Bank Entitled to Deduct Interest on Loan Connected to STARS Transaction

(Parker Tax Publishing June 2017)

A district court held that a bank was entitled to deduct the interest it incurred on a loan that was part of a structured trust advantaged repackaged securities (STARS) transaction. The court divided the transaction into two components, a trust structure and a loan, and found that the loan was not a sham transaction because it had substantial, nontax-related economic effects on the parties. Wells Fargo v. U.S., 2017 PTC 256 (D.C. Minn. 2017).

Wells Fargo & Co. engaged with Barclays, a British financial services company, in a complex structured trust advantaged repackaged securities (STARS) transaction. The transaction included four key elements: (1) Wells Fargo would voluntarily subject some of its income producing assets to U.K. tax by placing them in a trust with a U.K. trustee; (2) Wells Fargo would offset the U.K. taxes by claiming foreign tax credits on its U.S. returns; (3) Barclays would enjoy significant U.K. tax benefits, and (4) Barclays would compensate Wells Fargo with a monthly payment. Wells Fargo claimed foreign tax credits for the U.K. taxes it paid in connection with STARS and a deduction for the interest it paid on debt it incurred as part of the transaction. The IRS disallowed the credits and the interest deduction on the ground that STARS was a sham. Generally speaking, a transaction is 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).

The case was tried before a Minnesota district court jury, which adopted the IRS's view that STARS consisted of two separate, independent transactions - a trust structure and a loan. The jury considered whether each transaction had both a business purpose and economic substance. It found that the trust structure, which generated the disputed foreign tax credits, had neither a nontax business purpose nor a reasonable possibility of pretax profit and thus was a sham. However, the jury found that the loan had a reasonable possibility of pretax profit, but that Wells Fargo entered into the loan solely for tax related reasons. The district court noted that the jury's findings presented a question that the Eighth Circuit, the court to which the case is appeable, 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?

The district court asked Wells Fargo and the IRS to brief this issue, as well as the issue of whether Wells Fargo was subject to a negligence penalty under Code Sec. 6662(b)(1) in connection with its claim of foreign tax credits. The IRS argued that, because the jury found that the loan lacked a non-tax business purpose, the loan was a sham and thus no interest was deductible. With respect to the negligence penalty, Wells Fargo argued (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 Reg. Sec. 1.6662 - 3(b)(3).

After considering the briefs from each side, the district court held that (1) the loan was not a sham and thus the interest on the loan was deductible under Code Sec. 163, and (2) Wells Fargo was subject to the negligence penalty for underpayments associated with the disallowed foreign tax credits.

The court reviewed the decisions in three other cases involving identical STARS transactions and noted that in all three, the loan was treated as independent from the trust structure and the loan was not a sham. Next, in an effort to predict the approach that the Eighth Circuit was likely to adopt, the district court determined that the Eighth Circuit was 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. The court reasoned that a flexible approach was consistent with the Supreme Court's formulation of the sham transaction doctrine in Frank Lyon Co. v. U.S., 435 U.S. 561 (1978) which, the court said, applied a list of factors to weigh rather than a series of boxes to check. Flexibility also made sense, according to the court, in light of the rule that taxpayers are generally permitted to engage in tax planning. The court further reasoned that a flexible approach reflected how most courts analyze the economic substance of a transaction. The court noted that the IRS had cited no cases in which a court has disregarded a transaction that had real and substantial economic substance for the sole reason that the taxpayer's subjective purpose was to avoid taxes. The court also cited several decisions where tax motivated transactions were upheld on the basis of their objective economic substance. Finally, the court said that the flexible approach was consistent with the Eighth Circuit's application of the sham transaction doctrine.

Turning to the negligence penalty, the court noted that under Reg. Sec. 1.6662-3, a taxpayer is not negligent if its return position is based on one or more of the authorities enumerated in the regulations. The court determined that under the regulation, Wells Fargo was required to prove that it actually consulted the authorities that it said provided a reasonable basis for the position, and that it failed to do so. The court reasoned that a return position is essentially an opinion regarding what obligations the law imposes on the taxpayer, and that a taxpayer cannot base its return position on a set of authorities without actually consulting those authorities.

For a discussion of the deductibility of interest from a sham transaction, see Parker Tax ¶92,305. For a discussion of the reasonable basis exception to the negligence penalty for underpayment of taxes, see Parker Tax ¶262,120.05.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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