Bank of New York Mellon Corporation v. Commissioner, 140
T.C. No. 2, Code Sec(s) 901; 1504.
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 .
Case Information:
Code Sec(s):
901; 1504
Docket: Docket
No. 26683-09.
Date Issued:
02/11/2013
HEADNOTE
XX.
Reference(s): Code Sec. 901; Code Sec. 1504
Syllabus
Official Tax Court Syllabus
Counsel
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 million 2 and $115 million for 2001 and
2002 (years at issue), respectively. There are three issues for decision. The
first issue is whether petitioner is entitled to foreign tax credits under
section 901 3 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 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 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.
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 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 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 LIBOR 5 + 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 $1.49
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. 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.
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 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 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 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. 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.
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.
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 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.
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 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 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 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.
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
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 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 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.
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 [101 AFTR 2d 2008-1065] n.7 (2008) (citing Gregory v.
Helvering, 293 U.S. 465, 469 [14 AFTR 1191] (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 [6 AFTR 2d 5851] (1960); Helvering v. Gregory, 69 F.2d 809, 810
[13 AFTR 806] (2d Cir. 1934), aff'd, 293 U.S. 465 [14 AFTR 1191] (1935). In
Frank Lyon Co. v. United States, 435 U.S. 561, 583-584 [41 AFTR 2d 78-1142]
(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 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 [TC Memo 2012-106]; see also
New Phoenix Sunrise Corp. & Subs. v. Commissioner , 132 T.C. 161, 175
(2009), aff'd, 408 Fed. Appx. 908 [106 AFTR 2d 2010-7116] (6th Cir. 2010); Blum
v. Commissioner, T.C. Memo. 2012-16 [TC 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 [70 AFTR 2d 92-5196] (D.C. Cir.
1992), rev'g Fox v. Commissioner, T.C. Memo. 1988-570 [¶88,570 PH Memo TC];
Rice's Toyota World, Inc v. Commissioner, 752 F.2d 89, 91 [55 AFTR 2d 85-580]
(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
[97 AFTR 2d 2006-671] (6th Cir. 2006); Winn-Dixie Stores, Inc. v. Commissioner
, 254 F.3d 1313, 1316 [87 AFTR 2d 2001-2626] (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 [1999 RIA TC Memo ¶99,268].
Still other Courts 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 [98 AFTR 2d 2006-5249] (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 [82 AFTR 2d 98-6682] (3d Cir. 1998), aff'g in part, rev'g in
part T.C Memo. 1997-115 [1997 RIA TC Memo ¶97,115].
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
[67 AFTR 2d 91-1016] (2d Cir. 1991), aff'g T.C. Memo. 1989-684 [¶89,684 PH Memo
TC]; , Long Term Capital Holdings v. United States 330 F. Supp. 2d 122 [94 AFTR
2d 2004-5666] (D. Conn. , 2004), aff'd, 150 Fed. Appx. 40 [96 AFTR 2d
2005-6344] (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
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 [105 AFTR 2d 2010-1419] (S.D.N.Y. 2010), aff'd, 658 F.3d 276 [108 AFTR 2d
2011-6398] (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 [90
AFTR 2d 2002-7702] (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 [106 AFTR 2d 2010-5406]
(10th Cir. 2010). Petitioner argues that we should analyze the components of
the STARS transaction as an integrated arrangement for purposes of testing
economic 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 [TC Memo 2012-306]; Country Pine Fin., LLC v.
Commissioner T.C. Memo. 2009-251 [TC 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 [103 AFTR 2d 2009-2220]
(5th Cir. 2009); , Coltec Indus., Inc., 454 F.3d at 1352-1355; Black &
Decker Corp. v. United States, 436 F.3d 431, 436 [97 AFTR 2d 2006-841] (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 , 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 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
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 [101 AFTR 2d 2008-2397] (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 [64 AFTR
2d 89-5009] (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 [¶88,072 PH Memo TC]; 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.
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 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. 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 [TC 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.
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.
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.
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. 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 [98 AFTR 2d 2006-5616] (2d Cir. 2006); Saba P'ship v.
Commissioner, T.C. Memo. 2003-31 [TC 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 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.
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 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
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; , see also Am.
Elec. Power Co., Inc. v. United States, 326 F.3d 737, 744 [91 AFTR 2d
2003-2060] (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 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 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 [TC 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).
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 costs 16 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 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 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 [64 AFTR 2d
89-5841] (1989); Am. Chicle Co. v. United States, 316 U.S. 450, 451 [29 AFTR
193] (1942); Burnet v. Chicago Portrait Co., 285 U.S. 1, 7 [10 AFTR 800]
(1932). Congress intended the foreign tax credit to neutralize the effect of
U.S. tax on the business decision of 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 incomeare
deductible if we deny the foreign tax credits claimed for those taxes.
Respondent counters that the claimed transactional expenses and the U.K. taxes
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).
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 [1999 RIA TC Memo
¶99,411] (citing Gregory v. Helvering, 293 U.S. 465, 470 [14 AFTR 1191] (1935),
and Johansson v. United States, 336 F.2d 809, 813 [14 AFTR 2d 5605] (5th Cir.
1964)), aff'd, 251 F.3d 210 [87 AFTR 2d 2001-2451] (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.
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.
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.
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.
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 [98
AFTR 2d 2006-5956] (7th Cir. 2006).
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.
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.
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).
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 [88 AFTR 2d 2001-7339] (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 [87 AFTR 2d 2001-2492] (8th
Cir. 2001); Compaq Computer Corp. v. Commissioner, 277 F.3d 778, 785 [88 AFTR
2d 2001-7339] (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.
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).
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.
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).
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.
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 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 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.
15
We note that,
regardless of how the spread is characterized, the benefit of the spread was
more than offset by the additional transaction costs that BNY incurred to
obtain the spread.
16
See supra note 9.
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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