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By Erin McManus
Tax professionals are more concerned about a judge’s narrow interpretation of a penalty exception claimed by Wells Fargo than about the judge’s ruling on the economic substance of the tax shelter that led to the penalty.
The ruling, Wells Fargo & Co. v. United States, which sustained a negligence penalty against Wells Fargo & Co. for claiming $350 million in disallowed foreign tax credits, could affect a broad range of individual and corporate taxpayers challenging an IRS negligence penalty on the grounds that they had a reasonable basis for the position taken on their tax return that the agency later disallowed.
Judge Patrick J. Schiltz, U.S. District Judge for the District of Minnesota, concluded in the May 24 decision that “Wells Fargo must prove that it actually consulted authorities that purportedly provided a reasonable basis for the position taken in its return.”
That is, a taxpayer must point to a legal authority that was on the books when the taxpayer filed its return. But some tax specialists disagree. Andy S. Grewal, a tax law professor at the University of Iowa College of Law, says a taxpayer should be able to rely on a later court ruling or Internal Revenue Service guidance that would support the taxpayer’s position after the fact.
Under the judge’s approach, Grewal told Bloomberg BNA in an email May 25, “if helpful judicial or regulatory authorities arise after a taxpayer has filed a return, those authorities cannot help deflect the negligence penalty, because the taxpayer could not have been aware of them.”
The IRS imposes a penalty under tax code Section 6662(c) when it believes an understatement of tax liability was due to the taxpayer’s negligence. Schiltz cited Treasury Regulations Section 1.6662-3(b)(3), which sets forth the standard for a taxpayer to show it had a reasonable basis for taking a position on its return and avoiding the penalty even if the position is ultimately disallowed.
Grewal said “it would be more sensible to apply Section 1.6662-3(b)(1) in accordance with its plain meaning and examining all relevant authorities supporting the treatment of a position, whether or not the taxpayer was aware of them.” That section defines negligence for the purpose of the penalty and lists examples that “strongly” indicate negligence.
Ancel Martinez, vice president of corporate communications for Wells Fargo, told Bloomberg BNA that the bank disagreed with the penalty ruling and was reviewing the case to determine its next steps.
James Malone Jr., a principal at Post & Schell PC in Philadelphia, told Bloomberg BNA May 25 that if the decision gets traction on how to argue the reasonable basis exception to the negligence penalty, a taxpayer will have to show how it determined that its position was reasonable.
Grewal went a step further, saying the decision “expands the inquiry from the independent merits of a transaction to the thoughts floating in a taxpayer’s head.”
“Maybe clients have to be shown the regulations. Display eyeball reliance or open up the tax opinion. What’s at issue is whether they want to plead reliance on the opinion, which opens up all your discussions with your tax adviser,” Malone said.
Malone was referring to documents provided to clients by their tax advisers that generally provide an opinion on the legality or sustainability of a proposed tax position. Arguing reliance on the tax advisers effectively waives attorney-client and tax adviser privilege.
Even assuming a taxpayer is willing to bring in the tax opinion, “how much money and time can you spend deposing lawyers on what went into the opinion?” Malone said.
Grewal said the negligence penalty shouldn’t even be applied in an economic substance case regarding a transaction that occurred before Congress added economic substance to the tax code.
“The negligence penalty applies when a taxpayer has failed to comply with the ‘provisions of this title,’ but the court did not find any provision of the Internal Revenue Code with which the taxpayer failed to comply. Instead, the case was decided solely on judge-made laws that overrode legislative enactments,” Grewal said.
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