Economic substance remains a focus in US tax cases.

A US appeals court set aside a transaction in August that the parent company of Wells Fargo Bank did in 1999 on which the parent claimed a large capital loss. The court said the transaction had no substance other than a desire to generate tax losses.

Wells Fargo went through two bank mergers in the 1990s and ended up with at least 21 leases for office space that it no longer needed and that were underwater in the sense that it had to pay more rent than it could get from subleasing the property.

National banks are regulated by the Office of the Comptroller of the Currency. With some exceptions, the OCC does not allow such banks to own real estate that is not needed for banking operations. Banks have five years to dispose of excess real estate, but can get extensions.

KPMG proposed a transaction to Wells Fargo in 1998 that it called an “economic liability transaction.” The transaction was designed to produce a large capital loss by taking advantage of an anomaly in the US tax rules. Wells Fargo did the transaction in December 1999 after focusing internally on a suitable business purpose to justify the deal.

It made a capital contribution of government securities in which it had a basis of $426 million to a subsidiary corporation. It also contributed 21 leasehold interests in commercial properties. The subsidiary issued 4,000 shares of stock to Wells Fargo in exchange for the contributions and assumed the obligations to pay rent under the leases.

Normally an assumption of liabilities by a subsidiary is treated as if the subsidiary distributed cash equal to the liabilities assumed to the parent company: it reduces the basis the parent company has in the shares of the subsidiary. However, there is no basis reduction if the subsidiary will have a current deduction — in this case for rents — when it pays the liabilities.

Therefore, Wells Fargo had a basis in the shares of the subsidiary equal to the $426 million in government securities it contributed for the shares. Wells Fargo sold the shares to Lehman Brothers for $3.7 million and took a capital loss of $423 million.

It did not use the loss on its 1999 return as originally filed, but in 2003, filed an amended return on which it tried to carry the loss back to 1996 and get a refund of $82.3 million for the 1996 tax year.

The IRS denied the loss on grounds that the transaction lacked economic substance, and two courts agreed.

US courts set aside transactions that are purely tax motivated. Some courts used a two-prong test in 1999 when the transaction was done to assess whether there was any substance to a transaction. Others used a single-prong test. The appeals court in this case — for the 8th circuit — said it was unclear which approach should be used, but that it did not matter because the transaction failed both prongs. (Congress has since written a two-prong test directly into the US tax code.)

Prong one is whether the transaction had the potential to earn a profit. Wells Fargo argued the profit was in being relieved of the obligation to continue paying rent. Transferring the leases to the subsidiary relieved the bank of stringent OCC rules to dispose of the leases by putting them under a separate entity that was regulated by the Federal Reserve Board, rather than the OCC, and whose rules were less strict about making a quick sale of the leases.

The court said Wells Fargo could have earned such a “profit” simply by transferring the leases without also selling the subsidiary shares to Lehman. A profit on one leg of the transaction does not impart a profit motive to the rest of the transaction.

Prong two is whether there was a business purpose for the deal. An internal tax attorney at Wells Fargo said in an email: “We are working . . . on a project to move underwater leases to a special purpose entity to trigger unrealized tax losses.” The first Wells Fargo employee assigned to come up with a business purpose suggested two ideas that the new vice president for taxes described in an email as having a 99% risk of being found wanting on audit. An internal bank regulatory lawyer then suggested using the pressure from the OCC to sell the leases as the business purpose.

The court said between only three and 11 of the leasehold interests had to be sold. Moreover, the regulatory pressure to move the leases into a subsidiary did not explain the stock sale to Lehman, the court said.

The case is WFC Holdings Corp. v. United States.