Wells Fargo & Co. v. United States

• Decision Date: 24 May 2017
• Docket Number: Case No. 09–CV–2764 (PJS/TNL)
• Citation: 260 F.Supp.3d 1140
• Court: U.S. District Court — District of Minnesota
• Parties: WELLS FARGO & COMPANY, on behalf of itself and the members of its affiliated group filing a consolidated return, Plaintiff, v. UNITED STATES of America, Defendant.

260 F.Supp.3d 1140

WELLS FARGO & COMPANY, on behalf of itself and the members of its affiliated group filing a consolidated return, Plaintiff,

v.UNITED STATES of America, Defendant.

Case No. 09–CV–2764 (PJS/TNL)

United States District Court, D. Minnesota.

Signed May 24, 2017

B. John Williams, Jr., Alan Swirski, and Nathan Wacker, SKADDEN, ARPS, SLATE, MEAGHER & FLOM LLP; Walter A. Pickhardt, Charles F. Webber, Deborah A. Ellingboe, and Blake J. Lindevig, FAEGRE BAKER DANIELS LLP; Jeffrey A. Sloan, WELLS FARGO & COMPANY, for plaintiff.

Dennis M. Donohue, William E. Farrior, Harris J. Phillips, and Vassiliki Economides, UNITED STATES DEPARTMENT OF JUSTICE, for defendant.

ORDER

Patrick J. Schiltz, United States District Judge

This long-running tax litigation arises out of an extraordinarily complex transaction that plaintiff Wells Fargo & Company ("Wells Fargo") engaged in with Barclays, a British financial-services company. The transaction—called "Structured Trust Advantaged Repackaged Securities" or "STARS"—included 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 STARS by making a monthly "Bx payment."

Wells Fargo claimed foreign-tax credits for the U.K. taxes that it paid in connection with STARS. The Internal Revenue Service ("IRS") disallowed the credits on the ground that STARS was a sham. Generally speaking, "a transaction will be characterized as a sham if ‘it is not motivated by any economic purpose outside of tax considerations’ (the business purpose test), and if it ‘is without economic substance because no real potential for profit exists’ (the economic substance test)." IES Indus., Inc. v. United States , 253 F.3d 350, 353 (8th Cir. 2001) (quoting Shriver v. Comm'r , 899 F.2d 724, 725–26 (8th Cir. 1990) ). The Eighth Circuit has yet to decide whether a transaction will be characterized as a sham if it fails only one of these two prongs—i.e., if the transaction does not have a business purpose but does have economic substance, or if the transaction does not have economic substance but does have a business purpose. WFC Holdings Corp. v. United States , 728 F.3d 736, 744 (8th Cir. 2013) ("this court has not yet adopted a particular approach to the sham transaction test").

This case was tried to a jury, which adopted the government's view that STARS consisted of two separate, independent transactions—a trust structure and a loan. ECF No. 630 at 1. As instructed, the jury then determined whether each transaction had a business purpose and economic substance. The jury found that the trust structure had neither a non-tax business purpose nor a reasonable possibility of pre-tax profit. ECF No. 630 at 2. There is no dispute, then, that under the jury's findings, the trust structure (which generated the disputed foreign-tax credits) was a sham.¹

The jury had a different view of the loan, however. The jury found that the loan had a reasonable possibility of pre-tax profit but that Wells Fargo entered into the loan solely for tax-related reasons. ECF No. 630 at 2. The jury's findings thus squarely present the question that the Eighth Circuit has avoided in the past: Will a transaction be disregarded as a sham if it had objective economic substance but the taxpayer lacked a subjective non-tax business purpose?

At the Court's request, the parties have briefed this difficult issue, as well as the equally difficult issue of whether Wells Fargo is subject to a negligence penalty under 26 U.S.C. § 6662(b)(1) in connection with its claim of foreign-tax credits. Having considered the parties' arguments, the Court finds that (1) the loan was not a sham and (2) Wells Fargo is subject to the negligence penalty.

A. The Loan

As noted, the jury adopted the government's view that STARS consisted of two independent transactions: a trust structure and a loan. The loan took the form of a $1.25 billion contribution by Barclays to the Wells Fargo trust; Wells Fargo was obligated to repay that contribution (with interest) after five years. The loan carried an above-market interest rate of LIBOR² plus 20 basis points.³ Wells Fargo seeks to deduct its interest payments under 26 U.S.C. § 163(a), which generally permits the deduction of "all interest paid or accrued within the taxable year on indebtedness." The government resists, arguing that, because the jury found that the loan lacked a non-tax business purpose, the loan is a sham that must be disregarded for tax purposes.

Three other cases involving materially identical STARS transactions have worked their way through the federal courts. See Santander Holdings USA, Inc. v. United States , 844 F.3d 15 (1st Cir. 2016), pet. for cert. filed , Mar. 20, 2017 (No. 16–1130); Bank of N.Y. Mellon Corp. v. Comm'r , 801 F.3d 104 (2d Cir. 2015), cert. denied , ––– U.S. ––––, 136 S.Ct. 1377, 194 L.Ed.2d 360 (2016) ; Salem Fin., Inc. v. United States , 786 F.3d 932 (Fed. Cir. 2015), cert. denied , ––– U.S. ––––, 136 S.Ct. 1366, 194 L.Ed.2d 359 (2016). In all three cases, the courts treated the loan as independent from the trust structure (as did the jury in this case⁴ ). Santander , 844 F.3d at 19 & n.4 (taxpayer conceded for purposes of summary judgment and appeal that loan and trust should be bifurcated); Bank of N.Y. Mellon , 801 F.3d at 121 (rejecting taxpayer's argument that the Tax Court erroneously bifurcated the transaction); Salem , 786 F.3d at 940 (for purposes of appeal, taxpayer did not contest lower court's holding that transaction should be bifurcated). And in all three cases, the courts found that the loan was not a sham. Santander , 844 F.3d at 19 & n.4 (government did not contest lower court's holding that loan was not a sham); Bank of N.Y. Mellon , 801 F.3d at 123–24 (rejecting government's argument that loan was a sham); Salem , 786 F.3d at 955–58 (same).

Notwithstanding the fact that all three courts of appeals to have considered its argument have rejected it, the government continues to insist that the loan is a sham and that Wells Fargo is not entitled to deduct its interest expenses. The government contends that, even if a transaction has objective economic substance, it must be treated as a sham unless the taxpayer actually had at least one subjective, non-tax business purpose. To resolve this issue, it is necessary to predict which approach to the sham-transaction doctrine the Eighth Circuit will choose to adopt.

Having considered the parties' arguments, the Court concludes that the Eighth Circuit is likely to treat the objective and subjective components of the sham-transaction test as two factors in a single flexible analysis rather than as two separate, rigid tests. After all, courts created the sham-transaction doctrine in recognition of the fact that taxpayers display endless ingenuity in exploiting the tax code, making it impossible for Congress to anticipate and prevent all abuse. A doctrine that is intended to counter the creative and ever-evolving abuse of the tax code must necessarily be flexible. Reducing the sham-transaction doctrine to two mechanical, all-or-nothing tests would deprive the doctrine of the flexibility needed to accomplish its purpose.⁵

A flexible approach also reflects the Supreme Court's often-quoted formulation of the sham-transaction doctrine in Frank Lyon Co. v. United States , 435 U.S. 561, 98 S.Ct. 1291, 55 L.Ed.2d 550 (1978) :

[W]here ... there is a genuine multiple-party transaction with economic substance which is compelled or encouraged by business or regulatory realities, is imbued with tax-independent considerations, and is not shaped solely by tax-avoidance features that have meaningless labels attached, the Government should honor the allocation of rights and duties effectuated by the parties.

Id. at 583–84, 98 S.Ct. 1291. This language reads more like a list of factors to weigh than a series of boxes to check. Moreover, although some courts read this language to require the taxpayer to have a subjective non-tax purpose, nothing in it refers to a taxpayer's actual subjective motivation; the language can just as easily be read to describe the objective features of the transaction as seen through the lens of what an objectively reasonable taxpayer's purpose would be.

Such a reading makes particular sense in light of the Supreme Court's frequent admonition that taxpayers are allowed to engage in tax planning. See Gregory v. Helvering , 293 U.S. 465, 469, 55 S.Ct. 266, 79 L.Ed. 596 (1935) ("The legal right of a taxpayer to decrease the amount of what otherwise would be his taxes, or altogether avoid them, by means which the law permits, cannot be doubted."). An ironclad requirement that a taxpayer subjectively harbor at least one non-tax reason for engaging in a transaction would make it harder for taxpayers to engage in legitimate tax planning. It would also lead to the absurd result of two identical transactions being treated differently for tax purposes based solely on the subjective motivations of the two taxpayers.

This is not to say that taxpayers' subjective motives are irrelevant. Contemporaneous evidence that a taxpayer was motivated solely by tax benefits reinforces other objective evidence that the transaction lacked a real potential for pre-tax profit or had any utility aside from tax avoidance. A flexible approach would allow a court to weigh such evidence without giving rise to absurd results.

A flexible approach also reflects how most courts analyze the economic substance of a transaction. It is true, as the government points out, that courts have articulated a variety of approaches, with some explicitly saying that "the absence of a nontax business purpose is fatal."...