The common thread of these tax shelter is captured in Michael Graetz's famous characterization of a tax shelter as: "a deal done by very smart people that, absent tax considerations, would be very stupid." That is not a complete definition -- it is more like Potter Stewart's famous quotation (presented here in full):
I shall not today attempt further to define the kinds of material I understand to be embraced within that shorthand description ["hard-core pornography"]; and perhaps I could never succeed in intelligibly doing so. But I know it when I see it, and the motion picture involved in this case is not that.Well, these courts knew abusive tax shelters when they saw them, as did the jury and judges in Altria.
So, let's pick off one of these, WFC Holdings Corporations v. United States, 2011 U.S. Dist. LEXIS 113382 (D. MI 2011), here. This case involved Wells Fargo, the banking corporation, a repeat offender
in the abusive tax shelter game. See my prior blog Court Finds Tax Motivated Transactions are Bullshit (1/11/10), here, discussing the trial level opinion in Wells Fargo & Company v. United States, 91 Fed. Cl. 35 (2010), affirmed 631 F.3d 1319 (Fed. Cir. 2011) (with the appellate court concluding: "We sustain the trial court's conclusion that the SILO transactions at issue in this case run afoul of the substance-over-form doctrine and therefore are abusive tax shelters.")
So, what was Wells Fargo trying to do here? Well, it bought into a concept tax shelter hawked by KPMG (itself a repeat offender). Well, guys, it is just a variation on the failed theme presented in Coltec Indus., Inc. v. United States, 454 F.3d 1340, 1348-52 (Fed. Cir. 2006) and Black & Decker Corp. v. United States, 436 F.3d 431, 438-40 (4th Cir. 2006). I won't get into the tax concepts Wells Fargo wanted to exploit, but Wells Fargo ultimately failed to breathe any economic sustance / business purpose into the transaction that the Court believe served a single purpose to artificially exploit the tax code to produce an artificial tax loss.
To be sure, the Court did find that Wells Fargo made pretextual claims -- that's sounds like fabricated -- of certain alleged business purposes designed to smoke the truth past the IRS and the courts. Here are some interesting snippets in this regard:
Context: A Klein / defraud conspiracy is a conspiracy to impair or impede the lawful functions of the IRS. One of the functions on audit is to determine the real motives of parties entering tax advantaged transactions and specifically determine whether there were any nontax motives for the transaction and their importance to the arrangements.
From WFC Opinion:
These internal dynamics strongly suggest that the LRT was a tax-driven transaction, designed and sold by an accounting firm and developed by WFC's tax department in conjunction with CPG, and that WFC took steps to make it appear that tax advantages did not drive the LRT.Context: Shell Petroleum did not a not dissimilar transaction in which tax consequences played a heavy role from the inception -- until VP Tax / General Tax Counsel presented it to the CEO and allegedly deliberately chose not to tell the CEO about the major tax consequences of the structure of the transaction. (The apparent thinking of the VP Tax / General Counsel was that, if I deliberately keep the client uninformed about the major reason for the structure of the transaction, he may approve it anyway only for the "business reasons" he was told about.) Blessing -- even apparently believing -- that notion, the friendly district court served up a victory for Shell Petroleum. Shell Petroleum Inc. v. United States, 2008 U.S. Dist. LEXIS 51180 (S.D. Tex. 2008). Wells Fargo attempted a similar gambit, feeling that if it worked with the district judge in Texas, it should work on a district judge in Minnesota.
From WFO Opinion, where the district court was more skeptical of such a claim (n. 6):
WFC points to the testimony of its CEO, Kovacevich, who stated that he approved the LRT based on Dana's presentation of the non-tax business purposes for the transaction, and that his decision excluded any consideration of tax advantages. Any CEO presented with KPMG's estimate of the prospective millions of dollars in savings associated with the transaction would likely have no reason to disapprove of it. Yet, as explained below, both KPMG's base case and calculation of lease improvements are dubious and the proffered non-tax justifications for the transaction appear pretextual upon closer inspection. Kovacevich's approval, based on faulty and misleading information, does not disrupt the Court's conclusion that, as a whole, the LRT had neither a non-tax business purpose nor economic substance.Note in this regard, the Court handed out the pretextual label to several of Wells Fargo's claims:
• The scope and breadth of WFC's ignoring the form of the LRT, however, is strong evidence that WFC's purported "good bank customers" purpose in executing the transaction was a pretextual justification for a tax shelter. [This is repeated both in the findings and in the opnion.]And in similar vein:
• Yet, as explained below, both KPMG'spretextual upon closer inspection. Kovacevich's approval, based on faulty and misleading information, does not disrupt the Court's conclusion that, as a whole, the LRT had neither a non-tax business purpose nor economic substance.
• The presence of Lehman and the sale of the Preferred Stock can only be justified by the "good bank customer" business purpose, which, as discussed below, the Court finds pretextual.
• A "roundabout means to arrive at . . . straightforward ends" can indicate that the taxpayer's true motive was tax advantages rather than the proffered business purpose. Schering-Plough Corp. v. United States, 651 F. Supp. 2d 219, 270 (D.N.J. 2009).
• [V]iewing the LRT as a whole, the Court concludes that WFC has failed to establish a legitimate business purpose for the transaction other than tax benefits. As in Haberman Farms, Inc. v. United States, 305 F.2d 787, 792 (8th Cir. 1962), in which the Eighth Circuit rejected as a sham a transaction involving a farming business' transfer of certain liabilities into a subsidiary, "an analysis of [WFC's] asserted reasons [for the LRT] in the light of the facts leaves [the Court] with the distinct impression that in actuality the reasons are thin and tenuous and that the only substantive one among them is the tax motivation."[I do note that it is unclear to me whether the "thin and tenuous" characterization of the claims is or is not the same as untruthful.]
And from the conclusion:
The stock sale did not, of course, generate an actual bona fide loss to WFC. The transferring banks did not actually lose $423 million by buying the Preferred Stock and then immediately selling it to Wells Fargo, which then sold it to Lehman a few months later. No rational company would do that. WFC was, substantively, not $423 million poorer after the stock sale. It had an allegedly $423 million liability (held by the transferring banks) before the LRT and an allegedly $423 liability (held by Charter) afterwards. As in Shoenberg, the taxpayer "suffered no real loss, but solely a paper one which could be shown only by considering one part of an entire plan and transaction. The entire plan was devised for the purpose of showing such loss." 77 F.2d at 449. "[T]he generated loss was designed to be entirely artificial." Sala, 613 F.3d at 1253. A loss "structured from the outset to be a complete fiction" is compelling evidence that the underlying transaction lacks economic substance. Id.Obviously, at the end of the day, the Court based its conclusions on a detailed analysis of the facts presented in the trial. But, also at the end of the day, the Court reached the same conclusion that Vincent ("Vinny") Laguardia Gambini intuited at the beginning of another noteworthy trial:
WFC concedes that "the precise form of the LRT may have been driven by tax considerations (as many business transactions are). . . ." (Pl.'s Post-Trial Brief at 59, Docket No. 181.) WFC essentially asks the Court to turn a blind eye to the dearth of economic substance in the stock issuance and sale. While urging the Court to view the transaction as a whole, it nonetheless argues that "a simple recognition transaction brought about by the subsequent sale of stock should [not] be scrutinized for business purpose as part of an economic substance analysis." (Id. at 71 (citing Cottage Sav. Ass'n v. C.I.R., 499 U.S. 554, 562 (1991).) Cottage Savings Association, however, does not stand for this proposition, nor does the long line of caselaw directing courts to view a challenged transaction as a whole. See, e.g., Long Term Capital, 330 F. Supp. 2d at 191-92. WFC's high basis in a transferred asset does not, on its own, produce a capital loss; rather, it must engage in both a realization event and a recognition event to claim a deduction. In this case, WFC could claim the tax benefit only when the Preferred Stock was sold to Lehman. The absence of economic substance of that crucial step of the LRT is therefore highly relevant.
Although the Court has reason to question the precise calculation of anticipated losses, generally the Court accepts that WFC had a substantial liability on its hands in the form of post-merger superfluous property and underwater leases. WFC has established the existence of large, bona fide prospective losses from the bank's master rent expenses over the projected sublease rental income. Yet WFC took deductions for the master lease payments both before and after the LRT; the transferring banks took the deductions prior to the LRT, and Charter has taken deductions since the LRT, all reflected in WFC's consolidated tax return. (Dx. 669 at 9.) Those deductions are actually sustained. Through the LRT, however, WFC is seeking a deduction for those same losses (an amount approximating the present value of master lease payments the company anticipated losing, and deducting, in the future). This amounts to an attempted double deduction for tax purposes (the capital loss on the stock sale in addition to the continuing rent expense deductions taken by Charter). The actual rent expense deductions taken by the transferring banks and now Charter are real losses appropriately deducted as they are incurred. The purported $423 million loss on the stock sale is fictitious.
Moreover, based on the record evidence, the Court cannot readily conclude that WFC had a reasonable expectation of profit absent tax considerations even excluding the purported $423 million capital loss from the pre-tax profit analysis. KPMG's estimates of the savings generated from the LRT are flawed for numerous reasons. No independent third party evaluated the selected leases prior to the LRT; rather, KPMG relied upon the information provided by Dana and CPG. KPMG, the same firm that designed and marketed the LRT as a tax shelter and was paid to implement the LRT, also performed the improvement calculations in what would appear to be a conflict of interest. See Canal Corp. v. C.I.R., 135 T.C. No. 9, 2010 WL 3064428, at *13 (2010) ("Courts have repeatedly held that it is unreasonable for a taxpayer to rely on a tax adviser actively involved in planning the transaction and tainted by an inherent conflict of interest."). Notably, no quantification of the savings was ordered or made before Vandermark's involvement. The base case was repeatedly tweaked in order to achieve a capital loss reserve of a certain amount, as exemplified in the case of Seattle Tower. Two leases "in the money," for example, were re-characterized as underwater after KPMG changed certain assumptions in the base case scenario. The base case included space already held by the bank which was subsequently leased back to the bank by Charter. It assumed zero retention of subtenants and an inability to market a sublease for lease tails, two assumptions undercut by CPG's actual experiences in managing its properties. While the Court agrees with WFC that it had underwater leases likely to produce losses, the quantification of those projected losses is unreliable.
As a result, and for additional independent reasons, KPMG's quantification of the projected savings from the LRT through the "what if" scenarios is also unreliable. Beyond questionable data manipulation in the base case scenario on which the improvement calculations are based, the "what if" scenarios' projected savings rely on highly speculative assumptions. One "what if" scenario assumed that since the Sacramento project's structure enabled the bank to beat market expectations, the LRT would likewise facilitate millions of dollars in savings for the leased properties. As discussed above, however, the LRT is easily distinguishable from the Sacramento project; in particular, the factors that generated savings with regard to that project were absent from the design and implementation of the LRT. Another "what if" scenario presumed savings from filling in otherwise unmarketable lease tails (due to the change in regulatory regime), but the improvement was assumed for all of the selected leases regardless of whether the bank actually considered them at risk of ORE designation. The "what if" scenario based on the avoidance of disadvantageous transactions with good bank customers, moreover, improbably assumed that all in place subtenants would agree to an immediate raising of their rents. As discussed above, the Court finds that WFC's actions are inconsistent with an actual plan to use the LRT to avoid deals with good bank customers, and the record does not reflect success in doing so. Based on the record evidence undercutting WFC's proffered "success stories" of the LRT, the Court simply cannot accept Gotthardt's conclusion that the LRT generated at least $26 million in savings for WFC.
The parties hotly dispute the value of the extension options at Garland. Notably, WFC did not attempt to quantify the fair market value of the lease extension and purchase options on Garland contemporaneously; WFC derived its value estimation from the opinion of its expert, hired in connection with this lawsuit. Also notable is the fact that the transferring banks received nothing from Charter in exchange for relinquishing the Garland options WFC now claims were worth $37 million in early 1999. Nonetheless, in the Court's view, WFC has established that the lease extension and purchase options on Garland did have some value in 1998, and that moving that particular property into a non-banking subsidiary outside the OCC's regulatory jurisdiction enhanced WFC's ability to maximize its profits from those options. The Court finds it unnecessary to determine the value of WFC's interest in Garland, however, because this fact alone cannot rescue the LRT from the inevitable conclusion that it was a tax shelter devoid of economic substance. The question before the Court is not whether WFC had a reasonable expectation of profitability in transferring Garland into a non-banking subsidiary. The question before the Court is whether the LRT -- a three-step process involving twenty-one properties, the issuance of Preferred Stock, the sale of such stock from the transferring banks to WFC and from WFC to Lehman -- had economic substance when viewed as a whole. The Court concludes it did not.
The Court cannot isolate one part, or even a few parts, of one step of a large, complex transaction and find that its profit potential imbues the entire transaction with substance which is otherwise lacking. WFC asserts that the government asks the Court to dissect the LRT and find it invalid if even one piece lacks economic substance or a non-tax business purpose. See Shell, 2008 WL 2714252, at *35 (rejecting as "'slicing and dicing'" the government's "challenge only an isolated component of the overall transaction"). To the contrary, by focusing on Garland's profitability and asking the Court to disregard the stock sale to Lehman as a mere inconsequential recognition event, it is WFC that seeks to isolate a kernel of prospective profitability to justify a large, multi-step, multi-property transaction. This the Court cannot do. WFC has not shown that the LRT, viewed as a whole, had economic substance or a real purpose other than tax avoidance.
Vinny Gambini: [opening statements] Uh... everything that guy just said is bullshit... Thank you.