8th Circuit Holds Reasonable Basis Defense to Negligence Penalty Requires Taxpayers to Prove Actual Reliance on Authorities
On April 24, 2020 the Eighth Circuit Court of Appeals upheld the district court’s determination that Wells Fargo was not entitled to a tax credit on its 2003 tax return arising from a transaction the company entered into with a British bank. In Wells Fargo v. United States, No. 17-3578, the court determined that Wells Fargo was liable for a negligence penalty after claiming that credit. And, perhaps the most important takeaway from this holding was the Eighth Circuit’s conclusion that the reasonable basis defense to the negligence penalty, which Wells Fargo raised, requires a taxpayer to prove that they actually relied on relevant legal authority rather than prove objectively the authority supported the taxpayer’s position.
In 2002, Wells Fargo entered into a structured trust advantaged repackaged securities transaction (STARS) with Barclays Bank, a corporate citizen of the United Kingdom. The government argued that STARS was an unlawful tax avoidance scheme in which Wells Fargo exploited the differences between the tax laws of the U.S. and the U.K.. In 2003, Wells Fargo claimed foreign-tax credits on its federal tax return arising from STARS, but the Internal Revenue Service (IRS) disallowed those credits and found that Wells Fargo owed additional taxes. After paying the resulting tax deficiency, Wells Fargo filed a lawsuit to challenge the IRS’s decision and to obtain a refund. The government responded by imposing a “negligence penalty” on Wells Fargo as an offset defense because Wells Fargo underpaid its 2003 taxes after claiming this credit.
Under 26 U.S.C. § 61(a), the U.S. government taxes the income of its citizens, which includes corporations, “from whatever source derived.” To offset the problem of double taxation on income that is also taxed by a foreign jurisdiction, the Internal Revenue Code created the foreign-tax credit, in which the taxpayer can claim a dollar-for-dollar tax credit against its federal tax liability for taxes it paid to another country. However, this tax credit is granted only if there is a valid transaction. This article will not discuss the granular aspects of the complicated structure of the STARS transaction between Wells Fargo and Barclays besides the fact that the STARS comprised both a loan component and a trust component. The trust structure produced disputed foreign tax credits and the loan structure generated disputed interest deductions. The Eight Circuit found that the STARS’s trust component was a sham transaction, but not the loan component. A transaction is illegitimate if it is structured solely to obtain a tax benefit- meaning that it lacked economic substance outside of its tax considerations. Because the court found that the trust component of the transaction was a sham, Wells Fargo was not entitled to claim credits for any foreign taxes that it paid which arose from that transaction.
The Eighth Circuit also rejected Wells Fargo’s appeal that the district court erred in applying a negligence penalty. The district court imposed the negligence penalty on Wells Fargo because it found that the entity did not display prudence when preparing its tax return, warranting an $11.8 million penalty. Note, the Eighth Circuit upheld the district court’s determination requiring the government to refund to Wells Fargo a net amount of $13.65 million. Under 26 U.S.C. § 6662(b)(1) of the Internal Revenue Code, a taxpayer is liable for a “negligence penalty” of twenty percent of an underpayment of its taxes attributable to its “negligence.” The Code of Federal Regulations, the applicable regulation 26 C.F.R. § 1.6662-4(d)(3)(iii) creates a defense to the negligence penalty if the taxpayer’s “return position” was reasonably based on one or more of the authorities set forth in the regulation. The regulation defines a “return position” as the particular position a taxpayer adopts when the taxpayer determines its tax liability with respect to a particular item of income, deduction, or credit. The dispute between Wells Fargo and the government was whether a reasonable-basis defense requires evidence that the taxpayer actually relied on relevant legal authority to support its return position. Wells Fargo argued the standard need only be objectively reasonable. The government, on the other hand, argued the reasonable-basis defense required Wells Fargo to prove, through evidence, that they subjectively relied on the relevant authority.
The Eighth Circuit agreed with the government’s argument. The court looked to the plain meaning of the phrase “reasonably based” and found that in order to ‘base’ a return position on particular legal authority, a taxpayer may show that it actually relied upon those authorities in forming its position. And, citing previous cases, the court highlighted that in determining whether the negligence penalty applies, the focus is on the taxpayer’s conduct. Thus, the Eighth Circuit interpreted 26 C.F.R. § 1.662-3(b)(1) and (b)(3) to include a reliance requirement, even though the word “reliance” or similar language does not appear in the regulation.
Wells Fargo also argued that a subjective standard would result in the taxpayer waiving attorney-client privilege in order to prove that it actually relied on the relevant legal authority. The court noted this argument had “some appeal” but gave it short shrift. As a policy matter, the court noted that the actual reliance requirement “incentivizes taxpayers to actually conform to the requisite standard of care rather than simply taking the chance that there may be a reasonable basis for their underpayment of tax.”
While Judge Grasz did join the majority opinion in finding the transaction to be a sham, he provided a fiery dissent on the imposition of the negligence penalty. Judge Grasz argued the 26 C.F.R. § 1.6662-3(b)(3) does not necessitate a taxpayer show actual reliance on certain authorities to qualify for the reasonable-basis defense because such language is absent in the regulation. On the other hand, he points to a different regulation, 26 C.F.R. § 1.662-4, which is cross-referenced with the § 1.6662-3(b)(3) which explicitly includes the language that the taxpayer “analyzes the pertinent authorities in the manner described in this section and in reliance upon that analysis.” Citing to the Supreme Court’s reasoning regarding the canon of statutory construction, when Congress includes specific language in one section of a statute but omits it from another section of that same statute, it is presumed that Congress intended to omit such language. Thus, he concluded the fact that the regulation at issue does not specify actual reliance reveals there is no such requirement and an objective standard should govern.
Normally under a negligence standard, the conduct at issue is analyzed by asking what a reasonably prudent person would do under the same circumstances. That is to say, an objective test is applied. After this decision, a taxpayer could face penalties for adopting a return position even if it has plausible legal support. Wells Fargo is the first appellate opinion to hold that the reasonable basis for penalty defense purposes is based on a subjective rather than objective standard.