Santander Holdings USA, Inc. v. U.S., (DC MA 7/17/2018) 122 AFTR 2d ¶2018-5047
A district court has denied a bank, which was held by the Court of Appeals to have engaged in a Structured Trust Advantaged Repackaged Securities (STARS) transaction that lacked economic substance, summary judgment on its claims that it (i) wasn’t liable for accuracy-related penalties on understatements arising from the transaction, and (ii) was entitled to deduct foreign taxes paid in connection with the transaction.
Background—penalties. Taxpayers are subject to a 20% accuracy-related penalty for an underpayment of tax attributable to negligence or a substantial understatement of income. (Code Sec. 6662(b)(1), Code Sec. 6662(b)(2))
To avoid liability for the negligence penalty, a taxpayer must show that it had a “reasonable basis” for the return position that resulted in the understatement. (Reg. § 1.6662-3(b)(1)) To establish “reasonable basis,” a taxpayer must show, based on one or more of the acceptable authorities enumerated in the regs, that its return position was more than merely arguable or colorable. (Reg. § 1.6662-3(b)(3))
To reduce or eliminate the substantial understatement penalty, the taxpayer must show that there was either a reasonable basis for the chosen tax treatment that the taxpayer had “adequately disclosed” to IRS, or “substantial authority” to support the taxpayer’s return position that resulted in the understatement. (Code Sec. 6662(d)(2)(B)) “Substantial authority” means that “the weight of the [enumerated] authorities supporting the treatment is substantial in relation to the weight of [such] authorities supporting contrary treatment.” (Reg. § 1.6662-4(d)(3)(i))
Background—deduction for foreign tax expense. Both the U.S. and foreign countries may tax the foreign source income of U.S. taxpayers. To ease this double taxation burden, the Code permits most U.S. taxpayers who pay income taxes to a foreign country to either (i) deduct the taxes from gross income under Code Sec. 164 for U.S. purposes, or (ii) credit them dollar for dollar against their U.S. income tax liability on foreign source income under Code Sec. 901.
Facts. Sovereign Bancorp, Inc. (Sovereign), which was later known as Santander Holdings USA, Inc., engaged in a STARS transaction promoted by the U.K.-chartered Barclays Bank PLC (Barclays).
As part of the STARS transaction, Sovereign created a trust, the income of which was subject to both U.K. and U.S. income tax. Sovereign paid the U.K. taxes and then claimed a foreign tax credit under Code Sec. 901 in calculating its U.S. income tax liability. Barclays and Sovereign also engaged in certain complex transactions involving the trust that they claimed resulted in a loan in respect to which Sovereign made deductible interest payments to Barclay. Barclays also made a monthly payment to Sovereign in connection with the transaction.
IRS disallowed foreign tax credits claimed by Sovereign for 2003, 2004, and 2005, and imposed accuracy-related penalties. Sovereign sued to recover $234 million in federal income taxes, penalties, and interest.
District & Appellate court decisions. In 2013, a Massachusetts district court granted Sovereign partial summary judgment that the monthly payments made to it from Barclays should be accounted for as revenue to Sovereign in assessing whether Sovereign had a reasonable prospect of profit in the STARS transaction. (Santander Holdings USA, Inc. v. U.S., (DC WA 2013) 112 AFTR 2d 2013-6530)
Sovereign then moved for summary judgment on its claims for refunds of taxes paid in 2003, 2004, and 2005, as well as deficiency interest assessed by IRS. The district court again sided with Sovereign, upholding the legitimacy of the transaction and allowing Sovereign to claim interest deductions and foreign tax credits for the U.K. taxes paid. The court also concluded that Sovereign should not be assessed penalties. (Santander Holdings USA, Inc. v. U.S., (DC MA 11/13/2015) 116 AFTR 2d 2015-6795; see “District court upholds interest deductions and foreign tax credits from STARS transaction” (11/19/2015))
However, the Court of Appeals for the First Circuit reversed, finding that the government was entitled to summary judgment as to the economic substance of the transaction and that Sovereign wasn’t entitled to the foreign tax credits claimed. (Santander Holdings USA, Inc. v. U.S., (CA 1 12/16/2016) 118 AFTR 2d 2016-6914; see “CA-1: bank can’t claim foreign tax credits from STARS transaction” (12/22/2016), which the Supreme Court subsequently declined to review.) The case was then remanded to the district court.
Back before the district court, Sovereign moved for summary judgment that (i) as a matter of law, it cannot be subject to negligence or substantial understatement penalties, and (ii) it is entitled to a deduction for the U.K. taxes it paid in connection with the STARS transaction.
Summary judgment denied on penalty issue. The district court denied Sovereign’s motion for summary judgment that, as a matter of law, it had a reasonable basis for, or substantial authority in support of, its reporting position.
The court noted that, as a general proposition, there is no reasonable basis, and no authority, substantial or otherwise, to support a claim for a credit or deduction for a transaction that lacks economic substance. (Long-Term Capital Holdings LP v. U.S., (CA 2 2005) 96 AFTR 2d 2005-6344) Sovereign didn’t attempt to refute this general proposition, but instead argued that it should not apply in the present case. In support of its claim, Sovereign reasoned (i) that the Court of Appeals for the First Circuit, in ruling that the transaction lacked economic substance, created “new law” that should not foreclose penalty defenses; and (ii) that Sovereign was thus entitled to rely on certain favorable pre-existing caselaw. The court rejected this argument, noting that the First Circuit expressly found the circumstances of the favorable caselaw sufficiently different from the facts of Sovereign’s case such that it was unreasonable for Sovereign to rely on them as guidance.
Summary judgment also denied on foreign tax expense deduction. While the court disagreed with the government’s claim that Sovereign had waived any claim for expense deductions by not presenting the issue earlier, finding that its failure to do so was due to the fact that it had initially prevailed on its foreign tax credit claims (see above), it agreed that Sovereign wasn’t entitled to a ruling that it could deduct foreign tax expenses.
The parties disagreed as to the effect of the First Circuit’s determination that the transactions lacked economic substance—specifically, whether that meant that the transactions should be disregarded for all tax purposes, as argued by the government, or just for the purposes of the particular Code section under which the rejected tax benefit was sought (in this case, the foreign tax credit), as argued by Sovereign. The court ultimately rejected Sovereign’s argument as contrary to caselaw and found that a transaction’s lacking of economic substance is “broadly fatal” to any tax benefits from it—including Sovereign’s foreign tax expense deduction—and denied summary judgment.
References: For the economic substance doctrine, see FTC 2d/FIN ¶ M-5900 et seq.; United States Tax Reporter ¶ 77,014.35. For the deduction for foreign taxes, see FTC 2d/FIN ¶ K-4700; United States Tax Reporter ¶ 1644.