                              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
                                  -2-

allowing 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.

   Held: 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.

    Held, 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.

   Held, further, P is not entitled to depreciation deductions claimed
for 2001 with respect to its transactions with C and M.

   Held, 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.

   Held, 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.
                                          -3-

           Held, 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.

          Held, 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.




       1
        Natasha 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.
                                         -4-

      LARO, 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:

                                                                Penalty
             Year                   Deficiency                sec. 6662(a)

             1999                $431,174,592                 $86,234,918
             2001                   5,534,611                   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                            Spruce
      Municipal Electric Authority of Ga.            Scherer 1, Scherer 2, Scherer 3
      Municipal Electric Authority of Ga.            Wansley 1, Wansley 2



      2
      In 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.
      3
        Unless 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.
                                         -5-

      The 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;

      4
      Our 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.
                                          -6-

      3. 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.
                                        -7-

Unicom 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.
                                        -8-

       In 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 low-

voltage 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
                                         -9-

could 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. 5/16-

101 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 like-

kind 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 of 20-25 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-balance-

sheet 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.




      5
       The 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           6. As of the Closing Date, it is
 reasonable to expect that the fair         reasonable to expect that the fair
 market value of the Leased Property        market value of the Facility will
 will substantially exceed the applicable   substantially exceed the applicable
 Early Termination Amount at all times      Early Termination Amount at all times
 during the Lease Term;                     during the Lease Term;
 7) the Purchase Option Price is no less    7. The Cancellation Option Price is no
 than 105% of the estimated “fair           less than 105% of the estimated “fair
 market value” of the Leased Property       market value” of the Facility as of the
 as of the expiration of the Lease term,    expiration of the Lease Term, taking
 taking into account inflation and any      into account inflation and any
 reasonably anticipated improvements        reasonably anticipated improvements
 or modifications to the Leased             or modifications to the Facility and
 Property and after subtracting from        after subtracting from such value any
 such value any cost to the Lessor of       cost to the Lessor of acquiring
 acquiring possession of the Leased         possession of the Facility at the end of
 Property at the end of the Lease Term;     the Lease Term;
 8) as of the Closing Date, the Leased      8. As of the Closing Date, the
 Property’s remaining economic useful       Facility’s remaining economic useful
 life is __ years, and therefore the        life is expected to be 52 years, and
 Leased Property will have a remaining      therefore the Facility is expected to
 economic useful life at the expiration     have a remaining economic useful life
 of the maximum Service Agreement           at the expiration of the maximum
 Term equal to at least 20 percent of its   Service Agreement Term equal to at

      6
        The 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    least 20 percent of its remaining useful
Date;                                      life as of the Closing Date;
9) the Leased Property will have a “fair   9. The Facility will have a fair market
market value” at the expiration of the     value at the expiration of the Lease
maximum Service Agreement Term             Term of 38.4 percent of Closing Date
(determined without regard to inflation    fair market value (determined without
or deflation or any future                 regard to inflation or deflation or any
improvements) that is equal to at least    future improvements) and a fair market
20 percent of the current “fair market     value at the expiration of the maximum
value” of the Leased Property and after    Service Agreement Term of 20.0
subtracting from such value any cost to    percent of Closing Date fair market
the Lessor of acquiring possession of      value (determined without regard to
the Leased Property at the end of the      inflation or deflation or any future
Lease Term;                                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     13. Neither the physical attributes of
the Leased Property, the financial         the Facility, the financial standards of
standards of the Qualified Operator or     the Qualified Operator or Qualified
Qualified Bidder, the applicable return    Bidder, the applicable return
provisions or other terms and              provisions or other terms and
conditions of the Lease, Operating         conditions of the Lease, Operating
Agreement or Power Purchase                Agreement or Power Toll Processing
Agreement, nor any other identifiable      Agreement, nor any other identifiable
factor known to the Appraiser after        factor known to the Appraiser after
due inquiry, will create a material        due inquiry, will create a material
inducement to Lessee to exercise the       inducement to Lessee to exercise the
Purchase Option with respect to the        Cancellation Option with respect to the
Leased Property;                           Facility;
13) based on the comparative costs of      14. Based on the comparative costs of
the reasonably anticipated alternatives    the reasonably anticipated alternatives
                                       - 24 -

 expected to be available to Lessee at     expected to be available to Lessee at
 the expiration of the Lease Term,         the expiration of the Lease Term,
 Lessee will not be under any economic     Lessee will not be under any economic
 compulsion to exercise the Purchase       compulsion to exercise the
 Option;                                   Cancellation Option;
 17) the fixed net return required under   18. The fixed net return required
 the Service Agreement Option is less      under the Service Agreement Option is
 than 90% of the expected “fair market     less than 95 percent of the expected
 value” of such payments so that the       “fair rental value” so that the Service
 Service Agreement Option does not         Agreement Option does not create an
 create an economic compulsion for the     economic compulsion for the Lessee to
 Lessee to exercise the Purchase Option    exercise the Cancellation Option and it
 and it is expected that the Lessor will   is expected that the Lessor will not
 not exercise the Service Agreement        exercise the Service Agreement
 Option;                                   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.8 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%



      7
      We 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.
      8
       At 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 sale-

leaseback 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


      9
        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.10



      10
        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

investment.

      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.
                                      - 42 -

      4.    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.11



      11
        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


      12
       Although 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 into 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 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 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.


      13
       Georgia 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 12,000-

acre 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



      14
        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



      15
        As 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


      16
        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.




      17
        For 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




      18
       The 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 determined 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--1.5% 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


      19
        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

Rovakat, LLC v. Commissioner, T.C. Memo. 2011-225, slip op. at 29-30, aff’d,

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. Id. at 584.

The Supreme Court recognized that these attributes necessarily depend on the

facts of a particular case. Id. 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. Id. 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. Id. 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. See John

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. Id. at 16; see also sec. 1.467-4, Income

Tax Regs. After that, investors started using SILOs to obtain similar results. See

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. Id. 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. Id.

      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. Id.

             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 like-

kind 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). Id. 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 of 20.1
                                       - 105 -

years. Id. at 1370-1371. At the end of the sublease term, EZH could exercise the

purchase option and terminate the transaction. Id. 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. Id.

      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. Id. 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. Id. at 1379-

1380. 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 -

Id. 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. Id. 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. Id. 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. Id. 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.” Id. at 1381. Accordingly, ConEd’s deductions

related to the LILO were properly disallowed. Id.

             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). Id.

      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.” Id. 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. Id. 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. Id. 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. Id. 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. Id. 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.” Id. 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
                                        - 110 -

1379, and Wells Fargo, 641 F.3d at 1329. Id. 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. Id. 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. Id. 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. Id. 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. Id. 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. Id. 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. Id. at 123, 131-132.

According to the appraisals, the projected fair market value of the assets involved
                                        - 112 -

in the remaining SILOs was going to be substantially lower than the purchase

option exercise price. Id. 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. Id.

at 132-135. Thus, the Commissioner did not succeed with the substance-over-

form 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. John

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. Id. at 147. However, the Court refused to apply the OID rules

to John Hancock’s equity contributions in these transactions. Id. at 148. The

Court allowed a deduction for transaction expenses related to the acquisition of a

future interest in the underlying assets. Id. at 149.

II.   Whether the Substance of the Test Transactions Is Consistent With Their
      Forms
                                        - 113 -

      We 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), aff’g

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
                                        - 114 -

Co., Inc. v. Commissioner, 361 F.2d 93, 100-101 (5th Cir. 1966), aff’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), aff’g T.C. Memo. 1987-195 and T.C. Memo. 1990-

99.

      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[.]”); John

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. Cl. 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.
                                         - 116 -

      B.     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.
                                       - 117 -

      Finally, 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 tax-
      exempt 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 rent. The

rest of petitioner’s investment was either used to pay the accommodation fee to

CPS in the form of the NPV benefit or set aside pursuant to the Spruce CPUA to

secure the payments of the stipulated loss value during the period of the Spruce

sublease or the payment of the purchase option price at the end of the sublease.

CPS obtained credit enhancement and insurance for the CPUA from AIG, and the

interest rate risk was also insured.

      Thus, similarly to traditional SILOs or LILOs, the Spruce transaction

created a circular flow of money accompanied by a transfer of tax benefits from a
                                       - 119 -

tax-exempt to a taxable entity. See Wells Fargo, 641 F.3d at 1330. In addition,

the terms of the Spruce transaction ensured that only six months into the deal

petitioner would be in the same cash position as if it had taken out a loan to

finance the transaction, similar to traditional SILOs and LILOs. In effect, CPS did

not have any control over petitioner’s investment after the closing of the

transaction with the exception of the NPV benefit, which was CPS’ reward for

entering into the Spruce transaction. Accordingly, we are not persuaded by

petitioner’s argument that a 100% upfront out-of-pocket investment precludes the

finding that any of the test transactions were abusive.

      We also disagree with petitioner’s argument that the Spruce headlease or

sublease somehow significantly altered the parties’ rights and obligations with

respect to the Spruce station. Under the Spruce headlease, petitioner did not have

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

the Spruce station during the sublease term or the remainder of the headlease. If

petitioner were to return the Spruce station to CPS at the end of the headlease or if

the headlease was terminated, it was not required to meet any return conditions

except making sure the Spruce station was free from petitioner’s liens.

      Under the terms of the Spruce sublease, CPS accepted all the risks related to

the operation of the Spruce station throughout the sublease term. CPS also agreed
                                       - 120 -

to observe certain maintenance and operating standards, subleasing restrictions,

assignment rights, restrictions and requirements pertaining to alterations and

modifications, environmental compliance, and minimum insurance coverage.

These restrictions were designed to insulate petitioner’s risk during the sublease

term and ensure that in the worst case scenario--if CPS does not exercise its

cancellation option at the end of the sublease--the Spruce station would be in good

working condition. In short, CPS merely agreed to operate the station during the

sublease term in the same manner a reasonable owner would. Similar to John

Hancock, there is no evidence that before the closing date CPS was not already

adhering to the same operating, maintenance, or environmental standards. See

John Hancock Life Ins. Co. (U.S.A.) v. Commissioner, 141 T.C. at 113.

Petitioner’s expert Prof. McDermott also concluded that the contractual terms of

the test transactions mitigated many risks of ownership, including technological

obsolescence, failure of utility assets, long-term market value changes, failure of

payments, and changes in Government or regulatory requirements.

      With respect to sublease and assignment restrictions, CPS could always ask

petitioner for consent, the same as for improvements that could materially affect

the value of the leased property. In fact, in 2004, when CPS decided to build

Spruce II, which would share the site and some facilities with the Spruce station,
                                         - 121 -

petitioner gave its consent after a short site visit and receipt of a written

confirmation from CPS that the construction was not going to affect the Spruce

station value. Petitioner did not bother to visit the site after Spruce II was finally

completed and started to work.

      Next, we do not find that petitioner’s own due diligence efforts are

indicative of any ownership rights. Respondent points out that petitioner had to

complete the due diligence process within the strict time limits imposed by section

1031. As a result, petitioner did not follow up on certain red flags raised in

engineering reports. Moreover, Mr. Roling and others in petitioner’s tax

department only cursorily reviewed the tax opinion packages prepared by Winston

& Strawn. Mr. Berdelle, who testified that he read the entire Winston & Strawn

tax opinion, did not act on or inquire about inconsistencies therein of which

petitioner was, or should have been, aware.

      In most prior SILO/LILO cases taxpayers also engaged in extensive due

diligence before to entering into the transactions, including hiring prominent law

firms to draft documents, accounting firms to structure transactions and provide

appraisals, and engineering firms to evaluate the properties. See, e.g., ConEd I, 90

Fed. Cl. at 234-235. That nonetheless did not prevent the courts in those cases

from holding that the substance of such transactions was inconsistent with their
                                        - 122 -

form and that the taxpayers did not obtain genuine attributes of ownership. See,

e.g., ConEd II, 703 F.3d at 1378-1379, 1381 (discussing the appraisal prepared by

Deloitte and concluding that it was insufficient to support the taxpayer’s

contentions and was boilerplate; holding that the taxpayer failed to obtain genuine

attributes of ownership to support the claimed deductions).

      Finally, petitioner argues that it faced a substantial risk of loss in the event

of CPS bankruptcy despite the available credit enhancements. Petitioner attempts

to distinguish these cases from the SILO and LILO transactions in John Hancock

on this ground because in John Hancock none of the tax-exempt counterparties

were subject to the limitations stated in section 502(b)(6) of the Bankruptcy

Code.20 Respondent maintains that this risk was illusory and petitioner would be

able to recover its investment even if section 502(b)(6) of the Bankruptcy Code

limited the recovery available through the bankruptcy proceedings.

      We agree with respondent. Petitioner’s claim is inconsistent with the record

and is a mere attempt to blow out of proportion the risk of loss in the event of

CPS’ bankruptcy. First, according to FCLC, petitioner’s credit adviser, CPS was

generally very creditworthy. FCLC opined that the payment obligations and

      20
        Sec. 502(b)(6) of the Bankruptcy Code limits a lessor’s claim for
liquidated damages in bankruptcy resulting from the termination of a lease of real
property to an amount not to exceed three years’ rent plus any unpaid rent due
under the lease at the time a debtor files its bankruptcy petition.
                                      - 123 -

associated risks had been effectively identified and supported by credit

enhancements so even in the case of CPS’ bankruptcy petitioner would be able to

fully recover its investments from the credit enhancement providers.

      In 2000 CPS had one of the highest credit ratings in the country, and had

cash on hand of over $450 million and a reserve fund surety policy in excess of

$225 million. The City of San Antonio itself would have to file for bankruptcy

before CPS became bankrupt. As of 2000 there had never been a failure of a

major municipality in the history of the State of Texas. PwC explained that there

was “bulletproof assurance” to Unicom that there was no practical exposure to loss

during the first nine months of the CPS transaction, and that CPS’ going bankrupt

within the first six months of the transaction was commercially impossible. In

addition, CPS obtained sufficient credit enhancements to secure the risk of rent

nonpayment or early sublease termination.

      We find that petitioner’s speculations on what might happen if CPS filed for

bankruptcy do not add anything of substance to our analysis. No transaction is

absolutely protected from all possible risks, including catastrophic economic

events or destruction of property “by a biblical flood or a superbolide meteor”.

UnionBanCal Corp., 113 Fed. Cl. at 135. The record here supports respondent’s
                                        - 124 -

argument that petitioner faced a risk of loss only in such a catastrophic event.21

We do not consider this risk sufficient to hold that petitioner had genuine

attributes of ownership during the Spruce sublease term. See id.

      We also find that petitioner was sufficiently protected from the risk of

economic loss if the Spruce sublease terminated early. The sublease agreement

contained provisions that guaranteed that petitioner would receive stipulated loss

value payments in the event of CPS’ default. These payments were predetermined

and set forth in a schedule to the Spruce sublease agreement. The payments would

be made out of the funds set aside at the closing date pursuant to the CPUA.

      Petitioner argues that in case of an early Spruce sublease termination

petitioner would have to return any unaccrued prepaid rent to CPS. This argument

ignores the fact that after netting the unaccrued prepaid rent and the stipulated loss

value, petitioner would still recover its full investment in the lease, including

transaction fees and interest through the time of default. As Mr. Berdelle

explained in a memorandum prepared for the Unicom board meeting on April 4,

2000, requesting the approval of the like-kind exchange plan,

      [t]he stipulated loss values also include additional earnings protection
      of about $3 million per each $100 million of initial investment. For

      21
       Petitioner’s own expert Mr. McDermott stated in his expert report that the
bankruptcy of a municipal utility is a relatively low-probability event but has
occurred in other jurisdictions.
                                        - 125 -

      example, if there was a default on both the MEAG and CPS trans-
      actions (about $1.6 billion), Unicom would receive its investment and
      about $48 million pretax income in the year of default as earnings
      protection.

      The Spruce transaction documents were drafted to reflect this

understanding. We are thus satisfied that petitioner did not face any significant

risks indicative of genuine ownership during the Spruce sublease term.

             2.     CPS Cancellation Option Decision

      We next consider whether petitioner acquired the benefits and burdens of

ownership in the light of the options available to petitioner and CPS at the end of

the Spruce sublease period. First, we decide whether CPS was reasonably

expected to exercise its cancellation option at the end of the Spruce sublease

period. If it was, petitioner’s profit was fixed at the outset of the Spruce

transaction and petitioner did not acquire any benefits and burdens of ownership

with respect to the Spruce station. See John Hancock Life Ins. Co. (U.S.A.) v.

Commissioner, 141 T.C. at 139-143.

      Petitioner relies primarily on the Deloitte Spruce appraisal to show that CPS

was not “economically compelled” to exercise the cancellation option at the end of

the Spruce sublease. This is so, as petitioner sees it, because the cancellation

option price was set above the expected future fair market value of the Spruce

plant at the end of the Spruce sublease term. To support the Deloitte appraisal
                                         - 126 -

findings, petitioner invited several experts to submit expert reports and testify

during the trial. We will discuss this testimony in due course.

      Respondent relies primarily on the analyses of Dr. Skinner to argue that

because CPS is a tax-exempt entity, it valued the Spruce station at a much higher

level. Dr. Skinner asserts that there are a number of flaws with the Deloitte

appraisal, including the very high corporate income tax rate and discount rate. Dr.

Skinner suggested that because CPS was a tax-exempt entity, it would be more

appropriate to use a 0% corporate income tax rate and a discount rate equal to

CPS’ weighted average cost of capital, about 6.1%.22 This would result in a much

higher projected value for the Spruce plant at the expiration of the sublease.

      At the beginning of our analysis, we specify what constitutes “reasonable

likelihood” that a purchase option will be exercised at the end of the sublease

period. We reiterate that this Court does not require an “inevitable”,

“economically compelled”, or similar threshold for purchase option exercise

likelihood in evaluating SILO/LILO transactions. See id. at 95-97. We are also

not requiring a “more likely than not” likelihood of purchase option exercise.23

      22
         Dr. Skinner explained that because CPS did not pay dividends to its
shareholders, the appropriate weighted average cost of capital should be based on
the interest CPS usually paid on its bonds.
      23
           One of the recent cases considered by the Court of Federal Claims, while
                                                                        (continued...)
                                       - 127 -

We are looking simply at whether “in the light of all of the facts and circumstances

known on the closing dates of the transactions, whether * * * [the taxpayer’s]

lessee counterparties were reasonably likely to exercise their purchase options.”

See Id. at 97.

      Petitioner asserts that the Court of Appeals for the Seventh Circuit

compared the option exercise price to the anticipated fair market value of the

leased assets expected as of the closing of the lease in determining whether a

transaction constitutes a true lease. See, e.g., In re Marhoefer Packing Co., Inc.,

674 F.2d 1139, 1144-1145 (7th Cir. 1982) (considering whether option price was

“nominal” in comparison to the fair market value of leased assets at the time the

option could be exercised “as anticipated by the parties when the lease * * * [was]

signed,” for purposes of determining whether the lease should be recharacterized

as a security interest); M & W Gear Co. v. Commissioner, 446 F.2d 841, 846 (7th

Cir. 1971) (respecting Tax Court’s finding that the lessee, rather than the lessor,

acquired an equity interest in property, where “that the fair market value * * * was


      23
        (...continued)
acknowledging the reasonable likelihood standard as articulated in Wells Fargo &
Co. v. United States, 641 F.3d 1319 (Fed. Cir. 2011), and Consol. Ed. of N.Y., Inc.
v. United States, 90 Fed. Cl. 228 (2009), rev’d and remanded, 703 F.3d 1367 (Fed.
Cir. 2013), seems to use a “more likely than not” standard in its actual analysis.
See UnionBanCal Corp. v. United States, 113 Fed. Cl. 117, 131-132, 135-136
(2013).
                                        - 128 -

at least twice as much as * * * [lessee’s] option price”), aff’g 54 T.C. 385 (1970).

These cases lead petitioner to assert that “the appropriate standard for analyzing a

lessee’s purchase option must focus on objective economic realities and whether

those realities compel exercise or strongly favor exercise to a degree of certainty.”

      We do not find that the cases petitioner cites establish a legal standard

incompatible with this Court’s analysis in John Hancock and require economic

compulsion or circumstances that “strongly favor exercise to a degree of

certainty.” In M & W Gear Co. v. Commissioner, 446 F.2d at 844-845 (discussing

in detail evidence regarding the intent of the parties), the Court of Appeals for the

Seventh Circuit considered not only the comparable sale prices for the leased

assets, but the intent of the parties at the time of entering the transaction. In In re

Marhoefer Packing Co., Inc., 674 F.2d at 1141, the same Court of Appeals

discussed only the issue of whether a specific lease in question with a $1 purchase

option qualified as a true lease or a security under the provisions of the Uniform

Commercial Code. This discussion is not pertinent here because it does not

pertain to any tax law issues. Finally, none of the cases petitioner cites involve a

lease supported by defeasance arrangements where both a lessee and a lessor

would have certain options at the end of the lease and where the lessee would have

some obligations under options available to the lessor.
                                       - 129 -

      Thus, we will follow the legal standard of “reasonable likelihood” that this

Court has adopted in John Hancock following the Courts of Appeals for the

Second Circuit and the Federal Circuit. As to comparing the option exercise price

to the estimated future value of the asset in the context of SILO/LILO transactions,

this Court previously explained in John Hancock Life Ins. Co. (U.S.A.) v.

Commissioner, 141 T.C. at 99-100:

      [Lessee’s] purchase option decision is not a choice between the
      purchase option price and the estimated fair market value of the
      remaining leasehold interest. It is a choice between the cost to
      [lessee] * * * of exercising its purchase option and its expected costs
      of not exercising its purchase option. In determining its expected
      costs of not exercising its purchase option, * * * [the lessee] must
      analyze the likelihood and consequences of * * * [the taxpayer’s]
      choosing between the * * * [various options available to the taxpayer
      under the lease.]

      Neither petitioner nor respondent argues that there are legal, political,

industrial, or technical reasons that would weigh in favor of or against CPS’

exercise of its cancellation option.24 We will thus first concentrate on the financial

and economic aspects of the Spruce transaction and then will consider other

factors that we deem important for our analysis. See id. at 99.


      24
         Respondent argues that because of the perceived synergies CPS could
have derived from operating Spruce station and Spruce II together CPS was more
likely to exercise the cancellation option at the end of the sublease term. Because
CPS obtained petitioner’s permission and constructed Spruce II several years into
the sublease term, we do not rely on this argument in our analysis.
                                       - 130 -

      Petitioner argues that it would be financially disadvantageous for CPS to

exercise its cancellation option.25 According to the Spruce appraisal prepared by

Deloitte and dated as of the Spruce transaction closing date, June 2, 2000, the fair

market value of the Spruce plant was expected to be around $626 million on the

basis of a discounted cashflow analysis26 at the time the Spruce cancellation option

can be exercised (adjusted for inflation at 2.5% per annum). The Spruce

cancellation option price was set at $733,849,606. Petitioner suggests that this

should be the end of the analysis because a reasonable person acting in its best

      25
        We note that the Spruce transaction was terminated pursuant to the
agreement of the parties in 2014. Exelon received an additional $335 million as
the stipulated loss value payment from the CPUA proceeds, and CPS received $1
million. The record does not state the reason for termination.
      26
        The value would be $609,600,000 using a cost approach. The Spruce
appraisal stated, in relevant part:

      We are of the opinion that the discounted cash flow analysis provides
      a stronger indication of fair market value for the Facility than the cost
      approach since the discounted cash flow analysis reflects the impact
      to fair market value of the encumbered cash flows of the Facility.
      Since cash flows during this period are difficult to forecast with
      accuracy, we have conservatively relied upon the cost approach as the
      stronger indicator to estimate the residual value of the Facility at the
      end of the Lease Term and at the end of the Service Agreement Term.

       We note that the cost approach would result in lower projected future fair
market value according to Deloitte appraisals for the test transactions. We will use
the discounted cashflow analysis because petitioner relied mostly on discounted
cashflow in pricing the Spruce, Scherer, and Wansley transactions. We believe
this will provide us with more consistent results.
                                       - 131 -

economic interest would not overpay over a hundred million dollars for an asset

when it can easily replace the asset on the market.

      Petitioner’s expert Prof. Myers conducted the sensitivity analysis of the

Deloitte appraisal by changing certain assumptions such as the rate of inflation

and electricity prices. His report and testimony mostly confirmed the obvious:

when we change the assumptions used in the Deloitte appraisal, we are going to

end up with different results. However, we found Prof. Myers’ analysis helpful

because it shows a range of possible scenarios related to the cancellation option

exercise decision. Instead of giving the parties to a transaction a snapshot of the

value using rigid assumptions as in the Deloitte appraisals, Prof. Myers’ sensitivity

analysis represents a more reliable tool to evaluate the range of scenarios based on

varying economic assumptions. The following table sets out the fluctuation of the

projected future value of the Spruce plant under various assumptions27 according

to Prof. Myers:




      27
        For the base case scenario, Prof. Myers used Deloitte forecasted
cashflows; average inflation at 2.5% throughout the headlease term; electricity
prices starting at $31.75 per MWh in 2000 adjusted for inflation annually; plant
capacity factor at 90.3% in 2000, declining to 58.7% in 2032, and to 49.6% in
2052; corporate tax rate of 40.85%.
                                         - 132 -

   Scenario           Projected Spruce         Likely outcome and comments
                       value in 2032
 Base case             $618.3 million     CPS returns Spruce to Exelon and replaces
                                          Spruce on the market; Exelon is better off not
                                          exercising the service agreement option.
 Inflation +1.5%       $971.1 million     CPS exercises cancellation option.
  from base case
 Inflation !1.5%       $394.2 million     CPS returns Spruce to Exelon and replaces
  from base case                          Spruce on the market; CPS has to pay a $125.9
                                          subsidy to a PTPA provider to enter into the
                                          service agreement with Exelon; CPS still has
                                          $203.1 million overall benefit.
 Electricity prices    $953.5 million     CPS exercises cancellation option.
  +30% above
  base case
 Electricity prices    $283.2 million     CPS returns Spruce to Exelon and replaces it on
  !30% from base                          the market; CPS has to pay a $175.4 million
   case                                   subsidy to a PTPA provider to enter into the
                                          service agreement with Exelon; CPS still has
                                          $264.6 million overall benefit.

       According to Prof. Myers, CPS would never elect to repurchase the Spruce

station and cancel the headlease to avoid the cost of a PTPA subsidy. In other

words, if CPS deems it undesirable to exercise the purchase option, it will always

be better off with paying a subsidy to the PTPA provider and walking away from

the Spruce station at the end of the Spruce sublease term. Prof. Myers also

concluded that it was appropriate for Deloitte to use the 40.85% corporate tax rate

and a 10% discount rate because the tax-exempt status of an actual lessor does not

affect its pricing considerations when most other players on the market are taxable

entities.
                                       - 133 -

      Another expert who testified on behalf of petitioner, Mr. Reed, also opined

that because of uncertainty about the future “it would have been impossible based

on any realistic assessment of the future value of Exelon’s interest in the Facilities

to determine whether or not the parties were reasonably expected to exercise their

respective options.”

      Petitioner also introduced the testimony of Ms. Hughes, who opined that

Deloitte complied with the USPAP standards and its analysis framework was

appropriate and reasonable. Although the courts have previously admitted expert

reports with similar conclusions, such reports were given little weight. See, e.g.,

ConEd II, 703 F.3d at 1380 (discussing Kelly expert report). We find that Ms.

Hughes’ report did not add anything of substance to the discussion. Ms. Hughes

did not perform her own analysis and did not opine on the fair market value of the

assets at issue. She merely attempted to bolster the credibility of the Deloitte

work, and we do not find this attempt particularly helpful. As this Court has

previously explained, an appraiser’s compliance with USPAP is not the sole

determining factor as to whether the appraiser’s valuation report is reliable. See

Whitehouse Hotel Ltd. P’ship v. Commissioner, 131 T.C. 112, 127-128 (2008)

(declining to adopt USPAP as the sole standard for reliability of an appraisal),

vacated and remanded on other grounds, 615 F.3d 321 (5th Cir. 2010); SWF Real
                                          - 134 -

Estate LLC v. Commissioner, T.C. Memo. 2015-63, at *98 (declining to find that

an appraisal report was unreliable solely for failure to comply with USPAP

requirements and stating that the Court will independently review the report for

reliability).

       Respondent’s primary expert witness, Dr. Skinner, challenged the Deloitte

appraisal because it used too high a tax rate and discount rate. Dr. Skinner

suggested that because CPS was a tax-exempt entity, Deloitte should have used

pretax cashflows to determine the fair market value of the Spruce plant at the end

of the sublease. Dr. Skinner also asserted that the appropriate discount rate for the

Spruce plant should be 6.1%, on the basis of CPS’ weighted average cost of

capital. With the corrected assumptions, Dr. Skinner concluded that it would be

beneficial for CPS to exercise the cancellation option because it would value the

Spruce plant much higher than the Deloitte appraisal, at $1.5 billion. Dr. Skinner

further concluded that CPS would be “nearly certain” to exercise the cancellation

option at the end of the sublease term.

       First, we agree with petitioner that to the extent Deloitte was tasked to

determine the fair market value of the Spruce plant at certain points, it should have

disregarded the tax status of the actual buyer and should have used the prevailing

market discount rate. It is well established that fair market value is “the price at
                                        - 135 -

which property would change hands between a willing buyer and a willing seller,

neither being under any compulsion to buy and sell and both having reasonable

knowledge of relevant facts.” Bank One Corp. v. Commissioner, 120 T.C. 174,

209, 304-306 (2003), aff’d in part, vacated in part on other grounds, and remanded

sub nom. JPMorgan Chase & Co. v. Commissioner, 458 F.3d 564 (7th Cir. 2006);

Crimi v. Commissioner, T.C. Memo. 2013-51, at *60 (citing United States v.

Cartwright, 411 U.S. 546, 551 (1973)); see also sec.1.170A-1(c)(2), Income Tax

Regs. As this Court explained, under the willing buyer and willing seller standard,

“[t]he willing buyer and the willing seller are hypothetical persons, rather than

specific individuals or entities, and the individual characteristics of these

hypothetical persons are not necessarily the same as the individual characteristics

of the actual seller or the actual buyer.” Estate of Trenchard v. Commissioner,

T.C. Memo. 1995-121, 69 T.C.M. (CCH) 2164, 2169 (citing First Nat’l Bank of

Kenosha v. United States, 763 F.2d 891, 893-894 (7th Cir. 1985), Estate of Curry

v. United States, 706 F.2d 1424, 1428-1429, 1431 (7th Cir. 1983), Estate of Bright

v. United States, 658 F.2d 999, 1005-1006 (5th Cir. 1981), and Estate of

Newhouse v. Commissioner, 94 T.C. 193, 218 (1990)). This court has previously

declined to narrow the scope of willing buyer and willing seller to a particular

category of parties. Bank One Corp. v. Commissioner, 120 T.C. at 315.
                                       - 136 -

      The hypothetical willing buyer and willing seller test applies in situations

where the amount of tax due depends directly on the fair market value of the

property at issue. However, our task here is not to determine the fair market value

of the property, but rather whether it was reasonably likely that in the year 2032

CPS would exercise its cancellation option. As previously stated, that depends on

weighing the cost to CPS of exercising the option against the cost to CPS of not

exercising the option. The parties to the transaction are not hypothetical, but are

CPS and petitioner, each with unique characteristics. It is therefore entirely proper

for us to consider those unique characteristics in evaluating the likelihood that the

cancellation option at issue here would actually be exercised.

      We agree with Prof. Skinner that there are several flaws in the Deloitte

appraisal. First, Deloitte used the 9% State corporate income tax rate in all

appraisals for test transactions. According to Deloitte, “[t]he 9 percent tax rate

represents the appropriate corporate income tax rate in the state of Texas’ stepped

tax rate schedule based upon tax year and taxable amount.” In the context of the

Spruce transaction, this statement sounds odd. Texas does not impose a State

corporate income tax. It is possible that the cashflows from the Spruce plant thus

would be taxed at a different rate. This could potentially increase the value of the
                                        - 137 -

Spruce plant in both 2000 and 2032. However, we do not think this flaw

necessarily fatal to the Spruce appraisal.28

      Second, we find that Winston & Strawn attorneys interfered with the

appraisal process’ integrity and independence by providing Deloitte with the

wording of the conclusions it expected to see in the final appraisal reports.

Deloitte confirmed in its engagement letter that “[t]he appraisal will be conducted

in conformity with the * * * [USPAP] of the Appraisal Foundation and the

Principles of Appraisal Practice and Code of Ethics of the American Society of

Appraisers.” USPAP ethics rules require an appraiser to “perform assignments

with impartiality, objectivity, and independence, and without accommodation of

personal interests.” Appraisal Foundation, Uniform Standards of Professional

Appraisal Practice 2 (1999). USPAP ethics rules also prohibit an appraiser from

accepting an assignment “that includes the reporting of predetermined opinions

and conclusions.” Id.


      28
         If we calculate the present value of a stream of revenue equal to $100 per
year at 10% discount rate and with a 40.85% tax rate over a period of 30 years and
compare the results with the present value of the same revenue stream taxed at
35%, the difference will exceed $50. We note, however, because the tax rate
affects the numerator in the present value calculation, slight fluctuations in the tax
rate may not have a significant enough effect to require completely discarding an
appraisal as unreliable. To compare, a 1% change in the discount rate, which
affects the denominator, would also bring up by $50 the present value of the
revenue stream above.
                                         - 138 -

       Petitioner argues that the list of conclusions Winston & Strawn

communicated to Deloitte was merely a statement of the existing guidance and

tests on the issue of what is considered a true lease. We do not find this argument

persuasive. According to petitioner, Deloitte’s appraisal team was known for its

expertise and experience in the appraisal field. There was no reason for concern

that Deloitte was unaware of the existing guidance on characterization of leases

for Federal tax purposes. We see Winston & Strawn’s letter dated December 29,

1999, informing the Deloitte team of the conclusions the law firm needed to see in

order to issue an opinion at the requisite level as an attempt to obtain certain

results. Our finding is supported by a pattern of communications between

Winston & Strawn and Deloitte where Winston & Strawn provided regular

feedback at all stages of the project, starting with Deloitte’s engagement letter.

       Petitioner asserts, and Deloitte’s representative, Mr. Ellsworth, testified on

this point at trial, that Deloitte arrived at the fair market value of the assets at issue

independently. Nonetheless, even if that is true, Deloitte also performed the

appraisal of the relinquished power plants, Powerton and Collins. Deloitte

therefore was aware of the amount of untaxed gain petitioner was looking to defer.

This further undermines the reliability of the appraisal reports Deloitte provided

for all test transactions.
                                        - 139 -

      Further, in analyzing the likelihood of cancellation option exercise by CPS,

Deloitte failed to consider the costs of a potential subsidy CPS would have to pay

to a qualified bidder or operator to entice such a bidder/operator to enter into an

operating agreement or PTPA with petitioner if the energy industry does not fare

as well as expected. Prof. Myers, however, considered such costs and concluded

that in most cases CPS would still be better off taking the money and returning the

Spruce station to petitioner.

      As to the likelihood of the cancellation option’s exercise, it is unhelpful to

petitioner’s argument that Deloitte failed to consider the costs that CPS would

have to incur to bring the Spruce plant to the required (per the Spruce sublease

agreement) minimum operation standards for estimated annual capacity, net

energy output, and efficiency. Meeting these requirements is a prerequisite for

CPS to return the Spruce station to Exelon at the end of the sublease term.

According to the Spruce sublease agreement, if CPS were to fail to deliver the

Spruce station meeting the minimum operating and efficiency requirements, it

would have to pay the diminution of fair market value or will be given another

chance to exercise the cancellation option. Prof. Myers also failed to take these

costs into consideration in his analysis.
                                       - 140 -

      Thus, the price of failing to exercise the cancellation option for CPS would

consist of (1) undertaking investments required to bring the Spruce station into

compliance with the minimum operating standards and other return requirements;

(2) securing a replacement property or source of electricity and related costs; and

(3) potential subsidies to qualified bidders and transaction costs should Exelon

decide to exercise the operating agreement or the service agreement options.

      To be more specific, CPS and petitioner agreed that if CPS decided to return

the Spruce station at any time during the sublease or at the end of the sublease

term in 2032, the Spruce station was required, at a minimum, to have an annual

ratio of the actual net generation to the normal claimed capacity of at least 82%

(capacity factor), operating for 8,760 hours per year. The Spruce station was also

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.

      Deloitte and Prof. Myers, however, used significantly lower capacity factors

in their computations. These figures were based on Deloitte’s due diligence of the

Spruce station and the engineering reports provided by Stone & Webster. Both

Deloitte and Prof. Myers assumed the plant capacity factor to be 90.3% in 2000,

with gradual decline to 58.7% in 2032 (the end of the sublease term) and to 49.6%
                                       - 141 -

in 2052 (end of the Spruce headlease). These numbers, according to Prof. Myers,

reflected the gradual obsolescence of the plant.

      Discounted cashflow analysis performed by Deloitte and Prof. Myers

incorporated the plant capacity factor and the hours of operation to determine the

cashflows from the Spruce plant and determine its value in 2032. This “real

Spruce plant”, however, was not what petitioner was entitled to receive at the end

of the Spruce sublease period. Petitioner was entitled to receive, because CPS had

agreed to deliver, a plant that would operate in 2032 at a plant capacity factor 23%

greater than anticipated by petitioner’s experts. This “hypothetical Spruce plant”

would, therefore, generate a much higher revenue stream and would have a value

significantly higher than the value projected by Deloitte and Prof. Myers.29

      Therefore, we conclude that the plant Exelon was entitled to receive at the

end of the sublease term had characteristics distinctly different from those

      29
         According to the Deloitte appraisal, the plant capacity factor for Spruce
would go down to 72.2% by year 16 of the sublease, with the available hours of
operation going down to 6,325. Deloitte estimated that the Spruce plant would
operate at these levels up to year 30 of the sublease, and at year 31 of the sublease
the Spruce plant capacity would be at 58.7%, with hours of operation at 5,139 per
year. If the Spruce plant continued to operate throughout the term of the sublease
at a minimum return requirements level (82% capacity factor and 8,760 operation
hours per year), the cashflows in years 16-32 of the sublease would be at least
10% to 23% higher than anticipated by Deloitte. We also do not find reliable the
Spruce plant value determined under the cost approach in the Deloitte appraisal. It
is clear the appraisal considered the cost of purchasing an asset that would not
meet the minimum operating requirements under the Spruce sublease agreement.
                                        - 142 -

assumed by Deloitte and Prof. Myers. Although the parties did not submit any

evidence regarding the amounts CPS would be required to invest in the Spruce

station to meet the return standards, the requirement to do so significantly changes

the economics of the Spruce transaction.

      We note that Prof. Myers stated in his analysis that “a capacity factor 20%

above [Deloitte] forecasts would move the return vs. cancel boundary up enough

to include the base-case scenario [in Prof. Myers’ analysis that petitioner would

retain the plant].” What Prof. Myers has not considered in his analysis, however,

is how the parties allocated the risks and costs related to the diminution in the

power plant efficiency. According to the Spruce transaction agreement

documents, that risk was shifted to CPS. As we explained, if the Spruce plant

failed to meet the minimum operating standards at the time it was returned to

Exelon, CPS would have to either pay up the diminution in fair market value or

exercise the cancellation option to cut its losses.

      Under the circumstances, we find it significantly more likely that CPS,

should it attempt to walk away from the transaction and return the Spruce station

to Exelon, would face substantial economic losses. Accordingly, we find that the

range of scenarios under which CPS would decide to exercise its cancellation
                                         - 143 -

option is significantly broader than expected by petitioner’s experts, including

Prof. Myers.

      We also find that both petitioner and CPS, experienced power plant

operators having the benefit of professional legal and other advice, understood

that the terms of the Spruce transaction were inconsistent with the Deloitte

appraisal and the projected future value of the Spruce station. The parties

understood that it would be very difficult, if not impossible, for CPS to return the

Spruce plant at the end of a 32-year sublease in almost the same condition in

which CPS received it in 2000 without significant investment. Thus, the parties

understood and reasonably expected at the time of entering into the Spruce

transaction that CPS would exercise the cancellation option at the end of the

sublease because meeting the return conditions would be extremely burdensome.

According to Prof. Myers’ analysis, with the required capacity factor of 82% in

2032, more than 20% higher than projected in the Spruce appraisal, it would be

economically beneficial for CPS to exercise its cancellation option.

      Moreover, we note that when the City of San Antonio brought suit in court

to obtain a declaratory judgment of the continued validity of certain covenants in

its outstanding public securities--thereby allowing CPS to enter into the

transaction with petitioner--in its initial draft of the petition the city represented
                                       - 144 -

that it intended to exercise the cancellation option. Even though this

representation was subsequently deleted at the suggestion of Winston & Strawn

and PwC, this Court infers an understanding among the parties that CPS would

exercise the option to reacquire the Spruce plant. At the very least, it was

reasonably likely at the time of the transaction that the purchase option would be

exercised.

             3.    Conclusion

      We hold that the Spruce transaction fails the substance over form inquiry

because petitioner did not acquire the benefits and burdens of ownership of the

Spruce station. Petitioner’s investment was not subject to more than a de minimis

risk of loss. We need not consider the risks and benefits to petitioner of the

remaining headlease period because it was reasonably likely that the circular flow

of money allowing petitioner to fully recover its investment and interest would

close on the last day of the Spruce sublease.

      We agree with respondent that the transaction most closely resembles a

financial arrangement. Specifically, the Spruce transaction resembles a loan from

Exelon to CPS. Exelon funded the Spruce transaction entirely with its own funds

and received the funds back with interest in two tranches: the first tranche six

months after the closing date and the second tranche at the end of the Spruce
                                      - 145 -

sublease term in the form of the cancellation option payment. Exelon’s return on

its investment was predetermined, and Exelon did not have an upside potential or

much of downside risk with respect to the Spruce station. This is more indicative

of a loan than of a genuine equity investment.

      Accordingly, we sustain respondent’s disallowance of Exelon’s depreciation

deductions claimed on the 2001 tax return with respect to the Spruce transaction.

      C.    Scherer and Wansley Transactions

      Because the Scherer and Wansley transactions are structured and

documented very similarly, we discuss them together. We use the same analysis

framework as for the Spruce transaction.

            1.     Sublease Term Risks

      Petitioner and respondent make the same arguments for the Scherer and

Wansley transactions as for the Spruce transaction.

      First, as we noted in discussing the Spruce transaction, a 100% out-of-

pocket investment does not necessarily make a transaction nonabusive from a tax

standpoint. Here, petitioner indeed used the untaxed proceeds from the sale of the

Powerton station and did not use any loans to finance the Scherer and Wansley

transactions (collectively, MEAG transactions). However, petitioner got 77.9% of

its initial investment back just six months after the closing of the MEAG
                                       - 146 -

transactions in the form of prepaid rent from MEAG. A portion of the remaining

22.1% of the initial investment was placed into a trust account and invested in

low-risk securities to provide for the payment of the MEAG purchase option at the

end of the sublease period for MEAG transactions. Another portion was set aside

to provide MEAG with the NPV benefit in consideration for entering into the

transactions. For the same reasons we discussed for the Spruce transaction, we do

not find that an out-of-pocket investment automatically shows that petitioner

acquired benefits and burdens of ownership of Scherer and Wansley stations. This

is especially important when six months into the transaction petitioner was in

substantially the same cash position as with using loans to finance the leases.

      Second, similarly to the Spruce transaction, we do not see the rights and

obligations conveyed by the Scherer and Wansley respective headlease and

sublease agreements as significantly altering the rights of the parties. Petitioner

did not have any obligations to MEAG with respect to the maintenance, operation,

or insurance of the Scherer and Wansley stations during the sublease term or the

remainder of the headlease. Petitioner also did not have to meet any return

conditions in the case of headlease termination. The rights and obligations of the

parties under the Scherer and Wansley subleases were essentially the same as in

the Spruce transaction, with MEAG bearing all the costs and risks related to the
                                       - 147 -

interests in the stations it conveyed to petitioner in the MEAG transactions. As we

observed in the discussion of the Spruce sublease, the terms of the sublease

agreements were designed to insulate petitioner from any operational risks.

      Third, similar to the Spruce transaction, we do not find that petitioner’s due

diligence efforts are somehow indicative of a true ownership interest in the

Scherer and Wansley stations.

      We also do not find any merit in petitioner’s argument that it was exposed

to a risk of MEAG’s going bankrupt during the Scherer and Wansley sublease

terms. Petitioner received an opinion from Holland & Knight that confirmed that

the laws of the State of Georgia did not allow municipalities to declare

bankruptcy. Petitioner’s own expert, Dr. Gilson, confirmed in his expert report

that Georgia would have to change its laws to allow MEAG to declare bankruptcy.

We consider this scenario highly unlikely. See UnionBanCal Corp., 113 Fed. Cl.

at 135 (discussing that highly unlikely risks do not add substance to a LILO

transaction). In any event, credit enhancements put in place at the outset of the

MEAG transactions provided petitioner with sufficient protection from that risk.

      We find that petitioner also did not face a substantial risk of loss with

respect to the payment of the Scherer and Wansley rent by MEAG. The rent was

prepaid six months into the sublease term, and the stipulated loss value provisions,
                                        - 148 -

together with MEAG and UII swaps, insulated petitioner from any significant risk

of loss in this respect.

              2.     Purchase Option Decision

       We now turn to an analysis of whether it was reasonably likely that at the

closing of the Scherer and Wansley transactions MEAG would exercise its

purchase option. Similarly to the Spruce transaction, we will look not only at fair

market value of the assets involved as of the option exercise date, but also to the

costs to MEAG if it decides to forgo exercising the option. We will also briefly

address the rights of the Scherer and Wansley coowners, who also received a right

to exercise the purchase option if MEAG decided to forgo it.

                     a.    MEAG

       Neither petitioner nor respondent argues that there are legal, political,

industrial, or technical reasons that would weigh in favor of or against MEAG’s

exercise of its purchase option. Thus, we consider financial and economic aspects

of the MEAG transactions first.

       According to the Deloitte appraisal, the undivided interests petitioner

received under the MEAG transactions were estimated to have fair market values

of $203,800,000 for Wansley and $485,000,000 for Scherer using a discounted
                                       - 149 -

cash flow analysis,30 adjusted for inflation at 2.5% per annum, at the respective

lease expiration dates. The Wansley purchase option price was set at $214

million, and the Scherer purchase option price was set at $537.1 million, with

$143,543,915 and $179,284,424 allocable to the Wansley and Scherer test

transactions, respectively. Because the Deloitte appraisals and expert reports

addressed the Wansley transactions without allocating the values between

Wansley 1 and 2, we will use the aggregate analysis and will assume that the

projected value of the Wansley interest conveyed in the test transaction bears the

same ratio to the overall projected value of the Wansley as the purchase option

exercise value for the test transaction to the overall purchase option price.

      The Deloitte appraisals for the Scherer and Wansley stations suffer from the

same deficiencies we identified in our review of the Spruce appraisal. Deloitte

elected to use the 40.85% corporate tax rate that included a 9% State corporate tax

rate, even though MEAG does not pay income tax (and even if it did, Georgia

taxes its corporations at a flat 6% rate). Winston & Strawn attorneys were very

closely involved in the appraisal report preparation process. Deloitte did not

consider the costs MEAG would have to incur if it decided not to exercise the


      30
        The cost approach inflation-adjusted values are $191,300,000 for the
Wansley and $481,000,000 for the Scherer interest. For the same reasons we
discussed supra note 26, we will be using the discounted cashflow results.
                                       - 150 -

purchase option, including the costs of bringing the plants up to the required

operating standards. Deloitte also did not consider any additional factors that

could make MEAG’s cotenants consider exercising the purchase options,

including obtaining majority control over the Scherer and Wansley stations.

      Petitioner’s expert witnesses made the same arguments as for the Spruce

transaction. Mr. Reed opined that it was impossible to predict with a degree of

certainty whether MEAG or its cotenants would exercise the purchase options at

the end of the Scherer and Wansley subleases. Ms. Hughes opined that the

Deloitte appraisals conformed with the USPAP principles and the Deloitte analysis

was reasonable and appropriate. Prof. Myers conducted the sensitivity analysis of

the Deloitte appraisals and confirmed that if the inflation or electricity prices were

higher than predicted by Deloitte, it would increase the likelihood of MEAG’s

exercising the purchase options.31 Prof. Myers concluded that MEAG would never

purchase Wansley or Scherer in order to avoid the cost of a PTPA subsidy. Prof.

Myers also recognized that changes in other factors, including capital investments,

capacity factors, and discount rates will affect MEAG’s decision.



      31
        We also note that Prof. Myers used a different corporate tax rate (38.9%)
for the Wansley and Scherer transactions. His discounted cashflow results,
however, were comparable to those in the Deloitte appraisal reports because of
several adjustments made by Prof. Myers, such as capital investments.
                                       - 151 -

      Respondent’s expert witness Dr. Skinner suggested that Deloitte should

have used a 0% corporate tax rate to analyze the MEAG transactions and used a

6.3% discount rate based on cost of debt to MEAG. Dr. Skinner also suggested

that Deloitte should have conducted sensitivity testing at least for corporate rates.

With the new assumptions, Dr. Skinner concluded that MEAG would value the

Scherer and Wansley stations a lot higher than the purchase option price and thus

would be almost certain to exercise the purchase option.

      For similar reasons as those we discussed for the Spruce transaction, we

agree that Deloitte should have used a 0% corporate tax rate and the prevailing

discount rate in its analysis.

      As with the Spruce transaction, a further problem with the Scherer and

Wansley appraisals is that Exelon was entitled to a operating efficiency of Scherer

and Wansley at the end of the sublease significantly higher than the values used by

Deloitte in the respective appraisals. If the Scherer and Wansley stations did not

meet the minimum operating requirements outlined in the respective subleases,

MEAG would have to pay damages reflecting the diminution in the value of the

stations due to decreased efficiency. Deloitte and Prof. Myers failed to consider

these costs in analyzing whether MEAG would exercise the purchase options at

the end of the Scherer and Wansley subleases.
                                       - 152 -

      For Wansley, petitioner was entitled to receive, because MEAG had agreed

to deliver, the Wansley station at the end of the sublease with a capacity factor of

at least 62% based on 8,760 hours of operation per year with the net energy output

of at least 85%. The Wansley appraisal by Deloitte and Prof. Myers’ report

assumed a plant capacity factor of only 66.5% in 2000, declining to 39.2% in 2028

(Wansley sublease expiration year) and to 32.6% in 2045. These numbers were

based on the engineering reports prepared by Stone & Webster. Thus, petitioner

was entitled to receive Wansley at the end of the sublease operating at a capacity

factor only 4.5% lower than at the beginning of the sublease. Petitioner’s

entitlement with respect to the capacity factor was 22.8% higher than projected by

Deloitte and Prof. Myers.

      For Scherer, petitioner was entitled to receive, because MEAG had agreed

to deliver, the Scherer station at the end of the sublease term in 2030 with at least

62% capacity factor based on 8,760 hours of operation per year and net energy

output of 87.5%. Deloitte and Prof. Myers assumed the plant capacity factor to be

66.5% in 2000, declining to 39.9% in 2030. These numbers were based on the

engineering reports prepared by Stone & Webster. Thus, petitioner was entitled to

receive Scherer at the end of the sublease operating at a capacity factor only 4.5%

lower than at the beginning of the sublease. Petitioner’s entitlement with respect
                                       - 153 -

to the capacity factor at the time of the Scherer return was 22.1% higher than

projected by Deloitte and Prof. Myers.

      Our observations for the MEAG transactions are very similar to the Spruce

transaction discussion. Both petitioner and MEAG had vast experience with

operation of power plants. Both petitioner and MEAG had the benefit of legal,

tax, and other professional advice before and at the time of entering the

transaction. Both petitioner and MEAG agreed to the return conditions set out in

the Scherer and Wansley sublease contracts and understood the importance of the

minimum operating standards.

      Thus, it was reasonably likely at the time the MEAG transactions were

entered into that MEAG would exercise the purchase option at the end of the

Scherer and Wansley subleases, because meeting the return conditions would be

extremely burdensome, if not impossible, for MEAG.

      Petitioner may argue that Exelon faced a risk that MEAG would not have

sufficient funds to pay the purchase option exercise price. We observe that indeed

MEAG replaced the collateral pledged to Ambac Credit and Exelon under the UII

and MEAG swaps with MEAG’s own debt. We also observe, however, that both

Ambac Credit and petitioner consented to such an exchange. Ambac Credit and

petitioner would not have consented to the collateral replacement if they had
                                       - 154 -

anticipated they would have any problems with the payment at the end of the

sublease term. In fact, one of the goals of replacing the collateral was to replace

the Government securities, which did not give sufficient yield in the beginning of

the 2000s, with relatively secure but higher yield instruments. Because MEAG

could not declare bankruptcy under the laws of Georgia, we find that petitioner did

not bear any significant risk of nonpayment at the end of the sublease periods for

the Scherer and Wansley stations.

                    b.    Cotenants

      One of the significant differences between the MEAG transactions and the

Spruce transaction is that MEAG’s cotenants in the Wansley and Scherer stations

received the right to exercise the purchase option at the end of the subleases

should MEAG fail to do so. Petitioner and respondent did not put much emphasis

on that right in their briefs. Prof. Myers, petitioner’s expert, concluded that

cotenants would use the same analysis as MEAG to decide whether to exercise the

purchase options. We agree with this statement, but we also emphasize that the

cotenants may have some other significant considerations that may make it more

likely that they will step in and purchase the interests in the Scherer and Wansley

stations if MEAG fails to do so. This further insulates petitioner from the risk of

loss in the MEAG transactions or a risk of MEAG’s nonpayment.
                                       - 155 -

             3.    Conclusion

      We hold that the Wansley and Scherer transactions fail the substance-over-

form inquiry because petitioner did not acquire the benefits and burdens of

ownership of the Scherer and Wansley stations. It was reasonably likely at the

time the MEAG transactions were entered into that MEAG or its cotenants would

exercise the purchase options at the end of the sublease term. Accordingly, we do

not need to consider the risks and benefits to petitioner of the remaining headlease

periods. We agree with respondent that the MEAG transactions most closely

resemble financial arrangements. Specifically, the MEAG transactions resemble

loans from Exelon to MEAG because Exelon’s income was predetermined and the

transaction did not have an upside potential or significant downside risks for

Exelon. Because Exelon funded the transactions with its own funds and there are

two distinct tranches of money it expected to receive back, it is appropriate to

characterize each transaction as creating two loan instruments: one to be repaid

six months after the closing date in the form of prepaid rent, and the second to be

repaid at the time of the purchase option payment. Accordingly, we sustain

respondent’s disallowance of Exelon’s depreciation deductions claimed on the

2001 tax return with respect to the Spruce transaction.
                                       - 156 -

III.   Economic Substance of the Test Transactions

       Respondent further asserts that we should disallow petitioner’s depreciation,

interest, and transaction cost deductions claimed on the 2001 tax return because

the test transactions lacked economic substance. Respondent did not directly

challenge the 1999 like-kind exchange gain deferral under the economic substance

doctrine. Because we resolve the issues related to the disputed deductions claimed

in petitioner’s 2001 tax return on substance over form grounds, we need not

address this alternative theory.

IV.    Consequences for the 1999 Tax Year Section 1031 Like-Kind Exchange
       Adjustment

       Section 1031(a)(1) provides: “No gain or loss shall be recognized 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.” The

regulations further explain that “the words ‘like kind’ have reference to the nature

or character of the property and not to its grade or quality. One kind or class of

property may not, under * * * section [1031], be exchanged for property of a

different kind or class.” Sec. 1.1031(a)-1(b), Income Tax Regs.

       We have held that all of the test transactions failed the substance over form

inquiry because petitioner did not acquire the benefits and burdens of ownership in
                                         - 157 -

the assets involved in the test transactions. We have also concluded that the test

transactions are more similar to loans made by petitioner to CPS and MEAG

because petitioner’s return on its investment was predetermined at the time

petitioner entered into the test transactions. Accordingly, in 1999 petitioner

exchanged the Powerton and Collins power plants for an interest in financial

instruments. Such an exchange fails to meet the “like kind” requirement outlined

in the Code and the regulations. Thus, petitioner must recognize the gain it

received in 1999 on the sale of the Powerton and Collins plants under section

1001.

V.      2001 Interest Expense Deductions and Rental Income

        Six months after the closing of the test transactions, petitioner received

prepayment of all rent from CPS and MEAG due under the respective sublease

agreements. Petitioner reported the rent payments as income according to the

provisions of section 467.

        Section 467 governs the reporting of rental income from rental agreements

that are treated as leases for Federal income tax purposes and which either have

increasing or decreasing rents, or prepaid or deferred rents. See sec. 467(d)(1);

Sec. 1.467-1(c), (h)(12), Income Tax Regs. If a rental agreement constitutes a

section 467 rental agreement, the lessor and the lessee must take into account only
                                       - 158 -

the sum of the section 467 rent and interest during the taxable year. Sec. 1.467-

1(b), Income Tax Regs.

      We have concluded that petitioner did not acquire the benefits and burdens

of ownership in the Spruce, Wansley, or Scherer plant. We have also concluded

that the test transactions most closely resemble financial arrangements in the form

of loans from petitioner to CPS and MEAG. Thus, the agreements among

petitioner, CPS, and MEAG are not lease agreements for Federal tax purposes

under section 467, and petitioner may not deduct interest or include rental income

with respect to them for the taxable year 2001. This is consistent with our

conclusion that petitioner failed to enter into a like-kind exchange in 1999 and

must recognize the gain on the sale of the Powerton and Collins stations.

VI.   Original Issue Discount and Transaction Expenses

      A taxpayer receives OID income when a debt instrument is issued for less

than its face value. See Sec. 1273; United States v. Midland-Ross Corp., 381 U.S.

54, 85 (1965); and John Hancock Life Ins. Co. (U.S.A.) v. Commissioner, 141

T.C. at 147. “The holder of a debt instrument with OID generally accrues and

includes in gross income, as interest, the OID over the life of the obligation, even

though the interest may not be received until the maturity of the instrument.” John
                                       - 159 -

Hancock Life Ins. Co. (U.S.A.) v. Commissioner, 141 T.C. at 147 (citing section

1272(a)(1)).

      Respondent argues that petitioner has OID income arising out of petitioner’s

equity contribution that would be repaid through the cancellation/purchase options

with interest. Respondent suggests that such contributions should be treated in the

same manner as a zero-coupon bond. Respondent further contends that the terms

of each test transaction established a guaranteed, fixed return to Exelon through

the use of defeasance instruments. Respondent maintains that we should follow

the same approach as in John Hancock, where this Court upheld the

Commissioner’s recharacterization of a number of SILO transactions as in

substance a loan from the taxpayer to the counterparties and applied the OID rules.

Id. at 148.

      Petitioner’s main argument is that the test transactions should be

characterized as leases, not loans, and thus petitioner does not have any OID

income. For the reasons set forth in the previous portions of the opinion, this

argument lacks merit. Because petitioner, CPS, and MEAG reasonably expected

that the respective cancellation/purchase options would be exercised at the end of

the sublease period, the purchase option price was fixed, and the funds for

payments set aside (defeased) as of the closing date, the transactions represent
                                       - 160 -

fixed obligations similar to those discussed in John Hancock. Accordingly, we

uphold respondent’s application of the OID rules and his calculation of OID

income thereunder.

      In addition, we note that because each transaction was fully funded by

petitioner’s money and created two distinctive tranches of money--one payable in

six months, one at the end of the respective sublease term--each tranche should be

treated as a separate debt instrument under the OID rules.

      Ordinary and necessary business expenses paid or incurred in carrying on

any trade or business are generally deductible. See sec. 162(a). We have

concluded as to all test transactions that they are properly characterized as loans

from petitioner to CPS and MEAG. We also concluded that for each transaction,

the loan consisted of two tranches, one due six months after the closing date, the

other due at the time of the cancellation/purchase price option payment. Under

section 1.1273-2(g)(4), Income Tax Regs., transaction costs must be included as

an additional amount lent to the borrowers. See also John Hancock Life Ins. Co.

(U.S.A.) v. Commissioner, 141 T.C. at 149. Thus, petitioner’s transaction costs

related to the test transactions are not deductible and should be allocated to the
                                       - 161 -

respective loans. The parties are further directed to address the issue of

transaction cost allocation in Rule 155 computations.32

VII. Section 6662 Penalties

      A.     Overview

      Section 6662(a) and (b)(1) and (2) imposes a 20% accuracy-related penalty

on the portion of an underpayment of tax attributable to negligence or disregard of

rules and regulations or a substantial understatement of income tax. The accuracy-

related penalty does not apply to any portion of an underpayment for which a

taxpayer had reasonable cause and acted in good faith. See sec. 6664(c)(1).

      This Court previously held that the statutory provisions shifting the burden

of production to the Commissioner with respect to penalties are inapplicable to

corporations. See NT, Inc. v. Commissioner, 126 T.C. 191, 195 (2006) (holding

that section 7491(c) does not apply to a C corporation’s liability for a penalty, an

addition to tax, or an additional amount). Petitioner in the consolidated cases

before us is a corporation. Thus, the provisions of section 7491(c) do not apply.

      Respondent determined accuracy-related penalties pursuant to section

6662(a) of $86,234,918 for the 1999 tax year and $1,106,922 for the 2001 tax year

      32
        We recognize that there may be several ways to approach this issue. One
way would be to allocate transaction costs pro rata to the amounts of the respective
loans. The other way would be to allocate expenses on the basis of the billing
records and invoices of petitioner’s advisers related to the transactions at issue.
                                        - 162 -

in the respective notices of deficiency. Respondent determined these penalties on

the grounds of negligence and disregard of rules and regulations and substantial

understatements of income tax. Respondent has conceded the substantial

understatement of income tax grounds for the 2001 tax year.

      Petitioner argues that no penalty is appropriate in these cases because

petitioner was not negligent, did not disregard any applicable rules and

regulations, and acted reasonably and in good faith when relying on the tax advice

of its advisers, who adequately considered all relevant law under the applicable

standards at the time of the transactions. In addition, petitioner asserts that the

OID income cannot be included in the penalty computations because this argument

has only recently been introduced and developed by the Commissioner and the

courts, and petitioner could not anticipate such an assertion in 1999 and 2000, at

the time of closing the transactions.

      B.     Negligence or Disregard of Rules and Regulations

      We will address the issue of negligence or disregard of rules and regulations

first because it was determined as the ground for penalties in both notices of

deficiency on which these cases are based.

      Section 6662(a) and (b)(1) imposes a 20% penalty on any portion of an

underpayment of tax attributable to negligence or disregard of rules or regulations.
                                        - 163 -

Negligence includes “any failure to make a reasonable attempt to comply with the

provisions of the internal revenue laws or to exercise ordinary and reasonable care

in the preparation of a tax return.” Sec. 1.6662-3(b)(1), Income Tax Regs.

Negligence is “strongly indicated” when the taxpayer fails to make a reasonable

inquiry into correctness of an item that appears “too good to be true.” Id. subpara.

(1)(ii).

       Disregard includes “any careless, reckless or intentional disregard of rules

or regulations,” which includes “the provisions of the Internal Revenue Code,

temporary or final Treasury regulations * * * and revenue rulings or notices (other

than notices of proposed rulemaking) issued by the Internal Revenue Service and

published in the Internal Revenue Bulletin.” Id. subpara. (2). Disregard is

“careless” if the taxpayer does not use “reasonable diligence to determine the

correctness of a [tax] return position that is contrary to the rule or regulation.” Id.

Disregard is “reckless” if the taxpayer “makes little or no effort to determine

whether a rule or regulation exists under circumstances which demonstrate a

substantial deviation from the standard of conduct that a reasonable person would

observe.” Id. Finally, disregard is “intentional” if a taxpayer knows of the

disregarded rule or regulation. Id.
                                        - 164 -

      However, the penalty does not apply to any portion of an underpayment for

which a taxpayer had reasonable cause and acted in good faith. See sec.

6664(c)(1). This defense can be established through reasonable and good-faith

reliance on advice received from a competent tax professional. See United States

v. Boyle, 469 U.S. 241, 250-251 (1985); sec. 1.6664-4(b)(1), Income Tax Regs.

      Respondent argues that petitioner failed to make a reasonable attempt to

comply with the existing tax laws and failed to exercise ordinary and reasonable

care in the preparation of the tax returns for the years at issue. Respondent asserts

that Exelon should have known that the like-kind exchange and the test

transactions provided it with a result “too good to be true” and should have

evaluated the transactions more carefully. Respondent also asserts that Exelon

was aware that LILO transactions were already under scrutiny from the IRS and

did not sufficiently closely review the tax opinions provided by Winston & Strawn

at the time of entering into the transactions.

      Petitioner, in turn, argues that it conducted a thorough due diligence of all

aspects of the like-kind exchange and test transactions before deciding to engage

in them. Petitioner also argues that it reasonably relied in good faith on the advice

it received from its advisers on the various aspects of the transactions, including

tax treatment. Because the issue of whether petitioner under section 6662(a) was
                                       - 165 -

negligent or disregarded rules or regulations is so closely intertwined in these

cases with whether petitioner under section 6664(c) reasonably and in good faith

relied on advice it received from tax professionals, we consider the two issues

together.

      It is well recognized that taxpayers may establish that they should not be

liable for a section 6662 penalty if they acted in good faith and reasonably relied

on advice of a tax professional. Reliance on a professional tax adviser, however,

does not automatically establish reasonable cause and good faith. Sec. 1.6664-

4(b)(1), Income Tax Regs. Instead, all facts and circumstances must be taken into

account, including the taxpayer’s knowledge and experience and the reliance on

the advice of a professional. Id. In the case of reliance on an opinion or advice,

the facts and circumstances inquiry should account for “the taxpayer’s education,

sophistication and business experience,” as well as whether “the taxpayer knew, or

reasonably should have known, that the advisor lacked knowledge in the relevant

aspects of Federal tax law.” Id. para. (c)(1).

       To show that reliance on advice of a tax professional constitutes reasonable

cause, the taxpayer must prove by a preponderance of the evidence the following

three requirements: (1) the adviser was a competent professional who had

sufficient expertise to justify reliance, (2) the taxpayer provided necessary and
                                       - 166 -

accurate information to the adviser, and (3) the taxpayer actually relied in good

faith on adviser’s judgment. Neonatology Assocs., P.A. v. Commissioner, 115

T.C. 43, 99 (2000), aff’d, 299 F.3d 221 (3d Cir. 2002). Reliance may be

unreasonable when it is placed upon insiders, promoters, or their offering

materials, or when the person relied upon has an inherent conflict of interest that

the taxpayer knew or should have known about. Id. at 98. In addition, the advice

must not be based on unreasonable factual or legal assumptions and must not

unreasonably rely on representations, statements, findings, or agreements of the

taxpayer or any other person. Sec. 1.6664-4(c)(1)(ii), Income Tax Regs.

      Petitioner claims it reasonably relied in good faith on Winston & Strawn’s

tax advice and therefore no accuracy-related penalty should be imposed.

Respondent contends that petitioner’s reliance on Winston & Strawn was

unreasonable and not in good faith because Winston & Strawn was too involved in

the structuring of the transactions to provide a reliable tax opinion.

      First, we will analyze the factors outlined in Neonatology. The record in

these cases and the testimony of the parties establishes that petitioner carefully

considered various factors, including necessary expertise in tax, in selecting its tax

adviser. Winston & Strawn, in petitioner’s opinion, was a strong firm possessing

the necessary qualifications and expertise in handling similar deals.
                                       - 167 -

      We do not find that Winston & Strawn was so involved in structuring the

transaction that reliance on its tax opinions was per se unreasonable. Petitioner

contacted Winston & Strawn to provide advice on the transaction, and there is no

evidence that Winston & Strawn had a conflict of interest in rendering its advice.

Winston & Strawn billed its normal hourly rates, and its fee did not depend on the

closing of the test transactions. Cf. Kerman v. Commissioner, T.C. Memo. 2011-

54, slip op. at 43 (finding that a tax opinion was burdened with an inherent

conflict of interest where the fee for it was based on the amount of loss generated

for the taxpayers in a CARDS transaction), aff’d, 713 F.3d 849 (6th Cir. 2013).

Thus, petitioner met the first prong of the Neonatology test.

      As to the second prong of the Neonatology test, the parties do not dispute

that Winston & Strawn was closely involved in the transactions and knew all the

relevant facts to render a tax opinion. Respondent does not allege that petitioner

misrepresented any material facts to Winston & Strawn, and the record does not

contain any indicia that this was the case.

      However, as we discussed above, Winston & Strawn’s tax opinions were

based in large part on the appraisals prepared by Deloitte. We found that Winston

& Strawn interfered with the integrity and the independence of the appraisal

process by providing Deloitte with a list of conclusions it expected to see in the
                                       - 168 -

appraisals to be able to issue tax opinions at the “will” and “should” level. Such

interference improperly tainted the Deloitte appraisal, rendering it useless.

Further, because Winston & Strawn directed the conclusions that Deloitte had to

arrive at, we are highly suspicious that the tax opinions are similarly tainted.

      We also concluded that the technical and engineering assumptions used in

the Deloitte appraisals were inconsistent with the return conditions specified in the

test transaction documents, which made the exercise of the purchase/cancellation

options considerably more likely. Winston & Strawn, as the firm that drafted the

transaction documents and was closely involved in all stages of the test

transactions, knew or should have known of this defect and that its tax opinions

were therefore based on unreasonable assumptions and arrived at unreasonable

conclusions in the light of how the transactions were actually structured. See sec.

1.6664-4(c)(1)(ii), Income Tax Regs.

      The third prong of the Neonatology test requires the taxpayer to show that it

relied in good faith on the adviser’s judgment. There is a longstanding policy of

not requiring taxpayers to second-guess the work of a tax professional providing

the advice. As the Supreme Court has stated, “[t]o require the taxpayer to

challenge the attorney, to seek a ‘second opinion,’ or to try to monitor counsel on

the provisions of the Code himself would nullify the very purpose of seeking the
                                       - 169 -

advice of a presumed expert in the first place.” Boyle, 469 U.S. at 251; see also

Bruce v. Commissioner, T.C. Memo. 2014-178, at *56-*57 (finding it was

objectively reasonable for the taxpayer to rely on the advice of his longtime tax

adviser, even though the Court concluded that the advice was incorrect), aff’d, 608

F. App’x 268 (5th Cir. 2015); Estate of Giovacchini v. Commissioner, T.C. Memo.

2013-27, at *113-*114 (finding reasonable cause and good faith where there was

no requirement under the circumstances to second-guess the advice of a CPA).

      Sophistication and expertise of a taxpayer are important when it comes to

determining whether a taxpayer relied on a tax professional in good faith, or

simply attempted to purchase an expensive insurance policy for potential future

litigation. Petitioner had been involved in the power industry since 1913 and

described itself as “an electric utility company with experience in all phases of that

industry; from generation, transmission, and distribution to wholesale and retail

sales of power.” Although petitioner did not have experience with section 1031

transactions, it certainly had experience in operating power plants and must have

understood the concept of obsolescence.

      Petitioner indeed engaged many advisers to assist with the due diligence and

documenting the transactions at issue. Petitioner’s employees recognized that they

did not have expertise in like-kind exchanges and thus sought help from outside
                                       - 170 -

lawyers, accountants, and other consultants to guide them in the transactions.33

Petitioner formed an internal project team that was responsible for investigating

and evaluating the like-kind exchange opportunity. The team included high-level

employees with experience in tax, finance, and engineering. The team reported its

findings to petitioner’s board of directors, and the board approved the transactions.

Although the board did not have the benefit of reviewing the final versions of the

tax opinions, it did have a chance to ask questions of the Winston & Strawn team

as well as the PwC team.

      Petitioner’s employees and the board, however, had other considerations in

mind as well: They were under pressure to find a reasonable solution to the

problem of higher-than-anticipated revenue from the sale of its fossil fuel power

plants. The clock on the section 1031 transaction was ticking, and the amount at

stake--over $1.6 billion of potentially taxable sale proceeds--was too significant to

let the like-kind exchange plan fall apart. Our analysis of the test transactions

shows that petitioner knew or should have known that CPS and MEAG were

reasonably likely to exercise their respective cancellation/purchase options


      33
        In addition to Winston & Strawn, petitioner engaged PwC (financial and
accounting adviser), Arthur Andersen (accounting adviser), Sidley Austin
(regulatory counsel), Deloitte (valuation), Stone & Webster (engineering and
environmental adviser), Vinson & Elkins (Texas counsel), and Holland & Knight
(Georgia counsel).
                                       - 171 -

because they would not be able to return the Spruce, Scherer, and Wansley power

plants to petitioner without incurring significant expenses to meet the return

requirements.

      It is true that Winston & Strawn provided a very favorable tax opinion on

the test transactions, notwithstanding the obvious inconsistency of the return

provisions and the projected plant capacity factor at the end of the respective

subleases. Yet we are not persuaded that Winston & Strawn’s tax opinion can

serve as a shield for petitioner under the circumstances. We believe that petitioner

fully recognized that a plant with a capacity factor of 82%--the minimum rate at

which the Spruce station had to be running when returned by CPS upon expiration

of the sublease--would be worth significantly more than the same plant with a

capacity factor of 58%--the capacity factor used in the Deloitte appraisals.34

Petitioner, as a sophisticated power plant operator, must have appreciated that it

would be very expensive for CPS to sufficiently upgrade the plant to meet the

capacity requirements. Thus, petitioner must have understood that Winston &

Strawn’s tax opinions, based on the Deloitte appraisals, were flawed.

      This brings us to two conclusions: first, petitioner could not have relied on

the Winston & Strawn tax opinions in good faith because petitioner, with its

      34
        See supra note 29 for a fuller explanation of these numbers. The
difference in capacity factors for MEAG transactions was in the same range.
                                       - 172 -

expertise and sophistication, knew or should have known that the conclusions in

the tax opinions were inconsistent with the terms of the deal. Second, in the light

of the previous conclusion, petitioner’s alleged reliance on Winston & Strawn’s

tax advice fails the Neonatology test.35

      We note that petitioner expended significant resources on due diligence and

consulting fees related to the like-kind exchange and the test transactions.

However, we find troubling petitioner’s cavalier disregard of the risks connected

with the test transactions and the underlying facts. Mr. Berdelle, petitioner’s

controller and a senior employee with substantial discretionary and strategic

authority, testified that he had read the Winston & Strawn tax opinions and was

otherwise intimately involved in the decisionmaking process behind the proposed

transaction. In addition, Winston & Strawn had advised petitioner of certain tax

risks that could accompany the proposed transactions, and indeed petitioner

registered the test transactions as a confidential corporate tax shelter around the

same time it entered into the transactions.

      35
        Petitioner also alleges that it relied on its auditor, Arthur Andersen, to
raise red flags about the transactions. According to petitioner, Arthur Andersen
had no objections or challenges to petitioner’s reporting of the like-kind exchange.
Unlike petitioner, Arthur Andersen did not have the benefit of vast experience in
operating power plants and may have overlooked the issue of return conditions.
The record is also silent as to what documents related to the transactions were
actually reviewed by Arthur Andersen and to what extent. We are thus not
persuaded by petitioner’s argument.
                                       - 173 -

      It is true that Mr. Roling and other employees of petitioner besides Mr.

Berdelle had only cursorily read the opinion package prepared by Winston &

Strawn. This fact on its own might be sufficient to demonstrate a failure by

petitioner to exercise ordinary and reasonable care in entering into the transaction

and preparing the related tax returns. However, considering that petitioner (1) was

a sophisticated taxpayer, (2) claims to have read the Winston & Strawn tax

opinions in their entirety, (3) knew or should have known that Winston &

Strawn’s tax opinions based on the Deloitte appraisal reports were flawed, (4) was

apprised of the risk that the proposed transactions might be classified as corporate

tax shelters and registered them as such with the IRS around the same time it

entered into the test transactions, and (5) proceeded with the transactions anyway,

we find that petitioner disregarded the applicable rules and regulations. At a

minimum, petitioner carelessly disregarded the rules and regulations by failing to

“exercise reasonable diligence to determine the correctness of a return position.”

See sec. 1.6662-3(b)(2), Income Tax Regs. Moreover, petitioner’s use of Winston

& Strawn’s tax opinions--flawed as the opinions were because of Winston &

Strawn’s interference with the independence of the appraisal reports that

undergirded them--was misguided. We cannot condone the procuring of a tax

opinion as an insurance policy against penalties where the taxpayer knew or
                                       - 174 -

should have known that the opinion was flawed. A wink-and-a-smile is no

replacement for independence when it comes to professional tax opinions.

      We conclude that petitioner evinced disregard of rules and regulations

within the meaning of section 6662 with respect to ascertaining the tax

consequences of the test transactions. We further conclude that petitioner did not

have reasonable cause and act in good faith within the meaning of section 6664(c).

Accordingly, we uphold the accuracy-related penalties as determined by

respondent for tax years 1999 and 2001. Because we have sustained the accuracy-

related penalties on the ground of disregard of rules or regulations, we do not

address the parties’ arguments on a substantial understatement of income tax for

the 1999 tax year.

      C.     OID Income

      Petitioner argues that the OID income should not be a part of the penalties

calculation under section 6662 because there was no guidance at the time

petitioner filed its 1999 and 2001 returns that would suggest that the transactions

could be recharacterized as loans, and petitioner could not anticipate this

possibility. Petitioner also notes that respondent was inconsistent in his assertion

of OID income in previous LILO/SILO cases.
                                      - 175 -

      Section 6662(a) imposes an accuracy-related penalty applicable “to any

portion of an underpayment of tax required to be shown on a return”. Section

6664(a) defines an underpayment as “the amount by which any tax imposed by

this title exceeds the excess of--(1) the sum of--(A) the amount shown as the tax

by the taxpayer on his return, plus (B) amounts not so shown previously assessed

(or collected without assessment), over (2) the amount of rebates made.” Neither

section 6662 nor any other provision of the Code provides that an underpayment

should be reduced because a taxpayer did not anticipate that the Commissioner

would make a certain argument in litigating a tax case or because the

Commissioner was inconsistent in his prior litigation strategy. We therefore find

petitioner’s argument without merit. We hold that the OID income should be

included in the calculation of the underpayment subject to the section 6662

penalty for the 2001 tax year.

VIII. Conclusion

      We have considered all of the arguments that petitioner made, and to the

extent not discussed above, conclude that those arguments not discussed herein are

irrelevant, moot, or without merit. We have considered respondent’s arguments

only to the extent stated herein.
                            - 176 -

To reflect the foregoing,


                                           Decisions will be entered

                                      under Rule 155.
