Bank of New York Mellon Corporation, as Successor in Interest to The Bank of New York Company, Inc. v. Commissioner

140 T.C. No. 2UNITED STATES TAX COURT
BANK OF NEW YORK MELLON CORPORATION, AS SUCCESSOR IN
INTEREST TO THE BANK OF NEW YORK COMPANY, INC., Petitioner
v. COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 26683-09. Filed February 11, 2013.
B and its subsidiaries are an affiliated group (Ps). Ps engaged in
a Structured Trust Advantaged Repackaged Securities transaction
(STARS transaction). The STARS transaction provided Ps with
purportedly below market cost financing from a U.K. bank. As part of
the STARS transaction, Ps transferred income-producing assets to a
trust with a U.K. trustee and subject to U.K. tax on its income.
Ps claimed foreign tax credits and expense deductions on its
2001 and 2002 Federal consolidated returns in connection with the
STARS transaction. Ps also reported income from the assets
transferred to the trust as foreign source on the consolidated returns. R
determined that the STARS transaction lacked economic substance and
consequently disallowed the foreign tax credits, the expense deductions
and the reporting of the asset income as foreign source. Ps contend
that the STARS transaction had economic substance and that Congress
intended the foreign tax credit to apply to transactions like the STARS
transaction.
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Held: The STARS transaction lacked economic substance and is
disregarded for Federal tax purposes.
Held, further, because the STARS transaction lacked economic
substance, Ps are not entitled to the claimed foreign tax credits, the
claimed expense deductions or the foreign-source income treatment.
B. John Williams, Jr., Alan J.J. Swirski, Julia M. Kazaks, Cary D. Pugh,
Andrew J. McLean, Daniel C. Davis, Melissa R. Middleton, Shira M. Helstrom,
Brendan T. O’Dell, Bryon Christensen,1 John Marston, Manoj Viswanathan, Ilana
Yergin, Daniel Davis, and Kristin R. Keeling, for petitioner.
Jill A. Frisch, Curt M. Rubin, Anne O’Brien Hintermeister, Matthew J. Avon,
Justin L. Campolieta, and Michael A. Sienkiewicz, for respondent.
KROUPA, Judge: Respondent determined deficiencies in petitioner’s
Federal income tax of $100 million2 and $115 million for 2001 and 2002 (years at
issue), respectively. There are three issues for decision. The first issue is whether
1
Bryon Christensen, John Marston, Manoj Viswanathan, Ilana Yergin, Daniel
Davis and Kristin R. Keeling all withdrew as counsel after trial.
2
All monetary amounts have been rounded to the nearest million unless
otherwise indicated.
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petitioner is entitled to foreign tax credits under section 9013 claimed in connection
with a Structured Trust Advantaged Repackaged Securities transaction (STARS
transaction or STARS). We hold that petitioner is not because the STARS
transaction lacked economic substance. The second issue is whether petitioner is
entitled to deduct certain expenses incurred in furtherance of the STARS
transaction. We hold petitioner is not for the same reason. The final issue is
whether income attributed to a trust with a U.K. trustee used to effect the STARS
transaction is U.S. source income rather than foreign source income. We hold that
the income is U.S. source income.4
FINDINGS OF FACT
I. Background
Petitioner is a Delaware corporation that maintained its principal place of
business in New York, New York, when it filed the petition. Petitioner succeeded
to the tax liabilities of The Bank of New York Company, Inc. (BNY Parent) when
Mellon Financial Corporation merged with BNY Parent in 2007. BNY Parent was
3
All section references are to the Internal Revenue Code (Code) for the years
at issue, unless otherwise indicated.
4
There is also a question of whether respondent properly adjusted interest
expenses allocated to the foreign source income. We need not address this issue
because of our holding that the trust income reported as foreign source income is
U.S. source income.
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the common parent of an “affiliated group” (as that term is defined in section
1504(a)) of corporations that filed consolidated U.S. Federal income tax returns on
an accrual and calendar year basis. The Bank of New York (BNY) was a wholly
owned subsidiary of BNY Parent. BNY was in the banking business with
worldwide banking operations. Its business activities included taking in deposits,
borrowing money and investing in loans and securities.
The affiliated group through BNY entered into the STARS transaction in
2001 with Barclays Bank, PLC (Barclays), a global financial services company
headquartered in London, United Kingdom. The STARS transaction generated
approximately $199 million in foreign tax credits for the combined years at issue.
II. Introduction and Negotiation of STARS
Barclays and KPMG, an audit, tax and advisory firm, developed and
promoted STARS to U.S. banks. KPMG introduced STARS to BNY during
discussions with BNY’s tax director. Thereafter, tax professionals at KPMG and
Barclays presented STARS to BNY through various meetings, discussions,
promotional materials and correspondence.
STARS was represented as a “below market loan” in KPMG’s initial
presentation. KPMG indicated that STARS required a U.K. counterparty and a
certain trust structure holding income-producing assets. KPMG explained that the
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below-market cost would be achieved by the U.K. counter party “sharing” U.K. tax
benefits from STARS through an offset to the cost of the loan. Finally, KPMG
indicated that the U.K. tax benefits would be generated by subjecting income-
producing assets held by a trust to U.K. tax and thus generating foreign tax credits
that BNY could use to offset its U.S. tax liability.
BNY notified KPMG in August 2001 that it was prepared to move forward
with a STARS transaction with Barclays as the U.K. counterparty. BNY proposed
that it would contribute assets that would generate $93 million of annual U.K. tax
costs and expected Barclays to reduce the loan’s annual cost by half that amount.
Shortly thereafter, BNY agreed to supplement STARS by engaging in a “stripping
transaction.” The effect would be to accelerate and increase the tax benefits
STARS produced (i.e., foreign tax credits). And just before STARS closed, BNY
indicated to Barclays that it had decided to increase the targeted benefit.
III. The STARS Transaction
BNY closed the STARS transaction with Barclays in November 2001. The
key components of STARS were as follows.
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A. The STARS Structure
BNY used existing subsidiaries and created special-purpose entities to create
a structure (STARS structure) to carry out the STARS transaction. BNY
accomplished this by engaging in the following steps.
1. Step 1: REIT Holdings Funded
BNY contributed $6.46 billion of assets (BNY assets) to BNY REIT
Holdings, LLC (REIT Holdings), an existing BNY subsidiary treated as a
corporation for U.S. tax purposes. The BNY assets consisted of participating
interests in residential mortgage loans, commercial mortgage loans and consumer
loans (participation interests) and various asset-backed and agency securities. REIT
Holdings assumed $2.55 billion of BNY’s liabilities (BNY liabilities) in connection
with the contribution.
2. Step 2: InvestCo Organized and Funded
BNY organized BNY Investment Holdings (DE), LLC (InvestCo), as a
Delaware limited liability company. InvestCo elected to be taxed as a corporation
for U.S. tax purposes and was part of BNY’s affiliated group. REIT Holdings
capitalized InvestCo by contributing $10.409 billion of assets, consisting of the
BNY assets and BNY Real Estate Holdings, LLC’s common stock (the REIT
share), with a stated value of $3.95 billion (collectively, the STARS assets). In
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exchange, InvestCo assumed the BNY liabilities and issued a 100% ownership
interest in InvestCo to REIT Holdings.
3. Step 3: DelCo Organized and Funded
BNY organized BNY Delaware Funding (DE), LLC (DelCo), as a Delaware
limited liability company. DelCo elected partnership tax treatment for U.S. tax
purposes. InvestCo capitalized DelCo by contributing $9.243 billion worth of the
STARS assets. In exchange, DelCo assumed the BNY liabilities and issued to
InvestCo all of its class 1 ordinary shares (DelCo class 1 shares) worth $65 million
and its class 2 ordinary shares (DelCo class 2 shares) worth $6.628 billion.
The DelCo class 1 shares held all the voting rights in DelCo. The DelCo
class 2 shares had the right to receive approximately 99% of DelCo’s distributions.
The holders of DelCo class 1 shares had the exclusive right to appoint DelCo’s
managers. DelCo’s income was distributable in the absolute discretion of DelCo’s
managers.
4. Step 4: Organization, Funding and Terms of the STARS Trust
BNY formed the BNY STARS Trust (trust) as a common law trust. The trust
was authorized to issue class A units, a class B unit, a class C unit and a class D
unit (collectively, the trust units). The trust unit holders were contractually entitled
to monthly distributions in the following order. The class A unit holders were
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entitled to 1% of the trust distributable income. The class D unit holder was entitled
to trust distributable income equal to $25 million x (1-month LIBOR5 + 415 basis
points (basis points)) x 0.78. The class B unit holder was entitled to 99% of the
remaining distributable income, if the class C unit was in issue, or all remaining
distributable income if the class C unit was not in issue. The class C unit holder
was entitled to the remaining trust distributable income unless a default occurred.
InvestCo transferred the remaining STARS assets (approximately $1.2
billion) and the DelCo class 2 shares to the trust in exchange for the class A units
and the class B unit, which had stated values of $6.3 billion and $1.494 billion,
respectively.
The initial trustee was BNY, acting through its London branch (U.S. trustee).
The Bank of New York (DE), a wholly-owned subsidiary of BNY Parent, served as
the trust manager. Only the holder of all the class A units could nominate a
replacement trustee.
5
“LIBOR” is an acronym for “London Interbank Offering Rate.” See
generally Bank One Corp. v. Commissioner, 120 T.C. 174, 189 (2003), aff’d in
part, vacated in part and remanded sub nom. J.P. Morgan Chase & Co. v.
Commissioner, 458 F.3d 564 (7th Cir. 2006).
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5. Step 5: Organization and Ownership of NewCo
BNY organized BNY NewCo Funding (DE), LLC (NewCo), as a Delaware
limited liability company, with InvestCo as its sole member. NewCo elected
partnership treatment for U.S. tax purposes. InvestCo contributed 49% of the class
A units to NewCo in exchange for a membership interest with a $3.089 billion
stated value. This resulted in InvestCo having a 100% ownership interest in
NewCo. InvestCo then distributed 1% of its NewCo interest to REIT Holdings.
In sum, the above steps moved approximately $7.86 billion in net assets into
DelCo and the trust. The following chart summarizes steps 1 through 5.
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B. The STARS Loan
BNY and Barclays entered into the following agreements and transactions,
the net effect of which was to create a $1.5 billion loan to BNY from Barclays.
1. Class C Unit and Class D Unit Subscription
First, Barclays purchased the class C unit for $1.469 billion and the class D
unit for $25 million from the trust by a subscription agreement. The subscription
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agreement required Barclays to pay further subscription amounts to the trust equal
to the amount of any distributions on the class C unit. To ensure this, BNY
established a blocked account in Barclays’ name that Barclays could not access or
control (Barclays blocked account). Also, BNY and Barclays agreed that all class C
unit distributions were to be paid to the Barclays blocked account, and all further
subscription amounts Barclays owed were to be paid from the Barclays blocked
account.
2. Trust Class C Unit and Class D Unit Forward Sale Agreements
Second, InvestCo and Barclays entered into a forward sale agreement
obligating InvestCo to purchase the class C unit (class C unit forward sale
agreement) from Barclays in November 2006, or earlier in the event of default or
acceleration, for $1.498 billion. The sale price under the class C unit forward sale
agreement was equal to the $1.475 billion principal plus interest compounded
annually at 4.338% less a fixed amount based on the amount of U.K. taxes paid on
the trust income.
Investco and Barclays entered into another forward sale agreement obligating
InvestCo to purchase the class D unit (class D unit forward sale agreement ) from
Barclays within 90 days of the purchase by InvestCo of the class C unit, for $25
million plus any additional amount for any accrued but unpaid distributions on the
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class D unit. The sale price under the class D unit forward sale agreement was the
same as the original subscription price of the class D unit.
3. Zero Coupon Swap
Third, InvestCo and Barclays entered into a zero coupon swap agreement that
required InvestCo to make monthly payments equal to one-month dollar LIBOR
plus 30 basis points by reference to a $1.475 billion notional amount, less a spread
amount (spread). The spread was a fixed amount equal to one-half of the present
value of the expected U.K. taxes on the target class C unit income (discussed
below) each month. In exchange for InvestCo’s monthly payments, Barclays agreed
to pay $23 million to InvestCo on the zero coupon swap maturity date in November
2006. The payment was designed to equal the amount that exceeded the $1.475
billion InvestCo was obligated to pay under the class C unit forward sale agreement
if it continued in force until its expiration in November 2006.
4. Guaranty and Security for InvestCo’s Obligations Under the
Forward Sale Agreements and Zero Coupon Swap
a. Guaranty
Barclays and BNY entered into a credit default swap in November 2001.
Under the credit default swap, BNY guaranteed all obligations of InvestCo under
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the forward sale agreements and the zero coupon swap to Barclays in case of
InvestCo’s bankruptcy or default. In exchange, Barclays paid a fixed rate of 10
basis points on the notional amount of $1.475 billion.
b. Security Arrangements
To secure InvestCo’s obligations under the forward sale agreements and the
zero coupon swap, the trust and DelCo each pledged a portion of the STARS assets
(consisting of asset-backed and agency securities) as collateral. The trust
transferred $1.432 billion of securities (trust collateral securities) to a collateral
account, and DelCo transferred $1.166 billion of securities (DelCo collateral
securities) to another collateral account (DelCo securities account). Proceeds from
the securities were held in the same accounts, respectively. Barclays was granted a
security interest in the trust securities account and the DelCo securities account
(collectively, collateral accounts). BNY acted as the securities intermediary for the
assets held in these accounts. BNY guaranteed through a participation agreement
that the trust and DelCo together would hold at least $2.25 billion worth of high-
quality securities as collateral for so long as Barclays held the class C unit.
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5. Net Effect of the Subscription Agreements, Forward Sale
Agreements and Zero Coupon Swap
In sum, the forward sale agreements, the zero coupon swap and the security
arrangements converted Barclays’ initial subscriptions for the class C unit and class
D unit into a secured loan from Barclays to BNY for $1.5 billion at LIBOR plus 20
basis points (loan).6 BNY would pay the interest on the loan through the monthly
LIBOR-based amounts under the zero coupon swap, excluding the spread. BNY
would repay the principal through the forward sale prices, net of the fixed payment
of the zero coupon swap.
The following diagram broadly reflects the terms of the various agreements
making up the loan.
6
For simplicity, we net the zero coupon swap floating leg, the credit default
swap payment and the class D unit distributions in referring to the interest rate
(LIBOR plus 20 basis points) on the loan.
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C. Use of the STARS Loan Proceeds
The trust immediately redeemed InvestCo’s class B unit with the $1.494
billion the trust received from Barclays’ purchase of the class C unit and the class D
unit. InvestCo then placed $1.5 billion on deposit with a BNY branch office in the
Cayman Islands (Cayman branch). After an initial 11-day term, the money was held
on deposit at the Cayman branch in 1-month terms for the duration of STARS. The
Cayman branch booked this deposit as a liability to Barclays.
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D. Replacement of the U.S. Trustee
BNY and Barclays replaced the U.S. trustee with The Bank of New York
Trust and Depositary Company Limited (U.K. trustee), which was treated as a U.K.
resident for U.K. tax purposes. The U.K. trustee was a wholly-owned subsidiary of
BNY parent.
E. The Stripping Transaction
The parties entered into a series of agreements slightly over a month after
STARS closed to accelerate the U.K. taxes due on trust income by converting
periodic cashflows into an up-front taxable lump-sum payment (stripping
transaction). These agreements contemplated the following steps.
First, BNY would contribute $402 million to DelCo through REIT Holdings,
InvestCo and the trust. Second, the U.K. trustee would transfer the trust collateral
securities to BNY as “custodian” in exchange for principal-only receipts and
interest-only receipts. Third, DelCo would use the contributed funds to purchase
the interest-only receipts from the trust for $402 million. Fourth, the collateral
arrangements would be amended so that Barclays obtained a security interest in the
principal-only receipts and the interest-only receipts.
To effect the stripping transaction, the trust exchanged the trust collateral
securities for the interest-only receipts and principal-only receipts, which
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represented beneficial ownership in the interest payments and principal payments,
respectively. DelCo then purchased the interest-only receipts for $402 million from
the trust. The funds used to purchase the interest-only receipts were not transferred
in accordance with steps contemplated in the transaction documents. Instead, BNY
transferred $402 million directly to the trust’s bank account.
Barclays was granted a security interest in the principal-only and interest-only
receipts that were transferred to a trust security account and DelCo security account,
respectively.
For U.K. tax purposes, the trustee treated the $402 million from the sale of
the interest-only receipts as taxable income at the time of the sale. The U.K. trustee
was required to pay U.K. taxes on the taxable income. Under U.S. tax rules,
however, the trust did not report a gain or loss.
The post-tax income from the stripping transaction was distributed to the
class C unit holder in the next monthly period. BNY received its benefit, a portion
of the spread, over a period of 14 months.
Net the stripping transaction added $402 million in income to the trust, over
and above the monthly target amount, that was taxable in the United Kingdom and
generated additional trust taxes and foreign tax credits of $88 million in 2001.
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BNY ignored the stripping transaction in managing and disposing of the
stripped securities. When the trust manager sold a stripped security, the trust
manager would reconstitute the security and withdraw it from the collateral pool.
F. Management and Control of Trust Assets and DelCo Assets
The trust manager held absolute discretion in managing the trust assets. The
trust manager delegated its authority to BNY through a servicing agreement for
which BNY received a monthly fee. BNY also agreed to manage DelCo’s assets
for a monthly fee and was authorized to take any necessary action.
G. Allocation of STARS Risk
BNY and Barclays also took steps to apportion risk associated with STARS.
These steps are as follows.
1. Trust Class C Target Distributions and Indemnity Payments
for Shortfalls
BNY and Barclays executed agreements to protect against trust target income
shortfalls. The class C unit forward sale agreement provided that InvestCo would
pay an indemnity amount if any class C unit distribution was less than a certain
target amount for each period ($12 million for period 1, $338 million for period 2
and $30 million for all other periods). The class C unit indemnity amount equaled
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additional U.K. trust taxes (future valued) that the trust would pay if it met the target
class C unit distribution.
2. STARS Termination Rights
BNY and Barclays also included contractual mechanisms for each party to
terminate the STARS transaction on short notice. Barclays and InvestCo each had
the right, with or without cause, to accelerate the class C unit or the class D unit
forward sale date by serving a notice of a forward sale date not less than 5 days nor
more than 30 days after the notice (exit provision).
3. Allocation of U.K. Tax Risk
Additionally, BNY and Barclays agreed to certain provisions allocating U.K.
tax risk. BNY agreed under one provision to pay Barclays half of any trust tax that
was refunded if the U.K. tax authority did not respect Barclays’ U.K. tax position
with respect to the trust. In addition, Barclays and InvestCo agreed under another
provision to indemnify each other for one-half of any U.K. stamp duty reserve tax
imposed as a result of either forward sale agreement.
IV. U.K. Tax Treatment of STARS
A. Disclosure of STARS to the U.K. Tax Authority
Barclays engaged in transactions substantially similar to STARS with other
U.S. banks. Barclays disclosed one of those transactions to the U.K. tax authority
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in June 2001 while it was negotiating STARS with BNY. Barclays disclosed the
STARS transaction in April 2002 to the U.K. tax authority. The U.K. tax authority
advised Barclays that it agreed with Barclays’ tax reporting of the STARS
transaction in June 2002. The STARS transaction increased tax revenue for the
United Kingdom.
B. U.K. Tax Treatment of the Trust
The trust was treated as an unauthorized unit trust under U.K. law that
qualified as a collective investment scheme under the applicable U.K. regulatory
laws. When the U.K. trustee replaced the U.S. trustee, the trust became subject to
U.K. tax as a collective investment scheme for purposes of U.K. law. As a result,
the income arising from the trust assets was treated as income of the U.K. trustee,
which was subject to a 22% U.K. income tax under section 469 of the U.K. Income
and Corporations Taxes Act 1988. That U.K. income tax paid was a liability of the
U.K. trustee and not of any of the trust unit holders. The U.K. trustee owed the
U.K. income tax whether the trust made actual distributions to the trust unit holders.
C. U.K. Tax Treatment of Barclays
Under U.K. law, Barclays, as a trust unit holder, was deemed to receive
annual payments from the trust. Barclays owed U.K. corporation tax at a 30% rate
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on those deemed annual payments even if Barclays did not receive any trust
distributions. The deemed annual payments were equal to the income available for
distribution from the trust to Barclays as holder of the class C unit and class D unit,
grossed up for 22% U.K. income tax. Barclays was entitled to a U.K. tax credit of
22% on the deemed annual payment. Barclays could also claim a U.K. deduction
for contributing the class C unit distributions and for the spread amount paid to
InvestCo through the zero coupon swap.
V. STARS Cashflows
The STARS participants made various payments and monthly distributions
throughout STARS. These payments and distributions are explained as follows.
A. DelCo Distributions
DelCo held most of the STARS assets at closing. DelCo made monthly
distributions to InvestCo (class 1 shareholder) and the trust (class 2 shareholder)
with InvestCo receiving 1% and the trust receiving the remaining 99%. The
monthly distributions to the trust were sufficient for the trust to meet the target
distributions to Barclays. When DelCo’s income did not meet projected DelCo
distributions, DelCo satisfied the difference from its cash on hand. BNY also
arranged for the contribution of more income-producing assets to DelCo.
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B. Trust Distributions
The trust generated income from the trust assets and DelCo class 2
distributions. The trust set aside 22% of the trust income in reserves for U.K. taxes,
which were periodically sent to the U.K. tax authority. The remaining income was
distributed monthly to trust unit holders.
The trust made monthly class C unit distributions to the Barclays blocked
account. Those distributions were approximately equal to the corresponding target
distribution amounts. Barclays immediately contributed these distributions to the
trust to satisfy its obligation to pay further subscription amounts. The trust also
made the required monthly class D unit distributions to Barclays. Barclays retained
all of these distributions, totaling $7 million over the term of STARS.
Finally, the trust made monthly contributions to DelCo of amounts at least
equaling but often substantially exceeding the corresponding contributed income
amount from the Barclays blocked account starting after the first nine months of
STARS.
C. Zero Coupon Swap and Credit Default Swap Payments
InvestCo or Barclays made monthly payments as required under the zero
coupon swap. LIBOR was 2.09% when STARS closed and stayed below 3% until
almost mid-2005. During that period, the spread due from Barclays under the zero
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coupon swap was greater than the LIBOR plus 30 basis points amount due from
InvestCo. Barclays made net payments to InvestCo under the zero coupon swap of
$12 million for 2001 and $51 million for 2002. Over the life of STARS, Barclays
made net payments to BNY of $82.6 million under the floating leg of the zero
coupon swap. Additionally, Barclays made all required payments to BNY under the
credit default swap.
VI. Termination of STARS
STARS wound down and eventually terminated in late 2006 when InvestCo
and Barclays fulfilled their obligations under the forward sale agreements and the
zero coupon swap.
VII. BNY Tax Reporting of STARS
The trust, DelCo and NewCo each filed Forms 1065, U.S. Return of
Partnership Income, for the years at issue. BNY reported the income from the
STARS assets as income on its U.S. consolidated return. It reported this income,
however, as foreign source. BNY claimed foreign tax credits of $98,607,973 and
$100,285,767 for 2001 and 2002, respectively, for payments made to the U.K. tax
authority with respect to the trust income.
BNY treated the payments made to Barclays on the class D unit distributions
as a component of interest on the loan. With respect to the floating leg of the zero
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coupon swap, BNY netted the spread component and the LIBOR plus 30 basis
points component of the zero coupon swap. This treatment effectively resulted in
BNY claiming an interest deduction for the LIBOR plus 30 basis points interest
amount (zero coupon swap interest) for the years at issue as the spread component
exceeded the zero coupon swap interest component for each year. BNY reduced
unrelated interest expense by the net payments Barclays made to InvestCo under the
zero coupon swap for the years at issue.
BNY claimed $835,100 and $6,753,720 as deductible expenses, fees and
transaction costs for 2001 and 2002, respectively.
VIII. Deficiency Notice
Respondent timely issued a deficiency notice to petitioner and adjusted
petitioner’s taxable income by disallowing the foreign tax credits, disallowing
deductions for interest and transaction costs, and reclassifying income related to the
STARS transaction as U.S. source income.
OPINION
This complex transaction presents a case of first impression in this Court.
We are asked to decide whether petitioner is entitled to foreign tax credits and
certain expense deductions from the STARS transaction and also whether petitioner
is entitled to report income generated from the STARS assets as foreign source
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income. Respondent argues that the STARS transaction lacked economic substance.
Respondent asserts consequently that the foreign tax credits and expenses
attributable to STARS should be disallowed and the income from the STARS assets
should be characterized as U.S. source.7 Petitioner, in contrast, contends the
STARS transaction had economic substance. In this regard, petitioner asserts that
BNY entered into STARS to obtain low-cost funding for its banking business and
that it reasonably expected to earn a pre-tax profit from STARS. Additionally,
petitioner contends that the U.S. foreign tax credit was intended for transactions like
STARS.
We agree with respondent. The STARS transaction was structured to meet
the relevant requirements in the Code and the regulations for claiming the disputed
foreign tax credits. The STARS transaction in essence, however, was an elaborate
series of pre-arranged steps designed as a subterfuge for generating, monetizing and
transferring the value of foreign tax credits among the STARS participants. We
now turn to the merits of the STARS transaction under the economic substance
doctrine.
7
Respondent also argues that the foreign tax credits BNY claimed are
disallowed under substance over form doctrines (including the step transaction
doctrine) and under the statutory anti-abuse rule in sec. 269(a). We need not decide
these arguments because of our other holdings.
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I. Merits of the STARS Transaction Under the Economic Substance Doctrine
A. Overview
Taxpayers may structure business transactions in a manner that results in the
least amount of tax. See Boulware v. United States, 552 U.S. 421, 430 n.7 (2008)
(citing Gregory v. Helvering, 293 U.S. 465, 469 (1935)); Gerdau Macsteel, Inc. v.
Commissioner, 139 T.C. ___, ___ (slip op. at 163-164) (Aug. 30, 2012). Courts
have also long recognized, however, that even if a transaction complies literally with
the Code, it does not necessarily follow that Congress intended to cover the
transaction and allow a tax benefit. Knetsch v. United States, 364 U.S. 361, 365
(1960); Helvering v. Gregory, 69 F.2d 809, 810 (2d Cir. 1934), aff’d, 293 U.S. 465(1935). In Frank Lyon Co. v. United States, 435 U.S. 561, 583-584 (1978), the
Supreme Court explained the circumstances in which a transaction should be
respected for tax purposes:
[W]here, as here, there is a genuine multiple-party transaction with
economic substance which is compelled or encouraged by business or
regulatory realities, is imbued with tax-independent considerations, and
is not shaped solely by tax-avoidance features that have meaningless
labels attached, the Government should honor the allocation of rights
and duties effectuated by the parties. * * *
The Courts of Appeals have interpreted that language as creating an
“economic substance doctrine” with the following two prongs: (1) whether the
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transaction had economic substance beyond tax benefits (objective prong), and (2)
whether the taxpayer had shown a non-tax business purpose for entering into the
disputed transaction (subjective prong). See Gerdau Macsteel, Inc. v.
Commissioner, 139 T.C. at ___ (slip op. at 166); Reddam v. Commissioner, T.C.
Memo. 2012-106; see also New Phoenix Sunrise Corp. & Subs. v. Commissioner,
132 T.C. 161, 175 (2009), aff’d, 408 Fed. Appx. 908 (6th Cir. 2010); Blum v.
Commissioner, T.C. Memo. 2012-16.
There is a split among the Courts of Appeals, however, as to the proper
application of the economic substance doctrine, and alternative approaches have
emerged. Some Courts of Appeals require that a valid transaction have economic
substance or a non-tax business purpose. See, e.g., Horn v. Commissioner, 968
F.2d 1229, 1236-1238 (D.C. Cir. 1992), rev’g Fox v. Commissioner, T.C. Memo.
1988-570; Rice’s Toyota World, Inc v. Commissioner, 752 F.2d 89, 91 (4th Cir.
1985), aff’g in part, rev’g in part 81 T.C. 184 (1983). Other Courts of Appeals
require a valid transaction have both economic substance and a non-tax business
purpose. See Dow Chem. Co. v. United States, 435 F.3d 594, 599 (6th Cir. 2006);
Winn-Dixie Stores, Inc. v. Commissioner, 254 F.3d 1313, 1316 (11th Cir. 2001),
aff’g 113 T.C. 254 (1999); United Parcel Serv. of Am., Inc. v. Commissioner, 254
F.3d 1014, 1018 (11th Cir. 2001), rev’g T.C. Memo. 1999-268. Still other Courts
-28-
of Appeals adhere to the view that a lack of economic substance is sufficient to
invalidate a transaction regardless of the taxpayer’s subjective motivation. See, e.g.,
Coltec Indus., Inc. v. United States, 454 F.3d 1340, 1355 (Fed. Cir. 2006). And
still other Courts of Appeals treat the objective and subjective prongs merely as
factors to consider in determining whether a transaction has any practical economic
effects beyond tax benefits. See, e.g., ACM P’ship v. Commissioner, 157 F.3d 231,
248 (3d Cir. 1998), aff’g in part, rev’g in part T.C Memo. 1997-115.
An appeal in this case would lie to the Court of Appeals for the Second
Circuit absent stipulation to the contrary, and, accordingly, we follow the law of that
circuit to the extent it is directly on point. See Golsen v. Commissioner, 54 T.C.
742 (1970), aff’d, F.2d 985 (10th Cir. 1971). The Court of Appeals for the Second
Circuit has endorsed applying a flexible analysis in assessing economic substance.
Gilman v. Commissioner, 933 F.2d 143 (2d Cir. 1991), aff’g T.C. Memo. 1989-684;
Long Term Capital Holdings v. United States, 330 F. Supp. 2d 122 (D. Conn.
2004), aff’d, 150 Fed. Appx. 40 (2d Cir. 2005). The analysis evaluates both the
subjective business purpose of the taxpayer for engaging in the transaction and the
objective economic substance of the transaction. Gilman v. Commissioner, 933
F.2d at 148; Long Term Capital Holdings, 330 F. Supp. 2d at 171. These distinct
aspects of the economic substance inquiry do not, however, constitute discrete
-29-
prongs of a rigid two-step analysis. Long Term Capital Holdings, 330 F. Supp. 2d
at 171 n.68; see also Gilman v. Commissioner, 933 F.2d at 148. They are instead
simply more precise factors to consider in the overall inquiry of whether the
transaction had any practical economic effects other than the creation of tax losses.
Altria Grp. Inc. v. United States, 694 F. Supp. 2d 259, 282 (S.D.N.Y. 2010), aff’d,
658 F.3d 276 (2d Cir. 2011); Long Term Capital Holdings, 330 F. Supp. 2d at 171
n. 68. A finding of a lack of either economic substance or a non-tax business
purpose can be but is not necessarily sufficient for a court to conclude that a
transaction is invalid for Federal tax purposes. Altria Group, Inc., 694 F. Supp. 2d
at 282; Long Term Capital Holdings, 330 F. Supp. 2d at 171 n.68. The ultimate
determination of whether a transaction lacks economic substance is a question of
fact. See Nicole Rose Corp. v. Commissioner, 320 F.3d 282, 284 (2d Cir. 2003),
aff’g 117 T.C. 328 (2001). We now turn to the scope of the economic substance
doctrine.
B. Scope of the Economic Substance Inquiry
The first step in the economic substance inquiry is to identify the transaction
to be analyzed. See, e.g., Sala v. United States, 613 F.3d 1249, 1252 (10th Cir.
2010). Petitioner argues that we should analyze the components of the STARS
transaction as an integrated arrangement for purposes of testing economic
-30-
substance. In contrast, respondent argues that we should bifurcate the STARS
transaction and focus on the STARS structure, not the loan, for purposes of testing
economic substance. We agree with respondent.
The relevant transaction to be tested is the one that produces the disputed tax
benefit, even if it is part of a larger set of transactions or steps.8 See Nicole Rose
Corp. v. Commissioner, 320 F.3d at 284; Kipnis v. Commissioner, T.C. Memo.
2012-306; Country Pine Fin., LLC v. Commissioner, T.C. Memo. 2009-251; Long
Term Capital Holdings, 330 F. Supp. 2d at 183; see also Sala, 613 F.3d at 1252;
Klamath Strategic Inv. Fund v. United States, 568 F.3d 537, 545 (5th Cir. 2009);
Coltec Indus., Inc., 454 F.3d at 1352-1355; Black & Decker Corp. v. United States,
436 F.3d 431, 436 (4th Cir. 2006); ACM P’ship v. Commissioner, 157 F.3d at 260
n.57. Stated another way, the requirements of the economic substance doctrine are
not avoided simply by coupling a routine transaction with a transaction lacking
economic substance. See, e.g., Long Term Capital Holdings, 330 F. Supp. 2d at
8
Congress noted when codifying the economic substance doctrine in sec.
7701 in 2010 that under present law courts could “bifurcate a transaction in which
independent activities with non-tax objectives are combined with an unrelated item
having only tax avoidance objectives to disallow those tax motivated benefits.”
Staff of Jt. Comm. on Taxation, Technical Explanation of the Revenue Provisions of
the “Reconcilliaton Act of 2010” as amended, in combination with the “Patient
Protection and Affordable Care Act” 153 & n.352 (J. Comm. Print 2010).
-31-
183; see also ACM P’ship v. Commissioner, 157 F.3d at 260 n.57. A contrary
application would undermine the flexibility and efficacy of the economic substance
doctrine.
Accordingly, we focus our economic substance inquiry on the transaction that
gave rise to the disputed foreign tax credits. The disputed foreign tax credits were
generated by circulating income through the STARS structure. In contrast, the loan
was not necessary for the STARS structure to produce the disputed foreign tax
credits. It is the use of the STARS structure then that is relevant and that we test for
economic substance.
C. Economic Substance of the STARS Structure
1. Objective Economic Substance
We first consider whether BNY’s use of the STARS structure had objective
economic substance. The Court of Appeals for the Second Circuit in evaluating
objective economic substance focuses on whether the relevant transaction created a
reasonable opportunity for economic profit; i.e., profit exclusive of tax benefits.
Gilman v. Commissioner, 933 F.2d at 148; Long Term Capital Holdings, 330 F.
Supp. 2d at 172. Accordingly, we must determine whether use of the STARS
structure created a reasonable opportunity for economic profit. Respondent argues
-32-
that it did not. We agree and thus find that the use of the STARS structure lacked
objective economic substance.
The record reflects that BNY did not have a reasonable expectation that it
would make a non-tax economic profit from using the STARS structure. First, the
STARS structure did not increase the profitability of the STARS assets in anyway.
To the contrary, it reduced their profitability by adding substantial transaction costs,
e.g., professional service fees and foreign taxes incurred as result of using the
STARS structure.9
9
We have previously held that foreign taxes are economic costs for purposes
of the economic substance doctrine. See Compaq Computer Corp. v.
Commissioner, 113 T.C. 214 (1999), rev’d, 277 F.3d 778, 785 (5th Cir. 2001). We
are mindful that the Courts of Appeals for the Fifth and Eighth Circuits have
subsequently held that foreign taxes should not be taken into account in evaluating
pre-tax effects for purposes of the economic substance analysis. See IES Indus.,
Inc. v. United States, 253 F.3d 350 (8th Cir. 2001); Compaq Computer Corp. v.
Commissioner, 277 F.3d 778, 785 (5th Cir. 2001), rev’g 113 T.C. 214 (1999).
Nevertheless, the Supreme Court and the Court of Appeals for the Second Circuit
have yet to consider the issue, and we are not bound by Fifth and Eighth Circuit
precedent here.
We maintain the position we took in Compaq Computer with respect to
foreign taxes in the economic substance context. Economically, foreign taxes are
the same as any other transaction cost. And we cannot find any conclusive reason
for treating them differently here, especially because substantially all of the foreign
taxes giving rise to the foreign tax credits stemmed from economically meaningless
activity, i.e., the pre-arranged circular cashflows engaged in by the trust.
(continued...)
-33-
Additionally, the activities or transactions that the STARS structure was used
to engage in did not provide a reasonable opportunity for economic profit. The
STARS structure’s main activity was to circulate income between itself and
Barclays. Every month, as pre-arranged, DelCo would transfer pre-determined
amounts of income to the trust. Substantially all of the trust income was distributed
to the Barclays blocked account, which in turn was immediately recontributed to the
trust and then passed back to DelCo where it was available for BNY’s use. These
circular cashflows or offsetting payments had no non-tax economic effect.
Courts have consistently recognized that the presence of circular cashflows
strongly indicates that a transaction lacks economic substance. See Altria Group,
Inc., 658 F.3d at 289 (citing AWG Leasing Trust v. United States, 592 F. Supp. 2d
953, 983 (N.D. Ohio 2008)) (circular payments from and back to foreign bank
“strongly indicate” that SILO transaction “has little substantive business purpose
other than generating tax benefits”); Merryman v. Commissioner, 873 F.2d 879, 882
9
(...continued)
Additionally, excluding the economic effect of foreign taxes from the pre-tax
analysis would fundamentally undermine the point of the economic substance
inquiry. That point is to remove the challenged tax benefit and evaluate whether the
relevant transaction makes economic sense. See In re CM Holdings, Inc., 301 F.3d
96, 105 (3d Cir. 2002).
-34-
(5th Cir. 1989) (tax structuring disregarded where “money flowed back and forth
but the economic positions of the parties were not altered”), aff’g T.C. Memo.
1988-72; Prof’l Servs. v. Commissioner, 79 T.C. 888, 928 (1982) (disregarding pre-
arranged circular cashflows through a trust); see also Knetsch, 364 U.S. at 366(offsetting payments on annuity bond and notes resulted in sham). This follows
from the common sense proposition that a taxpayer is not entitled to benefits from
circular transfers the net result of which is effectively nothing.
The STARS structure was also used in connection with the stripping
transaction. The stripping transaction too resulted in a circular cashflow and did not
provide a reasonable opportunity for economic profit. In particular, the trust sold its
right to interest income from the trust collateral securities to DelCo for a lump-sum
payment taxable in the United Kingdom, which DelCo made with funds provided by
BNY. This reallocated the income and principal payments associated with the trust
collateral securities within the STARS structure. It did not alter the amount and
timing of the cashflows generated by the underlying assets. And because the sale of
the interest rights was funded by BNY and between entities within the STARS
structure, the stripping transaction had no potential to generate a non-tax economic
profit on the aggregate.
-35-
Petitioner argues that we should consider the income generated by the
STARS assets in evaluating whether the STARS structure had a reasonable
opportunity for economic profit. We disagree. Economic benefits that would result
independent of a transaction do not constitute a non-tax benefit for purposes of
testing its economic substance. See Gerdau Macsteel, Inc. v. Commissioner, 139
T.C. at ___ (slip op. at 174-175). Stated otherwise, benefits that are unrelated to
the transaction cannot be what motivates a taxpayer to engage in the transaction and
therefore are of no aid in determining whether the taxpayer would have engaged in
the transaction absent the tax effects. Id.Here, BNY’s control and management over the STARS assets did not
materially change as a result of their transfer to the STARS structure.10
Additionally, the STARS structure had no effect on the income stream generated by
the STARS assets. Accordingly, the STARS assets would have generated the same
10
DelCo held most of the income-generating STARS assets with the trust
holding the remaining STARS assets. BNY directly or indirectly held all the voting
rights of DelCo, the initial and successor trustee of the trust and the trust manager,
and thus effectively controlled those entities. In addition, BNY executed servicing
agreements that gave BNY control over the management of the STARS assets the
trust and DelCo held.
-36-
income regardless of being transferred to the trust. Thus, income from the STARS
assets was not an incremental benefit of STARS.
2. Subjective Economic Substance
We now turn to the subjective prong of the economic substance analysis.
This prong requires us to determine whether BNY had a legitimate non-tax business
purpose for the use of the STARS structure. See Long Term Capital Holdings, 330
F. Supp. 2d at 186. We find it did not. Petitioner claims that it used the STARS
structure to obtain “low cost financing” from Barclays.11 The record does not
support petitioner’s claimed business purpose. The STARS structure lacked any
reasonable relationship to the loan. And the loan was not “low cost.” To the
contrary, it was significantly overpriced and required BNY to incur substantially
more transaction costs than a similar financing available in the marketplace. We
find that petitioner failed to establish a valid business purpose and BNY’s true
motivation was tax avoidance. We base our finding on our analysis of the following
factors.
11
Petitioner’s experts opined on several other potential business purposes at
trial. The record does not support, however, that BNY contemplated those
suggested business purposes at the time it participated in STARS. We therefore
reject these after-the-fact rationalizations. See, e.g., Winn-Dixie Stores, Inc. v.
Commissioner, 113 T.C. 254, 285-286 (1999), aff’d, 254 F.3d 1313 (11th Cir.
2001).
-37-
a. The STARS Structure Lacked a Reasonable Relationship to
Petitioner’s Claimed Business Purpose.
Using unreasonable means to achieve a claimed business purpose indicates
that the taxpayer’s true motivation for the transaction is tax avoidance. See Long
Term Capital Holdings, 330 F. Supp. 2d at 186-187; see also Cherin v.
Commissioner, 89 T.C. 986, 993-994 (1987); CMA Consol., Inc. & Subs. v.
Commissioner, T.C. Memo. 2005-16. We now consider the relationship between
the STARS structure and petitioner’s claimed business purpose. Petitioner suggests
that the class C unit and the class D unit Barclays held served as collateral for the
loan. We are not persuaded.
BNY’s obligation with respect to the loan was more than adequately secured
by other arrangements independent of the trust. Barclays held a security interest in
a pool of high quality assets valued at $2.25 billion, creating a collateralization level
of 150%. Respondent’s expert Steven Schwarcz concluded that the collateralization
level (e.g., securitization) in a structured finance transaction is usually around 10%
and that the loan was substantially over collateralized. In addition to the collateral
arrangements, Barclays effectively had full recourse to BNY itself for repayment
through the credit default swap.
-38-
Petitioner’s expert W. Clifford Atherton suggested that the special-purpose
entities making up the STARS structure served a project financing (a type of
structured financing transaction) function. We disagree. Respondent’s expert Mr.
Schwarcz emphasized that special-purpose entities are typically used in connection
with a structured financing transaction to efficiently reallocate risk and reduce
information asymmetry.12 Mr. Schwarcz also highlighted that structured financing
transactions generally involve special-purpose entities incurring debt and using the
proceeds to finance the acquisition of income-producing assets. And the lenders
look to the cash produced by those assets for repayment, bearing the risk that the
cash will be insufficient to repay the debt.
These common indicia of a structured financing transaction are not present in
STARS. The loan proceeds were not used to purchase the STARS assets, and
Barclays did not look to any assets purchased with the financing proceeds for
repayment. And unlike a typical structured financing transaction, the special-
purpose entities in STARS did not function to efficiently reallocate risk.
12
Mr. Schwarcz defined “information asymmetry” as a scenario in which one
party has more information than the other party. According to Mr. Schwarcz,
structured financing transactions reduce information asymmetry by allowing parties
taking on risk to more efficiently assess that risk, typically by creating well-defined,
easily-valued and bankruptcy-protected sources of repayment.
-39-
In this regard, Mr. Schwarcz observed that STARS simply involved a full-
recourse secured financing. Mr. Schwarcz correctly concluded that, given the
characteristics of the loan, Barclays could have made the same $1.5 billion loan to
BNY, secured by the same assets constituting the collateral for the loan, using only
a loan agreement and a security agreement. Such an arrangement would have been
much simpler, avoided the use of the special-purpose entities and had substantially
lower transaction costs than STARS.
Efficiency aside, Mr. Schwarcz concluded that the special-purpose entities
used in the STARS transaction did not “realistically” function to transfer risk
between the parties. Mr. Schwarcz opined that the over-collateralization level of
the loan and the other security arrangements minimized Barclays’ risk with respect
to the loan. Accordingly, there was no significant risk for the special-purpose
entities to transfer.
Finally, Mr. Schwarcz concluded that the STARS structure did not reduce
information asymmetry between the parties. In contrast, he opined that STARS was
excessively complex given the economics of the loan and arguably increased
information asymmetry. We agree with Mr. Schwarcz that the STARS structure did
not perform a structured financing function.
-40-
Petitioner finally argues more generally that Barclays made the loan
contingent on the STARS structure and therefore the two transactions were
“commercially linked.” Again, we are not persuaded. Making a routine business
transaction contingent on an economically meaningless transaction, like the STARS
structure, is insufficient to establish that the nexus between the two is reasonable.
See, e.g., Long Term Capital Holdings, 330 F. Supp. 2d at 183.
In sum, the record does not support that the STARS structure performed any
significant banking, commercial or business function with respect to the loan.
Consequently, we find that the STARS structure did not bear a reasonable
relationship to the loan. This lack of reasonableness indicates BNY’s true
motivation--tax avoidance.
b. The STARS Financing Was Not Low Cost.
We now evaluate petitioner’s claimed business purpose that the loan was
“low cost.” Respondent argues that the spread should be disregarded in determining
the cost of the loan and that the loan was overpriced absent the spread. We address
each of respondent’s contentions in turn.
-41-
i. The Spread Was Not a Component of Interest.
We now consider whether the spread should be disregarded in determining
the cost of the loan. Respondent argues that it should because the spread in
substance was a tax effect and not a component of interest. We agree.
We are mindful in evaluating the substance of the spread that labels and
characterizations do not determine the tax consequences where they are inconsistent
with economic realities. Frank Lyon Co., 435 U.S. at 583-584 (labels must be
economically meaningful); TIFD III-E, Inc. v. United States, 459 F.3d 220 (2d Cir.
2006); Saba P’ship v. Commissioner, T.C. Memo. 2003-31 (payments characterized
as consulting fees held to be a guaranteed return to a purported partner).
The stated interest rate on the loan was LIBOR plus 30 basis points less the
spread. The spread was a fixed amount equal to one-half the present value of the
U.K. taxes the trust was expected to pay on the target class C unit income each
month. We acknowledge the spread was part of the formula for calculating the
interest expense on the loan. Its substance did not match, however, its form.
Respondent’s expert Anthony Saunders opined on the commerciality of the
loan’s pricing. Mr. Saunders noted that the pricing of a loan generally depends on
the time value of money and the risks presented to the lender through the particular
-42-
loan transaction. Mr. Saunders also noted that here the loan’s cost was such that
Barclays could not reasonably expect that the return (i.e., interest) it received from
BNY would exceed Barclays’ cost of funds. He further noted that, independent of
Barclays’ cost of funds, the interest rate was “negative” for most of the tenure of the
loan. That is, the “lender” (Barclays) was paying the “borrower” (BNY) to borrow
its funds. Mr. Saunders concluded that the loan’s pricing did not reflect the risk
inherent in the STARS transaction and more generally that the loan fundamentally
deviated from attributes of a standard banking transaction. He further concluded
that there were no unique economic conditions that might explain the non-economic
pricing.
Respondent’s expert Mr. Schwarcz also opined on the commerciality of the
loan. Like Mr. Saunders, Mr. Schwarcz noted that the loan had a “negative interest
rate.” Mr. Schwarcz opined that, in an arm’s-length commercial lending
transaction, a loan would not bear a negative interest rate, absent unique
circumstances external to the loan, e.g., to avoid a loss or to effect government
policy, such as stimulus. He noted that it makes no economic sense for a lender to
pay a borrower interest on a loan absent such a circumstance. He concluded there
were no special circumstances that warranted the loan bearing a “negative interest
rate” and the loan was not commercially reasonable.
-43-
Respondent’s expert Michael Cragg analyzed the pricing of the loan,
including the economics of the spread. He concluded that circulating income
through the STARS structure generated the economic benefit labeled the “spread”
by combining certain U.S. and U.K. tax effects. Mr. Cragg’s analysis showed that it
would not have been economically beneficial for Barclays to pay BNY the spread
absent the U.K. tax benefits from STARS. Similarly, Mr. Cragg’s analysis showed
that the STARS arrangement would not have been beneficial to BNY absent the
foreign tax credits arising from the payment of U.K. tax on the trust income. Mr.
Cragg ultimately concluded that the spread was economically derived and
contingent on the parties receiving certain U.S. and U.K. tax treatment with respect
to the STARS structure and as a result was not a pre-tax cashflow.
Petitioner denies that the spread was a tax effect because it was not expressly
contingent on either Barclays or BNY receiving any particular U.S. or U.K. tax
treatment or benefit. In this regard, petitioner asserts that BNY could under certain
circumstances keep the spread Barclays paid even if Barclays did not realize its
expected U.K. benefits.13 And petitioner asserts that Barclays’ obligation to pay
13
If the U.K. tax authority determined that the trust was not a collective
investment scheme before the due date of the U.K. trust tax, BNY could keep the
spread paid to date even though Barclays would not realize the anticipated U.K. tax
(continued...)
-44-
the spread did not vary depending on whether BNY’s U.S. tax treatment was
respected.
Petitioner’s argument is unpersuasive. The manner in which the parties
agreed to allocate tax risk does not preclude the spread from being a tax effect. The
spread’s value was derivative of expected U.S. and U.K. tax effects. And it would
not have been paid going forward if either of those effects had been foreclosed.
Indeed, STARS would no longer be economically beneficial to either BNY or
Barclays and each could terminate STARS on short notice.14
13
(...continued)
benefits. After the first due date of U.K. tax on trust income, however, BNY was
obligated to pay Barclays half of any STARS trust tax that would be refunded if the
U.K. tax authority did not respect Barclays’ tax position with respect to the STARS
structure. That amount would be roughly equal to spread payments BNY had
received.
We note that the risk of having to pay the spread before the first due date
without realizing the anticipated U.K. benefits was likely minimal. According to
petitioner’s U.K. regulatory expert, Michael Brindle, Q.C., the U.K. tax authority
would likely view the STARS structure as a collective investment scheme. In
addition, the STARS structure was promptly submitted to the U.K. tax authority for
approval and a similar transaction was already under review. And on net the
STARS transaction added revenue to the U.K. relative to its position without the
STARS transaction, increasing the likelihood that the U.K. tax authority would view
the STARS structure favorably.
14
Petitioner concedes that Barclays agreed to pay the spread based upon
expected U.K. tax benefits and that the spread was calculated as a percentage of
(continued...)
-45-
In sum, we agree with respondent’s experts. The spread artificially reduced
the loan’s cost and lacked economic reality. In substance the spread was contingent
on the parties’ anticipated tax treatment and was unrelated to the time value of
money or the attendant risks associated with the loan. We conclude, on the record
as a whole, that the spread was in substance not a component of loan interest.
The spread rather was a tax effect. It was embedded in the loan to serve as a
device for monetizing and transferring the value of anticipated foreign tax credits
generated from routing income through the STARS structure. That the generated
tax savings were used to offset the cost of the loan does not provide a valid non-tax
purpose. Indeed, courts have consistently recognized that intending to use tax
savings from a transaction lacking economic substance to underwrite or enhance the
commercial terms of a legitimate business transaction does not constitute a valid
non-tax purpose. See Winn-Dixie Stores, Inc. v. Commissioner, 113 T.C. at 287;
14
(...continued)
the present value of those benefits. Those U.K. tax benefits depended on the vitality
of the trust structure whose economic rationality for BNY depended on BNY
receiving a U.S. foreign tax credit for U.K. tax paid on trust income as the spread
equaled only half of the U.K. tax. Accordingly, Barclays’ U.K. tax benefit could
not be achieved without BNY achieving its U.S. tax benefit.
-46-
see also Am. Elec. Power Co., Inc. v. United States, 326 F.3d 737, 744 (6th Cir.
2003) (“Money generated by means of abusive tax deductions can always be
applied to beneficial causes, but the eventual use of the money thus generated is not
part of the economic sham analysis.”).
ii. The Loan Was Not Low Cost.
We now turn to respondent’s contention the loan was not “low cost” absent
the spread. Mr. Cragg compared the loan to available market financing. He opined
that the loan was a secured, highly collateralized loan, cancellable within 5 to 30
days. He further opined that comparable short-term financing, both secured and
unsecured, for a borrower similar to BNY is typically obtained through highly
efficient and standardized interbank relationships at or below an interest rate of 1-
month LIBOR and de minimis transaction costs (market benchmark loan). Absent
the spread adjustment, the loan’s interest rate (LIBOR plus 20 basis points) was
above the market benchmark loan. Beyond the additional interest expense, the loan
required BNY to incur substantial transaction costs in the form of professional
service fees and foreign taxes that would not exist in a comparable market
financing.15 In short, BNY could have obtained comparable financing in the market
15
We note that, regardless of how the spread is characterized, the benefit of
(continued...)
-47-
place at substantially less economic cost than that obtained through STARS. We
find that the loan was not “low cost.”
D. Economic Substance of the Integrated STARS Arrangement
The STARS transaction still lacks economic substance even if the STARS
structure and the loan are evaluated as an integrated transaction. Petitioner contends
that the integrated STARS transaction has objective economic substance because it
offered a reasonable opportunity for pre-tax profit. Petitioner asked its expert Mr.
Atherton to calculate the pre-tax profitability of the STARS transaction. Mr.
Atherton concluded that BNY reasonably could have expected a profit of more than
$1.6 billion before taking into account U.K. or U.S. income taxes over the life of the
STARS transaction.
We find that Mr. Atherton’s analysis of STARS’ pre-tax profitability contains
several critical flaws and is therefore not helpful to the Court. One such flaw with
Mr. Atherton’s pre-tax profitability calculation is that he includes income from the
STARS assets as revenues arising from the STARS transaction. As we previously
held, the pre-existing cashflows from the trust assets are not incremental to the
15
(...continued)
the spread was more than offset by the additional transaction costs that BNY
incurred to obtain the spread.
-48-
STARS transaction and therefore irrelevant to the objective economic substance
analysis.
Mr. Atherton’s pre-tax profitability analysis is also flawed because he
includes returns on asset-backed securities he assumes BNY contemplated acquiring
with the loan proceeds. Only cashflows arising from the transaction whose
economic substance is at issue are relevant to the pre-tax profitability analysis. See
Nicole Rose Corp. v. Commissioner, 320 F.3d at 284 (rejecting the taxpayer’s
argument that profits from an unrelated asset sale should be attributed to a lease
transaction generating the tax benefits at issue); ACM P’ship v. Commissioner, 157
F.3d at 260 (disregarding profits from funds acquired in a transaction and invested
outside of the structure being evaluated for economic substance); see also Kipnis v.
Commissioner, T.C. Memo. 2012-306 (economic substance should be reviewed
without reference to expected profit from an intended real estate investment that the
taxpayer expected to make with proceeds from the “CARDS” transaction); Long
Term Capital Holdings, 330 F. Supp. 2d at 183 (requirements of economic
substance are not avoided by coupling a routine profitable economic transaction
with no inherent tax benefits to a unique transaction that otherwise lacks profit
potential).
-49-
Here, the integrated STARS transaction’s net pre-tax effect was to create a
$1.5 billion loan at LIBOR plus 20 basis points. It did not generate any revenue,
only an obligation to repay the loan principal and interest. Any income from
investing the loan proceeds was not a cashflow arising from the integrated STARS
transaction. Rather, it resulted from a separate and distinct transaction. Thus,
income from investing the loan proceeds is not relevant to the economic substance
analysis of the integrated STARS transaction and should have been excluded from
the pre-tax profitability analysis. We note that even if the projected yield on the
loan proceeds Mr. Atherton assumed was relevant that yield is insufficient to offset
the foreign tax costs16 of the transaction.
The last critical flaw in his analysis is his including the spread in calculating
the cost of the loan, the effect of which is to reduce the cost. As we previously
found, the spread is a tax effect of the STARS structure and its value is effectively
funded by the foreign tax credits. Mr. Atherton therefore should not have reduced
the cost of the loan by the spread in his pre-tax profitability analysis.
Mr. Atherton’s analysis substantially inflates pre-tax income by including the
non-incremental income from the STARS assets, the projected yield from the loan
16
See supra note 9.
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proceeds and the spread as pre-tax income. When these items are omitted, all that
remains is the loan at LIBOR plus 20 basis points. As we previously, discussed,
Mr. Cragg’s analysis shows that the loan was overpriced and therefore not
profitable on a pre-tax basis. Mr. Cragg concluded more generally that it would
have been economically irrational for BNY to enter into the integrated STARS
transaction without the foreign tax credits BNY derived from it. Accordingly, we
find that the integrated STARS transaction lacks economic substance.
We now address the subjective economic substance of the integrated STARS
transaction. Here, petitioner argues that it was motivated to enter the STARS
transaction to obtain “low cost” financing. As we previously held, we reject that
business purpose because it lacks merit. Aside from that claimed business purpose,
petitioner contends it was motivated to enter into STARS by a realistic expectation
of pre-tax profit. Specifically, petitioner claims that BNY intended to use the loan
proceeds to grow its “investment portfolio” and earn a profit by investing in asset-
backed securities. As we previously held, any income from the investment of the
loan proceeds is not income from the integrated STARS transaction and therefore is
irrelevant to the objective economic substance analysis. Similarly, any profit
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petitioner expected to earn from investing the loan proceeds is not relevant to the
subjective economic substance analysis.17
E. Congressional Intent
We now consider whether the disputed tax benefits are what Congress
intended in establishing the foreign tax credit. Petitioner contends that the economic
substance doctrine does not warrant disallowing the disputed tax benefits because
Congress intended the foreign tax credit for transactions like STARS. We disagree.
The United States taxes income of its citizens, residents and domestic entities
on a worldwide basis. A U.S. corporation must include foreign source income in its
U.S. taxable income even though that income may also be subject to foreign tax.
Congress enacted the foreign tax credit to alleviate double taxation arising from
foreign business operations. See United States v. Goodyear Tire & Rubber Co.,
493 U.S. 132, 139 (1989); Am. Chicle Co. v. United States, 316 U.S. 450, 451
(1942); Burnet v. Chicago Portrait Co., 285 U.S. 1, 7 (1932). Congress intended
the foreign tax credit to neutralize the effect of U.S. tax on the business decision of
17
We note that petitioner failed to substantiate the claimed business purpose
otherwise. None of the STARS transactional documents or any other persuasive
contemporaneous evidence show that BNY considered investing the loan proceeds
in asset-backed securities. Nor did BNY consider any projected returns from such
an investment in evaluating whether to enter into STARS. And the record does not
reflect that loan proceeds were in fact used to purchase such securities.
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where to conduct business activities most productively. 56 Cong. Rec. App.
677-678 (1918) (statement of Rep. Kitchin). The enactment of the foreign tax credit
was also informed by fairness. See National Foreign Trade Council, Inc.,
International Tax Policy for the 21st Century, (Dec. 15, 2001).
The STARS transaction was a complicated scheme centered around
arbitraging domestic and foreign tax law inconsistencies. The U.K. taxes at issue
did not arise from any substantive foreign activity. Indeed, they were produced
through pre-arranged circular flows from assets held, controlled and managed within
the United States. We conclude that Congress did not intend to provide foreign tax
credits for transactions such as STARS.
II. Deductibility of STARS-Related Expenses
We now consider whether petitioner is entitled to deduct expenses incurred
in furtherance of STARS. Petitioner contends that it is entitled to deduct the
claimed transactional expenses and the zero coupon swap interest for 2001 and
2002, and petitioner asks the Court to hold that the U.K. taxes paid on trust
income are deductible if we deny the foreign tax credits claimed for those taxes.
Respondent counters that the claimed transactional expenses and the U.K. taxes
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are not deductible because the STARS transaction lacked economic substance as we
found. We agree.
Expenses incurred in furtherance of a transaction that is disregarded for a lack
of economic substance are not deductible. See Winn-Dixie Stores, Inc. v.
Commissioner, 113 T.C. at 294 (observing that “a transaction that lacks economic
substance is not recognized for Federal tax purposes” and that “denial of recognition
means that such a transaction cannot be the basis for a deductible expense”); see
also Gerdau Macsteel, Inc. v. Commissioner, 139 T.C. ___ (slip op. at 188). The
claimed transactional expenses, the zero coupon swap interest expense and the U.K.
taxes were all incurred in furtherance of the STARS transaction, which we
previously held lacks economic substance. Consequently, they are not deductible.
III. Foreign Source Income Adjustment
We next address respondent’s adjustment to BNY’s foreign source income.
Petitioner reported the income from the trust assets as foreign source income based
on a “resourcing” provision in paragraph 3 of article 23 of the Convention for the
Avoidance of Double Taxation and the Prevention of Fiscal Evasion with Respect to
Taxes on Income and Capital Gains, U.S.-U.K., Dec. 31, 1975, 31 U.S.T. 5668
(U.S.-U.K. tax treaty).
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Petitioner contends that the resourcing provision applies and that
respondent’s foreign source income adjustment was improper. We disagree. U.S.
tax laws and treaties do not recognize sham transactions or transactions that have no
economic substance as valid for tax purposes. Del Commercial Props., Inc. v.
Commissioner, T.C. Memo. 1999-411 (citing Gregory v. Helvering, 293 U.S. 465,
470 (1935), and Johansson v. United States, 336 F.2d 809, 813 (5th Cir. 1964)),
aff’d, 251 F.3d 210 (D.C. Cir. 2001). Because we previously held that the STARS
transaction is disregarded for U.S. tax purposes, BNY is treated for U.S. tax
purposes as owning the STARS assets and the income is treated as being derived by
BNY within the United States. Consequently, the U.S.-U.K. tax treaty, including
the resourcing provision, does not apply. We therefore sustain respondent’s
adjustment of petitioner’s foreign source income.
IV. Conclusion
In sum, the STARS transaction (bifurcated or integrated) lacks economic
substance and Congress did not otherwise intend to provide foreign tax credits for
transactions such as STARS. Accordingly, the STARS transaction is invalid for
Federal tax purposes and the foreign tax credits and expense deductions claimed in
connection with it are disallowed.
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We have considered all remaining arguments the parties made and, to the
extent not addressed, we find them to be irrelevant, moot or meritless.
To reflect the foregoing,
Decision will be entered for
respondent.