Economic substance: Supreme Court will not review WFC Holdings
TAX ALERT |
Those seeking clarity on the application of the economic substance doctrine were disappointed to learn that the U.S. Supreme Court on June 9, 2014, denied certiorari to WFC Holdings (WFC). The Eighth Circuit Court of Appeals upheld the U.S. District's ruling that WFC's lease restructuring transaction was a sham, concluding the transaction failed to have a business purpose and economic substance. WFC Holdings Corp. v. U.S., 112 AFTR 2d 2013-5815 (728 F.3d 736). Because the U.S. Supreme Court declined to hear the case, the decision by the Eighth Circuit stands, and that decision provides valuable insight with regard to the business purpose requirement.
The transaction in debate generated $423 million in losses, resulting in nearly $148 million in federal income tax savings. WFC executed the transaction in question, called the LRT/stock transaction (the transaction), based on advice provided by its tax advisor, KPMG. The transaction required WFC to complete a series of prearranged steps in order to create low-value stock that would have a high tax basis. Specifically, WFC transferred certain underwater leases to a wholly owned subsidiary and, in addition, the transferee subsidiary assumed certain liabilities of WFC. In this exchange, WFC received preferred stock in the subsidiary. The transaction was tax-free under sections 351 and 357. Under section 358, the basis of the preferred shares received by WFC took a basis equal to that of the assets transferred. However, the value of the stock received was depleted because of the liabilities assumed by the subsidiary as part of the transaction. This created a situation where the value of the preferred stock held by WFC was significantly lower than the tax basis. The preferred stock was then sold to a third-party investor, resulting in a realized tax loss. The IRS argued that WFC entered into the transaction solely to create stock with an artificially inflated basis in order to generate the loss and shelter other unrelated gain.
The Eighth Circuit ruled that WFC had no business purpose other than tax avoidance, finding that the decision to execute the transaction was made purely because of KPMG's marketed tax strategy. In this type of fact pattern, the Eighth Circuit stated that taxpayers will face "an uphill battle" in defending such transactions. A bona fide, nontax business purpose was thus paramount for WFC's transaction to be respected, and WFC was unable to convince the court that a nontax business purpose drove the transaction.
WFC was not completely ignorant of the transaction's need for a nontax business purpose. However, the first business purpose was determined by WFC after the decision to execute the transaction was already made. Further, this "original" business purpose was changed at the direction of WFC's tax director because he assumed the case would be audited by the IRS and he wanted a stronger business case. The Eighth Circuit noted a number of concerns related to the proffered business purpose, including that (1) the business purpose needs to drive the transaction rather than having a transaction drive the business purpose, and (2) the taxpayer's actions must be consistent with causing the transaction to fulfill the stated business purpose.
The facts showed WFC's actions were inconsistent with its purported business purpose. The alleged business purpose was to eliminate certain leases held by WFC from scrutiny by the Office of the Comptroller of the Currency (OCC). Under the OCC rules, WFC could have been compelled to divest some or all of its underwater leases at a time most unfavorable to WFC. Placing underwater leases into the subsidiary did have the potential to accomplish this desire. While possibly a valid business purpose at first blush, no due diligence was performed to insure the transaction accomplished such purpose. Evidence showed that WFC never contacted the regulatory agency to determine whether the leases in the transaction were actually subject to the regulations. Further, the Eight Circuit noted that even assuming for a moment some leases were subject to the regulations, these leases appeared to represent less than 50 percent of the total leases included in the transaction. Thus, not only did WFC find a business purpose after deciding to do the transaction, but its lack of due diligence signified the transaction was not driven by banking regulations. Had WFC offered this business purpose before deciding to proceed and had it engaged in the due diligence necessary to determine if the transaction would fulfill that business purpose, WFC would have created at least a prima facia case in its favor. Instead, WFC prepared a transaction to maximize tax losses and later decided to attach a nontax business purpose. As a result, WFC illustrates how taxpayer actions (or a lack thereof) will play a role in a court's decision as to whether a transaction had business purpose.
The Eighth Circuit ultimately concluded the transaction was a sham for failing to have both economic substance and a business purpose. Now, by statute, the question of whether a court would apply a two-prong test (or possibly an either-or test) with respect to the two factors (economic substance and business purpose) is relatively moot. In 2010, Congress codified the economic substance doctrine requiring both prongs, although this law would not have applied to WFC since the transaction took place in 1996. Nonetheless, the codification under section 7701(o)(1) reads:
In the case of any transaction to which the economic substance doctrine is relevant, such transaction shall be treated as having economic substance only if:
A. The transaction changes in a meaningful way (apart from Federal income tax effects) the taxpayer's economic position, and
B. The taxpayer has a substantial purpose (apart from Federal income tax effects) for entering into such transaction.
Congress still left it for the courts to decide when the economic substance doctrine is relevant and when it applies. Section 7701(o)(5)(C). Thus, court interpretations are still important.
The decision of the U.S. Supreme Court to deny WFC's petition will continue to leave questions unanswered as to exactly when the economic substance doctrine should apply. On the other hand, the ruling against WFC demonstrates three valuable insights regarding business purpose. First, a transaction must have an upfront, nontax-motivated business purpose. Second, the business purpose should drive the transaction and not be a transactional afterthought. Third, the actions of the taxpayer should support the purported business purpose. In the event the IRS challenges a transaction under section 7701(o), steep penalties are automatically applied – 40 percent instead of the usual 20 percent.
One question that will remain unanswered due to the U.S. Supreme Court's refusal to hear this case is the question of whether the Eighth Circuit went too far in its reasoning in the holding against WFC. Of primary concern are two points: (1) the Eighth Circuit believed the transaction was a sham because WFC could have achieved its stated business by implementing another form of transaction, and (2) WFC took unnecessary steps in receiving a preferred stock (rather than common) and then selling that stock to the third party.
By using these events in its analysis of the transaction, the Eighth Circuit appears to have gone too far. If one assumes that WFC really had developed a bona fide business purpose and then had conducted itself in a manner consistent with achieving that business purpose, then its actions of choosing a transaction that could produce a tax benefit (rather than some other form that would not, as alluded to by the Eighth Circuit) and receiving a preferred stock, which it then sold, would seem permissible under Gregory v. Helvering, 293 U.S. 465 (1935). Recall that in Gregory, the U.S. Supreme Court stated it is perfectly permissible for taxpayers to arrange their affairs in any manner permitted by law so as to minimize their taxes. Once WFC transferred the underwater leases to the subsidiary, the business purpose of relieving these assets from OCC regulation would seem to have been achieved. This would then arguably appear to be a bona fide transaction supported by a bona fide business purpose. The fact that WFC then sold stock at a loss did nothing to minimize or in any manner undermine the business purpose; it simply meant that WFC chose a transaction that would accomplish its business purpose and also allow it to recognize a loss and thereby minimize its overall taxes. This approach to the overall analysis of a transaction is also consistent with the U.S. Supreme Court's decision in Cottage Savings Association v. Commissioner, 499 U.S. 554 (1991).
Notwithstanding the Eighth Circuit Court's decision, the questions of how and when to apply the doctrine of economic substance in the structuring of transactions will continue to be important, but the resolution of these questions will remain unclear. One thing that should be clear, however, is that taxpayers should consult with their tax advisors on economic substance concerns relevant to a transaction.