United States: Tax Court Finds STARS Foreign Tax Credit Transaction Lacks Economic Substance

The Tax Court has held in Bank of New York Mellon Corporation v. Commissioner (140 T.C. No. 2) that a structured trust advantaged repackaged securities (STARS) transaction engaged in by Bank of New York (BNY) lacked economic substance and should be disregarded for federal tax purposes. Because the transaction lacked economic substance, the Tax Court ruled BNY was not entitled to the related foreign tax credits (FTCs), deductions for related transactional expenses or foreign source income treatment.

The case involved BNY and its subsidiaries in an affiliated group. BNY engaged in a STARS transaction beginning in 2001. BNY claimed that the STARS transaction provided the group with below-market cost financing from a U.K. bank. As part of the transaction, BNY transferred income-producing assets to a trust with a U.K. trustee and subject to U.K. tax on its income. BNY claimed foreign tax credits and expense deductions on its 2001 and 2002 consolidated returns in connection with the transaction. BNY also reported income from the assets transferred to the trust as foreign source income on the consolidated returns.

The IRS 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 income. BNY challenged the IRS in the Tax Court, contending that the STARS transaction had economic substance and that Congress intended the foreign tax credit to apply to transactions like the STARS transaction.

Because the years involved were 2001 and 2002, the case predated the 2010 codification of the economic substance doctrine in Section 7701(o). Therefore, the Tax Court applied the judicial version of the economic substance doctrine as interpreted by the Second Circuit Court of Appeals, which would be the jurisdiction of an appeal. Some circuits have ruled that transactions must have both economic substance and a nontax business purpose to be respected, while other circuits have ruled that only one is enough. The Second Circuit does not strictly follow either of these two common approaches to the economic substance doctrine. Instead, the Second Circuit considers both economic substance and nontax business purposes, with a conclusion under either prong not being dispositive. As noted by the Tax Court in this case, the Second Circuit treats each prong as a factor in a flexible analysis to determine whether a transaction had any practical economic effects other than the creation of tax losses.

The Tax Court first focused on the transaction that gave rise to the disputed foreign tax credits. The court bifurcated the STARS transaction and focused on the STARS structure, not the STARS loan. The Tax Court stated that the disputed foreign tax credits were generated by circulating income through the STARS structure and that the loan was not necessary for the STARS structure to produce the disputed foreign tax credits. Therefore, the focus of its inquiry was the use of the STARS structure.

The Tax Court’s inquiry was whether the relevant transaction created a reasonable opportunity for economic profits, i.e., profit exclusive of tax benefits. The Tax Court held that the BNY did not have a reasonable expectation that it would make nontax profit from using the STARS structure because (1) the STARS structure did not increase profitability of the STARS assets and in fact decreased profitability by adding substantial transaction costs, and (2) the main activity of the STARS structure was to circulate income between BNY and Barclays through a series of circular cash flows, including a stripping transaction. Thus, the Tax Court reasoned that these transactions had no nontax economic effect.

The Tax Court then sought to determine whether BNY had a legitimate nontax business purpose for the use of the STARS structure. The bank claimed that its business purpose was to obtain “low cost financing” from Barclays, but the court found that the STARS structure did not perform any significant banking, commercial or business function with respect to the loan because (1) the Barclays loan was more than adequately secured by other arrangements independent of the Class C and D units Barclays held in the trust, and (2) the special purpose entities constituting the STARS structure did not function to reallocate risk and reduce information symmetry, and therefore did not perform a structured financing function. Therefore, the Tax Court concluded that the STARS structure lacked a reasonable relationship to BNY’s claimed business purpose.

The Tax Court also found that the STARS financing was not low cost. In determining the cost of the loan, the Tax Court first considered whether the “spread” was a component of interest. The Tax Court found that, in substance, the spread was a tax effect: It was contingent upon the anticipated U.K. tax treatment, was unrelated to the time value of money or the risks associated with the loan, and served as a device to monetize and transfer the value of the anticipated FTCs generated from routing income through the STARS structure. Therefore, the Tax Court disregarded the spread in determining the cost of the loan.

Absent the spread adjustment, the Tax Court then found that the loan was not low cost because the interest rate was above the market benchmark loan, and it required BNY to incur additional transactional expenses (in addition to interest) for professional fees and foreign taxes that would not exist in comparable market financing.

Based on its determination that the STARS transaction lacked economic substance, the Tax Court also disallowed BNY’s deductions for claimed transactional expenses. Finally, regarding the FTC, the Tax Court concluded that Congress did not intend to provide foreign tax credits for transactions such as STARS. Regarding the foreign source income treatment for income attributable to a trust with a U.K. trustee, the Tax Court determined that, because the STARS transaction is disregarded for U.S. tax purposes, BNY is treated for U.S. tax purposes as owning the STARS assets. Therefore, income is treated as being derived by BNY in the United States. Consequently, the U.S.-U.K. tax treaty resourcing provisions do not apply.

In summary, although this case was decided on facts predating the 2010 enactment of the economic substance doctrine in Section 7701(o), the Tax Court’s reasoning provides insight into how courts may apply the two-prong codified economic substance doctrine.

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