United States: Eighth Circuit Disallows Capital Loss On Transaction That Lacked Economic Substance

The Court of Appeals for the Eighth Circuit affirmed a district court's decision denying the taxpayer — a bank — a capital loss  and corresponding tax refund from the carryback of the capital loss because the underlying transaction was a sham that lacked both economic substance and a business purpose.

In WFC Holdings Corporation. v. United States, No. 11-3616 (8th Cir. 2013), the taxpayer-bank contributed approximately $426 million of government securities and $423 million of underwater leases to a nonbank subsidiary corporation in exchange for newly issued subsidiary stock.  The underwater leases related to lease obligations acquired in a prior transaction where the payment obligations on the leases exceeded the expected rents to be received from subleasing the properties.

The bank's basis in the newly issued stock was $426 million, even though the stock had little value because the underwater leases were payment liabilities, and thus did not reduce the basis of the newly issued stock in the hands of the bank. The bank ultimately sold the newly issued stock as part of the overall transaction to an unrelated party for approximately $3.6 million and claimed a Section 165 loss on the sale of approximately $423 million.

The facts of the case predate the codification of the economic substance doctrine under Section 7701(o), and thus the Eighth Circuit applied the judicially created economic substance doctrine under Frank Lyon Co. v. United States, 435 U.S. 561 (1978) and Rice's Toyota World, Inc. v. Commissioner, 752 F.2d 89 (4th Cir. 1985).

In general, courts have applied a two-pronged test to determine whether a transaction lacks economic substance: First, courts consider whether the transaction lacks any real potential for profit (the economic substance prong), and second, courts consider whether the transaction lacks a business purpose outside of tax considerations (the business purpose prong). Some circuit courts of appeal require taxpayers to satisfy both prongs of the test to sustain the tax benefits claimed in a transaction. Other courts require taxpayers to satisfy only a single prong of the test to sustain the tax benefits claimed in a transaction. The Eighth Circuit has not adopted either an "and" or an "or" test in any previous case, and did not adopt one in this case because it found that the taxpayer failed both prongs of the overall economic substance analysis.

The taxpayer unsuccessfully contended that the contribution of the leases for new stock, followed by the sale of that stock, was undertaken for bona fide nontax business purposes. The taxpayer argued, in part, that certain of the underlying leases consisted of tainted property, or "other real estate owned" (so-called "OREO" leases) that banks are not permitted to hold long-term under industry-specific banking rules. The bank's disposal of those underwater leases, therefore, cured looming regulatory issues, according to the taxpayer's position. 

The Eighth Circuit disagreed with the taxpayer's characterization of the underwater leases and the corresponding business necessity of disposing of those leases.  The court noted that several of the underwater leases were not, in fact, tainted OREO leases, and that the bank could have cured the OREO problem merely by transferring the OREO leases to a nonbank entity, without also transferring government securities and without also selling the newly issued stock to an unrelated party.

The court also said the bank never communicated with the relevant government agency about the OREO leases or the possibility of obtaining an extension of the permissible holding period for the leases. It said that the bank furthermore failed to transfer, and instead continued to hold, several other tainted OREO leases pursuant to the transaction.

The taxpayer's stated nontax reasons for the transaction did not correspond with the district court's factual findings, the appeals court said. Consequently, the Eighth Circuit ruled that the taxpayer's transaction generating a putative $423 million loss lacked both economic substance and business purposes, and disallowed the loss and the refund claim. 

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