Wells Fargo Wins Some, Loses Most in its Iteration of the Stars Bullshit Tax Shelter (5/28/17)

In Wells Fargo & Company v. United States, 2017 U.S. Dist. LEXIS 80401 (D MN 2017), here, the court held that yet a tax shelter -- the Stars variety often discussed on this blog --  was, well, bullshit.  Actually, the jury had previously held that the transaction was sham (a politically correct euphemism for the concept embodied in the concept of bullshit as I and Vinny use it (for Vinny's iteration, see here)).  In short, Wells Fargo reached for the Stars, but its reach exceeded its grasp (well, it got the Stars, it just did not get the  principal tax benefit).  Its loss of the principal substantive tax benefit is not particularly exceptional (the appellate courts addressing the gambit had denied the principal benefit, but even without the benefit of those decisions, a taxpayer considering the shelter should have known it was bullshit, which raises the penalty issue also resolved in the case, which, to me, is the more important issue.

The decision gives Wells Fargo, part of the loaf, although not nearly half, on the substantive tax benefits claimed from the overall transaction.  How so?  The credit gambit in the overall transaction was done via a trust that the jury declared sham.  So, Wells Fargo  lost that part of the transaction (although I suspect it will renew the almost inevitable quixotic appeal).  The part it won was the interest deduction part.  The Court found that there was a real loan transaction with economic substance.  This was consistent with the jury's partial verdict and consistent with the holdings in the other courts of appeals' cases.  In this regard, the Court complimented the jury as follows (fn 4):

   n4 The Court pauses to note that a jury of laypersons resolved this case in a manner that parallels the decisions of three separate federal appellate panels in similar cases—a credit to how seriously the jurors took their responsibilities and how hard they worked to understand the extremely complicated evidence.

As an aside, that has been my experience with juries -- both as an advocate and as a juror.  They don't necessarily always reach the right result, but they do always work very hard  and most of the time get the right -- or at least a fair -- result.

The Court then moved to the issue:

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. n5
   n5 The Court acknowledges that, after Wells Fargo's STARS transaction concluded, Congress codified what the government calls the "conjunctive" approach—that is, a requirement that a transaction have both objective economic substance and a subjective non-tax business purpose. See 26 U.S.C. § 7701(o)(1). Importantly, however, the statute states that it applies "[i]n the case of any transaction to which the economic substance doctrine is relevant," and goes on to say that "[t]he determination of whether the economic substance doctrine is relevant to a transaction shall be made in the same manner as if this subsection had never been enacted." 26 U.S.C. § 7701(o)(1), (o)(5)(C). This suggests some flexibility in determining a threshold requirement of relevance before applying the doctrine.

* * * * 

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. 

* * * * 

The Court therefore adopts a flexible approach. Applying this approach, the Court holds that the loan was not a sham and that Wells Fargo is entitled to deduct its interest expenses. As the jury found, the $1.25 billion loan was a real transaction that had substantial, non-tax-related economic effects on the parties. The fact that Wells Fargo would not have entered into the loan but for the opportunity to gain unrelated tax benefits does not change that fact. And 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. As the Tax Court in Bank of New York Mellon observed: 

Petitioner did not use the loan proceeds to finance, secure or carry out the STARS structure. The loan was not necessary for the STARS structure to produce the disallowed foreign tax credits. Rather, the loan proceeds were available for petitioner to use in its banking business throughout the STARS transaction. Accordingly, the loan served a purpose beyond the creation of tax benefits . . . . 

Bank of N.Y. Mellon Corp. v. Comm'r, T.C. Memo 2013-225, 106 T.C.M. (CCH) 367, 2013 WL 5311057 at *4 (2013), aff'd, 801 F.3d 104 (2d Cir. 2015). All of what the Tax Court said about STARS in Bank of N.Y. Mellon is true about STARS in this case. Having successfully persuaded the jury (and the Court) that the (real) loan should be analyzed separately from the (sham) trust, the government is now obligated to honor the loan's actual economic substance. See ACM P'ship, 157 F.3d at 262 (refusing to "disregard actual, objective economic losses merely because they are incidental to a broader series [*13]  of transactions that are found to constitute an economic sham whose principal tax benefits must be denied").

Now, moving to the penalty on the tax from the part of the case it lost, the Court held that the taxpayer was subject to the negligence penalty.  To me, this was the more interesting part of the case.  Wells Fargo argued that it should not be subject to the 20% negligence penalty under § 6662, here, because it had a "reasonable basis" to claim the sham / bullshit tax credits.  See § 6662(a), (b)(1) and (c),.  The Court noted particularly that "The statute defines "negligence" to "include[] any failure to make a reasonable attempt to comply with the provisions of this title . . . ." 26 U.S.C. § 6662(c)."

For complicated shelters that can pass even a preliminary smell test, the taxpayer will often claim that its position was not negligent and, in any event, will fall back on a claim that of reasonable cause by exercising ordinary care and diligence, including reasonable reliance on a tax professional.  § 6664(c), here.  But, that defense puts at issue what, if anything the taxpayer did and what advice, if any, the taxpayer received.  This is often a killer for taxpayers whose internal and external communications as the deal was cooking may be a problem.  Apparently that was a problem for Wells Fargo, so it entered stipulations practically conceding that it made no claim that it had exercised reasonable diligence.  Here is was the court said:

In order to limit the scope of discovery, Wells Fargo stipulated that it would assert only two defenses to the government's negligence-penalty claim: (1) that STARS was not a sham and therefore Wells Fargo is not liable at all, and (2) that, even if STARS was a sham, there was an objectively reasonable basis for Wells Fargo's return position under the authorities referenced in § 1.6662-3(b)(3). ECF No. 94 ¶ 2. Wells Fargo further agreed that, in arguing against imposition of the negligence penalty, Wells Fargo would not make "[a]ny contention that relies upon Wells Fargo's efforts to exercise ordinary and reasonable care in the preparation of its tax return, or Wells Fargo's efforts to determine its proper tax liability under the internal revenue laws arising out of the STARS Transaction, to establish reasonable basis[.]" ECF No. 94 ¶ 3(a). In other words, Wells Fargo cannot argue that it in fact exercised ordinary and reasonable care in preparing its tax return, nor can it argue that it in fact relied on any of the authorities referenced in § 1.6662-3(b)(3) [here]. 

The parties' stipulation thus gives rise to a legal question: Is it enough for Wells Fargo to show that its return position had a reasonable basis under the authorities referenced in § 1.6662-3(b)(3)? Or must Wells Fargo prove that it actually consulted those authorities in preparing its tax return? Having carefully considered the parties' arguments, the Court concludes that Wells Fargo must prove that it actually consulted the authorities that purportedly provided a reasonable basis for the position taken in its return.

That sets it up nicely and states the Court's conclusion:  Wells Fargo's position is rejected, thus subjecting Wells Fargo to the negligence penalty.  I offer the balance of the Court's reasoning because it invokes Chevron / Auer deference and, is so well written:

As the government emphasizes, the penalty that it seeks to impose is a negligence penalty. The ordinary meaning of that term indicates that the focus of the inquiry will be on whether the taxpayer exercised due care. The statutory definition of "negligence" comports with this view. See 26 U.S.C. § 6662(c) (stating that "the term 'negligence' includes any failure to make a reasonable attempt to comply with the provisions of this title"). Case law likewise confirms that, in determining whether the negligence penalty applies, the focus is on the taxpayer's conduct. See Chakales v. Comm'r, 79 F.3d 726, 729 (8th Cir. 1996) ("the burden is on the taxpayer to prove that he did not fail to exercise due care or do what a reasonable and prudent person would do under similar circumstances"); Goldman v. Comm'r, 39 F.3d 402, 407 (2d Cir. 1994) (negligence requires a finding of a "lack of due care or the failure to do what a reasonable and prudent person would do under similar circumstances" citation and quotations omitted)); Pasternak v. Comm'r, 990 F.2d 893, 902 (6th Cir. 1993) (same); Zmuda v. Comm'r, 731 F.2d 1417, 1422-23 (9th Cir. 1984) (affirming a negligence penalty where the taxpayers "made no reasonable inquiry as to the legality of their plans"). 

Wells Fargo nevertheless contends that the Treasury regulation establishes the reasonable-basis standard as a purely objective legal defense to the negligence penalty. It is true that the language on which Wells Fargo relies is cast in objective terms: "A return position that has a reasonable basis as defined in paragraph (b)(3) of this section is not attributable to negligence." Treas. Reg. § 1.6662-3(b)(1). Read as a whole, however, the regulation is ambiguous concerning whether a taxpayer must have actually relied on the authorities referenced in paragraph (b)(3). 

Paragraph (b)(3) provides that the reasonable-basis standard is generally satisfied "[i]f a return position is reasonably based on one or more" of a set of authorities. Treas. Reg. § 1.6662-3(b)(3). This language suggests that the taxpayer must have actually consulted those authorities. It is the taxpayer who adopts a "return position" by determining its tax liability. See Treas. Reg. § 301.6114-1(a)(2)(i). A "return position" is, in essence, an opinion regarding what obligations the law imposes on the taxpayer. It is difficult to know how a taxpayer could "base" a return position on a set of authorities without actually consulting those authorities, just as it is difficult to know how someone could "base" an opinion about the best restaurant in town on Zagat ratings without actually consulting any Zagat ratings. It is also worth noting that Treas. Reg. § 1.6662-4(d)(2), which defines the "substantial authority" standard, explicitly states that it is an "objective standard" that involves "an analysis of the law and application of the law to relevant facts." In contrast to this regulation—which makes it clear that the taxpayer's subjective analysis is not relevant—no such language appears in the reasonable-basis regulation. 

The reasonable-basis provision in § 1.6662-3(b) is therefore ambiguous. That being the case, the Department's interpretation of its own regulation is controlling. Auer v. Robbins, 519 U.S. 452, 461, 117 S. Ct. 905, 137 L. Ed. 2d 79 (1997); see also Christensen v. Harris Cty., 529 U.S. 576, 588, 120 S. Ct. 1655, 146 L. Ed. 2d 621 (2000) (Auer deference applies when the regulation is ambiguous); Kennedy v. Plan Adm'r for DuPont Sav. & Inv. Plan, 555 U.S. 285, 292-96, 129 S. Ct. 865, 172 L. Ed. 2d 662 (2009) (deferring to the Treasury Department's interpretation of Treas. Reg. § 1.401(a)-13(c)(1)(ii)). 

There are exceptions to this rule, such as when an agency's interpretation is plainly erroneous or inconsistent with the regulation, Auer, 519 U.S. at 461, or "when there is reason to suspect that the agency's interpretation does not reflect the agency's fair and considered judgment on the matter in question," Christopher v. SmithKline Beecham Corp., 567 U.S. 142, 132 S. Ct. 2156, 2166, 183 L. Ed. 2d 153 (2012) (citation and quotations omitted). These exceptions do not apply here, however. The Department's interpretation is certainly a reasonable reading of the regulatory language; indeed, the Department's reading reflects the negligence penalty's focus on the reasonableness of the taxpayer's actual conduct. Cf. Decker v. Nw. Envtl. Def. Ctr., 568 U.S. 597, 133 S. Ct. 1326, 1337, 185 L. Ed. 2d 447 (2013) ("It is well established that an agency's interpretation need not be the only possible reading of a regulation—or even the best one—to prevail."). 

In addition, there is no indication that the Department has advanced a different interpretation in the past or that its current interpretation is a "post hoc justification adopted in response to litigation." Id. To the contrary, the Department long ago rejected suggestions that it formally rank the "reasonable basis" standard in a hierarchy of standards because "such a comparison would change the focus of the reasonable basis regulations from the taxpayer's obligation to determine his or her tax liability in accordance with the internal revenue laws to the probability of the return position prevailing in litigation." Definition of Reasonable Basis, 63 Fed. Reg. 66433, 66433 (Dec. 2, 1998). In other words, the Department has long emphasized that the reasonable-basis defense "focus[es]" not on the return position in the abstract, but rather on [*19]  the conduct of the particular taxpayer in formulating that position. n6
   n6 That said, an agency's interpretation of its regulations may be entitled to deference even if it is advanced for the first time in a legal brief. See Auer, 519 U.S. at 462 ("Petitioners complain that the Secretary's interpretation comes to us in the form of a legal brief; but that does not, in the circumstances of this case, make it unworthy of deference."). 

It is true, as Wells Fargo argues, that the Department's interpretation creates some overlap between the reasonable-basis defense to the negligence penalty and the good-faith defense under 26 U.S.C. § 6664(c)(1). The good-faith defense applies if there was reasonable cause for the underpayment and the taxpayer acted in good faith. The short answer to Wells Fargo's point is that it is impossible to avoid some overlap between the two standards. Under both standards, the nature and reasonableness of the taxpayer's conduct are relevant considerations. That does not mean, however, that the reasonable-basis and good-faith defenses are coextensive. Whereas good faith is broadly available as a defense to most of the penalties listed in 26 U.S.C. §§ 6662 and 6663, the reasonable-basis defense has a more limited application. Compare 26 U.S.C. § 6664(c)(1), with 26 U.S.C. § 6662(d)(2)(B), and Treas. Reg. § 1.6662-3(b), (c)(1). Moreover, there is no dispute that the reasonable-basis standard is a more stringent standard than the reasonable-cause standard applicable under § 6664(c)(1). Treas. Reg. § 1.6662-3(b)(3) ("the reasonable cause and good faith exception in § 1.6664-4 may provide relief from the penalty for negligence or disregard of rules or regulations, even if a return position does not satisfy the reasonable basis standard"). 

The Court therefore agrees with the government that, in order to establish the reasonable-basis defense, Wells Fargo would have to prove that it actually relied on the authorities that form the basis of that defense. Because Wells Fargo has waived its right to prove actual reliance, Wells Fargo cannot establish the defense. Wells Fargo is therefore subject to the negligence penalty.

JAT Comments:

1.  Note that the taxpayer stipulated away its case on the penalty.  Of course, the legal effect of the stipulation was not known until the Court adopted its Chevron / Auer analysis.

2.  I anticipate that the Court's Chevron / Auer analysis will give Wells Fargo much to chew on on appeal.  I wonder though, whether a full bore attack on the denial of the sham / bullshit credits will tend to weaken its position on the penalty.  Logically, in the opening appellate brief, the first argument will be that the sham/bullshit tax credits were not really sham/bullshit.  That argument is very weak and that will probably be apparent from the argument even before the reader gets to the Government briefs.  That means that the more defensible argument on the penalty (I am not saying that it is more persuasive, just more defensible in the current environment about deference) is presented last and a reader may be less inclined to full engage the argument after weeding pas the opening bullshit.  I wonder whether a reasonable business decision could be made to just forego the substance appeal and present only the penalty appeal  (Just my view, but having said that, I did understand that the appeal in the Compaq case, Compaq Computer Corp. v. Commissioner, 113 T.C. 214 (1999), rev’d 277 F.3d 778 (5th Cir. 2002), taxpayer presented both the substance and the penalty on appeal was taken with the thought that they really had a good shot only on the penalty but, alas, they won the substance which, of course, mooted the penalty)