Over the last few weeks, Stephen, Keith and I (with some help from others like Jack Townsend who is the lead author on the criminal penalties chapter) are all writing up the next update for IRS Practice and Procedure, and are sorting through and writing about 125 developments from March through early July for addition to the book.
A few of the developments are major ones we did not address in Procedurally Taxing. One is the Wells Fargo case from earlier this spring. You may recall Wells Fargo v US where Stu Bassin in a post on PT discussed the government’s loss in its efforts to use the economic substance doctrine to disallow interest expense deductions for a transaction that lacked a non tax business purpose. The case also has an interesting and important penalty component involving the government’s assertion of a negligence penalty in connection with Wells Fargo’s claiming of disallowed foreign tax credits.
The issue was teed up for the district court in a somewhat odd manner, with Wells Fargo stipulating that if the foreign credit generating transaction was a sham, it should not be subject to the penalty because “there was an objectively reasonable basis for Wells Fargo’s return position under the authorities referenced in § 1.6662–3(b)(3).”
The court held that the foreign credit generating transaction was a sham. Wells Fargo agreed to the stipulation to limit discovery, but the effect of the stipulation prevented it from arguing that it exercised ordinary and reasonable care in the preparation of its tax return. In other words, Wells Fargo felt that the authority for the position was sufficient to shield it from penalties without regard to any independent effort it made to assess the merits of the transaction prior to taking its position on its tax return. Wells Fargo did so because the regulations insulate from negligence a return position that has a reasonable basis; i.e., the position is reasonable based on one or more authorities (as further defined in the regulations).
In the opinion considering the penalties, the district framed the issue as follows:
Is it enough for Wells Fargo to show that its return position had a reasonable basis under the authorities referenced in § 1.6662–3(b)(3)? Or must Wells Fargo prove that it actually consulted those authorities in preparing its tax return?
The district court held that Wells Fargo was subject to the penalty because it had to prove that it in fact consulted with the authorities before adopting its position on the return. This was the view the government urged under the regulations; the taxpayer argued that the statute and regulatory focus is on an objective analysis, with the taxpayer’s efforts beside the point.
The Court found the regulations to be ambiguous, specifically that Treasury Regulation §1.6662-3(b)(3) states a reasonable basis is satisfied if “a return position is reasonably based on one or more” authorities. That was important, because under administrative law principles (so-called Auer deference) an agency is entitled to deference regarding an interpretation of an ambiguous question relating to the meaning of its own regulations.
At or around the time of the opinion, Jim Malone of Post & Schell wrote a terrific blog post critiquing the district court opinion, suggesting that perhaps Wells Fargo deserved to be penalized but that the court’s approach to the issue was “troubling”. There was also a piece in Bloomberg that quoted Jim and former PT guest poster Andy Grewal, with Andy saying that “it would be more sensible to apply Section 1.6662-3(b)(1) in accordance with its plain meaning and examining all relevant authorities supporting the treatment of a position, whether or not the taxpayer was aware of them.”
The Wells Fargo outcome is a departure from the norm in these cases because it has generally been thought that reasonable basis is an objective inquiry; i.e., if the position is more or less plausible based on an authority, then the taxpayer is free from the penalty. As Jim discusses, there are some cases along the lines suggesting that if a taxpayer had some separate reason to do a bit of digging then more than just objective analysis is warranted, yet the Wells Fargo opinion suggests a differing starting point than what many believed to be the case under the regulations.
I am not sure that other courts will follow this approach but it is something that advisers should be aware of when considering the effect of a stipulation as well as what may be necessary to put in the record if one is looking to rely on this defense to penalties.