WFC Holdings Corporation Plaintiff-Appellant.
United States of America Defendant-Appellee.
Submitted: May 16, 2013
Appeal from United States District Court for the District of Minnesota-Minneapolis
Before WOLLMAN, MURPHY, and SMITH, Circuit Judges.
SMITH, Circuit Judge.
WFC Holdings Corporation (WFC) appeals from the judgment of the district court,  which held that WFC is not entitled to a tax refund for a capital loss it claimed as a result of a complex transaction involving the transfer of leases and the sale of stock. We hold that WFC failed to adequately show that the transaction had either objective economic substance or a subjective, non-tax business purpose, and we affirm.
In 1996, Wells Fargo & Company ("Old Wells Fargo" or OWF) acquired First Interstate Bancorp ("First Interstate") in a hostile takeover. OWF and First Interstate had overlapping geographical footprints, and the acquisition left OWF with unexpected real estate liabilities consisting of a large number of leased properties that were no longer needed for its business operations. OWF remained obligated to pay rent on the properties. Some of the properties were "underwater, " meaning that OWF's rent obligations exceeded the amount of rent it could obtain from subleasing the property. In 1998, OWF merged with Norwest Corporation to become WFC. WFC retained the real estate liabilities that OWF had acquired through the latter's takeover of First Interstate.
Customarily, WFC files consolidated income tax returns for its various banking and non-banking subsidiaries. Among WFC's banking subsidiaries are Wells Fargo Bank, N.A. and Wells Fargo Bank (Texas), N.A. (collectively, "the Bank"). WFC's leases were held by the Bank, which is subject to the regulatory oversight of the Office of the Comptroller of the Currency (OCC). The OCC regulates federally chartered banks' real estate holdings pursuant to the National Bank Act (NBA). See 12 U.S.C. § 29. The NBA permits a national bank to hold real estate only for use in its banking business and other limited purposes. See id. Real estate held for other purposes, including "[f]ormer banking premises, " are referred to as "[o]ther real estate owned (OREO)" (or ORE).12 C.F.R. § 34.81(e)(2). "[F]ormer banking premises" that the bank currently leases qualify "as OREO when a bank no longer uses the property for its banking business." OCC Interpretive Letter, 1983 WL 145898, at *1–3.
The NBA requires national banks to dispose of OREO within five years. 12 U.S.C. § 29; see also 12 C.F.R. § 34.82(a) ("A national bank shall dispose of OREO at the earliest time that prudent judgment dictates, but not later than the end of the holding period (or an extension thereof) permitted by 12 U.S.C. 29."). "A national bank may comply with its obligation to dispose of [leased] real estate under 12 U.S.C. 29 . . . [b]y obtaining an assignment or a coterminous sublease, " i.e., a sublease coterminous with the bank's master lease. 12 C.F.R. 34.83(a)(3)(i). The OCC may extend the five-year disposition period for up to "an additional five years, if (1) the [bank] has made a good faith attempt to dispose of the real estate within the five-year period, or (2) disposal within the five-year period would be detrimental to the [bank]." 12 U.S.C. § 29. Furthermore, in 1996 the OCC amended the regulations to toll the disposition period for the duration of any non-coterminous sublease. 12 C.F.R. § 34.83(a)(3)(i). The 1996 amendment also permitted
[a] national bank holding a lease as OREO [to] enter into an extension of the lease that would exceed the holding period referred to in § 34.82 if the extension meets the following criteria:
(A) The extension is necessary in order to sublease the master lease;
(B) The national bank, prior to entering into the extension, has a firm commitment from a prospective subtenant to sublease the property; and
(C) The term of the extension is reasonable and does not materially exceed the term of the sublease . . . .
In 1998, prior to OWF's merger with Norwest to become WFC, KPMG, LLC ("KPMG") served as OWF's accounting firm. At that time, KPMG marketed a contingent-liability tax-reduction strategy it referred to as an "economic liability transaction." In accordance with this strategy, KPMG advised OWF that OWF's underwater leases could be used to reduce its federal income tax liability. The contingent-liability strategy called for accelerating future tax deductions to create current losses that could be used to shield current income from tax.
The strategy involved three steps. First, OWF would create a new subsidiary or locate an existing subsidiary holding corporation for use. Second, OWF would make a tax-free transfer of valuable assets and tax-deductible liabilities to the subsidiary. Combining features of sections of the Internal Revenue Code ("the Code") make this tax-free transfer theoretically possible. In general, a transfer of property into a corporation in return for stock in that corporation results in a taxable gain or loss, depending on the difference between the tax basis in the transferred property and the tax basis of the stock. But 26 U.S.C. § 351(a) provides that a taxpayer will recognize no gain or loss from its transfer of property into a corporation solely in exchange for that corporation's stock, provided that it controls the corporation immediately thereafter. Furthermore, 26 U.S.C. § 358(a)(1) provides that, as a general rule, a taxpayer's tax basis in the stock it receives through a § 351 tax-free transfer must be equal to the tax basis of the property transferred into the corporation. If, in addition to stock, a taxpayer receives money, it must reduce its tax basis in the stock by the same amount. 26 U.S.C. § 358(a)(1)(A)(ii). Generally, if, pursuant to a § 351 transfer, a corporation assumes some liabilities of the taxpayer, then the corporation's assumption of those liabilities is treated "as money received by the taxpayer." 26 U.S.C. § 358(d)(1). Thus, ordinarily, the corporation's assumption of the liabilities would require the taxpayer to reduce its tax basis in the stock. However, under 26 U.S.C. §§ 358(d)(2) and 357(c)(3), if the corporation assumes liabilities the payment of which would give rise to a tax deduction, then the corporation's assumption of those liabilities does not require the taxpayer to reduce its tax basis in the stock.
Accordingly, the second step of the contingent-liability strategy that KPMG proposed would require OWF to transfer valuable assets and an equal amount of tax-deductible future liabilities to the designated subsidiary holding corporation, in exchange for stock in that corporation. The stock's market value would be reduced by the negative value of the tax-deductible future liabilities, but the stock's tax basis would remain equal to the tax basis of the assets transferred to the corporation— unreduced by the negative value of the future tax-deductible liabilities. Finally, the third step would involve OWF selling the high-tax-basis/low-market-value stock to an outside third party at the low market value, resulting in a seemingly sizable capital loss that could be used to shield current income from tax.
KPMG advised OWF that the contingent-liability strategy required a non-tax business purpose to succeed. Thus, "[a]scertaining a non-tax business purpose was 'the first question' KPMG asked of clients considering the transaction." WFC Holdings Corp. v. United States, No. 07-3320 JRT/FLN, 2011 WL 4583817, at *4 (D. Minn. Sept. 30, 2011). Donald Dana managed OWF's Corporate Properties Group (CPG), which oversaw all properties owned or leased by every entity under OWF's control. Dana was responsible for identifying a non-tax business purpose for OWF's use of the contingent-liability strategy.
Dana identified two business purposes for transferring 21 of the Bank's leased properties to the designated subsidiary holding corporation. First, he proposed that managers of the designated subsidiary holding corporation could be incentivized to exceed market expectations by sharing in the equity of the properties. Second, the strategy would strengthen OWF's hand in negotiations with its "good bank customers"—customers who both (1) banked with OWF and (2) leased properties from OWF. At that time, OWF's senior tax attorney Karen Bowen "sent an internal email message in which she stated, 'We are working with CPG on a project to move underwater leases to a special purpose entity to trigger unrealized tax losses.'" Id. at *5 (citation omitted). OWF then merged with Norwest to become WFC.
Afterwards, WFC significantly revised the business purpose for the contingent-liability strategy. Dan Vandermark, the former Vice Present of Tax for Norwest, became the Vice President of Tax for WFC. Vandermark's position gave him discretion to veto the strategy's use as a tax-reduction strategy. Vandermark instructed Dana to create a business purpose document that would withstand IRS scrutiny. Vandermark considered the existing strategy to have a "99.9% chance of losing" a tax audit. Id. at *8. "Vandermark testified that . . . 'we knew we were going to be going to court on this, and so we wanted to be prepared for it from the get-go. So I told them that we would need to document—fully document every aspect of the—business purpose of this transaction.'" Id. (citation omitted). WFC regulatory attorney, Julius Loeser, subsequently articulated another business purpose for the contingent-liability strategy: the avoidance of OCC regulations.
Loeser explained by email that transferring underwater leases into a non-banking subsidiary would seem to confer a tremendous regulatory benefit to WFC. Specifically, Loeser explained that pursuant to OCC regulations, WFC had a limited time period in which to dispose (i.e. through assignment or termination) of leased space that was no longer actively used in banking operations and had not been coterminously subleased. By contrast, the Fed, with regulatory oversight over the non-bank subsidiary expected to receive the underwater leases, imposed no such mandatory disposition regulations for leased premises. Transferring underwater leases into a non-banking subsidiary would therefore allow WFC more flexibility in managing the leases.
Id. Dana wrote a new version of the business-purpose document that incorporated the regulatory purpose. The new document stated that CPG's ability to execute lease extensions to its subtenants was impeded by the OCC's rule that properties had to be disposed of within five years. It explained that transferring the leases to a non-banking subsidiary would cause them to fall under the Fed's less stringent regulatory regime.
As an example, Dana cited the Garland operations building on the fringe of downtown Los Angeles. The Garland building, acquired from First Interstate in 1996, is a 700, 000 square foot space rendered superfluous after the merger. The bottom floors have no windows and are essentially designed as a vault. WFC was liable to pay rent on a lease on the Garland building through 2009, with multiple purchase and lease extension options. Bank of America, WFC's competitor, was interested in leasing 130, 000 square feet of the Garland building, including the cash vault, but required more than a ten-year term. According to Dana, OCC regulations prohibited him from offering such a sublease beyond the mandatory disposition period. Accordingly, Bank of America walked away from the deal.
Id. at *9.
WFC's final stated business purpose for its strategy included (1) avoiding OCC regulatory restrictions, (2) strengthening its negotiating position with respect to its subtenant "good bank ...