38 3 Reduction of External Funding Needs
Lease In/Lease Out. There are even other forms of leasing transactions that re-
semble sale and lease-back. Lease In/Lease Out (LILO) transactions and the re-
lated Sale In/Lease Out (SILO) transactions are examples of tax-driven cross-
border leasing. They also provide a good example of the high legal risks inherent
in tax-driven long-term cross-border transactions.
LILO transactions are transactions in which a financial institution purports to
lease property and then purports to immediately sublease it back to the lessor.
Such lease arrangements are meaningful for the financial institution for example
where they transfer depreciation rights from a tax-exempt entity to a taxpaying en-
tity.^67
LILO transactions were used by more than 150 German municipalities that sold
facilities to US banks between 1996 and 2003.^68 One of those municipalities was
the city of Bochum. The city of Bochum handed over its sewerage system to a US
investor for 99 years in exchange for a payment of €500 million made by way of a
trust. It then leased back the network through a bank in return for a payment of
only €480 million, thereby making an instant profit of €20 million. What the US
investor got out of the arrangement was the opportunity under US law to set for-
eign investments against tax. This was because the leased assets were regarded as
assets belonging to the US investor under US tax law (although they belonged to
the city of Bochum under German law).
Such LILO transactions attracted plenty of negative publicity in Germany be-
cause of several legal and commercial risks caused by the long lease period. Be-
cause of US tax law, the bank required a covenant according to which the munici-
pality must keep open facilities that have been leased in and leased out and to keep
them in good repair. This was likely to increase costs for the municipality. In addi-
tion, the municipality might not even need those facilities in the future and would
prefer them to be closed down. In many cases, the municipality was responsible
for an adverse change risk. This was likely to increase costs even further due to
the long lease period. There was also a high change of law risk.
In the US, new cross-border LILO contracts were probihited under the Ameri-
can Jobs Creation Act of 2004. Since 2005, the IRS has regarded even earlier
cross-border LILO transactions as abusive, which has ruled out the tax benefits
that were the basis of existing transactions.
(^67) See, for example, Yip S, Credit Implications of IRS Scrutiny of LILO/SILO Transac-
tions and Proposed Accounting Guidance for U.S. Banks (February 2006). Available at
SSRN. For a description of a typical LILO transaction, see Thomas J (Yale University,
School of Management), The tax benefits of Lease-in Lease-out (LILO) transactions.
See also Frick J, op cit, pp 245–246.
(^68) Aus für Sparmodell, FAZ, 20 October 2004.