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Santander Holdings USA, Inc. v. United States

United States District Court, D. Massachusetts

July 17, 2018



          George A. O'Toole, Jr. United States District Judge

         The plaintiff, Santander Holdings USA, Inc., formerly known as Sovereign Bancorp, Inc. (“Sovereign”), filed this suit to recover approximately $234 million in federal taxes, penalties, and interest that were assessed and collected by the Internal Revenue Service (“IRS”) in connection with Sovereign's “Structured Trust Advantaged Repackaged Securities” (“STARS”) transaction. Because the facts of this case and the details of the STARS transaction have been described in other opinions related to this litigation, there is no need to repeat them here.[1] Familiarity with the general outline of the parties' dispute is presumed.

         In what is now the controlling decision, the Court of Appeals concluded that the STARS Trust transaction was profitless and that it was shaped solely by tax-avoidance features and therefore lacked economic substance. Accordingly, the court concluded that Sovereign's claims for credits under I.R.C. § 901 for the U.K. taxes it paid as a consequence of the Trust transaction were properly disallowed by the IRS. Santander Holdings, 844 F.3d at 21-26. After appeal, the case was remanded “for a trial limited to the penalties issue.” (Judgment at 1, Dec. 16, 2016 (dkt. no. 303).) Upon remand, Sovereign has moved for summary judgment on two distinct issues. The first seeks a ruling that, “as a matter of law, Sovereign cannot be subject to . . . negligence or substantial understatement penalties.” (Pl.'s Mot. for Summ. J. Regarding Penalties 1 (dkt. no. 320).) The second seeks a determination that “Sovereign is entitled to a deduction for the U.K. taxes it paid in connection with the STARS transaction.” (Pl.'s Mot. for Summ. J. Regarding Deduction for Foreign Tax Expense 1 (dkt. no. 322).) The parties briefed the issues thoroughly and were heard at oral argument.

         I. Summary Judgment Regarding Penalties

         In 2008, the IRS disallowed foreign tax credits and interest expense deductions that Sovereign claimed with respect to the STARS transaction for the taxable years 2003 through 2005. In addition, it imposed two accuracy-related penalties on the resulting tax underpayment for (1) negligence or disregard of rules or regulations, I.R.C. § 6662(b)(1), and (2) substantial understatement of income tax, id. § 6662(b)(2). The assessment of either of these non-cumulative penalties would require Sovereign to pay an additional twenty percent of the amount of underpayment of taxes. Treas. Reg. § 1.6662-2(c). Sovereign now argues, however, that it cannot be liable for either penalty because it has, as a matter of law, satisfied the criteria for recognized defenses to the assessment of the penalties.

         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. Id. § 1.6662-3(b)(1). “Reasonable basis” is a relatively high standard, requiring a taxpayer to show, based on one or more of the acceptable authorities enumerated in the Treasury regulations, [2] that its return position was more than merely arguable or colorable. Id. § 1.6662-3(b)(3). Defending the substantial understatement penalty is more difficult. It requires the taxpayer to show that there was either a reasonable basis for the chosen tax treatment that the taxpayer had “adequately disclosed” to the IRS, or “substantial authority” to support the taxpayer's return position that resulted in the understatement. I.R.C. § 6662(d)(2)(B). “Substantial authority” is an objective standard that is higher than a “reasonable basis” and is satisfied “if the weight of the [enumerated] authorities supporting the treatment is substantial in relation to the weight of [such] authorities supporting contrary treatment.” Treas. Reg. § 1.6662-4(d)(3)(i).[3]

         Courts have generally held, and the government now argues, that 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, such as the Trust transaction. See Salem Fin., Inc. v. United States, 112 Fed.Cl. 543, 593 (2013), aff'd in part, rev'd in part, and remanded, 786 F.3d 932 (Fed. Cir. 2015); Stobie Creek Invs., LLC v. United States, 82 Fed.Cl. 636, 706-07 (2008); Santa Monica Pictures, LLC v. Commissioner, 89 T.C.M. (CCH) 1157, *100 (T.C. 2005); Long Term Capital Holdings v. United States, 330 F.Supp.2d 122, 204 (D. Conn. 2004), aff'd sub nom. Long-Term Capital Holdings, LP v. United States, 150 Fed.Appx. 40 (2d Cir. 2005). This general proposition seems to follow logically from the application of the economic substance doctrine, as it would make little sense to allow a taxpayer, whose transaction was determined objectively to lack economic substance notwithstanding technical compliance with the tax code and relevant authorities, to nevertheless avoid the penalties associated with the sham transaction by relying on the same authorities that were rejected in the assessment of the transaction's economic substance. Sovereign does not attempt to refute this general proposition, but rather argues that it should not apply in the present case because the Court of Appeals created “new law” when it determined that foreign tax payments should be regarded as a pre-tax expense in assessing the profitability of the Trust, (Pl.'s Memo. in Supp. of Mot. for Summ. J. Regarding Penalties 2 (dkt. no. 321)), an approach that Sovereign argues was contrary to the decisions in Compaq Computer Corp. v. Commissioner, 277 F.3d 778 (5th Cir. 2001), and IES Industries, Inc. v. United States, 253 F.3d 350 (8th Cir. 2001), the only cases that had addressed whether foreign taxes should be considered pre- or post-tax items at that time that Sovereign entered the STARS transaction (and filed the relevant tax returns). The gist of Sovereign's argument is that the circuit's ultimate holding, that the Trust transaction lacked economic substance, rested on the conclusion that Compaq and IES were too factually distinguishable to provide controlling guidance regarding the treatment of foreign tax expenses, Santander Holdings, 844 F.3d at 22-24, n.11, which was in effect “new law, ” and therefore should not trigger the broad general rule foreclosing penalty defenses. This proposition underlies all of Sovereign's present arguments.

         The economic substance of the Trust transaction was the central issue in the circuit court's decision, and it was resolved against Sovereign. Any disagreements that Sovereign had with the court's decision, and any potential for relief from it, including the present contention that the decision created “new law, ” were extinguished by the denial of Sovereign's petition for certiorari. (See Order, Jun. 26, 2017 (dkt. no. 313) (denying petition for writ of certiorari).)

         Sovereign now argues that it was reasonable to rely on the Compaq and IES cases because they were the only appellate guidance at the time of the STARS transaction on the question of pre- or post-tax treatment of foreign taxes, and for that reason they are sufficient for defending the understatement penalties. But this misses the circuit's point, which was that the factual circumstances of the two prior cases were sufficiently different from the STARS circumstances that, even at the time of the STARS transaction, it was unreasonable to rely on them as guidance. See Santander Holdings, 844 F.3d at 24 n.11. In other words, the question whether there was a “reasonable basis” for Sovereign's reliance on Compaq and IES has already been determined adversely to Sovereign by the circuit's opinion.

         Sovereign is not entitled to judgement as a matter of law that it had a reasonable basis for or substantial authority in support of its reporting position regarding the pre-tax accounting for foreign taxes paid.

         II. Summary Judgment Regarding Deduction for Foreign Tax Expense

         Sovereign next argues that it is entitled to expense deductions under I.R.C. § 164 for the U.K. taxes paid on the Trust transaction, notwithstanding the denial of credits for those same expenses under § 901. It claims that the circuit's decision regarding the transaction's lack of economic substance was confined to what was directly and formally at issue, foreign tax credits under § 901, and that the language of § 164 establishes congressional intent to allow expense deductions even though credits are disallowed or the underlying business transactions are unprofitable.

         A. Mandate Rule

         As a preliminary matter, the government argues that Sovereign has waived any claim for expense deductions by not presenting the issue as an alternative argument during the appeal, and by failing to petition for rehearing after the circuit's decision. Alternatively, it contends that the deduction claims were implicitly rejected by the circuit's ruling that the transaction lacked substance and the ...

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