Court Issues Pro-Taxpayer Ruling in STARS Case: Leaves Economic Substance Argument Open

Posted by John Cohn and Lee Meyercord           In a structured trust advantaged repackaged securities (“STARS”) transaction case, a Federal District Court in the Eighth Circuit granted Wells Fargo’s motion for partial summary judgment that payments by Barclays to Wells Fargo based on Barclays’ U.K. tax benefits from the transaction were pre-tax income, but left open for further proceedings whether Wells Fargo had a business purpose for entering into the STARS transaction.  The decision is available here.  BackgroundThe case involves a typical STARS transaction. Wells Fargo transferred income-producing assets to a U.K. trust that was disregarded for U.S. income tax purposes, but a U.K. resident for U.K. tax purposes, which caused the trust to be subject to U.K. tax.  Wells Fargo was subject to U.S. tax on the trust’s income and claimed a foreign tax credit under Section 901 for the U.K. taxes paid. Barclays, a U.K. bank, acquired an interest in the trust, which Wells Fargo agreed to repurchase.  For U.S. tax purposes, Barclays’ investment was treated as a secured loan to Wells Fargo.  For U.K. tax purposes, Barclays was treated as owning an interest in the trust.  Barclays reported its share of the trust income for U.K. tax purposes, but re-contributed that allocation to the trust.  The allocation to Barclays and re-contribution created a net tax benefit for Barclays, because Barclays was entitled to a credit for the U.K. taxes that the trust paid and a deduction for the contribution back to the trust. Barclays shared the net tax benefit with Wells Fargo through a below-market loan.  The interest that Wells Fargo was required to pay on the loan was reduced by what is referred to as the “Bx payment,” which was 47.5% of the U.K. tax credits Barclays received from the transaction.  It is not uncommon in these transactions for the Bx payment to exceed the amount owed on the loan, in which case Barclays would make a net payment to Wells Fargo on the loan.The IRS denied Wells Fargo’s foreign tax credits contending that the STARS transaction was a sham and lacked economic substance.  Wells Fargo paid the U.S. taxes and sued for a refund in district court.  In the district court proceeding, Wells Fargo filed a motion for partial summary judgment that (i) the Bx payment was pre-tax income; (ii) the STARS transaction was motivated by a business purpose other than tax considerations; (iii) Section 269 does not apply to the STARS transaction; and (iv) Wells Fargo’s tax reporting position has a reasonable basis.Bx PaymentThe court granted Wells Fargo’s motion for summary judgment that the Bx payments were pre-tax income.  The import of this ruling was that the Bx payment would be regarded as an item of income for purposes of countering the IRS’s arguments regarding the economic substance of the transaction and the sham transaction analysis.  The Bx payment increased Wells Fargo’s taxable income and income tax burden.  While the government argued that the Bx payment was effectively a tax rebate of the U.K. taxes paid, the court concluded that there is no legal authority for treating payments from one bank to another as tax rebates or tax refunds.  While the court noted that it is “absolutely clear that the magnitude of the Bx clearly was derived by reference to anticipated U.K. tax benefits to Barclays, that reference does not convert the private payment into some kind of disbursement or refund.” Business Purpose The court denied, however, Wells Fargo’s motion for summary judgment that it had a non-tax business purpose for entering into the STARS transaction.  Instead, the court left open for further proceedings the role of the business purpose test in the sham analysis under Eighth Circuit law and factual questions regarding Wells Fargo’s intent in entering into the transaction.  This case may play an important role in clarifying the role of the business purpose test in the sham analysis in the Eighth Circuit. Section 269 and Reasonable Basis for Tax Reporting Position Section 269 allows the IRS to deny the benefit of a deduction or credit where a taxpayer makes an acquisition and the principal purpose for which such acquisition was made is evasion or avoidance of income tax by obtaining such deduction or credit.  The court granted Wells Fargo’s motion for summary judgment that Section 269 did not apply to asset transfers made to facilitate the STARS transaction, because the asset acquisitions in the STARS transaction did not create the tax benefits under U.S. law that Wells Fargo claimed here.  The court also found that, even if the transaction is subsequently determined to be a sham, the Code, regulations, treaties and judicial decisions provided Wells Fargo with a reasonable basis for its reporting position.The Wells Fargo case will likely be the fourth case to emerge from the IRS’s attempts to disallow the tax benefits involved in a STARS transaction.  For a discussion of the decisions in the first three cases, see the article here.  If you have any questions about this case or related issues, please contact one of us or any of the other Tax lawyers at Thompson & Knight.