Downey S&L Assoc v. Comdisco Inc ( 2006 )

In the
United States Court of Appeals
For the Seventh Circuit
____________
No. 05-1697
IN RE:
COMDISCO, INC.,
Debtor.
APPEAL OF:
DOWNEY SAVINGS AND LOAN ASSOCIATION, F.A.
____________
Appeal from the United States District Court
for the Northern District of Illinois, Eastern Division.
No. 04 C 6280—George W. Lindberg, Judge.
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ARGUED DECEMBER 5, 2005—DECIDED JANUARY 17, 2006
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Before POSNER, KANNE, and SYKES, Circuit Judges.
POSNER, Circuit Judge. Comdisco, now in bankruptcy, had
a contract with Downey, which Downey alleged Comdisco
had broken. After a trial, the bankruptcy judge decided
there had been no breach. The district court affirmed, and
Downey appeals. The issue is the interpretation of a sale
and leaseback arrangement intended by Downey to gener-
ate a considerable tax savings for it. Both the sale and the
lease specify that Illinois law is to govern any dispute
arising from the contracts.
2 No. 05-1697
Comdisco, a large dealer in IBM mainframe computers,
sold $46 million worth of these computers to Downey,
which in turn leased them back to Comdisco for five
years; Comdisco in turn subleased them to its customers.
Downey is not in the computer business—it is a savings and
loan association—but it happened to have large loss
carryforwards from which it sought to reap a cash benefit
by using them to offset taxable income. The problem was
that the loss carryforwards were about to expire. So the
parties arranged that simultaneously with the sale of the
computers to Downey and their lease back to Comdisco,
Comdisco would pay Downey a sum equal to the dis-
counted present value of the annual rentals specified in the
lease. This enabled Downey to report the entire amount as
taxable income in the year received but to use the loss
carryforwards to wipe out the tax due on the amount. There
was no net tax benefit—not yet, anyway—because the loss
carryforwards merely offset taxable income that Downey
would not have had but for the lease. But as the owner of
the computers Downey was entitled to depreciate them over
their useful life, and the depreciation expense thus calcu-
lated could be used to offset taxable income received by
Downey during that five-year period, thus generating a
net tax benefit. The loss carryforwards could not have been
applied directly to future income because they were about
to expire. The sale and leaseback enabled them to be used
indirectly to reduce future income tax.
However, for the sale and leaseback to accomplish this
“NOL soak-out” (that is, for it to soak up net operating
losses with taxable income so that the losses would generate
a tax benefit), the transaction had to have a business
rationale besides just beating taxes. A transaction that
would make no commercial sense were it not for the
opportunity to beat taxes would be deemed a sham by the
No. 05-1697 3
Internal Revenue Service. The general principle (“sub-
stance over form”) is illustrated by Gregory v. Helvering,
293 U.S. 465, 468-70 (1935), and Yosha v. Commissioner,
861 F.2d 494, 495-98 (7th Cir. 1988), and its application to
sale and leaseback arrangements by Frank Lyon Co. v. United
States, 435 U.S. 561, 583-84 (1978); Rice’s Toyota World, Inc. v.
Commissioner, 752 F.2d 89, 91-95 (4th Cir. 1985), and Mukerji
v. Commissioner, 87 T.C. 926, 957-62 (1986).
To avoid this fate, the transaction had, at a minimum,
to satisfy two conditions: Downey could not pay more
for the computers than their market price (this condition is
conceded to have been satisfied), and had to have a reason-
able prospect of obtaining a profit, over and above any tax
savings, from the deal. If the price it paid for the computers
was just equal to the present value of the lease and the
computers would have no value at the end of the five years,
when Downey would be free to sell them or release them,
there would be no profit for Downey and so the sale and
leaseback would be deemed a sham. The sum of the present
value of the lease and the present value of the reasonably
forecast residual value of the computers had to exceed the
price paid by Downey for the computers; otherwise Downey
had no expectation of making a profit.
It might seem that if Downey could expect to make a
profit from the transaction Comdisco would expect to incur
a loss and therefore the transaction must have been a
commercial chimera after all, regardless of residual value.
Not necessarily. Provided that the present value of the lease
(what Comdisco paid Downey) was less than the purchase
price (what Downey paid Comdisco), Comdisco would be
receiving a net cash payment; and in that event the sale and
leaseback arrangement might be defensible as a method of
financing, equivalent to a loan (specifically, as we are about
to explain, a nonrecourse loan) to the seller-lessee,
4 No. 05-1697
Comdisco. Public Hospital of Town of Salem v. Shalala 83 F.3d
175, 178 (7th Cir. 1996); In re Secured Equipment Trust of
Eastern Air Lines, Inc., 38 F.3d 86, 87 (2d Cir. 1994); In re
Dibert, Bancroft & Ross Co., 117 F.3d 160, 177 (5th Cir. 1997).
“Might,” not “would”; and recall our earlier qualification:
“at a minimum.” It is uncertain whether the transaction had
any purpose other than to create a tax saving for Downey
that it agreed to share with Comdisco to induce the latter to
participate. The transaction was the equivalent (for all but
tax purposes) of a nonrecourse loan, which is to say a loan
in which the lender can look only to the collateral (the
computers) for repayment; the borrower has no personal
obligation to repay. The loan here was, as we said, the
difference between the price that Downey paid for the
computers and the upfront lease payment by Comdisco. The
only way in which the sale contract and lease permitted
Downey to recover the loan at the end of the five-year lease
was by Downey’s selling (or conceivably re-leasing) the
computers at that time, when it would be free to do so. This
meant that the risk of fluctuations in the market value of the
computers was borne by Downey, even though Downey
was not in the computer business and Comdisco was.
Downey’s only motive for the transaction may have been to
save taxes, and Comdisco’s only motive to be paid a share
of the savings.
We cannot be certain of this; maybe Downey specializes in
making loans secured by computers and holds a diversified
portfolio of such loans that dampens the effect of fluctua-
tions in the market value of particular computers, cf. W. P.
Carey & Co. LLC, Hoover’s In-Depth Company Records (Dec.
21, 2005), though there is no suggestion of these things in
the record. As long as there was some nontax business
rationale for the transaction, the fact that tax considerations
figured prominently in the motivation for the transaction
No. 05-1697 5
would not be fatal. United Parcel Service of America, Inc. v.
Commissioner, 254 F.3d 1014, 1019-20 (11th Cir. 2001). At all
events, whether the Internal Revenue Service would have
questioned the transaction regardless of the residual value
of the computers the parties have not said and we do not
know. All that matters for this appeal is the Service’s
insistence that in an NOL soak-out the forecast of the
residual value of the leased equipment at the expiration of
the lease must not be unreasonably generous. Coleman v.
Commissioner, 16 F.3d 821, 824-25 (7th Cir. 1994); Gilman v.
Commissioner, 933 F.2d 143, 148-49 (2d Cir. 1991); Rice’s
Toyota World, Inc. v. Commissioner, supra, 752 F.2d at 92-93.
The Service is concerned with an inflated forecast because
the lower the residual value is expected to be, the likelier the
transaction is to be a sham. To illustrate, suppose the
purchase price in the sale part of the sale and leaseback
arrangement is 100 and the forecasted residual value
(discounted to present value) of the purchased property is
30. Then the present value of the lease would be 70, and it
would be easy to see how the sale and leaseback could
indeed be a method of financing the lessee, since he would
be receiving the purchase price of 100, immediately paying
70 back to the lessor, and thus retaining 30 to finance his
other operations. But suppose that the expected residual
value of the leased equipment is not 30 but 5, so that all the
lessee receives is a “loan” of 5. The suspicion of a sham
transaction is now strong; and in fact the IRS insists that, at
least for purposes of the taxpayer’s obtaining advance
clearance of the transaction, the forecasted residual value be
at least 20 percent of the purchase price. IRS Rev. Proc. 2001-
28 § 4.01(3).
Marshall & Stevens, a nationwide valuation firm, was
asked, probably by Comdisco although the bankruptcy
6 No. 05-1697
court made no finding, to forecast the residual value of the
computers that Comdisco was selling to Downey. M&S
forecast that the computers would be worth $9 million upon
the expiration of the lease—a shade under the IRS’s 20
percent benchmark but close enough to make a challenge by
the Service unlikely on the basis of the benchmark (for
remember that it’s what the taxpayer must show to get
advance clearance), provided that the forecast was reason-
able. So the deal closed.
That was in 1990. In 1995 the lease expired and Downey
was revested with the computers. Their market value, it
turned out, was so much lower than $9 million—it was a
paltry $200,000—that the IRS became suspicious. Eventually
it determined that the sale and leaseback transaction had
been largely though not entirely a sham, and denied about
half of the tax benefit that Downey had sought, and as a
result Downey owed $7.8 million in additional taxes.
Downey does not deny that it owes the additional taxes,
but it says that the fault is Comdisco’s and so Comdisco
should reimburse it for them. Downey owes the additional
taxes not because the market value of the computers in 1995
was much less than the 1990 forecast by M&S but because
the IRS concluded that that forecast had been irresponsible.
Downey argues that the sale and lease contracts made
Comdisco responsible for the appraiser’s negligence in
preparing an appraisal that the IRS would not accept. Yet
Downey has not sued M&S, even though Comdisco is in
bankruptcy and the appraisal firm is not. It is true that the
firm had no direct contractual relation with Downey and
that its appraisal report disclaims any warranty of its
forecast. But Downey might have been expected to depict
itself as a third-party beneficiary of the contract between
Comdisco and M&S, assuming that, as Downey contends,
No. 05-1697 7
Comdisco had retained the latter to prepare the appraisal,
or to argue that M&S had a tort duty of care toward
Downey because it knew that Downey would rely on the
report. And while M&S disclaimed any warranty of the
value estimated in its report, it did not disclaim a duty of
due care in arriving at the estimation. However, for what-
ever reason, Downey is seeking relief only against
Comdisco, and we express no view on whether it might
have had a good claim against the appraiser.
Downey relies on a provision of the lease which states that
“the inaccuracy in any material respect of any representa-
tion or warranty made by [Comdisco] herein [i.e., in the
lease] or in the Equipment Purchase Agreement [the sale
part of the sale and leaseback arrangement] or any docu-
ment or certificate furnished by [Comdisco] in connection
herewith or therewith” is a breach. We assume that M&S’s
appraisal report was among the documents furnished by
Comdisco to Downey. But that document does not contain
any representation or warranty made by Comdisco. Indeed,
for Comdisco to have inserted its own representations into
the report would have endangered the tax-shelter aspect of
the transaction; the IRS is more likely to accept a residual
valuation done by an independent appraiser than one done
by the tax-shelter promoter himself. See Casebeer v. Commis-
sioner, 909 F.2d 1360, 1364 (9th Cir. 1990); Estate of True v.
Commissioner, 390 F.3d 1210, 1221-22 (10th Cir. 2004);
Pearlstein v. Commissioner, T.C. Memo. 1989-621 (1989).
Contractual language can be bent when necessary to avoid
absurd or even just commercially unreasonable results.
Beanstalk Group, Inc. v. AM General Corp., 283 F.3d 856, 860
(7th Cir. 2002); Merheb v. Illinois State Toll Highway Authority,
267 F.3d 710, 713 (7th Cir. 2001); Health Professionals, Ltd. v.
Johnson, 791 N.E.2d 1179, 1193 (Ill. App. 2003). But the literal
8 No. 05-1697
reading happens in this case to be the reasonable one. Given
the difficulty of forecasting the value of a computer five
years in the future, a tax-shelter promoter (which seems a
reasonable characterization of Comdisco’s role in the
transaction) would be reluctant to assume responsibility for
an error by an independent appraiser. Of course Downey is
asking only that Comdisco be held legally responsible for a
negligent error—not that it be held liable for a forecast that
just happens to turn out to be erroneous. But were this the
rule it would require Comdisco, for reasons of self-pro-
tection, to involve itself in the appraisal—to look over
M&S’s shoulder in order to make sure that the appraiser
was using methods that would not get Comdisco into
trouble—and this second-guessing would compromise
the appraiser’s independence and thus endanger the tax
objective of the sale and leaseback. It would also expose the
tax-shelter promoter to a high probability of being sued,
as the disappointed taxpayer would look for every pos-
sible ground on which to shift its loss of anticipated tax
benefits to the promoter.
Not only was the case correctly resolved; it should
not even have been tried. In general, as we noted in Bank
of America, N.A. v. Moglia, 330 F.3d 942, 946 (7th Cir. 2003)
(Illinois law), issues of interpretation in contract cases
should be resolved on the basis of the contract’s language in
order to minimize the costs and uncertainties of enforcing
contracts. Only if the language is unclear and cannot
be disambiguated without reference to facts that can be
determined only by means of a trial, or if there is some
compelling reason to think that the language though clear is
so only because critical contextual factors have
been ignored, is there any reason to burden the parties
with a trial on the meaning of the contract. Neither con-
dition was satisfied here. The contract does not purport
No. 05-1697 9
to make Comdisco responsible for errors negligent or
otherwise by the appraiser, and there is nothing in the
surrounding circumstances to suggest that such a term
should be interpolated in order to avoid an interpretation
that would make no commercial sense.
AFFIRMED.
A true Copy:
Teste:
_____________________________
Clerk of the United States Court of
Appeals for the Seventh Circuit
USCA-02-C-0072—1-17-06