United States: Eighth Circuit Affirms District Court, Transactions Lacked Economic Substance In Wells Fargo

On August 22, the Eighth Circuit affirmed a holding by the US District Court for the District of Minnesota that a transaction involving lease transfers lacked objective economic substance and a subjective business purpose.1 The court rejected taxpayer Wells Fargo's contention that it had engaged in the transaction to avoid bank regulations regarding the leases.


When Old Wells Fargo ("OLF") acquired First Interstate Bancorp ("First Interstate") in 1996, the two banks had a number of leased properties in similar locations. After OWF merged with Northwest Corporation to become Wells Fargo ("WFC") in 1998, WFC retained the lease obligations.

Tax-Reduction Strategy

The court found that before the merger, an accounting firm which marketed a contingent-liability tax-reduction strategy called an "economic liability transaction" advised OWF that OWF's leases could be used to reduce its federal tax liability by creating current losses to shield current income from tax. The accounting firm recommended a strategy that included OWF making a tax-free transfer of valuable assets and tax-deductible liabilities to a subsidiary in exchange for corporate stock. The value of the corporate stock would be reduced by the value of the liabilities, but the stock basis would remain equal to the tax basis of the assets transferred. OWF would then sell the stock to an outside third-party at the low market value, resulting in a large capital loss.

Under section 351(a), a taxpayer recognizes no gain or loss from its property transfer into a corporation solely in exchange for stock, provided that it controls the corporation immediately after the transfer. Under section 358(a)(1)(A)(ii), a taxpayer's basis in the stock it receives in such a transfer must equal its tax basis in the property transferred, and the taxpayer must reduce its basis in the stock by the amount of any money it receives in addition to stock. Assumption of liabilities is treated as money received by the taxpayer under section 358(d), but if the corporation assumes liabilities, the payment of which would give rise to a deduction, its assumption of the liabilities will not reduce its tax basis in the stock.2 According to the court's findings, the accounting firm told OWF that the strategy needed a non-tax business purpose to succeed. Ultimately, WFC wrote a business-purpose document that explained the regulatory benefit of transferring the leases into a non-banking subsidiary. If the leases were in a non-banking subsidiary, WFC would have more flexibility in managing them because they would fall under less rigid regulations. According to WFC, the transfer would also strengthen the bank's negotiating position with bank customers and incentivize managers.

Once it had established its business purpose, WFC transferred government securities with a tax basis of $426 million and leasehold interest to a holding corporation that issued 4,000 shares of its stock to the bank and assumed the lease obligations. An unrelated third party purchased the stock from WFC for $3.7 million. WFC claimed a deduction for a $423 million capital loss on its 1999 return and filed a refund claim in 2003 claiming a capital loss carryback from its 1999 tax return that resulted in part from the 1999 capital loss. WFC claimed an $82 million refund for 1996.

The IRS disallowed WFC's refund, and WFC filed suit in district court. The district court held in favor of the IRS and found that although the government had not proven that WFC violated its requirements, the transaction failed both the business purpose and economic substance parts of the economic substance doctrine.

Appellate Court Analysis

Relying on Frank Lyon,28 the court analyzed the transaction under the economic substance doctrine. Under the economic substance doctrine, a court must disregard a transaction that a taxpayer enters into without a valid business purpose for the purpose of claiming tax benefits. In the Eighth Circuit, courts examine a transaction's economic substance under a two-part test that looks at (1) whether there is any economic purpose outside of tax considerations (the "business purpose test") and (2) whether a real potential for profit exists (the "economic substance test").3 The court concluded that the transaction at issue lacked both an economic purpose and economic substance.

WFC argued that the district court's findings showed that the transaction had economic substance. The appellate court rejected this: "WFC has misconstrued the district court's findings. WFC's transfer of the Garland lease to Charter—one economically beneficial component of a much larger, complex transaction—does not impart substance to the larger LRT/stock transaction. We agree with the district court...."

The appellate court also agreed with the district court's business purpose analysis. The appellate court reiterated its conclusion that the transaction had no real potential for profit but still evaluated the district court's discussion of WFC's three bases for business purpose—the favorable bank regulations applicable after the transaction, strengthening its position with customers, and incentivizing managers. The district court had stated that WFC could have achieved the same regulatory result without creating a new class of stock and selling it simply by transferring the leases to a non-banking subsidiary. The appellate court did not find that the district court's analysis employed an improper approach and held that the district court made no error in finding that WFC had failed to meet its burden of proof that it engaged in the transaction for regulatory reasons. The court likewise held that the district court did not err in holding that the transfer was not motivated by improving its relationship with customers or incentivizing managers.

Notably, the Eighth Circuit highlighted the circuit court split over the application of the economic substance doctrine. The court declined to decide whether a transaction could fail only the economic substance or the business purpose tests and still fail the economic substance doctrine test because this transaction failed both tests.


1 WFC Holdings Corp. v. US, No. 11-3616 (8th Cir. Aug. 22, 2013).

2 Sections 358(d)(2) and 357(c)(3).

3 Frank Lyon Co. v. United States, 435 US 561 (1978).

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