Citation: Wells Fargo & Company v. U.S, (DC MN 8/10/2012) 110 AFTR 2d ¶ 2012-5188
Gather round children, whilst I tell a tale of the most widely-read but poorly-written book of all time,
50 Shades of Grey the Internal Revenue Code.
Our story is set in the
destitute great state of California. Our central figure is the national banking chain of Wells Fargo. Like all corporations operating in California, Wells Fargo pays taxes each year for the privilege of doing business within the state. The tax is based on the income earned in Year 1, but is paid for the privilege of doing business within the state in Year 2. Importantly, the tax is actually paid in Year 1 in the form of estimated payments.
Under California state law as it has existed since 1972, the tax Wells Fargo pays based on its Year 1 income for the privilege of doing business in Year 2 is not refundable. To illustrate, even if Wells Fargo pulled out of California on Day 1 of Year 2, it is still required to pay the tax for the right to conduct business in Year 2.
As an accrual basis taxpayer, this led Wells Fargo to believe that it could safely accrue the state tax deduction at the end of Year 1, as it would have satisfied the “all-events” test at that time.
As a reminder, meeting the all-events test is required under I.R.C. § 461 in order for an accrual basis taxpayer to deduct a liability. The all events test requires an accrual basis taxpayer to jump through three hoops:
1. The fact of the liability must be fixed. In simple terms, this means that whatever event that is necessary to give rise to Well Fargo’s requirement to make payment has occurred by the end of Year 1.
2. The amount can be determined with reasonable accuracy, and
3. Economic performance has occurred.
Wells Fargo, quite naturally, took the position that all three prongs of the all-events test were met. The fact of the liability was fixed at the end of Year 1, it argued, because the amount due could not be refunded in Year 2, regardless of whether or not Wells Fargo conducted business within California. Furthermore, the amount of the liability could be determined with reasonable accuracy, as the liability was based on Year 1, rather than Year 2 income. And finally, economic performance had occurred, because under Regulation Section § 1.461-4(g)(6), economic performance occurs with respect to a liability for taxes as it is paid, which Wells Fargo did during Year 1 in the form of estimated payments.
Unfortunately for Wells Fargo, their deduction was not to be. And why not? Because of an arcane remnant left over the in the statute at I.R.C. § 461(d). Section 461(d) provides:
In the case of a taxpayer whose taxable income is computed under an accrual method of accounting, to the extent that the time for accruing taxes is earlier than it would be but for any action of any taxing jurisdiction taken after December 31, 1960, then, under regulations prescribed by the Secretary, such taxes shall be treated as accruing at the time they would have accrued but for such action by such taxing jurisdiction.
That’s a bit confusing, so allow me to clarify: this rule provides that if a state changes its tax laws after 1960 — and, as a result of that change, the accrual date of the payment of state taxes is moved up to an earlier year — then the change in the state tax laws is ignored for purposes of federal tax law. In other words, it is the state law that was in place in 1960 that governs the timing of a deduction for federal income tax purposes. If that state law is changed post-1960 to a allow for a more favorable, accelerated deduction, the change is ignored. As the District Court explained in reaching its decision, “Time stands still in this tiny corner of the federal tax world.”
Now, that provision on its own wouldn’t be problematic. But as indicated above, the general rule that the tax paid by California corporations such as Wells Fargo in Year 1 for the right to do business in Year 2 was not refundable didn’t come to be until 1972. Prior to 1972, if a business pulled out of California in Year 2, it could be refunded the tax paid in Year 1, either in part or in full.
In other words: Before 1972 = California state law said the Year 1 tax could be refunded.
After 1972 = California state law said the Year 1 tax could not be refunded.
And for some reason no one can explain, the Internal Revenue Code continues to provide that when determining whether a liability to pay California taxes is fixed at the end of Year 1, it is the state law in effect in 1960 that governs, despite the rather relevant fact that we currently reside in the year 2012.
Faced with these facts and the language in I.R.C. § 461(h), the District Court had no choice but to hold that the all-events test had not been met at the end of Year 1. Because under the state law in place in 1960, if Wells Fargo left California on Day 1 of Year 2 it would receive a refund of the entire liability, the Year 2 liability was not fixed at the end of Year 1. The fact that a new law had been in place for 40 years providing that the Year 1 tax was not refundable was irrelevant.
The lesson? Cut us tax people some slack. When you ask us a question and we don’t feel comfortable giving an off-the-cuff answer, it’s not an indication that we’re not knowledgeable. Rather, our trepidation is the the result of being burned enough by outdated or inexplicable sections of the Code and regulations to know that we’d better check things out before we commit to a response.
*second thing may not have happened.