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Santander Argues Against Penalties in STARS Case

AUG. 25, 2017

Santander Holdings USA Inc. et al. v. United States

DATED AUG. 25, 2017
DOCUMENT ATTRIBUTES

Santander Holdings USA Inc. et al. v. United States

SANTANDER HOLDINGS USA, INC. & SUBSIDIARIES,
Plaintiff,
v.
UNITED STATES OF AMERICA,
Defendant.

UNITED STATES DISTRICT COURT
DISTRICT OF MASSACHUSETTS

Hon. George A. O’Toole, Jr.

August 25, 2017

Leave to File Granted on August 23, 2017

PLAINTIFF’S MEMORANDUM OF LAW IN SUPPORT OF ITS MOTION FOR
SUMMARY JUDGMENT REGARDING PENALTIES

SKADDEN, ARPS, SLATE, MEAGHER & FLOM LLP
1440 New York Ave NW
Washington, DC 20005

Attorneys for Plaintiff Santander Holdings USA, Inc.


TABLE OF CONTENTS

INTRODUCTION

PROCEDURAL HISTORY

MATERIAL UNDISPUTED FACTS

ARGUMENT

I. Sovereign Had a Reasonable Basis for Its Tax Reporting Position

A. Sovereign’s Reasonable-Basis Defense Presents an Issue of Law that Can Be Decided on Summary Judgment.

B. The Government Incorrectly Argues that Sovereign Cannot Rely on the Reasonable-Basis Defense.

II. Sovereign Adequately Disclosed its Reporting Position

A. Even if Disclosure Was Not Adequate, Penalties Are Inappropriate Because Substantial Authority Supported Sovereign’s Tax Reporting Position

III. Under the Law Extant at the Time that Sovereign Filed the Relevant Tax Returns, the Trust Transaction Was Not a “Tax Shelter.”

A. The Question of Whether a Transaction Is a “Tax Shelter” Requires a Separate Analysis from the Judgment on the Merits and Can Be Decided on Summary Judgment.

B. Whether a Transaction is a Tax Shelter Must Be Judged Under the Law as of the Time Sovereign’s Returns Were Filed.

C. Under the Law in Force at the Relevant Times, the Trust Transaction Was Not a Tax Shelter.

CONCLUSION

TABLE OF AUTHORITIES

CASES

Alpha I, L.P. v. United States, 93 Fed. Cl. 280 (2010)

Auer v. Robbins, 519 U.S. 452 (1997)

Bank of N.Y. Mellon, Corp. v. Comm’r, 801 F.3d 104 (2d Cir. 2015), cert. denied, 136 S. Ct. 1377 (2016)

Bowen v. Georgetown Univ. Hosp., 488 U.S. 204 (1988)

Burditt v. Comm’r, T.C. Memo. 1999-117

Campbell v. Comm’r, 134 T.C. 20 (2010), aff’d, 658 F.3d 1255 (11th Cir. 2011)

Chemtech Royalty Assocs., L.P. v. United States, Nos. 05-944-BAJ-DLD, 06-258-BAJ-DLD, 07-405-BAJ-DLD, 2013 WL 704037 (M.D. La. Feb. 26, 2013)

Chemtech Royalty Assocs., L.P. v. United States, 823 F.3d 282 (5th Cir. 2016), cert. denied, 137 S. Ct. 624 (2017)

In re CM Holdings, Inc., 254 B.R. 578 (D. Del. 2000), aff’d, 301 F.3d 96 (3d Cir. 2002)

Compaq Computer Corp. v. Comm’r, 277 F.3d 778 (5th Cir. 2001)

Crawford v. Comm’r, T.C. Memo. 1993-192

Everson v. United States, 108 F.3d 234 (9th Cir. 1997)

Galedridge Constr., Inc. v. Comm’r, T.C. Memo. 1997-485

IES Indus., Inc. v. United States, 253 F.3d 350 (8th Cir. 2001)

Kingdomware Techs., Inc. v. United States, 107 Fed. Cl. 226 (2012), aff’d, 754 F.3d 923 (Fed. Cir. 2014)

Kretschmer v. Comm’r, T.C. Memo. 1989-242

Matthies v. Commissioner, 134 T.C. 141 (2010)

NPR Invs., L.L.C. v. Comm’r, 740 F.3d 998 (5th Cir. 2014)

Peerless Indus., Inc. v. United States, No. Civ. A. 92-2163, 1994 WL 13837 (E.D. Pa. Jan. 19, 1994), aff’d, 37 F.3d 1488 (Table) (3d Cir. 1994)

Principal Life Ins. Co. v. United States, 116 Fed. Cl. 82 (2014)

Salem Financial, Inc. v. United States, 786 F.3d 932 (Fed. Cir. 2015), cert. denied, 136 S. Ct. 1366 (2016)

Salty Brine I, Ltd. v. United States, Nos. 10-CV-108-111-C, 161-C, 11-CV-137-C, 12-CV-227-C, 13-CV-014-C, 2013 WL 4038993 (N.D. Tex. May 16, 2013), aff'd, 761 F.3d 484 (5th Cir. 2014)

Santander Holdings USA, Inc. v. United States (“Santander I”), 977 F. Supp. 2d 46 (D. Mass. 2013)

Santander Holdings USA, Inc. v. United States (“Santander II”), 144 F. Supp. 3d 239 (D. Mass 2015), rev’d and remanded, 844 F.3d 15 (1st Cir. 2016), cert. denied, 137 S. Ct. 2295 (2017)

Santander Holdings USA, Inc. v. United States, 844 F.3d 15 (1st Cir. 2016), cert. denied, 137 S. Ct. 2295 (2017)

Smoker v. Comm’r, T.C. Memo. 2013-56

Southgate Master Fund, LLC v. United States, 651 F. Supp. 2d 596 (N.D. Tex. 2009), aff’d 659 F.3d 466 (5th Cir. 2011)

Stiebling v. Comm’r, No. 95-70391, 1997 WL 257465 (9th Cir. May 14, 1997)

Stobie Creek Invs., LLC v. United States, 82 Fed. Cl. 636 (2008), aff'd, 608 F.3d 1366 (Fed. Cir. 2010)

Summa Holdings, Inc. v. Comm’r, 848 F.3d 779 (6th Cir. 2017)

U.S. ex rel Ondis v. City of Woonsocket, 587 F.3d 49 (1st Cir. 2009)

Valero Energy Corp. v. United States, No. 06-C-6730, 2007 WL 4179464 (N.D. Ill. Aug. 23, 2007)

Well Fargo & Co. v. United States, 750 F. Supp. 2d 1049 (D. Minn. 2010)

Well Fargo & Co. v. United States, No. 09-cv-2764-PJS-TNL, 2017 WL 2274955 (D. Minn. May 24, 2017)

STATUTES & REGULATIONS

I.R.C. § 6662

I.R.C. § 6664

I.R.C. § 7701

Taxpayer Relief Act of 1997, Pub. L. No. 105-34, 111 Stat. 788

Treas. Reg. § 1.6011-4

Treas. Reg. § 1.6662-3

Treas. Reg. § 1.6662-4

Definition of Reasonable Basis, 63 Fed. Reg. 66,433 (Dec. 2, 1998)

ADMINISTRATIVE

I.R.S. Chief Couns. Adv. 2008-26-036 (Feb. 29, 2008)

Rev. Proc. 2003-77, 2003-2 C.B. 964, supplemented, Rev. Proc. 2004-73

Rev. Proc. 2004-73, 2004-2 C.B. 999, supplemented, Rev. Proc. 2005-75

Rev. Proc. 2005-75, 2005-2 C.B. 1137, supplemented, Rev. Proc. 2006-48, 2006-2 C.B. 934

LEGISLATIVE

H.R. Rep. No. 111-443, vol. 1 (2010)

S. Rep. No. 97-494, vol. 1 (1982)

Staff of the J. Comm. on Tax’n, 106th Cong., 1st Sess., Study of Present-Law Penalty and Interest Provisions Vol. 1, 160, at Table 7 (Comm. Print 1999) (JCS-3-99)

OTHER AUTHORITIES

Closing Agreement, In re Washington Mut., Inc., No. 08-12229 (Bankr. Del. Sept. 1, 2010), ECF No. 5375-4

Report Responding to Eight Mots. by Pl. as Listed & Described Herein at 107, Wells Fargo & Co. v. United States, No. 09-cv-2765-PJS-TNL (D. Minn. July 22, 2014), ECF No. 486

Restatement (Second) of Torts (Am. Law Inst. 1965)

United States’ Obj. to the Special Master’s Report & Order Dated July 22, 2014 at 53, Wells Fargo & Co. v. United States, No. 09-cv-2765-PJS-TNL (D. Minn. Sept. 9, 2014), ECF No. 500

United States’ Resp. to Wells Fargo’s Partial Summ. J. Mot. That It Had Reasonable Basis for Its Tax Reporting of STARS at 21, Wells Fargo & Co. v. United States, No. 09-cv-2765-PJS-TNL (D. Minn. Feb. 3, 2014), ECF No. 455


INTRODUCTION

Through two separate opinions, this Court ruled in favor of Sovereign, upholding Sovereign’s tax reporting of the STARS transaction and rejecting the Government’s arguments under the economic substance and other related common law doctrines. On appeal, the First Circuit reversed this Court, determining that the STARS transaction lacked economic substance and, as a result, that Sovereign is not entitled to foreign tax credits claimed in connection with STARS.

The Government now argues that Sovereign should be subject to civil tax penalties on the underpayments of tax resulting from the First Circuit’s decision. Such penalties are inappropriate. Congress provided for civil tax penalties as a tool “designed to deter the use of undisclosed questionable [tax] reporting positions.”1 The penalty regime, however, also reflects Congress’ recognition “that taxpayers and the Government may reasonably differ over the sometimes complex Federal tax laws, and that a penalty is not appropriate . . . in many cases in which there is a large underpayment.”2

Here, there can be no question that Sovereign and the Government “reasonably differ[ed]” over the economic substance of the STARS transaction. The First Circuit’s decision turned on a single issue: its decision to treat foreign tax payments as a pre-tax expense in determining whether Sovereign could reasonably expect to earn a profit before taxes from the STARS transaction.3 But that dispositive holding contradicted the only case law to address the issue at the time that Sovereign was actually engaged in the STARS transaction.4 Both the Fifth and Eighth Circuits had previously rejected attempts to treat foreign tax as an expense when applying the economic substance doctrine.5 Moreover, the IRS itself twice recognized that its position regarding foreign tax expense was unsupported by the law extant in 2003 through 2005, both in the administrative determination made at the conclusion of its audit of Sovereign’s STARS transaction and in a memorandum setting forth the official position of the IRS Office of Chief Counsel.6

Moreover, the First Circuit’s explanation supporting its treatment of foreign taxes as an expense for purposes of the economic substance analysis reinforces that the First Circuit was creating new law not in existence at the time Sovereign filed its 2003, 2004, and 2005 tax returns. The First Circuit relied exclusively on a decision in another STARS case published more than eight years after Sovereign had exited the STARS transaction — Salem Financial, Inc. v. United States7 — and expressly disagreed with the only cases on point at the time that Sovereign participated in the STARS transaction. Notably, the Federal Circuit noted its divergence from prior case law in the Salem Financial decision.8 And, in another STARS case, the Second Circuit stated even more explicitly that its decision to treat foreign tax as an expense was a split from the decisions in Compaq and IES.9

In the context of assessing whether a tax penalty should be imposed because of Sovereign’s tax reporting of the STARS transaction, Sovereign’s disagreement with the Government in this case is eminently reasonable. Indeed, this Court twice held that STARS had economic substance before the First Circuit’s contrary decision. Sovereign’s reporting position that the STARS transaction had economic substance is consistent with the same authorities relied upon by this Court in reaching its summary judgment decisions. Years after Sovereign unwound its STARS transaction, the common law evolved such that the First Circuit ultimately determined that the STARS transaction lacked economic substance. While the effect of that decision is that Sovereign underreported its tax liability with respect to STARS, Sovereign should not be penalized for failing to anticipate novel developments in the common law. For the reasons set forth below, as a matter of law Sovereign cannot be subjected to penalties in this case.

PROCEDURAL HISTORY

This case involves the tax treatment of a structured financing transaction — the STARS transaction — through which Sovereign borrowed $1.15 billion from Barclays. As part of that transaction, Sovereign contributed $6.7 billion in assets to a Trust, which “engaged in a series of actions that generated a U.K. tax benefit for Barclays.”10

The primary dispute in this case — and the issue on which the First Circuit decided against Sovereign — is whether the Trust transaction has economic substance. Through two decisions on motions for summary judgment, this Court decided that the Trust transaction had economic substance and that, as a result, Sovereign was entitled to foreign tax credits and deductions in connection with that transaction.11 Specifically, this Court held that Sovereign reasonably expected to earn a pre-tax profit from the Trust transaction because: (1) the Barclays Payment should be treated as pre-tax income as a matter of law,12 and (2) the U.K. tax paid by Sovereign in connection with the transaction could not be treated as a pre-tax expense for purposes of testing economic substance.13 Given that expected profit, this Court determined that the Trust transaction was “objectively judged to have had economic substance” and that no trial was needed on the subject of Sovereign’s subjective intent in entering into STARS.14

On appeal, the First Circuit did not address the treatment of the Barclays Payment, and, accordingly, this Court’s holding on that issue remains undisturbed.15 The First Circuit’s reversal turned solely on the treatment of Sovereign’s U.K. tax payments.

The First Circuit held that the U.K. tax expense should be included in a pre-tax profit calculation while the disputed foreign tax credits should be ignored.16 On the basis of that holding, the First Circuit “conclude[d] both that the STARS Trust transaction had no objective non-tax economic benefit and that Congress, in creating the foreign tax credit regime, did not intend that it would cover this type of generated transaction.”17 Accordingly, Sovereign’s foreign tax credits were disallowed — and the disputed penalties are even at issue — for one reason and one reason only: the treatment of Sovereign’s U.K. tax payments in the pre-tax profit test.

MATERIAL UNDISPUTED FACTS

As set forth below, the question of Sovereign’s liability for penalties turns entirely on legal issues. Indeed, there are only two facts relevant to this motion, and they are both undisputed. First, Sovereign disclosed the STARS transaction in two forms attached to its tax return for each year in question: (1) a Form 8833, and (2) a Form 8886.18 Second, because of the Barclays Payment, the Trust transaction was expected to be profitable before consideration of U.K. tax expense or any other taxes.

ARGUMENT

In specified circumstances, the Code authorizes the imposition of civil penalties assessed on the amount of a tax underpayment.19 Here, the Government alleges that Sovereign should be subject to: (1) the “negligence” penalty,20 or (2) the “substantial understatement” penalty.21 If either penalty applies, Sovereign would owe a penalty equal to 20% of any underpayment related to STARS.

A taxpayer is not subject to penalties merely because its tax position is determined to be incorrect. Rather, if a taxpayer is determined to have underpaid its tax liability, there must be a separate determination regarding whether the statutory and regulatory requirements are met for the imposition of penalties. Thus, for example, for a negligence penalty to be imposed, the taxpayer must have “fail[ed] to make a reasonable attempt to comply with the provisions of [the Code].”22

The Code and regulations also specify defenses to penalties, two of which are at issue in this motion.23 First, the negligence penalty is not applicable if the taxpayer had a “reasonable basis” for its tax reporting position.24 Second, the substantial-understatement penalty is not applicable to the extent that the taxpayer (i) adequately disclosed to the IRS the disputed transaction, and (ii) had a reasonable basis for its tax reporting position.25 That defense to the substantial-understatement penalty, however, is unavailable to the extent that the underpayment is “attributable to a tax shelter.”26

Taken together, this motion therefore presents three issues:

1. Whether Sovereign had a reasonable basis for its reporting position. If Sovereign did have a reasonable basis, then it cannot be subject to the negligence penalty and has also satisfied one of the prongs for the defense to the substantial-understatement penalty.

2. Whether Sovereign adequately disclosed its reporting position. This is the second prong to Sovereign’s defense against the substantial-understatement penalty.

3. Whether Sovereign’s underpayment is attributable to a “tax shelter,” within the meaning of section 6662(d)(2)(C)(ii).

For the reasons set forth below, each of those questions must be answered in Sovereign’s favor under applicable law and the undisputed facts in this case.

I. Sovereign Had a Reasonable Basis for Its Tax Reporting Position.

Treasury Regulations provide an absolute defense to the negligence penalty: any “return position that has a reasonable basis . . . is not attributable to negligence.”27 A “reasonable basis” exists if a return position is “reasonably based on one or more of the authorities set forth in § 1.6662-4(d)(3)(iii) (taking into account the relevance and persuasiveness of the authorities, and subsequent developments).”28 The “authorities set forth in § 1.6662-4(d)(3)(iii)” include the Code, Treasury Regulations, Revenue Rulings, Tax Treaties, IRS notices or announcements, and case law. The weight a court gives to an authority must be considered in light of its relevance and persuasiveness (for example whether it is distinguishable), the type of authority, and its age (especially with respect to IRS guidance such as private letter rulings).29

The Congressional Joint Committee on Taxation has quantified “reasonable basis” as a position having a 20% or greater chance of success if challenged.30 Therefore, the reasonable-basis standard permits a taxpayer to take a reporting position that is 80% likely to lose without being penalized.

In assessing whether Sovereign had a reasonable basis for its reporting position, the relevant inquiry is the state of the law at the time its tax return was filed.31 Consistent with that rule, as the Government has itself recognized, a taxpayer cannot rely on authority that “did . . . not exist at the time [the taxpayer] filed the return in question.”32

Based on authorities extant when it filed its 2003-2005 tax returns, there was a reasonable basis for the reporting position reflected on Sovereign’s returns. The Government has already conceded that Sovereign complied with all applicable statutes and regulations.33 Moreover, as objectively demonstrated by this Court’s summary judgment decisions, Sovereign had a reasonable basis for its position that the STARS transaction had economic substance.

The Government’s position that the Trust transaction lacked economic substance is based on two legal arguments: (1) that the Barclays Payment should be ignored for purposes of the pre-tax profit test, and (2) that the foreign taxes paid in connection with the transaction must be treated as a pre-tax expense. This Court rejected the Government’s first argument (regarding the Barclays Payment).34 That holding was not disturbed on appeal and is the law of the case.35 Thus, the sole reason that the First Circuit found the Trust transaction lacked economic substance — and the sole reason that penalties are even at issue in this case — is the First Circuit’s decision to include Sovereign’s U.K. tax payments in the pre-tax profit analysis.36

At the time it filed the relevant tax returns, Sovereign had a reasonable basis for excluding U.K. tax from its pre-tax profit analysis. As discussed above, the reasonable basis standard requires merely that Sovereign had a 20% chance of prevailing on its position. Notably, at the time Sovereign filed its STARS-related tax returns, only two cases had addressed the issue of the treatment of foreign taxes in applying the economic substance doctrine. In both cases, the circuit court held that foreign tax should not be treated as an expense for purposes of assessing the pre-tax profit of a transaction of a cross-border transaction.37

Court cases are among the types of authorities that a taxpayer may use to demonstrate a reasonable basis, and Sovereign had a reasonable basis for its reporting position on the basis of those two circuit decisions alone.38 “When a legal issue is unsettled, or is reasonably debatable” a negligence penalty is generally not appropriate.39 Here, the legal issue was not merely “unsettled,” it actually appeared to be settled in Sovereign’s favor. Indeed, at the time Sovereign filed its tax returns, there was no contrary authority;40 IES and Compaq were the only extant cases to have addressed the issue of the treatment of foreign tax expense for purposes of the pre-tax profit test. Courts that have reached a different conclusion in recent years have expressly noted their departure from those cases.41 And, while IES and Compaq were decided in the context of different transactions, those cases nevertheless support Sovereign’s return position in this case. This Court implicitly recognized as much when it agreed with the analysis in IES and Compaq.42 Thus, Sovereign easily clears the low hurdle of demonstrating a reasonable basis.

A. Sovereign’s Reasonable-Basis Defense Presents an Issue of Law that Can Be Decided on Summary Judgment.

As discussed above, the reasonable-basis defense turns on the question of whether Sovereign’s “return position is reasonably based on one or more [applicable authorities.]”43 To determine whether that standard is satisfied, the Court must review legal authorities to determine whether or not they reasonably support Sovereign’s position in this case. That is a legal question for the Court to decide, not a jury.

The Government may take the position that the reasonable-basis defense is a subjective test. Specifically, the Government may argue that in evaluating whether Sovereign’s reporting position had a “reasonable basis,” the Court may consider only those authorities that Sovereign can prove that it subjectively considered before filing its return. And, the Government will argue, that is a factual question to be put to the jury.

That argument is wrong. The “reasonable basis” standard is an objective standard, not a subjective one. The Internal Revenue Code does not ask whether the taxpayer has a reasonable basis; it asks whether “there is a reasonable basis for the tax treatment of [an] item.”44 Similarly, the relevant regulation does not ask whether the taxpayer has a reasonable basis, it asks whether “[the] return position [has] a reasonable basis.”45 Of course, a “return position” is incapable of subjectively considering anything. Thus, the plain language of the Code and regulations demonstrates that the reasonable-basis defense must be objective.

Treating the reasonable-basis defense as an objective standard is also consistent with Treasury Regulations regarding the meaning of “substantial authority.” Like reasonable basis, substantial authority is a defense to certain penalties under section 6662.46 Like reasonable basis, the substantial authority standard “involv[es] an analysis of the law and application of the law to relevant facts.”47 The Treasury Regulations even expressly compare the reasonable basis and substantial authority standards, providing that substantial authority is simply a “more stringent” standard.48 Notably, the Treasury regulations expressly provide that “[t]he substantial authority standard is an objective standard.”49

The irrelevance of a taxpayer’s subjective views is further demonstrated by the fact that the Code prohibits taxpayers from relying on “legal opinions or opinions rendered by tax professionals” to support a reasonable-basis defense.50 The Government’s view that Sovereign must offer proof that it subjectively considered authorities when that proof would necessarily consist of opinions that are expressly excluded from consideration under the regulations is nonsensical.

Courts applying the reasonable-basis defense have also focused on the objective legal support for a reporting position and ignored whether the taxpayer actually considered the supporting authorities. For example, in Matthies v. Commissioner, the court made no findings regarding what the taxpayers considered at the time they filed their returns, relying instead on the uncertain state of the law, and, on that ground, held that the taxpayers had a reasonable basis for their return position as a matter of law.51

The Treasury Regulations also provide that the reasonable-basis standard of Code section 6662(b)(1) is not the same as the statutorily separate “reasonable-cause” defense in Treasury Regulation section 1.6664-4, which requires a specific inquiry into the taxpayer’s belief.52 The Government’s effort to make the reasonable-basis standard of Treasury Regulation section 1.6662-3(b)(3) into a subjective one would render the reasonable-basis defense a useless redundancy of the reasonable-cause standard of Code section 6664.53

Ignoring all the above authority, the District of Minnesota incorrectly held that the reasonable-basis defense requires proof of subjective reliance on the supporting authorities.54 That decision is wrong for several reasons. First, the Wells Fargo court begins its analysis by noting that reasonable basis is a defense to the negligence penalty, and that negligence normally focuses “on whether the taxpayer exercised due care.”55 That observation is wholly irrelevant. The fact that “there is a reasonable basis for the [reported] tax treatment” is also a defense to the substantial-understatement penalty, which is a penalty applicable when purely objective criteria regarding the amount of the underpayment are met.56 Moreover, the Wells Fargo court incorrectly reasons that because negligence is subjective, any defense to negligence must also be subjective. The law provides numerous examples of objective defenses to liability that otherwise turns on subjective behavior.57

Second, the Wells Fargo court manufactures “ambiguity” in the regulation setting forth the reasonable basis standard, arguing that the requirement that a return position be “based” on supporting authority suggests an inquiry into the subjective considerations of the taxpayer.58 The First Circuit, however, has construed the phrase “based upon” as providing an objective standard in the context of a different statute.59 Moreover, the “taxpayer” is not mentioned a single time in the relevant regulation; instead, the focus of the reasonable basis standard is on whether the “return position” is supported by relevant authority.60

Third, having imagined ambiguity where there is none, the Wells Fargo court decided that it should defer to “the Department’s interpretation of its own regulation.”61 The interpretation to which the court referred, however, was the litigating position of the “Department” — i.e., the Department of Justice.62 The Department of Justice, of course, plays no role in the issuance of the Treasury Regulations and its position in trial briefs is not entitled to deference.63

B. The Government Incorrectly Argues that Sovereign Cannot Rely on the Reasonable-Basis Defense.

The Government also argues that the above-cited authority supporting Sovereign’s position is wholly irrelevant. In the Government’s view, a taxpayer cannot have a reasonable-basis defense if a transaction is ultimately determined to lack economic substance.

The Government made the same argument in the Wells Fargo case, stating that “no authority exists to recognize tax results for transactions that have no purpose other than to claim tax benefits.”64 The Special Master in that case rejected that argument, noting correctly that “it seems quite inappropriate to conclude that a taxpayer that eventually loses a sham transaction case cannot avoid the negligence penalty even when there was a reasonable basis for its reporting.”65

The Government’s argument is a tautology that would convert the negligence penalty into a strict-liability penalty in every case where a transaction was found to lack economic substance. In fact, when Congress changed the law prospectively in 2010, it adopted this position — imposing strict-liability penalties for transactions that lack economic substance.66 At the time Sovereign filed its tax returns relevant in this case, however, the law was that a taxpayer’s reporting position could have a reasonable basis, even if a portion of the transaction at issue was later determined to lack economic substance.

Indeed, courts have specifically stated that a taxpayer can have a reasonable basis (or even substantial authority)67 for a reporting position with respect to a transaction that lacked economic substance.68 And, even courts that ultimately determined that a taxpayer did not have adequate support for his or her reporting position have analyzed the offered authorities to determine their weight and relevance.69 If a transaction that lacks economic substance were automatically subject to a penalty, courts would end their analysis immediately after concluding that the transaction lacked economic substance.

Sovereign undoubtedly had a reasonable basis here. At the time that Sovereign filed its relevant tax returns, the only authorities that addressed the dispositive issue in this case — the treatment of foreign tax in a pre-tax profit analysis — directly supported Sovereign’s position.70

II. Sovereign Adequately Disclosed its Reporting Position.

A taxpayer has a defense to the substantial-understatement penalty where (1) there is a reasonable basis for its tax position and (2) the disputed tax position was adequately disclosed in the tax return.71 As discussed above, Sovereign had a reasonable basis for reporting on the basis that the Trust Transaction had economic substance.

Sovereign also adequately disclosed the STARS transaction in its tax returns. The Treasury Regulations provide that such disclosure can be made in a return in accordance with an annual revenue procedure that identifies the circumstances under which disclosure is adequate for the purpose of reducing the understatement of income tax under section 6662(d).72 For the 2003, 2004, and 2005 taxable years, the IRS issued Revenue Procedures 2003-77, 2004-73, and 2005-75, respectively, to provide guidance for determining when disclosure is adequate for purposes of section 6662(d).73 Each of those revenue procedures provides that adequate disclosure can be made on a properly completed Form 8833.74

Sovereign filed a properly completed Form 8833 with each of its tax returns for the 2003, 2004, and 2005 taxable years.75 As required by the applicable revenue procedures, each Form 8833 was completed in a clear manner and fully in accordance with its instructions and clearly identified the amounts of foreign tax credits claimed in each year (all of which were claimed in connection with STARS). The relevant revenue procedures provide that, where such a disclosure has been made on a Form 8833, “[a]dditional disclosure of facts relevant to, or positions taken with respect to, issues involving any of the items [disclosed in a Form 8833] is unnecessary.”76 Accordingly, Sovereign has provided adequate disclosure with respect to the disputed foreign tax credits for purposes of reducing the understatement of income tax under section 6662(d).

In fact, Sovereign made additional disclosures beyond those required in the relevant revenue procedures. Specifically, Sovereign filed a protective Form 8886 with each of its tax returns for the 2003, 2004, and 2005 taxable years.77 The purpose of Form 8886 — like that of Form 8275, which is among the enumerated forms on which disclosure can be made for purposes of section 6662 — is to provide additional information concerning certain tax positions to allow the IRS to identify, review, and potentially challenge those positions. Each Form 8886 filed by Sovereign alerted the IRS to items on its tax return that could warrant a closer review and provided sufficient detail for the IRS to be able to understand the tax structure of any transaction that was disclosed and the identify of all parties thereto. Indeed, Sovereign’s disclosures of the STARS transaction on its Forms 8886 were substantially the same as the disclosure required on a Form 8275.78

Moreover, when the IRS developed its plan to audit the STARS transaction, it in fact started by reviewing Sovereign’s Forms 8886 and 8833.79 Accordingly, Sovereign successfully alerted the IRS to the STARS transactions in its return, and Sovereign exceeded the requirements for making adequate disclosure of the disputed foreign tax credits.

A. Even if Disclosure Was Not Adequate, Penalties Are Inappropriate Because Substantial Authority Supported Sovereign’s Tax Reporting Position.

To the extent a taxpayer does not make adequate disclosure, the taxpayer can still defend against the substantial-understatement penalty by demonstrating that there was substantial authority for the disputed reporting position.80 Like the reasonable-basis standard, whether a reporting position is supported by substantial authority is judged objectively based only on authority existing at the time the return is filed.81 A tax reporting position can be supported by substantial authority even if the position has less than a 50-percent chance of prevailing in litigation.82 “There is substantial authority for the tax treatment of an item . . . if the weight of the authorities supporting the treatment is substantial in relation to the weight of authorities supporting contrary treatment.”83

There was substantial authority for the tax treatment of the STARS transaction as reported by Sovereign. As described above, the only authorities on the dispositive issue in this case unanimously supported the return position on Sovereign’s tax returns.84 Accordingly, the weight of the authority supporting Sovereign’s reporting position must be “substantial in relation to the weight of authorities supporting contrary treatment,” which was none.85

III. Under the Law Extant at the Time that Sovereign Filed the Relevant Tax Returns, the Trust Transaction Was Not a “Tax Shelter.”

Sovereign understands that the Government will take the position that Sovereign cannot

avail itself of the reasonable-basis-and-adequate-disclosure defense to the substantial-understatement penalty. Specifically, the Code provides that such defense is not applicable where an underpayment is attributable to a “tax shelter” within the meaning of section 6662(d)(2)(C)(ii). Applying the law as it existed at the time that Sovereign filed its relevant tax returns, however, the Trust transaction was not a tax shelter.

A. The Question of Whether a Transaction Is a “Tax Shelter” Requires a Separate Analysis from the Judgment on the Merits and Can Be Decided on Summary Judgment.

For purposes of section 6662, a “tax shelter” is any transaction “a significant purpose [of which] is the avoidance or evasion of Federal income tax.”86 Although this standard is based on the “purpose” of the transaction, the taxpayer’s subjective intent is irrelevant. To the contrary, the question of whether a transaction is a tax shelter is to be “based on objective evidence,” including factors such as: (1) whether “the transaction[ ] [is] structured with little or no motive for the realization of economic gain,” and (2) whether the taxpayer has “mischaracterize[ed] . . . the substance of the transaction.”87 Given that the tax shelter standard is objective, courts can decide the question of whether a transaction is a tax shelter on summary judgment without evidence of the taxpayer’s subjective motivation.88 Indeed, both this Court and the First Circuit have determined the purpose of the STARS Trust transaction based upon an objective evaluation of the undisputed facts in response to cross-motions for summary judgment.89

There is relatively little case law interpreting the term “tax shelter.” The only court to examine the meaning of “tax shelter” under section 6662 in any detail is the District Court for the Northern District of Illinois.90 As held in Valero, the “significant purpose” standard is not satisfied if tax avoidance is merely “one of the purposes” of the transaction — it must be a “significant purpose.”91 By the same token, it is not enough for the IRS to demonstrate that the transaction resulted “in a significant tax benefit.” Instead, for a transaction to be a “tax shelter,” it must “produce[ ] a significant tax benefit” and have a “relative absence of other significant benefits or purposes.”92

Notably, a handful of courts have considered whether a transaction that lacks economic substance is a tax shelter within the meaning of section 6662. While those courts have considered facts found in connection with the substantive economic substance determination, they have also engaged in a separate analysis under the tax shelter standard.93 If lack of economic substance was sufficient by itself to make a transaction a tax shelter, that analysis would be unnecessary. Thus, this Court must undertake a separate analysis to determine whether the Trust transaction was a “tax shelter.” And, as discussed below, that determination cannot be based on the First Circuit’s finding regarding the “purpose” of the Trust transaction, which was based on case law that developed years after the return positions at issue were reported.

B. Whether a Transaction is a Tax Shelter Must Be Judged Under the Law as of the Time Sovereign’s Returns Were Filed.

As discussed above, a taxpayer has a defense to penalties where it can show that its return position was supported by applicable authority, e.g., because the return position has a “reasonable basis” or is supported by “substantial authority.”94 The law is clear, however, that a taxpayer cannot rely on authorities that post-date the filing of its tax return to defend against penalties.95 Instead, the support for a reporting position is judged at the time that the relevant tax return was filed.96 Applying this principle, taxpayer attempts to rely on law that post-dates the filing of the relevant return have repeatedly been rebuffed.97 The Government has itself invoked this principle in another STARS case, arguing that a taxpayer cannot rely on authority that “did . . . not exist at the time [the taxpayer] filed the return in question.”98

This rule makes sense from a policy perspective. The relevant event is the reporting of a tax position on a tax return. The reasonableness of that reporting position should be judged under the authority that existed at that time. A taxpayer should not be able to avoid penalties just because new authority developed between the time it filed its return and the time the validity of that position is litigated.

That same principle must apply to prevent the Government from relying on subsequent authority to support its penalty case. Put simply, if a taxpayer cannot escape penalties because the law later develops in its favor, the Government also cannot argue that penalties should be imposed on the basis of subsequent, Government-favorable authority. Instead, the question of whether a taxpayer should be subject to penalties should be decided based on the law that existed at the time the relevant return position was reported.99

C. Under the Law in Force at the Relevant Times, the Trust Transaction Was Not a Tax Shelter.

The Trust transaction was not a tax shelter within the meaning of section 6662.100 To support its position that STARS was a tax shelter, the Government will undoubtedly cite to the First Circuit’s “find[ing] that the Trust transaction is ‘shaped solely by tax-avoidance features’ . . . that ‘lack a bona fide business purpose,’”101 and that “generating U.S. foreign tax credits was the Trust transaction’s whole function.”102 Those findings, however, regarding the purpose of STARS were premised entirely on the decision to treat foreign tax as a pre-tax expense for purposes of applying the economic substance doctrine. In particular, the First Circuit held that “[w]hen . . . the U.K. taxes are factored into the pre-tax profitability calculation, the Trust transaction is plainly profitless.”103 It was only after determining that the transaction was “profitless” under its new pre-tax profit test that the First Circuit opined on the purpose of STARS.104

While the First Circuit’s findings undeniably address issues that appear similar to the question of whether STARS was a tax shelter, they are irrelevant to the penalty analysis in this case. As discussed in detail above, the First Circuit’s decision regarding the treatment of foreign tax expense is new law that did not exist at the time Sovereign engaged in STARS.105 At the conclusion of Sovereign’s STARS transaction, the IRS determined based on the official position of the IRS Chief Counsel’s Office that its “position that foreign taxes are costs for economic substance purposes [wa]s at odds with [Compaq and IES].”106 And the Second and Federal Circuits, when holding that foreign tax should be considered as part of the economic substance analysis, “disagree[d] with decisions of the Fifth and Eighth Circuits (Compaq and IES, respectively).”107

In its decision in this case, the First Circuit expressly “us[ed] similar reasoning” to that employed in the Federal Circuit’s 2015 decision in Salem Financial.108 The fact that the First Circuit’s decision was made in the context of Sovereign’s STARS transaction — as opposed to later-developed legal precedent in a case involving a different taxpayer — is legally irrelevant. The First Circuit’s holding in Sovereign’s case turns entirely on the legal holding that foreign tax should be treated as a pre-tax expense, and that newly created law cannot be relied upon for purposes of determining whether the Trust transaction was a tax shelter under section 6662 at the time Sovereign filed its returns in 2004, 2005, and 2006.

Applying the law in place in 2004 through 2006, the Trust transaction cannot be treated as a tax shelter. As discussed above, a transaction is a “tax shelter” if it: (1) “produced a significant tax benefit” and (2) had a “relative absence of other significant benefits or purposes.”109 Neither of those elements is satisfied. First, viewed through the contemporaneous legal lens and looking at the objective evidence, the Trust transaction did not generate any tax benefit, much less a significant tax benefit. As this Court held when applying the economic substance case law extant at the time Sovereign filed its returns, “Sovereign’s payment of the U.K. tax and claiming of the U.S. foreign tax credit did not produce an improper tax benefit.”110 Indeed, Sovereign “did not avoid any tax or reduce its income tax cost.”111 Instead, Sovereign merely paid U.K. tax rather than U.S. tax; the U.S. foreign tax credits operated to avoid double tax.112 Sovereign certainly considered the availability of a foreign tax credit in deciding whether to enter into the STARS transaction, but “[t]he fact that it considered the credit does not mean that its motive was simply to obtain the credit.”113

Second, Sovereign reasonably expected a profit from the Trust transaction when U.K. taxes are ignored (as required under the reasoning of Compaq and IES).114 As this Court recognized when applying that standard, Sovereign entered into the Trust transaction because that transaction “brought Sovereign the Barclays payment, a substantial economic benefit.”115

This Court’s prior decisions reflects the proper analysis of STARS under the law extant when the tax returns at issue in this case were filed. At that time, the only two courts to address the issue had held that foreign tax expense should be excluded from a proper pre-tax profit analysis. If that is done here, then Sovereign plainly expected a large profit from the STARS Trust through the Barclays Payment. That profit was a “significant benefit[ ] or purpose[ ] . . . of the transaction,” and, at the same time, Sovereign expected no tax benefit at all.116 Thus, the STARS Trust was not a tax shelter.

CONCLUSION

For the foregoing reasons, Sovereign respectfully asks that the Court rule that, as a matter of law, Sovereign cannot be subject to the negligence or substantial-understatement penalties.

Respectfully submitted this 25th day of August, 2017.

COUNSEL FOR PLAINTIFF

Rajiv Madan, D.C. Bar #463317
Christopher Bowers, D.C. Bar #468117
Royce Tidwell, D.C. Bar #986763
Christopher Murphy, D.C. Bar #500886
Nathan Wacker, D.C. Bar #1004278
SKADDEN, ARPS, SLATE, MEAGHER & FLOM LLP
1440 New York Ave. NW
Washington, D.C. 20005
Telephone: (202) 371-7000
Facsimile: (202) 393-5760
Email: raj.madan@skadden.com
chris.bowers@skadden.com
royce.tidwell@skadden.com
christopher.murphy@skadden.com
nathan.wacker@skadden.com

JONATHAN S. MASSEY
Massey & Gail LLP
1325 G Street, N.W., Suite 500
Washington, DC 20005
Telephone: (202) 652-4511
Email: jmassey@masseygail.com

LEONARD A. GAIL
PAUL J. BERKS
Massey & Gail LLP
50 E. Washington St., Suite 400
Chicago, IL 60602
Telephone: (312) 379-0469
Email: lgail@masseygail.com
pberks@masseygail.com

FOOTNOTES

1S. Rep. No. 97-494, vol. 1, at 273 (1982).

2Id.

3Santander Holdings USA, Inc. v. United States, 844 F.3d 15, 23-24 (1st Cir. 2016), cert. denied, 137 S. Ct. 2295 (2017).

4Sovereign entered into the STARS transaction in 2003 and unwound the transaction in 2007. Only the 2003 through 2005 tax years are directly at issue in this case.

5Compaq Computer Corp. v. Comm’r, 277 F.3d 778 (5th Cir. 2001); IES Indus., Inc. v. United States, 253 F.3d 350 (8th Cir. 2001).

6IRS Form 886A at IRS00136280-81 (attached hereto as Ex. 1); I.R.S. Chief Couns. Adv. 2008-26-036 (Feb. 29, 2008) (“The position that foreign taxes are costs for economic substance purposes is at odds with two decisions addressing the availability of foreign tax credits. . . .” I.R.S. Chief Counsel Advice 2008-26-036 is a legal advice memorandum written by the IRS Office of Chief Counsel with respect to Sovereign’s STARS transaction during the IRS’s audit of that transaction.

7F.3d 932 (Fed. Cir. 2015), cert. denied, 136 S. Ct. 1366 (2016).

8F.3d at 947-48.

9Bank of N.Y. Mellon, Corp. v. Comm’r, 801 F.3d 104, 124 (2d Cir. 2015), cert. denied, 136 S. Ct. 1377 (2016) (“[W]e agree with the Federal Circuit in Salem and disagree with decisions of the Fifth and Eighth Circuits (Compaq and IES, respectively)” — “it is appropriate, in calculating pre-tax profit [for foreign tax credits], for a court both to include the foreign taxes paid and to exclude the foreign tax credits claimed.”).

10Santander Holdings, 844 F.3d at 20.

11Santander Holdings USA, Inc. v. United States, 977 F. Supp. 2d 46 (D. Mass. 2013) (“Santander I”); Santander Holdings USA, Inc. v. United States, 144 F. Supp. 3d 239 (D. Mass 2015) (“Santander II”), rev’d and remanded, 844 F.3d 15 (1st Cir. 2016), cert. denied, 137 S. Ct. 2295 (2017).

12Santander I, 977 F. Supp. 2d at 52-54.

13Santander II, 144 F. Supp. 3d at 242-44. As an alternative position, this Court noted that if U.K. tax was included in the pre-tax profit calculation, the foreign tax credits must also be included. Id. at 243.

14Santander I, 977 F. Supp. 2d at 54.

15Santander Holdings, 844 F.3d at 23.

16Santander Holdings, 844 F.3d at 23.

17Id. at 24. The First Circuit went on to analyze whether the Trust transaction might be respected even though it was not profitable, but its treatment of foreign tax was the dispositive holding. See id. at 25-26. If the U.K. tax was ignored, then the Trust transaction was indisputably profitable because of the Barclays Payment and, accordingly, would have had economic substance. The First Circuit’s analysis of whether an unprofitable Trust transaction should nevertheless be respected would have been irrelevant.

18Forms 8833 (attached hereto as Ex. 2); Forms 8886 (attached hereto as Ex. 3).

19Section 6662. Unless otherwise specified, all references to “Code,” “section(s),” or “§ ” herein are to the Internal Revenue Code of 1986 (26 U.S.C., et seq.) as in effect for the year at issue; all references to “Treasury Regulation(s),” “Treas. Reg. §, ” or “Regulation(s)” refer to regulations promulgated by the U.S. Treasury Department, as in effect for the years at issue.

20Section 6662(b)(1).

21Section 6662(b)(2); see also First Am. Answer to Am. Compl. at 12-13 (Oct. 11, 2011), ECF No. 84. The Government does not argue that Sovereign disregarded the applicable rules and regulations. See section 6662(b)(1). To the contrary, the Government has conceded that Sovereign complied with all applicable rules and regulations, instead arguing that the STARS transaction violated the common-law economic substance doctrine. Santander Holdings, 844 F.3d at 17 (“As the government concedes, the STARS transaction complied on its face with then-existing U.S. statutory and regulatory requirements.”).

22Section 6662(c).

23Under section 6664(c)(1), the Government cannot impose section 6662 penalties where the taxpayer had reasonable cause for its reporting position and took that position in good faith. Sovereign maintains that the reasonable cause defense applies in this case, but does not rely on that defense for purposes of this motion because it presents fact issues that would require a trial to resolve.

24Treas. Reg. § 1.6662-3(b)(1).

25Section 6662(d)(2)(B).

26Section 6662(d)(2)(C)(i).

27Treas. Reg. § 1.6662-3(b)(1).

28Treas. Reg. § 1.6662-3(b)(3). As an example of a “subsequent development,” a district court case is not authority when a court of appeals has reversed the case before the return is filed. See Treas. Reg. § 1.6662-4(d)(3)(iii).

29Treas. Reg. § 1.6662-3(b)(3).

30Staff of the J. Comm. on Tax’n, 106th Cong., 1st Sess., Study of Present-Law Penalty and Interest Provisions Vol. 1, 160, at Table 7 (Comm. Print 1999) (JCS-3-99) (“Joint Committee Study”).

31Campbell v. Comm’r, 134 T.C. 20, 32 (2010), aff’d, 658 F.3d 1255 (11th Cir. 2011) (judging whether taxpayer had a “reasonable basis” based on the law “[a]t the time petitioner filed his original return”).

32United States’ Resp. to Wells Fargo’s Partial Summ. J. Mot. That It Had Reasonable Basis for Its Tax Reporting of STARS at 21, Wells Fargo & Co. v. United States, No. 09-cv-2765-PJS-TNL (D. Minn. Feb. 3, 2014), ECF No. 455.

33Santander Holdings, 844 F.3d at 17.

34Santander I, 977 F. Supp. 2d at 52-54.

35Santander Holdings, 844 F.3d at 23.

36See supra pp. 4-5.

37IES, 253 F.3d at 354; Compaq, 277 F.3d at 784-86.

38See Treas. Reg. §§ 1.6662-3(a)(3), -4(d)(3)(iii).

39Everson v. United States, 108 F.3d 234, 238 (9th Cir. 1997) (citation omitted).

40Congress’s codification of the economic substance doctrine in 2010 also confirms that the treatment of foreign tax as a pre-tax expense was a departure from prior law. Congress used existing case law as the foundation of its 2010 codification, defining the term “economic substance doctrine” by reference to “the common law doctrine.” Section 7701(o)(5)(A). Section 7701(o) was intended to “provide[ ] a uniform definition of economic substance,” but “not alter the flexibility of the courts in other respects.” H.R. Rep. No. 111-443, vol. 1, at 295 (2010). In other words, Congress would not have needed to include a section requiring that foreign tax be treated as a pre-tax expense unless that was not the common law.

41As discussed above, the Federal Circuit and the Second Circuit each previously noted that their decisions were directly contradicted by Compaq and IES. Supra Notes 8-9 and accompanying text. For its part, the First Circuit recognized it reached a different result than the Fifth and Eighth Circuits, but held that IES and Compaq “did not analyze [the] STARS transactions and so are distinguishable factually.” Santander Holdings, 844 F.3d at 24, n.11.

42Santander II, 144 F. Supp. 3d at 243-44.

43Treas. Reg. § 1.6662-3(b)(3).

44Section 6662(d)(2)(B)(ii)(II) (emphasis added). Section 6662(d)(2)(B)(ii)(II) discusses a “reasonable basis” in the context of a defense to the substantial-understatement penalty. Under the Treasury Regulations, the same “reasonable basis” standard applies with respect to both the negligence and substantial-understatement penalties. Treas. Reg. § 1.6662-4(e)(2)(i) (for purposes of defining “reasonable basis” for purposes of the defense to substantial-understatement penalties, cross-referencing definition of reasonable basis in the negligence penalty regulations).

45Treas. Reg. § 1.6662-3(b)(1) (emphasis added).

46See section 6662(d)(2)(B)(i).

47Treas. Reg. § 1.6662-4(d)(2).

48Id.; see also Treas. Reg. § 1.6662-3(b)(3).

49Treas. Reg. § 1.6662-4(d)(2).

50Treas. Reg. §§ 1.6662-4(d)(3)(iii), -3(b)(3) (incorporating Treas. Reg. § 1.6662-4(d)(3)(iii)).

51T.C. 141, 154-55 (2010); see also Burditt v. Comm’r, T.C. Memo. 1999-117 (holding that the taxpayer had substantial authority and a reasonable basis based solely on the objective, unsettled nature of the law at the time the return was filed); cf. Smoker v. Comm’r, T.C. Memo. 2013-56, at *19 (“Because substantial authority [a more stringent standard than reasonable basis] is measured objectively, a taxpayer’s belief about the weight of authority in support of his position is irrelevant.”).

52Treas. Reg. § 1.6662-3(b)(3).

53Even if Sovereign is required to demonstrate reliance, the undisputed evidence shows that it actually relied upon the authorities that support its position in this case. As discussed above, the economic substance of STARS turns on the treatment of foreign tax expense, and there were only two authorities that addressed that subject at the time Sovereign filed its returns: IES and Compaq. Supra pp. 8-10. Both of the tax opinions obtained by Sovereign regarding the proper tax treatment of STARS contain extensive discussions of those two cases. KPMG Tax Opinion at 54-55 (Nov. 12, 2003) (excerpts attached hereto as Ex. 4); Sidley Austin Tax Opinion at 72-74 (Nov. 6, 2003) (excerpts attached hereto as Ex. 5).

54Well Fargo & Co. v. United States, No. 09-cv-2764-PJS-TNL, 2017 WL 2274955 (D. Minn. May 24, 2017).

55Id. at *6.

56Section 6662(d)(2)(B)(ii)(II), (d)(1); see also supra Note 44.

57For example, torts requiring proof of tortfeasor intent, a subjective inquiry, may be excused if the conduct is based on objective criteria including the plaintiff’s consent or public or private necessity. See, e.g., Restatement (Second) of Torts §§ 158, 167, 196, 197, 892 (Am. Law Inst. 1965) (intentional intrusion on land is privileged if pursuant to plaintiff’s consent in fact or public or private necessity); id. at §§ 216, 217, 252, 262, 263 (same for trespass to chattel or conversion).

58Well Fargo, 2017 WL 2274955, at *7.

59U.S. ex rel Ondis v. City of Woonsocket, 587 F.3d 49, 57-58 (1st Cir. 2009) (holding statutory term “based upon” in False Claims Act means objectively similar and rejecting argument that determining if complaint was “based upon” prior disclosure would “require[ ] proof” of actual reliance).

60Treas. Reg. § 1.6662-3(b)(3) (“The reasonable basis standard is not satisfied by a return position;” “[i]f a return position is reasonably based;” “the return position will generally satisfy the reasonable basis standard;” “if a return position does not satisfy the reasonable basis standard.” (emphases added)).

61Id.

62The Wells Fargo court also cites a statement from a preamble to Treasury Regulations for support that the “reasonable basis” standard is subjective. Well Fargo, 2017 WL 2274955, at *7. That language is irrelevant, however, because the plain language of the Treasury Regulations unambiguously demonstrates that “reasonable basis” is an objective test. See Principal Life Ins. Co. v. United States, 116 Fed. Cl. 82, 104 (2014) (“Where the text of a regulation is less than clear, the court may look to the preamble of the regulation to determine the administrative construction thereof.” (emphasis added)); Kingdomware Techs., Inc. v. United States, 107 Fed. Cl. 226, 243 (2012), aff’d, 754 F.3d 923 (Fed. Cir. 2014) (similar). Put simply, the cited language from the preamble is directly inconsistent with the actual language of the Treasury Regulations. Compare, e.g., Treas. Reg. § 1.6662-3(b)(3) (ranking “reasonable basis” against other tax reporting standards) and Treas. Reg. § 1.6662-4(d)(2) (same) with Definition of Reasonable Basis, 63 Fed. Reg. 66,433 (Dec. 2, 1998) (“The final regulations do not rank the [tax reporting] standards . . .”).

63Bowen v. Georgetown Univ. Hosp., 488 U.S. 204, 212 (1988) (“[W]e have declined to give deference to an agency counsel’s interpretation of a statute where the agency itself has articulated no position on the question, on the ground that ‘Congress has delegated to the administrative official and not to appellate counsel the responsibility for elaborating and enforcing statutory commands.’”) (quoting Inv. Co. Inst. v. Camp, 401 U.S. 617, 628 (1971)). In an attempt to support its deference to the Department of Justice’s litigating position, the Wells Fargo court cited Auer v. Robbins, 519 U.S. 452 (1997). That case, however, stands for no such proposition. In Auer, the position to which the Supreme Court deferred were the views offered by the Secretary of Labor — i.e., the head of the agency charged with administering the rules in question — in an amicus brief filed with the Court. 519 U.S. at 461.

64United States’ Obj. to the Special Master’s Report & Order Dated July 22, 2014 at 53, Wells Fargo & Co. v. United States, No. 09-cv-2765-PJS-TNL (D. Minn. Sept. 9, 2014), ECF No. 500.

65Report Responding to Eight Mots. by Pl. as Listed & Described Herein at 107, Wells Fargo & Co. v. United States, No. 09-cv-2765-PJS-TNL (D. Minn. July 22, 2014), ECF No. 486.

66See sections 6662(b)(6), 6664(d)(2), 7701(o).

67“Reasonable basis” is merely a less stringent version of the expressly objective “substantial-authority” standard, even incorporating the same rules for determining whether a position has reasonable basis or substantial authority (other than applying the higher standard for substantial authority). Compare Treas. Reg. § 1.6662-3(b)(3) with Treas. Reg. § 1.6662-4(d)(2).

68See, e.g., Southgate Master Fund, LLC v. United States, 651 F. Supp. 2d 596, 666 (N.D. Tex. 2009), aff’d 659 F.3d 466 (5th Cir. 2011) (“Taxpayers may have substantial authority for their positions even when the underlying transactions are disallowed as lacking economic substance.”); Peerless Indus., Inc. v. United States, No. Civ. A. 92-2163, 1994 WL 13837, *10 (E.D. Pa. Jan. 19, 1994), aff’d, 37 F.3d 1488 (Table) (3d Cir. 1994).

69See, e.g., In re CM Holdings, Inc., 254 B.R. 578, 648-49 (D. Del. 2000) (analyzing whether taxpayer had “substantial authority” where transaction lacked economic substance), aff’d, 301 F.3d 96 (3d Cir. 2002); Stiebling v. Comm’r, No. 95-70391, 1997 WL 257465, *5 (9th Cir. May 14, 1997) (similar).

70Supra pp. 8-10.

71Section 6662(d)(2)(B)(ii).

72Treas. Reg. § 1.6662-4(f)(1), (2).

73Rev. Proc. 2005-75, 2005-2 C.B. 1137, supplemented, Rev. Proc. 2006-48, 2006-2 C.B. 934; Rev. Proc. 2004-73, 2004-2 C.B. 999, supplemented, Rev. Proc. 2005-75; Rev. Proc. 2003-77, 2003-2 C.B. 964, supplemented, Rev. Proc. 2004-73.

74Rev. Proc. 2005-75, § 4.02(4)(b); Rev. Proc. 2004-73, § 4.01(4)(b); Rev. Proc. 2003-77, § 4.01(4)(b).

75See IRS Form 886-A at IRS00136263 (attached hereto as Ex. 1). Examples of Sovereign’s Forms 8833 are attached hereto as Ex. 2.

76Rev. Proc. 2005-75, § 4.01(1); Rev. Proc. 2004-73, § 4.01; Rev. Proc. 2003-77, § 4.01.

77See Forms 8886 for each relevant tax year (attached hereto as Ex. 3). The filing of a Form 8886 constitutes adequate disclosure with respect to certain reportable transactions for the purposes of reducing any potential understatement penalty imposed under section 6662A. See section 6662A(a), (c); section 6664(d)(3)(A); Treas. Reg. § 1.6011-4(d).

78In the years at issue, Form 8275 required a complete description of the items being disclosed, a calculation of the amount at issue, and “a description of the relevant facts and the nature of the controversy affecting the tax treatment of the item or a concise description of the legal issues presented by the these facts.” Instructions for Form 8275 (attached hereto as Ex. 6). On its Forms 8886, Sovereign described the structure of the STARS transaction, the expected tax treatment of the STARS, and provided an estimate of the amount of the foreign tax credits expected to be claimed. See Ex. 3 at IRS00128341, IRS00128338, IRS00136163.

79IRS Memo. regarding “Examination Plan” at IRS00133609 (attached hereto as Ex. 7).

80Section 6662(d)(2)(B)(i).

81Treas. Reg. § 1.6662-4(d)(2); id. at (d)(3)(iv)(C).

82Treas. Reg. § 1.6662-4(d)(2).

83Treas. Reg. § 1.6662-4(d)(3)(i).

84Supra pp. 8-10.

85Treas. Reg. § 1.6662-4(d)(3)(i).

86Section 6662(d)(2)(C) (flush language).

87Treas. Reg. § 1.6662-4(g)(2)(i) (flush language). Prior to the years at issue in this case, the statutory definition of a “tax shelter” for purposes of section 6662 required that a principal purpose of the transaction be tax avoidance. In 1997, section 6662 was amended to reflect the current significant-purpose standard. Taxpayer Relief Act of 1997, Pub. L. No. 105-34, 111 Stat. 788, 928. The relevant Treasury Regulations still reflect the old statutory definition of a “tax shelter.” See Treas. Reg. § 1.6662-4(g)(2)(i). Nevertheless, those regulations illustrate the types of factors that should be considered in evaluating whether a transaction is a tax shelter.

88See Alpha I, L.P. v. United States, 93 Fed. Cl. 280, 318-21 (2010) (deciding transaction was a tax shelter on motion for summary judgment).

89See Santander Holdings, 844 F.3d at 24 (“Exposure to U.K. taxation for the purpose of generating U.S. foreign tax credits was the Trust transaction’s whole function.”); Santander II, 144 F. Supp. 3d at 245 (“There was a genuine, non-tax business purpose for Sovereign’s participation in the STARS transaction.”).

90See Valero Energy Corp. v. United States, No. 06-C-6730, 2007 WL 4179464 (N.D. Ill. Aug. 23, 2007). The issue in Valero was the application of the tax shelter exception to the federally authorized tax practitioner privilege of section 7525, which incorporates the section 6662 tax shelter definition.

91Id. at *9.

92Id.

93See, e.g., Stobie Creek Invs., LLC v. United States, 82 Fed. Cl. 636 (2008), aff’d, 608 F.3d 1366 (Fed. Cir. 2010) (analyzing whether transactions that lacked economic substance were “tax shelters” based on the purpose of the transactions); Chemtech Royalty Assocs., L.P. v. United States, Nos. 05-944-BAJ-DLD, 06-258-BAJ-DLD, 07-405-BAJ-DLD, 2013 WL 704037, *30 (M.D. La. Feb. 26, 2013), aff’d 823 F.3d 282 (5th Cir. 2016) (same); Salty Brine I, Ltd. v. United States, Nos. 10-CV-108-111-C, 161-C, 11-CV-137-C, 12-CV-227-C, 13-CV-014-C, 2013 WL 4038993, *18 (N.D. Tex. May 16, 2013), aff’d, 761 F.3d 484 (5th Cir. 2014) (same).

94Supra pp. 7-8, 20-21.

95Treas. Reg. § 1.6662-4(d)(3)(iv)(C) (“There is substantial authority for the tax treatment of an item if there is substantial authority at the time the return containing the item is filed or there was substantial authority on the last day of the taxable year to which the return relates.”); Chemtech Royalty Assocs., L.P. v. United States, 823 F.3d 282, 290 (5th Cir. 2016), cert. denied, 137 S. Ct. 624 (2017) (interpreting foregoing regulation to mean that an authority “is relevant for purposes of the substantial-authority inquiry only if it existed at the time the return containing the item was filed or the last day of the taxable year to which the return relates”); NPR Invs., L.L.C. v. Comm’r, 740 F.3d 998, 1013 (5th Cir. 2014) (holding that cited regulation was inapposite because regulation did not exist when returns were filed).

96Campbell, 134 T.C. at 32.

97See, e.g., Galedridge Constr., Inc. v. Comm’r, T.C. Memo. 1997-485, at *5 (case decided after taxpayer filed the return for the taxable year at issue is not relevant to substantial authority analysis); Crawford v. Comm’r, T.C. Memo. 1993-192, *16 (same); Kretschmer v. Comm’r, T.C. Memo. 1989-242 (same).

98United States’ Resp. to Wells Fargo’s Partial Summ. J. Mot. That It Had Reasonable Basis for Its Tax Reporting of Sales at 21, Wells Fargo & Co. v. United States, No. 09-cv-2765-PJS-TNL (D. Minn. Feb. 3, 2014), ECF No. 455.

99The Sixth Circuit recently recognized the problem with ever-changing applications of the economic substance doctrine and other anti-abuse doctrines. “If the government can undo transactions that the terms of the Code expressly authorize, it’s fair to ask what the point of making these terms accessible to the taxpayer and binding on the tax collector is.” Summa Holdings, Inc. v. Comm’r, 848 F.3d 779, 782 (6th Cir. 2017). There, the Sixth Circuit held for the taxpayer on the question of the taxpayer’s substantive tax liability. That same concern — holding taxpayers liable for unanticipated changes in tax law — counsels even more strongly for not imposing penalties in this case.

100It is worth noting that of the six STARS transactions that the Government argues are virtually identical, the IRS did not even assert penalties with respect to two transactions. See Bank of N.Y. Mellon, 801 F.3d 104 (no penalty even assessed); Wells Fargo & Co. v. United States, 750 F. Supp. 2d 1049, 1050 (D. Minn. 2010) (penalties first asserted by DOJ in litigation as “an ‘offset’ or ‘recoupment’ defense”). Furthermore, the public settlement documents show that the IRS agreed to resolve a third STARS transaction with no penalty owed. Closing Agreement at 7, ¶ 4, In re Washington Mut., Inc., No. 08-12229 (Bankr. Del. Sept. 1, 2010), ECF No. 5375-4 (settlement agreement with no penalty liability).

101Santander Holdings, 844 F.3d at 23.

102Id. at 24.

103Id. at 23-24.

104See id. at 23-24 (deciding to treat foreign tax as expense); id. at 24 (“Accordingly, we conclude both that the STARS Trust transaction had no objective non-tax economic benefit and that Congress, in creating the foreign tax credit regime, did not intend that it would cover this type of generated transaction. Exposure to U.K. taxation for the purpose of generating U.S. foreign tax credits was the Trust transaction’s whole function.” (emphasis added)).

105See supra pp. 2-3, 10.

106IRS Form 886-A at IRS00136280 (attached hereto as Ex. 1) ; see also I.R.S. Chief Couns. Adv. 2008-26-036.

107Bank of N.Y. Mellon, 801 F.3d at 124. See also Salem Fin., 786 F.3d at 947-48.

108Santander Holdings, 844 F.3d at 23.

109Valero, 2007 WL 4179464, at *9.

110Santander I, 977 F. Supp. 2d at 53.

111Santander II, 144 F. Supp. 3d at 245.

112Santander I, 977 F. Supp. 2d at 53.

113Santander II, 144 F. Supp. 3d at 246.

114The Treasury Regulations specifically identify the potential for profit from a transaction as a factor to be considered in determining whether a transaction is a tax shelter. Supra Note 87 and accompanying text.

115Santander II, 144 F. Supp. 3d at 246-47.

116See Valero, 2007 WL 4179464, at *9.

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