United States: "FTC Generator" Case Update

On May 18, 2015, two foreign tax credit ("FTC Generator") cases were argued before the Second Circuit Court of Appeals.6 In both cases, Bank of New York Mellon and American International Group, the taxpayer lost the FTC Generator issue in the lower court. In Bank of New York Mellon, the Tax Court held that a structured trust advantaged repackaged securities ("STARS") deal lacked economic substance (pre-codification under Section 7701). Consequently, the court held BNY could not claim foreign tax credits or deductions for expenses related to the transaction, and income from the transaction was treated as US-source income.  

Bank of New York Mellon

The STARS transaction was structured to provide BNY with below market cost financing. The complex transaction structure involved BNY transferring income-producing property into a trust subject to UK tax. As part of the transaction, BNY entered into forward sale agreements, a zero coupon swap agreement, a credit default swap and security arrangements with a British bank. The arrangements created a $1.5 billion secured loan from the British bank to BNY.

As a result of the STARS transaction, BNY claimed foreign tax credits of approximately $200 million and expense deductions of approximately $7.6 million in 2001 and 2002. BNY also reported the income from the assets transferred to the trust as foreign sourced.

The Tax Court shot down the STARS transaction under the economic substance doctrine. Under the objective prong of the doctrine, the Tax Court held that the STARS structure lacked economic substance because BNY did not have a reasonable expectation of making a non-tax profit by using the STARS structure. The court explained that the STARS structure did not increase the profitability of BNY's income-producing assets, and the structure's main activity was circulating income. The Tax Court refused to take into account the profit from the STARS assets when evaluating the transaction, stating that "[e]conomic benefits that would result independent of a transaction do not constitute a non-tax benefit for purposes of testing its economic substance."7

When evaluating the structure under the objective prong, the Tax Court followed its holding in Compaq Computer Corp. v. Commissioner8, which held that foreign taxes are treated the same as any other transaction cost when determining whether the transaction makes economic sense. The Tax Court acknowledged that "the Court of Appeals for the Fifth and Eighth Circuits have ... held that foreign taxes should not be taken into account in evaluating pre-tax effects for purposes of the economic substance analysis."9 Nevertheless, the Tax Court determined that it was not bound by the precedent in the Fifth and Eighth Circuits because the case would be appealable to the Second Circuit and neither the Supreme Court nor the Second Circuit has decided the issue.

BNY appealed to the Second Circuit, arguing, in part, that the Tax Court erred in applying the economic substance doctrine, and focused on the business purpose of the transaction – borrowed funds on favorable terms. The government cross appealed and argued that BNY was not entitled to an interest deduction. The three judge panel (Cabranes, PJ., Chin, Raggi, JJ.) gave BNY's counsel more pushback than government counsel and appeared skeptical of BNY's arguments.

American International Group

The same panel heard oral argument in a separate appeal by AIG, challenging the District Court's decision denying AIG's partial motion for summary judgment that it was entitled to certain foreign tax credits. The District Court agreed with the government that transactions resulting in foreign tax credits are subject to a requirement of economic substance.

AIG entered into the six transactions at issue from 1993 to 1997 by selling a foreign lender preferred shares in an SPV with a commitment by AIG-FP to repurchase those shares after a fixed term of years for the original purchase price. Primarily using the proceeds from the sale of shares, the SPV acquired investments that generated income over time for which it paid taxes to the local tax authority. The income was generally distributed to the lender, which paid little to no taxes on the distribution by characterizing the preferred stock as an equity investment and the distribution as a tax-exempt distribution from a subsidiary to its parent under the tax law in the lender's jurisdiction. AIG then claimed foreign tax credits for all foreign taxes paid by the SPV and applied the credit amounts in excess of its US tax liability on the transactions to other unrelated taxes. AIG argued that the sale of preferred stock was a loan and the SPV remained an AIG subsidiary under US tax law because there was an obligation to repurchase the stock. Accordingly, AIG deducted the amount of the distribution to the lender as interest and claimed foreign tax credits.

The government argued that the transaction lacked economic substance because it allegedly did not have purpose or utility beyond the expected tax benefits. The District Court accepted the government's argument. Accordingly, AIG needed to demonstrate economic substance for its transaction and that "what was done, apart from tax benefits, is what was intended by Congress."10

AIG argued that it anticipated a pretax profit of $168.8 million for the transactions in question. It reached this amount by considering the SPV's investment income and subtracting payments to the purported lender and operational costs. However, the court noted that this calculation took into account the effects of the tax exempt payments to the purposed lender, which in turn provided a more favorable dividend rate to AIG-FP because of its anticipated tax benefit. The government's expert opined that there would be no gain for AIG if the dividend were taxable to the lender. AIG argued that the transaction should not be rewritten by the government as in a fictional "world without taxes." But the court disagreed, stating that the tax exempt status of the dividend wassignificant to the transactions and should be reflected in the profit calculation. The District Court found that the evidence in the record was not sufficient to satisfy AIG's burden for partial summary judgment on the foreign tax credit issue.  

At oral argument in the Second Circuit, AIG's counsel argued that the economic substance doctrine should not apply to AIG's transaction, that AIG made a pre-tax profit and increased its tax burden and that no court had ever struck down a similar transaction with a pre-tax profit under the economic substance doctrine. On the other hand, the government explained that the foreign tax had never been paid by the taxpayer, which was inconsistent with the purpose of the credit: to eliminate double taxation. The panel seemed to be more receptive to the government's argument, but reserved decision. Stay tuned.

Salem Financial Inc.

On May 14, the Federal Circuit Court affirmed a decision by the Court of Federal Claims holding that a subsidiary of BB&T Corporation was not entitled to an estimated $500 million in foreign tax credits associated with a STARS foreign tax credit generator transaction.11 The court also upheld penalties for negligence and substantial underpayment of taxes. However, the court held that the taxpayer was entitled to claim interest deductions for the interest it paid on the STARS loan and remanded to the Court of Federal Claims for reassessment of the penalty amount.

The STARS transaction was jointly developed and marketed by Barclays Bank and an accounting firm to generate foreign tax credits for a US taxpayer. Pursuant to BB&T's STARS transaction, in effect from August 2002 through April 2007, BB&T established a trust containing approximately $6 billion in revenue-producing bank assets, the revenues from which were cycled through a UK trustee before returning to the trust. The assessment of UK taxes generated UK tax credits that were shared evenly between Barclays and BB&T. There was also a $1.5 billion loan from Barclays to BB&T, with a higher interest rate than BB&T's normal cost of borrowing. Barclays made monthly "Bx" payments to BB&T, representing BB&T's share of the foreign tax credits, which had the effect of reducing the interest cost of BB&T's loan.

BB&T argued that the STARS transaction should be viewed as a single integrated transaction, whereby the existence of the trust permitted Barclays to offer BB&T a $1.5 billion loan at a favorable rate. However, looking at the economic realities of the integrated transaction, the Court of Federal Claims concluded that the transaction must be disregarded for lack of economic substance.

On appeal, the Federal Circuit Court agreed with the trial court's holding that the loan and the trust transaction must be bifurcated for purposes of economic substance, and not considered as a single integrated transaction. Examining the economic reality of the STARS transaction, the Court concluded that the transaction, which generated tax credits, was "simply a money machine."12 The Circuit Court agreed with the trial court that the STARS transaction was "a contrived transaction performing no economic or business function other than to generate tax benefits," which had no incremental effect on the taxpayer's activities and had no realistic prospect of producing a profit.13. The Court noted that the transaction exposed BB&T to no economic risk. The only risk was that the IRS may challenge the tax treatment of the transaction.

The Circuit Court also found that the STARS transaction had no non-tax business purpose: the STARS Trust was a "prepackaged strategy" created to generate US and UK tax benefits. The Court rejected BB&T's argument that it sought to earn a profit in the form of the Bx payment, and that earning a profit is a business purpose. The Court held that the Bx payment did not represent profit from any business activity; it was simply the way the parties shared in the tax benefits of the trust transaction.

BB&T also argued that it was entitled to deduct interest it paid on the $1.5 billion STARS loan, which the trial court disallowed, holding that the loan, like the trust, lacked economic substance. The Circuit Court agreed with the taxpayer and concluded that the loan resulted in a substantive change in BB&T's economic position. It had "real economic utility to BB&T."14

Accordingly, BB&T was entitled to claim interest deductions for the interest it paid on the loan. On the subject of penalties, the Circuit Court upheld the trial court's decision to impose an accuracy-related penalty under Section 6662(a). The Circuit Court was not satisfied that the taxpayer established reasonable cause for the underpayment by relying on a tax opinion and advice from PWC.

The chart below summarizes the status of other currently-docketed FTC cases.


6 See Bank of New York Mellon Corp. v. Commissioner, 140 T.C. 15 (2013); American International Group, Inc. v. United States, 111 A.F.T.R. 2d 2013-1472 (S.D.N.Y. 2013).

7 140 T.C. 15 at 36.

8 113 T.C. 217 (1999).

9 140 T.C. at 32 n. 9.

10 111 A.F.T.R.2d 2013-1472, at 1473.

11 Salem Financial Inc. v. United States, No. 14-5027 (Fed. Cir. May 14, 2015)

12 Slip. Opn. at 31.

13 Id. at 30.

14 Id. at 43.

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.

Similar Articles
Relevancy Powered by MondaqAI
In association with
Related Topics
Similar Articles
Relevancy Powered by MondaqAI
Related Articles
Related Video
Up-coming Events Search
Font Size:
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
Confirm Password
Mondaq Topics -- Select your Interests
 Law Performance
 Law Practice
 Media & IT
 Real Estate
 Wealth Mgt
Asia Pacific
European Union
Latin America
Middle East
United States
Worldwide Updates
Registration (you must scroll down to set your data preferences)

Mondaq Ltd requires you to register and provide information that personally identifies you, including your content preferences, for three primary purposes (full details of Mondaq’s use of your personal data can be found in our Privacy and Cookies Notice):

  • To allow you to personalize the Mondaq websites you are visiting to show content ("Content") relevant to your interests.
  • To enable features such as password reminder, news alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our content providers ("Contributors") who contribute Content for free for your use.

Mondaq hopes that our registered users will support us in maintaining our free to view business model by consenting to our use of your personal data as described below.

Mondaq has a "free to view" business model. Our services are paid for by Contributors in exchange for Mondaq providing them with access to information about who accesses their content. Once personal data is transferred to our Contributors they become a data controller of this personal data. They use it to measure the response that their articles are receiving, as a form of market research. They may also use it to provide Mondaq users with information about their products and services.

Details of each Contributor to which your personal data will be transferred is clearly stated within the Content that you access. For full details of how this Contributor will use your personal data, you should review the Contributor’s own Privacy Notice.

Please indicate your preference below:

Yes, I am happy to support Mondaq in maintaining its free to view business model by agreeing to allow Mondaq to share my personal data with Contributors whose Content I access
No, I do not want Mondaq to share my personal data with Contributors

Also please let us know whether you are happy to receive communications promoting products and services offered by Mondaq:

Yes, I am happy to received promotional communications from Mondaq
No, please do not send me promotional communications from Mondaq
Terms & Conditions

Mondaq.com (the Website) is owned and managed by Mondaq Ltd (Mondaq). Mondaq grants you a non-exclusive, revocable licence to access the Website and associated services, such as the Mondaq News Alerts (Services), subject to and in consideration of your compliance with the following terms and conditions of use (Terms). Your use of the Website and/or Services constitutes your agreement to the Terms. Mondaq may terminate your use of the Website and Services if you are in breach of these Terms or if Mondaq decides to terminate the licence granted hereunder for any reason whatsoever.

Use of www.mondaq.com

To Use Mondaq.com you must be: eighteen (18) years old or over; legally capable of entering into binding contracts; and not in any way prohibited by the applicable law to enter into these Terms in the jurisdiction which you are currently located.

You may use the Website as an unregistered user, however, you are required to register as a user if you wish to read the full text of the Content or to receive the Services.

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 or with the prior written consent of Mondaq. You may not use electronic or other means to extract details or information from the Content. Nor shall you extract information about users or Contributors in order to offer them any services or products.

In your use of the Website and/or Services you shall: comply with all applicable laws, regulations, directives and legislations which apply to your Use of the Website and/or Services in whatever country you are physically located including without limitation any and all consumer law, export control laws and regulations; provide to us true, correct and accurate information and promptly inform us in the event that any information that you have provided to us changes or becomes inaccurate; notify Mondaq immediately of any circumstances where you have reason to believe that any Intellectual Property Rights or any other rights of any third party may have been infringed; co-operate with reasonable security or other checks or requests for information made by Mondaq from time to time; and at all times be fully liable for the breach of any of these Terms by a third party using your login details to access the Website and/or Services

however, you shall not: do anything likely to impair, interfere with or damage or cause harm or distress to any persons, or the network; do anything that will infringe any Intellectual Property Rights or other rights of Mondaq or any third party; or use the Website, Services and/or Content otherwise than in accordance with these Terms; use any trade marks or service marks of Mondaq or the Contributors, or do anything which may be seen to take unfair advantage of the reputation and goodwill of Mondaq or the Contributors, or the Website, Services and/or Content.

Mondaq reserves the right, in its sole discretion, to take any action that it deems necessary and appropriate in the event it considers that there is a breach or threatened breach of the Terms.

Mondaq’s Rights and Obligations

Unless otherwise expressly set out to the contrary, nothing in these Terms shall serve to transfer from Mondaq to you, any Intellectual Property Rights owned by and/or licensed to Mondaq and all rights, title and interest in and to such Intellectual Property Rights will remain exclusively with Mondaq and/or its licensors.

Mondaq shall use its reasonable endeavours to make the Website and Services available to you at all times, but we cannot guarantee an uninterrupted and fault free service.

Mondaq reserves the right to make changes to the services and/or the Website or part thereof, from time to time, and we may add, remove, modify and/or vary any elements of features and functionalities of the Website or the services.

Mondaq also reserves the right from time to time to monitor your Use of the Website and/or services.


The Content is general information only. It is not intended to constitute legal advice or seek to be the complete and comprehensive statement of the law, nor is it intended to address your specific requirements or provide advice on which reliance should be placed. Mondaq and/or its Contributors and other suppliers make no representations about the suitability of the information contained in the Content for any purpose. All Content provided "as is" without warranty of any kind. Mondaq and/or its Contributors and other suppliers hereby exclude and disclaim all representations, warranties or guarantees with regard to the Content, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. To the maximum extent permitted by law, Mondaq expressly excludes all representations, warranties, obligations, and liabilities arising out of or in connection with all Content. In no event shall Mondaq 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 of the Content or performance of Mondaq’s Services.


Mondaq may alter or amend these Terms by amending them on the Website. By continuing to Use the Services and/or the Website after such amendment, you will be deemed to have accepted any amendment to these Terms.

These Terms shall be governed by and construed in accordance with the laws of England and Wales and you irrevocably submit to the exclusive jurisdiction of the courts of England and Wales to settle any dispute which may arise out of or in connection with these Terms. If you live outside the United Kingdom, English law shall apply only to the extent that English law shall not deprive you of any legal protection accorded in accordance with the law of the place where you are habitually resident ("Local Law"). In the event English law deprives you of any legal protection which is accorded to you under Local Law, then these terms shall be governed by Local Law and any dispute or claim arising out of or in connection with these Terms shall be subject to the non-exclusive jurisdiction of the courts where you are habitually resident.

You may print and keep a copy of these Terms, which form the entire agreement between you and Mondaq and supersede any other communications or advertising in respect of the Service and/or the Website.

No delay in exercising or non-exercise by you and/or Mondaq of any of its rights under or in connection with these Terms shall operate as a waiver or release of each of your or Mondaq’s right. Rather, any such waiver or release must be specifically granted in writing signed by the party granting it.

If any part of these Terms is held unenforceable, that part shall be enforced to the maximum extent permissible so as to give effect to the intent of the parties, and the Terms shall continue in full force and effect.

Mondaq shall not incur any liability to you on account of any loss or damage resulting from any delay or failure to perform all or any part of these Terms if such delay or failure is caused, in whole or in part, by events, occurrences, or causes beyond the control of Mondaq. Such events, occurrences or causes will include, without limitation, acts of God, strikes, lockouts, server and network failure, riots, acts of war, earthquakes, fire and explosions.

By clicking Register you state you have read and agree to our Terms and Conditions