The Tax Court held that the loan portion of a STARS transaction engaged in by Wells Fargo was not a sham; however, the court further found that the company was subject to negligence penalties on taxes attributable to foreign tax credits generated by the STARS transaction that were disallowed.
Background
In 2001, Barclays Bank PLC—a British financial services company—marketed a transaction to American bank Wells Fargo & Co. called Structured Trust Advantaged Repackaged Securities, or STARS, in which Barclays proposed to Wells Fargo that it partner with Barclays in a series of complicated transactions designed to exploit differences between the tax laws of the United States and of the United Kingdom. The transaction would include four key elements: (1) Wells Fargo would voluntarily subject some of its income-producing assets to U.K. taxation by placing them in a trust with a U.K. trustee; (2) Wells Fargo would offset those U.K. taxes by claiming foreign tax credits on its U.S. returns; (3) Barclays would enjoy significant U.K. tax benefits as a result of Wells Fargo's actions; and (4) Barclays would compensate Wells Fargo for engaging in the STARS transaction by making a monthly payment to Wells Fargo. Wells Fargo agreed to participate in the STARS transaction.
However, when Wells Fargo and other banks claimed foreign tax credits to offset their tax payments to the United Kingdom, the IRS upset the applecart by disallowing the credits on the grounds that the STARS transaction was a sham that lacked economic substance and that existed solely to generate tax benefits. After extensive preliminary legal wrangling, the case was tried in federal district court.
Sham-transaction determination: The jury found, as the IRS had argued, that the STARS transaction consisted of two independent transactions, a trust structure and a loan. The jury then considered whether each separate transaction was a sham, applying the test from Rice's Toyota World, Inc., 752 F.2d 89 (4th Cir. 1985). Under that test, a transaction is a sham that should be disregarded for tax purposes if (1) it has no real potential for profit apart from tax benefits (it lacks economic substance), and (2) it was not motivated by any economic purpose outside of tax considerations (it lacks a business purpose). The jury found that the trust structure had neither a nontax business purpose nor a reasonable possibility of pretax profit. Thus, the district court found that the trust structure was indisputably a sham.
However, the jury found that the loan had a reasonable possibility of pretax profit but that Wells Fargo entered into it solely for tax-related reasons. The Eighth Circuit (the appellate circuit where Wells Fargo's appeal would lie) has never addressed whether a transaction is a sham if the transaction meets only one of the elements of the sham-transaction test. Therefore, to determine whether the transaction was a sham based on the jury's findings, the district court was required to decide how the Eighth Circuit would resolve that question.
Negligence penalty: Also left to the district court was the issue of whether Wells Fargo was subject to a negligence penalty for the underpayments associated with the IRS's disallowance of its claimed foreign tax credits. Under Sec. 626(b)(1), a taxpayer is liable for a 20% penalty on any portion of an underpayment that is attributable to negligence.
Under Regs. Sec. 1.6662-3(b)(1), if a return position has a reasonable basis, as defined in Regs. Sec. 1.6662-3(b)(3), it is not attributable to negligence. Under Regs. Sec. 1.6662-3(b)(3), a return position will generally satisfy the reasonable-basis standard if it is reasonably based on one of the authorities set forth in Regs. Sec. 1.6662-4(d)(3)(iii).
To limit the scope of discovery in the case, Wells Fargo stipulated that it would limit the defenses it asserted to the negligence penalty. Based on these stipulations, Wells Fargo could not argue that it in fact exercised ordinary and reasonable care in preparing its tax return or that it in fact relied on any of the authorities referred to in Regs. Sec. 1.6662-3(b)(3). The IRS argued that the regulations required Wells Fargo to prove that it actually consulted these authorities in preparing its tax return to avoid the penalty, so Wells Fargo was liable for the penalty. Wells Fargo, on the other hand, argued Regs. Sec. 1.6662-3(b)(1) established the reasonable-basis standard as an objective legal defense to the negligence penalty, and it could avoid the penalty simply by showing that its return position had a reasonable basis under the authorities referred to in Regs. Sec. 1.6662-3(b)(3).
The court's decision
The district court, applying the sham-transaction test the way it believed the Eighth Circuit would, held that the loan was not a sham. It held that the negligence penalty applied, finding that Regs. Sec. 1.6662-3(b) was, as a whole, ambiguous on the point at issue and, consequently, it should follow the IRS's interpretation of the regulations because that interpretation was not plainly erroneous or inconsistent with the regulations.
Characterization of loan: The court first considered whether the Eighth Circuit would treat the objective and subjective components of the sham-transaction test as two factors in a single flexible analysis or as two separate, rigid tests. It concluded that the Eighth Circuit would adopt a flexible approach, based on the flexible approach's superiority for combating abusive tax planning, its consistency with the Supreme Court's opinion in Frank Lyon Co., 435 U.S. 561 (1978), its use by most courts in economic substance analysis, and its past use by the Eighth Circuit in applying the sham-transaction doctrine.
The court then analyzed the loan under the flexible approach. It agreed with the jury that the $1.25 billion loan was a real transaction that had substantial, non-tax-related economic effects on the parties. According to the court, that Wells Fargo would not have entered into the loan but for the opportunity to gain unrelated tax benefits did not change that fact. Furthermore, the court stated, although Wells Fargo's purpose in entering the loan was not to borrow money from Barclays but to disguise the sham nature of STARS, the loan was not economically integral to the trust structure and did not play a role in generating the abusive foreign tax credits. Thus, the loan was not a sham.
Negligence penalty: The court found that the ordinary meaning of the term "negligence" indicates that in determining whether to impose a negligence penalty, the focus will be on whether the taxpayer exercised due care, and the statutory definition of negligence and the case law involving the negligence penalty reflected this view. The court further found that while Regs. Sec. 1.6662-3(b)(1) was cast in objective terms that indicated consulting the authorities was not necessary to avoid the penalty, the language in Regs. Sec. 1.6662-3(b)(3) suggested the opposite. Thus, the court concluded that read as a whole, the reasonable-basis provision in Regs. Sec. 1.6662-3(b) was ambiguous on this point.
Citing several Supreme Court cases, the court determined that, because the regulation was ambiguous, the IRS's interpretation of the regulation was controlling, but that this rule would not apply if the Service's interpretation was plainly erroneous or inconsistent with the regulation. The court concluded that those exceptions did not apply, finding that the IRS's interpretation was "certainly a reasonable reading of the regulatory language" that reflected a focus on the taxpayer's conduct. It also stated that acceptance of the IRS interpretation was supported by the fact that there was no indication that the IRS had previously espoused a different interpretation of the regulation or that its current interpretation was an after-the-fact justification that it had taken in response to litigation.
Therefore, the court applied the IRS's interpretation. Because, under it, Wells Fargo was required to prove that it actually consulted the authorities referred to in Regs. Sec. 1.6662-3(b)(3) and, due to its stipulation, Wells Fargo had waived the right to argue that it had actually consulted those authorities, the court held that Wells Fargo was subject to the negligence penalty.
Reflections
The court here seems to be on relatively firm ground in its prediction that the Eighth Circuit would find that the loan portion of the STARS transaction was not a sham. Three other courts of appeal (the First, Second, and Federal circuits) that have considered materially identical STARS transactions involving other banks have come to the same conclusion. However, the Federal Circuit, in holding that the loan transaction was not a sham, overturned a decision of the Court of Federal Claims that the loan was a sham.
Wells Fargo & Company, No. 09-CV-2764 (D. Minn. 2017)
