLP Valuation Group (Deloitte) performed a

valuation allocating the sale price among the transferred power plants.

On December 15, 1999, UII closed the sale to Edison Mission with respect

to two plants, the Collins Generating Station (Collins station or Collins power

plant) and the Powerton Generating Station (Powerton station or Powerton power

plant) for $930 million and $870 million, respectively. These stations together

had a book value of approximately $1.3 billion at the time of the sale. Pursuant to

EME agreement terms, UII transferred the Collins and Powerton stations to State

Street Bank & Trust Co. (State Street), the qualified intermediary for the putative

like-kind exchange described more fully in the following sections, and State Street

- 12 then transferred the stations to Edison Mission in exchange for the consideration

described above.

In its filings with the ICC, ComEd represented that the sale would not

impair ComEd's obligations to provide power to customers because ComEd would

be buying back the output generated by the sold power plants for a number of

years and would also be able to buy energy on the open market. ComEd planned

to reinvest some of the proceeds in its remaining lines of business and to pay the

transaction expenses.

III.

Unicom's Search for Tax Planning Opportunities

After Unicom announced the planned sale of the fossil fuel power plants in

May 1999, it became clear that there would be a large taxable gain resulting from

the sale. Unicom diligently searched for opportunities to minimize the tax impact

and to reinvest some of the proceeds of the sale.

Richard Roling, assistant vice president of tax and assistant comptroller at

Unicom from the early 1990s through 2001, was responsible for the tax function at

Unicom, including filing tax returns, planning, research, and ensuring compliance

with the tax laws. In 1999 Mr. Roling reported to Robert E. Berdelle, controller of

Unicom at the time. Mr. Berdelle's responsibilities included safeguarding

Unicom's assets, maintaining books and records, and issuing financial reports and

- 13 regulatory filings. Furthermore, Mr. Berdelle supervised Unicom's tax

department, along with Unicom's business planning and other functions.

Mr. Roling approached Arthur Andersen (Unicom's auditor at the time),

Pricewaterhouse Coopers (PwC), and Deloitte to identify the appropriate tax

strategy. Arthur Andersen presented Unicom with a strategy involving a foreign

currency swap, but Mr. Roling rejected it because it was too complex and did not

align with the existing Unicom business. PwC first presented the idea of a likekind exchange coupled with a sale-leaseback to Unicom sometime in August and

September 1999.

In essence, PwC suggested that its strategy would allow Unicom to defer the

recognition of gain on Unicom's sale of the fossil fuel power plants through a

section 1031 like-kind exchange into a "passive leveraged lease investment."

Instead of paying the tax on the gain, Unicom would be able to reinvest that sum.

The deferred tax would be financially similar to a 0% borrowing note. By

reinvesting it, Unicom could receive a significant yield premium. Moreover,

leveraging the new lease in such a manner would leave Unicom in substantially

the same cash position.

The PwC strategy envisioned a lease term in the range of20-25 years with

an "enhancement and defeasance structure providing for AA rated or better

- 14 enhancement of the lessee's entire financial obligations to Unicom." PwC

compared the costs for maintaining the new lease investment with maintaining a

typical debt private placement. Under the strategy, Unicom would lease the

exchange assets to the lessee under a triple net lease with an end-of-term fixed

purchase option. Unicom would pass on a portion of its tax deferral benefit to the

lessees through a reduction in rental obligation. The lessee would "defease its

rental obligations, and thereby monetize the lower rental cost into an upfront cash

benefit."5

PwC pointed out to petitioner that municipal utilities and rural electric

cooperatives seeking to monetize tax benefits they could not use because of their

tax-exempt status would be interested in entering into a sale-leaseback transaction.

PwC also suggested that taxable entities desiring to obtain low cost/off-balancesheet financing alternatives might also be interested.

After the initial consultation with PwC, Mr. Roling decided to present the

idea of the like-kind exchange to his superiors.

5The final structure of the like-kind exchange and sale-leaseback was

different, as explained further in this Opinion.

- 15 IV.

Unicom's Decision To Enter Into the Test Transactions

Mr. Roling first presented the PwC strategy to Mr. Berdelle. Although Mr.

Berdelle initially did not fully understand the strategy, he decided it had promise

and was in line with Unicom's tax strategy. John C. Bukovski, the chief financial

officer of Unicom, gave Mr. Roling permission to move forward with the like-kind

exchange strategy and present it to the Unicom's board of directors for

consideration and approval.

On October 5, 1999, two months after receiving ICC approval to sell

ComEd's fossil fuel power plants, ComEd submitted a notice to the ICC stating

that it was considering entering into a like-kind exchange for at least several of the

fossil fuel power plants.

On October 14, 1999, Unicom and PwC executed an agreement whereby

Unicom retained PwC to act as its financial adviser in connection with the

proposed like-kind exchange strategy. On October 20, 1999, Mr. Berdelle

provided information on the strategy to Unicom's board of directors. He presented

the strategy during the board meeting held on October 27, 1999, seeking and

receiving approval for various preliminary steps necessary to pursue the concept

and preserve the option of entering into a like-kind exchange transaction.

- 16 Mr. Berdelle assembled a team to further evaluate the like-kind exchange

opportunity. That team consisted of a number of Unicom's employees from

various departments, including the tax department, treasury and finance

departments, engineers, and outside consultants. Core members of the team,

including Mr. Berdelle, Robert Hanley, a tax department employee, and Mr.

Roling, would meet weekly, if not more often, to discuss the status of the project.

Neither Mr. Roling nor anyone on his staff in the tax department had any

experience with like-kind exchanges. Because Unicom did not have the internal

expertise necessary to adequately assess all of the legal and technical aspects of

the proposed like-kind exchange, Unicom employed a number of consultants and

advisers to work on the project, including performing due diligence of potential

replacement properties.

Unicom retained a Chicago law firm, Winston & Strawn LLP (Winston &

Strawn) to advise on the legal aspects of the transaction, including its tax

consequences. In addition, in March or April of 2000 Unicom engaged Stone &

Webster Management Consultants, Inc. (Stone & Webster), to provide engineering

and environmental reports on prospective replacement properties. Unicom

retained Deloitte to conduct an appraisal of the relinquished properties and

potential replacement properties in November 1999. In addition, petitioner

- 17 engaged PwC (financial and accounting adviser), Arthur Andersen (accounting

adviser), Sidley Austin (regulatory counsel), Vinson & Elkins (Texas counsel),

and Holland & Knight (Georgia counsel).

V.

Identification of Properties To be Relinquished in the Like-Kind Exchange

On or about December 9, 1999, six days before the closing of the sale under

the EME agreement, Unicom identified the Collins and Powerton stations as the

properties it would try to exchange for like-kind replacement properties. Mr.

Roling concluded, on the basis of the valuations from Deloitte, that the fair market

value of the Collins station at that time was $930 million, with an expected taxable

gain of $823 million, while the fair market value of Powerton station was $870

million, with an expected taxable gain of $683 million. Unicom did not plan to

execute a like-kind exchange for any of the other fossil fuel power plants it was

selling.

VI.

Identification of Like-Kind Replacement Properties and Due Diligence

A.

Identification of Replacement Properties

Because section 1031 has a strict timeframe for identification--on or before

the 45th day after the date on which the relinquished property is transferred--and

acquisition of replacement property--within 180 days of the date on which the

relinquished property is transferred (or, if earlier, the transferor's tax return due

- 18 date for the year in which the transfer of the relinquished property occurs)-Unicom started looking for potential replacement properties before the closing of

the sale under the EME agreement.

By November 1999 PwC had identified 26 prospective lessees. Unicom did

not participate in the initial identification process. On or about November 9-10,

1999, PwC, on behalf of Unicom, sent proposals to a number of potential lessees

for the sale-leaseback portion of the like-kind exchange. PwC contacted both

taxable and tax-exempt entities. City Public Service (CPS) and Municipal Electric

Authority of Georgia (MEAG) were among the potential lessees contacted by

PwC. Each proposal sent by PwC contained statements indicating that Unicom

was simultaneously soliciting other prospective lessees for expressions of interest

and that the proposal was subject to due diligence by Unicom and its consultants.

After receiving initial expressions of interest from several potential lessees,

Unicom and its advisers analyzed the submitted materials.

The closing of the sale of the two fossil fuel power plants under the EME

agreement on December 15, 1999, started the clock under section 1031. Unicom

and UII had to identify like-kind replacement properties by January 29, 2000 (45

days from closing), and had to acquire the properties by June 12, 2000 (180 days

from closing).

- 19 On January 28, 2000, Unicom timely submitted to State Street, the qualified

intermediary, its identification of like-kind replacement properties for both the

Collins and Powerton stations. Unicom identified the Spruce station and certain

related common facilities owned by CPS as a replacement for the Collins station.

Unicom identified a 15.1% undivided interest in the Wansley station and a 30.2%

undivided interest in the Scherer station (both owned by MEAG) as a replacement

for the Powerton station. Those partial interests in the Wansley and Scherer

stations were at that time owned by MEAG as a tenant in common along with

Georgia Power Co., Oglethorpe Power Corp., and the City of Dalton, Georgia.

B.

Due Diligence on Replacement Properties

1.

Engineering and Environmental Analysis

Walter Hahn, a mechanical engineer with expertise in plant operability and

over 25 years' experience working on power plants, was ComEd's director of

technical services in 2000. Mr. Hahn coordinated engineering and environmental

analysis efforts for the like-kind exchange project at ComEd. To perform the

analysis, Mr. Hahn hired Stone & Webster, an engineering consulting firm that

ComEd had previously used for other engineering studies.

Stone & Webster assessed the power plants' contemporaneous condition

and expected remaining life, the projected capital costs, operating and

- 20 maintenance expenses, and environmental issues relating to the future operations

and maintenance of the replacement stations and conducted an environmental

permit review and permit compliance assessment. Stone & Webster's review

process involved data collection, site visits, and the review and analysis of all

information obtained before drafting reports and offering conclusions.

Stone & Webster's team found the Wansley and Scherer stations to be well

maintained and in clean and orderly condition, probably in the top 2%-3% of units

in the country in generation, efficiency, and overall availability and reliability.

Stone & Webster's team found that the Spruce station was also well maintained,

was running at good efficiency, and could run at high capacity factors. However,

Stone & Webster did uncover certain problems with the plants. For example,

Stone & Webster identified stress corrosion cracking in the low pressure turbine

sections of the Wansley station. Stone & Webster also raised concerns about the

potential for the U.S. Environmental Protection Agency to take action relating to

maintenance activities at Wansley. At the Scherer station, Stone & Webster

identified spills associated with transformer failures and fires. Unicom chose not

to follow up on any of these and other findings.

In addition, two ComEd engineers visited all of the stations before June

2000. Their review, however, was not as thorough as Stone & Webster's and

- 21 involved only short site visits and interviews. ComEd engineers did not find any

problems with any of the stations.

2.

Appraisal of Replacement Properties

Deloitte prepared appraisal reports for all three replacement properties as

well as for the fossil fuel power plants sold by Unicom under the EME agreement.

The reports provided current valuations of the replacement properties, as well as

valuation opinions as to the plants' residual values and remaining useful lives, and

the likelihood of the prospective lessees' being economically compelled to

exercise their cancellation or purchase options. In preparing the reports, Deloitte

sought to address specific requirements set forth in Internal Revenue Service (IRS)

published guidance on leasing transactions, such as the requirements articulated in

Rev. Proc. 75-21, 1975-1 C.B. 715, and Rev. Proc. 75-28, 1975-1 C.B. 752.

By letter dated December 29, 1999, Winston & Strawn provided Deloitte

with a list of "appraisal conclusions we anticipate will be necessary to support our

tax opinion issued in connection with any leasing transaction entered into by

ComEd [Unicom's subsidiary]." That list was later reproduced almost verbatim in

Deloitte appraisal reports. The following table shows side by side some of the

- 22 conclusions from the Winston & Strawn letter and conclusions appearing in the

Deloitte appraisal reports.6

Winston & Strawn Letter

Spruce Appraisal Report (Deloitte)

6) as of the Closing Date, it is

reasonable to expect that the fair

market value of the Leased Property

will substantially exceed the applicable

Early Termination Amount at all times

during the Lease Term;

6. As of the Closing Date, it is

reasonable to expect that the fair

market value of the Facility will

substantially exceed the applicable

Early Termination Amount at all times

during the Lease Term;

7) the Purchase Option Price is no less

than 105% of the estimated "fair

market value" of the Leased Property

as of the expiration of the Lease term,

taking into account inflation and any

reasonably anticipated improvements

or modifications to the Leased

Property and after subtracting from

such value any cost to the Lessor of

acquiring possession of the Leased

Property at the end of the Lease Term;

7. The Cancellation Option Price is no

less than 105% of the estimated "fair

market value" of the Facility as of the

expiration of the Lease Term, taking

into account inflation and any

reasonably anticipated improvements

or modifications to the Facility and

after subtracting from such value any

cost to the Lessor of acquiring

possession of the Facility at the end of

the Lease Term;

8) as of the Closing Date, the Leased

Property's remaining economic useful

life is __ years, and therefore the

Leased Property will have a remaining

economic useful life at the expiration

of the maximum Service Agreement

Term equal to at least 20 percent of its

8. As of the Closing Date, the

Facility's remaining economic useful

life is expected to be 52 years, and

therefore the Facility is expected to

have a remaining economic useful life

at the expiration of the maximum

Service Agreement Term equal to at

6The Scherer, Wansley, and Spruce appraisal reports prepared by Deloitte

contain mostly similar boilerplate in the conclusions, with slight differences

attributable to the specific terms of the transactions and fair market value figures.

We use the appraisal for the Spruce station as an example to illustrate the effect of

the Winston & Strawn letter on the conclusions reached by Deloitte.

- 23 remaining useful life as of the Closing

Date;

least 20 percent of its remaining useful

life as of the Closing Date;

9) the Leased Property will have a "fair

market value" at the expiration of the

maximum Service Agreement Term

(determined without regard to inflation

or deflation or any future

improvements) that is equal to at least

20 percent of the current "fair market

value" of the Leased Property and after

subtracting from such value any cost to

the Lessor of acquiring possession of

the Leased Property at the end of the

Lease Term;

9. The Facility will have a fair market

value at the expiration of the Lease

Term of 38.4 percent of Closing Date

fair market value (determined without

regard to inflation or deflation or any

future improvements) and a fair market

value at the expiration of the maximum

Service Agreement Term of20.0

percent of Closing Date fair market

value (determined without regard to

inflation or deflation or any future

improvements). Both uninflated

residual values are at least 20 percent

of the current fair market value of the

Facility and after subtracting from

such value any cost to the Lessor of

acquiring possession of the Facility at

the end of the Lease Term;

12) neither the physical attributes of

the Leased Property, the financial

standards of the Qualified Operator or

Qualified Bidder, the applicable return

provisions or other terms and

conditions of the Lease, Operating

Agreement or Power Purchase

Agreement, nor any other identifiable

factor known to the Appraiser after

due inquiry, will create a material

inducement to Lessee to exercise the

Purchase Option with respect to the

Leased Property;

13. Neither the physical attributes of

the Facility, the financial standards of

the Qualified Operator or Qualified

Bidder, the applicable return

provisions or other terms and

conditions of the Lease, Operating

Agreement or Power Toll Processing

Agreement, nor any other identifiable

factor known to the Appraiser after

due inquiry, will create a material

inducement to Lessee to exercise the

Cancellation Option with respect to the

Facility;

13) based on the comparative costs of

the reasonably anticipated alternatives

14. Based on the comparative costs of

the reasonably anticipated alternatives

- 24 expected to be available to Lessee at

the expiration of the Lease Term,

Lessee will not be under any economic

compulsion to exercise the Purchase

Option;

expected to be available to Lessee at

the expiration of the Lease Term,

Lessee will not be under any economic

compulsion to exercise the

Cancellation Option;

17) the fixed net return required under

the Service Agreement Option is less

than 90% of the expected "fair market

value" of such payments so that the

Service Agreement Option does not

create an economic compulsion for the

Lessee to exercise the Purchase Option

and it is expected that the Lessor will

not exercise the Service Agreement

Option;

18. The fixed net return required

under the Service Agreement Option is

less than 95 percent of the expected

"fair rental value" so that the Service

Agreement Option does not create an

economic compulsion for the Lessee to

exercise the Cancellation Option and it

is expected that the Lessor will not

exercise the Service Agreement

Option;

Winston & Strawn provided continuous and substantial feedback to Deloitte

on the drafts of the appraisal reports. Although Winston & Strawn did not give

Deloitte directions as to the specific fair market value for each replacement

property, Deloitte knew from its previous work on appraising Unicom's plants

sold under the EME agreement how much gain Unicom was looking to defer.

With respect to all three replacement properties, Deloitte discussed the

results obtained under three standard valuation approaches: cost of replacement

approach, market approach, and discounted cashflow approach. Deloitte

concluded that the discounted cashflow analysis represented the most reliable

- 25 approach to determining the current fair market value of the assets in the test

transactions in all of the cases.7

To arrive at the fair market values of the replacement plants at the end of the

sublease terms, Deloitte used the maximum Federal statutory corporate income tax

rate of 35% and a State corporate income tax rate of 9% (total of 40.85%) even

though the plants were in Texas, which did not have a State corporate income tax,

and in Georgia, which had a 6% State corporate income tax rate." Deloitte used

the same discount rate of 10% for all three plants and assumed inflation of 2.5%

per annum. Deloitte did not perform any sensitivity analysis.

For the Spruce station, Deloitte assumed the plant capacity factor to be

90.3% in 2000, declining to 58.7% in 2032 and to 49.6% in 2052. For the

Wansley station, Deloitte assumed the plant capacity factor of 66.5% in 2000,

declining to 39.2% in 2028 and to 32.6% in 2044. For the Scherer station,

Deloitte assumed the plant capacity factor to be 66.5% in 2000, declining to 39.9%

7We note, however, that Deloitte relied mostly on the cost approach to

determine the fair market value of the assets at the end of the leaseback term.

8At the time of Deloitte's appraisal, Texas had a corporate franchise tax

equal to the greater of 0.25% of a corporation's net taxable capital or 4.5% of its

net taxable earned surplus. Tex. Tax Code Ann. sec. 171.002 (West 2000). In

addition to its corporate income tax, Georgia levied a graduated corporate net

worth tax, ranging from $10 to $5,000. Ga. Code Ann. sec. 48-13-73 (2013).

- 26 by 2030. Deloitte did not analyze in its appraisal reports how a change in a

capacity factor might influence the future fair market value of the assets at issue.

After performing the analysis, Deloitte concluded that CPS and MEAG

would not be economically compelled to exercise their cancellation or purchase

options at the end of their respective subleases. If based on the Deloitte analysis,

the fair market value of all the replacement properties at the end of the leaseback

term would be less than the cancellation or purchase option price. In arriving at

this conclusion, Deloitte did not consider noneconomic factors or any

arrangements between the parties setting aside the money for the option payment

at the beginning of the lease.

3.

Financial and Economic Analysis

Ruth Ann Gillis, Unicom's chief financial officer in 1999-2000, coordinated

the financial and economic due diligence on the Spruce, Wansley, and Scherer

transactions. Ms. Gillis reviewed both the creditworthiness of CPS and MEAG

and the quality of the leased stations. At the end of the due diligence process, Ms.

Gillis felt comfortable recommending that the board of directors enter into the

transactions.

PwC acted as a financial adviser in connection with the like-kind exchange

and the sale-leaseback transactions. PwC's engagement included the following

- 27 services: (i) assessing Unicom's specific needs from economic, tax, accounting,

commercial, and regulatory standpoints in connection with the proposed like-kind

exchange; (ii) developing a strategy matching target replacement property with the

relinquished property; (iii) identifying target replacement property owned by both

tax-exempt lessees and taxable lessees; (iv) arranging for a tax and accounting

analysis regarding the like-kind exchange; (v) providing economic analyses and

pricing models and issuing reports regarding accounting treatment for the life of

the like-kind exchange; and (vi) issuing an opinion regarding the application of

accounting principles to the like-kind exchange. Subsequently, PwC also acted as

the designated tax shelter organizer on behalf of Exelon and registered the

transactions with the IRS as a confidential tax shelter.

Petitioner retained First Chicago Leasing Corp. (FCLC), a wholly owned

subsidiary of Banc One Capital Corp. (Banc One), to serve as a supplemental

investment adviser to the Unicom Group. FCLC provided Unicom with financial

and risk analysis of, and advice relating to, the like-kind exchange. FCLC

considered all material credit risks as having been adequately addressed through

the transaction structure and financial enhancements such that the transactions at

issue possessed above-average safety from a credit risk perspective with respect to

payment of scheduled rent, purchase options, or early termination damage claims,

- 28 thus protecting Unicom's investment return. FCLC advised that CPS and MEAG

were generally very credit-worthy, strong, investment-grade entities and would

remain primarily liable for all rent and purchase option obligations. FCLC also

concluded that Unicom would not suffer losses due to failure on the part of CPS

and MEAG to pay rent, sums due for purchase options, or liquidated damages at

the appropriate times.

With respect to the risk of bankruptcy of CPS or MEAG, FCLC concluded

that "the potential adverse effects of the real estate classification in a bankruptcy

are being borne in these transactions by the credit support parties and not

Unicom." FCLC further concluded that Unicom could rely on being able to get a

full payout in cash if a bankruptcy of a lessee occurred. FCLC did not evaluate

the risks related to the service contract period after the expiration of the sublease

to CPS or MEAG.

Marsh USA, Inc., advised Unicom on standard insurance practices for the

U.S. utility industry and the appropriate terms for property damage and

commercial liability insurance in the Spruce, Wansley, and Scherer transactions.

4.

Legal and Tax Analysis

Winston & Strawn analyzed the qualification of the replacement properties

against the relevant tax tests for like-kind exchanges, helped negotiate the

- 29 transactions with CPS and MEAG, drafted the various transaction documents, and

analyzed the tax consequences thereof. Winston & Strawn also analyzed the

relevant leasing authorities and legal risks associated with the Spruce, Wansley,

and Scherer transactions. Winston & Strawn worked with local legal counsel in

Illinois, Georgia, and Texas to assist with regulatory, corporate, real estate and

title, and engineering and surveying issues with respect to the Spruce, Wansley,

and Scherer stations.

Winston & Strawn was closely involved in the due diligence process,

including marking up the engagement agreement with Deloitte and, as previously

discussed, providing Deloitte with a list of desirable conclusions and comments on

the appraisal report drafts.

Winston & Strawn provided two tax opinion packages containing opinion

letters and supporting memoranda to Unicom, dated as of the closing of the saleleaseback transactions, on the Federal income tax treatment of the transactions.

The opinion package for the exchange of the Collins station for Spruce totaled 357

pages, while the opinion package for the exchange of the Powerton station for

Wansley and Scherer was 392 pages. Winston & Strawn's primary tax opinions

concluded the following.

- 30 (a) The exchange of Unicom's fossil fuel power generating facilities in

Illinois with the lessees' fossil fuel power generating facilities "should be treated

as a valid exchange of like kind or like class property under section 1031 of the

Code."

(b) Each of the Spruce, Wansley, and Scherer leases "will be treated as a

true lease for federal income tax purposes pursuant to which UII [Unicom] will

directly or indirectly receive the taxable income and deductions associated with

the ownership of" the Spruce, Wansley, and Scherer stations, respectively.

(c) Substantially all of the section 467 rental payments "will be treated" as

loans to Unicom "rather than as current rental income."

(d) The Spruce, Wansley, and Scherer leases "will transfer ownership" of

the Spruce, Wansley, and Scherer stations to Unicom for Federal income tax

purposes.

Although Winston & Strawn provided generally favorable opinions, it

separately warned Unicom that there are certain risks related to Federal tax law,

including recent guidance by the Internal Revenue Service on lease-in/lease-out

(LILO) transactions and the possibility that the proposed transaction might be

subsequently classified as a corporate tax shelter.

- 31 Unicom retained Vinson & Elkins LLP to provide legal advice and opinion

as to Texas law relevant to the Spruce transaction. Unicom retained Holland &

Knight LLP to provide legal advice and opinion as to Georgia law relevant to the

Scherer and Wansley transactions.

With respect to the review by Unicom's own employees of the analysis and

conclusions provided in the Winston & Strawn legal opinions, Mr. Roling testified

that he did not get beyond the first seven of several hundred pages of the opinion,9

and Unicom's internal tax personnel also did not review the legal analysis in the

draft opinions. Mr. Berdelle, however, testified that he did read the Winston &

Strawn tax opinions in their entirety.

C.

Board Approval

At the March 9, 2000, Unicom board meeting, John Rowe, Chief Executive

Officer and Chairman of ComEd and Unicom, introduced a discussion of the

proposed like-kind exchange, and Mr. Berdelle presented information to the board

°Mr. Roling testified that he read seven pages of an opinion, but it is not

apparent to which opinion he referred. The record shows that Winston & Strawn

provided two tax opinion packages, in addition to drafts throughout the

preparatory stages of the transactions. However, in certain places, the record

indicates that an employee of petitioner reviewed an "opinion", in the singular.

Here and elsewhere in our Opinion, we use the singular and the plural forms of the

word as appropriate to reflect whichever grammatical number the record

establishes on that particular point.

- 32 on the like-kind exchange and the sale-leaseback proposal as it had developed

since the December 1999 board meeting. On March 28, 2000, the board received

a memorandum explaining the nature of the transactions and a credit and

investment analysis, as well as expected economic results.

On April 4, 2000, Mr. Berdelle presented the proposed like-kind exchange

to the board in more detail, and representatives of the Winston & Strawn team and

Mr. Jenkins from PwC responded to the board's questions about the credit risks,

the tax risks, and the financial returns associated with the transaction. Mr. Rowe,

Mr. Berdelle, and Ms. Gillis all recommended that the board approve the like-kind

exchange, and the board followed their advice.

At the time the transactions were approved, some results of the due

diligence, including legal opinions, valuation reports, and engineering due

diligence reports, were not yet available in their final form. It is unknown whether

the board reviewed the draft reports and opinions, but the board memorandum

dated March 28, 2000, discussed some tax and legal risks.¹°

¹°Specifically, appendix D discussed the risks related to the MEAG

transaction, and appendix E discussed the risks related to the CPS transaction. On

the risks related to a MEAG bankruptcy, the conclusion was that the risk was

mitigated by MEAG's inability to become a debtor under current Georgia law. On

the risks related to a CPS bankruptcy, it was considered to be an "unlikely event"

mitigated by the credit enhancement.

- 33 Test Transactions

I.

Spruce

A.

CPS and Its Decision To Enter Into the Spruce Transaction

CPS is a municipal gas and electric utility owned by the City of San

Antonio, Texas, that sells gas and electricity to its customers. CPS' mission

statement obligates CPS to provide low-cost, reliable gas and electricity service to

its customers. As an entity owned by a municipality, CPS is tax exempt.

In the late 1990s CPS' electric system served a territory consisting of

substantially all of Bexar County, Texas, and small portions of seven adjacent

counties. The CPS system was within the Electric Reliability Council of Texas

(ERCOT) region, which was entirely within the State of Texas and served about

85% of Texas' electrical load. ERCOT includes approximately 500 power plants.

ERCOT is not connected to the national grid, and, as a result, Texas power

producers are not subject to FERC regulations.

CPS owned 15 electric generating units and a 28% interest in the South

Texas Project's two nuclear generating units. The Spruce station's generating

capacity was approximately 12.3% of the generating capacity of CPS' electric

system. The electricity prices for CPS' customers in 1999 were the lowest among

the 20 largest cities in the United States and the lowest among major Texas cities.

- 34 CPS' board of trustees has five members: one director is always the mayor

of the City of San Antonio, and the other four each represent one quadrant of the

city. As a part of the City of San Antonio, CPS has its financial statements

included in the annual financial reports of the City of San Antonio. The City of

San Antonio shares in CPS' revenues, and the percentage of gross revenues to be

paid over or credited to the City of San Antonio each fiscal year by CPS is

determined (within the 14% limitation) by the governing body of the City of San

Antonio.

CPS had been presented with other similar transaction opportunities before

Unicom's proposal, but CPS rejected these prior proposals for various reasons.

After receiving the proposal from Unicom and reviewing valuations and the

transaction documentation, the CPS board determined that the transaction did not

violate CPS' bond covenants and gave its approval for the transaction in 2000.

The City Council of San Antonio also approved the Spruce transaction. A January

27, 2000, CPS presentation to the San Antonio City Council Executive Board

described the Spruce transaction as a "sale of tax benefits to a taxable entity." In

making the decision, CPS did not obtain an appraisal of its own and relied on the

appraisal prepared by Deloitte for Unicom.

- 35 In order to proceed with the Spruce transaction, the City of San Antonio

brought suit in Texas State court to obtain a declaratory judgment on the continued

validity of certain covenants in its outstanding public securities issued for the

purpose of financing the construction and improvement of its electric and gas

systems, which included the Spruce station. The City of San Antonio represented

in the petition that the encumbrance would be limited to the value of the private

company's (Unicom's) "future right to obtain a possessory leasehold interest in the

[f]acility (a) after the 30-year lease back to the City has expired and (b) if the City

elects not to exercise its right to cancel the [headlease] after the 30-year lease back

to the City has expired." In the initial draft of the petition, the City also

represented that it intended to exercise the cancellation option. However, this

statement was later deleted at the suggestion of Winston & Strawn and PwC, who

reviewed the petition on behalf of Unicom and provided comments.

The City of San Antonio represented in its petition that it retained fee

ownership in the Spruce station and retained possession and rights to operate it

during the leaseback term. The City of San Antonio also represented that all the

rent would be prepaid six months after the closing date on the leaseback

transaction and that the City of San Antonio would make an investment that upon

maturity would provide the amounts necessary to pay for the cancellation option.

- 36 The City estimated that the net present value of the rights which Unicom would

acquire in the future was approximately $40 million.

B.

Key Terms of the Spruce Lease and Sublease

1.

Lease and Sublease

On June 2, 2000, the City of San Antonio, acting by and through CPS,

entered into a sale-leaseback transaction with Unicom, through UII and its wholly

owned subsidiaries, Spruce Equity Holdings, L.P., and Spruce Holdings Trust,

with respect to the Spruce station. In essence, the money transferred by Unicom to

CPS was to be split in three funds: the first fund would be returned to Unicom as

a prepayment of sublease by CPS, the second fund would be set aside for

investment that would secure the payment of the cancellation option should CPS

decide not to reacquire the Spruce station at the end of the sublease, and the third

fund would be retained by CPS and could be used for its current needs.

a.

Spruce Headlease Agreement

Pursuant to the headlease agreement for the Spruce transaction (Spruce

headlease), CPS leased the Spruce station to Unicom for a term of 65 years,

starting June 2, 2000, and terminating on June 2, 2065 (Spruce headlease term),

unless terminated earlier. The Spruce headlease term exceeded the Spruce

station's estimated remaining useful life of 52 years, as determined in the Deloitte

- 37 appraisal report dated June 2, 2000 (Spruce appraisal). Since the headlease term

exceeded the plant's remaining useful life, the transaction could qualify as a sale,

making it a SILO, not a LILO.

Under the Spruce headlease, Unicom agreed to pay $725 million to CPS on

the closing date, June 2, 2000 (Spruce headlease rent). This amount was equal to

the estimated fair market value of the Spruce station on the closing date according

to the Spruce appraisal prepared by Deloitte. The appraised fair market value

served as the basis for determining Unicom's investment in the transaction, and

the parties did not further negotiate the investment amount. Deloitte estimated

that as of the end of the Spruce sublease in 2032 the fair market value of the

Spruce station would be $626 million if based on the discounted cashflow analysis

($609.6 million if based on the cost approach).

b.

Spruce Sublease Agreement

Under the Spruce sublease agreement (Spruce sublease), CPS leased back

from Unicom all of Unicom's right, title, and interest in the Spruce station under

the Spruce headlease. The sublease term commenced on June 2, 2000, and was

scheduled to terminate on March 2, 2032, for a term of 31.75 years.

Under the Spruce sublease, CPS was obligated to prepay rent to Unicom for

the entire sublease term in the amount of $557,329,539 on November 30, 2000

- 38 (Spruce base rent). The Spruce base rent accrued and was allocated annually pro

rata, commencing on the first day of the sublease term. If the Spruce sublease

terminated early, Unicom was required to return to CPS any unaccrued base rent.

The Spruce sublease was a net lease, requiring CPS to pay all costs and

expenses in connection with the Spruce station. In addition, CPS was required to

maintain insurance on the Spruce station under the terms of the sublease.

2.

Default

The parties to the Spruce transaction agreed that the Spruce headlease could

not be terminated or extinguished by any circumstances of any character or for any

reason, with certain limited exceptions including CPS' defaulting under the Spruce

sublease terms.

The Spruce sublease provided for early termination if CPS were to default

under the terms of the sublease. The events of default included, among other

provisions, failure to pay the Spruce base rent, failure of any material

representation or warranty made by CPS, or failure to properly maintain the

Spruce station. In case there was significant damage to the Spruce station so as to

render the station beyond repair, CPS could elect to either replace the Spruce

station or terminate the Spruce sublease.

- 39 In any of these scenarios, Unicom had a number of remedies against CPS,

including collecting the stipulated loss value of the Spruce sublease, and taking

possession of the Spruce station to operate, sell, or sublease it to somebody else.

The stipulated loss value was predetermined on the closing date and based on the

Deloitte Spruce appraisal and was meant to ensure Unicom's return on the

mvestment.

3.

Property Rights and Obligations

Under the Spruce headlease, Unicom had the right to use, operate, and

possess the Spruce station without interference from CPS. Unicom did not have

any obligations to CPS in respect of maintenance, operation, or insurance of the

Spruce station under the headlease. Upon the Spruce headlease expiration,

Unicom could return the Spruce station to CPS. Unicom was not obligated to

make any representations or warranties with respect to the Spruce station except

that it was free and clear of liens in case CPS decided to exercise its cancellation

option at the end of the Spruce sublease term.

The Spruce sublease was a triple-net lease, meaning that CPS was

responsible for all the costs and expenses, foreseen or unforeseen, in connection

with the Spruce station, including costs of operation, maintenance, insurance,

improvements and other expenses. The Spruce sublease contained a covenant of

- 40 quiet enjoyment in favor of CPS unless it defaulted under the sublease. CPS

could, at its own expense, use, operate, service, repair, and maintain the property

as long as it complied with the industry standards and applicable laws and did not

have a material adverse effect on the Spruce station, did not result in risk of

criminal liability, and did not involve any material risk of loss, forfeiture, or sale

of the Spruce station. CPS was solely responsible for environmental compliance

and any necessary remedial measures. CPS was also responsible for obtaining and

maintaining property and liability insurance coverage meeting certain

requirements set out in the Spruce sublease agreement.

Unicom's rights under the Spruce sublease were very limited. Unicom had

the right to inspect the Spruce station no more than once a year. CPS was required

to seek Unicom's consent with respect to proposed improvements, corporate

consolidations, subleases, and assignments.

CPS had limited rights to encumber the property throughout the Spruce

sublease term, and could not create any liens on the property after the Spruce

sublease term expiration. Unicom, on the other hand, could incur liens on the

property after the termination of the Spruce sublease, provided that CPS did not

exercise its cancellation option.

- 41 CPS took the Spruce station from Unicom on an as-is basis. However, at

the end of the Spruce sublease term CPS was required to return the Spruce station

in good working order and meeting the predetermined minimum operational

standards. For example, the Spruce Station was required to have an annual ratio of

the actual net generation to the normal claimed capacity operating for 8,760

hours/year of at least 82.0%. The Spruce station was required to have the ratio of

available generation to maximum generation of at least 89% and have an annual

ratio of the heat energy output of not more than 10,950 Btu/kWh. These

conditions applied to the return of the Spruce station at the end of the Spruce

sublease term in 2032 as well.

If CPS decided to return the station to Unicom at the end of the sublease,

CPS was required to arrange at its own expense for any necessary permits for

Unicom to operate the Spruce station and for engineering and environmental

inspections, as well as to arrange for Unicom fuel supply contracts and

transmission agreements, together with other agreements necessary to operate the

station. Failure to comply with these requirements would trigger a CPS default

under the agreement, and Unicom could pursue its contractual remedies.

-424.

Cashflows

Unicom paid $725 million to CPS under the Spruce headlease on June 2,

2000. Of that amount, CPS retained a lump sum of approximately $88 million, of

which the City of San Antonio received about $12.3 million.

On the same date, CPS entered into the collateralized payment undertaking

agreement (CPUA) with AIG Financial Products (Jersey), Limited (AIG-FP).

Under the CPUA, CPS would pay AIG-FP a fee of $88,995,790 (undertaking fee).

In exchange, AIG-FP would use the proceeds from the undertaking fee to make

payments to Unicom, for the benefit of CPS, at the end of the Spruce sublease

term in the amounts and on the dates specified in the CPUA. In essence, the

payments matched both in timing and amount the amounts CPS would owe to

Unicom upon CPS' exercise of the fixed purchase option (cancellation option)

available to CPS at the end of the Spruce sublease term. The cancellation option

allowed CPS to terminate the Spruce headlease at the end of the Spruce sublease

term and completely regain the ownership of the station."

" CPS' payment to AIG-FP of the undertaking fee was absolute,

unconditional, irrevocable, and not refundable to CPS under any circumstances,

including CPS' bankruptcy. CPS did not have any rights or interest in any portion

of the undertaking fee, and the fee could not be subject to any lien, claim, or

remedy by CPS or its creditors. After the payment, the undertaking fee ceased to

be an asset of CPS and became an asset of AIG-FP.

- 43 The CPUA required AIG-FP to deliver the cash received as the undertaking

fee to Wilmington Trust Co. to be held as collateral pledged primarily to Unicom

until CPS paid its obligations under the various transaction agreements. In the

event of an early termination of the Spruce sublease, Unicom would receive a

"termination amount" under the terms of the CPUA from the undertaking fee

proceeds.

As additional protection of Unicom's interest in the amounts set aside under

the CPUA, American International Group, Inc. (AIG), guaranteed the obligations

of AIG-FP under the CPUA. CPS also obtained a financial guaranty insurance

policy from Financial Security Assurance (FSA). Specifically, the policy provided

certain protections to CPS in case of its bankruptcy or in the event of CPS' default

or early termination of the sublease.

Further, from the Spruce headlease rent, CPS transferred the following

amounts to secure the Spruce sublease base rent due on November 30, 2000:

(1) about $327.3 million to Wilmington Trust Co. as custodian of an

account that would be pledged to Unicom;

(2) about $50 million to an account pledged to AIG Financial Products

Corp. to support CPS' obligations under the letter of credit reimbursement

agreement;

- 44 (3) about $162 million to an account pledged to FSA to support CPS's

obligations under the insurance and indemnity agreement to the Spruce sublease.¹²

C.

End of Sublease Term

1.

CPS's Cancellation Option

At the end of the Spruce sublease term, March 2, 2032, CPS would have the

option of terminating the Spruce sublease and causing Unicom to terminate the

Spruce headlease (cancellation option) for the price of $733,849,606. Because the

entire amount of the cancellation option payment was financed through the CPUA,

CPS would not have to contribute or borrow any additional cash. According to the

appraisal prepared by Deloitte, the fair market value of the Spruce station on the

cancellation option exercise date in 2032 would be around $626 million if based

on a discounted cashflow analysis and around $609.6 million if based on a cost

approach.

If CPS chose not to exercise the cancellation option, it would trigger

provisions of the Spruce sublease describing conditions for returning the Spruce

station to Unicom. Among other things, CPS would have to ensure that the station

meet operational standards, arrange for various inspections, obtain operating

¹²Although the total amount set aside was roughly $539 million, some of the

money was invested by the custodians in low-risk securities to provide sufficient

income to cover the entire $557 million Spruce base rent.

- 45 permits for Unicom, and arrange for Unicom to enter into fuel supply contracts,

transmission agreements, and other contracts with third parties necessary to

operate the Spruce station. Failure to comply with these requirements would

trigger a default and the right of Unicom to seek contractual remedies, as

discussed below.

2.

Unicom's Options

If CPS chose not to exercise the cancellation option at the end of the

sublease term, Unicom would have three choices. First, Unicom could require

CPS to arrange for a "qualified operator" to enter into an operating agreement with

Unicom. Second, Unicom could require CPS to arrange for a "qualified bidder" to

enter mto a service agreement. If Unicom did not provide CPS with written notice

of which option it decided to exercise, Unicom would be deemed to have

exercised both the operating agreement and the service agreement options.

Finally, Unicom could take possession of the Spruce station and could operate it

and sell its energy production without exercising the operating agreement or

service option.

If Unicom exercised the service agreement or operating agreement option

and CPS failed to implement the service agreement or operating agreement option

by the end of the Spruce sublease, such failure would constitute an event of default

- 46 and trigger the right of Unicom to pursue appropriate remedies. However, under

certain circumstances CPS would have another opportunity to exercise the

cancellation option at the same price.

a.

Operating Agreement

Under the operating agreement option, CPS was required to find a qualified

operator for the Spruce station. CPS could not be the qualified operator. A

qualified operator would have to, among other requirements, have its senior longterm debt rated no lower than Aa2 by Moody's and AA by S&P or have a

comparable rating by another rating agency acceptable to Unicom or be deemed

similarly creditworthy in the sole opinion of Unicom. Alternatively, a qualified

operator could obtain a guaranty of its obligations under the operating agreement

by any person with its senior unsecured long-term debt rated no lower than Aa2 by

Moody's and AA by S&P, or have a comparable rating by another rating agency

acceptable to Unicom.

The operating agreement option contemplated that the electric output of the

Spruce station would be sold to third parties under the power toll processing

agreements, discussed in the next section.

Deloitte included in its appraisal a list of potential power purchasers and

operators. The only entity with an acceptable credit rating was General Electric

- 47 Corp., meaning that most potential qualified operators would have to make

guaranty arrangements.

3.

Service Agreement

If CPS did not elect to exercise its cancellation option and Unicom elected

to exercise the service agreement option, CPS was required to arrange for the

submission of one or more bids from qualified bidders to enter into the power toll

processing agreement with Unicom for a term of 9.58 years. Unicom expected the

power toll processing agreement to be substantially in the form attached to the

Spruce sublease agreement. CPS was also required to arrange for the qualified

bidder to satisfy all of the conditions precedent to entering into the power toll

processing agreement on or before the expiration date for the Spruce sublease.

A qualified bidder would have to have--or have its obligations under the

power toll processing agreement guaranteed by any person that had--senior

unsecured long-term debt obligations rated no lower than Aa2 by Moody's and

AA by S&P or have a comparable rating for its senior unsecured long-term debt

obligations by another rating agency acceptable to Unicom. If a bidder or a

guarantor did not have debt with such a rating, Unicom could determine whether

the bidder or guarantor satisfied the creditworthiness requirements at its sole

discretion.

- 48 The power purchase bids would have to provide Unicom with net power

revenue in the amounts and at the times set forth in the Spruce sublease. Unicom

could reject any bid if it concluded that the bid would require the Spruce station to

be operated inconsistently with the standards and operational practices and

policies of operators of similar facilities in similar circumstances. In that event,

CPS would be entitled to arrange for one or more alternative bids. If CPS were

unable to find a qualified bidder or Unicom rejected all bidders on or before the

Spruce sublease expiration date, CPS would have to exercise the cancellation

option.

II.

Scherer and Wansley

A.

MEAG and Its Decision To Enter the Scherer and Wansley

Transactions

MEAG was created by the State of Georgia to own and operate electric

generation and transmission facilities and supply bulk wholesale electric power to

its 49 member municipalities, 48 cities, and one county in Georgia. MEAG's

mission is to deliver low-cost power to its participants and, with respect to its own

generation plants, operate them at the lowest cost. MEAG sells power to its cities

at cost and any profit it earns has to inure to the benefit of its cities.

- 49 MEAG is a member of a power marketing agency called the Energy

Authority, which optimizes MEAG's resources and identifies the most economical

method for MEAG to supply power to its members. These options could entail

selling output to the market from one of the power plants MEAG owns and then

buying lower-cost power from a third party, or selling some of MEAG's extra

capacity during colder months to Florida, North Carolina, or Alabama.

MEAG's portfolio of assets consists primarily of investments in power

plants, including undivided ownership interests in the Scherer and Wansley

stations.¹³ Typically, MEAG issues debt to finance the construction of a power

plant, capitalizing the interest during the construction, and then bills cities

monthly for the debt service, the operating expenses, and the fuel expenses.

MEAG is a governmental entity and is tax exempt. State law restricts

MEAG's investments primarily to U.S. Treasuries, repurchase agreements backed

by treasuries and agencies, and money market funds that have treasuries and

agencies. In 1999 MEAG opened an account with $435 million that was intended

to grow with interest until 2008 when MEAG thought deregulation would occur,

but the power market in Georgia was never deregulated.

¹³Georgia Power Co., Oglethorpe Power Corp., and the City of Dalton are

the coowners of the Scherer and Wansley Stations. Georgia Power Corp. operates

the Scherer and Wansley Stations.

- 50 James Fuller was MEAG's treasurer at the time the Wansley and Scherer

transactions were negotiated and closed. Mr. Fuller led MEAG in the negotiations

with petitioner and the other third parties involved in the transactions. During the

negotiations, Mr. Fuller reviewed the transaction documents and the terms relating

to the fixed price purchase option. Mr. Fuller also reviewed the Deloitte appraisal,

but MEAG did not do an appraisal of its own. MEAG originally acquired the

Wansley and Scherer stations at cost.

Before entering into the Scherer and Wansley transactions, MEAG obtained

certain consents from the coowners of the stations, Georgia Power Co., Oglethorpe

Power Corp., and the City of Dalton. MEAG also retained R.W. Beck to evaluate

the impact of the sale of these plants on MEAG's participants to comply with the

provisions of the bond indentures issued to finance the Wansley and Scherer

stations.

B.

Key Terms of the Scherer Transaction

Plant Robert W. Scherer Unit Nos. 1 and 2 (Scherer station) is on a 12,000acre site near Forsythe, Georgia, and includes a powerhouse containing Units 1

through 4, various ash ponds, a water pond, a coal storage yard, a 550-kilovolt

substation, and a man-made lake. Only Units 1 and 2 of the Scherer station were

part of the leasing transactions with Unicom. The leased property did not include

- 51 the coal stockpile, inventories, intangibles, and unit trains owned by MEAG at the

sites. Units 1 and 2 of the Scherer station are conventional coal-fired units

equipped with a single boiler and turbine generator, commissioned in 1982 and

1984, respectively.

1.

Lease and Sublease

On June 9, 2000, Unicom, acting through Scherer Holdings 1, LLC, and

UII, entered into a sale-leaseback transaction with MEAG involving an undivided

interest in the Scherer station (Scherer transaction).

a.

Headlease

Pursuant to the headlease agreement for the Scherer transaction (Scherer

headlease), MEAG leased to Unicom (i) a 10.0% undivided interest in the Unit 1

site, the Unit 2 site and the unit common facilities site, and a 5.0% undivided

interest in the Plant Scherer Common Facilities Site, (ii) a 10.0% undivided

interest in Unit , Unit 2, and the unit common facilities, and (iii) a 5.0% undivided

interest in the Plant 27 Scherer Common Facilities (collectively, Scherer station)

for a term of 61.75 years, starting June 9, 2000 and terminating on September 9,

2061 (Scherer headlease term), unless terminated earlier. The Scherer headlease

term exceeded the Scherer station's estimated remaining useful life of 49 years, as

- 52 determined in an appraisal report on the Scherer Station dated June 9, 2000,

prepared by Deloitte (Scherer appraisal).

Under the Scherer headlease, Unicom agreed to pay MEAG $201,986,755

on the closing date, June 9, 2000 (Scherer headlease rent). The Scherer headlease

rent equaled the estimated fair market value of the Scherer station as of June 9,

2000, as determined by Deloitte in the Scherer appraisal. The parties did not

further negotiate the fair market value of the station, and Mr. Fuller could not

recall whether MEAG had obtained written advice on the valuation of the Scherer

station from anyone other than Deloitte.

MEAG had the right to inspect the Scherer station site throughout the

duration of the headlease. Unicom did not have any obligations to MEAG as to

maintenance, operation, or insurance of the interests conveyed under the

headlease.

b.

Sublease

On the same date, June 9, 2000, Unicom and MEAG entered into an

agreement to lease back the Scherer station (Scherer sublease). MEAG leased

back from Unicom all of Unicom's right, title, and interest in the Scherer station

under the Scherer headlease. The sublease term commenced on June 9, 2000, and

- 53 was scheduled to terminate on September 9, 2030, for a total term of 30.25 years

(Scherer sublease term).

MEAG had an absolute and unconditional obligation to prepay Scherer

sublease rent of $157,414,216 to Unicom on December 7, 2000. Similar to the

Spruce transaction, the Scherer sublease was a triple net lease, meaning that

MEAG was solely responsible for any expenses associated with the sublease. The

parties allocated all the risks related to the Scherer sublease to MEAG. MEAG

was also responsible for maintaining property and liability insurance which met

the requirements set forth in the Scherer sublease.

2.

Default

Similarly to the Spruce transaction, MEAG and CPS could not declare a

default under the headlease. The Scherer sublease, however, had provisions

outlining what events would constitute a default by MEAG. Such events included,

among others, MEAG's failure to pay the Scherer sublease rent on time, failure of

material representation or warranty, or failure to properly maintain the Scherer

station. MEAG had an opportunity to cure such defaults.

In addition, the Scherer sublease also specified certain "Events of Loss", in

case of which MEAG could elect to either rebuild or replace the specific unit in

question or to terminate the sublease with respect to that unit.

- 54 In the event of default, Unicom had the following contractual remedies: (1)

enforce performance by MEAG at MEAG's cost or recover damages for a breach;

(2) terminate the Scherer sublease and demand that MEAG return possession of

the subleased assets to Unicom; or (3) demand that MEAG pay any supplemental

sublease rent due plus the stipulated loss value, and, upon such payment, transfer

all of its right, title, and interest in the leased assets back to MEAG. If Unicom

chose to proceed with the second or third option, it was required to return

unaccrued rent in the form of an early termination amount, as determined on

schedule 2 of the Scherer sublease agreement. If Unicom chose to proceed with

the second option, MEAG would still have an option to purchase the undivided

interest in the Scherer station at a price equal to the higher of stipulated loss value

as of the date of sublease termination due to a default or the then fair market sale

value.

If an event of loss occurred and MEAG chose not to rebuild or replace a

specific unit, MEAG would have to pay Unicom a stipulated loss value, as set

forth in schedule 2 to the Scherer sublease agreement. Unicom would then have to

pay to MEAG an early termination amount, which would reflect any unaccrued

rent as of the date of the event of loss.

- 55 3.

Property Rights and Obligations

Unlike the Spruce transaction, where Unicom received a 100% interest in

the Spruce station, the Scherer headlease transferred only a partial interest in the

Scherer station to Unicom. Unicom received a right of quiet enjoyment under the

headlease. This, however, did not result in Unicom's authority to operate the

Scherer station.¹4 Unicom had the right to use the ground interest to construct,

install, operate, use, repair, and relocate and remove facilities and structures on or

under the Scherer site. Unicom, however, in general did not have any obligations

to MEAG with respect to maintenance, operation, or insurance of the Scherer

station interest under the headlease.

Upon the expiration of the Spruce headlease, Unicom was to return its

interest to MEAG on the "as is" and "with all faults" basis. MEAG had the right

to inspect the property after the expiration of the leaseback term. Unicom was

responsible for a percentage of certain taxes and assessments with respect to the

ground interest described in the Scherer headlease agreement from the date the

leaseback to MEAG ended and until the end of the headlease. Both MEAG and

¹#Operation of the Scherer station was governed by the agreement among

MEAG, Georgia Power Co., Oglethorpe Power Corp., and the City of Dalton. At

the time Unicom and MEAG entered into the sale-leaseback arrangements,

Georgia Power Co. operated both the Scherer and Wansley stations.

- 56 Unicom agreed to limit their ability to incur liens with respect to the Scherer

station interest transferred by the Scherer headlease.

Under the Scherer sublease, MEAG received the same interest in the

Scherer station it transferred to Unicom under the Scherer headlease. Overall, the

rights of MEAG under the sublease were similar to the rights of CPS under the

Spruce sublease. MEAG's rights with respect to subleasing its interest during the

sublease term were broader than those of CPS: MEAG did not need separate

approval for a sublease if it met certain requirements. Unicom had the right to

inspect the premises during the sublease once a year and the right to consent to the

assignment by MEAG of its rights under the Scherer sublease.

Under the Scherer sublease, MEAG took the Scherer station interest from

Unicom on an as-is basis. If MEAG or other tenants in common of the Scherer

station did not exercise the purchase option at the end of the Scherer sublease or if

MEAG was required to return the Scherer station interest to Unicom after a

default, MEAG was required to meet certain conditions, including having the

Scherer station meet certain operational standards and be free from major defects,

in good working order, and in a good state of repair. Unicom was entitled to

receive, and MEAG agreed to deliver, the Scherer station with at least a 62%

capacity factor based on 8,760 hours of operation per year and net energy output

- 57 of 87.5%. In addition, MEAG was required to be in compliance with other

agreements governing ownership and operation of the Scherer station and have no

outstanding amounts due under those contracts.

If MEAG were required to return the Scherer station interest to Unicom, and

Unicom chose the service agreement option, MEAG was to arrange at its own

expense for any necessary permits for Unicom or a qualified bidder under the

service agreement to operate the Scherer station. MEAG was also required to

arrange for an environmental inspection, as well as to arrange for Unicom fuel

supply contracts and transmission agreements, together with any other agreements

necessary to operate the station. Failure to comply with the prerequisites to

returning the Scherer station interest would trigger for MEAG, under certain

circumstances, the requirement to pay to Unicom an amount equal to the

diminution in the fair market sale value of the interest caused by MEAG's failure

to comply with the return conditions.

4.

Cashflows and Collateral Agreements

Unicom and MEAG chose to structure the cashflows for the Scherer and

Wansley transactions differently from those for the Spruce transaction. In part this

was so because of MEAG's limited authority to invest in securities.

- 58 Pursuant to the Scherer headlease, on June 9, 2000, Unicom paid the

Scherer headlease rent of $201,986,755 to MEAG.

On June 9, 2000, MEAG entered into the Government securities pledge

agreement (Scherer pledge agreement) with Ambac Credit Products, LLC (Ambac

Credit), and State Street, as agent and intermediary. Pursuant to the Scherer

pledge agreement, MEAG would pay from the Scherer headlease rent

$152,228,894 to State Street to purchase Government securities on the closing

date of the Scherer transaction. The pledge agreement required MEAG to pledge

these Government securities to Ambac Credit first and Unicom second to secure

MEAG's obligation under the Scherer sublease to make the Scherer base rent

payment on December 7, 2000.

State Street also paid Ambac Credit $1,544,674 on the closing date of the

Scherer 1 transaction on behalf of MEAG. In exchange, Ambac Credit agreed to

make certain payments on behalf of MEAG pursuant to a credit swap agreement

between Ambac Credit and UII (UII swap agreement). The payment also covered

the financial guaranty insurance policy issued by Ambac Assurance Corp., No.

SF0353BE, dated June 9, 2000 (Scherer FGIP).

Under the UII swap agreement, Ambac Credit was obligated to pay UII the

excess of the stipulated loss value over all payments UII received with respect to

- 59 the stipulated loss value or purchase option price from other sources, plus the early

termination amount. In exchange, UII would be required to surrender its right,

title, and interest under the Wansley transaction to Ambac Credit, the swap

provider.

Under the Scherer FGIP, Ambac Assurance Corp. unconditionally and

irrevocably guaranteed the payments by the swap provider under the UII swap

agreement. The payment obligation under the UII swap agreement is triggered by

the occurrence of any of several events, including MEAG's failure to pay the base

rent or the stipulated loss value, certain misrepresentations by MEAG, MEAG's

insolvency or bankruptcy, and MEAG's failure to perform or observe the

covenants and obligations under the Wansley transaction documents.

On June 9, 2000, MEAG entered into a credit swap agreement with Ambac

Credit (MEAG swap agreement). Ambac Credit paid MEAG $372,890, and

MEAG agreed to make the payments described in the MEAG swap agreement.

MEAG's payment obligations under the MEAG swap agreement are the same as

those described under the UII swap agreement. State Street paid $1,000,934 of

various transaction expenses on the closing date of the Scherer transaction on

behalf of MEAG.

- 60 On June 9, 2000, MEAG also transferred $47,576,143 to various collateral

accounts for investment in short-term collateralized flex repurchase agreements.

The collateral accounts served as collateral for MEAG's purchase option

obligation under the Scherer sublease.

The effect of the transactions discussed above was to set aside funds from

the Scherer headlease rent to fund MEAG's obligations to pay the Scherer rent and

the purchase option under the Scherer sublease.

5.

End of Sublease Term

Similarly to the Spruce transaction, at the end of the sublease term MEAG

or one of its cotenants in common could exercise the purchase option to regain all

the rights to the Scherer station. If that did not happen, Unicom could exercise its

rights under the operating agreement or service agreement option, or could choose

to purchase and sell its share of the Scherer output on the market.¹5

a.

MEAG's Purchase Option

At the end of the Scherer sublease term, September 9, 2030, MEAG has the

option of terminating the Scherer sublease and causing Unicom to terminate the

Scherer headlease for the price of $179,284,424 (Scherer purchase option). If

¹sAs discussed supra note 14, Unicom's authority to operate the Scherer

station was limited, so we do not consider it as a viable possibility in our analysis.

- 61 MEAG chooses not to exercise the Scherer purchase option, one or more of

MEAG's cotenants in common will then have the right to acquire Unicom's

interest in the Scherer station.¹6 To exercise the Scherer purchase option, MEAG

will have to give written notice to Unicom no later than January 15, 2029.

If neither MEAG nor its cotenants in common decide to exercise the Scherer

purchase option, MEAG will have to comply with all of the requirements for

returning the Scherer station interest to Unicom as described above.

b.

Unicom's Options

i.

Operating Agreement Option

Under the terms of the Scherer sublease, if neither MEAG nor its cotenants

exercise their purchase options, Unicom can exercise the operating agreement

option. This option will not be available to Unicom if, at the time of exercise,

MEAG is not an operator of the Scherer station under the agreements governing

MEAG's relationships with cotenants and management and operation of the

Scherer station.

If MEAG is an operator of the Scherer station, Unicom can then require

MEAG to arrange for a qualified third party to enter into an operating agreement

¹°Georgia Power Co., Oglethorpe Power Corp., and the City of Dalton all

had the right to exercise the purchase option for the undivided interest in the

Scherer station if MEAG chose not to.

- 62 with Unicom to operate the Scherer station. The electric output of the Scherer

station would be sold to third parties under power purchase agreements while the

station was operated and maintained on behalf of Unicom by the qualified

operator.

A qualified operator would, among other requirements, have, or have its

obligations guaranteed by a guarantor who has, a rating not lower than Aa2 by

Moody's and AA by S&P, or be deemed similarly creditworthy by Unicom and be

otherwise reasonably acceptable to Unicom. Failure by MEAG to implement its

obligations under the operation agreement option would lead to MEAG's default

under the Scherer sublease. Under certain circumstances, MEAG and its cotenants

would get another opportunity to exercise the purchase option. If they decided not

to do so, Unicom would have to use other remedies available to it under the

Scherer sublease.

ii.

Service Agreement Option

If MEAG or its cotenants chose not to exercise the purchase option and

MEAG was not an operator of the Scherer station at that time, the only option

available to Unicom would be to exercise its rights under the service agreement

option.

- 63 Under the service agreement option, Unicom could require MEAG to

arrange for the submission of one or more power purchase bids from "qualified

bidders" to enter into power purchase agreements with Unicom.

Similarly to the Spruce transaction, a qualified bidder would have to meet

certain creditworthiness requirements or have its obligations under the power

purchase agreement guaranteed by an entity with sufficient creditworthiness.

MEAG could itself submit a bid as a qualified bidder subject to meeting all the

qualified bidder requirements. The parties contemplated that a qualified bidder

would enter into a power purchase agreement and would purchase the electric

output from the Scherer station for the term of 8.69 years. On the basis of the

Deloitte appraisal, the parties believed that after the end of the power purchase

agreement term, the remaining economic useful life of the assets under the Scherer

headlease would be 10.6 years or 20.53% of the estimated overall useful life

remaining as of the closing date in 2000.

The requirements for the net power revenue under the power purchase

agreement to be received by Unicom were predetermined and set out as schedules

to the Scherer sublease. However, these payments were not guaranteed unless the

plant actually produced power in the required amounts and at certain efficiency

standards.

- 64 Unicom could reject any bids at its sole discretion. If MEAG failed to

provide Unicom with qualified bidders to enter into the power purchase agreement

or if Unicom rejected all such bids, that would constitute an event of default under

the agreement. Under certain circumstances, MEAG would have an additional

opportunity to exercise the purchase option. Otherwise, Unicom could use the

standard remedies available under the provisions governing events of default.

Similar to the Spruce sublease, if Unicom did not give notice as to which

option it elected, it would be deemed to have elected to exercise both the operating

agreement and the service agreement options if both options are available.

MEAG's failure to implement its obligations under both options would constitute

its default under the sublease, which would result in either another chance to

exercise the purchase option or Unicom's entitlement to other contractual

remedies.

C.

Key Terms of the Wansley Transaction

Power Plant Wansley (Wansley station), on a 5,225-acre site near

Carrollton, Georgia, included two conventional power generation units, as well as

a 320-acre ash disposal pond, a 126-acre potable water pond, a 40-acre coal

storage yard, a 15-acre 500-kilovolt substation, and a 606-acre service water pond

that provides cooling water for the plant. At the time of the transaction in 2000,

- 65 Wansley station comprised two self-contained 865 MW coal-fired units. Units 1

and 2 are conventional coal-fired units equipped with a single boiler and turbine

generator, commissioned in 1982 and 1984, respectively. The leased property did

not include the coal stockpile, inventories, intangibles, and unit trains owned by

MEAG at the sites.

1.

Lease and Sublease

a.

Headlease

On June 9, 2000, MEAG entered into the Wansley transaction with Unicom

(through Wansley Holdings 1, LLC and UII) involving an undivided interest in

Plant Hal Wansley Units 1 and 2 (together, Wansley station), as well as certain

common facilities. In the Wansley transaction, MEAG leased a 10%

undivided interest in the Wansley station¹7 to Unicom through its wholly owned

subsidiaries for a term of 56.75 years (Wansley headlease). Deloitte appraised the

undivided interest in the Wansley station as of the closing date of June 9, 2000, at

$172 million. Deloitte determined that the Wansley headlease term of 56.75 years

exceeds the Wansley station's estimated remaining useful life of 45 years.

¹7For the sake of clarity, references in this Opinion to the lease or sublease

of the Wansley station are to be understood as referring to a lease or sublease of

the 10% undivided interest in the Wansley station.

- 66 On June 9, 2000, under the Wansley headlease, Unicom paid $172,185,430

to MEAG for the lease of the Wansley station (Wansley headlease rent).

According to Deloitte, the Wansley headlease rent was approximately equal to the

estimated fair market value of the Wansley station on June 9, 2000. The appraised

fair market value served as the basis for determining Unicom's investment in the

transactions, and the parties did not further negotiate the investment amount.

Deloitte estimated that as of the end of the sublease the fair market value of the

Wansley station would be about $485 million if based on the discounted cashflow

approach and $481 million if based on the cost approach.¹8

b.

Sublease

On June 9, 2000, MEAG and Unicom, through Wansley Holdings 1, LLC,

entered into the sublease agreement, whereby MEAG leased the Wansley Station

back (Wansley sublease) from Unicom for a term of 27.75 years. MEAG leased

back from Unicom all of Unicom's rights, title, and interest in the Wansley station.

The Wansley sublease was scheduled to terminate on March 9, 2028. Under the

terms of the Wansley sublease, MEAG was obligated to pay rent to Unicom of

¹8The Wansley appraisal prepared by Deloitte did not allocate the values

between Wansley 1 and 2.

- 67 $134,087,903, on December 7, 2000, six months after the closing of the Wansley

transaction (Wansley base rent).

The Wansley sublease was a net lease, similar to the Spruce and Scherer

subleases. MEAG was responsible for all costs and expenses associated with the

Wansley station throughout the sublease. In addition, MEAG had to maintain

property and liability insurance on the Wansley station meeting the requirements

set out in the sublease.

2.

Default

Provisions governing events of default and events of loss are substantially

the same in the Wansley and Scherer transactions. The Wansley sublease outlines

different operating standards that the station must meet if it is returned to Unicom

in an event of default, but other conditions are either very similar or the same.

3.

Property Rights

The property rights of Unicom and MEAG under the Wansley transaction

are substantially identical to those in the Scherer transaction and need not be

separately stated here.

4.

Cashflows and Collateral Agreements

MEAG and Unicom used the same structure of cashflows and collateral

agreements for the Wansley transaction as for the Scherer transaction.

- 68 Pursuant to the Wansley headlease, on June 9, 2000, Unicom paid the

Wansley headlease rent of $172,185,430 to MEAG.

On June 9, 2000, MEAG entered into the Government securities pledge

agreement with Ambac Credit and State Street as agent and intermediary. MEAG

paid State Street $129,768,893 from the Wansley headlease rent to purchase

Government securities on that same date. MEAG pledged the Government

securities to Ambac Credit and Unicom to secure MEAG's obligation to pay the

base rent under the Wansley sublease on December 7, 2000. It was projected that

the Government securities would equal the Wansley base rent of $134,087,903.

On June 9, 2000, MEAG provided UII with the UII swap agreement and the

financial guaranty insurance policy issued by Ambac Assurance Corp., No.

SF0356BE, dated June 9, 2000 (Wansley FGIP). On the same date, State Street,

on behalf of MEAG, paid Ambac Credit $1,200,317.76, in consideration of

Ambac Credit's agreement to make the payments described in the UII swap

agreement and in the Wansley FGIP. The obligations of the parties are the same

as under the UII swap agreement and the Wansley FGIP in the Scherer transaction.

On June 9, 2000, MEAG entered into the MEAG swap agreement with

Ambac Credit, and Ambac Credit paid MEAG $287,226 in consideration of

MEAG's agreement to make the payments described in the credit swap between

- 69 MEAG and Ambac Credit. MEAG's payment obligations under the MEAG swap

agreement are the same as those described under the UII swap agreement. On

behalf of MEAG, State Street Bank also paid $860,927 of transaction expenses on

the closing date.

Also on the closing date, MEAG transferred $40,642,518 to collateral

accounts for investment in short term collateralized flex repurchase agreements, as

collateral for the purchase option, with a pledge first to Ambac Credit and second

to UII.

5.

End of Sublease Term

The end of sublease term options for Unicom and MEAG regarding the

Wansley station are substantially the same as those in the Scherer transaction.

MEAG and Georgia Power Co. could exercise the purchase option at the end of

the Wansley sublease. The purchase option price was set at $143,543,915. If they

chose not to do so, Unicom would be able to proceed with the operating agreement

and service agreement options, similar to the provisions in the Scherer

transactions. Alternatively, Unicom could get its share of the Wansley station

output and sell it on the market.

Under the service agreement option, the electric output from the Wansley

station would be purchased by third parties for the term of 8.09 years, and after the

- 70 end of the power purchase agreement term the parties projected the remaining

economic useful life of the Wansley station to be 9.17 years, or 20.38% of the

estimated overall useful life remaining as of the closing date in 2000.

D.

MEAG's Net Present Value Benefit

MEAG was entitled to receive a payment of approximately $110 million for

its participation in the Scherer and Wansley transactions (MEAG NPV benefit).

Mr. Fuller informed MEAG's board of directors in June 2000 that the MEAG

NPV benefit for entering into the transactions would be approximately 11.19% of

the value of each lease in the Wansley station and 12.34% of the value of each

lease in the Scherer station. MEAG placed the NPV benefit into a trust account

with State Street until 2014, at which time MEAG was expected to transfer the

funds to the municipal competitive trust. MEAG's rights to use the NPV benefit

until then were limited under the corresponding agreements because the trust

account was pledged to lower the cost of insurance of the transactions and to

secure the payment of early termination fees.

Post-Closing Events

I.

Construction of Spruce II

At the time that CPS built the Spruce station, CPS had also intended to

build, on an unspecified future date, a second generating plant (Spruce II) on the

- 71 same site as the Spruce station. The Spruce transaction documents reflected the

existence of such plans but in terms that did not convey absolute certainty.

On June 16, 2004, CPS informed Unicom in writing of CPS' intention to

exercise its right to install and use additional facilities on the site of the Spruce

station. CPS intended for this expansion--Spruce II--to share facilities with the

Spruce station, such as a "control room", a "computer room", "coal conveyers", a

"demineralizer", a "limestone silo ball mill", and a "limestone slurry storage tank".

Although CPS would also build other operational facilities strictly for the benefit

of Spruce II's operations, those facilities would be situated on the same land

occupied by the Spruce station.

The letter dated June 16, 2004, from CPS requested prior written approval

of the Spruce II construction from Unicom under the terms of the Spruce

headlease. In evaluating CPS' request, Thomas Miller, Exelon's vice president of

finance, and Randy Specht, from petitioner's engineering group, visited the Spruce

site on December 17, 2004. Messrs. Miller and Specht met with CPS' plant

personnel and toured the facility. In addition to the tour, Mr. Miller requested

written representations from CPS that the Spruce II station would not interfere

with or harm petitioner's interest in the Spruce station. CPS provided such written

representations. Exelon, which at the time became a successor to Unicom by

- 72 virtue of merger, then executed an approval authorizing the construction of the

Spruce II plant. Exelon did not visit the site after the Spruce II project was

completed in 2010 to examine the outcome.

II.

Registration of the Test Transactions as Corporate Tax Shelters

On or about April 5, 2000, before the closing of the test transactions,

Winston & Strawn circulated the initial draft of a designation agreement whereby

PwC as designated organizer agreed to register the Spruce, Scherer, and Wansley

transactions as tax shelters with the IRS in accordance with section 6011 and

applicable regulations. On May 2, 2000, PwC informed the parties involved in the

test transactions that the transactions would be registered as confidential corporate

tax shelters pursuant to section 6111(d) and applicable regulations and provided

the parties with the proposed designation agreement which, upon execution, would

appoint PwC as a designated organizer. On or about June 9, 2000, PwC and the

other parties involved in the Scherer, Wansley, and Spruce transactions entered

into a designation agreement for registration of confidential tax shelters under

section 6111(d).

On or about June 1, 2000, PwC filed with the IRS in Kansas City, Missouri,

Form 8264, Application for Registration of a Tax Shelter (Confidential Corporate

- 73 Tax Shelter), for the Spruce transaction. On June 16, 2000, the IRS assigned tax

shelter registration No. 00167000008 to the Spruce transaction.

On or about July 13, 2000, PwC filed a supplemental Form 8264 with the

IRS in Kansas City, Missouri, for the Spruce, Scherer, and Wansley transactions.

On July 18, 2000, the IRS issued tax shelter registration No. 00167000008 for the

Scherer and Wansley transactions.

Unicom's tax return for its 1999 tax year included an appropriate disclosure

statement under the then-effective regulations for a reportable transaction for UII

on account of the test transactions. It also properly disclosed tax shelter

registration No. 00167000008 on Form 8271, Investor Reporting of Tax Shelter

Registration Number, issued by the IRS in connection with the Spruce, Scherer,

and Wansley transactions. PwC monitored the status of the tax shelter

registrations, including the registration No. 00167000008, for Unicom/UII and the

Spruce, Scherer and Wansley transactions.

III.

MEAG Collateral Substitution

Enhancements in the Scherer and Wansley transactions were structured

differently from those in the Spruce transaction. CPS and Unicom used a CPUA

as credit enhancement to secure the sublease obligations and provide the funds for

the cancellation option exercise to CPS at the end of the sublease. In the Scherer

- 74 and Wansley transactions, MEAG and Unicom used credit swap contracts issued

by Ambac Credit to secure the payment of the purchase option exercise price.

Under the swap contracts, MEAG would pledge high-quality securities primarily

to Ambac Credit and secondarily to UII to pay the termination fees under the

subleases or purchase option price. MEAG detennined how it wanted to invest the

money, with the ultimate goal to have sufficient funds to pay the purchase option

price at the end of the Scherer and Wansley subleases.

Initially MEAG decided to invest the funds in short-term repurchase

agreements, Federal agency discount notes, and a managed portfolio with

Government-backed agency and Treasury securities. These short-term

investments were rolled over and reinvested as they came due. Any ongoing

investment risk, such as changes in interest rates over time, was borne entirely by

MEAG.

In 2001 MEAG first suggested changing its investment portfolio by

investing either in adjustable rate mortgage securities guaranteed by a Federal

agency or Government-sponsored enterprise or in short-term money market funds

rated AAA. Exelon agreed to the substitution. The securities continued to be

pledged to Ambac Credit and Exelon.

- 75 Because the early 2000s ended up being a period of low interest rates, the

funds invested by MEAG grew at a rate insufficient to fully fund the future

purchase options. In 2006 MEAG proposed another substitution to Exelon,

whereby MEAG would replace the existing collateral with a pledge of MEAG's

own newly issued bonds insured by Ambac Credit. In August 2006 Exelon agreed

to MEAG's request. This allowed MEAG to receive the funds it needed for

environmental compliance and certain operational needs. Overall, MEAG

replaced $173 million worth of collateral securities with its own bonds. MEAG

also pledged an extra $81,171,330 of securities to Ambac Credit in 2007. In

essence, MEAG remained obligated under the sublease agreements, and the bonds

securing those sublease obligations were just another form of MEAG payment

obligation.

When Ambac Credit's credit rating declined, MEAG contacted Exelon and

received a waiver of the requirement that the bond insurance company maintain a

certain credit level.

IV.

Postclosing Monitoring

After the closing dates of the Spruce, Wansley, and Scherer transactions, the

lessees were required to provide Unicom with certain financial and operational

information. For example, CPS contacted petitioner regarding the impact of

- 76 higher property insurance rates following the September 11, 2001, attacks. In

addition, as discussed above, Unicom consented to the construction of Spruce II

and the MEAG collateral substitution.

In 2008 employees from Exelon's corporate finance and asset management

groups inspected the Spruce, Wansley, and Scherer stations as part of a

"compliance review" to ensure that the facilities were being operated and

maintained properly. Before the on-site inspections, Exelon's employees reviewed

various operating and financial performance indicators and data, and also

requested applicable documents for the leased stations from CPS and MEAG. The

review did not raise any red flags. Exelon did not conduct compliance reviews in

any other years even though it had the right to visit the sites and request related

documents each year.

V.

Early Termination of the Spruce Transaction

Pursuant to an omnibus termination agreement, on or about February 26,

2014, CPS and Exelon terminated the Spruce transaction. Upon termination of the

Spruce transaction, Exelon received $335 million in exchange for terminating its

interests in the Spruce station. Possession of the Spruce station passed to CPS,

free and clear of any claims or liens by Exelon.

- 77 Tax Returns, Notices of Deficiencies, Trial

I.

Tax Returns

A.

1999 Tax Year

Unicom timely filed the Unicom Group's consolidated Federal income tax

return for the 1999 tax year. On or about April 1, 2004, Exelon, as successor to

Unicom, filed Form 1120X, Amended U.S. Corporation Income Tax Return, for

the Unicom Group's 1999 tax year. On or about August 25, 2004, Exelon filed a

second amended tax return for the Unicom Group's 1999 tax year. On or about

January 9, 2007, Exelon filed a third amended tax return for the Unicom Group's

1999 tax year.

On its 1999 income tax return, Unicom had indicated taxable income of

$2,484,829,531 and filed Form 8824, Like-Kind Exchanges, describing the

transactions at issue here. Unicom had not included in income deferred section

1031 gain of $1,231,927,407 arising out of the test transactions.

B.

2001 Tax Year

On or about September 26, 2002, Exelon, as successor to Unicom, filed its

consolidated Federal income tax return for the 2001 tax year. On or about April 1,

2004, Exelon filed an amended tax return for its 2001 tax year. On or about

January 30, 2007, Exelon filed a second amended tax return for the 2001 tax year.

- 78 On its 2001 income tax return, Exelon reported taxable income of

$1,412,586,105. With respect to the transaction with CPS, Exelon had claimed a

depreciation deduction of $2,968,648 an interest expense deduction of

$38,261,289, and an amortized transaction costs deduction of $183,708. Exelon

reported $40,476,248 of taxable rental income. Exelon had not reported taxable

original issue discount income with respect to the transaction (which respondent

determined claims to be $5,939,981 for the 2001 tax year).

With respect to the transactions with MEAG, Exelon had claimed a

depreciation deduction of $5,447,849 an interest expense deduction of

$46,547,887, and an amortized transaction costs deduction of $231,814. Exelon

reported $50,370,556 of taxable rental income. Exelon had not reported taxable

original issue discount income with respect to the transaction (which respondent

determined claims to be $7,078,805 for the 2001 tax year).

II.

Notices of Deficiency

A.

1999 Tax Year

On September 30, 2013, respondent timely issued a statutory notice of

deficiency to petitioner for its income tax liabilities for the tax year ending

December 31, 1999 (1999 notice of deficiency). Respondent determined a

- 79 deficiency in tax for 1999 of $431,174,592 and a penalty under section 6662(a) of

$86,234,918.

Respondent disallowed petitioner's treatment of the transactions with CPS

and MEAG as section 1031 like-kind exchanges. The 1999 notice of deficiency

stated that deferred section 1031 gain of $1,231,927,407 should be included in

income for tax year 1999, because petitioner "did not acquire and retain significant

and genuine attributes of a traditional owner, including the benefits and burdens of

ownership, of the Replacement Property."

The 1999 notice of deficiency determined a section 6662 accuracy-related

penalty of 20% on the grounds of negligence or disregard of rules and regulations,

or a substantial understatement of income tax.

B.

2001 Tax Year

On September 30, 2013, respondent timely issued a separate statutory notice

of deficiency to petitioner for its income tax liability for the tax year ending

December 31, 2001 (2001 notice of deficiency). Respondent determined a

deficiency in tax for 2001 of $5,534,611 and a penalty under section 6662(a) of

$1,106,922.

The 2001 notice of deficiency disallowed depreciation deductions of

$2,968,648 and $5,447,849 claimed by Exelon for the CPS and MEAG sale-

- 80 leaseback transactions, respectively, because "the taxpayer failed to acquire and

retain significant and genuine attributes of a traditional owner, including the

benefits and burdens of ownership". Respondent disallowed interest expense

deductions of $38,261,289 and $46,547,887, and amortized transaction costs

deductions of $183,708 and $231,814, for the CPS and MEAG transactions,

respectively. Respondent determined that because the transactions with CPS and

MEAG were in substance loans, petitioner should have reported original issue

discount (OID) income of $5,939,981 and $7,078,805 resulting from the deemed

loans to CPS and MEAG, respectively. Furthermore, according to respondent,

because petitioner did not acquire ownership interests in the CPS and MEAG

transactions, it was not required to report rental income of $40,476,248 and

$50,370,556, respectively, from the subleases in 2001.

In the alternative, respondent determined that sale-leaseback transactions

with CPS and MEAG lack economic substance and should be disregarded for

Federal income tax purposes. Accordingly, respondent disallowed petitioner's

deductions of depreciation, interest expense, and transaction costs, and reversed

rental income.

- 81 The 2001 notice of deficiency imposed a 20% accuracy-related penalty

under section 6662 on the grounds of "negligence or disregard of rules and

regulations regarding * * * [petitioner's] tax treatment of the SILO transactions."

In the alternative, respondent determined the section 6662 penalty for 2001

for a substantial understatement of income tax attributable to a tax shelter item of a

corporation. Respondent conceded the issue of a substantial understatement of

income tax under section 6662(a) and (b)(2) for 2001 before trial, so we need not

in this Opinion address this ground for imposition of the section 6662 penalty for

2001.

III.

Trial

Exelon timely filed petitions in both cases on December 13, 2013. The

Court held a three-week special trial session in Chicago, Illinois. During the trial,

the parties presented the testimony of 16 fact witnesses and 10 expert witnesses.

Both parties rely heavily on expert opinions to support their arguments. The

parties' expert witnesses, their qualifications, and their Court-recognized areas of

expertise are listed below. We also briefly summarize the conclusions of the

experts in their respective expert reports.

- 82 A.

Petitioner's Expert Witnesses

1.

Stewart Myers

The Court recognized Stewart Myers as an expert in finance, valuation, and

investments in the energy industry, as well as analysis of complex financial

transactions including leases and real options. Prof. Myers has a Ph.D. in finance

and economics from Stanford, and he is the Robert C. Merton professor of

financial economics at the MIT Sloan School of Management, where

he has taught since 1966.

Prof. Myers' graduate-level textbook, Principles of Corporate Finance (with

Professors Richard Brealey and Franklin Allen) is a highly regarded treatise. He

has also published dozens of articles on corporate finance and financial

economics. He was also a director for Entergy Corp., a large public utility and

merchant power generator based in New Orleans, Louisiana, that also has

generating plants in the eastern and northeastern United States.

In his expert report Prof. Myers discussed the primary factors that affect the

decisions of the parties involved in the test transactions to exercise their respective

options. Prof. Myers testified that, while both MEAG and CPS do not pay income

tax, their tax-exempt status does not affect their valuation of the leased stations.

- 83 Prof. Myers also testified that the accepted financial practice always makes

decisions based on after-tax cashflows and rates of return.

Prof. Myers conducted sensitivity analysis involving several variables such

as inflation and electricity price to determine the range of future market values of

residual interests in the Spruce, Scherer, and Wansley stations and to see how it

would affect the decisions of CPS and MEAG to exercise their

cancellation/purchase options at the end of the sublease terms. He concluded that

both CPS and MEAG would return their respective interests in the subleased

stations to Exelon if the values of these interests at the end of the sublease terms

were less than the purchase option prices. This would also cover the "base"

scenario outlined in the Deloitte appraisal.

We find Prof. Myers' sensitivity analysis helpful because it illustrates that

even a difference of 1%-2% in the inflation rate would dramatically change the

future market value of an interest over a 30-year term. For example, in the case of

the Spruce station, a 4% inflation rate--1.5% higher than the rate assumed by

Deloitte--would result in the future market value of the plant of $971.1 million,

almost $250 million above the exercise price of $723.2 million for the cancellation

option and almost $350 above the fair market value projected by the Deloitte

appraisal. Conversely, a 1% inflation rate--l.5% lower than the rate assumed by

- 84 Deloitte--would result in the future market value of the plant of $394.2 million,

almost $330 million less than the cancellation option exercise price and over $200

million less than the fair market value projected by the Deloitte appraisal.

2.

John Reed

The Court recognized John J. Reed as an expert in transactions involving

energy, industry firms and assets, energy market economic analyses, and

evaluation and financial analysis related to the energy industry. Mr. Reed is a

graduate of the Wharton School of the University of Pennsylvania, where he

received a bachelor of science degree in finance.

Mr. Reed is currently the chairman and CEO of Concentric Energy

Advisors, Inc., a financial advisory and management consulting firm for energy

industry firms. Mr. Reed has over thirty-five years of experience in the energy

industry, including as an executive in energy consulting firms and as chief

economist for Southern California Gas Co., the largest U.S. gas utility. He has

also been involved in the purchase, sale, and valuation of energy-related assets,

including the sales of over 50 fossil fuel power generating facilities.

In his expert report Mr. Reed concluded that, at the time Unicom, CPS, and

MEAG entered into the test transactions, a significant uncertainty existed with

respect to the future value of the Scherer, Spruce, and Wansley stations. Mr. Reed

- 85 concluded that CPS' and MEAG's tax-exempt status would not influence their

analysis of the future market value of the plants.

3.

Karl A. McDermott

The Court recognized Karl A. McDermott as an expert in regulatory

economics, the history of regulation, and capital investment decisionmaking in the

power utility industry in the United States. Prof. McDermott has a Ph.D. in

economics from the University of Illinois at Urbana-Champaign and serves as the

Ameren distinguished professor of business and government at the University of

Illinois Springfield. He has served as a lecturer and teacher for 36 years on topics

regarding public utilities, banking, energy market regulation, gas wholesale

markets, and macroeconomics. He has also published articles on the energy

industry, the ICC, and energy market regulation. Prof. McDermott served as a

commissioner for the ICC from 1992 to 1998, during the period when Illinois

deregulated its energy market.

Prof. McDermott provided the Court with a primer on the U.S. energy

market that also covered the periods both before and after many States (including

Illinois) deregulated. In his expert report Prof. McDermott concluded that

Unicom's investment in leases with CPS and MEAG allowed it to achieve the

same risk and reward profile it had had before the deregulation of generation

- 86 assets in Illinois. Prof. McDermott stated that bankruptcy of CPS or MEAG was a

relatively low probability although such bankruptcies had occurred in other

jurisdictions.

4.

Stuart Gilson

The Court recognized Stuart Gilson as an expert in the financial

consequences of bankruptcy, including decisionmaking and financial

consequences relating to bankruptcy proceedings. Prof. Gilson has a Ph.D. in

finance from the University of Rochester and is a tenured professor in the Finance

Department of Harvard Business School. His academic and consulting

experiences focus on corporate finance, business valuation, credit analysis, and

corporate restructuring and bankruptcy; and he has written several articles and

case studies on those subjects.

In his expert report Prof. Gilson concluded that Unicom faced a risk of loss

arising from a CPS or MEAG bankruptcy.¹9 In the event of a CPS or MEAG

bankruptcy, section 502(b)(6) of the Bankruptcy Code could limit the recovery

available to Unicom to rent for the greater of one year or 15%, not to exceed three

¹°Prof. Gilson assumed that Georgia bankruptcy law would be changed to

allow municipalities to take advantage of chapter 9 of the Bankruptcy Code.

Alternatively, Prof. Gilson assumed that MEAG could have filed for protection

under chapter 11 of the Bankruptcy Code if the bankruptcy court had determined

that MEAG did not qualify as a municipality.

- 87 years, of the remaining term of the sublease. In his analysis Prof. Gilson did not

consider various credit enhancements and contractual provisions available to

Unicom in the case of a CPS or MEAG bankruptcy. Prof. Gilson concluded that

the net financial impact on Unicom of an early sublease rejection would depend on

the fair market value of the facility at the time of rejection. At low fair market

value, Unicom could experience a loss at sublease rejection, but with the fair

market value increase the net financial impact on Unicom would become

increasingly positive.

5.

Mark E. Zmijewski

The Court recognized Mark E. Zmijewski as an expert in the field of

accounting, and particularly accounting for financial analysis of leases. Prof.

Zmijewski is the Leon Carroll Marshall professor of accounting at the University

of Chicago Booth School of Business, where he has served on the faculty since

1984. Prof. Zmijewski has an M.B.A. in accounting and a Ph.D. in accounting

from the State University of New York at Buffalo. Prof. Zmijewski teaches

courses in valuation, mergers and acquisitions, financial analysis, accounting, and

entrepreneurship. He has also published articles on accounting, discounted

cashflow valuations, and securities regulation.

- 88 In his expert report Prof. Zmijewski concluded that the test transactions

were structured as direct financing leases rather than SILOs. Prof. Zmijewski also

concluded that the test transactions are not front loaded under any of the options

available in the lease and are not tax driven.

6.

Ingrid Sarapuu

The Court recognized Ingrid Sarapuu as an expert in lease financing,

leasing, and asset financing. Ms. Sarapuu has an M.B.A. from the University of

Chicago Booth School of Business. She has been a licensed securities principal

with Series 7, 24, 63, and 79 certifications. She also has over 30 years of

executive experience in leveraged leasing and corporate finance in the private

sector. In her expert report Ms. Sarapuu concluded that the test transactions are

consistent with traditional leasing structures. Ms. Sarapuu also opined that

Unicom engaged and appropriately employed various specialists and advisers to

complete the test transactions.

7.

Nancy Heller Hughes

The Court recognized Nancy Heller Hughes as an expert in the valuation of

power facilities. Ms. Hughes has an M.B.A. in finance and accounting from the

University of Chicago Booth School of Business. She is also an accredited senior

appraiser in the public utility discipline (as certified by the American Society of

- 89 Appraisers) and a certified depreciation professional (as certified by the American

Society of Appraisers). She has also performed many appraisal and depreciation

studies for businesses in the energy industry.

Ms. Hughes opined in her expert report that the Deloitte appraisals of

Spruce, Scherer, and Wansley used an appropriate process for the purpose of

producing credible appraisal reports under the Uniform Standards of Professional

Appraisal Practice (USPAP). Ms. Hughes concluded that Deloitte's conclusions

were appropriate, supported in its appraisal reports, and prepared in accordance

with generally accepted appraisal procedures. Ms. Hughes did not offer an

opinion of what the fair market value of the Spruce, Scherer, and Wansley stations

would be at various stages of the test transactions.

B.

Respondent's Expert Witnesses

1.

Douglas J. Skinner

The Court recognized Douglas J. Skinner as an expert in accounting and

financial economics. Dr. Skinner is the deputy dean for faculty and Eric J.

Gleacher distinguished service professor of accounting at the University of

Chicago Booth School of Business. Dr. Skinner holds a Ph.D. in applied

economics: accounting and finance from the University of Rochester. Dr. Skinner

has published research on a variety of topics in accounting, auditing, and corporate

- 90 finance, including how securities prices respond to corporate disclosures, how

accounting information is used in contracts between various corporate

stakeholders, the nature of corporate debt agreements, and many others.

Dr. Skinner concluded that the analyses in the Deloitte appraisals are flawed

in a number of respects, but focused on two flaws in particular. First, in

performing the discounted cashflow calculations necessary to value the underlying

assets at the end of the sublease term, Deloitte applied the maximum statutory

corporate income tax rate to the forecasted cashflows. Dr. Skinner opined that in

asset valuation, the tax status of the buyer or seller can matter. According to Dr.

Skinner, here, where both CPS and MEAG are tax-exempt entities, their cashflows

are about 40% higher than the cashflows Deloitte assumes, significantly increasing

the value of the assets at the sublease termination dates. Second, Dr. Skinner

concluded that Deloitte also applied too high a discount rate to these cashflows,

further reducing the estimated value of the assets.

Dr. Skinner recalculated the value of each asset using Deloitte's cashflows

and applying a 0% tax rate and lower discount rates of 6.1% for Spruce and 6.3%

for Wansley and Scherer. His calculations show an estimated value for each asset

at the sublease expiration date that is substantially higher than the

cancellation/purchase option exercise price. Thus, Dr. Skinner concluded that it

- 91 was nearly certain that CPS and MEAG will exercise their respective

cancellation/purchase options at the end of the sublease terms, allowing Exelon to

obtain the option proceeds without ever bearing any significant risk of loss.

In addition Dr. Skinner opined that CPS and MEAG would be economically

compelled to exercise their cancellation/purchase options because of the "onerous"

conditions they would face if they did not exercise their respective options.

Dr. Skinner in his expert report shows that, absent tax benefits available

under section 1031, Exelon would never recover its initial investment in the lease.

Thus, Dr. Skinner concluded that Exelon would be able to generate a positive

return from the transactions only because of the tax benefits.

2.

Christopher Knittel

The Court recognized Christopher Knittel as an expert in energy and

environmental economics, industrial organization, and regulation. Dr. Knittel is

the William Barton Rogers professor of energy economics in the Sloan School of

Management at the Massachusetts Institute of Technology. He has a Ph.D. in

economics from the University of California at Berkeley. Dr. Knittel's research

focuses on energy and environmental economics and policy, and how consumers,

firms, and policymakers interact in the marketplace. Dr. Knittel has written

articles on topics related to energy markets, policy and pricing; testified in front of

- 92 the U.S. House of Representatives Subcommittee on Agriculture, Energy and

Trade; and consulted for large corporations and regulatory agencies on energy and

environmental issues.

Dr. Knittel opined that the test transactions did not provide Exelon with new

sources of operating profits, improve the company's environmental impact or

supply management, assist Exelon with gaining market-entry benefits, improve

knowledge-sharing, or achieve economies of scale. Dr. Knittel also opined that the

test transactions were not compelled by the Illinois Restructuring Act. On the

basis of his analysis of the potential direct and ancillary economics, he concluded

that the test transactions did not provide Exelon with any non-tax-related

economic benefits.

3.

Uppender Saraon

The Court recognized Uppender Saraon as an expert in structured finance

and leasing transactions. Mr. Saraon is a former director of Citigroup with a

graduate degree in management from the MIT Sloan School of Management. Mr.

Saraon opined that the structure of the test transactions, including the credit

enhancement provisions, was very different from traditional U.S. leveraged leases.

- 93 C.

Concurrent Witness Testimony Procedure

The Court, with prior agreement of the parties, directed certain expert

witnesses, including Prof. Myers, Dr. Skinner, and Mr. Reed, to testify

concurrently. The procedure was implemented in substantially the same way as in

Royakat, LLC v. Commissioner, T.C. Memo. 2011-225, slip op. at 29-30, M,

529 F. App'x 124 (3d Cir. 2013). See also Green Gas Del. Statutory Tr. v.

Commissioner, 147 T.C. __, __ (slip op. at 52, 60-61) (July 14, 2016); Buyuk,

LLC v. Commissioner, T.C. Memo. 2013-253, at *29-*30, *39-*40; Crimi v.

Commissioner, T.C. Memo. 2013-51, at *34, *40-*43. The Court found the

procedure especially helpful in illuminating the major aspects of certain issues in

these cases and enabling the Court to facilitate its findings of fact.

OPINION

I.

Overview

Section 1031(a)(1) prevents the recognition of gain or loss "on the exchange

of property held for productive use in a trade or business or for investment if such

property is exchanged solely for property of like kind which is to be held either for

productive use in a trade or business or for investment." Our task in these cases is

to analyze a set of transactions in which petitioner engaged in an attempt to defer

taxation of almost $1.6 billion of gain on the sale of its two power plants. To

- 94 achieve this result, petitioner entered into what it asserts were deferred like-kind

exchanges under section 1031, with the replacement property being interests

obtained in sale-leaseback transactions. The character of that replacement

property interest is yet to be determined.

While traditional LILOs and SILOs involved leveraged leases, petitioner

invested the proceeds from the sale of its own power plants to fully fund the

transactions. The purported tax benefits were primarily derived from the deferral

of income tax under section 1031 and various deductions related to the

replacement properties. Although this Court has previously ruled on the tax

consequences of certain SILO and LILO transactions, we have never ruled on the

tax consequences of an ostensible like-kind exchange involving a SILO-like

transaction funded fully by a taxpayer's own equity contribution. Therefore, these

cases present an issue of first impression.

We note that while these cases involve several issues separate from but

related to the validity of the test transactions under section 1031, our analysis of

the latter question will govern our disposition of the former. Accordingly, we

shall turn first to the section 1031 like-kind exchange issue.

- 95 A.

Overview of the Parties' Arguments

1.

Petitioner's Arguments

In 1999 after conducting an evaluation of its strengths and weaknesses in

the new deregulated energy market, petitioner decided to sell its entire fleet of

fossil fuel power plants. After realizing that the sale would occur at a price almost

two times higher than petitioner's initial estimate, petitioner sought ways to

preserve the gain and possibly defer the income tax.

Petitioner contends that the test transactions represent valid deferred section

1031 like-kind exchanges, where petitioner exchanged its "active" ownership

interests in two power plants in Illinois for "passive" leasehold interests in power

plants in Georgia and Texas. Petitioner argues that it engaged in thoughtful

decisionmaking and an extensive due diligence process in an effort to maximize

the value for its shareholders and diversify its risks. Petitioner asserts that it

acquired benefits and burdens of ownership with respect to assets involved in the

test transactions because petitioner remained exposed to significant risks not only

during the residual period of the headleases but also during the leaseback period.

Petitioner opposes respondent's attempts to characterize the test transactions

as SILOs because they are structured not as leveraged leases but as direct leases

financed entirely from petitioner's own funds. As petitioner sees it, it merely

- 96 reinvested the proceeds from the sale of its assets into similar assets in other

geographical areas.

In doing so, petitioner maintains it acted in good faith and relied on services

of independent and highly qualified advisers. Thus, petitioner argues that it

should not be held liable for the penalties under section 6662 proposed by

respondent.

2.

Respondent's Arguments

Respondent primarily contends that the test transactions among petitioner,

CPS, and MEAG did not transfer any benefits and burdens of ownership to

petitioner because they were not true leases. Respondent argues that petitioner's

SILOs were "prepackaged, promoted tax products which subjected [p]etitioner to

no residual value risk, only a theoretical, de minimis credit risk." In essence, as

respondent sees it, the test transactions are more similar to low-risk loans. Thus,

because petitioner exchanged ownership interests in power plants for financial

instruments (low-risk loans), petitioner failed to meet section 1031 like-kind

exchange requirements.

Further, respondent argues that because the substance of each test

transaction is a loan rather than a lease, these loans should generate original issue

discount (OID) income under section 1272. According to respondent, petitioner is

- 97 not entitled to depreciation deductions under section 168, interest deductions

under section 467, or transaction cost deductions under section 162.

In the alternative, respondent argues that the test transactions lack economic

substance because they were driven by tax considerations and the desire to defer

taxation of a $1.6 billion gain, not by a legitimate business purpose. Accordingly,

respondent urges the Court to disregard the test transactions altogether and

conclude that petitioner failed to enter into a like-kind exchange. Respondent

maintains that petitioner never expected to realize pretax benefits from the test

transactions alone. However, together with the tax deferral benefits available

under section 1031, petitioner would be able to more than make up for the

economic losses associated with the test transactions.

Further, respondent argues that petitioner is also liable for accuracy-related

penalties under section 6662 for both tax years, 1999 and 2001, for negligently

engaging in transactions that it should have known were "too good to be true".

According to respondent, petitioner's tax reporting also resulted in a substantial

understatement of income tax for the 1999 tax year.

B.

Primer on Leveraged Leases, LILOs, and SILOs

We have discussed in detail the seminal cases and regulations related to

leveraged leases, LILOs, and SILOs in this Court's opinion in John Hancock Life

- 98 Ins. Co. (U.S.A.) v. Commissioner, 141 T.C. 1, 15-16, 54-77 (2013). We briefly

reiterate some of that analysis here to provide the reader with sufficient details

relevant to the cases at hand.

Frank Lyon Co. v. United States, 435 U.S. 561 (1978), is the seminal

Supreme Court case discussing leveraged lease transactions. The taxpayer in

Frank Lyon engaged in a sale-leaseback transaction to finance the construction of

a new building. Out of the required $7.64 million, Frank Lyon invested $500,000

of its own money and financed the remainder with a third-party lender through a

secured mortgage with the building serving as a collateral. In addition, Frank

Lyon made a promise to assume personal responsibility for the loan's repayment

and an assignment to the lender of the rental payments under the lease. Id. at 566-

568.

The lease in Frank Lyon was a net lease requiring lessee to pay taxes,

insurance, and utilities. Lessee had an option to purchase the building at certain

times during the lease and at the end of the 25-year lease term. Lessee also had an

option to renew the lease for additional periods of time. Frank Lyon claimed

depreciation deductions and interest expense deductions related to the building.

Id. at 567-569.

- 99 After considering the transaction, the Supreme Court held that the form of a

sale-leaseback transaction will be respected for Federal tax purposes as long as the

lessor retains significant and genuine attributes of a traditional lessor. E at 584.

The Supreme Court recognized that these attributes necessarily depend on the

facts of a particular case. R According to the Supreme Court, several factors

weighed in favor of the taxpayer in Frank Lyon. Frank Lyon bore the financial

risks of the transaction by assuming responsibility for loan repayment and

investing its own money in the transaction. E at 581. The Supreme Court

concluded that there was a real possibility that the lessor could walk away from

the transaction at the end of the initial lease. The parties negotiated the deal in

good faith and were independent of each other. The parties paid the same tax

rates, making the transaction tax neutral. The rent and purchase option prices

were reasonable, and Frank Lyon assumed the credit risk of the lessee's defaulting

on its rent payments. R at 575-584.

Around the time the Supreme Court issued its ruling in Frank Lyon, the

Government was working on developing a set of rules to determine whether a

leveraged lease transaction is a true lease or something else. In 1975 the

Commissioner issued guidelines for advance ruling purposes on whether a

leveraged lease will be respected for Federal tax purposes as a lease. Rev. Proc.

- 100 75-21, 1975-1 C.B. 715. In 1984 Congress enacted what has become known as

the "Pickle rule", which subjected property leased to a tax-exempt entity to

unfavorable depreciation rules. Deficit Reduction Act of 1984, Pub. L. No. 98-

369, sec. 31, 98 Stat. at 509.

The unintended consequence of the Pickle rule was the proliferation of

LILO transactions with tax-exempt entities. LILO transactions were designed to

work around the Pickle rule because the taxable party leased the property from the

tax-exempt counterparty instead of buying it, and then immediately subleased it

back to the tax-exempt entity. To fund the transaction, the taxable party typically

took out a nonrecourse loan covering 80%-90% of the initial lease. M J_olln

Hancock Life Ins. Co. (U.S.A.) v. Commissioner, 141 T.C. at 11.

The sublease to a tax-exempt entity would typically be shorter than the

initial lease term. At the end of the sublease, the tax-exempt entity usually has the

option to purchase the remainder of the leasehold interest in the initial lease. Even

if the tax-exempt entity decides not to exercise its purchase option, the taxable

party could still compel the tax-exempt entity to renew the sublease, take

possession of the asset, or procure the replacement sublease. To return the asset to

the taxable party, the tax-exempt entity would typically need to meet certain

conditions, including refinancing the nonrecourse loan involved in the

- 101 transactions. Failure to meet the return conditions meant that the tax-exempt

entity had to exercise the purchase option. See Id.

In 1999 LILO transactions became less popular because of a change in the

regulations under section 467, which required that prepayment of the initial lease

rent be treated as a loan for tax purposes. E at 16; see also sec. 1.467-4, Income

Tax Regs. After that, investors started using SILOs to obtain similar results. M

John Hancock Life Ins. Co. (U.S.A.) v. Commissioner, 141 T.C. at 16.

A typical SILO transaction would be similar to a LILO except that the term

of the initial lease extends beyond the remaining useful life of the asset, as is the

case with the Spruce, Scherer, and Wansley test transactions here. Thus, the initial

lease is treated as a sale for Federal tax purposes. The end-of-sublease options for

the taxable entity usually include either compelling the lessee to arrange a service

contract for the asset for a predetermined term or to take possession of the asset.

Id.

The payments in SILO and LILO transactions are typically secured by the

various defeasance instruments. Although the form of such instruments differs

from one transaction to another, typically they entail setting aside several deposits

with third-party financial institutions--payment undertakers--for various payments

due under the transaction documents, including purchase options. E at 12. As a

- 102 result of defeasance, the parties to the transaction do not have to come up with any

out-of-pocket payments during the initial lease term. I_d.

In 2002 the Commissioner issued Rev. Rul. 2002-69, 2002-2 C.B. 760,

which explained that LILO transactions should be properly characterized as a

future interest in property. Consequently, a taxpayer may not deduct rent or

interest paid or incurred in connection with such a transaction. In the ruling the

Commissioner stated that he would challenge tax benefit claims based on LILO

transactions under the substance over form and economic substance doctrines. Id.

Congress eliminated the benefits associated with LILO and SILO

transactions in the American Jobs Creation Act of 2004, Pub. L. No. 108-357,

secs. 847-849, 118 Stat. at 1601. John Hancock Life Ins. Co. (U.S.A.) v.

Commissioner, 141 T.C. at 16. That law was prospective in effect and did not

apply to transactions entered by taxpayers before its effective date. I_d.

C.

Recent SILO/LILO Cases

As this Court observed in 2014 in John Hancock Life Ins. Co. (U.S.A.) v.

Commissioner, 141 T.C. at 58, "[t]axpayers have lost their fight for claimed tax

benefits in SILO and LILO transactions in all Courts of Appeals in which they

have appeared." This still remains true.

- 103 The Commissioner has often used the doctrines of economic substance and

substance over form to challenge the legitimacy of sale-leaseback transactions.

See, e.g., Id. at 58-77 (analyzing prior SILO/LILO cases and arguments advanced

by the litigants). We will discuss these judicial doctrines in more detail in other

parts of this Opinion.

Our conclusion on whether petitioner entered into a valid like-kind

exchange under section 1031 hinges on the proper characterization of the test

transactions. If the transactions did not transfer the benefits and burdens of

ownership to petitioner, then the test transactions are properly characterized not as

leases but as loans. And if the transactions are characterized as loans, then

petitioner had exchanged power plants for interests in financial instruments, which

would cause petitioner to fail the requirements of section 1031. To aid in our

analysis, we examine two cases, Consol. Edison Co. of N.Y., Inc. v. United States

(ConEd II), 703 F.3d 1367 (Fed. Cir. 2013), rev'g and remanding Consol. Ed. of

N.Y., Inc. v. United States (ConEd I), 90 Fed. Cl. 228 (2009), and John Hancock

Life Ins. Co. (U.S.A.) v. Commissioner, 141 T.C. 1, in chronological order. While

Consol. Edison and John Hancock did not involve purported section 1031 likekind exchanges, the similarities between the two cases and the instant cases are

many, and their legal reasoning is apposite here.

- 104 1.

Consol. Edison

There are many factual similarities between the cases at hand and the facts

in Consol. Edison, so we will briefly reiterate the key facts.

In the mid-to-late 1990s Consolidated Edison (ConEd) was a publicly held

vertically integrated utility company organized and operating in New York.

ConEd I, 90 Fed. Cl. at 232. In an attempt to offset the effects of the electric

industry deregulation, ConEd underwent a major internal restructuring and

decided to enter, through one of its subsidiaries, into one or more LILO

investments. Id. at 233-234. On December 15, 1997, ConEd entered into a LILO

transaction with EZH, a Dutch electric utility (ConEd LILO). R at 234-235.

ConEd retained Cornerstone Financial Advisors L.P. to obtain financial

services in connection with the EZH LILO. Id. at 234. ConEd retained the law

firms of Shearman & Sterling, LLP as its United States legal counsel, and Loeff,

Claeys, Verbeke as its Dutch legal counsel, as well as Deloitte as its appraiser,

Duke Engineering & Services as its independent engineer, and Tauw Milieu,

International, as its environmental consultant. Id. at 235.

Under the terms of the ConEd LILO, ConEd leased from EZH a 47.47%

undivided interest in a Dutch power plant for 43.2 years. ConEd II, 703 F.3d at

1370. ConEd immediately leased back the interest to EZH for a term of20.1

- 105 years. E at 1370-1371. At the end of the sublease term, EZH could exercise the

purchase option and terminate the transaction. E at 1372. If EZH declined to

exercise the purchase option, ConEd could either force it to renew the sublease for

an additional term of 16.5 years or take possession of the interest in the power

plant and operate it during the remaining term of the initial lease. I_d.

In its appraisal Deloitte concluded that there would be no "economic

compulsion" for EZH to exercise the purchase option at the end of the sublease

because the option price exceeded the projected value of the property. R at 1379.

Richard Ellsworth, who led the Deloitte appraisal team, testified at trial that he did

not consider any noneconomic factors in arriving at this conclusion. R at 13791380. On the basis of this conclusion and the record of the case as developed at

trial, the trial court concluded that the ConEd LILO was a true lease. ConEd I, 90

Fed. Cl. at 340. The Court of Appeals for the Federal Circuit reversed and

remanded the case. ConEd II, 703 F.3d at 1369.

The Court of Appeals explained that at the time the trial court rendered its

ruling it did not have the benefit of the decision in another LILO/SILO case, Wells

Fargo & Co. v. United States, 641 F.3d 1319 (Fed. Cir. 2011). ConEd II, 703 F.3d

at 1377. Thus, the trial court used the wrong legal standard in determining

whether ConEd acquired benefits and burdens of ownership in the ConEd LILO.

- 106 IA The Court of Appeals clarified that the relevant standard was whether there

was a reasonable likelihood that the purchase option at the end of the sublease

period would be exercised, not whether this outcome was "certain" or "virtually

certain". Id. at 1376.

The Court of Appeals concluded that the analysis performed by Deloitte for

the ConEd LILO was "boilerplate" and was insufficient to support ConEd's

claims. R at 1378-1379. The Court of Appeals noted that Richard Ellsworth,

who prepared the appraisal for the ConEd LILO, admitted at trial that Deloitte

"never once found that there was 'economic compulsion' to exercise a purchase

option" in about a hundred appraisal reports prepared for LILO transactions. E at

1380. The Court of Appeals commented that the appraisal failed in several

respects, including not considering noneconomic factors, defeasance of funds for

the purchase option payment, and the costs to EZH that would result from

ConEd's exercise of the renewal or retention options. I_4 at 1379.

After considering the arguments of the parties in ConEd II, the Court of

Appeals concluded that "EZH was reasonably likely to exercise the purchase

option * * * [and] ConEd has failed to show that the substance of the transaction

included a genuine leasehold interest in which ConEd would bear the benefits and

- 107 burdens of a lease transaction." R at 1381. Accordingly, ConEd's deductions

related to the LILO were properly disallowed. M.

2.

John Hancock Life Ins. Co. (U.S.A.) v. Commissioner

This Court first considered the Federal income tax consequences of SILO

and LILO transactions in John Hancock Life Ins. Co. v. Commissioner, 141 T.C.

1. John Hancock Life Insurance Co. (John Hancock) entered into 27 LILOs and

SILOs between 1997 and 2001. Id. at 6. The Court considered seven test

transactions, including three LILOs and four SILOs (John Hancock test

transactions). I_d.

John Hancock invested in SILOs and LILOs primarily as a means to

diversify its investments in domestic and international assets to provide it with

sufficient cashflow. Id. at 8. All of the John Hancock test transactions had a

typical structure for LILOs and SILOs, featuring a set of agreements including a

headlease, a sublease with a fixed purchase option at the end, and various

defeasance arrangements.

The Court considered the application of both the economic substance

doctrine and the substance over form doctrine to the John Hancock test

transactions: "In order to conclude that John Hancock is entitled to its claimed

deductions, we must determine both that the test transactions have economic

- 108 substance and that the substance of each test transaction is consistent with its

form. There is no clear formula by which to answer these questions, nor do we

attempt to create one." R at 78.

The Court analyzed both objective and subjective sides of the John Hancock

test transactions and concluded that they satisfied the economic substance inquiry

because John Hancock had a realistic expectation of profit and a business purpose

when entering into the transactions. R at 78-89.

To determine whether the John Hancock test transactions' form was

consistent with their substance, the Court followed the same analysis the Supreme

Court used in Frank Lyon for leveraged leases. E at 89-90 (citing Frank Lyon,

435 U.S. at 584). Thus, the Court had to determine whether John Hancock held a

true leasehold interest in each LILO property and obtained an ownership interest

in each SILO property. John Hancock Life Ins. Co. (U.S.A.) v. Commissioner,

141 T.C. at 89-90.

After discussing various factors previously considered in other cases, the

Court reiterated its commitment to evaluate the John Hancock test transactions on

the basis of the overall facts and circumstances in determining whether the

substance of the transactions was consistent with their form. R at 90-91 (citing

Levy v. Commissioner, 91 T.C. 838, 860 (1988), Torres v. Commissioner, 88 T.C.

- 109 702, 721 (1987), Gefen v. Commissioner, 87 T.C. 1471, 1490-1495 (1986),

Mukerji v. Commissioner, 87 T.C. 926, 967-968 (1986), and Estate of Thomas v.

Commissioner, 84 T.C. 412, 433-438 (1985)). For each of the John Hancock test

transactions, the Court considered risk allocation during the initial lease period,

likelihood of purchase option exercise by the original property holder at the end of

the sublease term, end-of-sublease alternatives for the parties involved in the

transaction and related costs and risks.

The Court concluded that for all test transactions, John Hancock did not

assume more than a de minimis risk during the sublease period because of

contractual protections, various credit enhancements, and rent defeasance. R at

94, 113-114, 145.

Next, the Court evaluated the likelihood of the original property holders'

exercising their respective purchase options at the end of subleases. The Court

recognized that "[t]he courts that have analyzed SILO and LILO cases have

adopted varying standards in determining whether a party to a SILO or LILO

transaction will exercise its purchase option." R at 95. After analyzing various

standards, the Court adopted the "reasonable likelihood" standard articulated by

the Courts of Appeals for the Second Circuit in Altria Grp., Inc. v. United States,

658 F.3d 276, 286 (2d Cir. 2011), and the Federal Circuit in ConEd II, 703 F.3d at

-1101379, and Wells Fargo, 641 F.3d at 1329. R at 95-97. The inquiry into the

likelihood of purchase option exercise is determinative because if the original

property holder is reasonably expected to exercise the purchase option at the end

of the sublease, the obligations of the parties under SILO/LILO would offset each

other, so that a taxpayer would be insulated from any economic risk of loss and

would not be able to take advantage of any potential gain. E at 94. Instead, a

taxpayer would be guaranteed a fixed return on its investment at the end of a

sublease term. This would indicate that the taxpayer did not obtain any benefits or

burdens associated with the leasehold or ownership interest transferred in a

SILO/LILO.

For the LILO transactions in John Hancock, the Court concluded that "any

legal, political, industrial, or technical objections to the nonexercise of the

purchase options can be overcome, and thus are not determinative of whether [the

LILO counterparty] is reasonably likely to exercise its purchase option." John

Hancock Life Ins. Co. (U.S.A.) v. Commissioner, 141 T.C. at 99, 107. Thus, the

Court based its ultimate conclusion primarily on financial analysis, including a

comparison of the costs of the purchase option and alternative end-of-sublease

options. In all LILO test transactions, the Court concluded that it was reasonably

likely that the LILO counterparties would exercise their respective purchase

- 111 options. R at 109-110. The Court came to the same conclusion for one of the

SILO transactions, the SNCB SILO. Id. at 145. Thus, the Court held that the

substance of all the LILO and SNCB SILO transactions was inconsistent with their

form and that these transactions resembled loans because John Hancock did not

acquire genuine attributes of ownership or leasehold interest. E at 109-110, 145.

As a result, the Court held that John Hancock was not entitled to rental expense

and depreciation deductions related to these transactions. R at 109-110, 145.

The Court also disallowed the interest expense for the nonrecourse loans John

Hancock took out to finance the transactions. Id. at 146-147. Further, the Court

recharacterized the equity contributions into these transactions as a loan giving

rise to the original issue discount (OID) income. R at 148. The Court held that

pursuant to section 1.1273-2(g)(4), Income Tax Regs., John Hancock's transaction

costs with respect to LILOs and the SNCB SILO must be included as an additional

amount lent to borrowers and are not deductible under section 162. Id. at 149.

For the remaining SILO transactions, the Court concluded, after considering

financial analyses presented by the parties and various nonfinancial constraints,

that exercising the purchase option at the end of the sublease was not the only

financially viable alternative for the SILO counterparties. E at 123, 131-132.

According to the appraisals, the projected fair market value of the assets involved

-112in the remaining SILOs was going to be substantially lower than the purchase

option exercise price. R at 114-115, 123-124. Thus, the Court assumed that

these options would not be exercised and proceeded with the analysis of whether

John Hancock had any economic risk after the end of the sublease and until the

end of the lease. The Court then concluded that John Hancock indeed faced

economic risks indicative of ownership during that period under the service

contract option because any payments under that option were not guaranteed. M.

at 132-135. Thus, the Commissioner did not succeed with the substance-overform argument for these remaining transactions.

With respect to the remaining SILO transactions, the Court held that John

Hancock acquired a future interest in the transferred assets and was thus not

entitled to depreciation deductions before the purchase option exercise date. J_olin

Hancock Ins. Co. (U.S.A.) v. Commissioner, 141 T.C. at 137. Because John

Hancock had only future interest in the assets, the Court disallowed any interest

deductions as well. R at 147. However, the Court refused to apply the OID rules

to John Hancock's equity contributions in these transactions. E at 148. The

Court allowed a deduction for transaction expenses related to the acquisition of a

future interest in the underlying assets. E at 149.

II.

Whether the Substance of the Test Transactions Is Consistent With Their

Forms

-113We will first address the issue of whether the substance of the test

transactions is consistent with their forms because this is the primary argument on

which respondent challenges petitioner's 1999 like-kind exchange. From the

notices of deficiency and the parties' filings in these cases, it appears that

respondent did not directly challenge the 1999 like-kind exchange gain deferral

under the economic substance doctrine. Respondent asserts this economic

substance argument only with respect to depreciation, interest, and transaction cost

deductions reported on the 2000 tax return.

A.

Substance Over Form Doctrine Overview

The courts have long used the substance over form doctrine to determine the

true nature of a transaction and appropriately recast it for Federal income tax

purposes. See Feldman v. Commissioner, 779 F.3d 448, 455 (7th Cir. 2015),

T.C. Memo. 2011-297, John Hancock Life Ins. Co. (U.S.A.) v. Commissioner, 141

T.C. at 57 (citing United States v. B.F. Ball Constr. Co., 355 U.S. 587 (1958), and

Commissioner v. Court Holding Co., 324 U.S. 331 (1945)). We apply the

substance over form principles only when warranted and generally respect the

form of a transaction. John Hancock Life Ins. Co. (U.S.A.) v. Commissioner, 141

T.C. at 57 (citing Gregory v. Helvering, 293 U.S. 465 (1935), and Blueberry Land

-114Co., Inc. v. Commissioner, 361 F.2d 93, 100-101 (5th Cir. 1966), af[g 42 T.C.

1137 (1964)).

We view the transactions as a whole to determine whether the substance

over form doctrine applies. See Commissioner v. Court Holding Co., 324 U.S. at

334; John Hancock Life Ins. Co. (U.S.A) v. Commissioner, 141 T.C. at 91. As the

Supreme Court held in Frank Lyon, 435 U.S. at 584, the form of a sale-leaseback

transaction will be respected for Federal tax purposes as long as the lessor retains

significant and genuine attributes of a traditional lessor. We also look at whether

the taxpayer has undertaken substantial financial risk of loss of its investment on

the basis of the value of the underlying property. Coleman v. Commissioner, 16

F.3d 821, 826 (7th Cir. 1994), af[g T.C. Memo. 1987-195 and T.C. Memo. 199099.

The courts considering SILO/LILO transactions have almost universally

concluded that the taxpayers never obtained the benefits and burdens of ownership

or attributes of a traditional lessor and, thus, were not entitled to claim various

associated deductions. See ConEd II, 703 F.3d at 1381-1382 (finding that the

LILO was not a genuine lease and sublease); Altria Grp., Inc. v. United States, 658

F.3d at 291 (affirming jury finding that a series of LILO and other transactions

failed the substance over form inquiry); Wells Fargo, 641 F.3d at 1330 (sustaining

- 115 the trial court's conclusion that the SILO transactions ran afoul of the substance

over form doctrine); BB & T Corp. v. United States, 523 F.3d 461, 464 (4th Cir.

2008) ("[A]lthough the [transaction] form * * * involved a lease financed by a

loan, BB & T did not actually acquire a genuine leasehold interest[.]"); J_ohn

Hancock Life Ins. Co. (U.S.A.) v. Commissioner, 141 T.C. at 109-110, 145

(concluding that all LILO transactions and some SILO transactions at issue were

in substance financial instruments, loans); UnionBanCal Corp. v. United States,

113 Fed. C1. 117, 136 (2013) (concluding that the taxpayer did not obtain the

requisite ownership interest to claim the deductions); AWG Leasing Tr. v. United

States, 592 F. Supp. 2d 953, 981-982 (N.D. Ohio 2008) (finding that a SILO

transaction involving an interest in a German waste-to-energy plant did not convey

an ownership interest to the taxpayer to justify the deductions). The only notable

exception is the SILO transactions analyzed in John Hancock Life Ins. Co.

(U.S.A.) v. Commissioner, 141 T.C. at 111-137, where this Court concluded that

because exercising the purchase option at the end of the sublease was not the only

economically viable option for the original property owners and John Hancock

was exposed to more than de minimis risk after the end of the sublease period,

John Hancock acquired a future ownership interest in the underlying properties.

-116B.

Spruce Transaction

1.

Sublease Term Risks

Petitioner advances several arguments to support its contention that it

indeed had acquired benefits and burdens of ownership during the sublease term.

First, petitioner maintains that it made a meaningful equity contribution to acquire

the leases. Unlike parties in traditional LILO/SILO transactions, petitioner did not

use any loans to pay the Spruce headlease rent. Instead, it paid with the proceeds

of a recent sale of its own power plant. CPS returned only 76.9% of the headlease

rent to prepay the rent during the Spruce sublease term. Petitioner argues that the

23.1% CPS retained after prepayment of the Spruce sublease rent satisfies any

equity tests derived from judicial decisions and administrative guidance.

Second, petitioner maintains that the rights and obligations conveyed by the

Spruce headlease and sublease agreements are typical of traditional leases and

significantly alter the rights of the parties. Specifically, petitioner cites the

necessity for CPS to obtain consent for improvements that could have a material

impact on the value of the subleased property.

Third, petitioner points to its extensive due diligence efforts as indicative of

obtaining a true ownership interest in the Spruce station.

-117Finally, petitioner claims that it was exposed to a significant risk of loss in

case of CPS' bankruptcy and sublease rejection because of the limitations of

section 502(b)(6) of the Bankruptcy Code.

We begin with an observation that what made SILO and LILO transactions

abusive was not only the amount of equity invested by the parties entering into

such transactions but rather the circular flow of money such transactions created.

As the Court of Appeals for the Federal Circuit explained in Wells Fargo, 641

F.3d at 1330:

[W]e are left with purely circular transactions that elevate form over

substance. The only flow of funds between the parties to the

transaction was the initial lump sum given to the tax-exempt entity as

compensation for its participation in the transaction. From the taxexempt entity's point of view, the transaction effectively ended as

soon as it began. The benefits to Wells Fargo continued to flow

throughout the term of the sublease, however, in the form of deferred

tax payments. The third-party lender and its affiliate were also

compensated for their participation, as were the creators and

promoters of the transactions. These transactions were win-win

situations for all of the parties involved because free money--in the

form of previously unavailable tax benefits utilized by Wells Fargo-was divided among all parties. The money was not entirely "free," of

course, because it was in effect transferred to Wells Fargo from the

public fisc.

Here, the funds necessary to fund the headlease rent came from the untaxed

proceeds of the Collins power plant sale by petitioner. In addition to attempting to

reap the benefits of long-term tax deferral under the section 1031 rules for like-

- 118 kind exchanges, petitioner claimed various tax deductions associated with its

participation in the Spruce, Scherer, and Wansley transactions. Unlike the

taxpayer in Frank Lyon, which entered into a sale-leaseback with another taxable

entity such that the transaction was tax neutral as a result, petitioner entered into a

transaction with a tax-exempt entity. This would allow petitioner to double-dip

into the tax benefits by deferring the tax under section 1031 and using deductions

related to the test transactions.

The structure of the cashflows in the Spruce transaction guaranteed the

return of 76.9% of petitioner's initial investment just six months after the closing

date in the form of rent prepayment under the Spruce sublease. During that

period, CPS obtained credit enhancements to secure the payment of the ren

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