ORDER
• 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,
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.
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 LIBOR
Three other cases involving materially identical STARS transactions have worked their way through the federal courts. See Santander Holdings USA, Inc. v. United States,
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.
A flexible approach also reflects the Supreme Court’s often-quoted formulation of the sham-transaction doctrine in Frank Lyon Co. v. United States,
[Wjhere ... there is a genuine multiple-party transaction with economic substance which is compelled or encouraged by business or regulatory realities, isimbued 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,
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,
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.” ASA Investerings P’ship v. Comm’r,
For example, in ASA Investerings, the court found both that the- challenged partnership was not formed for a business purpose^ and that the foreign partner “could make no profit from the transaction .... ” ASA Investerings,
[A] transaction has a ‘business purpose,’ when we are talking about a going concern like UPS, as long as it figures in a bona fide, profit-seeking business; ... There, may be no tax-independent reason for a .taxpayer to choose between these different ways of financing the business, .but it does not mean that the taxpayer lacks a ‘business purpose.’ Toconclude otherwise would prohibit tax-planning.
United Parcel Serv.,
Salem Financial (the STARS case decided by the Federal Circuit) is illustrative of the latter approach. In a previous case, the Federal Circuit had suggested that “the [sham-transaction] doctrine may well also apply if the taxpayer’s sole subjective motivation is tax avoidance even if the transaction has economic substance .... ” Coltec Indus., Inc. v. United States,
Other courts have similarly upheld tax-motivated transactions on the basis of their objective economic substance. See ACM P’ship v. Comm’r,
Finally, it is worth noting that a flexible approach is consistent with the manner in which the Eighth Circuit has applied the sham-transaction doctrine. For example, in determining whether a transaction has economic substance, the Eighth Circuit has focused not merely on whether the transaction generated a non-tax-related profit, but on the size of that profit. Specifically, the Eighth Circuit has said that “[m]odest profits relative to substantial tax benefits are insufficient to imbue an otherwise dubious transaction with economic substance.” WFC Holdings Corp. v. United States,
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 bor
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,
B. The Negligence Penalty
The parties next dispute whether Wells Fargo is subject to the negligence penalty under 26 U.S.C. § 6662(b)(1) for the underpayments associated with the IRS’s disallowance of Wells Fargo’s claimed foreign-tax credits. Ünder that statute, a taxpayer is liable for a 20 percent penalty on any portion of a underpayment that is attributable to negligence. 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).
The Treasury Department (“the Department”) has promulgated a regulation— Treas. Reg. § 1.6662-3 — that further refines the meaning of “negligence.” Among other things, the regulation provides that “[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)(l). Paragraph (b)(3) of the regulation, in turn, states that a return position “will generally satisfy the reasonable basis standard” if it .is “reasonably based on one or more of the authorities set forth in § 1.6662 — 4(d)(3)(iii) (taking into account the relevance and persuasiveness of the authorities, and subsequent developments) .... ”
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).
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,
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)(l). 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-baJis standard is generally satisfied “[i]f a return position is reasonably based on one or more” of a set of authorities. Treas. Reg. § l,6662-3(b)(3). This language suggests' that the taxpdyer must have actually consulted those authorities. It is the taxpayer who ádopts a “return position” by determining its tax liability. See Treas.' Reg. § 301.6114-l(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.
There are exceptions to this rule, such as when an agency’s interpretation is plainly erroneous.or inconsistent with the regulation, Auer,
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 thq “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 oh the return position in the abstract, but rather on the conduct of the particular taxpayer in formulating that position.
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 mor¿ limited application. Compare 26 U.S.C. § 6664(c)(1), with 26 U.S.G."§ 6662(d)(2)(B), and Treas. Reg. § 1.6662-3(b), (c)(1). Moreover, there is no dispute that the reásoñáble-basis standard is a more stringent standard than the reasonable-cause standard applicable
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.
ORDER
Based on the foregoing, and on all of the files, records, and proceedings herein, IT IS HEREBY ORDERED THAT:
1. Plaintiff is entitled, under 26 U.S.C. § 163(a), to deduct the interest expenses associated with the loan that was part of the STARS transaction.
2. Plaintiff is subject to the negligence penalty under 26 U.S.C. § 6662(b)(1) for the underpayments associated with the foreign-tax credits that it claimed in its reporting of the STARS transaction.
3. The parties are directed to meet and confer on a proposed form of judgment incorporating these rulings. The parties must submit their proposal to the Court no later than June 30, 2017.
Notes
. The jury’s findings with respect to the trust structure depended in part on the jury’s finding that the Bx payment was a tax benefit rather than an item of pre-tax revenue, ECF
. "The London InterBank Offered Rate (LI-BOR) is a benchmark interest rate disseminated by the British Bankers’ Association based on the rate at which certain banks predict they can borrow funds. LIBOR is a reference point in determining interest rates for financial instruments in the United States and globally.” Gelboim v. Bank of Am. Corp., — U.S. —,
. The parties structured the STARS transaction to offset this interest rate with the Bx payment that Barclays was contractually obligated to make to Wells Fargo each month. Under the jury’s finding that the trust structure and the loan are separate, however, the Bx payment is not part of the loan transaction and therefore does not reduce the amount of interest that Wells Fargo can claim on its tax returns (assuming that the loan is not a sham).
. 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.
. The Court acknowledges that, after Wells Fargo’s STARS transaction concluded, Con- ■ gress 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(d)(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)(l), (o)(5)(C). This suggests some flexibility in determining a threshold requirement of relevance before applying the doctrine.
. 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,