Lease Ruling Unlocks Troubles at KeyCorp

Company will raise $1.5b in capital and slash its dividend, while planning other reactions to a costly negative court decision.
Stephen TaubJune 12, 2008

KeyCorp said an unfavorable tax ruling is leading it to actions that include raising $1.5 billion in capital and halving its dividend. The goal is to preserve about $200 million of capital annually, the company noted in a regulatory filing.

The embattled financial institution also said it will record an after-tax accounting charge to earnings and capital in the second quarter of about $1.1 billion to $1.2 billion for certain leasing-related litigation and certain other leveraged lease transactions.

Late last month, KeyCorp disclosed that an adverse decision had been received in the so-called AWG Leasing litigation, and that management was reviewing its options for appeal, among other things. The transaction at the heart of the issue involved a cross-border leveraged lease transaction entered into by AWG Leasing Trust, in which KSP Investments, Inc., an affiliate of KeyCorp was a partner. KeyCorp had characterized the transaction as an acquisition, through a long-term head lease, of an industrial energy facility that was then leased back to the former owner.

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KeyCorp said that, as is typical with sale/leaseback transactions, it claimed depreciation deductions on its tax returns as the tax owner of the plant (through its interest in KSP) and also deductions on loans KSP used to finance the transaction. In its ruling, however, a court held that, among other things, KSP did not acquire tax ownership of the facility. Therefore, KeyCorp was not entitled to the depreciation deductions or deduction of transaction costs, and that interest on the debt was not deductible because the debt was not “genuine indebtedness.”

“KeyCorp disagrees with the court’s re-characterization of the transaction and will continue to evaluate whether it will appeal the decision to the U.S. Court of Appeals for the Sixth Circuit,” the company said in the latest filing. Meanwhile, it said it is required to recalculate its accounting recognition of lease income from the inception of the AWG Transaction and recognize a reduction in its net investment on its financial statements.

KeyCorp also stressed that while the judge’s opinion applies directly only to the AWG Leasing litigation, the decision may have implications for KeyCorp accounting treatment of certain other leveraged lease transactions within KeyBank’s portfolio of lease-in, lease-out leases, qualified technological equipment leases, and service contract leases.

As a result, under FASB Staff Position 13-2, Accounting for a Change or a Projected Change in the Timing of Cash Flows Relating to Income Taxes Generated by a Leveraged Lease Transaction, the firm has recalculated its recognition of lease income from inception for all of the leases in the affected categories and recognized a reduction in its net investment and a corresponding charge to capital and income for the remaining LILO, QTE and service cntract leses in its portfolio.

The financial firm said the total reduction in its net investment and the corresponding noncash aftertax charge to income and capital that KeyCorp expects to record in the second quarter for these leveraged lease transactions is about $625 million to $725 million. It also noted that management expects future earnings to increase over the remaining terms of the affected leases by about two-thirds of this amount. In addition, KeyCorp is recording a charge to income and capital for the after-tax interest cost equal to about $475 million on the contested tax liabilities.

KeyCorp said that it will record a higher tax provision in future periods for the on-going accrual of interest on the disputed tax balance, until the dispute is finally resolved.

“Management notes that, while it has recognized the effects of the adverse court decision for financial statement purposes, it continues to believe that the tax treatment it applied to its leveraged lease transactions complied with all applicable tax laws, regulations and judicial authorities in effect at the time, and management intends to continue to defend this position,” KeyCorp said.

The $1.5 billion of additional equity capital will come from offerings of common shares and perpetual convertible preferred stock. The offerings are not contingent upon each other. KeyCorp said that proceeds from the offerings are intended to restore capital to strengthen its balance sheet, and will be used for general corporate purposes.