United States: District Court Upholds STARS Transaction Ruling Payment Is Included

On October 17, 2013, Judge George A. O'Toole of the US District Court of Massachusetts issued an opinion holding that a structured trust advantaged repackaged securities ("STARS") transaction entered into by Sovereign Bancorp, Inc. (now known as Santander Holdings USA, Inc.) ("Sovereign") was not a sham, but rather had objective economic substance as a result of a payment Sovereign received from the counterparty which was included in Sovereign's pre-tax profit. ¹ The opinion was consistent with the remarks of the district court judge in a September 25, 2013 pretrial conference when ruling that Sovereign's motion for partial summary judgment would be granted.² The ruling marks a significant taxpayer victory in the so-called "foreign tax credit generator" cases.

Background

The STARS transaction involved a complex structure in which Sovereign transferred $6.7 billion in income-producing property to a trust subject to UK income tax. The income from the trust, which was attributed to Sovereign, was also subject to US income tax, and Sovereign claimed a foreign tax credit under section 901 for the. amount of UK income taxes paid.³ The transaction allowed the counterparty to obtain favorable UK tax treatment and, as a result of the favorable tax treatment, the counterparty extended a loan to Sovereign at a below-market rate. As part of the loan, the counterparty made a payment to Sovereign equal to one-half of the amount of UK income taxes paid on the trust income.

The government asserted that the payment from the counterparty to Sovereign should be excluded from Sovereign's calculation of pre-tax profit as an "effective rebate," which would mean that Sovereign did not in substance pay one-half of the UK taxes. According to the government, because the payment was an effective rebate and, as such, a "tax effect," the transaction failed the objective economic substance doctrine as it did not have a reasonable possibility of a pre-tax profit.

Rebate and Pre-Tax Profit Analysis

The district court concluded that the government's rebate argument was "wholly unconvincing" in light of the explicit provisions in the Code and the regulations addressing when a payment of foreign taxes may be considered rebated to the taxpayer. The court disregarded the expert witness testimony of the government regarding whether the payment was a rebate, explaining that the question is not one of fact for an expert witness, but rather a question of law to be answered by the judge.⁴ The court ultimately determined the payment was not a tax effect because the payment was not an actual rebate of taxes from the UK to Sovereign and there was no authority for characterizing the payment as an "effective" or "constructive" rebate. The court supported its conclusion by citing to case law and private letter rulings that have addressed payments with respect to taxes between private parties and have concluded that such payments are not tax items.

After concluding the payment from the counterparty to Sovereign was not a rebate or tax effect, the court held that the payment was properly regarded as income to Sovereign for purposes of determining whether the transaction had a reasonable prospect of a pre-tax economic profit under the economic substance doctrine. The court explained that treating the payment as revenue to Sovereign is consistent with substance of the regulations and existing case law, such as Compaq Computer Corp. v. Commissioner⁵ and IES Industries, Inc. v. United States,⁶which affirmed the basic principle articulated in Old Colony Trust Co. v Commissioner⁷ that income tax paid on behalf of a taxpayer is income to the taxpayer. Because the payment was treated as pre-tax income to Sovereign, the transaction had a reasonable prospect of profit and, thus, the transaction had economic substance.

In addition, the court rejected the government's more general argument that the transaction was a sham to generate foreign tax credits for Sovereign. The court stated that even if the payment was intended to be an assumption of half of the UK tax liability by the counterparty, Sovereign still paid the full UK tax for purposes of the foreign tax credit and was entitled to claim the resulting foreign tax credit on its US tax return.

Economic Substance Analysis

Unlike other STARS transaction cases, such as Bank of N.Y. Mellon Corp. v. Commissioner, the court did not apply the subjective economic substance test, which generally requires a court to consider the subjective purpose or motivation of a taxpayer. The court, which is located in the First Circuit, did not expect that the First Circuit Court of Appeals would require a court to apply the subjective economic substance analysis when it objectively determines that a transaction has economic substance. Thus, the court concluded it was not necessary to analyze Sovereign's subjective intent for entering into the transaction

Footnote

1 Santander Holdings USA, Inc. v. United States, 1:09-11043-GAO (D. Mass. 2013).

2 The transcript of the pretrial conference may be found on the Tax Analysts website: http://www.taxanalysts.com (see Doc. 2013-23149, 2013 T.N.T. 191-19).

3 All section references are to the Internal Revenue Code (the "Code") and all references to regulations are to the Treasury regulations issued thereunder, unless otherwise noted.

4 The court noted that recent decisions in similar STARS transaction cases appear to have treated the question of whether the payment was a rebate or tax effect as a matter of fact rather than a matter of law. See Salem Fin., Inc. v. United States, -- Fed. Cl. --, 2013 WL 5298078, at *39-40 (Sept. 20, 2013); Bank of N.Y. Mellon Corp. v. Commissioner, 140 T.C. 15, 40-43 (Feb. 11, 2013). For a discussion of Bank of N.Y. Mellon Corp. v. Commissioner, you may refer to "Tax Court Disregards STARS Transaction as Lacking Economic Substance," Focus on Tax Controversy and Litigation, at 1 (February, 2013), available at http://www.shearman.com/files/Publication/528b88d0-8154-4ee1-be90- 3c6e45042fc7/Presentation/PublicationAttachment/22667e17-0aa7-4675-8d2f-4ba7afbdfff0/Tax-Court Disregards-STARS-Transaction-02-2013-TAX.pdf . See also Kevin Dolan, "The Foreign Tax Credit Diaries – Litigation Run Amok," Tax Notes (Aug. 26, 2013) (explaining the main issue in foreign tax credit borrowing cases, such as the STARS transaction cases, should be how to apply the for-profit test of the economic substance doctrine in the context of foreign tax credits).

5 277 F.3d 778, 784-85 (5th Cir. 2001).

6 253 F.3d 350, 354 (8th Cir. 2001).

7 279 U.S. 716, 731 (1929) ("The question in this case is, 'Did the payment by the employer of the income taxes assessable against

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