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.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Authors
 
In association with
Related Video
Up-coming Events Search
Tools
Print
Font Size:
Translation
Channels
Mondaq on Twitter
 
Register for Access and our Free Biweekly Alert for
This service is completely free. Access 250,000 archived articles from 100+ countries and get a personalised email twice a week covering developments (and yes, our lawyers like to think you’ve read our Disclaimer).
 
Email Address
Company Name
Password
Confirm Password
Position
Mondaq Topics -- Select your Interests
 Accounting
 Anti-trust
 Commercial
 Compliance
 Consumer
 Criminal
 Employment
 Energy
 Environment
 Family
 Finance
 Government
 Healthcare
 Immigration
 Insolvency
 Insurance
 International
 IP
 Law Performance
 Law Practice
 Litigation
 Media & IT
 Privacy
 Real Estate
 Strategy
 Tax
 Technology
 Transport
 Wealth Mgt
Regions
Africa
Asia
Asia Pacific
Australasia
Canada
Caribbean
Europe
European Union
Latin America
Middle East
U.K.
United States
Worldwide Updates
Check to state you have read and
agree to our Terms and Conditions

Terms & Conditions and Privacy Statement

Mondaq.com (the Website) is owned and managed by Mondaq Ltd and as a user you are granted a non-exclusive, revocable license to access the Website under its terms and conditions of use. Your use of the Website constitutes your agreement to the following terms and conditions of use. Mondaq Ltd may terminate your use of the Website if you are in breach of these terms and conditions or if Mondaq Ltd decides to terminate your license of use for whatever reason.

Use of www.mondaq.com

You may use the Website but are required to register as a user if you wish to read the full text of the content and articles available (the Content). You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these terms & conditions or with the prior written consent of Mondaq Ltd. You may not use electronic or other means to extract details or information about Mondaq.com’s content, users or contributors in order to offer them any services or products which compete directly or indirectly with Mondaq Ltd’s services and products.

Disclaimer

Mondaq Ltd and/or its respective suppliers make no representations about the suitability of the information contained in the documents and related graphics published on this server for any purpose. All such documents and related graphics are provided "as is" without warranty of any kind. Mondaq Ltd and/or its respective suppliers hereby disclaim all warranties and conditions with regard to this information, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. In no event shall Mondaq Ltd and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use or performance of information available from this server.

The documents and related graphics published on this server could include technical inaccuracies or typographical errors. Changes are periodically added to the information herein. Mondaq Ltd and/or its respective suppliers may make improvements and/or changes in the product(s) and/or the program(s) described herein at any time.

Registration

Mondaq Ltd requires you to register and provide information that personally identifies you, including what sort of information you are interested in, for three primary purposes:

  • To allow you to personalize the Mondaq websites you are visiting.
  • To enable features such as password reminder, newsletter alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our information providers who provide information free for your use.

Mondaq (and its affiliate sites) do not sell or provide your details to third parties other than information providers. The reason we provide our information providers with this information is so that they can measure the response their articles are receiving and provide you with information about their products and services.

If you do not want us to provide your name and email address you may opt out by clicking here .

If you do not wish to receive any future announcements of products and services offered by Mondaq by clicking here .

Information Collection and Use

We require site users to register with Mondaq (and its affiliate sites) to view the free information on the site. We also collect information from our users at several different points on the websites: this is so that we can customise the sites according to individual usage, provide 'session-aware' functionality, and ensure that content is acquired and developed appropriately. This gives us an overall picture of our user profiles, which in turn shows to our Editorial Contributors the type of person they are reaching by posting articles on Mondaq (and its affiliate sites) – meaning more free content for registered users.

We are only able to provide the material on the Mondaq (and its affiliate sites) site free to site visitors because we can pass on information about the pages that users are viewing and the personal information users provide to us (e.g. email addresses) to reputable contributing firms such as law firms who author those pages. We do not sell or rent information to anyone else other than the authors of those pages, who may change from time to time. Should you wish us not to disclose your details to any of these parties, please tick the box above or tick the box marked "Opt out of Registration Information Disclosure" on the Your Profile page. We and our author organisations may only contact you via email or other means if you allow us to do so. Users can opt out of contact when they register on the site, or send an email to unsubscribe@mondaq.com with “no disclosure” in the subject heading

Mondaq News Alerts

In order to receive Mondaq News Alerts, users have to complete a separate registration form. This is a personalised service where users choose regions and topics of interest and we send it only to those users who have requested it. Users can stop receiving these Alerts by going to the Mondaq News Alerts page and deselecting all interest areas. In the same way users can amend their personal preferences to add or remove subject areas.

Cookies

A cookie is a small text file written to a user’s hard drive that contains an identifying user number. The cookies do not contain any personal information about users. We use the cookie so users do not have to log in every time they use the service and the cookie will automatically expire if you do not visit the Mondaq website (or its affiliate sites) for 12 months. We also use the cookie to personalise a user's experience of the site (for example to show information specific to a user's region). As the Mondaq sites are fully personalised and cookies are essential to its core technology the site will function unpredictably with browsers that do not support cookies - or where cookies are disabled (in these circumstances we advise you to attempt to locate the information you require elsewhere on the web). However if you are concerned about the presence of a Mondaq cookie on your machine you can also choose to expire the cookie immediately (remove it) by selecting the 'Log Off' menu option as the last thing you do when you use the site.

Some of our business partners may use cookies on our site (for example, advertisers). However, we have no access to or control over these cookies and we are not aware of any at present that do so.

Log Files

We use IP addresses to analyse trends, administer the site, track movement, and gather broad demographic information for aggregate use. IP addresses are not linked to personally identifiable information.

Links

This web site contains links to other sites. Please be aware that Mondaq (or its affiliate sites) are not responsible for the privacy practices of such other sites. We encourage our users to be aware when they leave our site and to read the privacy statements of these third party sites. This privacy statement applies solely to information collected by this Web site.

Surveys & Contests

From time-to-time our site requests information from users via surveys or contests. Participation in these surveys or contests is completely voluntary and the user therefore has a choice whether or not to disclose any information requested. Information requested may include contact information (such as name and delivery address), and demographic information (such as postcode, age level). Contact information will be used to notify the winners and award prizes. Survey information will be used for purposes of monitoring or improving the functionality of the site.

Mail-A-Friend

If a user elects to use our referral service for informing a friend about our site, we ask them for the friend’s name and email address. Mondaq stores this information and may contact the friend to invite them to register with Mondaq, but they will not be contacted more than once. The friend may contact Mondaq to request the removal of this information from our database.

Emails

From time to time Mondaq may send you emails promoting Mondaq services including new services. You may opt out of receiving such emails by clicking below.

*** If you do not wish to receive any future announcements of services offered by Mondaq you may opt out by clicking here .

Security

This website takes every reasonable precaution to protect our users’ information. When users submit sensitive information via the website, your information is protected using firewalls and other security technology. If you have any questions about the security at our website, you can send an email to webmaster@mondaq.com.

Correcting/Updating Personal Information

If a user’s personally identifiable information changes (such as postcode), or if a user no longer desires our service, we will endeavour to provide a way to correct, update or remove that user’s personal data provided to us. This can usually be done at the “Your Profile” page or by sending an email to EditorialAdvisor@mondaq.com.

Notification of Changes

If we decide to change our Terms & Conditions or Privacy Policy, we will post those changes on our site so our users are always aware of what information we collect, how we use it, and under what circumstances, if any, we disclose it. If at any point we decide to use personally identifiable information in a manner different from that stated at the time it was collected, we will notify users by way of an email. Users will have a choice as to whether or not we use their information in this different manner. We will use information in accordance with the privacy policy under which the information was collected.

How to contact Mondaq

You can contact us with comments or queries at enquiries@mondaq.com.

If for some reason you believe Mondaq Ltd. has not adhered to these principles, please notify us by e-mail at problems@mondaq.com and we will use commercially reasonable efforts to determine and correct the problem promptly.