leagle/decision/In%20FDCO%2020110930H88 WFC HOLDINGS CORPORATION v. U.S. Civil No. 07-3320 (JRT/FLN). WFC HOLDINGS CORPORATION, Plaintiff, v. UNITED STATES OF AMERICA, Defendant. United States District Court, D. Minnesota. September 30, 2011. Thomas P. Cole, Gregory E. Van Hoey, and Jacqueline C. Brown, UNITED STATES DEPARTMENT OF JUSTICE, TAX DIVISION, P.O. Box 7328, Ben Franklin Station, Washington, DC, for defendant. FINDINGS OF FACT, CONCLUSIONS OF LAW, AND ORDER FOR JUDGMENT JOHN R. TUNHEIM, District Judge. Plaintiff WFC Holdings Corporation (WFC or Wells Fargo1) brought this action against the United States seeking a refund of federal income taxes in the amount of at least $82,313,366 for the tax year ending December 31, 1996. (Compl. ¶ 1, Docket No. 1.) According to the government, WFCs refund demand is based on capital losses accruing from a sham transaction intended to operate as a tax shelter. A trial on the merits was conducted by the Court without a jury on October 4, 5, 7, 8, 12, 13, 14, 20, 22, 25, and November 3, 2010. The parties presented closing arguments on February 18, 2011. Having considered each partys evidence, exhibits, and arguments of counsel, the Court enters its Findings of Fact, Conclusions of Law, and Order for Judgment, pursuant to Rule 52(a)(1) of the Federal Rules of Civil Procedure. FINDINGS OF FACT 1. All of the Findings of Fact set forth herein are undisputed or have been proven by a preponderance of the evidence. 2. To the extent that the Courts Conclusions of Law include what may be considered Findings of Fact, they are incorporated herein by reference. I. CORPORATE STRUCTURE 3. Wells Fargo & Company, formerly known as Norwest Corporation (Norwest), is a diversified financial services company that, together with its subsidiaries, provides banking, insurance, investment, mortgage, and consumer finance services. (Joint Stip. ¶ 1, Docket No. 157.) 4. WFC Holdings is the successor-in-interest to the corporation previously known as Wells Fargo & Company (Old Wells Fargo, or simply Wells Fargo when the distinction is irrelevant), which was acquired by Norwest on November 2, 1998, through the merger of Old Wells Fargo into WFC Holdings. (Id. ¶ 2.) 5. Following the 1998 Norwest merger and at all times relevant to this lawsuit, WFC Holdings was the parent corporation of an affiliated group of corporations, including Wells Fargo Bank, N.A. and Wells Fargo Bank (Texas), N.A. (the transferring banks or, individually and/or with other Wells Fargo banking operations the bank). (Id. ¶¶ 2-3.) 6. Following the 1998 Norwest merger and at all times relevant to this lawsuit, Wells Fargo & Company owned and continues to own all of the outstanding stock of WFC Holdings. (Id. ¶ 8.) 7. Following the 1998 Norwest merger and at all times relevant to this lawsuit, WFC has been the common parent corporation of Charter Holdings, Inc. (Charter). (Id. ¶ 10.) 8. Charter was known as AMFED Financial, Inc. (AMFED) prior to December 10, 1998. (Id. ¶ 15.) 9. At all relevant times, each of the transferring banks was and continues to be a national banking association subject to the regulatory oversight of the Office of the Comptroller of the Currency (OCC) of the United States Department of the Treasury. (Id. ¶ 13.) 10. At all relevant times, Charter was and continues to be a holding company subject to the regulatory oversight of the Federal Reserve Board (the Fed). (Id. ¶ 16.) 11. The transferring banks, their parent corporation WFC Holdings, and Charter were at all relevant times and continue to be domestic corporations. (Id. ¶¶ 4, 9, 14.) 12. As the parent corporation of an affiliated group of corporations including WFC Holdings and Charter, WFC files consolidated income tax returns for such entities. (Id.) II. LEASE RESTRUCTURING TRANSACTION AND REFUND CLAIM: SUMMARY 13. The transaction at issue in this case — known as the underwater lease transaction or lease restructuring transaction (LRT) — consisted of three steps, summarized briefly here and elaborated upon below. 14. First, on December 17, 1998, pursuant to an exchange agreement among the transferring banks, WFC, and Charter, the banks transferred government securities with an aggregate fair market value of $429,899,099 and a tax basis of $427,849,534, and leasehold interests in twenty-one commercial properties (comprised of twenty-two master leases, collectively the selected leases) to Charter in exchange for 4,000 shares of Series A Preferred Stock (Preferred Stock) in Charter and Charters assumption of the lease obligations. By transferring the leases to Charter, the transferring banks transferred to Charter both assets (i.e. the leasehold interests) and their associated liabilities (i.e. the rent payable under such leases). (Id. ¶¶ 20, 25, 41.) 15. The accounting firm KPMG LLP (KMPG) estimated the present value of the future cash flows associated with the transferred leases to be negative $425,899,099. (Id. ¶ 25.) 16. Second, on December 17, 1998, the transferring banks sold their 4,000 shares of Charter Preferred Stock to WFC for $4,000,000 in cash. (Id. ¶ 26.) 17. Third, on February 26, 1999, WFC sold 4,000 shares of the Preferred Stock to Lehman Brothers, Inc. (Lehman) for $3,750,022.22. (Id. ¶ 27.) 18. WFC timely filed with the Internal Revenue Service (IRS or government) a federal corporate income tax return for the tax year ending December 31, 1999 which included a deduction for a capital loss in the amount of $423,849,534 (1999 Capital Loss), but WFC did not utilize any portion of the 1999 Capital Loss in its 1999 tax return. (Joint Stip. ¶ 29.) 19. On March 25, 2003, WFC filed a refund claim, Form 1120X, with the IRS, claiming a refund of federal income taxes previously paid by Old Wells Fargo on the 1996 tax return. (Id. ¶ 31.) 20. In its refund claim, WFC claimed a net capital loss carryback from its 1999 tax return which was in part attributable to the 1999 Capital Loss. (Id. ¶ 32.) 21. On April 6, 2007, the IRS disallowed the refund claim with respect to the carryback at issue in this suit. (Id. ¶ 34.) III. ACQUISITION OF FIRST INTERSTATE/UNDERWATER LEASES 22. The LRT at issue began with WFCs acquisition of a large quantity of real estate. 23. On January 23, 1996, Old Wells Fargo reached an agreement to acquire First Interstate Bancorp (First Interstate), another financial services company. The acquisition was completed on April 1, 1996. (Id. ¶¶ 36-37.) 24. At the time of the First Interstate acquisition, Old Wells Fargo was a publicly traded bank holding company with business operations concentrated in California. (Id. ¶ 35.) 25. First Interstate was also based in the Western United States, with particular concentrations in California and Texas. (Id. ¶ 36.) 26. Generally, when WFC is considering acquiring another company, its Corporate Properties Group (CPG) values the targets real estate portfolio, the value of which is integrated in WFCs offer price. (Tr. 68.) 27. From 1985 to the present, through dozens of acquisitions and mergers, Donald Dana has run CPG; he is the companys top real estate executive. (Tr. 64, 67.) 28. CPG oversees all owned and leased real property held by every entity under the Wells Fargo umbrella, with the exception of real properties acquired by foreclosure. (Tr. 66.) 29. WFCs real estate portfolio consists of over 110 million square feet of space with a present market value of approximately $10 billion. Real estate expenses account for either the second or third largest category of expenses in WFCs organization. (Tr. 65-66, 81.) 30. CPGs responsibilities include negotiating the acquisition (i.e. purchase or lease) and disposition (i.e. sale or sublease) of properties, and managing existing properties. CPGs portfolio includes retail properties such as bank branches and administrative properties such as accounting offices. (Tr. 66, 72.) 31. WFC does not always use or occupy all of the space under each master lease it holds for the entirety of the lease term. WFC mitigates the losses associated with rental payments for unused space through three methods: assignment of the lease, sublease of the space, or termination of the lease. (Tr. 68-69, 77.) 32. Because Old Wells Fargo acquired First Interstate through a hostile takeover, information regarding First Interstates real estate portfolio was generally unavailable to CPG prior to the acquisition. CPG was therefore unable to accurately value the assets and liabilities in First Interstates real estate portfolio prior to WFC making an offer price. (Tr. 80-81.) 33. Because the First Interstate acquisition joined two companies with significantly overlapping geographic footprints, Old Wells Fargo was left with a large quantity of excess leased space that it no longer needed for its business operations, but on which it remained obligated to pay rent. (Tr. 106-07.) 34. After the acquisition, Old Wells Fargo discovered that it had vastly underestimated the costs of integrating the companies real estate portfolios. (Tr. 105-06.) 35. Old Wells Fargo maintained loss reserves on its books for properties it deemed underwater, meaning Old Wells Fargos contractual rent and related obligations exceeded the market rent that it projected it could obtain from the properties (as through a sublease) over the remainder of the leases. (Tr. 335.) 36. By March 1996, Old Wells Fargo calculated that the losses from the underwater leases acquired from First Interstate exceeded $310 million, while losses from Old Wells Fargo branches rendered redundant by the merger were approximately $185 million. By July 1996, Old Wells Fargo calculated that the total costs associated with combining the companies real estate portfolios could exceed $1 billion, instead of its pre-acquisition estimate of approximately $360 million in losses associated with obtaining First Interstates real estate portfolio. (Px. 7; Tr. 94-95, 105-06.) 37. CPG took efforts to dispose of the excess property, selling or subleasing more than 362 such properties in 1997. It nonetheless still had a large number of administrative properties as well as some retail properties. (Tr. 106-07.) IV. THE ECONOMIC LIABILITY TRANSACTION: DESIGN, MARKETING, AND SALE TO WFC 38. Joel Resnick, formerly a partner at KPMG, WFCs accounting firm, offered testimony regarding a tax product KPMG marketed to clients called an economic liability transaction. (Resnick Dep. 26-28.) 39. An economic liability transaction involves a corporate entity with a significant contingent economic liability, such as the prospect of liability in a series of pending asbestos-related lawsuits, post-retirement employee medical benefits, underwater lease obligations, or other unmature obligations. The parent corporate entity transfers assets and the contingent liability to a subsidiary in exchange for stock in the subsidiary; the fair market value of the stock equals the value of the assets minus the contingent liability. The parent entity receiving the stock then sells it to an unrelated third party, generating a deductible capital loss of approximately the same amount as the projected amount of the transferred contingent liability. In deducting this capital loss against its unrelated capital gains, the parent entity reduces its federal income tax liability, or as KMPG described it, the entity engages in capital gain sheltering. The subsidiary corporation that assumed the contingent liability, however, also deducts its payments of the contingent liabilities as they accrue. The parent entity and subsidiary file a consolidated federal income tax return. (Resnick Dep. 28-29, Walker Dep. 17-18; Dx. 49, 64, 298.) 40. KPMG employees developing the economic liability transaction product knew that a company needed a non-tax business purpose to justify the transaction. Ascertaining a non-tax business purposes was the first question KPMG asked of clients considering the transaction. (Walker Dep. 37-40; Dx. 53.) 41. An internal KPMG memorandum dated May 19, 1997 lists various theories that might be asserted by the Internal Revenue Service to challenge the validity of the Economic Liability transaction[,] and suggests that the IRS might prevail in its challenge to a deduction generated by an economic liability transaction. Nonetheless, in May 1997, KPMG approved the marketing of the economic liability transaction to appropriate clients. KMPG charged clients a fixed fee, generally based on the size of the anticipated capital loss generated, for its work in facilitating the transaction. (Dx. 57; Walker Dep. 53.) 42. On February 18, 1998, KPMG representatives met with representatives from Old Wells Fargo, including its tax director Richard Dick Hayes and senior tax attorney Karen Bowen. Through a presentation, KPMG representatives explained the economic liability transaction in the context of CPGs underwater leases. KPMG represented to WFC that WFC would not need to recognize an accounting loss upon its sale of the stock to a third party, but could claim as a tax deduction the entire amount of the transferred contingent liabilities, the underwater leases. KMPG also clarified that WFC would need to represent to KPMG that the restructuring was motivated in part by significant non-tax reasons[,] namely reducing its anticipated losses from the lease obligations. (Dx. 71 at WFC-11-0330; Dx. 68, 69; Bowen Dep. 55-56.) 43. In a letter sent by KPMG to Hayes on March 6, 1998, KMPG proposed that Wells Fargo engage KMPG to assess the feasibility of, design, and implement coordinated loss strategies related to losses inherent in the assets managed by the Corporate Properties Group (CPG). KMPG copied Ross Kari, then Wells Fargos Chief Financial Officer, on the letter along with other WFC officials. (Dx. 73; Kari Dep. 11-13.) 44. On June 3, 1998, as KPMG commenced developing WFCs economic liability transaction, it sent Hayes and Dana sample documents illustrative of documentation necessary to complete the proposed restructuring transaction. The documentation included memoranda summarizing representations for a sample tax opinion letter, a certificate of amendment of certificate of incorporation, a support agreement, an exchange agreement, and a stock purchase agreement, among numerous other documents. (Dx. 87.) 45. Following the announcement of the proposed merger between Old Wells Fargo and Norwest on June 8, 1998, KPMG characterized the economic liability transaction as a quick hit tax-planning strategy to be accomplished before the merger. KPMG estimated that the transactions involving the underwater leases could generate tax savings of $80 million. KPMG represented that it had already begun to identify assets to be used in the transaction by working with Dana and others from CPG. (Dx. 100 at WFP2-08096, WFP2-09098-99.) 46. WFC agreed to pay KPMG a commission of $3 million for its work on the LRT, the economic liability transaction involving the underwater leases. KPMG employee Todd Voss managed the project, which involved coordinating the actions of approximately two dozen people including KPMG personnel, WFC employees, and outside lawyers. (Dx. 123, 437.) 47. On August 18, 1998, Bowen sent an internal e-mail message in which she stated, We are working with CPG on a project to move underwater leases to a special purpose entity to trigger unrealized tax losses. (Dx. 120 (emphasis added).) 48. An engagement letter from KPMG dated August 18, 1998, refers to KPMGs $3 million fee for designing and implementing the LRT for projected tax savings. (Dx. 123.) A subsequent, more detailed engagement letter sets forth agreed upon procedures for KPMGs work in ascertaining the banks leasehold equity position in twenty-one selected leases. This letter, dated September 1, 1998, does not refer to any prospective tax benefits. (Dx. 147.) Although the date September 1, 1998 appears below Danas signature on that letter, it was backdated. The parties signed and faxed the letter in January 1999. (Dx. 435, 706 at 254-59.) V. DEVELOPING THE LRT: BUSINESS PURPOSE 49. An initial step of developing the LRT was document[ing] [a] valid nontax business purpose for transferring the lease obligations. KPMG initially assigned this task to Hayes and Bowen in WFCs tax department. Bowen, however, responded that far more effective documentation would originate with the business drivers, prepared in nontax-oriented style (with our review and input as needed). (Dx. 110.) Accordingly, Don Dana was tasked with identifying a non-tax business purpose for the LRT. (Dx. 195.) 50. In an August 31, 1998 draft by Dana to document the business purpose of the LRT, Dana wrote, in response to the question Why a separate subsidiary?: It has been over 2-1/2 years since our merger with [First Interstate]. We have done all we can with these underwater leases using traditional methods, we are about to enter into a new merger with Norwest, and I am concerned that focus and attention necessary to effectively manage these assets will be diluted. A separate subsidiary, similar to the one I set up years ago when we built and leased the 500,000 square foot Wells Tower in Sacramento, will preserve focus and attention by segregating the most hard core liabilities and directly incenting key managers for performance in excess of market expectations. (Dx. 142 (emphasis added).) Dana proposed incenting property managers to share in the equity of the subsidiary to the extent that their disposition of property exceeded the market expectations formed by an independent real estate review. . . . (Id.) 51. On or around September 10, 1998, Voss — the KPMG employee managing the LRT — sent Dana a sample business purpose document used by another KPMG client. (Dx. 156.) The business purposes articulated in the sample document likewise primarily relate to efficiencies obtained through centralization. (Id.) It reflected a similar sample document sent to WFC in February 1998. (Dx. 71 at KPMG-Box02-0294 to 0295.) 52. On September 19, 1998, Dana emailed to Wells Fargo and KPMG personnel involved in the LRT an updated and slightly lengthened draft of his business purpose document. (Dx. 188.) The business purpose as articulated by Dana remained focused on the benefits of focusing management and incentivizing disposition of the underwater leases. (Id.) Dana also, however, included a new justification relating to valuable customers of WFC (good bank customers) which sought to leverage their banking relationship to obtain favorable lease terms: We can be tougher on greedy landlords. While it may sound cosmetic, operating in a separate subsidiary with a different name limits the ability of our good customer landlords to leverage their lending or deposit relationship in sublease approval negotiations. In short, it changes the expectations of landlord and brokers, allowing us to act more like a real estate company and less like a financial institution. (Dx. 188.) 53. As late as September 30, 1998, an internal KPMG email reflected the companys understanding that WFCs business purpose in conducting the LRT was to provide a capital gain stock incentive to certain key employees to incent them to drive down the amount of [the] `underwater lease liabilit[ies]. . . . [Wells Fargos] real estate person . . . feels quite comfortable in defending this business purpose so long as the incentive plan is consistent with his views. (Dx. 204.) 54. The business purpose document, however, was dramatically revised following a change in management of WFCs tax department after the Norwest merger. 55. Prior to the merger, Dick Hayes was WFCs Vice President of Tax while Dan Vandermark was the Vice President of Tax for Norwest. (Bowen Dep. 38.) Ultimately, Vandermark became the Vice President of Tax for the merged bank. (Dx. 154.) 56. On September 29, 1998, Karen Bowen advised Dana that Vandermark had learned about the LRT and had expressed concerns with the transaction, in particular with the asserted business purpose. Bowen advised that there were several suggestions of how to bolster the business purpose. . . . With regard to the new concerns, Dana responded that [i]ts important that we get a green light or red light on this deal as soon as possible. This continues to be a huge burden on me and my people despite the best efforts of KPMG to shoulder much of the work, and I personally will have a lot to say if this turns out to have been a huge waste of time. (Dx. 201.) 57. Vandermark, who according to Bowen was attempting to exercise control during the leadership transition and ensure that he received some credit for concluding the transaction, asserted that the LRT was at risk of being challenged by the government. (Bowen Dep. 121-22.) In particular, Vandermark believed that the asserted business purpose of incentivizing managers through the issuance of equity was bullshit because there were numerous other ways to incentivize managers with a similar economic return. (Id. at 123.) According to Bowen, [i]t was [Vandermarks] expressed belief at that time. . . that the existence and desire to offer the incentive plan in the way we had crafted it did not contribute to the business purpose. (Id. at 124.) 58. Vandermark expressed his concerns directly to Dana, instructing him to revise the business case with the expectation that the IRS would one day review it. By Danas account, Vandermark wanted a business purpose document that could withstand IRS scrutiny, rather than Danas draft which he testified was aimed at a narrower audience of executives and officers of WFC who needed to approve the transaction. (Tr. 234.) 59. Dana testified that Vandermark was his colleague, not his superior, and that Vandermark did not have authority to pull the plug on the LRT. (Tr. 235; see also Tr. 324 (testimony from WFCs Chief Executive Officer (CEO) that Danas position was more senior than Vandermarks).) According to a contemporaneous email message from KPMGs Voss, however, Don [Dana] said that Vandermark is controlling the strategy [on the LRT] . . . [and Dana] reiterat[ed] that Vandermark has veto power over the LRT transaction. (Dx. 271 (emphasis added).) Dana testified that Vandermark had veto power only over whether the LRT was to be structured and used for a tax benefit, not whether it would occur. (Tr. 299.) 60. Vandermark testified that, in his opinion, WFC wouldnt get through an audit lottery with such a large transaction. Accordingly, we knew we were going to be going to court on this, and so we wanted to be prepared for it from the get-go. So I told them that we would need to document — fully document every aspect of the — business purpose of this transaction. (Vandermark Dep. 36.) 61. Dana testified that the concerns expressed by Vandermark were unrelated to his reasons for pursuing the LRT, and that he was committed to proceeding with the transaction regardless of whether Vandermark approved of it from a tax perspective. (Tr. 150-51.) Bowen similarly testified that early on, prior to meetings with KPMG about the transaction, Don Dana said he would do this transaction whether we got tax benefits or not. (Bowen Dep. 136.) Vandermark also recalled Danas assertion that he intended to transfer some leases into a non-banking subsidiary regardless of the tax benefits. (Vandermark Dep. 67-69.) 62. An internal KPMG email from October 6, 1998 indicates that Vandermark gave the LRT a 99.9% chance of losing a tax audit unless, among other issues, its business purpose was bolstered and quantified. KPMG understood that Vandermark received authority from WFCs CEO to pull the plug on the transaction if his concerns were not adequately addressed. (Dx. 213.) 63. On October 7, 1998, WFC regulatory attorney Julius Loeser explained by email that transferring underwater leases into a non-banking subsidiary would seem to confer a tremendous regulatory benefit to WFC. Specifically, Loeser explained that pursuant to OCC regulations, WFC had a limited time period in which to dispose (i.e. through assignment or termination) of leased space that was no longer actively used in banking operations and had not been coterminously subleased. By contrast, the Fed, with regulatory oversight over the non-bank subsidiary expected to receive the underwater leases, imposed no such mandatory disposition regulations for leased premises. Transferring underwater leases into a non-banking subsidiary would therefore allow WFC more flexibility in managing the leases. Loeser had gathered this information in the course of speaking with Ken Kinoshita of the Federal Reserve Bank of San Francisco. (Dx. 216.) 64. A memorandum dated October 13, 1998, to Dana from another CPG regulatory attorney references Loesers conversation with Kinoshita and affirms the information he obtained and his analysis. The memorandum purports to respond[] to your question regarding possible regulatory advantages of transferring, by assignment, bank premises into a non-banking subsidiary. (Px. 38 at 26.) 65. On October 13, 1998, Dana circulated an expanded, fourteen-page version of his business purpose document. The cover sheet for the document included the statement, The business case stands on its own, but if you can figure out how to get some tax breaks in the process — GREAT! For the first time, Dana articulated in writing another business purpose of the LRT: regulatory concerns. According to Dana, CPGs ability to execute lease extension options on behalf of prospective subtenants was impeded by the OCCs time-sensitive mandatory disposition rules. By transferring such leases to the non-banking subsidiary, thus causing the leases to fall under the Feds regulatory oversight, WFC could avoid such restrictions and capitalize on existing lease tails. (Dx. 225 at WFC-37-0248, WFC-37-0254.) 66. As an example, Dana cited the Garland operations building on the fringe of downtown Los Angeles. The Garland building, acquired from First Interstate in 1996, is a 700,000 square foot space rendered superfluous after the merger. The bottom floors have no windows and are essentially designed as a vault. WFC was liable to pay rent on a lease on the Garland building through 2009, with multiple purchase and lease extension options. Bank of America, WFCs competitor, was interested in leasing 130,000 square feet of the Garland building, including the cash vault, but required more than a ten-year term. According to Dana, OCC regulations prohibited him from offering such a sublease beyond the mandatory disposition period. Accordingly, Bank of America walked away from the deal. (Id. at WFC-37-0254.) 67. In his October 13 business purpose document, Dana also elaborated on his explanation of the good bank customer purpose, comparing the LRT to his efforts with the Wells Tower in Sacramento (the Sacramento project). (Id. at WFC-37-0255-WFC-37-0259.) 68. Danas speak-now-or-forever-hold-your-peace[] draft of the business purpose document and subsequent final draft, dated November 17, 1998, were substantially similar, retaining and further expanding upon the regulatory benefit and good bank customer purposes, as well as the purpose of centralization/incentivizing managers. (Px. 37, 44, Tr. 251.) 69. WFC ultimately proffered three non-tax business purposes to justify the LRT: (1) avoiding regulatory restrictions, (2) avoiding unfavorable deals with good bank customers, and (3) creating management efficiencies. VI. DEVELOPING THE LRT: BASE CASE AND WHAT IF SCENARIOS 70. Another initial step of developing the LRT was determining which properties to utilize in the
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