Expert independence: Interfere at your own risk
rofessional standards require valuation experts to perform assignments with impartiality, objectivity and independence. The U.S. Tax Court’s opinion in Exelon Corp. v. Commissioner serves as a cautionary tale for attorneys who would seek to influence an expert’s conclusions. The court found that a law firm’s interference in the valuation process tainted the expert’s opinion and rendered it “useless.”
Section 1031 exchange strategy
In 1999, Exelon sold its fossil fuel power plants, generating $1.6 billion in taxable gain. To minimize the tax blow, the company employed a complex “likekind” exchange strategy. Under Internal Revenue Code Section 1031, taxpayers are allowed to defer gain by exchanging certain relinquished properties for one or more like-kind replacement properties.
Exelon used the proceeds from the sale of its fossil fuel plants to invest in several sale-leaseback transactions involving power plants owned by tax-exempt public utilities in different states. Exelon leased the power plants from these third parties for terms that exceeded the plants’ useful lives, and then subleased them back to the public utility companies (the sublessees). At the end of the subleases, the sublessees had cancellation/purchase options that allowed them to buy back their properties.
Treatment of these transactions as like-kind exchanges provided Exelon with significant tax benefits: In addition to deferral of its taxable gain, the taxpayer enjoyed various tax deductions as owner of the replacement properties.
Exelon retained a law firm to advise it on the legal aspects of the transactions and to provide opinions on the tax consequences. The taxpayer also hired a large national accounting firm to value the relinquished properties and potential replacement properties.
The lynchpin of Exelon’s tax strategy was the fair market value of the replacement properties at the end of the sublease term. If the replacement properties were worth less than the buyback price, the public utility companies wouldn’t be economically compelled to exercise their options. Thus, the transactions would qualify as equity investments rather than loans or other financial arrangements.
The IRS issued a notice of deficiency for nearly $437 million in income taxes plus 20% accuracy-related penalties totaling more than $87 million. The IRS argued that Exelon didn’t satisfy the requirements of Sec. 1031, because it failed to “acquire and retain significant and genuine attributes of a traditional owner, including the benefits and burdens of ownership, of the [replacement property].”
The Tax Court sided with the IRS, finding the transactions more akin to loans than equity investments. The court cited the testimony of an IRS expert who identified several flaws in Exelon’s valuations, including reliance on unreasonably high tax and discount rates. The expert estimated that the value of the plants at the end of the subleases would be substantially higher than the exercise price of the buyback option, making it “nearly certain” that the utility companies would exercise their options. As a result, Exelon’s investment lacked “an upside potential or significant downside risks.”
The court opinion emphasized that the law firm had undermined the reliability of Exelon’s expert opinions by interfering with the integrity and independence of the valuation process. The firm sent the accounting firm a letter listing “appraisal conclusions we anticipate will be necessary to support our tax opinion,” which appeared almost verbatim in the expert’s reports. And it provided “continuous and substantial feedback” on draft valuation reports.
The law firm didn’t explicitly direct the expert to arrive at a specific fair market value for each replacement property. But the accounting firm knew, from its valuations of the plants Exelon sold, how much gain Exelon sought to defer. The court also upheld the $87 million in accuracy-related penalties. Exelon asserted its reliance on professional tax advice as a defense, but the court found that reliance to be “misguided.” (See “Use of experts doesn’t safeguard against penalties” above.)
Handle with care
Exelon illustrates the importance of respecting the objectivity of valuation professionals. Even the perception that an expert’s independence has been compromised can be devastating to your case.