Credit Implications of IRS Scrutiny of LILO/SILO Transactions and Proposed Accounting Guidance for U.S. Banks

Abstract

In recent years, the Internal Revenue Service (IRS) has challenged companies' ability to accelerate the timing of tax deductions related to certain leveraged lease transactions, commonly known as Lease-In/Lease-Out (LILO) and Sale-In/Lease-Out (SILO) transactions. LILOs/SILOs are lease arrangements that essentially transfer depreciation rights from a tax-exempt entity to a taxpaying corporation. Historically, companies have used the timing differences associated with claiming these accelerated tax deductions to reduce income tax payments to the IRS in the early years of the transactions. Companies have also benefited from the relatively high rates of return on these transactions in the initial years. Currently, a number of U.S. banks with exposure to LILOs have settled or are in the process of settling with the IRS. The LILO settlements have resulted in a substantial change in the timing of tax benefits over the terms of the affected leases and an assessment of interest and penalties. Moody's is unaware of any banks that have settled with the IRS regarding SILOs, as institutions believe that these transactions are supported by tax law. These events have contributed to the Financial Accounting Standards Board's (FASB) decision to propose new guidance addressing accounting for leveraged leases. The purpose of this special comment is to (1) provide an overview of a typical LILO/SILO transaction and the FASB proposals that would impact the accounting for these transactions, and (2) discuss the credit implications for U.S. banks. To date, LILO settlements between banks and the IRS have not led to negative rating actions. Moody's will evaluate the rating implications of future LILO and/or SILO settlements on a case-by-case basis by assessing the impact on a bank's profitability, capital, and liquidity. If a bank is not adequately reserved for interest and penalties, profitability and capital will be negatively impacted in the period of settlement, although Moody's would adjust profitability for this non-recurring expense. Moody's will also evaluate the impact of the settlement on a bank's liquidity position. Likewise, the impact of after-tax cumulative charges resulting from new accounting guidance (expected to be adopted in early 2006) will be assessed for the banks affected on an individual basis. Total lease income generated over the lives of the leases will remain unchanged. However, the charge recorded in the year of adoption will have a negative impact on net income and capital. Profitability and capital will be positively impacted in future years as the amount of the charge will be recognized as lease income over the remaining terms of the affected leases. In Moody's view, the new accounting guidance will capture the true economic reality of the lease transactions.