On September 23rd, the Tax Court issued a supplemental opinion finding interest paid by the predecessor of Bank of New York Mellon Corporation (both entities referred to herein as "BNY") on a loan connected with a Structured Trust Advantaged Repackaged Securities ("STARS") transaction to be a deductible expense.1 BNY entered into the transaction through ancillary agreements with Barclays and by forming a new structure, including a trust subject to tax in the United Kingdom that would pay UK tax and generate foreign tax credits for BNY. In a previous opinion in February of 2013, the Tax Court found this structure to be lacking economic substance and disallowed BNY's purported foreign tax credits and expense deductions generated by the plan.2 In the earlier decision, the Tax Court bifurcated the challenged transaction into the STARS portion and a separate loan from Barclays to BNY for purposes of the economic substance analysis. BNY did not challenge the Tax Court's primary findings regarding the economic substance of the STARS structure or the disallowance of the foreign tax credits. Instead, it argued that it should be entitled to deduct the interest expense on the bifurcated loan portion based on the Tax Court's earlier finding that the loan proceeds were available for use by BNY in its banking business throughout the STARS transaction period. BNY suggested that the Tax Court's finding logically leads to the conclusion that the loan was not a necessarycomponent of the structure that created the disallowed foreign tax credits, and therefore served some legitimate purpose other than generating tax benefits.
The Tax Court considered BNY's request for consideration based on the law of the Second Circuit, where an appeal from the Tax Court in the case would lie. The court cited Second Circuit tax shelter cases involving loans, stating that interest is not deductible if the payment arises from an "economically empty" transaction, which is one that does not have a "purpose, substance or utility" other than the expected tax considerations.3 BNY argued that the loan was deductible under this standard because the proceeds were not used to finance the disallowed STARS transaction and were instead to be considered separately. The government noted that the precedent cases involved a single tax benefit rather than a bifurcated structure but argued that the addition of a second tax benefit should not change the result. The Tax Court disagreed with the government, distinguishing the tax shelter precedents where loans were "integral or intertwined with [the] transaction lacking economic substance."4 In those cases, the loans in question were used to finance the transaction that lacked economic substance and their sole benefit and purpose were the generation of deductions from the tax shelter to offset unrelated income. In contrast, BNY's loan was not required to generate or finance the foreign tax credits in the STARS transaction. Instead, the proceeds were available for BNY to use in its banking business for other purposes, thus serving some utility other than generating the relevant tax benefits. The government also challenged the deductibity of the interest payments because BNY could have found financing at a lower cost in the marketplace had the loan not been related to the STARS transaction. Although gross mispricing is evidence of a sham, the Tax Court stated that interest may still be deductible if there is a "real loan that is used for economically substantive activity", even if the borrower is motivated by favorable tax treatment.5 Therefore, the court found that BNY was entitled to deduct the interest because, although the financing may have been overpriced, the proceeds were available for BNY's use in its banking business for legitimate purposes, suggesting that this was a real loan rather than a sham.
Footnote
1 Bank of New York Mellon Corp. v. Commissioner, T.C. Memo. 2013-225.
2 Bank of New York Mellon Corp. v. Commissioner, 140 T.C. 15 (2013).
3 T.C. Memo 2013-225 (citing Lee v. Commissioner, 155 F.3d 584, 586 (2d Cir. 1998); Goldstein v. Commissioner, 364 F.2d 734, 740 (2d Cir. 1966, aff'g 144 T.C. 284 (1965)).
4 T.C. Memo. 2013-225. 15 Id.
15 Id.
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