Foreign Income & Taxpayers
The Tax Court held that a bank was not entitled to the tax benefits generated by a Structured Trust Advantaged Repackaged Securities (STARS) transaction because the transaction lacked economic substance.
Background
The Bank of New York Mellon Corp. is a Delaware corporation that maintained its principal place of business in New York City. It is the successor to the tax liabilities of The Bank of New York Co. Inc., which merged with Mellon Financial Corp. in 2007 (after the transaction at issue in the current case took place). The Bank of New York (BNY) was a wholly owned subsidiary of The Bank of New York Co. Inc. BNY was in the banking business with worldwide banking operations. Its business activities included taking in deposits, borrowing money, and investing in loans and securities.
BNY entered into a STARS transaction in 2001 with Barclays Bank PLC (Barclays), a global financial services company based in London. The STARS transaction generated approximately $199 million in foreign tax credits for BNY for the combined years at issue.
Introduction and Negotiation of STARS
Barclays and an accounting firm developed and promoted STARS to U.S. banks. The accounting firm introduced STARS to BNY during discussions with BNY’s tax director. STARS was represented by the accounting firm to BNY (and other banks) as a “below market loan” from Barclays, who acted as the U.K. counterparty in the transaction. The below-market cost would be achieved by Barclays’s “sharing” U.K. tax benefits from STARS through an offset to the cost of the loan. The U.K. tax benefits would be generated by subjecting income-producing assets held by a trust to U.K. tax and thus generating foreign tax credits that BNY could use to offset its U.S. tax liability.
The STARS Transaction
As described by the Tax Court, the STARS transaction consisted of three parts: creating the STARS entity structure, using the structure to carry out the STARS loan, and using the loan proceeds and the STARS structure to generate foreign tax credits.
The STARS structure: The STARS structure is illustrated in simplified form in the exhibit. BNY first funded a preexisting REIT (REIT Holdings) subsidiary with $6.46 billion in various loan assets, and the REIT assumed $2.55 billion of BNY’s liabilities.
Next, BNY formed and funded InvestCo, a Delaware LLC that elected to be taxed as a corporation and was part of BNY’s affiliated group. REIT Holdings capitalized InvestCo with $10.409 billion of assets in exchange for a 100% ownership stake in InvestCo and the assumption of REIT Holdings’s BNY liabilities.
Third, BNY formed DelCo, a Delaware LLC that elected partnership treatment. InvestCo capitalized DelCo by contributing $9.243 billion in STARS assets to it, in exchange for all of DelCo’s class 1 and class 2 ordinary shares and DelCo’s assumption of the BNY liabilities InvestCo had assumed from REIT Holdings.
Fourth, BNY formed the BNY STARS Trust as a common law trust. The trust was authorized to issue four classes of units (A, B, C, and D units), which each had different income distribution rights. InvestCo transferred its remaining STARS assets ($1.2 billion) and its Delco class 2 shares to the trust in exchange for the class A and class B trust units. BNY was the initial trustee of the trust.
In the final step, BNY formed NewCo, a Delaware LLC that elected to be treated as a partnership with InvestCo as its sole member. InvestCo contributed 49% of the class A units to NewCo in exchange for a 100% membership interest in NewCo. InvestCo then distributed 1% of its NewCo interest to REIT Holdings.
In sum, the above steps moved approximately $7.86 billion in net assets into DelCo and the trust.
STARS loan: BNY and Barclays and the various intermediary STARS entities entered into the following agreements and transactions, the net effect of which was to create a $1.5 billion loan to BNY from Barclays. First, Barclays purchased the class C unit for $1.469 billion and the class D unit for $25 million from the trust by a subscription agreement.
Second, InvestCo and Barclays entered into a forward sale agreement obligating InvestCo to purchase the class C unit (class C unit forward sale agreement) from Barclays in November 2006, or earlier in the event of default or acceleration, for $1.498 billion. The sale price under the class C unit forward sale agreement was equal to the $1.475 billion principal plus interest compounded annually at 4.338% less a fixed amount based on the amount of U.K. taxes paid on the trust income. The parties also entered into a forward sales agreement with respect to the D unit.
Third, InvestCo and Barclays entered into a zero coupon swap agreement that required InvestCo to make monthly payments equal to one-month dollar LIBOR plus 30 basis points by reference to a $1.475 billion notional amount, less a spread amount (spread). The spread was a fixed amount equal to one-half of the present value of the expected U.K. taxes on the target class C unit income (discussed below) each month.
In sum, the forward sale agreements, the zero coupon swap, and other security arrangements made by the parties converted Barclays’s initial subscriptions for the class C unit and class D unit into a secured loan from Barclays to BNY for $1.5 billion at LIBOR plus 20 basis points (loan). BNY would pay the interest on the loan through the monthly LIBOR-based amounts under the zero coupon swap, excluding the spread. BNY would repay the principal through the forward sale agreements.
Use of STARS loan proceeds: Upon receipt of the funds for the purchase of the class C and D unit, the trust redeemed InvestCo’s class B unit with those funds and parked the money in a Cayman Islands account. In addition, BNY and Barclays replaced the U.S. trustee of the trust with a U.K. trustee wholly owned by the parent of BNY, which was treated as a U.K. resident for U.K. tax purposes. When the U.K. trustee replaced the U.S. trustee, the trust became subject to U.K. tax as a collective investment scheme for purposes of U.K. law. The U.K. income tax paid was a liability of the U.K. trustee and not of any of the trust unit holders. The U.K. trustee owed the U.K. income tax whether or not the trust made actual distributions to the trust unit holders.
The parties then entered into a series of agreements to accelerate the U.K. taxes due on trust income by converting periodic cash flows into an upfront taxable lump-sum payment (the stripping transaction). In step one of the stripping transaction, BNY contributed $402 million to DelCo through REIT Holdings, InvestCo, and the trust.
Next, the U.K. trustee transferred the trust collateral securities to BNY as “custodian” in exchange for principal-only receipts and interest-only receipts.
Third, DelCo used the contributed funds to purchase the interest-only receipts from the trust for $402 million. Finally, the parties amended the collateral arrangements so that Barclays obtained a security interest in the principal-only receipts and the interest-only receipts.
With respect to the stripping transaction, for U.K. tax purposes, the trustee treated the $402 million from the sale of the interest-only receipts as taxable income at the time of the sale and paid the U.K. taxes on the income. Under U.S. tax rules, however, the trust did not report a gain or loss.
Cash Flow Between the Parties in STARS
As part of the STARS transaction, DelCo would transfer predetermined amounts of income to the trust. Substantially all of the trust income was distributed to Barclays, and in turn was immediately recontributed to the trust and then passed back to DelCo where it was available for BNY’s use.
BNY’s Tax Treatment of STARS Transaction
The trust, DelCo, and NewCo each filed Forms 1065, U.S. Return of Partnership Income, for the years at issue. BNY reported the income from the STARS assets as income on its U.S. consolidated return. It reported this income, however, as foreign source income.
BNY claimed foreign tax credits of $98,607,973 and $100,285,767 for 2001 and 2002, respectively, for payments made to the U.K. tax authority with respect to the trust income. BNY also took an interest deduction for interest payments made related to the loan portion of the transaction. In addition, BNY claimed $835,100 and $6,753,720 as deductible expenses, fees, and transaction costs for 2001 and 2002, respectively.
The IRS’s Deficiency Notice
The IRS issued a timely deficiency notice to BNY, which adjusted BNY’s taxable income by disallowing the STARS-generated foreign tax credits and deductions for interest and transaction costs, and reclassifying the income earned on the STARS assets as U.S.-source income.
BNY challenged the IRS’s determination in Tax Court. The IRS argued that the STARS transaction lacked economic substance and should be disregarded. BNY, in contrast, contended the STARS transaction had economic substance because BNY entered into the transaction to obtain low-cost funding for its banking business and that it reasonably expected to earn a pretax profit from the transaction. Additionally, BNY maintained that the U.S. foreign tax credit was intended for transactions like STARS.
The Tax Court’s Decision
The Tax Court determined that the STARS transaction lacked economic substance and that Congress did not intend to provide foreign tax credits for transactions such as the STARS transaction. Thus, it held that BNY’s STARS transaction was invalid for federal tax purposes and that the IRS had properly disallowed the foreign tax credits and expense deductions BNY claimed related to the transaction and recharacterized the income from the STARS assets as U.S.-source income. The court stated, “The STARS transaction was structured to meet the relevant requirements in the Code and the regulations for claiming the disputed foreign tax credits. The STARS transaction in essence, however, was an elaborate series of pre-arranged steps designed as a subterfuge for generating, monetizing and transferring the value of foreign tax credits among the STARS participants” ( Bank of N.Y. Mellon Corp ., slip op. at 25).
Economic substance analysis in Second Circuit: Because the case was appealable to the Second Circuit, the Tax Court looked to the law of that circuit to determine the form of economic substance analysis it would use. The court found that precedent in the Second Circuit regarding the economic substance analysis requires an evaluation of both the subjective business purpose of the taxpayer for engaging in the transaction and the objective economic substance of the transaction, but not as separate prongs of a rigid two-step analysis. Instead, they are factors to consider in the overall factual inquiry of whether the transaction had any practical economic effects other than the creation of tax losses.
Scope of the economic substance inquiry: Because the STARS transaction consisted of distinct components, the court was required to decide whether to analyze the components separately or together as one integrated transaction. The IRS favored bifurcating the STARS structure and the STARS loan for this purpose, while BNY favored treating them as a single transaction.
The Tax Court found that the relevant transaction to be tested was the one that produced the disputed tax benefits, which were the foreign tax credits. Because the parties created the foreign tax credits by circulating income through the STARS structure, and the loan transaction was not necessary to create the foreign tax credits, the court determined that it would test only the STARS structure for economic substance.
Objective economic substance analysis: The Tax Court found that in evaluating objective economic substance, the Second Circuit focuses on whether the relevant transaction created a reasonable opportunity for economic profit (i.e., profit exclusive of tax benefits) and therefore applied this standard in its analysis. The court concluded the STARS structure lacked objective economic substance because:
- The record reflected that BNY did not have a reasonable expectation that it would make a nontax economic profit from using the STARS structure because the STARS structure did not increase the profitability of the STARS assets in any way, and, in fact, it added substantial transaction costs, e.g., professional service fees and foreign taxes incurred as a result of using the STARS structure.
- The STARS structure’s main activity was to engage in a circular cash flow of income between the STARS structure and Barclays that had no economic effect.
- The stripping transaction that was conducted through the structure also resulted in a circular cash flow that had no potential for economic profit.
- The income of the STARS assets held in the structure could not be taken into account in the analysis. The court found that an economic benefit that would result independently from a transaction does not constitute a nontax benefit for economic substance purposes.
Subjective economic substance analysis: Under the subjective prong of the economic substance analysis, the Tax Court determined that under Second Circuit precedent it was necessary to determine whether BNY had a legitimate nontax business purpose for the use of the STARS structure. The court, considering BNY’s claims that it used the STARS structure to obtain “low cost financing” from Barclays, found that the evidence did not support this business purpose because the STARS structure lacked any reasonable relationship to the loan and the loan was not low cost for BNY. Having eliminated this claimed business purpose, the court concluded that BNY had failed to establish a valid business purpose and its true motivation was tax avoidance.
With respect to the relationship between the STARS structure and the loan, BNY argued that the STARS structure (in particular, the C and D units held by Barclays) served as collateral for Barclays’s loans to BNY. The Tax Court rejected this argument outright. Relying on expert testimony, the court concluded that BNY’s obligation with respect to the loan was more than adequately secured by other arrangements independent of the trust. It also concluded that the special-purpose entities in the STARS structure did not serve any structured financing transaction purpose or realistically function to transfer risk between the parties.
The court further found that given the characteristics of the loan, Barclays could have made the same $1.5 billion loan to BNY, secured by the same assets constituting the collateral for the loan, using only a loan agreement and a security agreement, which would have been much simpler, avoided the use of the special-purpose entities, and had substantially lower transaction costs than STARS.
In determining whether the loan was low cost, the Tax Court first considered whether the spread (which was dependent on the foreign tax credits generated in the STARS transaction) was a component of interest. The IRS contended that the spread was a tax effect, not a component of interest. BNY argued that the spread was not a tax effect because it was not expressly contingent on either Barclays or BNY receiving any particular U.S. or U.K. tax treatment, noting that in certain cases BNY could keep the spread even if Barclays did not realize its expected U.K. tax benefits, and the payment of the spread was not dependent on whether BNY’s tax treatment was respected. The Tax Court agreed with the IRS, finding that the spread value was derivative of expected U.S. and U.K. tax effects, and the manner in which the parties allocated tax risk did not preclude the spread from being treated as a tax effect.
The Tax Court then looked at whether, absent the spread, the loan was low cost. It found that BNY could have obtained comparable financing in the marketplace at substantially less economic cost than that obtained through the STARS transaction, and thus the loan was not low cost.
Congressional Intent for Foreign Tax Credits
In an alternative argument, BNY contended that the economic substance doctrine does not warrant disallowing the disputed tax benefits, because Congress intended the foreign tax credit for transactions like STARS. The Tax Court, after noting that the purpose of the foreign tax credit is to alleviate double taxation arising from foreign business operations, stated that,
The STARS transaction was a complicated scheme centered around arbitraging domestic and foreign tax law inconsistencies. The U.K. taxes at issue did not arise from any substantive foreign activity. Indeed, they were produced through pre-arranged circular flows from assets held, controlled and managed within the United States. We conclude that Congress did not intend to provide foreign tax credits for transactions such as STARS. [Bank of N.Y. Mellon Corp., slip op. at 52]
Foreign-Source Income Adjustment
BNY reported the income from the trust assets as foreign-source income based on a “resourcing” provision in paragraph 3 of article 23 of the United States-United Kingdom tax treaty. The IRS recharacterized the income as U.S.-source income. The Tax Court stated that U.S. tax laws and treaties do not recognize sham transactions or transactions that have no economic substance as valid for tax purposes.
Because it already held that the STARS transaction was disregarded for U.S. tax purposes, it further held that BNY should be treated for U.S. tax purposes as owning the STARS assets and the income should be treated as being derived by BNY within the United States. Consequently, the U.S.-U.K. tax treaty, including the resourcing provision, did not apply, and the IRS’s adjustment was correct.
Reflections
Many large banks other than BNY engaged in STARS transactions with Barclays, resulting in similar enormous foreign tax credit claims. When broken down, though, it is clear that the STARS transaction is merely an extremely complicated device to game the foreign tax credit rules in favor of the transaction’s participants.
These cases involve high stakes—the IRS determined $215 million in tax deficiencies for the two years at issue. With that amount of money at risk, participants have every motivation to engage in a sort of cat-and-mouse game with the IRS, hoping that the IRS will not catch up. They may not be expecting that the transaction will stand up to scrutiny so much as that it will not be scrutinized in the first place.
Reportedly, the IRS only discovered the STARS transaction after being tipped off by the British tax agency, HMRC, as a result of increased international cooperation in fighting tax shelters between Australia, Canada, the United Kingdom, and the United States, which formed the Joint International Tax Shelter Information Centre in 2004 (Houlder, et al., “Tax Wars: A Fight Worth Billions,” Financial Times (Sept. 25, 2011)). So either the IRS’s tax shelter efforts are paying off, or this time the banks got unlucky.
Bank of N.Y. Mellon Corp., 140 T.C. No. 2 (2013)
