Court: District Court, D. Minnesota; May 24, 2017; Federal District Court
The tax litigation involving Wells Fargo and Barclays centers on the 'Structured Trust Advantaged Repackaged Securities' (STARS) transaction, which comprised four elements: Wells Fargo subjected its income-producing assets to U.K. taxation via a U.K. trust; it claimed foreign-tax credits on its U.S. returns to offset these taxes; Barclays received significant U.K. tax benefits from this arrangement; and Barclays compensated Wells Fargo with monthly payments. The IRS disallowed Wells Fargo's foreign-tax credits, deeming STARS a sham, which is defined by the absence of economic purpose (business purpose test) or economic substance (economic substance test). The Eighth Circuit has not clarified if a transaction can be a sham if it meets one prong but fails the other.
A jury trial concluded that the STARS trust structure did not have a non-tax business purpose or potential for profit, thus it was classified as a sham. Contrarily, the jury found that the loan aspect of STARS had potential for profit but was solely motivated by tax considerations. This raises the question of whether a transaction can be disregarded as a sham if it possesses objective economic substance but lacks a subjective non-tax business purpose. Following arguments from both parties, the Court determined that the loan was not a sham and that Wells Fargo is liable for a negligence penalty related to its foreign-tax credit claims.
The jury determined that the STARS transaction involved two separate components: a trust structure and a loan. The loan, a $1.25 billion contribution from Barclays to the Wells Fargo trust, required repayment with interest after five years, with an interest rate of LIBOR plus 20 basis points. Wells Fargo aims to deduct its interest payments under 26 U.S.C. § 163(a), which allows for deductions on interest paid or accrued within the taxable year. The government disputes this, arguing that the jury found the loan lacked a non-tax business purpose, rendering it a sham for tax purposes.
Three similar cases—Santander Holdings USA, Inc. v. United States, Bank of N.Y. Mellon Corp. v. Comm’r, and Salem Fin. Inc. v. United States—have concluded that the loan was independent of the trust and not a sham. Despite these precedents, the government maintains that a transaction must also reflect a subjective non-tax business purpose to avoid being classified as a sham. The court anticipates that the Eighth Circuit will likely adopt a flexible approach, treating the objective and subjective elements of the sham-transaction doctrine as interrelated factors rather than rigid tests, recognizing the need for adaptability in countering tax code exploitation.
A flexible approach to the sham-transaction doctrine, as articulated in Frank Lyon Co. v. United States, emphasizes the importance of recognizing genuine multi-party transactions with economic substance, especially when influenced by business or regulatory realities and not solely by tax avoidance motives. This doctrine suggests that the government should respect the rights and obligations established by the parties unless the transaction is devoid of real economic substance, as indicated by the absence of meaningful pre-tax profit or utility outside of tax benefits.
The excerpt argues against a strict requirement for taxpayers to demonstrate a subjective non-tax motive, asserting that such a standard could inhibit legitimate tax planning and lead to inconsistent tax treatment of identical transactions based on differing taxpayer motivations. While subjective motives can be relevant, they should not solely dictate the assessment of the transaction's legitimacy. Courts generally consider objective factors and recognize that a bona fide business purpose can exist even when the primary motive is tax-related, as highlighted by the rulings in ASA Investerings and United Parcel Service cases. Ultimately, the text advocates for a balanced evaluation of both subjective and objective elements to ensure fair treatment in tax planning contexts.
Some courts have suggested that a lack of business purpose can invalidate a transaction; however, case outcomes indicate that this assertion is often dicta or that subjective motives lose significance when a transaction has substantial objective economic substance. In the STARS case (Salem Financial), the Federal Circuit overturned a lower court's ruling that labeled the STARS loan as a sham, despite a finding that tax avoidance was the sole motivation for the loan. The Federal Circuit emphasized the objective economic substance of the loan over the taxpayer's subjective motives. Other courts have similarly upheld transactions with tax motivations based on their objective economic substance, indicating a discrepancy between judicial statements and actual rulings. The Eighth Circuit's application of the sham-transaction doctrine focuses not only on the presence of non-tax-related profit but also on the magnitude of such profit, asserting that modest profits relative to substantial tax benefits do not confer economic substance. The Court adopts a flexible approach, determining that the loan in question was not a sham and that Wells Fargo is entitled to deduct its interest expenses. The jury concluded that the $1.25 billion loan had significant economic effects unrelated to taxes, and while Wells Fargo's motivation was tied to tax benefits, this did not negate the loan's objective economic substance. The loan was not integral to the trust structure or the generation of foreign-tax credits.
Petitioner did not utilize loan proceeds to fund or support the STARS structure, which was unnecessary for generating the contested foreign tax credits. Instead, the loan facilitated the petitioner’s banking operations during the STARS transaction, indicating its role extended beyond merely generating tax benefits. The Tax Court's findings regarding STARS in the Bank of New York Mellon case apply similarly here. The government, having successfully argued for separate analysis of the legitimate loan from the allegedly sham trust, must recognize the loan's actual economic substance.
The parties also dispute whether Wells Fargo faces a negligence penalty under 26 U.S.C. § 6662(b)(1) due to underpayments linked to the IRS's disallowance of foreign tax credits. This statute imposes a 20% penalty for underpayments attributed to negligence, defined as a failure to make a reasonable attempt to comply with tax provisions. Relevant Treasury regulations specify that a return position with a reasonable basis is not deemed negligent.
Wells Fargo has limited its defenses to two points: (1) asserting that STARS was not a sham, thus negating liability, and (2) if STARS is deemed a sham, claiming an objectively reasonable basis for its tax return position based on the authorities referenced in the regulations. Notably, Wells Fargo has agreed not to argue that it exercised ordinary care in preparing its tax return or relied on those authorities when asserting its defenses. This stipulation raises a legal question about whether Wells Fargo must demonstrate that its return position was based on the referenced authorities or prove that it consulted those authorities during the return preparation.
Wells Fargo is required to demonstrate that it consulted the authorities it claims provided a reasonable basis for its tax return position. The government seeks a negligence penalty, which focuses on whether the taxpayer exercised due care, as defined under 26 U.S.C. § 6662(c). Case law indicates that the burden lies with the taxpayer to prove they did not fail to exercise due care. Wells Fargo argues that Treasury regulations offer an objective legal defense to the negligence penalty, stating that a return position with a reasonable basis is not negligent. However, the relevant regulations are ambiguous regarding whether actual reliance on the cited authorities is necessary. The reasonable-basis standard, while generally satisfied by consulting a set of authorities, implies that actual consultation is necessary for a taxpayer to base their return position on those authorities. The regulation on 'substantial authority' is explicitly objective, contrasting the ambiguous language found in the reasonable-basis regulation. Due to this ambiguity, the Department's interpretation of its own regulation is controlling, as clarified by Auer v. Robbins, which applies when regulatory language is not clear.
The Supreme Court case Kennedy v. Plan Adm’r for DuPont Sav. Inv. Plan confirms deference to the Treasury Department’s interpretation of Treas. Reg. 1.401(a)-13(c)(1)(ii), with exceptions only for interpretations that are plainly erroneous or inconsistent, or when there are concerns about the agency's judgment. In this instance, the Department's interpretation is deemed reasonable, reflecting the negligence penalty’s emphasis on a taxpayer's actual conduct rather than merely the abstract return position. The agency's interpretation does not need to be the sole or best reading of the regulation to be upheld. Furthermore, the Department has consistently maintained its stance against ranking the 'reasonable basis' standard, emphasizing that the reasonable-basis defense focuses on the taxpayer’s conduct in determining tax liability.
Wells Fargo's argument highlights the overlap between the reasonable-basis defense against the negligence penalty and the good-faith defense under 26 U.S.C. 6664(c)(1). While both defenses consider the nature and reasonableness of taxpayer conduct, they are not identical; the reasonable-basis defense is more limited in application compared to the broader good-faith defense available for various penalties under 26 U.S.C. 6662 and 6663. Additionally, the reasonable-basis standard is stricter than the reasonable-cause standard, which can provide relief from negligence penalties even if the taxpayer's return position does not meet the reasonable basis requirement.
Wells Fargo must demonstrate actual reliance on the authorities for its reasonable-basis defense, which it has waived, thus precluding the establishment of this defense and resulting in a negligence penalty. The Court orders that: (1) the Plaintiff may deduct interest expenses related to the STARS transaction loan under 26 U.S.C. 163(a), and (2) the Plaintiff incurs a negligence penalty for underpayments associated with foreign-tax credits under 26 U.S.C. 6662(b)(1). The parties are instructed to propose a judgment reflecting these rulings by June 30, 2017. The jury's determination that the Bx payment constitutes a tax benefit rather than pre-tax revenue aligns with the Court's view, affirming that the Bx payment merely facilitates the distribution of tax benefits from the STARS transaction. The Court notes that the STARS transaction was structured to offset LIBOR with the Bx payment, but since the jury found the trust structure and loan are distinct, the Bx payment does not affect the interest claim on tax returns. The Court commends the jury for their diligence in handling complex evidence, and acknowledges that Congress later codified the conjunctive approach requiring both economic substance and non-tax business purpose in transactions, but emphasizes that the relevance of the economic substance doctrine is determined as if this statute had not been enacted. Agency interpretations of regulations may warrant deference even if presented in legal briefs.
